ROBS Explained for Small Businesses

When you need cash to start a business, it may be tempting to take advantage of a “rollover as business startup plan,” or ROBS, especially if much of your savings is tied up in retirement accounts. ROBS allows retirement account holders to invest those funds free of taxes or early withdrawal penalties into their new business venture.

If you can’t — or don’t want to — borrow money or bring on investors for your startup, this may seem like an appealing financing solution. But there are risks, too. We’ll help you better understand the pros, cons and details of setting up a ROBS plan.

What is a ROBS?

Let’s start with what it isn’t: a ROBS isn’t a withdrawal from your retirement account or a loan against it. (We’ll talk more about those options later.) Instead, funds are rolled into a new retirement account which buys shares into your corporation — in essence, that new plan becomes the owner of your business.

So in order to make use of a ROBS plan, you first need an incorporated business. Corporations – specifically C corporations – are the sole businesses eligible to participate in ROBS because they have the ability to sell stock.

Once your C corp has set up  a qualified retirement plan, you would roll over your existing retirement funds. The ROBS plan then allows the new retirement account to buy shares in your corporation, freeing up money your business needs to operate. In other words, the proceeds from the sale of stock could be used as working capital.

We’ll walk you through the steps a bit later in this story.

In this guide:

  • What can a ROBS plan be used for?
  • Pros and cons
  • Setting up a ROBS plan
  • Ongoing requirements for ROBS
  • Alternatives
  • The bottom line

What can a ROBS plan be used for?

Although it’s called a “rollover as business startup plan,” ROBS isn’t just for new businesses. Entrepreneurs can use a ROBS to open a new business or purchase an existing business, including franchise locations. Any type of business is fair game, with the exception of lending or factoring companies.

This doesn’t mean it’s necessarily easy to set up a ROBS plan — it’s likely your business will receive increased scrutiny from the IRS, which calls the plans questionable. “When a plan sponsor administers a plan in a way that results in prohibited discrimination or engages in prohibited transactions, it can result in plan disqualification and adverse tax consequences to the plan’s sponsor and its participants.”

Here are some other things to keep in mind when considering a ROBS plan:

Pros and cons of a ROBS

Pros

  • Interest-free funding. Traditional financing like a business loan would come with interest, which could be high depending on your credit profile. A ROBS plan gives you access to money that doesn’t come with any interest. Your credit history wouldn’t be a factor either.
  • Cash flow goes back into the business. Rather than worrying about making loan payments, you can put all profits toward growing the business.
  • Full control of your retirement funds. Instead of relying on a fluctuating stock market or other types of investments, you’re investing in yourself. You’re betting on a higher return from your own business.
  • Avoids tax penalties. A ROBS plan allows access to retirement funds without tax penalties. If you wanted to withdraw your retirement funds instead of rolling them over, the IRS would immediately tax the money, leaving less at your disposal. Withdrawing money from a retirement fund before you are 59½ years old could result in a 10% penalty in addition to the income tax you’d have to pay on the withdrawal.

Cons

  • High level of risk. Because you’ve invested all of your retirement savings in your business, you could lose all your funds if the business fails, savings that might be difficult, if not impossible, to regain by the time you hope to retire.
  • Potential cost. You may need to work with a company that can set up and administer the ROBS arrangement. Those companies can charge hefty fees. Forming and maintaining a corporation can also be costly, depending on the state in which you operate.
  • Annual requirements. The IRS requires annual filings for a qualified retirement plan like a 401(k). You would need to file the proper forms each year to make sure your retirement fund, which owns your business, remains compliant. If not, the IRS could disqualify your ROBS plan.

Setting up a ROBS plan

A ROBS arrangement has several components that require your effort. Here are some basic steps to take to set up your ROBS plan.

1. Set up a corporation.

You first need to establish your new business as a C corporation. As the business owner, you would need to file articles of incorporation with your state’s secretary of state office. C corps operate independently of owners and can raise funds through the sale of stock. Because you would be buying stock with your retirement funds, your business would have to be a C corp to pursue a ROBS plan.

