With a lot of baby boomers nearing retirement, some may be looking for alternatives to the stock market for investing their accumulated retirement plan assets. Some may even be approached by promoters promising that they can use their funds in their 401K, IRA, profit-sharing, or annuity plans to open a business without paying taxes on the distribution. In its most recent newsletter here, the IRS has provided a lot of helpful information on the legal pitfalls pertaining to the design of these programs. The IRS is calling these programs “ROBS” which stands for “Rollovers as Business Startups.”
The IRS outlines in this Memorandum issued October 1, 2008 how the programs typically work:
An individual establishes a shell corporation sponsoring an associated and purportedly qualified retirement plan. At this point, the corporation has no employees, assets or business operations, and may not even have a contribution to capital to create shareholder equity.The plan document provides that all participants may invest the entirety of their account balances in employer stock. The individual becomes the only employee of the shell corporation and the only participant in the plan. Note that at this point there is still no ownership or shareholder equity interest.
The individual then executes a rollover or direct trustee-to-trustee transfer of available funds from a prior qualified plan or personal IRA into the newly created qualified plan. These available funds might be any assets previously accumulated under the individual’s prior employer’s qualified plan, or under a conduit IRA which itself was created from these amounts. Note that at this point, because assets have been moved from one tax-exempt accumulation vehicle to another, all assessable income or excise taxes otherwise applicable to the distribution have been avoided.
The sole participant in the plan then directs investment of his or her account balance into a purchase of employer stock. The employer stock is valued to reflect the amount of plan assets that the taxpayer wishes to access.
The individual then uses the transferred funds to purchase a franchise or begin some other form of business enterprise. Note that all otherwise assessable taxes on a distribution from the prior tax-deferred accumulation account are avoided.
After the business is established, the plan may be amended to prohibit further investments in employer stock. This amendment may be unnecessary, because all stock is fully allocated. As a result, only the original individual benefits from this investment option. Future employees and plan participants will not be entitled to invest in employer stock.
A portion of the proceeds of the stock transaction may be remitted back to the promoter, in the form of a professional fee. This may be either a direct payment from plan to promoter, or an indirect payment, where gross proceeds are transferred to the individual and some amount of his gross wealth is then returned to promoter.
The IRS notes that it has identified 9 promoters of these programs. Here are the main legal deficiencies being identified in the programs, according to the Memorandum:
We have examined a number of these plans – having opened a specific examination project on them based off referrals from our determination letter program – and found significant disqualifying operational defects in most. For example, employees in some arrangements have not been notified of the existence of the plan, do not enter the plan or receive contributions or allocable shares of employer stock. Additionally, we have identified that plan assets are either not valued or are valued with threadbare appraisals. Required annual reports for some plans have not been filed. In several situations, we have also found that the business entity created from the ROBS exchange has either not survived, or used the resultant assets on personal, nonbusiness purchases.
The IRS states that there are “two primary issues raised by ROBS arrangements”: (1) violations of nondiscrimination requirements, in that benefits may not satisfy the benefits, rights and features test of Treas. Reg. § 1.401 (a)(4 )-4. and (2) prohibited transactions, due to deficient valuations of stock.
Many promoters will claim that they have IRS approval for their program, when in fact the IRS has only approved the form of the Plan document. The Memorandum notes that the violations that occur are typically operational and not document failures.
In the past, I have had clients ask me about these programs after being approached by promoters. It will be nice to be able to point folks to these resources as a “starting point” for further discussions.
UPDATE: More on this from Joe Kristan: “The dangers of ROBS-ing your retirement plan.”