For prospective buyers in the U.S. with substantial assets lodged in a 401(k), 501 (k), IRA or other retirement fund, Rollovers as Business Start-Ups (ROBS) may provide a means of financing with some very significant advantages.
When we say ‘substantial’, that means a minimum of $50,000 to roll over. Otherwise, the set-up and monthly maintenance costs for the quite complex ROBS arrangement will be too great a proportion of the investment to justify using this scheme.
However, for significant investment amounts the costs are entirely viable and quite advantageous. Set-up fees paid to an experienced ROBS provider are normally around $5000 upfront, with an ongoing annual administration fee of up to $2000. Legally speaking it is actually possible to do all the work yourself, without using a ROBS provider, but that would be foolhardy with many IRS and DOL compliance complexities ready to trip you up.
In fact, the steps are much too complicated to cover comprehensively in an article such as this one. However, here is an introduction to the world of ROBS, what it is and basically how it works.
Age is no barrier
You don’t have to be any particular age to roll-over funds from your eligible tax-deferred retirement account. It doesn’t matter how young or old you are. You just need to have the funds in credit and then work systematically through the rollover process. The great advantage is that this is not a loan at all, so there are no loan fees and no interest to pay. At the end of the day, it’s your money. You are simply accessing it for business investment purposes. The funds cannot be used to service personal expenses or to acquire purely personal assets. ROBS is for business investment only. As one potential source of finance to be considered, it can be used in parallel with other financings, including loans.
In essence, you will be rolling over your money from one retirement fund into another new one, which your business will set-up. If you are buying an existing business you will put the necessary structures in place for the roll-over prior to the transfer of the business. The modest set-up costs cannot be covered by the ROBS itself. You need to cover these separately up front.
How does it work?
The first step is creating a C corporation (C-corp). This is obligatory and cannot be circumvented. However, this part is actually very easy and quite inexpensive, although specific details will vary slightly from State to State. The more complex step is then setting up an employee retirement plan, most commonly a new 401(k), for the new entity. At this point, you roll over the amount you have decided on from your existing personal 401(k), 501(k) or IRA into the new corporation’s retirement plan. The plan purchases stock in the C-corp, acquiring a shareholding on behalf of all employees, as will be explained shortly, and that purchase amount is released as your business capital. The ROBS rollover is now completed. There is no loan of any kind involved to repay. Of course, the retirement fund earns its share of the profits for future distribution and takes its share of any hit if the business loses money.
In the next stage the C-corp, of which you are the part-owner and also technically an employee, uses the capitalization from the ROBS to build a new business or buy and develop an existing one. The funds can be used for any normal legitimate business purpose, but not for personal expenses that only you benefit from and not for over-payment to yourself of any inflated management or director fees. In fact, any salary payment to yourself must not come from the rolled-over funds directly but must come only out of operating expenses. As we said, it’s your money – but in return for the release of investment funds, the new C-corp retirement plan retains its shareholding in the business and receives its share of all profits after reasonable expenses. The retirement fund will be a significant or even the major shareholder (depending on what other financing sources were used) and as director, you are required to the best of your ability to operate the company to the financial benefit of the fund and its members. You will be covered by the C-corp retirement plan and profits accrued by the fund will ultimately benefit you when drawn down.
Administration of this complex legal arrangement is demanding and really needs to be outsourced to an expert ROBS provider, although this is not legally mandatory. Ongoing monitoring for IRS and the DOL, and other statutory compliance including managing the annual IRS Form 5500 return is definitely no work for the business operator. However, the fees for this administration are actually minuscule compared to the loan costs on a comparable amount of financing from traditional loan sources.
Remember it’s still a retirement fund
ROBS advantages come with some complexities. One of these is that all employees of your new business have the right to join the C-corp retirement fund which you have set up. Note that you yourself must be classified as an employee managing or directing the business. There is no legal specification of the number of hours you must actively work on the business or how much you may pay yourself from the business operation, except that payments to yourself must be deemed ‘reasonable’. Otherwise, they will be treated as a ROBS prohibited transaction. This means that using a ROBS arrangement may not be quite as suitable for buying businesses with a ‘passivity premium’ because of requiring very little owner presence or investment of time.
All employees of the business will have the right to join the retirement fund and legally must be invited to do so. The ROBS provider routinely oversees this notification as part of the ongoing monitoring of the arrangement. For smaller businesses, this is unlikely to be an issue as the definition of ‘employee’ is quite restrictive. Contract service providers and casual workers are not covered at all. Eligibility varies slightly from State to State but essentially an employee must be at least 21 years of age, have worked for the business for twelve months or longer, and have worked a minimum of 1,000 hours during the preceding year. Processing the employee contributions and employer liabilities under the plan is quite onerous and is best handled through the ROBS advisor. However, many smaller online businesses will actually have few or not even any additional employees.
Winding up a ROBS arrangement
Often people enthusiastically enter into an arrangement in the excitement of a new business venture without working through what the eventual exit will entail. With a standard business loan, with all the associated costs and often punishing interest rates, paying out the loan when the business is eventually sold is very straightforward even if financially penalizing.
By contrast, exiting a ROBS provision is inexpensive but a little more complex. If the business is sold then the C-corp retirement fund as a shareholder receives its due share of the sale price, minus funds required to wind down the business and pay out existing liabilities. The retirement plan is then wound up and its assets distributed proportionally to all employees who have contributions in the fund. As the business owner and director your own closing balance in the fund is simply rolled over into a new or existing personal IRA for your (highly tax-effective) benefit. Essentially, through ROBS you have used your assets in an eligible retirement plan to finance business for as long as you operate the business, maybe for many years. At no point through this arrangement have you taken a loan or drawn down cash, and hopefully the ROBS has saved you lots of money.
However, it would be remiss in this article not to cover the implications of a less positive scenario in which the business makes a loss or even totally folds. Simply put, if the business has lost money and is sold for a lesser value than it was set up or acquired for, then the retirement fund and all of its beneficiaries, including you, take a hit. In the event of a total business failure, the assets you originally held in your original retirement plan will have been wiped; but as the ROBS is not a loan there is no financial liability to repay. Formally unwinding the ROBS must still be done according to law and the C-corp retirement plan is then closed out. Any other employees covered by the plan must have their situation and options explained to them. The ROBS provider would attend to this.
ROBS presents a positive opportunity
The ROBS scheme, while it may sound a bit daunting from the explanation provided above, is actually a very innovative business-backing initiative. It enables entrepreneurs to access money which is locked away in a retirement fund for business ventures, without the burden of normal business loans and with the prospect of strong profit returns on personal investment.
Start-up businesses and online businesses which have been bought and built up using some capital from ROBS arrangements actually have a significantly higher success rate than businesses relying more heavily on business loans for the primary financing. This may possibly be because business buyers who are backed by both retirement fund assets and the sophistication to understand the ROBS provisions are likely to have the capacity and the necessary perseverance to develop financially successful business outcomes.
ROBS arrangements are not for everyone. If you have $50,000 or more locked away in eligible retirement plan assets, make some time to talk to an expert ROBS provider. A substantial one-off first-time advisory consultation is generally offered totally free and without obligation. Be aware that the adviser will have a vested interest in talking up the arrangement, but you can always walk away. It’s a fascinating and potentially highly lucrative financing option to explore.