Entrepreneurs often ask me questions about startup funding — how and where they go about finding all the money they need to launch their ventures. These questions always lead to a conversation about friends-and-family, angel investors, seed funding firms (or “incubators”), venture capital firms, commercial banks, the SBA, and other government grants and funds.
During the Great Recession, however, many of these sources dried up or disappeared entirely because home equity plummeted, average credit scores dropped, unemployment rose, and access to credit tightened dramatically. The “usual” ways that people funded their dreams simply weren’t available anymore. Entrepreneurs were forced to get creative.
Enter the “Rollover as Business Startup,” or ROBS, as an alternative funding source. Basically, an entrepreneur rolls over funds from a traditional 401(k) or IRA into a new ROBS retirement plan. The new ROBS plan then invests the retirement funds in the new venture.
Not surprisingly, ROBS have become more popular in the past several years given the state of the economy. An article in today’s New York Times addressed the ROBS phenomenon and explained how three different entrepreneurs used ROBS and successfully converted their 401(k) retirement funds into cash for their new businesses.
But I don’t often recommend ROBS. While the concept sounds seductively simple, the fact is that creating a compliant, legal ROBS plan is very complicated. It requires navigating a thicket of IRS and Department of Labor regulations. Annual compliance can be costly, both in terms of time and money invested. Mistakes can lead to fines, fees, or the disqualification of the plan (and, thus, a huge tax bill). On top of all this, you are putting your retirement security at great risk. It is the rare entrepreneur for whom the benefits of a ROBS outweigh its costs and risks, in my opinion.
The IRS issued a lengthy memorandum in October 2008 announcing “guidelines” for using ROBS to fund startup businesses. In this memorandum, the IRS acknowledges that while some ROBS may “serve legitimate tax and business planning needs,” others are of “questionable” legality because they “serve solely to enable one individual’s exchange of tax-deferred assets for currently available funds” and thus, to illegally avoid the income and other taxes that would ordinarily be assessed on that exchange. This memorandum makes it very clear: the IRS believes that many ROBS plans “do not operationally comply with established law and guidance.”
This past February 2013, the IRS published its ROBS Project Summary. The goal of the IRS’ ROBS Project was (1) to determine the extent of ROBS plan usage, (2) to determine the extent to which ROBS plans in use were compliant (or not) with federal tax, ERISA, and other laws, and (3) to design “compliance strategies” based on these findings. The published summary confirmed that many ROBS plans were not filing the proper forms and that many of the companies that used ROBS funding had gone out of business in the first three years.
Bottom line — creating a ROBS plan may be technically legal, but it is fraught with dangerous pitfalls. If you are seriously contemplating using your retirement savings to start a new business, I urge you to get competent legal and accounting advisors to assist you.