Peek-ing Into "Rollover As Business Startup" IRAs

They are called ROBS – an acronym for “Rollovers as Business Startups.” The idea is to own a business through your IRA. Perhaps your IRA could be the bank in the transaction. Perhaps the business will go exponential, which would do wonders for your IRA balance.

Me? I do not particularly care for them. 

Why? This field is so fraught with landmines I cannot help wonder why I would want to cross it. And like Al Pacino in Godfather 3, “just when I thought I was out, they pull me back in.” “They” would be a client whom we will call Jay. We were discussing a biomedical startup on the east side of Cincinnati. High risk, high reward: that type of thing. Should it hit he would be having breakfast on his yacht off the coast of St. Augustine. Maybe I could visit.

“If it goes wrong,” said Jay, “I lose my investment. There is still plenty of time for me to recover.”

In this case, Jay was right. Jay would not be working at the business. He would not be renting property or equipment to the business. He would be a passive investor, which reduces his tax risk considerably. 

But what if the business had to borrow money? What do you think the odds are that a small business, with little or no track record, would be able to borrow without the owner’s guarantee? Remember, Jay (or rather, Jay’s IRA) would be an owner. 

This is a trap. Let’s discuss how someone fell into the trap.

In 2001, Lawrence Peek (Peek) and Darrell Fleck (Fleck) decided to buy a fire protection company, Abbott Fire & Safety, Inc (AFS). The brokerage firm facilitating the deal introduced them to Christian Blees, a CPA. Mr. Blees presented a tax strategy, which he called “IACC.” IACC involved establishing a self-directed IRA, transferring money into it from another IRA or 401(k), setting up a new corporation and having the self-directed IRA purchase shares in the new corporation.

In other words, a ROBS.

There is also something subtle here. Mr. Blees had structured a tax strategy, and he sold the strategy to clients. What was his role here? We will come back to this.

Anyway, reams of paperwork were exchanged and signed, with all the waivers and exculpatories and whatnots. Peek and Fleck set up their self directed IRAs. Each puts in $309,000 for a 50% share in a new company (FP). FP in turn acquires Abbott (AFS).

Problem. AFS cost $1,100,000. FP had only $618,000 in cash. What to do? Easy! FP borrows money. Peek and Fleck give personal guarantees.

Peek and Fleck were well advised. In 2003, they each converted one-half of their IRA into a Roth. They each converted the remaining half in 2004. Remember that there is no tax in the future when money comes out of a Roth. FP is going to the stars, and Peek and Fleck are going to make a tax-free bundle.

In 2006, they sell the company for approximately $1.7 million, to be collected over two years.

The IRS examines the 2006 and 2007 tax returns. The IRS voids the IRAs. This means the IRS includes the gain from the sale of FP stock on their personal returns. The IRS also assesses the substantial understatement (20%) penalty. As backup bombardment, the IRS imposes excise taxes for excess contributions to the IRAs.

What…? 

Let’s walk through this.

An IRA is (generally) exempt from tax under Section 408(e)(1). A tax pro however will continue reading. A little further, Section 408(e)(2)(A) says that an account will cease to be an IRA if “the individual for whose benefit any individual retirement account is established… engages in any transaction prohibited by Section 4975.”

It behooves us to review Section 4975 and to stay as far away from it as possible.

Let us look at this ticking bomb defining a prohibited transaction:

4975(c)(1)(B)  (the) lending of money or other extension of credit between a plan and a disqualified person

So what? There was a guarantee, not a loan, right?

However, a guarantee is considered an indirect extension of credit (this is the Janpol case).

Peek and Fleck argued that the guarantee was between them and FP, not between them and the IRAs.

The Court pointed out the obvious: FP was owned by the IRAS, so - in the end – Peek and Fleck were transacting with their IRAs.

Oh,oh…  a prohibited transaction.

The Court noted that the guarantees existed without interruption since 2001. This meant that the IRAs ceased to be IRAs in 2001, when Peek and Fleck signed the guarantees. Yipes!

The Court now addressed the “substantial underpayment” penalty. Peek and Fleck immediately defended themselves by arguing that they had relied upon a CPA: Christian Blees. Reliance on a pro has long been accepted as reasonable cause to sidestep the penalty.

