Most businesses start something like this — you wake up one day and go, “Eureka! I am going to start my own business.” You kick on your shoes, roll up those sleeves, brag to all your friends, and get to work! Then everything evolves over time from there. If your idea works, then you grow by reinvesting your profit back into your successful idea. If it fails, well, you lick your wounds and learn a bunch of invaluable life lessons.
However, not all business ventures start out so simple. Some ventures involve substantial financial capital. Some people wake up in the morning and go, “Eureka! I am going to start a New Zealand-themed franchise steakhouse!” Then they do some research and realize that they will need excellent credit, be ready to sign a 10-year contract, and just … a modest sum of $300,000 in cash!
Most entrepreneurs would only be able to meet 2 out of 3 of these requirements. Most of us on this Earth don’t have a few hundred thousand dollars laying around. And the entry price into certain franchises can vary from a few thousand to a few million dollars!
In order to meet franchise requirements, or to fund a capital-intensive startup such as in the food service business, entrepreneurs look to the ROBS Arrangement as a potential means to finance that Eureka moment.
Understanding the organizational structure of a ROBS Arrangement is crucial to entrepreneurs who wish to consider this as a financing alternative for owning their own business.
Here is how the mechanics of the ROBS works:
Step One – You’ve done all your homework and decide a ROBS Arrangement makes sense.
This is a major life decision, and success or failure can have a tremendous impact on your whole future. You’ve discussed your idea at length with your spouse, lawyer, accountant, financial advisor, retirement specialist, life coach, spiritual leader, parents, friends, and anyone I forgot to mention. You can never, ever, ever rush through Step One! You’ve also read our blog post about ROBS Arrangements as a Retirement Strategy.
In light of all of that, you are committed to the ROBS Arrangement.
Step Two – Your ROBS attorney creates a C-Corporation in the state where you will be doing business.
You need a ROBS attorney — plain and simple. Don’t attempt to do anything this unique on your own. You’ll waste money filing forms and creating filing obligations for yourself which will only induce future headaches on your budget. Let go of that internal instinct to do everything yourself and use a ROBS-specific lawyer to help with Incorporation.
Unless your business is physically located in Delaware, you can skip asking the question, “Should I incorporate in Delaware?” In a ROBS, incorporation happens in the state you are set to do business within. You need to talk with your lawyer about that — this is what they do. We often see taxpayers who wish to skip some of the legal bills by making the C-Corp themselves, and often they leverage the rumor mill to do this in Delaware. Then they pay the lawyer extra to clean up what they started plus the original legal fee they tried to avoid.
As a shareholder of a corporation, you should familiarize yourself with the nuances of the corporate board room and your role as management. You are expected to act and perform your duties as the CEO of a corporation. Maintaining this distinction helps from a compliance perspective. As such, you should stay on top of keeping minutes, drafting your decisions into resolutions, and creating as much contemporaneous evidence as possible which demonstrates you doing all the right things in both appearance and fact — which benefits the shareholders.
Step Three – Initial board meeting addresses the adoption of a ROBS 401(k) Plan.
At this phase, your corporation is just your business idea and a stack of legal paperwork showing as such. In order to get started, your corporation needs to raise capital. As CEO, you vote to start a company-sponsored ROBS 401(k) Plan for its employees. The CEO must fully understand the fiduciary responsibilities that come with sponsoring and adopting the plan. You should speak with a ROBS 401(K) plan provider to learn more about this plan. It’s required, has special compliance rules, and must be offered to all your eligible employees. It’s better to understand your obligations as the plan provider before starting a ROBS business.
Step Four – Once the ROBS 401(k) Plan is formed, the rollover of funds occurs from your old 401(k)/IRA into the C-Corporation’s ROBS 401(k) plan.
The entrepreneur should speak with the 401(k)-plan provider about the steps involved with the rollover. They should also anticipate receiving an additional 1099-R tax form that they need to include in their following years tax returns. Otherwise, the plan providers make this a rather painless transfer of assets from one tax-deferred retirement account into another.
Step Five – The C-Corporation has a stock issuance.
Up to this point, the C-Corporation is now your business idea, a stack of legal documents, and a company sponsored 401(k) Plan that has one participant (you) with a cash balance within the account.
The Corporation announces its initial stock issuance. At this point, the entrepreneur decides how they wish to participate in the issuance. Stock is issued at its par value — and all of this is outlined in that stack of legal documents. (Read them!)
Ownership is determined from the stock ledger. If the entrepreneur puts $20,000 of their personal funds into the company in exchange for 20,000 shares
at a $1 par value, and the 401(k) contributes $80,000 and receives 80,000 shares at a $1 par value— then the entrepreneur directly owns 20% of the company. For tax purposes, they indirectly own 100% of the company — and that comes with additional compliance rules to consider.
Step Six – Get to work!
The ROBS entrepreneur is obligated to work for the company — this cannot be a passive investment. Once operations begin, the shareholder needs to keep diligent track of their time and activities performed for the company. All their services performed for the company are paid through payroll wages. The entrepreneur should expect to receive a W-2 from the corporation reporting wages paid for services performed.
Just like any other business, the first few years are brutal. New businesses must invest in their infrastructure while expensing resources in search of sales. This is where you’ll need grit and determination to make your business a success. Failure means that your C-Corp stock becomes a worthless investment in your 401(k) portfolio.
Step Seven – Issuing Dividends
The C-Corporation is subject to a 21% income tax rate (tax year 2021). After all expenses, shareholder wages, and then the C-Corp tax, the surplus cash balance in the business is available to management either as working capital to cover daily operations, or as funds to be issued to shareholders.
It is not advisable to hoard cash in a ROBS that does not have a legitimate business purpose because this isn’t in the best interests of shareholders. CEOs might be tempted to hold onto cash simply because they don’t want to send most of it back to the retirement plan. This is putting themselves before the shareholders — and that goes against the responsibilities of management.
Once the company has retained earnings it wishes to distribute, the shareholders have a board meeting and declare a dividend payment to the shareholders of record as of a specified date. On that date, the company issues dividends in accordance with the ownership outlined in the stock ledger from the date of declaration. Unlike an S-Corp that reports distributions on a K-1, you’ll receive a 1099-DIV for dividends received. Include this in your personal tax return.
Step Eight – Exit Strategy
No two entrepreneurs have the same circumstances, skills, assets, goals, and retirement objectives. Knowing when you want to exit from your business idea is best strategized with your team of professional advisors — as soon as possible. If you are going to operate a ROBS Arrangement, having a ROBS CPA can add value to your overall bottom line.
You can learn more about ROBS Arrangements and Franchise Accounting by clicking here.
This blog and its authors provide this content strictly for informational purposes. No content herein should be misconstrued as financial advice. Everyone’s specific circumstances vary — Always consult with a qualified, licensed financial advisor, legal counsel, and tax professional before venturing into any investment or business activities.