Tax Implications of ROBS
Some business owners look at a rollover as business startup (ROBS) as a clever way to generate capital for their business while avoiding income tax liabilities on their 401(k) funds they are withdrawing. As with any major financial move, it’s not that simple. This is not a tax-avoidance scheme. In fact, a ROBS can cause serious IRS problems for you and your business if you fail to follow the correct procedures in setting it up.
Let’s take a deeper look at the tax implications of a ROBS, along with some of the key information you need to know before setting up a rollover as business startup.
Tax-Free Fund Withdrawal
It is true that a ROBS allows you to take funds out of your personal 401(k) account to pay for qualified business expenses. You are technically not withdrawing the money, though. You are transferring it to a new retirement plan and then investing it directly into your business. You will first need to establish a new retirement plan for your C-corporation and the funds can then be transferred there tax-free. Then, those new 401(k) funds can be used to purchase shares of stock in the company. That money can then be invested in qualified business expenses.
Obviously, there are several key steps you need to take to get the money from your personal 401(k) account to your business. These funds can ultimately be moved without paying taxes or early withdrawal penalties if you are under the age of 59 1/2. However, these funds are going into your business and you will be subject to business taxes on any revenue they help you generate. To say it’s truly a “tax-free” solution would be misleading. You are investing in yourself as a business owner. The good news is if you are making enough money through your business to pay taxes, then that’s a step in the right direction.
IRS and DOL Compliance
Both the Internal Revenue Service and Department of Labor will have specific compliance standards you must meet when establishing a ROBS. Failure to meet these regulations could lead to fines, tax penalties and audits. Here are a few compliance standards to follow:
- The new retirement plan established must comply with IRS regulations.
- The fees and costs are reviewed by fiduciaries and must be appropriate and paid in a timely fashion to third-party vendors.
- All required annual files must be filed, including Form 5500.
- Eligible employees are offered participation in the retirement plan.
- All eligible employees are given the same ability to invest in the plan and buy shares of stock—the same as the business owner.
Risk of Tax Audit
Tax audits are rare, but establishing a ROBS will certainly put you on the IRS’s radar. Your business, retirement plan and use of ROBS funds will be under more scrutiny. If you fail to follow the proper steps to set up the accounts and share purchases, an audit could be concern. The same is true if you are using your funds for inappropriate personal expenses or other non-qualified business expenses. You will want to tread lightly and follow each step properly. You will want to make sure you are spending any money on the right things and catalog all spending accurately. If you do everything correctly, you shouldn’t be facing an audit. At the very least, you will have all the necessary proof and documentation to provide if you are audited. This can help you avoid any costly tax penalties or fines.
These are just a few tax implications to understand when considering a rollover as business startup (ROBS) for your business. The best recommendation is to work with an experienced financial advisor who can guide you through each step of the process and keep you on the right track. Contact Illumination Wealth today if you have questions about ROBS or want to get started with establishing one.
Also, be sure to check out our recent articles in this ROBS series for a full overview of everything you need to know about this business financing strategy:
Rollovers as Business Startups (ROBS)—Advantages & Disadvantages