June 03, 2009
We routinely have clients and prospective clients ask us how they can start or buy their own business using retirement plans. More often than not, they have heard about this either from a franchise seller or from companies that heavily promote this technique.
While all our accounts are self-directed, and we don’t give investment advice, we do provide our take on the IRS regulations regarding the purchase or structure of certain investments within retirement plans.
Regarding this particular “strategy” we have always advised that it is a much more complicated arrangement than many of its promoters would lead clients to believe. Our advice has been to contact an attorney well versed in ERISA (Employee Retirement Income Security Act) and setting up employer based retirement plans such as 401(k)’s.
We have recently been provided with an IRS generated memorandum to their Directors for Employee Plans Examinations and Employee Plans Rulings & Agreements to be distributed to their staff. The subject is: “guidelines regarding rollovers as business start-ups”.
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This memorandum brings up several potential problem areas that we have been discussing with our clients. In this article I’ll discuss some of the main points and then will give you the option of contacting us to get the entire memorandum.
The executive summary states: “A version of a qualified plan is being marketed as a means for prospective business owners to access accumulated tax-deferred retirement funds, without paying applicable distribution taxes, in order to cover new business start up costs. For purposes of this memorandum, these arrangements are known as Rollovers as Business Startups, or ROBS. While ROBS would otherwise serve legitimate tax and business planning needs, they are questionable in that they may serve solely to enable one individual’s exchange of tax-deferred assets for currently available funds, by using a qualified plan and its investment in employer stock as a medium. This may avoid distribution taxes otherwise assessable on the exchange. Although a variety of business activity has been examined, an attribute common to this design is the assignment of newly created enterprise stock into a qualified plan as consideration for these transferred funds, the valuation of which my be questionable.”
Beware everyone, these arrangements are now on the radar of the IRS and the Department of Labor and they WILL be looking into many of these arrangements for prohibited transactions and non-compliance issues. In the memorandum it states that the IRS has identified at least 9 providers of such plans. It further states that while these providers may have received an approval letter from the IRS for their prototype plan, which we have learned some providers are using as proof of the “strategy’s” sanction by the IRS, the plan documents themselves wouldn’t be in question – it is the operation of the plan that will be scrutinized.
Here are the steps that are generally followed in setting up this type of transaction:
- An individual sets up a shell corporation that would sponsor a qualified retirement plan. This corporation typically has no employees, operations or assets at this point.
- The plan document put in place states that all participants in the plan may invest the entire account balance in company stock.
- The individual who set up the plan becomes the only employee and participant. Usually at this point there is no ownership or equity interest in the company.
- The individual either rolls over or transfers current retirement plan funds, either from a previous employer plan or IRA, into the newly created plan. Any taxes that might ordinarily be owed by taking a distribution are avoided as the assets go directly into another tax-deferred vehicle.
- The only participant of the new plan then directs the purchase of his assets into company stock, which is then valued at the amount of the plan assets invested.
- These funds are then used by the individual to purchase a business/franchise or initiate a different type of business.
- Many times after the business is established, the plan is amended to prohibit further investments in the company stock, thereby making it impossible for any other employees to invest in company stock.
- In some cases a portion of the proceeds of the stock transaction are remitted back to the promoter.
So, you may ask, what’s the problem? Some IRS and Department of Labor issues to be aware of are violations of the non-discrimination requirements of the regulations of qualified plans and possible prohibited transactions because of stock valuations that have no professional valuations and are set based on the amount of initial assets being invested.
When employers set up a qualified plan, the plan may not favor highly compensated employees. Since these plans are initially designed so that only the individual who set up the business and plan will ever take advantage of the company stock purchase, discrimination is an issue because no non-highly compensated employee will ever be able to take advantage of company stock purchases.
There are several areas to be looked at for potential prohibited transactions. However, the main areas that come to mind are improper supportive documentation for the valuation of the stock, the plan promoter receiving professional fees paid out of the proceeds of company stock purchase as the promoter can be seen as a fiduciary and not able to accept such payment.
Several other areas of concern are mentioned in the memorandum, which are too numerous to go into here. Suffice it to say, a thorough review of such an arrangement should be made by a qualified attorney intimately familiar with the nuances of crafting these arrangements.
While we know that many people are looking for ways to capitalize a new business in this turbulent economy, risking retirement funds (whatever might be left of them) to do so in violation of IRS regulations is a risk that can be avoided. There are other ways to use retirement funds to make permitted investments and there are many other ways to fund a new business.
For a copy of the entire IRS memorandum, please e-mail us your name, location, e-mail address and request to [email protected]. To discuss other strategies for funding a business and acceptable investments in retirement plans, contact our office at 888-857-8058.
Jaime J. Raskulinecz, CPM is the CEO of Entrust Northeast, LLC, a NJ licensed Real Estate Broker and CEO and principal of Rainbow Property Management, LLC, AMO. Entrust Northeast is a locally owned and operated office that is part of The Entrust Group, the largest and oldest administrator of self-directed retirement plans in the country. Entrust Northeast has become one of the first and only area companies to enable investors to harness their IRA assets to purchase a wide array of nontraditional investments such as real estate, notes, private placements, accounts receivables, limited partnerships and gold. Ms. Raskulinecz has been a successful real estate investor herself for more than 20 years. Jaime can be reached at 973-857-8058 or [email protected]. www.entrustnortheast.com