We get asked all the time, “How do I use my 401(k) to start a business without paying penalties and taxes from early withdrawal?”
The answer comes from two sets of laws which work in tandem with one another. The first is the Internal Revenue Code (IRC) § 4975 (d)(13), and the second is ERISA §408 (e).
IRC §4975 outlines taxes imposed on prohibited transactions.
Want to exchange property between yourself and your retirement plan? Prohibited! Want to lend money between you and your plan? Prohibited! Are you considering furnishing services to your retirement plan? Prohibited! Want to leverage your retirement funds to your own benefit? Guess what? Prohibited!
Prohibido! Proibito! Verboten! Jìnzhǐ! Kinshi! Zapreshchennyy! It doesn’t matter what language you speak — the IRS doesn’t want you messing with your retirement accounts!
However, IRC §4975 (d)(13) offers us an exemption to the rule — if the rollover qualifies as an acquisition or sale of qualifying employer securities (QES), pending certain conditions are met, then the rollover is not subject to the taxes imposed by IRC §4975.
So, what are these conditions?
Well, ERISA §408 (e) says that:
(1) The acquisition, sale or lease must be for adequate consideration
What does this mean? Basically, you can’t rip off your retirement plan. How about an example:
Tommy “Two-Times” Fraudjulini wants to use a ROBS to start his own concrete-shoe company. His C-Corp issues shares to him for $1 par value. He acquires 10,000 shares in this way. Then his ROBS 401(k) plan purchases shares at $10,000 per share. The plan can only afford 10 shares. This ensures Tommy control of the company — but guess what? ERISA §408 (e)(a)(1) says “fuhgeddaboudit” — this transaction was not made in exchange for adequate consideration.
Had Tommy issued shares accordingly, his 401(k) would own 100,000 shares at a $1 par value and he would own 10,000 shares. This ensures that both parties paid adequate consideration for their respective shares.
If Tommy had things his way, he would own 99.9% of the company (10,000 shares of 10,010 total). However, when shares are issued in exchange for adequate consideration — Tommy only directly controls 9.09% of his company (10,000 of 110,000 total issued).
Sorry Tommy — you might want to consider another line of business. Concrete shoes are so 1970’s anyway!
ERISA §408 (e) also states that:
(2) No commission may be charged directly or indirectly to the plan with respect to the transaction
When a ROBS Arrangement issues shares, the shareholders can’t get kickbacks and commissions for promulgating or advertising the stock issuance. How about another example:
Tommy “Two-Times” is at it again. This time, being disheartened by his previous scheme’s failure, he decides to charge his retirement plan a 10% finder’s fee for the privilege of investing in his company. Upon issuance of stock, he turns around and puts 10% of the proceeds in his personal bank account.
ERISA §408 (e)(a)(2) says that this violates the tax-exempt status of the rollover because he received a 10% commission from the retirement plan. The ROBS entrepreneur can never personally benefit from the rollover or issuance of stock. Prohibited!
Lastly, ERISA §408 (e) also states that:
(3) In the case of an acquisition or lease of qualifying employer real property, or an acquisition of qualifying employer securities, by a plan other than an eligible individual account plan, the acquisition or lease must comply with the requirements of section 407(a) of the Act.
To further that point, section 407(a) states:
… a plan may not acquire or hold any employer security which is not a qualifying employer security or any employer real property which is not qualifying employer real property….
What this means is that the ROBS 401(k) plan cannot use funds to acquire investments that are not Qualified Employer Securities (QES). Therefore, you can’t roll over your retirement into a ROBS and then go around purchasing other investments willy-nilly. Ready for an example? Here we go:
Thwarted yet again by accounting do-gooders, Tommy now hopes to defraud his ROBS Arrangement by rolling over his retirement funds, but then subsequently purchasing a private residence and a yacht, compliments of the ROBS 401(k) plan. Neither of these assets are Qualified Employer Securities. Upon audit, the IRS finds that he has violated the tax-exempt status of the ROBS arrangement. He is now subject to back taxes, penalties, and interest on the funds he rolled over from his old IRA into the ROBS arrangement. Not to mention potential criminal charges…
If you’ve noticed, there is a persistent theme here — If you are going to use your retirement funds to start a business, then the transaction must be at arms-length, at fair value, and intentioned to legitimately fund the purchase or acquisition of a business.
Before you decide to venture into a ROBS arrangement — it’s best to contact us at Baum CPA to ensure a ROBS arrangement makes sense for your entrepreneurial vision. Learn more about Baum CPA’s ROBS expertise at this site.
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.