Is it ever prudent for a client to fund a startup with retirement savings? (Illustration: Ellen Weinstein)

Say you have a client who is tired of working 9 to 5, five days a week, and comes to you with a plan to open the café they’ve always dreamed of running. However, instead of financing the new venture with a small business loan, they want to use their 401(k) plan.

Most advisors will instinctively pump the brakes as soon as they hear clients mention cashing in a qualified retirement account to capitalize a new business, but a rollovers-as-business-startups (ROBS) transaction allows a prospective business owner to use his or her retirement savings without incurring a tax penalty.

It should come as no surprise that there are caveats to these types of transactions.

First is that while they aren’t expressly prohibited, the IRS doesn’t exactly look on them favorably.

The Employee Plans Compliance Unit of the IRS studied ROBS in 2010 and found that while they are “not considered an abusive tax avoidance transaction,” they were “questionable in that they may serve solely to benefit one individual.”

Second, obviously, is that if the business fails in its first two years, as a third of new businesses do, the client is facing an uncertain future with a significant dent in his or her retirement savings.

David Nilssen, co-founder and CEO of Guidant Financial, which facilitates ROBS transactions, acknowledges that the strategy sounds inordinately risky. “A lot of people when they first hear about ROBS, they’ll say, ‘You let people do what with their retirement plan?’” he told Investment Advisor. Individuals and their advisors have to decide if a ROBS is appropriate, he said, “but that doesn’t eliminate the risk” of starting a business.

How ROBS Work

“What we do is dependent on specific exemptions in both tax and ERISA law that were put in place to effectively encourage investments in small business; similar laws to what you’ll see with regards to ESOPs, with similar intentions,” Nilssen said.

The first step is to establish the new business as a C corporation with a retirement plan. Nilssen said that’s usually a 401(k) plan. Funds from the original retirement plan are then rolled into the new C corp’s plan, which invests in stock in the new company, Nilssen said. The “401(k) sends money to the corporation and in exchange becomes a shareholder.”

Any employees at the new corporation must also be allowed to purchase company stock if they wish. Among the ROBS concerns the IRS identified in 2010 is that some plan sponsors might amend the plan to prevent other participants from purchasing stock. Sponsors that do so could violate qualification requirements for the plan.

Other concerns the IRS listed included sponsors’ failure to file Forms 5500, 1120 or 1099-R. Plans with one participant (which may include a participant and a spouse) that have less than $250,000 are exempt from filing Form 5500. ROBS plan sponsors still have to file a Form 5500 because even if the new plan only covers the business owner, “the plan, through its company stock investments, rather than the individual, owns the trade or business,” according to the IRS.

Nilssen recommended advisors who assist clients on ROBS transactions work with an experienced tax professional. “By default, most professionals will steer their clients to an S corp or an LLC. It is a different taxable animal,” he said.

The investment itself is tax deferred, Nilssen said, although “there could be taxes on the sale of that investment, trying to get money back in the 401(k) plan, but there are strategies to minimize that.”

Once the new plan is in place, the client will have an active 401(k) plan with the ongoing costs and administrative responsibilities associated with that, Nilssen pointed out. “They do have to make sure that the plan stays open, and that they’re continuing to provide that as an employee benefit to the future staff.”

Another thing to keep in mind: When they have no other shareholders, small business owners can generally pay themselves whatever they want. That’s not the case in a ROBS plan, as there are two shareholders: “the individual and the individual’s retirement plan,” Nilssen said. “The individual has to do what is in the exclusive benefit of their retirement plan. They are the fiduciary on that plan.”

Who Should Use ROBS

While there are clear risks associated with ROBS, Nilssen said they can be beneficial to clients and advisors, too.

For one, they give investors more freedom to do something they love without incurring a lot of debt. “Some of the most common things we hear [from customers] are, ‘I wanted to invest in something that I had direct control over,’” he said.

If they choose to use a traditional loan to finance their new venture, “in that case, I’m going to put a 25% down payment down to satisfy the bank’s need for liquidity and that’s money I’ve already paid taxes on,” Nilssen said. “I’m going to have to collateralize my home and other assets to utilize credit to get that loan, and at the end of that, I still have debt that I have to service on a monthly basis.”

With a ROBS transaction, “there’s no underwriting procedure, and the transaction can happen in as little as 21 days.” Because they’re using cash instead of debt, “they don’t have the corresponding overhead that a traditional business would take on,” which Nilssen said leads to “higher success rates among our customers.”

Nilssen said about 80% of his customers are still in business five years after starting their own company. Using data from the Bureau of Labor Statistics, the Small Business Administration found that between 1995 and 2010, two-thirds of businesses with employees survive at least two years, and about half last five years. A Dun & Bradstreet report found 39% of small businesses last five years, Nilssen said.

Three-quarters of Guidant customers are in their 40s and 50s, he said. “If someone expects that they’re only going to work for the next five years, this may not make a lot of sense.” He added that over half of his customers are using other sources of financing to start their new business in addition to the ROBS transaction.

