Under ordinary conditions, laid-off employees obtain replacement employment or create their own opportunities through start-up businesses. The sheer number of persons currently seeking employment, coupled with low employer demand and absence of traditional funding for start-ups or any other businesses, has caused many laid-off employees to consider use of qualified retirement plan account balances as a source to fund their own start-up businesses.
Various advisors and franchisors have developed structured programs that assist qualified retirement plan account balance rollovers into newly created plans that are then used to provide working capital for start-up companies. Such programs are commonly known as rollovers to business start-ups (“ROBS”). They have attracted the attention of laid-off employees strapped for cash as well as the IRS, which recently conducted a comprehensive study of ROBS marketing, structuring, and use, resulting in a detailed memorandum that should be reviewed carefully by everyone considering ROBS to fund a start-up venture.
The IRS notes that ROBS are intended to provide funding for the establishment of a business or franchise by applying tax-exempt retirement plan balances to the purchase of capital stock in a newly-formed company, while avoiding plan distributions that would otherwise be subject to income and excise taxes when balances are made available to the employee-plan participant.
The typical ROBS user is an individual seeking to start a personal business who has accumulated tax-deferred investment funds, usually in the form of a defined contribution account created under a prior employer’s plan. The user is generally advised by a ROBS promoter or sponsor. Implementation of the ROBS generally proceeds with the following sequential steps:
· The individual establishes a new corporation sponsoring an associated and purportedly qualified retirement plan. At this point, the corporation has no employees, assets or business operations, and may not even have a contribution to capital to create shareholder equity.
· The plan document provides that all participants may invest the entirety of their account balances in employer stock.
· The individual becomes the only employee of the new corporation and the only participant in the plan.
· The individual then executes a rollover or direct trustee-to-trustee transfer of available funds from a prior qualified plan or personal IRA into the newly created plan. These funds might be any assets previously accumulated under the individual’s prior employer’s qualified plan, or under a conduit IRA which itself was created from such amounts. Because assets have been moved from one tax-exempt account to another, income or excise taxes otherwise applicable to the distribution are avoided.
· The sole plan participant then directs investment of his or her account balance into a purchase of new company stock. The stock is valued to reflect the amount of plan assets that the individual desires to access.
· The individual then uses the transferred funds to purchase a franchise or begin some other form of business enterprise, while income and excise taxes on the distribution from the prior tax-deferred accumulation account are avoided.
· Once the business is established, the plan may be amended to prohibit further investments in company stock, although amendment may be unnecessary since all stock is fully allocated. Consequently, only the original individual benefits from this investment option. Future employees and plan participants will not be entitled to invest in company stock.
· A portion of the proceeds from the stock transaction may be remitted back to the promoter, in the form of a professional fee. This may be either a direct payment from plan to promoter, or an indirect payment, where gross proceeds are transferred to the individual and some amount of his gross wealth is then returned to the promoter.
The IRS examined many commonly offered ROBS programs and found significant disqualifying operational defects in most. For example, required annual reports for some plans were not filed and the business entity created from the ROBS exchange often did not survive or applied the freed-up capital for personal, non-business purchases.
A primary concern related to potential violations of nondiscrimination requirements resulting from the fact that new company employees were not notified of the existence of the plan, did not enter the plan or receive contributions or allocable shares of employer stock. Another concern related to potential violations of prohibited transaction rules. All ROBS arrangements involve an exchange of start-up company stock for cash from the new company plan, and the exchange would be a prohibited transaction unless the stock has adequate value to substantiate the cash payment made by the plan. In many cases, there were no plan assets valuations or valuations that relied upon threadbare appraisals that often consisted of a single sheet of paper, signed by a purported valuation specialist, and were questionable because the valuation simply approximated available funds without a comprehensive valuation of the new venture, its assets, and prospective operations.
The IRS acknowledged that specific facts must be evaluated on a case by case basis to determine whether a particular ROBS transaction complies with established law and guidance. For this reason, individuals considering a ROBS transaction should confer with knowledgeable counsel.