NEW YORK (MainStreet) Entrepreneurs looking to fund a new business have often turned to their own retirement assets for seed capital. Whether as a loan drawn on their own 401(k) or through retirement plan withdrawals triggering not only taxes, but often penalties few budding business owners may have known about another tax-free funding strategy: the Rollover for Business Startups (ROBS). However, due to some recent Tax Court decisions, that option may be threatened.
ROBS plans have been in existence for years, but the IRS has been wringing its hands about the "scheme" since 2008. While the IRS says the strategy is "not considered an abusive tax avoidance transaction," it is a practice that's "questionable." Two recent U.S. Tax Court decisions have further heightened the concern.
In order to tap a retirement account for the launch or purchase of a business, a new corporation is formed, which then establishes a 401(k) plan allowing for the purchase of company stock as one of its investment options. The entrepreneur-to-be then rolls over their existing IRA or 401(k) from a previous employer into the new plan and buys stock in the new corporation. The funds are then used to purchase an existing business or franchise, or seed the new startup.
It has been a sophisticated, tax-deferred and penalty-free way to use retirement assets to launch a venture; all well and good, until recently.
The IRS has issued guidance in the past voicing concern that such arrangements have usually served to solely benefit one individual's access to tax-deferred assets. And with the high rate of failure for new businesses, the IRS noted that a number of individuals have lost all of their retirement assets -- as well as their dream of owning a business.
"The ROBS plans we looked at spanned a cross section of businesses including those in senior care, cleaning services, fitness, health food, real estate, machinery, daycare, pet products and services, and consulting," the IRS notice says. "The ROBS plan typically had only one participant, the individual that completed the rollover and who was the sole employee. However, some of the successful ROBS had gone on to hire additional employees. After the ROBS plan sponsor purchases the new company's employer stock with the rollover funds, the sponsor amends the plan to prevent other participants from purchasing stock."