Investing Your IRA/401k In Your Own Business?

From Bob Jennings at TaxSpeaker. Check out more at taxspeaker.com

Over the years I have strongly urged our class attendees to run, not walk away from clients investing their IRA or 401k in a new business or franchise. Why? Although some of these investments are legal, many fail basic formation tests, and most fail IRS continuing compliance tests during business operation.

What happens if the investment is not legal or does not comply with the formation or compliance rules? Simply put, the entire amount of the account is disqualified as a retirement account and the entire retirement account is treated as a fully taxable distribution which may even be subject to the additional 10% early withdrawal penalty.

The IRS even has a name for this, ROBS (Rollover business startup), which some promoters use in their marketing-that should scare away anyone with common sense! The IRS initiated a ROBS examination program in 2009. Results from the ROBS Project indicated that, although there were some success stories, most ROBS businesses either failed or were on the road to failure with high rates of bankruptcy (business and personal), liens (business and personal), and corporate dissolutions by individual Secretaries of State. Some of the individuals who started ROBS plans lost not only the retirement assets they accumulated over many years, but also their business. Much of the retirement savings invested in their unsuccessful ROBS plan was depleted or ‘lost,’ in many cases even before they had begun to offer their product or service to the public. In some cases, large recurring promoter fees or legal issues were a factor.

Here is how a common ROBS promoter advises clients.

Compliance issues are numerous. Here are many of the issues determined both within and outside of the IRS examinations:

• Failure to recognize that an IRA may not own stock in an S corporation.

• Incorrect determination of a new company’s stock value when the company has no assets, history or goodwill, thus disqualifying the price paid for ownership.

• Incorrectly relying on an IRS determination letter to the plan sponsor. These letters do not give plan sponsors protection from incorrectly applying the plan’s terms or from operating the plan in a discriminatory manner. When a plan sponsor administers a plan in a way that results in prohibited discrimination or engages in prohibited transactions, the plan can be disqualified and DOL also becomes involved.

• Failing to file annual mandatory Form 5500 or 5500EZ. The annual filing exemption only applies to 1 individual owner plans with <$250,000 in the plan. Because in most ROBS setups, the plan does not meet this exemption because the plan, rather than the individual, owns the company stock, thus disqualifying the annual 5500 filing exemption.

• Failing to provide participant reports.

• Amending the plan after formation to prohibit other employees from participating, thus making the plan discriminatory.

• Self-dealing is very common and immediately disqualifies the retirement account.

Examples of prohibited activities:

In an IRA/SEP-IRA, Simple-IRA. Roth:

• Working for or in an asset owned by the IRA-this would include “flipping houses”  after the IRA purchases the home and the IRA owner does the repairs

• Drawing a salary from the new business owned by an IRA

• Renting to or from the IRA

• Selling to or buying from an IRA

• Co-signing or guaranteeing a loan issued to an IRA

• Paying a promoter fee out of an IRA

• Lending money to or borrowing money from the IRA by the owner

• Doing any of the above activities with a family member or related party

• Determining the “appraised value” of a new entity with no assets, history, goodwill or activity, at an amount equal to the amount rolled in

• Any of a multitude of other self-dealing activities

In a 401-k: 

• Failure to file annual Forms 5500 or 5500EZ

• Buying from, selling to, leasing from or to, and lending from or to the plan

• Co-signing or guaranteeing a loan for the plan

• Failing to comply with anti-discrimination rules, particularly with plan amendments and reporting and employee participation

• Failing to notify employees of the existence of a plan

• Any number of other potential violations exist

Summary

Utilizing a retirement account to start a new business is risky financially and just as risky at the IRS level. Frankly, in today’s world of high demand for the services of the professional, as practice management advice we continue to strongly recommend against dealing with the multitude of problems and extreme high risk of liability in dealing with clients that choose to follow the questionable tax advice of a 3rd party that does not even sign the return. Think about this big picture: the tax professional is the liable party signing the return on a questionable position advised by someone else. That is not a recipe for business success for a growing tax business!