In your ROBS Arrangement, you need to know what a “disqualified person” is and how to handle transactions that involve disqualified persons. Why? Because if you don’t, you could be hit with a 15% excise tax penalty under IRC § 4975 for mishandling your retirement plan assets!
Why do we have to worry about “disqualified persons” in a ROBS Arrangement? This is because Congress and her minions — the IRS and the Department of Labor — do not want taxpayers to misuse their retirement plan funds or shift tax-deferred wealth from one taxpayer to another.
The “ROBS Arrangement” is essentially a retirement plan, and the assets of the Corporation are indirect assets of that retirement plan. If the taxpayer running a ROBS Arrangement Corporation chose to, they could do things like employ their family members, sign contracts over to their friends, and otherwise conduct business in a manner that prioritizes their personal affairs over that of the retirement plan. To Uncle Sam, this is a violation of the taxpayer’s fiduciary responsibilities to their retirement plan assets. To dissuade such entrepreneurial taxpayers from abusing their retirement plan assets, the tax code defines parties you should limit business with as “disqualified persons.”
Who is a “disqualified person”?
You can find the complete (and slightly nauseating) list of disqualified persons under IRC § 4975 (e)(2). But here’s the short, distilled list for you to digest.
A disqualified person includes:
- A lineal descendant member of the family and their spouses
- An officer, director, or highly compensated employee
- A 10 percent or more shareholder
- Any fiduciary of the retirement plan
- Anyone providing services to the retirement plan
- An employer and their employees who are covered by the retirement plan
- An employee organization any of whose members are covered by the retirement plan
- An owner of 50 percent or more of any business, partnership, or corporation within a controlled group of common ownership.
When you think about it, these disqualified “persons” are just any identifiable group related to the ROBS entrepreneur’s sphere of business and family members. Some of them aren’t even people! The list above is highly watered down for our readers, so it is important to confirm who ranks as a disqualified person in your situation — by asking advice from a specifically qualified professional, such as the ROBS experts at Baum CPA. You can schedule an initial consultation with Baum CPA simply by clicking here!
Why are “disqualified persons” important to a ROBS entrepreneur?
The same tax code that identifies disqualified persons (IRC § 4975) also tells us that these parties cannot receive any form of compensation from the ROBS Corporation unless it is for compensation received in exchange for services rendered, or reasonable reimbursements to cover operating expenses.
This means that you should avoid using ROBS Corporate dollars to do business with any disqualified person unless it is paid as taxable wages — or reimbursed expenses.
On this note, it’s best to consult with a CPA familiar with ROBS before doing business with a disqualified person. The tax professionals at Baum CPA are expertly familiar with ROBS Arrangements and the complexities of staying out of trouble with the IRS when running a ROBS Corporation. Click here to schedule an initial consultation with Baum CPA today!
Paying disqualified persons
If you have disqualified persons as employees, you need to ensure that they are bona fide employees of the company, are compensated in accordance with their job position, and their compensation is accurately reported on Form W-2. Employed persons should avoid receiving any fringe benefits such as driving company cars for personal use, borrowing funds from the company, or using assets of the company for their own personal benefit in any manner. They should also receive the same compensation any other employee would be offered in that role – including access to the ROBS retirement plan.
Here’s an example:
Bobby Boyd used $250,000 of IRA funds to start a Bagel Shop. He hires his sons as employees — ages 36, 15, and 3 years old. He casually nicknamed them “Large,” “Medium,” and “Small,” for this example.
Bobby’s 36-year-old adult son, Large is the store manager, works a full 40 hours a week, receives his health and retirement benefits through the shop, and contributes to the ROBS retirement plan. Large is a skilled bagel artisan and has been making bagels professionally for years. He is a highly qualified candidate for the job. If the eldest son were to quit his position, Bobby would immediately need to hire a replacement manager.
