Rollover as Business Startup (ROBS)
Tens of thousands of small business owners have used their retirement funds to finance their business without paying taxes or penalties. The IRS refers to this strategy as a rollover as business startup (ROBS) transaction. The transaction entails using 401k funds to purchase stock issued by the company that operates the business. Since the funds are not withdrawn from the 401k, the transaction does not trigger taxes and penalties.
While the IRS has consistently acknowledged that a ROBS transaction is legitimate it has also highlighted compliance violations that it has found with respect to ROBS transactions. One compliance concern is whether the ROBS transaction violates the Exclusive Benefit Rule which requires that all plan assets are used for the exclusive benefit of employees and their beneficiaries. It is possible that a violation of this rule could be found if the business owner receives salary or other compensation for the services he or she performs for the business that is unreasonably high. As such, it is prudent for the business owner to understand the factors that may be employed in evaluating the reasonableness of such compensation.
Evaluating the reasonableness of the business owner’s compensation is not a “black and white” exercise (e.g., the IRS does not maintain a schedule of reasonable salaries). Instead, the evaluation is based on the specific facts and circumstances in consideration of several factors. In a 2013 case the Tax Court considered the following factors in evaluating the reasonableness of compensation paid to the sole shareholder of a C-corporation in his role as president:
1. Employee’s Role in the Company - Relevant considerations include:
3. Character and Condition of the Company - Relevant considerations include the company’s:
5. Internal Consistency – This factor considers whether there is an internal inconsistency in a company’s treatment of payments to employees that may indicate that the payments go beyond reasonable compensation.
6. The Independent Investor Test: This factor considers whether an independent investor would approve of owner’s compensation package that depleted the business’s assets without appropriately paying the investor.
Takeaways:
While the IRS has consistently acknowledged that a ROBS transaction is legitimate it has also highlighted compliance violations that it has found with respect to ROBS transactions. One compliance concern is whether the ROBS transaction violates the Exclusive Benefit Rule which requires that all plan assets are used for the exclusive benefit of employees and their beneficiaries. It is possible that a violation of this rule could be found if the business owner receives salary or other compensation for the services he or she performs for the business that is unreasonably high. As such, it is prudent for the business owner to understand the factors that may be employed in evaluating the reasonableness of such compensation.
Evaluating the reasonableness of the business owner’s compensation is not a “black and white” exercise (e.g., the IRS does not maintain a schedule of reasonable salaries). Instead, the evaluation is based on the specific facts and circumstances in consideration of several factors. In a 2013 case the Tax Court considered the following factors in evaluating the reasonableness of compensation paid to the sole shareholder of a C-corporation in his role as president:
1. Employee’s Role in the Company - Relevant considerations include:
- The position held by the employee;
- Hours worked;
- Duties performed; and
- General importance of the employee to the success of the company.
3. Character and Condition of the Company - Relevant considerations include the company’s:
- Size;
- Complexity;
- Net income; and
- General economic condition.
5. Internal Consistency – This factor considers whether there is an internal inconsistency in a company’s treatment of payments to employees that may indicate that the payments go beyond reasonable compensation.
6. The Independent Investor Test: This factor considers whether an independent investor would approve of owner’s compensation package that depleted the business’s assets without appropriately paying the investor.
Takeaways:
- A business owner who finances his business via a ROBS transaction should not receive salary or other employee compensation that is unreasonably high.
- Evaluating the reasonableness of a salary is not a “black & white” exercise but rather requires considering the relevant facts and circumstances in light of several factors.
- For any entrepreneur looking to finance his or her business with 401k, IRA or other retirement funds, it is imperative to work with professionals that specialize in rollover as business startup (ROBS) transactions.
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