Funding a Business with a 401K (without Incurring IRS Penalties or Upfront Tax Obligations)

The Rollover for Business Startups (ROBS) funding concept began in the 1980s.  And, throughout the next 30+ years, has been shown to be a legitimate, IRS-acceptable financial interchange. A ROBS transaction offers entrepreneurs and business owners the opportunity to access qualified retirement funds without incurring –

• A penalty.
• Interest costs.
• The creation of debt.
• Upfront tax obligations.

It is important to emphasize that a ROBS transaction is NOT some newfangled form of debt. A Rollover for Business Startups (ROBS)– a viable method for funding a business with a 401K– is a somewhat complex financial maneuver that legally transfers eligible retirement funds from one custodial company to a brand-new custodian for the startup business.

Learning How a ROBS Works

There are 5 simple steps required for funding a business with a 401K.

#1 — Create a C-Corp

In terms of legal entities, the new business you plan to start must be formed as a C-Corporation (C-Corp). This is the only legal entity that passes the legal muster of the Internal Revenue Service (IRS) requirements. Technically, a C-Corp is the only legal entity that permits the sale of shares of the new business by a retirement account lawfully. Therefore, it is noted that other popular legal entities like –

• A sole proprietorship,
• An S corporation.
• A Limited Liability Corporation (LLC), or
• A partnership cannot be the legal entity of the new business if you wish to complete a ROBS transaction that complies with IRS regulations!

Get 401K Funding

Recommended Provider for 401K Business Funding Those interested in a ROBS transaction are advised to speak with a legal or tax expert to fully grasp the tax implications of a C-Corp. business identity. At Small Business Brain, we recommend Benetrends Financial, the leading small business lending group that has assisted entrepreneurs with completing ROBS transactions via their Rainmaker Plan for the last 35+ years.

#2 — Define the Startup Business’ Retirement Plan

Next, a new retirement plan must be established for your new business. There are several retirement plan options that are eligible for a ROBS transaction. First, though, you must locate a financial custodial company to administer the new retirement plan. Available retirement plans include-

•  The 401K.
• Profit Sharing.
• Defined Benefits, or any combination thereof.

The right plan is contingent on several business specific issues, which can be evaluated with the help of your new retirement account custodian.

#3 — Transfer Existing Retirement Account Funds to the New Retirement Plan.

Next, you need to transfer the funds to the new retirement account. Contact your current retirement’s custodians. Transfer times vary and depend upon the custodian’s processes.

#4 — Retirement Plan Purchases Stock in the Corporation

The 4^th Step is when you purchase stock in your new C-Corp business using the funds in the newly funded (and created) retirement plan. It is noted that a ROBS transaction can be combined with other business financing methods like the loan issued by the Small Business Administration or other small business creditors.

#5 — Funds Become Available to the Corporation

The last step of funding a business with a 401K is when you begin to invest the monies in your new business. Note though, these transferred funds can only be used for a ‘normal’ business (i.e. not personal) use.

Eligibility Requirements for Funding a Business with a 401K

A ROBS transaction can be accomplished with personal funds held in a tax-deferred, qualified retirement account. Essentially, though, this requirement precludes the use of money held in a Roth 401K or a Roth IRA. Tax-deferred retirement accounts that are used most often for a ROBS transaction would include –

• A 401k.
• A SEP — known as a Simplified IRA.
• A 403b.
• A traditional IRA.
•  A Keogh.
• A TSP — a Thrift Savings Plan.
• Funding a Business with a 401K Requires Minimum Retirement Funds of $50K to be Cost Effective.
• Be a Legitimate Employee of the New Business.

Benefits & Concerns when Funding a Business with a 401K

As with any financial transaction, a ROBS transaction has both benefits and areas of concern. These are discussed below.

The Benefits

• Retirement funds are available without incurring taxes or penalties.
• Your available investment funds are being used as ‘pre-tax’ earnings.
• Funds can be used to pay yourself a salary when opening the business, given certain limitations.
• A ROBS transaction is typically completed in a matter of weeks, not months.
• Your business equity and company value become optimized.
• A ROBS transaction is a proven funding method that complies with IRS rules.

The Concerns

• The Possibility of Losing your Retirement Money.
• You could be tagged for an IRS audit.
• You must Administer a Retirement Plan.

A ROBS transaction needs to be proactively managed as there are reporting tasks and administrative duties required to maintain a compliant account.

ROBS Prohibited Transactions

A ROBS transaction requires strict adherence to its rules, which means proactively avoiding ROBS prohibited transactions. Using the funds obtained through a ROBS transaction for one of the specifically disallowed purposes will likely expose a business owner to penalties and/or unexpected tax obligations. Remain vigilant and avoid the following –

Personal Use of Business Property – IRS Section 4975 adds a 15% tax to monies involving disqualified people.

Unsuitable Owner Compensation – When funding a business with a 401K, you are tasked with a fiduciary responsibility managing the use of the retirement funds.

Comparing ROBS & Startup Business Loans

Historically, the most popular method to fund a new business (or a business expansion) was unsecured lines of credit or business loans. Despite that fact that the business loan often caused a strain on the business’ cash flow (due to the monthly payment obligation of the loan), it remained the only option for a long time.

A ROBS transaction is NOT a loan so there are no monthly payments to disrupt the business’ cash flow stream. However, both a business loan and a ROBS transaction have benefits and concerns that should be evaluated carefully. Consider the following –

The Ease of Use – A ROBS transaction tends to be a more complex transaction and requires a business to be set up as a C-Corp. However, the additional work required for a ROBS pays off, as there are no fees or interest due.

The Cost – A ROBS transaction requires the payment of expenses to accomplish the transaction and to maintain the new retirement account. Despite these costs, a ROBS transaction tends to be more cost-effective when considering the significant interest paid for a business loan.

The Flexibility – Each type of funding offers differing types of flexibility. A ROBS transaction allows you to decide how to use the available funds for any business purpose. Both types of financing set restrictions on a case-by-case basis.

The Accessibility – A ROBS transaction, with all criteria met, is more easily accessible than a business loan because business owners can obtain the money without having to apply for financing approval.

It is noted that a ROBS transaction is often used in conjunction with a business loan.

The Take-Away

Each investment, by definition, is defined by the amount of risk it carries. It is up to you to decide which financing method will work for your startup business. Either way, an investor should always be cognizant of the fact that there is something on the line for every investment.