Roll Over for Business Start-Ups (ROBS)
Some buyers of businesses obtain funding by tapping into their retirement savings from an eligible account (such as a 401K) without incurring taxes or early withdraw penalties. This strategy is called ‘Roll Over for Business Start-Ups’ (ROBS) and is recognized by the Internal Revenue Service (IRS) as an “arrangement in which prospective business owners use their retirement funds to pay for new business start up costs.” The most commonly used ROBS process entails an employed individual with a 401K plan creating a C corporation attached to a new 401K plan, rolling over their existing 401K plan into the new 401K plan, and using capital in the new 401K plan to buy stock in the C Corporation. Once injected with capital, the C corporation buys the assets of a business or uses the capital as start up expenses for a new business.
Requirements of ROBS Plans
There are several eligibility requirements as to whether a retirement fund qualifies for a ROBS strategy. First, eligible retirement plans must be a 401K (most common), traditional IRA, Keogh, SEP, TSA, or 403(b). Next, the administration rules of the existing plan governing roll overs and early withdraw fees must be followed. Lastly, the rolled over funds must then be attached to a C Corporation. A C Corporation is the only corporate entity that can sell shares to a retirement plan. Selling shares enables the funds to be released from the retirement fund into the C Corporation on a tax-free and penalty-free basis. Without question, individuals seeking to employ a ROBS strategy should obtain legal and accounting advice prior to considering this plan.
Advantages of ROBS Plans
Besides the obvious benefit of gaining access to one’s retirement fund without incurring taxes or penalties, a ROBS strategy enables a buyer of a business to avoid the need for external financing. Many prospective buyers of businesses may not be able to get a loan backed by the Small Business Administration (SBA). Often there are credit and collateral requirements that a buyer may not meet. The business itself may also not qualify because of non-transparent financials or a lack of tangible assets. Further, there are significant lending costs for the appraisal, interest costs on the loan, and the risk of taking on a large amount of debt. For prospective buyers with a large retirement fund who lack the means or desire to incur the costs and risks associated with externally financing a business deal, a ROBS strategy has important advantages.
Disadvantages of ROBS Plans
- The main disadvantages of using a ROBS plan as a way to buy or fund a new business are its up front costs, legal risks, and financial risks.
- The up front costs for establishing a ROBS plan with a consultancy company such as Guidant is about $5,000.
- This does not include legal and accounting costs which can add substantially to the up front costs.
- Legal risks when using a ROBS plan stem from the fact that the new retirement plan is heavily regulated by the IRS and the Employee Retirement Income Security Act (ERISA).
- These regulations involve substantial annual reporting and regulatory requirements that require the assistance of a legal and compliance expert.
- For example, the retirement plan set up under a new C Corporation must allow employees of the company to participate in the retirement plan.
- This in theory should enable the other employees to also buy stock in the C Corporation (along with the owner who must be an employee of the C Corporation).
- The owner invariably amends the retirement plan to prevent other employees from purchasing stock in the C Corporation, as the owner wants to protect its ownership stake in the business.
- The IRS has described ROBS plans as “questionable” because they are for the sole benefit of the owner insofar as other employee participants of the 401K plan do not own shares in the C corporation (as the owner does).
- Users of ROBS plans finally face financial risk by jeopardizing their retirement nest egg.
- If the retirement funds deployed to buy a business is lost due to the business failing, then the buyer will have lost their hard earned savings built up during their working life.
- High costs from legal compliance and promoter fees are cited by the IRS as contributory factors for the disproportionate amount of business failings that were purchased using a ROBS strategy.
- Individuals considering a ROBS plan should always have reserve capital in case the business fails.
Using ROBS to Purchase Franchises
A ROBS strategy is often deployed to purchase franchises, including new franchised locations from the franchisor and franchise resales from existing franchisees. Consultancy companies who promote ROBS online emphasize their use to purchase franchises. Many prospective buyers of franchises are looking to strike out on their own after a long professional career. Such buyers often have large retirement savings but no experience running a business, and thus make good candidates for a ROBS strategy (in the view of the paid consultancy companies promoting ROBS). Without experience running a business, it is difficult for such buyers to obtain external financing. Although a ROBS strategy may work for some buyers of franchises, they still face the same up front costs, legal risks, and financial risks as any user of a ROBS strategy.
The strategy of using a Roll Over for Business Start-Ups (ROBS) plan to buy a business is not for everyone, and should be approached cautiously with expert legal and accounting advice. Although gaining access to one’s retirement funds without incurring taxes or penalties to buy a business and thus avoiding the need for external financing sounds tempting, there are substantial costs and risks associated with this strategy.
Give Martin at Five Star Business Brokers of Palm Beach County a call today at 561-827-1181 for a FREE evaluation of your business.