Rollovers as Business Start-Ups (ROBS): Thinking about the Risks and
by Michael E. Sheehan, Esq.
Attorney, Michael Sheehan describes the pros and cons of using retirement
funds to capitalize a new franchise or business. It’s a comprehensive look into
the subject of Rollovers as Business Start-Ups.
Few old saws have survived the test of time better than “things that appear
to be too good to be true usually are.” And that’s the usually reliable adage
that the Internal Revenue Service applies to Rollovers as Business Start-Ups
(ROBS). In fact, the best thing that the IRS has ever publicly said about ROBS
is that they are not “per se” non-compliant. That’s faint comfort for the
faint-hearted, but tax professionals say that the IRS has recognized that a
properly structured and administered ROBS plan can serve legitimate tax and
business planning purposes.
And that’s apparently enough consolation to continue a surge in demand for ROBS
plans. Prospective business owners still have limited funding alternatives
as the credit squeeze on small businesses shows few signs of abating. And that’s
a boon to some ROB’s providers.
What is a ROBS?
ROBS plans are a means by which prospective business owners use their
existing retirement savings to pay for a business start-up or the acquisition of
a new business, all without paying any otherwise applicable distribution taxes
or penalties. In a 2011 article in BNA’s Daily Tax Report, Brian McManus and
Mark Matthews, two tax attorneys with Morgan, Lewis & Bockius LLP, describe the
typical ROBS plan structure as including the following sequential steps:
- The prospective business owner forms a new corporation,
- The new corporation adopts a prototype 401(k) plan that
specifically allows plan participants to direct the investment
of their plan accounts into a selection of investment options,
including the stock of the new corporation,
- The prospective business owner then elects to participate in
the 401(k) plan and, as permitted by the plan, directs a
rollover or trustee-to-trustee transfer of retirement funds from
another qualified retirement plan into the newly established
- The prospective business owner then directs the investment
of the 401(k) plan account to purchase the newly issued stock of
the new corporation, and
- The company uses the proceeds from the sale of the stock to
invest in the start-up or acquire an existing business.
An additional step in the structure is to secure an IRS Determination Letter
(DL), which will say only that the ROBS plan currently meets Internal Revenue
Some ROBS plan promoters will say the DL amounts to the IRS’s imprimatur; the
IRS says it simply means you haven’t done anything wrong yet. That’s because the
DL is much like a drivers license. If you drive improperly, you can lose your
license or worse. The DL says you’re ready to put the key in the ignition, but
everything you do after your car is in gear must comply with the traffic laws.
And it’s pretty easy to run a red light or get into a wreck with your ROBS plan.
All the more reason to ensure that plan is done right by a qualified service
“Too good to be true” implies a free ride or at least an outsized return. But
ROBS plans typically have both upfront and on-going costs. And to be
cost-effective you need to make a fairly substantial rollover investment.
On-going costs include plan administration, tax filings and yearly business
valuations, all of which add up and must be done correctly to prevent the
“ticket” that’s paid in distribution taxes and penalties.
ROBS to Riches?
Apparently a lot of people think so. In a recent article in the New York
Using Your 401(K) to Buy a Small Business, Barbara Taylor reported that,
according to its co-founder and CEO David Nilssen, Guidant Financial, the
industry leader in self-directed IRAs and innovative small business financing,
saw significant growth in its business since the credit markets collapsed in
2008 and early 2009 as well as a 196% increase in inquiries between 2009 and
2011. Moreover, Messrs. McManus and Matthews report that “industry experts
estimate that since 2005 more than 10,000 start-up businesses have been
capitalized through rollover arrangements.” In addition, DRDA, PLLC, a CPA firm
focused on small and middle market businesses, hasn’t seen such an appreciable
uptick in its self-directed 401(K) BORSATM (Business Owners Retirement Savings
Account) plan, but they see many deals transacted without bank financing.
Many prospective franchisees and business owners appear to be thumbing their
noses at banks and leveraging their own retirement capital. And they do so
contrary to conventional wisdom and in the face of warnings from the IRS as well
as many financial advisors.
The bookend to the “too good to be true” admonition is not to “put all of
your eggs in one basket.” The IRS Employee Plans Compliance Unit (EPCU) recently
completed its ROBS compliance project and found that “while some of the ROBS
were successful, many of the companies in [its study] sample had gone out of
business within 3 years of operation.” In an earlier publication, the IRS went a
little further saying that “most” ROB’s businesses from their sample “failed or
were on the road to failure.”
So, why in the world would anyone want to take such a risk? The short answer
is that with the credit markets for new small businesses still thawing,
prospective business owners may have no funding alternative for their start-up
business dreams. American Banker recently reported in “Small
Businesses Absent from Commercial Lending Surge” that “many banks … remain
reluctant to lend to all but the most creditworthy firms.” And there’s not much
relief in sight, although Franchise Times, citing the International Franchise
Association and BoeFly, reported in its September 2012 issue that “lending to
franchisees increased 4.58 percent, year over year, in June.” Unclear is how
much of that four and a half percent is comprised of large, multi-unit
A more complicated answer may be that conventional wisdom about investing
your retirement funds didn’t fare too well during the credit crisis. Many
people, including me, obligingly listened to our paid advisors and shored up the
risk profile in our 401(k) s with “safe” investments like Fannie Mae and Freddie
Mac bonds. So it may be that many prospective business owners find greater
appeal in taking a risk with their retirement funds in their own business rather
than in someone else’s.
Where does that leave us? Like any type of business financing, ROB’s plans
are not without risk and the gravity of that risk is underscored by the IRS’s
cautious view of them. Note: I made a couple of inquiries to the EPCU about ROBS
failure rates but was told that they “can’t release statistical information for
[their ROBS] project.” So, we can’t even reconcile their statements that “many”
or “most” ROB’s plans fail.
On the other hand, any business venture is defined by risk, particularly a
start-up or newly acquired business. And whether they tap their savings or
retirement funds or sign a personal guarantee for an SBA loan that puts their
home equity on the table, prospective business owners must accept that an
investment in a new business is inherently risky.
Whether you decide to finance a new business start-up or acquisition with a
ROBS plan or another form of alternative financing, go with a provider that has
plenty of expertise, experience and infrastructure. You really don’t want to
bargain shop with the stakes so high. Guidant’s Nilssen adds that, “For most new
business owners, regardless of the type of financing being used, their business
represents the most significant investment they’ll make in their lifetime. That
makes it worthwhile to invest in a good team of advisors to help find, buy and
navigate the early stages of a business.”
Mike Sheehan is a franchise consultant and attorney. He is the president of
Focus Ventures (www.focusonfranchise.com)
and formerly served as a securities attorney and as general counsel for a
Fortune 100 financial services company.
His Franchise Focus Blog (www.franchisefocus.blogspot.com)
focuses on helpful information, tips and current news for prospective
This article should not be construed as legal or tax advice or a legal or tax
opinion on any specific facts or circumstances. The contents are intended for
general information purposes only and you are urged to consult your own legal,
financial and tax experts concerning your own situation and any specific
questions you may have.
© 2012 Mike Sheehan. All rights reserved.