ROB-ing your retirement account

Using a retirement fund rollover to finance a new business has its benefits — and drawbacks.

From the pages of In Business magazine.

There are many famous Robs — Rob Gronkowski, Rob Lowe, Rob Reiner, Rob Schneider, or even folk hero Rob Roy — but ROBS, in the financial world, is an acronym for “rollovers for business startups.” Mention it to financial investors and they may harrumph or snicker. Mention it to accountants, and while they may acknowledge it, they’ll likely not want to discuss it. In fact, in this article, most of the local financial professionals we spoke with preferred not to have their names or company names published due to compliance issues.

The fact is, ROBS can be a great way to finance a new business using retirement funds, but buyer beware — if not done correctly, tax and legal problems can result.

ROBS 101

ROBS falls under the self-directed IRA umbrella and is perhaps a lesser-known method of using retirement funds to start a business. It is legal and monitored on many fronts, yet tends to be common in the franchise world as an option for those who later in life — we’ll say baby boomers — want to transition into a new occupation. ROBS also allow the business entrepreneur to work in the business they purchase.

ROBS can be used with 401(k)s, traditional IRAs, and 403(b) plans, but financial advisors we spoke with seemed generally uncomfortable with the idea of shifting retirement dollars into new business ventures. Understandably, they don’t want their clients risking their retirement money on unproven ventures. “If someone wanted to use their IRA dollars they could always just withdraw the funds subject to taxation, of course,” notes a local CPA.

Nathan Brinkman, president at Triumph Wealth Management, also cautions against moving money out of retirement funds to launch a new business. “Unless you have a rock-star idea, I have a tough time with people putting all of their retirement money into [a new business],” he says. “The IRS is watching these ROBS but hasn’t done anything yet. Get ready for an audit, as it will be highly scrutinized.”

Financial advisors have skin in the game, of course, and earn fees on the retirement accounts. The U.S. government, meanwhile, protects retirement accounts and doesn’t want people risking those funds. It could also stand to lose potential tax revenue if the business fails.

Given all that, how would this work for “Joe Smith” if he decided to pursue the option? Let’s say Joe has spent his lifetime saving for retirement and still has 10 or 15 productive years left to work after retiring from career number one. He’s always had a dream of owning his own business and has a good chunk of 401(k) savings tempting him every day.

Arranged correctly — and that is the caveat — the ROBS method allows Joe to roll over his retirement funds into the new business without paying any penalties or taxes.

ROBS work only with C corporations so the first thing Joe must do is create one with the help of an attorney and financial advisor very familiar with the rollover process. The transaction must be completed correctly to qualify under IRS code, notes David Nilssen, CEO and cofounder at Guidant Financial, in his report titled “Special Report: Rollovers for Business Start-ups (ROBS).” Guidant has helped more than 10,000 business owners set up ROBS since 2003, but there are other companies operating in the same space including Benetrends, which pioneered the ROBS concept over 30 years ago, FranFund (specializing in franchises), or CatchFire Funding.

Back to Joe: His new C corporation establishes a 401(k) plan and any existing 401(k) funds from his first company are rolled into the new 401(k) under the C corporation. The new 401(k) purchases stock (at fair market value) in the new company making the C corporation cash rich and debt free and able to start a new business or franchise.

Such a transaction, Nilssen states, is not unlike purchasing stock in a publicly held company like Apple, but instead Joe is purchasing the stock of a privately held company. “Once the investment is made the 401(k) plan owns stock in the business and the corporation holds the cash. The corporation then uses that cash to rent space, buy equipment, buy supplies, hire employees, etc. — basically any legitimate business expense,” Nilssen explains in his report.

As for Joe, his original retirement funds are now invested in his own business rather than traditional IRA investment products.

There are several advantages to this plan, Nilssen notes. Joe can defer income into a retirement account, grow wealth invested in the company on a tax-deferred basis, and invest in a wide array of business ventures. He no longer has to be tied to investing retirement money into bonds, stocks, mutual funds, or money market accounts.

Once incorporated, Joe’s new business can adopt a 401(k) plan that allows its trustees to acquire and hold employer stock in a private business. “The plan allows employees to roll funds over from their eligible retirement accounts into the new 401(k) plan,” Nilssen reports, and when rolled over, up to 100% of those funds can be invested into the purchase of company stock. “In effect, the money in the owner’s 401(k) plan is transferred to the corporation in exchange for most or all of the company’s stock,” he explains, and the owner-employees must begin making ongoing contributions as soon as possible.

Usually when people borrow startup capital it creates debt that must be repaid and may also require collateral. This ROBS scenario differs because when the business generates cash, that cash can be reinvested back into the business. So ROBS can be used to supplement bank financing or SBA loans even if Joe didn’t come to the table with sufficient retirement funds to finance his new company.

Nilssen lists several advantages to the entrepreneur, or “Joe”:

  1. Joe’s new business gets a 401(k) plan.
  2. Joe has control over his investment performance.
  3. Joe starts debt-free: ROBS don’t accrue interest, they can reduce overhead, and potentially allow a businessperson to reinvest more into growing their business because they don’t need to repay debt.
  4. Retirement funds can be used as a down payment for a business loan.
  5. No collateral is necessary to qualify.

Audrey Randall, president at Paradigm Franchise Group, says the ROBS concept is IRS approved although many financial firms don’t understand it. For that reason she warns entrepreneurs to work with ROBS experts because the concept is often misunderstood and highly regulated.