Too bad, said the Court. Mr. Blees was not a disinterested professional. He was selling a financial product. Heck, he had given it a name: “IACC.” He was not functioning as an independent CPA in this matter. No, he was functioning  as a “promoter.” Reliance on a promoter is not grounds for reasonable cause.

The Court affirmed the substantial understatement penalty.

What about the Roth conversions in 2003 and 2004? Each man would have paid tax upon conversion. Can they now get that money back?

The Court did not address this. Why? Remember that, after three years, a tax year will close. This means that the IRS cannot amend it. It also means that you cannot amend it. This case was decided in May 2013, so unless Peek and Fleck did something special to keep the 2003 and 2004 years open, there was no way to amend those years. They would simply have been out the tax they paid.

And have to pay tax again.

What else could go wrong?

The Court mused on the following questions:

(1) Did wage payments to Peek and Fleck constitute prohibited transactions?

(2) Did rent payments by FP to a company owned by Mrs. Peek and Mrs. Fleck constitute prohibited transactions?

(3) Did Peek and Fleck put too much money into their (Roth) IRAs, thereby triggering the excise tax for excess contributions?

The Court reviewed the wasteland after the nuclear blast of retroactively disqualifying the IRAs and decided that it did not need to consider these issues. Perhaps it felt the bodies were sufficiently dead.

As I said, I do not especially care for ROBS. They can detonate in a hundred different ways. Today we talked about just one of them. 

Obama’s $3 Million IRA Cap

We have received several calls on the proposed $3 million cap on 401(k)s and IRAs. Some of those discussions have been spirited.

What is it? Equally important, what is it not?

The proposal comes from the White House budget. Here is some text:

The budget will also show how we can provide targeted tax relief to strengthen the economy, help middle class families and small business and pay for it by eliminating tax loopholes and make the tax system more fair. The budget will include a new proposal that prohibits individuals from accumulating over $3 million in IRAs and other tax-preferred retirement accounts. Under current rules, some wealthy individuals are able to accumulate many millions of dollars in these accounts, substantially more than is needed to fund reasonable levels of retirement saving. The budget would limit an individual’s total balance across tax-preferred accounts to an amount sufficient to finance an annuity of not more than $205,000 per person per year in retirement, or about $3 million in 2013."

Let us point out several things:

(1)    The proposal would not force monies out of an existing retirement plan. It would instead prevent new monies going into a plan.

This raises a question: should one draw enough to reduce the balance below $3 million, would one be able to again contribute to the plan?

(2)    The proposal uses the term tax “preferred” rather than tax “deferred.”  This indicates that the proposal would reach Roth IRAs. Roth IRAs are not tax deferred, as there is no tax when the funds come out. They instead are tax “preferred.”

There is some rhyme or reason to this proposal. $205,000 is the current IRC Section 415 limit on funding defined benefit (think pension) plans. The idea here is that the maximum tax deduction the IRS will allow is an amount actuarially necessary to fund today a pension of $205,000 sometime down the road. The closer one is to retirement, the higher the Section 415 amount. The farther one is, the lower the Section 415 amount. This proposal is somewhat aligning limits on contribution plans with existing limits on benefit plans.

(3)    The $3 million is an arbitrary number, and presumably it would change as interest rates and actuarial life expectancies change over time. If longevity continues to increase, for example, the $3 million may be woefully inadequate. Some planners consider it inadequate right now, at least if one is trying to secure that $205,000 annual annuity.

(4)    Would the annuity amount increase with inflation? Assuming an average inflation rate of 4.5 percent, one would lose almost three-quarters of a fixed annuity’s purchasing power over 30 years.

The frustrating thing about the proposal is that it affects very few people. The Employee Benefit Research Institute estimates that only 1% of investors have enough to be subject to this rule. This of course feeds into the perceived anti-success, anti-wealth meme of this White House.

(5)    The amount of money to be raised over a decade is also chump change for  the federal government: less than $10 billion.

Something to remember is that account balances in 401(k), SEP, SIMPLE and regular IRA accounts will be taxable eventually. IRAs are subject to minimum distribution rules, for example. The larger the balances, the more the government will take in taxes. Dying will not make the tax go away. In fact, it may serve to accelerate required distributions to a beneficiary and taxes to the government.