Bobby’s 15-year-old son, Medium is a rambunctious high-schooler who periodically asks to make some extra money cleaning tables and boiling bagels. His hourly commitment to the company is not just seasonal, but sporadic — and highly dependent upon whenever he needs a handout. Bobby sometimes just pays Medium with cash straight from the register, and sometimes through his payroll software.
Bobby’s 3-year-old son, Small can’t even spell ‘bagel,’ but — because some popular person made a TikTok video that was both “informative and funny” — Bobby put Small onto the company payroll for “the write-off.” After all, that famous TikTok received 10 million views! How could it be wrong?
Unknowingly, Bobby has committed a few prohibited transactions. From his point of view, he’s just paid his family — in his family business — his own family business, anyhow! But because his Corporation’s assets are also his retirement plan’s assets, he has misused his company funds on two occasions under § 4975.
Let’s start with what Bobby did right:
Large is a bona fide employee of the business, and based on the facts and circumstances, he’s clearly employed by the company in a key role. Large is a disqualified person because he is both a lineal descendant of Bobby, and seemingly a director or key employee of shop operations. But, as long as Large receives all his compensation through payroll, reported on Form W-2, and that compensation is considered reasonable at fair market value for such a position, there is no reason why Large can’t be employed by the business.
Large’s employment agreement should be well documented, the terms should be fair and equivalent to what the position pays in the labor market, and Large cannot receive any company perks, bonuses, or handouts unless these costs are taxed as wages and reported on Form W-2. So long as Large’s employment meets these considerations, he should be good to keep crafting those artisanal bagels!
What Bobby did wrong:
Medium, on the other hand, has a more challenging time demonstrating that he’s a bona fide employee of the company. He seemingly works whenever he wants and takes his compensation right out of the till sometimes. Some of his wages are thereby not being reported correctly on a W-2. These expenses the Corporation is incurring are prohibited transactions and are subject to a 15% tax penalty. In addition, Bobby needs to amend his payroll and pay payroll taxes on the wages he paid straight from the register.
Small, the youngest son, clearly cannot provide reasonable services to the Corporation, and the advice that encouraged his employment was very bad advice. This is because Bobby now gets to cough up a 15% tax penalty on the amount “paid” to his 3-year-old. As a general rule, it’s wise to stay off social media when searching for tax advice!
Leasing / Renting / Lending between disqualified persons
In a ROBS Arrangement, it is best to generally avoid any sort of leasing, lending, or renting of Corporate assets with disqualified persons. This poses a challenge to entrepreneurs who own multiple businesses, or who want to use their retirement funds to do business with their other companies. These situations are better avoided. If you are already in a situation where you are lending, leasing, or renting assets to a disqualified person, it’s smart to have the situation evaluated for prohibited transaction potential. The expert tax advisors at Baum CPA know the ins and outs of tax code governing ROBS Corporations, and are ready to help entrepreneurs steer clear of IRS problems. Just click here to book a meeting with Baum CPA!
Here are some examples on what to avoid:
Bobby Boyd’s Bagel Shop has quickly turned into a massive enterprise, and Bobby wants to lease a warehouse he owns personally to his ROBS bagel Corporation. The bagel business needs more storage space, and Bobby’s warehouse is within walking distance of the shop. From a business point of view, it is a no-brainer that this space should be used to Bobby’s advantage — and also advantageous to the business. Bobby decides that his bagel shop will pay $7,000 a month in rent to his warehouse, even though he could only get $5,000 if he leased the space to someone else. Bobby didn’t bother to draft a lease agreement, either — after all, everything is Bobby’s, right?
Bobby’s Bagel Shop very likely committed a few prohibited transactions here. If we adhere to § 4975 (e)(2), Bobby’s warehouse is a disqualified person because Bobby indirectly owns 100% of his bagel corporation and his warehouse (50% or greater common control), and as such, cannot do business with retirement plan assets, directly or indirectly, unless it is recognized as compensation or reimbursed reasonable expenses. Last we checked, you can’t pay a salary to a warehouse, and so the taxpayer would need to justify the rent expense as a bona fide business expense like any other. However, Bobby’s Bagel Shop is paying a premium above fair market value — which means that economic value is leaving the retirement plan (on purpose) — and going into his personal account (Bobby’s warehouse). This is plainly prohibited.
