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February 26, 2009

R.O.B.S. A Retirement Nest Egg to fund a Start-up? That’s Risky Business!


by Denise Appleby CISP, CRC, CRPS, CRSP, APA –


Sometimes it is challenging for self-employed individuals to obtain loans from lending institutions, and looking to family and friends may be just as difficult if they do not have the resources. As a result, an increasing number of small business owners are looking to their retirement nest egg as a means of financing their small business ventures. While this may seem like a good idea for a cash-strapped entrepreneur, it could result in could do more damage to a retirement nest egg than the worst stock market crash in history.  As such, individuals should be extremely cautious about looking to their retirement nest for funding their business.


How it Works

The objective is accomplished by an individual establishing a C- Corporation business- usually a franchise, and the business then sponsors (adopts) a qualified plan. The qualified plan is then funded by rolling assets from a traditional IRA or an employer sponsored plan such as a SEP IRASIMPLE IRA, 403(b), 457(b), or qualified plan-such as a 401(k) . In the final stage, the qualified plan purchases shares of the business- usually 100% of the Corporate Stock- with the rollover funds. The qualified plan now holds 100% of the corporate stock, and the business owner now has the cash from the plan to fund the business. The withdrawal of funds from the plan is not reported to the IRS, and is not included in the individual’s income. These programs are commonly referred to as ERSOPs- an acronym for Entrepreneur Rollover Stock Purchase. The IRS refers to them as Rollovers as Business Startups (ROBS).

The IRS’ Position

The IRS has indicated that while they believe that a ROBS by itself does not result in noncompliance, they have found significant disqualifying resultant issues that are causes for concern, and as such, each of these transactions must be reviewed on a case-by-case basis in order to determine whether they are in compliance with the tax code. The issues that have been identified by the IRS include the following:

  • The transaction may provide a front for individuals to withdraw the funds from their retirement accounts, without the amounts being reported to the IRS. As such, taxes would not be paid on amounts that would otherwise be taxable.

  • In some cases, the funds are used for non-business purposes. In other cases where the funds are used for financing the business  but unfortunately the business subsequently fails, the end result is  that the funds are not available to be returned to the qualified plan.

  • There may be some question as to whether the transaction represents an equitable sale, as the value of the capital stocks may be substantially lower than the amount for which they are sold to the plan, and could possibly result in a prohibited transaction. According to the IRS, the valuation done for the capital stocks “…is often devoid of supportive analysis”, and they find that “…this may create a prohibited transaction, depending on true enterprise value”.

  • Many of the plans are required to file Form 5500-Series returns, but fail to do so. This could result in some qualification issues, as well as the potential for penalties  being assessed for failure to file the Form 5500 returns.

  • The plan may fail to satisfy the non-discrimination rules for several reasons.  One example is the non-availability of the option to purchase employer stocks, to other employees. Typically, after the  qualified plan is adopted by the business, it (the qualified plan) is amended to allow the ROBS, and after the ROBS is completed the plan is amended to remove the provision. This, in effect, makes the feature available only to the owner of the business who is often the only employee at the time of the transaction, and not rank and file employees who may be hired afterwards. Under qualified plan rules, amendments that appear to be timed so that non-highly compensated employees (NHCE) do not benefit from a plan provision could result in noncompliance.

There are others issues that create cause for concern. For instance, the fact that contributions to the profit sharing plan may be discretionary does not absolve the employer from making contributions indefinitely, while the plan is maintained.  Instead, an employer is required to make contributions to its profit sharing plan on a consistent and recurring basis. Therefore, although contributions are discretionary, an employer who establishes the plan, funds it once – in this case to facilitate the ROBS- and never make a contribution  again, runs the risk of the plan being disqualified.


The business owner is not the only involved party that needs to be concerned.  The IRS indicated that the individual who brokered the transaction could be a fiduciary if certain conditions  exist. The broker’s fiduciary status would result in the receipt of fees for brokering the transaction being a prohibited transaction, and as a consequence the broker would be subject to the prohibited transaction fees.

You say ERSOP- the IRS Says ROBS- Should You Call the Whole Thing Off?

While the use of ROBS can provided much needed start-up funds to new small business owners, the transaction puts the retirement funds at risk. As such, small business owners considering any such transactions should contemplate the following before taking steps to engage in ROBS’:

  • If the business fails, the retirement nest egg used to fund the start-up would be lost.

  • If the ROBS is determined to be a prohibited transaction, the individual will owe the IRS a penalty of 15% of the amount invested. This is increased to 100% if the prohibited transaction is not corrected by a certain deadline. Click here for a definition of a prohibited transaction

  • The fees for evaluating the transaction, valuing the business, and the annual administrative fees can add up to significant amounts.

Unless the transaction is vetted by the IRS or an ERISA expert such as an ERISA attorney, it may not be worth the risk.

Consider a Qualified Plan Loan Instead

An alternative option is to take a loan from the qualified plan. Of course, the loan is limited to the lesser of 50% of the individual’s vested account balance or $50,000. In some instances, $50,000 may not be enough to fully finance the start-up, but it could be a good start. If a loan option is chosen, the loan must satisfy regulatory requirements, and the plan must still satisfy plan document, operational, demographic, and employer eligibility requirements as long as it is in existence.

Still Want to Risk IT?

If the individuals still wants to engage in a ROBS, the services of an experienced and qualified plan administrator and an ERISA attorney should be engaged. The ERISA attorney should review the proposed transaction in order to determine if would result in a prohibited transaction or cause any reason for disqualification of the plan. The plan administrator should review the plan often- at least annually- to ensure compliance with the requirements of the plan document, as well as operational, demographic and employee eligibility requirements.

Work with qualified professionals

It can be difficult for an enterprising entrepreneur to accept that due to the lack of adequate financial resources a dream cannot be realized. For an individual facing such a situation, using their retirement nest egg may not seem like a bad idea. However, before deciding to use a ROBS to fund the business start up, careful consideration must be given to the idea.  If ultimately the decision is made to use a ROBS as a solution, not only should the legitimacy of the transaction be explored, but the feasibility and profitability of the prospective business should be considered as well. Consulting with parties that advise on and specialize in compliance issues related to the plan operation is a good  place to start.


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