The budget was dead on arrival at Capitol Hill. Let us hope that less ideologically rigid minds on the Hill keep it so.

“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.

The Backdoor Roth IRA

The following question came up recently:

I make too much money to contribute to a Roth. Is there another way to make an additional contribution to my retirement savings?

How much is too much money? If you are single the upper limit is $122,000. If you are married the upper limit is $179,000. We are assuming, by the way, that you are covered by a plan – say a 401(k) - at work.

So what do you do?

Fund a nondeductible IRA. What is this? It is the third “flavor” of an IRA. We all know the regular IRA, where you put away money, deduct it on your tax return and pay tax on the monies down the road when you take the money out. For a Roth, you put away money, take no deduction but pay no tax when you take out the money. Then there is the nondeductible. You get no deduction and the money is (partially) taxable when you take it out.

For example, say that you put away $50,000 in nondeductibles which are worth $250,000 when you start drawing. The withdrawal is 20% nontaxable ($50,000/$250,000). Another way to say this is that 80% will be taxable.

Nondeductibles are the stepchild of IRAs. You want to fund a Roth (if you can) before considering a nondeductible.

Say that you are single, in your 40s and make $200,000 per year. I recommend that you fund a nondeductible IRA for $5,000, because $5,000 is the best you can do. You have to fund your IRA by April 15^th under all flavors of IRA. Let April 15^th pass and convert the nondeductible to a Roth. How do you do that? It may be as easy as going on the broker’s website and moving the monies between the two IRAs. Think of it as moving monies between a savings and checking account.

It used to be that one could not do this, but the tax rules have been changed to allow it.

What is the downside? There are two, and the second one can be an insurmountable hurdle to some taxpayers.

(1)    First, any income in the nondeductible becomes immediately taxable. In our example, if the $5,000 is now worth $5,450, you will have $450 of taxable income. If you do what I recommend, chances are the income will be negligible as you did not leave the monies in the nondeductible for very long.

(2)    Second, the pro rata rule. If you have monies in other IRAs, you have to use a fraction. The numerator is the amount you have in the nondeductible. The denominator is the total you have in all IRAs. For example, if you have a $5,000 nondeductible and $95,000 in a regular IRA, your ratio will be 5% ($5,000/ ($5,000 + $95,000). If you convert in this scenario, the conversion will be 95% taxable.

How do you handle issue (2)? If you have a retirement plan at work and the plan allows you to roll-in, then you would roll-in your $95,000 regular IRA. At this point the only IRA you have is the $5,000 nondeductible. Your ratio now is $5,000/$5,000, meaning that 0% is taxable.

The nice thing about a nondeductible is that there is no income limit. If you make $1 million per year, you can still contribute to a nondeductible.

How long do you let the money cool before converting? Tax advisors disagree. Some advisors recommend at least six months, whereas others say that you can do so the next day. I would recommend more than a day and not more than December 31^st of the year of the conversion.

One more bit of advice. If you fund a nondeductible, put it in its own account, preferably titled “Nondeductible.” Do not commingle your IRAs. This is not Neapolitan ice cream.

Retirement and Health Plan Limits for 2012

Here are the 2012 contribution limits for the following retirement plans:

·         401(k) limits increase from $16,500 to $17,000. The same limit applies to 403(b) and  457 plans.

·         IRA limits remain the same at $5,000

·         SEP limits increase from $49,000 to $50,000

·         SIMPLE limits remain the same at $11,500

·         Catch-up contributions remain the same

o   $5,500 for 401(k), 403(b) and 457 plans

o   $2,500 for SIMPLEs

o   $1,000 for IRAs

Here are the new limits for high deductible health plans:

·         Health Savings Accounts

o   Individual contribution limits increase from $3,050 to $3,100

o   Family contribution limits increase from $6,150 to $6,250

·         High Deductible Health Plans

o   Minimum out-of-pocket limits remain the same at $1,200 and $2,400 for individuals and families, respectively

o   Maximum out-of-pocket limits increase from $5,950 to $6,050 for individuals and from $11,900 to $12,100 for families

·         Flexible Spending Accounts

o   No federal limits for 2012 but your employer may designate a limit

o   Federal limit of $2,500 beginning in 2013