If you’re starting a new business, you need resources. One way to fund your business might be through a “rollover as business startup,” also known as a ROBS. This arrangement allows would-be business owners to tap into their retirement savings to pay for their new corporation’s startup costs or to buy an existing business. Like other types of small business financing, a ROBS has its own pros, cons, and legal issues for entrepreneurs to consider.
Key Points
• A “rollover as business startup” (ROBS) is a way for prospective small business owners to use their retirement savings to fund the new business tax-free.
• A ROBS rollover is only possible with an existing 401(k), IRA, or other tax-deferred retirement account.
• The business must operate as a C corporation to be eligible for a ROBS.
• Executing a ROBS is a complex transaction; there are many ways to run afoul of tax law.
• Investing your retirement savings in a new business through a ROBS could put your money at risk.
Understanding ROBS (Rollover for Business Startups)
A ROBS can help cover startup costs as an alternative to small business loans. If you’re pondering a ROBS, the first step is to understand how the process works and how it compares to traditional business financing.
How ROBS Works
During a ROBS, money from eligible retirement accounts — such as a 401(k) or a traditional individual retirement account (IRA) — is rolled over and invested in a new business or franchise. Here’s how.
• The entrepreneur sets up a C corporation (a corporation structure that allows shareholders).
• A plan sponsor creates a retirement plan for the new corporation.
• The entrepreneur becomes an employee of the C corporation and also the beneficiary of the new retirement plan.
• The entrepreneur executes a 401(k) rollover of money from their existing retirement accounts into the new retirement plan; the sponsor then uses those funds to purchase stock in the C corporation.
• The entrepreneur can use the proceeds from the sale of the stock to fund the business.
ROBS vs Traditional Business Financing
One of the biggest differences between ROBS and traditional startup business loans is that ROBS does not require a credit check. Many traditional business financing options have minimum credit scores for approval.
Examples of credit-based financing would be business lines of credit (including a business credit card) and targeted business loans like equipment loans.
Recommended: Equipment Financing
The ROBS Process
The ROBS process can be complicated. It involves a series of specific legal and tax arrangements, so you will likely want to hire an accountant and a lawyer to handle the process. They can help keep you from running afoul of IRS requirements and provide detailed tips for starting your new business.
Legal Requirements and Setup Steps
Setting up and completing a ROBS usually follows some established steps. As noted above, it involves forming a C corporation, after which a plan sponsor creates a tax-advantaged retirement plan for that corporation. The entrepreneur is the C corporation’s employee and the new retirement plan’s beneficiary. This allows the tax-free 401(k) rollover of the entrepreneur’s money from their existing accounts into that new plan. The ROBS plan then uses the rolled-over assets to purchase the C corporation’s stock; the proceeds go toward funding the new business.
Potential Tax Implications
With a ROBS, you roll over money directly from your existing retirement account into the new plan’s account, so you typically don’t have to pay taxes on the distributions. And if you follow 401(k) withdrawal rules, you’ll likely escape the 10% penalty for taking your money out before age 59½.
However, a ROBS does call for specific tax filings. The IRS requires the sponsor of the new retirement plan to file a Form 5500, “Annual Return/Report of Employee Benefit Plan,” each year.
Also, at the time of the rollover, the sponsor of the new plan needs to issue you a copy of the 1099-R form, “Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.” You’ll need to report that information on your tax return.
To make sure you’ve covered all your bases, it may be wise to have an accountant or a tax lawyer on your side as you go through the ROBS process.
Pros and Cons of ROBS Financing
ROBS financing, like all financing methods, has its pluses and minuses. Reviewing the benefits and drawbacks will help you decide what’s best for your finances and business.
Benefits for Entrepreneurs
• ROBS is a tax-free way to fund a startup or purchase an existing business without taking on new debt. After all, you’re using your own money.
• There are no credit requirements involved in doing a ROBS. So this method could be an option to consider if you have bad credit.
• A ROBS transaction doesn’t require a loan approval process. As a result, you don’t have to meet strict lender requirements like minimum annual revenue amounts.
Risks and Considerations
• You are risking your retirement money by tying it to the success of your company. According to the IRS, most ROBS businesses either fail or are at risk of failure, with high rates of bankruptcy, liens, and corporate dissolutions.
• There is an opportunity cost to taking your money out of the market. Even if your business succeeds, you will lose the potential gains from a rising stock market, the tax-deferred savings of an IRA or 401(k), and the power of compound interest over time.
• You must set up your business as a C corporation. This could add costs and extra requirements for small businesses. C corporations have to pay taxes on profits, hold annual shareholder meetings, and adopt more extensive record-keeping and operational processes.
Recommended: Small Business Grants: Where to Find Funding
Is ROBS Right for Your Business?
Before undertaking a ROBS, you should consider whether you and your business are well suited for this process.
Ideal Candidates and Situations
If there is an ideal candidate for a ROBS, it’s likely to be someone with:
• A full understanding of a C corporation’s structure and compliance requirements, and
• An amply funded retirement account with money they can afford to put at risk, and
• Enough funds to sustain the administrative expenses of setting up and maintaining the corporation and the new retirement plan
With these issues in mind, some advisers caution that ROBS may be your best option only if you’re unable to qualify for other forms of business funding. A business owner with a poor credit score or short business history might be in this position.
The Takeaway
ROBS can be a tax-free way to fund a business by using your own retirement savings. However, ROBS is not without its risks and costs, most notably that an unsuccessful business could deplete your retirement money. Setting up a ROBS is a complex process, so it’s wise to consider all pros and cons before deciding whether to go the ROBS route.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
How much does it cost to set up a ROBS transaction?
Setting up a ROBS transaction typically involves fees of up to $5,000. There are also ongoing plan administration charges.
What retirement accounts can be used for ROBS?
The retirement accounts that can be used for ROBS include 401(k) plans, traditional IRAs, governmental 457(b) retirement plans, 403(b) retirement plans, Thrift Savings Plans, SIMPLE IRA plans, SEP IRAs, and Keogh plans. Some retirement accounts are not eligible; two examples are tax-exempt 457(b) retirement plans and Roth IRAs.
What are the IRS requirements for a compliant ROBS setup?
For a ROBS to be IRS compliant, you must establish a C corporation with a qualified retirement plan. You will need to file a Form 5500 with the IRS each year. Additional rules may apply to your particular situation, so it’s prudent to check with an accountant or other tax professional.
What happens to my retirement funds if the business fails?
If you execute a ROBS and the startup business later fails, you could lose your retirement funds. It’s important to understand this before undertaking a ROBS.
Can I use ROBS to buy an existing business?
Yes, you can use ROBS to buy an existing business, not just a new business. However, the existing business must be structured as a C corporation.
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