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IRS Takes on Retirement Plan Investment Strategy

by Douglas Lineberry on March 25, 2009

The IRS released a memorandum in Oct 2008 discussing a particular retirement plan investment strategy whereby retirement plan assets (usually 401(k) assets) are invested in stock of a start up company. The idea behind the strategy is to use your retirement assets to capitalize a start-up business without having to cash out the retirement plan (and pay taxes and early distribution penalties). The memorandum raises significant concerns with the strategy and makes clear the IRS’s position that implementing the strategy could be very problematic for the taxpayer.

Upon reviewing the memorandum, I didn’t get past the first page before it was clear that the IRS was going to express a very dim view on the strategy. They describe the arrangement as Rollovers as Business Startups, or “ROBS”. You don’t have to know the IRS well to know that if they are describing your transaction as ROBS, the result is probably not going to be good.

The basic operation of this strategy is the formation of a new business entity (usually a corporation) and the immediate formation of a qualified retirement plan. The client then directs a rollover transfer of his or her existing retirement plan assets (most often a 401(k) plan or something similar from a prior employer) into the new plan. The new plan contains a provision allowing the plan to invest in the employer company’s securities (that is, the stock of the newly formed corporation). Voila, the plan purchases the stock and the company gets the money, and then the client uses the money to pursue his or her new business opportunity. (The IRS points out that this strategy is often marketed as a way to obtain use of retirement funds to purchase a franchise.)

Using retirement account assets as business start-up capital is risky! You may be engaging in a prohibited transaction!

The IRS describes two primary issues raised by the strategy. First, the transaction often only benefits the principal setting up the business. Typically after the corporate stock is acquired by the plan, the plan document is then amended to bar further investments in employer stock. In this regard, the strategy may violate ERISA non-discrimination requirements. Second, the plan usually acquires the stock for all of the available assets in the plan. That is, the value of the stock is set at the amount of plan assets. If an appraisal is prepared at all, it is often a flimsy single page statement with no real substantiation of the value of the stock. Absent a legitimate valuation and acquisition of stock for an appropriate price (based on the valuation), the principal has likely engaged in a prohibited transaction.

Another prohibited transaction may exist where the promoter’s fees are paid by the corporation (out of what were previously plan assets).

The IRS memorandum raises several other issues and problems that may exist with the “ROBS” transaction. Based on the release of the memorandum at least one of the larger companies that promote this strategy have stopped offering it, but others appear to take the memorandum as guidance as to how they should be implementing the strategy, not that there are significant issues that they should probably stop implementing the strategy.

The bottom line is that this strategy is very risky in light of the IRS guidance set forth in the memorandum. If you were considering it you should consult with independent legal counsel that is experienced in retirement plans, and if you have implemented the strategy you should probably do the same and determine whether you need to take remedial measures.

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