Investing Retirement Funds in a Business or Franchise

Growing numbers of small business and franchise entrepreneurs are discovering that their retirement assets can be diversified into investments outside of the stock market. They’re finding that, through …

Growing numbers of small business and franchise entrepreneurs are discovering that their retirement assets can be diversified into investments outside of the stock market. They’re finding that, through a vehicle commonly referred to as Rollover as Business Start-ups (ROBS), they are allowed to legally invest 401(k) money in their own small business without taking a taxable distribution or getting a loan. It’s estimated that in 2010, more than 4,000 individuals will become entrepreneurs by investing their existing retirement assets into a business – and in turn – will create more than 25,000 jobs.

Entrepreneurs who work with expert companies to correctly complete a private investment in their own company often cite this “investment in oneself” as especially attractive since they wholeheartedly believe in their ability to open, operate and successfully lead a business. Another reason this type of transaction is attractive to an entrepreneur is because they can invest in their business without getting a loan. This means that the new business can reinvest the initial cash flow into the business instead of sending it off to a bank in the form of interest payments. It is reasonable to assume that a business that is not servicing high interest loans has a shorter “runway” to reach profitability. Guidant Financial reports that its clients are 63% more likely to succeed than other traditional business owners.

ROBS transactions generally involve four or five steps which, although complex, can potentially be completed in less than three weeks. The process generally includes the following steps:

  1. A new business entity, a C corporation is formed on the client’s behalf
  2. The client then rolls up to 100% of their eligible retirement funds into a newly created 401(k) plan;
  3. This plan, in turn, invests in the stock of the new corporation;
  4. The corporation, now flush with funds and free of debt acquires a small business or franchise.

There are many reasons that an entrepreneur would choose to invest in their own business. Reasons may include, but are not limited to:

  • They believe a small business they own and control is the best investment for their retirement plan.
  • They receive a debt-free equity injection into the enterprise;
  • They can provide their employees (including them) with a 401(k) plan, a benefit rarely seen in American small business today

The legal requirements for establishing and operating 401(k) plans were created under the Employee and Retirement Income Security Act (ERISA), which identifies the guidelines for 401(k) plan investments. These 401(k) plans, also called pension plans, are carefully protected by the IRS and DOL, so all transactions involving them need to ultimately benefit of the plan.

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ROBS transactions are increasing in popularity, especially in a financial climate unfriendly to borrowers. Yet they’re still misunderstood by far too many financial advisors and tax preparers who don’t understand the transaction’s complexities and often make naive mistakes,  inadvertently putting their clients’ retirement plans at risk. Even IRS examiners at times have accidently attempted to apply inapplicable rules.

One such area involves the rules governing Defined Benefit Plans and ESOPs (Employee Stock Ownership Plans.) Because ROBS transactions are usually structured as 401(k) Profit-Sharing Plans, the rules for Defined Benefit Plans and ESOPs do not apply. This is a point often confused because ROBS transactions do involve Defined Contribution Plans. When the ROBS structure is initially created, the plan documents should define how much the employer is contributing annually—not the specific amount of retirement income the plan participants/employees are guaranteed to receive as required in a Defined Benefit Plan.

The other issue at hand is the all-too-frequent confusion between Profit-Sharing Plans and ESOPS. Although both plans involve investing in employer securities, only on rare occasions are ROBS plans structured as ESOPs. One of the unique benefits of an ESOP is the ability to borrow funds from the employer to purchase qualifying employer securities. Consequently, the plan must obtain independent appraisals of these securities. In comparison, a ROBS transaction using a 401(k) profit-sharing plan does not provide this benefit and therefore is not required to meet ESOP-specific rules.

Between ERISA guidelines and Code rules, there are numerous places where even “experts” can get confused. For this reason, it is imperative that an individual engage the services of a company – one that employs and engages true experts – that has experience setting up and maintaining thousands of such arrangements. It is also important that the individual involve a tax professional to evaluate whether this form of small business or franchise investing is right for them. Even my company, Guidant Financial, with over 4,000 clients nationally, arranges for each client to meet two times with an independent, outside tax and ERISA attorney at no additional cost before finalization of the client’s transaction. 

For true entrepreneurs, owning a business by investing in one’s self is nothing short of empowering. By working with experts who understand the many benefits of ROBS transactions and the guidelines governing them, entrepreneurs will continue to create the small businesses that form the backbone of America’s economy.

Any individual, who desires to invest their retirement funds into a business through a rollover, should consult a knowledgeable and experienced attorney who is familiar with the ROBS transaction as Nilssen is not a tax or ERISA attorney and readers should not interpret this article as legal advice. He encourages readers of this article to get legal advice before attempting to utilize the strategies discussed.

About the Author:

David Nilssen is a cofounder of Guidant Financial. Guidant is the nation’s leading provider of rollovers for business start-up transactions. His company has helped more than 5,000 individuals from diverse backgrounds invest their existing retirement assets into a small business or franchise. His company has been included on Inc. Magazine’s list of the fastest growing companies in America three years running and in 2007, Nilssen was recognized by the Small Business Administration as the National Young Entrepreneur of the Year.

You may also be interested in the following articles:
Buying A Small Business Using Retirement Funds: Acquiring A Small Business Using ROBS Can Meet The IRS Prohibited Transaction Exception

Rollovers for Business Start-Ups (ROBS): Investing retirement funds into a franchise without taking a taxable distribution


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