This is the same scenario as the CEO of a Fortune 500 company leasing his personal condo to the corporation at a premium, which is directly an expense to the shareholders and reduces shareholder value. Would the shareholders raise concerns or lawsuits? Possibly. The ROBS entrepreneur must be the fiduciary voice that safeguards and preserves the retirement plan’s assets and conducts business in a manner that benefits — not harms — the retirement plan. Striking deals that reduce shareholder value and increase personal wealth are the types of prohibited transactions that § 4975 is designed to safeguard against.
Here’s another example:
Bobby’s Bagel Shop has a superior credit score, and as such, Bobby’s corporate credit card has a stellar 5% cash back with no limits — something he cannot get with his personal credit score. Bobby is ready to remodel his personal home, which has a total projected project cost of $80,000. Bobby realizes that if he uses his corporate credit card, he could arbitrarily earn $4,000 in cash back rewards. Bobby pays his personal remodeling expenses with corporate credit, immediately pays off the corporate credit card with personal funds, and when the $4,000 bonus rewards deposit, he moves it to his personal checking account.
Bobby has likely made a few prohibited transactions. First, he is eroding the corporate veil by misusing corporate assets and access to credit for his own personal gain. Even though there is a clear economic incentive to conduct business in this manner, and ultimately the corporation ends up breaking even with no financial injury endured, Bobby is borrowing from his retirement plan assets — albeit only for mere minutes — in a manner that directly benefits him. As soon as Bobby pockets the rewards, he has undoubtedly misused plan assets — which are neither wages nor reimbursements.
This is the same scheme as the CEO of a Fortune 500 company using corporate funds to float their lifestyle, leveraging the company’s credit offerings to make a direct profit for themselves in an arbitrary manner. Would the shareholders have a problem with this arrangement? After all, as soon as the CEO takes those rewards for themself, the share price goes down — a cost felt directly by the shareholders.
Home Offices
A lot of taxpayers seem to get excited about the notion of writing off their home offices — after all — they are “getting that write-off” and there’s a definitive and measurable personal benefit that comes from subsidizing your cost of living with corporate funds.
While the home office deduction tends to spark the same excitement that you might get from a coupon hunter whose total at the checkout is $0, the reality is that the home office deduction isn’t all that valuable. Most home offices tend to average a $2,000–3,000 annual reimbursement, which translates into a Federal C-Corp tax savings of ~$420–630. In addition, the mixed nature of the home office as both a personal asset with a business purpose invites ambiguity into the ROBS Arrangement. Is the home office reimbursement W-2 compensation to the shareholder? Is it a reasonable reimbursement? What metrics are used to compute the home office deduction? In the strictest viewpoint, the shareholder is benefiting from providing personal assets to the business in exchange for corporate funds.
For such a small deduction, why invite such uncertainty into the ROBS? It’s best to take that same $2,000–3,000 and put it into your ROBS retirement plan — you will get the same deduction, with zero risk of misusing plan assets — AND — you’re using the retirement plan as Congress intended! A win-win!
The Bottom Line
The rules bestowed upon us in § 4975 are meant to help entrepreneurs avoid misusing their retirement plan assets. A ROBS Corporation isn’t the place to shop for tax breaks and loopholes — it’s a business entity which should be managed to maximize shareholder value — because ultimately this is what leads to tax savings.
When it comes to the bottom line for your ROBS Corporation, the professionals at Baum CPA are experts in accounting, taxes, payroll, and advisory services in the specialized realm of business operations under ROBS Arrangements. Click here to schedule an initial consultation with Baum CPA today!
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.