IRA & 401k Franchise Business Financing and Funding-Do's and Don'ts
Labeled as Rollover as Business Startups, or ROBS by the Internal Revenue Service (IRS), the use of retirement funds to finance or fund one’s own franchise business has exploded in popularity, with over 15,000 businesses funded using retirement funds in the last 10 years. To help current and future entrepreneurs keep abreast of the ROBS 401k/PSP regulatory requirements, I have put together the following list of do’s and don’ts guide for anyone considering funding or financing a franchise business using retirement funds (e.g., IRAs and qualified plans such as 401k, 403b, 457, DB, TSP, etc.) either as the sole financing source or in conjunction with other forms of financing (e.g., bank loan, SBA loan, seller financing, etc.).
The Do’s - IRA & 401k Franchise Business Financing and Funding
1) Do familiarize yourself with the use of retirement funds to finance one’s own business by consulting with a retirement funds professional and by reading the following material.
- IRS publications:
Fall of 2010 Retirement News for Employer:
- Additional Resources
The 401k business funding FAQ page at MySolo401k.net
This IRS View: https://www.linkedin.com/pulse/20141105032412-361793377-irs-view-401k-business-financing
2) Do understand the steps involved in the ROBS franchise financing process, which entail the following:
- Register a C-Corporation;
- Draft a 401k/PSP that allows for the use of rollover funds to purchase employer securities (stock shares);
- Setup a brokerage account for the new 401k/PSP;
- Transfer/Rollover the former employer retirement funds (e.g., 401k, PSP, DBP, TSP, 457b, and 401a) or IRAs to the new 401k/PSP brokerage account;
- Establish a bank account for the franchise corporation ;
- Deposit the funds from the 401k/PSP brokerage account into the franchise corporation’s bank account; and
- Fund the business.
3) Do check with your former employer or current employer before starting the Rollover as Business Startup arrangement to ensure the retirement funds can be transferred out.
4) Do offer the new ROBS 401k/PSP to all eligible employees in order to not run afoul with the 401k discrimination rules.
5) Do communicate the plan to eligible employees by providing them with 401k/PSP election forms.
6) Do perform annual testing of the 401k/PSP to ensure nondiscrimination.
7) Do file an annual for the 401k/PSP.
8) Do obtain an if employees other than spouses or business owners participate in the plan.
9) Do appraise the assets of the 401k/PSP including the franchise on an annual basis.
10) Do update the 401k/PSP written documents for any changes in the law.
11) Do take a reasonable salary only once the franchise starts generating .
The Dot's - IRA & 401k Franchise Business Financing and Funding
1) Do not use Roth retirement funds () to finance a business including a franchise as the retirement account regulations do not permit it.
2) Do not transfer Roth IRA funds to 401k/PSP as the do not permit it.
3) Do not start taking a salary from the franchise until it starts generating revenue.
4) Do not use the 401k/PSP funds for your personal use.
5) Do not use the 401k/PSP funds as collateral for a personal loan.
6) Do not use the 401k/PSP assets for personal use.
7) Do no subject the 401k/PSP to prohibited transactions.
8) Do not over contribute to the 401k/PSP.
MISCELLANEOUS QUESTIONS:
QUESTION 1: Salary: Can I be compensated for working in the business funded with my 401k, and how much?
ANSWER: Yes, you can be compensated as a W-2. However, of course, you will legitimately need to be working in the business and then wait to receive a salary until the business is operational an earning income. Your salary should not be unreasonably high (i.e., no more than what the company would have to pay someone else to do all of the things that you do).
QUESTION 2: Valuation for Existing Business: If I use the ROBS 401k structure to fund my existing C-corp business, do I have to value my business?
ANSWER: Yes, since you are funding your existing business, you need a pre-ROBS valuation of the existing business so that you can demonstrate satisfaction of the requirement that the 401k receive an adequate amount of stock for the investment of 401k funds. It is for this reason that the valuation of your business should be completed by a 3rd party valuation provider. While the IRS doesn’t necessarily specify items that must be in the valuation report, they have issued guidance on valuing a closely-held business (e.g., see IRS Revenue Ruling 59-60). Moreover, it is certainly a best practice if the valuation is prepared by a third party who is a business valuation specialist or someone who has relevant training and experience.
What is more, an annual valuation will also be required going forward once the business has been funded with your 401k funds. An annual valuation is needed for all businesses funded via a ROBS 401k Business Financing plan as the value of the stock needs to be reported on the annual filing for the 401k (i.e. Form 5500). Given that the regulatory expectation is that this valuation be performed by a third party provider with relevant experience and expertise, the ROBS 401k provider will generally include the ongoing valuation in their annual fee.
QUESTION 3: Stock Buy-Back: After I rollover my retirement money from my 401k/IRA to fund or start-up a franchise or other business, can I buyout the 401k’s ownership interest in my business?
ANSWER: The funds for the stock buyback need to come from the corporation. You could not purchase the stock back from the company using personal funds. Furthermore, the mechanics of the buyback, the corporation would purchase the stock back from the 401k over one or a series of purchase provided that it would have to do so at fair market value at the time of each buyback. As the value should be supported by a business valuation, it may be most efficient to do so at the end of the year as you will need to obtain a valuation for reporting purposes as of the end of the year (regardless of whether the corporation is buying shares back) and could use the valuation for both purposes. The money would flow from the corporate bank account back to the 401k brokerage account on a tax-deferred basis. (2) the business financing 401k provider would assist with the buyback as part of their annual fee for no additional charge. (3) The corporation would continue to sponsor a 401k but you would no longer own shares via the 401k.
QUESTION 4: Stock Options: can the C-Corp grant stock to employees as part of compensation during and/or after the business financing 401k?
ANSWER: No, you cannot have a stock option plan, because the 401(k) Plan that is invested in the C-Corporation cannot be unfairly diluted. However, once the 401(k) is no longer invested in the business you can decide based on the facts and circumstances of the business if you would like to provide that option to employees.
QUESTION 5: Interact with Spouse's Business: Can my 401k funded business do business with my husband's business?
ANSWER: The C Corporation that is funded with your retirement money cannot interact with another business that is owned by you or your husband. For example, the C Corporation cannot sublease space to your husband’s business, cannot share a marketing budget or joint promotions, etc. – in other words, both businesses must be operated as strictly separate businesses. This does not mean, however, that you are prohibited from working in his business (as long as you do so independently from the C Corporation business) – similar to as if you had a separate job along with working in the C Corporation. Moreover, he may work for the C Corporation as a W-2 employee (as long as he does so independently from his business).
QUESTION 6: Employee 401k Participation Eligibility:Here are a couple questions related to employee eligibility for 401K plan:
- Does the length of service relate to actual employment start date? ANSWER: Actual employment start date
- Is the 1,000 hour per year work requirement based on calendar year or anniversary date? ANSWER: Calendar year
In sum, the use retirement funds to finance a franchise is an allowable transaction provided the retirement account rules are satisfied at all stages. To learn more about how to finance a franchise business using retirement funds visit at Mysolo401k.net or call at 800-489-7571.
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