Use Your Retirement to Invest in A Small Business
May 3, 2017
Do you need alternative funding for your business? There are two arrangements that can make it possible:
- Self-directed IRAs
- Rollovers as Business Start-ups (ROBS) (also known as 401(k) business financing)
Both allow for an individual to invest up to 100 percent of their existing retirement assets into a business or franchise – but – under very different circumstances.
Self-directed IRAs are passive investment vehicles. Under Internal Revenue Code 4975 (c)(1)(A-F) — also known as prohibited transactions — it clearly states that an individual (disqualified person) cannot interact with the assets of the plan, meaning they cannot be involved in running the business in which they choose to invest.
Other guidelines related to self-directed IRAs include:
- Taking a Salary: Since self-directed IRA owners aren’t allowed to work for the business they invest in, they’re also not eligible to pay themselves a salary. This would qualify as a prohibited transaction that could void the entire arrangement.
- Unrelated Business Income Tax (UBIT): According to the IRS, a business is subject to the UBIT if 1) it’s a trade or business, 2) it’s regularly carried on, and 3) it’s not substantially related to furthering the exempt purpose of the organization. Self-directed IRAs are potentially subject to UBIT because of the third stipulation. In most cases, the way the business generates income isn’t related to the self-directed IRA pass-through investment.
- Guaranteeing Business Loans: Self-directed IRAs cannot be used to guarantee loans of any type — personal or business-related.
- Amount of personal ownership: Any personal, individual ownership of a business using a self-directed IRA can create a prohibited transaction, depending on the facts and circumstances. The personal, individual ownership of 50 percent or more of a business will trigger a prohibited transaction that voids the arrangement every time.
These regulations make self-directed IRAs ideal for those looking only to invest in a business without any disqualified persons as shareholders, and where they won’t be involved in the business’s operation.
Rollovers as Business Start-ups (ROBS) - A Better Option
For those wanting more control over the business they invest in, a ROBS arrangement can be a much better plan. Using 401(k) business financing, you can use funds from an eligible retirement account to invest into a business or franchise without incurring any taxes or penalties — and you can work for the business. In fact, under ROBS regulations, an individual must be involved in the business as a bona fide employee.
401(k) business funding is made possible through exemptions Congress made to the prohibited transactions rules to encourage investments in small businesses, and they require a different structure than a passive investment through a self-directed IRA.
Here’s how the ROBS structure works:
- A new C corporation is established.
- That corporation sets up a new qualified retirement plan that can invest in private stock — usually a 401(k).
- Funds from an existing, eligible retirement account [401(k), IRA, 403(b), etc.] are rolled into the new retirement plan.
- The new plan invests in stock of the C corporation.
- The corporation then acquires or starts a small business with those funds.
Other rules related to the ROBS arrangement include:
- Taking a Salary: Business owners can pay themselves a salary as compensation for their work – as long as it’s deemed “reasonable.” We suggest waiting to take a salary until the business generates operational revenue. Taking a salary from operational revenue, as opposed to taking the salary from the proceeds of the plan’s purchase of corporate stock, also avoids any suggestion of a prohibited transaction involving the personal use of plan assets for individual benefit.
- Unrelated Business Income Tax: The UBIT doesn’t apply to the ROBS structure because this tax only pertains to business income generated by organizations and entities that are exempt from tax. The C Corporation that owns the ROBS business is not a tax-exempt entity.
- Guaranteeing Business Loans: Funds from ROBS can be used as a down payment on a loan. Many entrepreneurs use other forms of small business financing (i.e. – SBA loans, unsecured credit, etc.) to supplement their ROBS investment, expanding their buying power while preserving personal credit.
- Amount of ownership: With ROBS, an individual can own up to 100 percent of a business.
While self-directed IRAs can be a good option for those who aren’t interested in being directly involved in running a business, a number of rules and regulations apply to this method of financing that can make the transaction difficult.
ROBS arrangements, on the other hand, are explicitly for entrepreneurs who want to invest in a business or franchise they control and for which they can work. Both come with ongoing responsibilities one must consider. Feel free to contact us if you have questions on how these two business funding options can work for you.