An alternative financing technique using 401(k)s is fast becoming a way to help laid-off executives launch their own businesses. But this unique strategy must carefully follow IRS and ERISA rules.

The financing strategy, called a "Rollover as a Business Start-up" (or a ROBS), lets would-be entrepreneurs generate instant cash flow from their 401(k)s.

The ROBS transaction works this way: A businessperson creates a Subchapter C corporation and sets up a retirement plan, but does not initially issue stock. The businessperson then rolls over his or her existing 401(k) into the new retirement plan. Afterward, the new corporation issues stock and transfers it to the new retirement plan in exchange for cash.

If the ROBS is set up correctly, no interest is owed, there are no IRS penalties for early withdrawal and the money needn't be repaid. In addition, ROBS money may be used to help an entrepreneur qualify for a loan from the bank or the Small Business Administration.

However, to realize all these benefits, the IRS requires that properly structured plans meet antidiscrimination rules and that stock transferred into the newly created retirement plan be properly valued.

ROBS have rapidly gained in popularity at a time when borrowers are otherwise having difficulty getting bank loans for business start-ups. Traditional loans against 401(k)s are prohibited for people who no longer work for a company. Most lenders want at least 40% of a small business loan collateralized. And home equity loans, the darling of the real estate boom, are less available now thanks to tightened lending standards and distressed home values.

Small businesses that are successful in obtaining loans generally pay higher loan interest rates than big corporations. Meanwhile, smaller banks, which have long serviced small businesses, are under scrutiny by bank regulators because of weak balance sheets and inadequate reserves.

ROBS transactions, typically ranging from as little as $10,000 to more than $500,000, funded more than 4,000 businesses in 2009, according to a study by FRANdata in Arlington, Va., which tracks data on franchise businesses. More than 60% of ROBS transactions were used to start franchise businesses, FRANdata says. The financing technique had an $8 billion impact on the economy in 2009, generating 62,000 direct and indirect jobs.

Investors have been using these transactions since the 1990s, but the strategy has taken off in a big way since the 2008 financial crisis. There are at least nine companies that market ROBS programs, according to the IRS. Some 70% of the transactions are believed to have been set up by two companies: Guidant Financial Group Inc. in Bellevue, Wash. and BeneTrends Inc. in North Wales, Pa.

These companies and other ROBS providers say they will set up the C corporation and profit-sharing plan based on ERISA and IRS regulations. They also provide ongoing guidance. Guidant Financial and BeneTrends say they will pay for a CPA and tax attorney if the businesses they help get started are audited. BeneTrends goes so far as to guarantee it will pay all fines and legal fees if the IRS rules against a business.

Most companies charge an initial start-up fee of $5,000 to service a ROBS transaction. Ongoing support services run at least $1,000 annually.

"Business is up 40% this year," says Leonard Fischer, CEO for BeneTrends. "We've done 1,500 [ROBS] plans with an average transaction of $175,000 for every type of business imaginable this year."

David Nilssen, the founder of Guidant Financial, says his company expects to write 1,500 plans by year's end, up about 30% from last year. The average amount of the ROBS transactions is $165,000, which is typically put down on a bank loan of $500,000 or less. Since Nilssen launched his company, he's done 4,500 plans that resulted in $2 billion in franchise loans.

"We are seeing a strong demand," he says. "The number of prospects inquiring about financing is up 60% over last year. We've talked to a number of tax attorneys and CPAs that want to familiarize themselves with the plans."

Using a ROBS transaction, Hal Mottet, of Lake Oswego, Ore., and a partner used $1.4 million of their retirement funds to finance the $3.5 million purchase of Empire Container Corporation in Carson, Calif., Bloomberg News reported. Last year, Ted Sarasin, a former technology manager with Chase Bank, used his retirement savings to start a Chem-Dry franchise in Red Oak, Texas, according to Guidant Financial.

