6 Mistakes to Avoid When Establishing a ROBS

July 20, 2022
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As we continue our series on rollovers as business startups (ROBS), we want to look at some common mistakes you will want to avoid. We’ve covered some pros and cons, the 5 key steps you need to take to establish your ROBS and use your 401(k) funds for business capital, and 10 of the most important facts to understand.

ROBS can be highly scrutinized by the Internal Revenue Service (IRS) and Department of Labor (DOL). You must follow the proper steps and be very careful about how you utilize your funds for qualified business expenses. This is how you minimize the risk of audits, fines, fees and other penalties. Here are some of the major mistakes you will want to avoid when establishing a ROBS:

1. Not Following the Proper Steps

We highly recommend you read our previous article about “5 Steps to Establishing a ROBS.” There are some very important and specific steps you need to take, including making sure your business is a C-corporation and creating a new 401(k) plan that allows you to invest funds into your business as purchased company shares. If you fail to follow the proper steps, you could be facing significant problems with the IRS.

2. Business Owner Compensation

One very common mistake is paying yourself (and/or other owners in the company) too much. As a business owner, you have a fiduciary responsibility to the new retirement account that will be established through the ROBS. If you are paying yourself an excessive amount in salary or benefits with funding from this source, you are risking a lot. It is also important to know that you cannot originate any owner compensation directly from the ROBS funds. The owner’s compensation must be paid from the C-corp’s operating income. Again, it is vital to follow the proper steps and understand the rules about when and how your ROBS can be used toward certain business expenses.

3. Personal Use of ROBS Funds

You cannot use ROBS funds for any personal uses outside of the business. You should also not be benefitting from use of any business-related property. The IRS could place a 15% tax on any transactions or usages of company property involving a disqualified person—including the owner, their spouse or their immediate family.

4. Not a Loophole

Some business owners view ROBS as ways to take money out of their 401(k) accounts without paying income taxes and early withdrawal penalties. These are benefits of a ROBS if the funds are utilized properly. If you are trying to use this plan as a loophole to take money out early and use it for personal expenses or other non-business needs, you will likely find yourself in trouble.

5. No Promoter Fees

ROBS funds cannot be used to pay fees to a “promoter” who is helping raise capital for the business. The money must be used to pay specific and qualified business expenses per IRS rules and regulations. Failing to understand how these funds can be utilized is a recipe for disaster.

6. Lack of Government Compliance

The IRS and the Department of Labor will hold ROBS investments to very strict compliance standards. They will look to make sure the retirement plan was properly established and all expenses are allowable. All employees within the company must also have the ability to invest in the retirement plan. Annual filings like Form 5500 must also be made. Don’t skip over any steps or try to skirt the rules, or you may be facing fines, penalties and other problems with the government.

To make sure you properly establish your ROBS and manage your investment funds legally and to your best benefit, it pays to work with an experienced financial advisor. Contact Illumination Wealth today to schedule an introductory consultation and get started with your rollover as business startup.