Proceed with caution when using your IRA to invest in businesses (article)

Proceed with caution when using your IRA to invest in businesses (article)

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Alternative investments offer unique opportunities to grow the value of your benefit plan at a faster rate than traditional investments. One of the alternative investments being touted in the marketplace is to invest in a new business using money from your qualified retirement plan through a transaction referred to as Rollover as Business Startups (ROBS). When designed and administered properly, the ROBS structure can work. The IRS and Department of Labor, however, continue to attack these structures at every opportunity.

To implement a ROBS, a taxpayer forms a new corporation (typically a C corporation – a qualified plan in not eligible to be an S corporation shareholder), sets up a new 401(k) and rolls over an existing 401(k) plan, individual retirement account (IRA) or other qualified plan into the new 401(k) plan. The new plan purchases company stocks, and the business founder goes about building his or her company.

The Employee Retirement Security Act of 1974 (ERISA) permits qualified plans to be used this way, but individuals must be careful with these transactions.  It's a relatively new area, and as such, the IRS has ROBS transactions and other activities funded by benefit plans under a magnifying glass. Recent court activity indicates that if ROBS transactions do not strictly follow the Internal Revenue Code's requirements for allowed benefit plan transactions, individuals directing those transactions will face steep penalties. Those interested in ROBS transactions should use the lessons learned in court as a guide for how to keep their arrangements in compliance.

History and Overview

Discussion of whether your ROBS transaction will bring IRS scrutiny depends on whether the IRS considers it a prohibited transaction. Internal Revenue Code Section 4975(c)(1)(A) defines a prohibited transaction as any direct or indirect:

  • Sale, exchange or leasing of property between a plan and a disqualified person;
  • Lending of money or extension of credit between a plan and a disqualified person;
  • Furnishing of goods, services or facilities between a plan and a disqualified person;
  • Transfer, use or benefit of plan income or assets by a disqualified person;
  • Act by a disqualified person who is a fiduciary where he or she deals with the plan assets in a way that benefits the fiduciary (self dealing); or
  • Receipt or any consideration for a personal account by any disqualified person who is a fiduciary from someone who is dealing with the plan assets or the transaction involving the plan assets.

A disqualified person is a fiduciary, person providing services to the plan, an employer or employer organization whose employees are covered by the plan or an owner with 50 percent or more of the voting interest over the company stock.

One of the early tests of whether qualified plans could be used to fund new business entities came with Swanson v. Commissioner (1996). Swansons' Tool, an S corporation, created a Domestic-International Sales Corporation (DISC) to export its products. It used a self-directed IRA to purchase the initial shares of the DISC. Swansons repeated the procedure to create a Foreign Sales Corporation (FSC) a few years later. The IRS declared that both of these arrangements were prohibited transactions. The court sided with Swanson, however, which opened the door for similarly structured arrangements. Hellweg v. Commissioner (2011) recently validated the ruling of Swanson v. Commissioner.

The decision kicked off a pattern that continues today; taxpayers tried new arrangements with their benefit plans, and the IRS came back with new attempts to limit those arrangements. IRS Notice 2004-8, for example, made Roth IRA management companies listed transactions, which required individuals who engaged in those or similar transactions to disclose the transactions or face strict liability penalties.

ROBS Transactions in Court

ROBS transaction became increasingly popular during this period. The IRS and the Department of Labor (DOL) teamed up in 2008 to evaluate the ROBS transactions, and early results revealed significant operational defects. The plans frequently had the company's founder as the only participant, which violated ERISA procedure. Employees didn't receive shares of company stock as required by ERISA. They did not file their annual reports as required by ERISA. A number of prohibited transactions took place because of poor appraisals that overvalued the company's stock.

The IRS scrutiny of ROBS transactions is also showing up in court. In Ellis v. Commissioner (2013), a taxpayer set up a limited liability corporation (LLC) and rolled over his 401(k) to a self-directed IRA. He used the self-directed IRA to fund his new business, which sold used cars. The taxpayer served as the general manager for the used car business and paid himself a salary, which is where the IRS and the courts got involved. The court held that the taxpayer was a fiduciary of his IRA, and that he and his company were disqualified persons under Section 4975. Therefore, when he had the company pay him a salary, he engaged in a prohibited transaction.

The company and the IRA were essentially the same, the court said, because the assets of the IRA consisted exclusively of the used car business's stock and the taxpayer owned more than 50% of the company.

Lessons Learned

It is critical that you conduct a ROBS transaction within the parameters of the current regulations. If the IRS finds the use of the IRA to be a prohibited transaction, the results are costly. The IRS treats the IRA as if the assets were distributed and then taxes the individual on the full amount of the plan assets. The prohibited transaction also counts as an early termination of the plan, which triggers excise taxes and other penalties.

For more information about ROBS transactions or to discuss other alternative benefit plan investments, contact your local CBIZ MHM tax professional.


Copyright © 2015, CBIZ, Inc. All rights reserved. Contents of this publication may not be reproduced without the express written consent of CBIZ. This publication is distributed with the understanding that CBIZ is not rendering legal, accounting or other professional advice. The reader is advised to contact a tax professional prior to taking any action based upon this information. CBIZ assumes no liability whatsoever in connection with the use of this information and assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.

CBIZ MHM is the brand name for CBIZ MHM, LLC, a national professional services company providing tax, financial advisory and consulting services to individuals, tax-exempt organizations and a wide range of publicly-traded and privately-held companies. CBIZ MHM, LLC is a fully owned subsidiary of CBIZ, Inc. (NYSE: CBZ).

Proceed with caution when using your IRA to invest in businesses (article)Alternative investments offer unique opportunities to grow the value of your benefit plan at a faster rate than traditional investments. One of the alternative investments being touted in the marketplace is to invest in a new business using money from your qualified retirement plan through a transaction referred to as Rollover as Business Startups (ROBS). ...2015-03-31T09:33:00-05:00

Alternative investments offer unique opportunities to grow the value of your benefit plan at a faster rate than traditional investments. One of the alternative investments being touted in the marketplace is to invest in a new business using money from your qualified retirement plan through a transaction referred to as Rollover as Business Startups (ROBS).