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.