Many business owners face the same dilemma when attempting to get their businesses operational: getting funding. This is why some might explore the idea of using retirement accounts to fund a new business or business purchase.
A rollover for business startup (ROBS) allows you to use your retirement funds to pay for initial startup or acquisition costs. However, using a ROBS can be a risky move, and close consideration must be made when weighing the pros and cons of putting your retirement eggs into one basket. Understanding the process, options, and stakeholders involved is a starting place in reviewing rollovers as a potential funding outlet. Below, we’ll delve further into what a ROBS is and how it works.
- A rollover for business startups (ROBS) is a non-traditional funding form that uses a retirement account to cover initial costs of starting up.
- A ROBS works only on eligible retirement accounts to fund a C corporation, making it not an option for those who want to use LLC or other business structures.
- Using a ROBS is a risky decision and needs to be carefully considered by the business owner and ROBS provider.
What Is a Rollover for Business Startups (ROBS)?
A ROBS is a type of funding mechanism for covering startup costs in a new business or purchasing an existing business. A prospective business owner rolls over retirement funds from an individual retirement account (IRA) or a 401(k) into a new business venture, usually with the support of a ROBS provider, attorney, and accountant.
A ROBS is not a loan taken out against a retirement account, which means there is no debt to repay or interest payments to cover monthly. That can make it an attractive method as opposed to a small business loan that often comes with high interest rates.
How a ROBS Works
A business structure that allows for shareholders, such as a C corporation, must be formed first before a 401(k) plan is set up for that C corp. Once established, the business owner’s retirement funds are rolled over into the new 401(k). Finally, those funds are used to purchase stock in the C corp, and that sale translates to cash that’s invested into the business for startup costs.
Putting your retirement funds into a startup can be a risky business decision to make. The current state of your account as well as other options for income upon retirement play key factors in whether a ROBS is a smart move.
Let’s take two scenarios as an example. Entrepreneur A has more than $250,000 in a retirement fund, has a projected startup need of $100,000, and a spouse who can cover daily expenses. This person also brings business acumen and a strong business plan. Entrepreneur A would be a candidate for a ROBS.
Entrepreneur B, meanwhile, has $150,000 in a retirement fund, is nearing retirement age, and wants to open a brick-and-mortar business with significant overhead. With little business experience and no other forms of income available, Entrepreneur B is not an ideal candidate for a ROBS.
Pros and Cons of a ROBS
Here are some pros and cons to consider when considering a ROBS.
Not taking on debt or monthly interest payments, because it’s an alternative form of funding
No early withdrawal penalties or taxes for pulling out of your retirement fund before age 59 1/2
Growth potential in your new retirement funds based on the company’s success
A major risk with retirement funds and not being prepared for retirement if the business fails
Must operate as a C corp with different tax implications from an LLC or sole proprietorship
If audited, process may be more complex
- Not taking on debt: A rollover for business startup means you can avoid debts at steep interest rates by reinvesting profits back into your business rather than paying off debt. You also won’t see the consequences of a business loan on your business or personal credit report.
- No early withdrawal penalties: Generally, retirement funds are subject to an early withdrawal penalty if you take these funds out before the eligible retirement age of 59 1/2. The IRS considers a ROBS a non-abusive, tax-free transaction.
- Growth potential: Retirement funds benefit from compound growth and stock market prices. However, funds rolled over come with major potential for growth based on business success. This may be a more lucrative strategy than leaving your funds in a previous 401(k), although that depends solely on how well the business operates.
- A major risk with your retirement funds: The biggest fallback of a ROBS tends to be the most important to consider. You are taking a major risk by rolling over your retirement fund into covering startup costs. The IRS found that many ROBS businesses failed and left business owners with no retirement assets.
- Must operate as a C corp: A ROBS can only function with a C corporation as the business structure allows for shareholders. Yet some businesses may function better as an LLC for tax purposes, recordkeeping, and ownership purposes. For example, C corps pay taxes on their profits, whereas an LLC does not pay taxes on business income because it’s considered a pass-through entity.
