Rollovers as Business Start-Ups (ROBS): Thinking about the Risks and Rewards

Few old saws have survived the test of time better than “things that appear to be too good to be true usually are.” And that’s the usually reliable …

Few old saws have survived the test of time better than “things that appear to be too good to be true usually are.” And that’s the usually reliable adage that the Internal Revenue Service applies to Rollovers as Business Start-Ups (ROBS). In fact, the best thing that the IRS has ever publicly said about ROBS is that they are not “per se” non-compliant. That’s faint comfort for the faint-hearted, but tax professionals say that the IRS has recognized that a properly structured and administered ROBS plan can serve legitimate tax and business planning purposes.

And that’s apparently enough consolation to continue a surge in demand for ROBS plans. Prospective business owners still have limited funding alternatives as the credit squeeze on small businesses shows few signs of abating. And that’s a boon to some ROBS providers.
What is a ROBS?
ROBS plans are a means by which prospective business owners use their existing retirement savings to pay for a business start-up or the acquisition of a new business, all without paying any otherwise applicable distribution taxes or penalties. In a 2011 article in BNA’s Daily Tax Report, Brian McManus and Mark Matthews, two tax attorneys with Morgan, Lewis & Bockius LLP, describe the typical ROBS plan structure as including the following sequential steps:
  • The prospective business owner forms a new corporation,
  • The new corporation adopts a prototype 401(k) plan that specifically allows plan participants to direct the investment of their plan accounts into a selection of investment options, including the stock of the new corporation,
  • The prospective business owner then elects to participate in the 401(k) plan and, as permitted by the plan, directs a rollover or trustee-to-trustee transfer of retirement funds from another qualified retirement plan into the newly established corporate plan,  
  • The prospective business owner then directs the investment of the 401(k) plan account to purchase the newly issued stock of the new corporation, and
  • The company uses the proceeds from the sale of the stock to invest in the start-up or acquire an existing business.
An additional step in the structure is to secure an IRS Determination Letter (DL), which will say only that the ROBS plan currently meets Internal Revenue Code requirements.
Some ROBS plan promoters will say the DL amounts to the IRS’s imprimatur; the IRS says it simply means you haven’t done anything wrong yet. That’s because the DL is much like a drivers license. If you drive improperly, you can lose your license or worse. The DL says you’re ready to put the key in the ignition, but everything you do after your car is in gear must comply with the traffic laws. And it’s pretty easy to run a red light or get into a wreck with your ROBS plan. All the more reason to ensure that plan is done right by a qualified service provider.
“Too good to be true” implies a free ride or at least an outsized return. But ROBS plans typically have both upfront and on-going costs. And to be cost-effective you need to make a fairly substantial rollover investment. On-going costs include plan administration, tax filings and yearly business valuations, all of which add up and must be done correctly to prevent the “ticket” that’s paid in distribution taxes and penalties.
ROBS to Riches?
Apparently a lot of people think so. In a recent article in the New York Times about Using Your 401(K) to Buy a Small Business, Barbara Taylor reported that, according to its co-founder and CEO David Nilssen, Guidant Financial, the industry leader in self-directed IRAs and innovative small business financing, saw significant growth in its business since the credit markets collapsed in 2008 and early 2009 as well as a 196% increase in inquiries between 2009 and 2011. Moreover, Messrs. McManus and Matthews report that “industry experts estimate that since 2005 more than 10,000 start-up businesses have been capitalized through rollover arrangements.” In addition, DRDA, PLLC, a CPA firm focused on small and middle market businesses, hasn’t seen such an appreciable uptick in its self-directed 401(K) BORSATM (Business Owners Retirement Savings Account) plan, but they see many deals transacted without bank financing.
Many prospective franchisees and business owners appear to be thumbing their noses at banks and leveraging their own retirement capital. And they do so contrary to conventional wisdom and in the face of warnings from the IRS as well as many financial advisors.
The bookend to the “too good to be true” admonition is not to “put all of your eggs in one basket.” The IRS Employee Plans Compliance Unit (EPCU) recently completed its ROBS compliance project and found that “while some of the ROBS were successful, many of the companies in [its study] sample had gone out of business within 3 years of operation.” In an earlier publication, the IRS went a little further saying that “most” ROBS businesses from their sample “failed or were on the road to failure.”
So, why in the world would anyone want to take such a risk? The short answer is that with the credit markets for new small businesses still thawing, prospective business owners may have no funding alternative for their start-up business dreams.  American Banker recently reported in “Small Businesses Absent from Commercial Lending Surge” that “many banks … remain reluctant to lend to all but the most creditworthy firms.” And there’s not much relief in sight, although Franchise Times, citing the International Franchise Association and BoeFly, reported in its September 2012 issue that “lending to franchisees increased 4.58 percent, year over year, in June.” Unclear is how much of that four and a half percent is comprised of large, multi-unit operators.
A more complicated answer may be that conventional wisdom about investing your retirement funds didn’t fare too well during the credit crisis. Many people, including me, obligingly listened to our paid advisors and shored up the risk profile in our 401(k)s with “safe” investments like Fannie Mae and Freddie Mac bonds.  So it may be that many prospective business owners find greater appeal in taking a risk with their retirement funds in their own business rather than in someone else’s.
Where does that leave us? Like any type of business financing, ROBS plans are not without risk and the gravity of that risk is underscored by the IRS’s cautious view of them. Note: I made a couple of inquiries to the EPCU about ROBS failure rates but was told that they “can’t release statistical information for [their ROBS] project.” So, we can’t even reconcile their statements that “many” or “most” ROBS plans fail.
On the other hand, any business venture is defined by risk, particularly a start-up or newly acquired business. And whether they tap their savings or retirement funds or sign a personal guarantee for an SBA loan that puts their home equity on the table, prospective business owners must accept that an investment in a new business is inherently risky.
Whether you decide to finance a new business start-up or acquisition with a ROBS plan or another form of alternative financing, go with a provider that has plenty of expertise, experience and infrastructure. You really don’t want to bargain shop with the stakes so high. Guidant’s Nilssen adds that, “For most new business owners, regardless of the type of financing being used, their business represents the most significant investment they’ll make in their lifetime. That makes it worthwhile to invest in a good team of advisors to help find, buy and navigate the early stages of a business.”
 Mike Sheehan is a franchise consultant and attorney. He is the president of Focus Ventures ( and formerly served as a securities attorney and as general counsel for a Fortune 100 financial services company. His Franchise Focus Blog ( focuses on helpful information, tips and current news for prospective franchisees.
This article should not be construed as legal or tax advice or a legal or tax opinion on any specific facts or circumstances. The contents are intended for general information purposes only and you are urged to consult your own legal, financial and tax experts concerning your own situation and any specific questions you may have.
© 2012 Mike Sheehan. All rights reserved.

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