Charles C. Scott, President, Pelleton Capital Management, Ltd.
Kiplinger Consumer News Service
Q: I want to get out of the corporate rat race and follow my passion! But how do I pay for this?
A: Boy, if I had a nickel for every time I have heard this, I’d be a wealthy man.
Recently, I was talking with Mathew, a friend of a client. Mathew is a senior executive in large national company and is looking for a change of scene. A change so he can pursue what he’s really good at and loves to do, but doesn’t have the opportunity to do in the company where he is now. He’s been pretty successful but is frustrated with the corporate bureaucracy that gets in the way of his good ideas. So, he’s looking at creating his own enterprise but has some critical questions.
Ever heard this before? We certainly have.
It seems to be happening all the time and not just among younger entrepreneurs. The fastest-growing area in business start-ups is coming from the 50- and 60-year-old segment of the population. They are taking the risks not necessarily out of need, but because they are seeing opportunities.
These entrepreneurs have been and interesting group for financial advisers to work with, according to Greg Bresiger in an article he wrote for Financial Advisor magazine.
Bresiger gave some good examples of questions to ask: What’s the real goal? Are you ready to compete with the 28-year-old who is eager to work 80 hours a week? Are you tapping your experience base or going into something completely new? What if it fails?
So, having considered all of this, you’ve done your homework and you’re ready to start the new enterprise. Where will the money come from? Family? Friends? A small-business loan? A home equity loan? What about your 401(k) plan assets?
What!!? My 401(k)? Are you nuts?
You’re willing to sacrifice your retirement dollars and start a business on your own. What have you been smoking? After all, small businesses fail at a very high rate, with over 1 out of 3 going under in the first two years and half failing within five years.
In addition, how do you get at the 401(k) dollars without paying income tax on the money as it comes out, and even a penalty if you’re younger than 59?
Ever heard of a “rollover-as-business-startup” transaction? Let’s just call it “ROBS” for short.
I hadn’t heard of it either until a few months ago.
So, how exactly does this work, and how does the IRS feel about it?
Let’s start with the IRS. They looked into this in 2010 and their Employee Plans Compliance Unit concluded this was not abusive in avoiding taxes, but certainly only would benefit one person – the 401(k) owner.
I’m going to say it now, and I’ll repeat this at the end, you need to make sure you’re working with a professional who really understands how this all works. If your CPA is helping you with this, you need to know that this person is well versed in the ROBS process and feels like it makes sense for you.
CPAs are, by nature, pretty conservative, so be sure yours is willing to be a little outside the box on this idea, and truly understands the process.
Let’s now look at how this all comes together.
Both tax law and ERISA (Employee Retirement Income Securities Act of 1974) law have some exemptions designed to allow investments in small business, sort of like what an Employee Stock Option Plan (ESOP) does.
You start by setting up the company as a C-type corporation that has a 401(k) plan of its own. The owner transfers funds from the previous employer’s 401(k) plan into the new 401(k) plan, and that plan buys shares in the new company, thereby becoming a shareholder of the new company.
So right here there are going to be some costs associated with starting a corporation and creating a 401(k) plan, so don’t be surprised.
Here are a couple of key points:
The funds rolled over from your previous retirement plan are not taxed, so there are no income taxes to pay nor any potential early withdrawal penalties if you are under age 59 Â½.
Also, you need to understand that you, as an owner, are a different entity from the 401(k), which is also an owner. Even though it was your retirement money in the first place, you need to operate as if the 401(k) owner is a really picky partner, and make sure you follow the 401(k) rules to the letter.
If there are other employees of the company, they must be offered the chance to buy stock also, otherwise the IRS would not be satisfied the company plan meets the necessary requirements.
Other IRS issues revolve around the filing of various tax forms, most often the 5500 form, which, in the case of ROBS, needs to be filed annually.
And you should expect the IRS to pay extra attention to you, making sure you do everything by the book.
Do you see the need for working with someone familiar with all of these requirements? You better!
And you still have a live, working 401(k) plan that comes with the costs of administration and the requirements of making sure any current or future employees understand the workings of the plan. And the plan trustee, you the business owner, is a fiduciary of the plan, and as such, needs to always act in the best interest of the plan, not just themselves.
And here is the time to make sure that the new business owner understands the complexities of a 401(k) plan and should know enough to hire a professional plan administrator to make sure all of the details of the plan are taken care of.
If all of this seems like a lot of extra stuff to deal with, it is, but the overall benefits might just outweigh the hoops that need to be jumped through.
For example, there’s no need to take out a loan, have the debt to pay back, and you get to forgo the delight of dealing with a lending institution – a bank usually – which comes with all of the documentation and lending underwriting and all of the other requirements that banks demand.
Remember, banks like to lend to people who don’t really need to borrow the money in the first place. It’s not likely that it’s the person wanting to start their own business. At least not without a huge commitment to collateralizing the loan from the start.
But the upside is that you, the owner, are in control, at least from a financial point of view, without the bank as your unwanted “partner.”
And don’t forget another key issue – the new business owner doesn’t have to stop saving for retirement.
They have set up the 401(k) plan in the first place, and as an employee, they will have the ability to make contributions to the plan from their income, therefore continuing to grow their retirement assets.
As I said before, and it requires repeating, you need to make sure you’re working with a professional who really understands how this will all work.
I can’t caution you enough about this idea. You are taking a huge risk with your “retirement” money. You truly need to know if you can afford to mess up your retirement to follow your dream. Remember the failure rate of small businesses mentioned earlier.
And it’s very prudent to have some other substantial funds set aside just in case this doesn’t work out.
Don’t put all of your retirement “eggs” into this one “basket.”
Is this something that’s right for everyone? Of course not, but it just might be the right fit for that great idea you’ve been hatching for a long time, just wondering how the heck you were going to come up with the funds to make it happen.
ROBS (rollover-as-business-startup) could be the solution.
And for heaven’s sake do your homework first.
Here are some additional resources if you want to find out more about the ROBS process.
From the Small Business Administration: https://www.sba.gov/blogs/can-your-retirement-plan-own-your-business
From the IRS: https://www.irs.gov/retirement-plans/employee-plans-compliance-unit-epcu-completed-projects-project-with-summary-reports-rollovers-as-business-start-ups-robs
More from the IRS: https://www.irs.gov/pub/irs-tege/robs_guidelines.pdf