2. Establish a qualifying retirement account.

Your newly formed C corp needs to provide a retirement plan where you can invest your existing retirement funds. The retirement plan you choose must be a qualifying retirement account as defined by the IRS. The available plans include 401(k), 403(b), 457(b), Keogh Plan, Simplified Employee Pension, Thrift Savings Plan and Traditional Individual Retirement Account (IRA). A Roth IRA would not be acceptable in a ROBS plan.

3. Roll over existing funds.

Once the qualifying retirement account is set up in your corporation’s name, you can deposit funds from your previous retirement account.

You may want to hire a third-party provider to help with the ROBS transaction. Several business financing companies offer assistance to new business owners setting up a ROBS plan. Although a ROBS provider could ensure you take the right steps, the service would be an additional cost.

4. Buy stock in your new company.

The funds in the retirement account would be used to buy stock in the business, which would provide working capital for you to spend.

5. Use money to cover business expenses.

The corporation would receive funds from the sale of stock when the transaction is complete. You can use the money to start your operation and cover costs such as equipment, leasing space, franchise expenses or hiring employees.

Ongoing requirements for ROBS

After setting up a ROBS plan to fund your business, you must keep up with ongoing maintenance. There are several requirements you have to meet on an annual basis to keep your ROBS arrangement and your corporation compliant.

IRS Form 5500

Retirement plans must annually file Form 5500 with the IRS. The form states the current value of your plan’s assets, including the stock shares you originally purchased.

Taxes

Corporations typically owe the IRS estimated or annual income tax, employment tax and excise tax, depending on your industry. Corporations with $10 million or more in assets usually file at least 250 returns each year. More than 40 states also levy a corporate income tax, adding to your annual requirements.

Annual report

Each year, corporations must file an annual report that includes information about the business such as name, address, type of business and several officers such as the CEO. There may be a filing fee associated with the annual report.

Corporate minutes

Meetings within a corporation are often regulated. When business owners, managers, partners or shareholders have meetings, recorded minutes must be filed later to document the events of the meeting. A certain person within the organization is usually assigned to keep track of physical and digital copies of minutes.

Alternatives to a ROBS plan

Although a ROBS plan would keep you out of debt, there are other ways to fund a startup that wouldn’t put a large chunk of your retirement savings on the line. You could consider the following options. These are just a few ideas — you might get more ideas for startup loans here. And if you’re considering a ROBS plan because you want to use your own savings, not outside money, here are some other ways to bootstrap your startup.

Many retirement plans offer participant loans. You could borrow 50% of your vested amount or $50,000, whichever is less. Plans generally require full repayment within five years, including interest. If you don’t pay back the loan, your remaining balance would be subject to the IRS’ 10% early distribution penalty. You may be required to meet additional criteria, such as obtaining a spouse’s approval, depending on your type of retirement plan.

Although it may not provide enough money for large expenses like a new building or equipment, a business line of credit could help with other startup needs such as inventory. An advantage to a line of credit is that you only draw from it when you need it, but lenders may look for relatively high credit scores and revenue requirements plus a year or more in business.

A form of collateral helps reduce the risk for lenders that originate secured business loans. These loans typically have lower interest rates than unsecured business loans but may take longer to get approved. Plus, if a business defaults on a secured business loan, it puts professional assets — and perhaps the owner’s personal assets — at risk.

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The bottom line

One of the biggest obstacles business owners face when starting a new venture is finding financing to support the operation. Business owners who have been putting money away toward retirement could tap into those savings to fund their startup.

A ROBS plan would grant you early access to your retirement fund so you could pay for a new or existing business. You could withdraw money from an existing retirement account without facing penalties from the IRS and reinvest that money in your business.

To take advantage of the ROBS option, you would need to set up your business a C corp. This would allow you to purchase stock in your company with your retirement funds, then use the profit from the sale of stock as working capital.

A ROBS plan may sound like a way for you to efficiently use your retirement money, but it comes with a risk. If the business fails, you could lose your nest egg.

An owner of C corporation with ample retirement savings would be best suited for a ROBS plan. Before moving forward in the process, consider consulting a financial adviser or consultant who could help you make the right decision each step of the way.