- If audited, the process may be more complex: While utilizing a ROBS doesn’t necessarily mean an increased risk of an audit, the audit process may be more complex for a ROBS-funded business because the IRS will likely review documentation about the retirement plan, business operations, and the steps taken to fund the business.
How To Set Up a ROBS
As a form of funding for startup costs, a ROBS can be a viable option for a business owner once they’ve reviewed the requirements and looked into all options.
First, there are eligibility requirements you must meet to consider a ROBS:
- Have a retirement account that is tax-deferred, such as a 401(k), 403(b), or traditional IRA
- Be an active employee in your business and take a salary that aligns with the average for your position and responsibilities
- Be prepared to offer other employees the opportunity to invest in the C corp’s retirement plan
After meeting the requirements above, meet with the proper financial advisor to outline a plan. Many business owners decide to work with a ROBS provider because they are the most experienced in this funding mechanism. However, a lawyer and accountant can also help you receive proper guidance.
Expect to spend approximately $5,000 to set up your ROBS. This cost covers registering as a C corp, creating its 401(k), and submitting IRS paperwork. The fee is not considered a startup cost and is ineligible to be covered out of the ROBS money.
You are now ready to move forward with rolling over your retirement funds and must follow the process carefully to meet IRS procedures:
- Establish a C corp, a business entity that allows for shareholders and can issue stock
- Create a proper retirement plan, often a 401(k) for the C corp, and select a custodian to manage it
- Roll over your current retirement funds to the newly created 401(k)
- Buy stock in the C corp using the retirement funds
- Receive money from the stock purchase and use for startup costs
The work associated with setting up a ROBS doesn’t end once you have received the money from the stock purchase. You will need to ensure all annual filings are completed on time using, for example, IRS Form 5500, to show you are providing employees the option to invest in the company’s retirement plan, and that you’re paying the monthly ROBS maintenance fees to your provider.
Alternatives To Financing Your Business With a ROBS
A ROBS may be a promising funding option when you need to cover startup costs. However, putting your retirement money into an unstable business can be risky. Startups in the early stages of development face an uphill battle, as evidenced by the roughly 15% to 20% of small businesses that fail within their first year of operation.
Any financial advisor would ask you to consider other forms of financing that keep your retirement fund intact. These would include:
- Small business loans or grants through the SBA
- Family and friend fundraising
- Crowdsourced funding
You may also have the option of taking out a loan on an eligible retirement plan. The IRS mandates that the maximum loan amount is either 50% of the vested balance or $50,000, whichever is less. It’s important to note that this is not a ROBS, but a loan with a repayment period.
Is a ROBS Right for You?
A ROBS is an option to consider funding your new business or acquiring an established business or franchise. But there are pros, cons, and requirements that need to be given serious attention. You may weigh the advantages (tax-free, no debt) and disadvantages (no retirement funds, audits) differently than a fellow entrepreneur, so speak with an accountant or ROBS provider to thoroughly review the opportunity.
Frequently Asked Questions (FAQs)
What happens if I do a ROBS rollover, then don’t start a business?
The IRS prohibits certain transactions for ROBS funds, including any personal or non-business purchases. As such, a rollover that isn’t used to fund a business, no matter the circumstances, would be at risk of taxes and penalties.
What happens if I sell my business after doing a ROBS?
Knowing how to close out a ROBS depends on what type of sale occurs. All sales will first cover business obligations before the remaining funds are distributed to stockholders. In a stock sale, for instance, income tax would be paid upon distribution with no corporate tax. Further, cash received for the stock could be rolled over into an IRA.
Can I do more than one ROBS?
There isn’t necessarily a limit on how many rollovers you can do as long as you have the proper retirement funds and meet the requirements. However, doing a single ROBS can be risky on its own and lead to IRS scrutiny, which could increase by doing more than one.