Thursday, November 8, 2012
“ROB”-ing a 401(k) Plan
A CPA acquaintance from New Jersey came into town and spent a couple of days at the office. Why? Well, maybe he wanted to get away from New Jersey. Actually, he wanted to take a look at some of the policies and procedures we utilize. He only recently purchased his own practice.
He said something that surprised me, and which I thought we could discuss this week. He funded his accounting practice by using his 401(k) funds. This technique is sometimes referred to as “rollover for business startup.” The acronym is “ROBS.” Catchy, eh?
What do I think about ROBS? Frankly, I am a bit uncomfortable with them. There is the issue of concentrating your retirement monies in a venture also intended to provide current income. Should it fail both income and retirement monies vanish. I am financially conservative, as you can guess.
The second issue is technical: there are a number of ways this structure can run afoul of some very technical requirements. You have tax law, you have ERISA, you have … well, you have enough to cause concern.
Let’s give this CPA acquaintance a name. We will call him “Garry,” mostly because his name actually is Garry. Here is what Garry did:
(1) Garry created a corporation. The corporation had no assets, no employees, no business operations, no shareholders. Accountants call this a “shell” corporation.
(2) The corporation adopted a retirement plan. The plan allowed for participants to invest the entirety of their account in employer stock.
(3) Garry became an employee of the corporation.
(4) Garry rolled-over his 401(k) (or a portion thereof) to the newly-created retirement plan.
(5) Garry had the plan purchase the employer stock.
(6) The corporation now had cash, which …
(7) The corporation used to purchase an accounting practice.
What can possibly go wrong? Here are several areas:
(1) You need a solid valuation for the 401(k) purchase of the employer stock. I would not want to go into the IRS with only a rough calculation on the back of an envelope. The trustee of the plan has fiduciary responsibility. Granted Garry is both the fiduciary and beneficiary, but he still has responsibilities as trustee.
(2) The workforce has to be able to participate in the plan.
a. This is a qualified plan. There are nondiscrimination requirements, same as any other qualified plan.
b. This is not a problem for a one-man shop. What will Garry do when he hires, however?
i. Here is what he better do: amend the plan to prohibit further investment in employer stock. Future employees will not be allowed to invest in Garry’s accounting firm stock.
(3) There is a fiduciary standard for investment diversification.
a. You can see the problem.
i. Maybe Garry can open a second accounting office. You know, diversify.
(4) Garry is paying for all this. Some brokers will charge over $5,000 to set up a ROBS.
a. Oh, there are also ongoing annual charges. The plan will have an annual Form 5500 filing requirement, for example.
b. There may also be periodic valuations, requiring Garry to pay a valuation expert.
i. Why? Because Garry has a difficult-to-value asset in a qualified plan. Difficult-to-value does not mean Garry gets a free pass on valuing the asset. It does mean that it is going to cost him.
(5) These transactions have caught the attention of the IRS. This does not mean that his transaction will be audited, challenged or voided, but it does mean that he has walked into a spotlight.
a. Garry had to gauge his IRS risk-tolerance as well as his financial diversification risk-tolerance.
Are ROBS considered “out there” tax-wise? Actually, no. There are tens of thousands of these structures and their businesses up and running. Garry is in good company. And while the IRS has scowled, that doesn’t mean that ROBS are not viable under the tax code and ERISA. It does mean that Garry should be careful, though. Professional advice is imperative.