Franchising is a popular choice for boomers who want to start their own business, he said. Over a third of Guidant customers are using their retirement savings on a franchise. “There’s a huge draw to franchising by baby boomers because not only do they want to invest in a business, but they want to invest in a business where they’re not by themselves. Having a franchise system that’s already predefined plays into their strength as a business manager who’s now starting a business,” Nilssen said. 

Nilssen added that using a ROBS transaction to fund a new business doesn’t mean investors stop saving for retirement. “By setting up the 401(k) plan they now have available to their business, of which they’re going to be an employee, not only is the 401(k) going to invest in the stock of the corporation, but they’ll have the ability as they earn an income to defer more capital.”

For advisors, ROBS can be part of their client acquisition strategy. “Investment advisors themselves are often looked at as a commodity in the marketplace, so it becomes a relationship-based sale or a referral-based sale,” he said. “There’s a great opportunity for those who want to get ahead of the market, because this is a very fast growing market, and want to help educate the community about it.”

Nilssen reiterated that it’s important for RIAs to work closely with a “tax professional who not only understands but embraces these strategies.” He noted that “a CPA does not have to understand ROBS to get their CPA designation.”

Advisors should look for someone who has experience not just in the number of years they’ve been facilitating ROBS transactions, but in the number of clients they’ve helped, he said.

What the DOL Fiduciary Rule Means for ROBS

Max Schatzow, an associate in the securities practice at Stark & Stark, said that advisors who assist clients on ROBS transactions would “absolutely be fiduciaries subject to the new fiduciary rule that becomes effective in June if they are providing ‘investment advice.’”

As such, they would have to ensure they don’t commit any prohibited transactions outlined in ERISA Section 406 or Section 4975 of the Internal Revenue Code, Schatzow said.

Advisors who do commit prohibited transactions could “potentially rely on the Best Interest Contract Exemption and may even be level-fee fiduciaries,” he said, but they could not use the BICE to “provide relief from transactions prohibited by ERISA section 406(a)(1)(C), or from the taxes imposed by Code Section 4975(a) and (b) by reason of Code Section 4975(c)(1)(C), regarding the furnishing of goods, services or facilities between a plan and a party in interest.”

Schatzow said, “The provision of investment advice to a plan under a contract with a plan fiduciary is a service to the plan, and compliance with the BIC exemption will not relieve an advisor or financial institution of the need to comply with ERISA Section 408(b)(2), Code Section 4975(d)(2), and applicable regulations thereunder.”

Other ERISA provisions advisors have to examine include valuation of company stock, highly compensated employees and exclusive benefits, he said.

Nilssen said that advisors aren’t providing advice if “merely talking about ROBS,” as long as they’re not receiving fees or compensation on a ROBS transaction. “The safest course of action would be for advisors to not accept referral fees from ROBS providers,” he said.

However, advisors should tread carefully. “It may be possible for an advisor to use a BIC exemption if receiving compensation on the transaction was important, but they’d need to seek counsel from their attorneys to advise on whether or not it would provide appropriate risk mitigation,” Nilssen said.

ROBS and Wealth Managers

Kelly Pedersen, founder and CEO of Caissa Wealth Strategies, is familiar with the ROBS process, having used funds from her IRAs to start Caissa in 2009.

“I set it up as debt for the company; the company owned me,” she said. “As we went along, we paid the debt off and as soon as the cash was back in the accounts I was able to transfer them” to a custodian.

“It worked great,” she said, noting that it was relatively inexpensive — $400 at the time — to set up the account.

“You have to come in with your business plan and walk them through exactly what it is, and provide the valuations of it, and your pro formas and your balance sheet,” she said. Business owners have to continue to provide annual valuation statements, Pedersen said, and pay annual account fees.

“There are significant intricacies to doing that. Anyone starting a new company, or if they’re trying to add money via their IRA to a company that’s already present, there are some rules that you definitely don’t want to cross over,” she warned.

ROBS should be a business owner’s last source of funding, Pedersen said. The purpose of an IRA is “to save for retirement, not to start businesses, so it really should be your last resource.”

By the same thinking, investors shouldn’t use their entire IRA if they do decide to fund a business this way. “Let’s say you do go belly up and something happens to your company: You really don’t get any tax benefits from starting the investment and having a loss, so you really do lose those benefits as well.”

If a client’s business does well, though, “you have all that appreciated growth within a Roth that has very favorable tax benefits.”

She echoed Nilssen’s suggestion that advisors with clients interested in these strategies work with a professional who has a lot of experience and understands the many intricacies a ROBS transaction entails.

“There are a lot of intricacies that need to be [understood]. They aren’t normal questions that would be obvious to ask,” Pedersen said. “If you don’t know what to ask, you may miss something and you could really wreak havoc for your tax return or your business structure if you don’t do it properly.”

— Read Prohibited Transactions in a Post-Fiduciary Rule World on ThinkAdvisor.