Although ROBS can provide a cheap source of capital for new business ventures, at least one financial planner, Graydon Coghlan, president of the Coghlan Financial Group in San Diego, is skeptical. He says he would not recommend a ROBS transaction in this precarious economic and tax environment without a thorough review of a client's finances and business plan.

"They are taking on a huge risk with their retirement savings," says Coghlan, whose firm manages $500 million in IRA rollover assets. "You don't know how much follow-up capital the person has to maintain the business if it does not run smoothly."

Tax attorneys and CPAs also are concerned that the IRS may audit the businesses that use these transactions. Fines for noncompliance with IRS rules can run up to 115% of the amount withdrawn from the 401(k), plus ordinary income taxes.

"A ROBS transaction is a tax shelter whereby an individual uses pretax passive retirement assets, such as funds from a 401(k), to capitalize a new or existing business without paying taxes on the retirement assets," says Brian Weinstock, a principal with the St. Louis law firm Danna McKitrick. "It is a tax shelter that is established for the purpose of avoiding or evading federal income taxes."  

The IRS has expressed similar concerns. In June of this year, the agency's Employee Plans Compliance Unit said it would do follow-ups on ROBS transactions that have already been approved. The unit wants to be sure the companies remain in compliance with reporting and filing requirements.

Michael D. Julianelle, the IRS director of employee plans, separately noted in an October 2008 memorandum that a number of ROBS transactions were noncompliant.

Julianelle says that during an examination, the IRS found "disqualifying operational defects" in most ROBS plans. Employees in some arrangements were not notified of the company profit-sharing plan or did not receive their share of the company stock in the plan. Plan assets were not valued or were valued with "threadbare appraisals." Annual reports were not filed. Several businesses failed or assets were used for personal and non-business purchases.

The Small Business Administration, which honored Guidant Financial Group in 2007 for its "outstanding success and support of small business," denies any affiliation with ROBS transactions. "We don't endorse this method of financing," says Michael Stamler, a spokesperson with the Washington, D.C.-based SBA.

The agency does, however, consider ROBS transactions acceptable as down payments on an SBA loan, Stamler says, adding that the 401(k) proceeds represent the business owner's equity stake in his or her firm.

Attorney Weinstock recommends that financial advisor clients avoid ROBS transactions altogether. "The problem with a ROBS transaction might not be the structure of the deal, but more so with operating and administering the deal after the transaction is completed," he says. "You could see more audits over the next few years."

While the IRS has not officially said these transactions are illegal, it will scrutinize ROBS setups case by case, he says.

Fischer, BeneTrends' CEO, is also a tax attorney, and he disagrees with these assessments. He says he has met with the IRS undersecretary of the Treasury about ROBS transactions.

"As long as the transaction is based on the rules set forth in the 2008 IRS memorandum, there is no problem," he says.

Fischer adds that only 1% of the 3,500 plans his firm administers have been audited by the IRS. None was fined. Nilssen of Guidant Financial also says that less than 1% of the businesses using his services have been audited. And again, none was fined.

William Brighenti, a CPA in Berlin, Conn., recommends that people determined to use a ROBS transaction do the following:
Hire an appropriate attorney to prepare the new retirement plan document.

Avoid using the master and prototype plan offered by firms that market ROBS. A number of ROBS promoters, he says, are on the IRS watch list.

Have an objective valuation of the stock of the new corporation prepared with supporting detailed analysis. An obvious red flag to the IRS would be the value of the corporate stock being assessed at the amount of funds rolled over into the retirement plan. The lack of a bona fide appraisal would raise questions.

Before purchasing a franchise through promoters charging fees out of the proceeds of the stock purchase, consider whether the promoters can be construed by ERISA or the IRS as fiduciaries rendering investment advice. It may violate IRS rules for a fiduciary to receive a payment from plan assets.

Allow future employees to acquire employer stock. Otherwise, the government might see the plan showing discriminatory favor to highly compensated employees in violation of ERISA rules.
Establish the plan as permanent.
Never pay purely non-business expenses from the plan.