Tapping Retirement Money for Your Business? Be Careful

When Ed Wills was laid off last year from his information-technology job at a robotics company in Grandview, Mo., he didn't have enough money in his company 401(k) plan to retire. But he did have enough money in his account to fund a new business – tax free.

To withdraw the money without paying the usual taxes and penalties for early withdrawal, Wills executed a maneuver called a rollover as business start-up, or ROBS. It works like this: In January, with help from small-business finance company Benetrends, Wills established a 401(k) plan for his company, Wills Family Associates, which operates a franchise-consulting business. He then rolled the money from his old company 401(k) into his company's new retirement plan.

Finally, in exchange for company shares, the business withdrew $30,000 from the new retirement account for marketing, web site development and other startup costs. The funds are not a loan; a feature Wills says helped his company turn profitable more quickly.

"To be able to start a business without having a loan with monthly payments really helps you get the company off the ground and get cash flow going," he says.

Does this all sound too good to be true? It might be. Turns out, many ROBS plans may violate tax laws. The IRS recently instructed its auditors to scrutinize ROBS transactions.

While the IRS has stopped short of pronouncing all ROBS plans illegal, in 2008, the agency did signal its hostile attitude in a retirement-plan newsletter, writing "from our experience, many ROBS arrangements quite simply do not comply with the law."

But an article published in Franchise Times cited compelling figures from franchise-data firm FranData that showed more than 4,000 businesses started using ROBS funding last year. More than 60 percent of those businesses were franchises.

And with that, the IRS's auditors are expected to step up their focus on ROBS, says Stephen Dobrow, past-president of the American Society of Pension Professionals and Actuaries.

"I've been presented with three ROBS plans and the way they were set up, I believe all three would be ruled prohibited transactions by the IRS, if they investigated, Dobrow says."

ROBS transactions aren't new, but they've become popular as traditional bank lending has declined.  Dobrow says unqualified brokers have sprung up in the downturn, selling quick-and-dirty ROBS plans that can easily run afoul of complex pension laws.

Where do ROBS plans run into trouble? Here are some the biggest red flags:

• Never starting an active business. If you set up a ROBS ostensibly to start a business, but your business never launches, you're in big trouble.
• Excluding employees from the plan. A 401(k) plan must, by law, include all of a company's qualified workers. "Simply put, often plan terms aren't followed," Dobrow says.
• Using ROBS money for the owner's salary. ROBS withdrawals must be used for general business purposes. He says, "If you pay yourself a salary, what you've done is a subterfuge around the tax laws."
• Startups funded entirely with ROBS. Retirement money shouldn't be the only money source that gets your startup off the ground. Dobrow says, "If the rollover assets are all the money in the deal, IRS is going to determine it's a prohibited transaction."
• Failure to communicate. Retirement plans have strict communication requirements for informing workers of available benefits and open enrollment periods. An annual report must also be filed with the IRS.
• No satisfactory business valuation. Fly-by-night operators, Dobrow says, are offering companies instant valuations on the cheap. But to legally exchange company shares for the retirement money, a thorough, professional valuation must be done.

Financial companies that offer ROBS programs defend their plans and insist they are legal. At Benetrends in North Wales, Pennsylvania, founder and CEO Leonard Fischer says his company has assisted more than 40 clients with IRS audits of their ROBS plans, and none were found to have problems. He says Benetrends set up more than 1,200 ROBS transactions last year and is on track to do more plans this year.

"I would recommend this program for the most conservative client I have," Fischer says.

If you want to set up a ROBS transaction, Dobrow says, be sure an experienced pension professional is involved. Ask for a guarantee you'll be held harmless if the plan fails to pass muster later.

In these cases, the ROBS transaction must be unwound, the IRS has said. That means all funds must be replaced in the account and tax paid for early withdrawal, along with penalty fees and an additional 15 percent excise tax.

Despite all the negative attention to ROBS, business owner Wills says he doesn't have any regrets.

"This is a very viable funding plan," he says and is confident his plan complies with the law. Besides, he prepaid Benetrends for any legal defense his plan may need in future.