ROBS are common in the franchise industry, Randall says, but anyone looking to buy, start, or own a business can consider it an option. “I’ve been in this business and in insurance and franchising a long time. The number one reason businesses fail is because they’re undercapitalized. The second reason is the amount of debt they carry. You don’t want to go into debt to afford your franchise,” she states.

Randall says ROBS allows an entrepreneur an opportunity to fund their business tax free and without penalties because their 401(k) rolls over into the C corporation so they can avoid any penalties.

Pitfalls include the potential for attracting an IRS audit, according to Adam Bergman in his Forbes article, “What You Need To Know About Using Retirement Money for Business Funding.”

In 2008, the IRS issued a memorandum stating that ROBS were legal and not considered an abusive tax avoidance transaction, but in many cases they were also not found to be in full compliance with the IRS and the rules and procedures of the Employee Retirement Income Security Act (ERISA). In 2010, the IRS revisited the issue and acknowledged the potential for abuse but confirmed that if done correctly, ROBS are not illegal.

Bergman suggests the IRS is concerned about individuals pulling retirement funds out of their retirement savings to invest in new businesses that historically have high failure rates. If the new business fails the IRS loses potential tax revenues, but if an individual uses retirement savings to purchase stocks, mutual funds, or even real estate, their account values might fluctuate but their accounts would likely not be entirely lost.



Dogging it out

Greg Reetz owns Bark Busters, a dog training franchise in Madison. His wife used the ROBS method through Benetrends when first launching the business in 2006 but Reetz is the sole owner now. “We took my retirement 401(k) money and created a C corporation. By doing that we avoided certain taxes,” he notes.

Greg Reetz with canine companions Rayna, on lap, and Hanna. His Bark Busters Home Dog Training franchise was initially funded with ROBS.

In fact, the couple used all of Reetz’s retirement money, putting 70% into the new business, which also covered the franchise fee, and 30% into the new 401(k).

“Eventually we had to take most of the 30% and put it into the business,” Reetz acknowledges. “There were no tax repercussions but we had to demonstrate to the IRS where that money was going to not get penalized.”

The decision to use his retirement this way was very risky, he admits, “but I think the model is worth taking a look at for baby boomers. You must have business sense though,” he advises. He quit his job as an insurance adjuster to join his wife in the dog-training business. Ten years later, he says he’s recouped his investment.

401(k) flexibility

People hoping to pursue a new business venture later in life should be careful not to invest money they can’t afford to lose, and they should always seek financial advice to be sure they’re considering all options and following all the rules. That said, 401(k)s can be an excellent investment tool.

One local advisor, “Sam,” says people often assume that 401(k)s can only be used to invest in publicly traded stocks and bonds or real estate when in fact they can be invested “in pretty much anything” except antiques, collectibles, and gold.

“If you look at a lot of baby boomers sitting on cash because they’re afraid of the market, one of their great opportunities is to use the 401(k) to provide a loan to a business. They can charge interest and those interest payments go right back into the 401(k). It’s awesome and most people don’t know they can do it,” Sam says.

“If I’m going to invest in something personally and know the chance of losing money is high, I’d much rather lose my 401(k) money than money I’ve already paid taxes on, so it would hurt me much less.”

The best way to avoid a lot of red tape when using a 401(k), he says, is to invest in someone else’s company and retain a minority — not majority — interest. “You can even buy into your own business so long as you don’t have a controlling stake,” Sam states. That’s because having a majority interest would be viewed as benefiting the investor today, whereas 401(k) money is intended to be a future benefit.

Distilling a dream

Nick Quint, 70, had a dream. The president and chief distiller at Yahara Bay Distillers Inc. spent most of his life in the bottled water industry before being bought out several years ago. Semi-retired, he dabbled in a small appliance business before deciding to pursue an idea that had been stewing for a while.

“Back then, the recession was going on and banks were all under fire. I just had a gut feeling that the spirits and craft brewing industry was about to thrive and wouldn’t get affected by it and it wasn’t really,” Quint states.

In 2007 he financed his new company more traditionally. He didn’t use a rollover, nor was his money in a 401(k). He had a traditional IRA, but he used funds that were in another investment account to fund Yahara Bay.

Quint says his banker laughed when he first suggested the idea of starting an urban distillery. “How are we going to get rid of all of that when you go bankrupt?” the banker asked him. Undeterred, Quint used all the money he could until he couldn’t go any further. “At that point, the bank figured I was serious enough so they gave me a small line of credit,” he says.

Quint had no prior experience in distilling or wine making. “I wanted to see if I could build a business from scratch,” he says. “I’d read about these small distilleries and figured I can’t die without trying. I never expected it to get to where it is.” Quint still has the same banker.

“I’ve seen a lot of startup businesses where the first thing they do is pay themselves,” says Quint about risks and rewards. “We’ve lived off Social Security for the past 10 years. Absolutely this was a financial risk, but I believed in myself enough and most of the funds went to equipment, which usually holds some value. So my real risk was a lease and I was good at negotiating. My original landlord wanted 10 years but I talked him down to two.”

Yahara Bay Distillers has 15 employees and recently moved to a new location in Fitchburg, quadrupling its space.

“It was difficult initially to pour money into this,” Quint admits. “I did a lot of soul-searching and I kept enough back that if I lost everything that I put in, I’d have to work but I wouldn’t be destitute. I still have that same amount. It has not done well in the market, but it wasn’t like if this failed I’d be out on the street. I still have a mortgage, so it was difficult, but I would have hated to miss it.”

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