Idaho and California residents looking to leverage their retirement accounts to fund a startup may consider a roll over business startup. A roll over business startup (ROBS) is a business started by an individual using their retirement account or 401K to fund and own the business. This structure allows the plan owner to avoid tax on distribution and put 100% of the funds to use in starting a new business. However, with this benefit comes a complicated maze of unique rules and prohibited transactions. Engaging in a prohibited transaction will result in a 15% tax on the amount involved in the transaction imposed during the first taxable period and a 100% tax imposed if the issue is not corrected thereafter. The Employee Retirement Security Act (ERISA) imposes a further tax of 5% and 100% respectively.
One such specific transaction prevents the direct or indirect “transfer to, or use by or for the benefit of, a disqualified person of the income or assets of the plan”. Put simply, a disqualified person is not able to use the funds from the retirement account or any assets of the account for his or her own benefit. Stock in, or value of the company would likely be an asset of the plan and transfer of that stock to a disqualified person would likely benefit the disqualified person, thus being a prohibited transaction.
A disqualified person is anyone who has express authority to control the investments of the plan or a family member or agent of such a person. When the owner of the plan is also the owner of the company (which is often the case), the owner of the plan has express authority to control the investments of the plan and, as such, is a disqualified person.
Given the rules laid out in the Internal Revenue Code, it seems that issuance of stock to the owner of a ROBS business would be a prohibited transaction without any exemptions. However, the IRC provides an exemption for prohibited transaction consideration under ERISA Sections 406 and 408(e). This exemption is for acquisitions or sales of qualifying employer securities so long as they are exchanged for “adequate consideration” or a price that is not unfavorable to the plan. Adequate consideration the fair market value determined in good faith. The ERISA exception allows the owner of a ROBS company to purchase stock of the company at fair market value as determined by a bona fide appraisal of the company.
To avoid prohibited transactions when issuing yourself stock from your 401K ROBS, it is essential that you get a bona fide appraisal of the company and then purchase that stock at fair market value.
If you are interested in learning more about how to properly set up a ROBS, Fisher Hudson Shallat’s Idaho and California attorneys can offer further guidance on how to properly set up these transactions.