EXECUTIVE COMPENSATION
Appeals Court Deals Rollovers as
Business Start-Ups (ROBS) a Blow as a
Business Financing Strategy
by Paul J. Schneider, JD, LLM
Factual Setting
One of the traits that most up-and-coming executives have in common is that they have been employed
by several employers. In order to move up the corporate ladder they have changed jobs as part of their career development. As a consequence, these executives
receive distributions of their account balances in their
former employers 401(k) plans which they transfer to
a rollover IRA. Over time these executives can accrue
substantial balances in one or more rollover IRAs.
The proper investment of their IRA balances becomes
a major issue for these executives.
During the last 15 years or so one answer to this
investment problem that has been suggested by various financial planning professionals and promoters
with respect to executives who are interested in business ownership is to take their IRA balances and use
them to finance a new business.1 In that event the
executive ends up funding the purchase of the new
business with tax-deferred money and at the same
time avoids the imposition of any taxes that typically
apply to a retirement plan withdrawal. The IRS refers
to these programs by the pejorative acronym ROBS,
or rollovers as business start-ups.2
During the early years the structure of the ROBS
took the form of direct IRA investments. In other
words, the executive would roll over a distribution
from an employers retirement plan to a rollover IRA
or would use the balance in an existing rollover IRA
to purchase the stock of a C corporation. This C cor-
ABSTRACT
Under the Rollover as Business Start-Ups
strategy an executive funds the purchase of
a new business with tax-deferred funds and
at the same time avoids the imposition of any
taxes that typically apply to a retirement plan
or IRA withdrawal. This column reviews the
structure of the two forms of ROBS transactions and analyzes the tax and ERISA issues
associated with the ROBS strategy in light of
two Tax Court decisions as well as a recent
federal appeals court decision. In addition, this
column demonstrates why the ROBS strategy is not per se noncompliant with applicable
tax law, but nevertheless warns that it is not a
strategy for the faint of heart or for someone
who is not equipped to pay close attention to
details. Finally, in light of the recent negative
case law, this column evaluates whether the
ROBS strategy continues to be a viable mechanism for the investment of an executives
retirement funds and if so, what steps should
be taken to avoid the form and operational defects to which the IRS pays most attention.
Vol. 70, No. 1 | pp. 27-32
This issue of the Journal went to press in December 2015.
Copyright 2016, Society of Financial Service Professionals.
All rights reserved.
JOURNAL OF FINANCIAL SERVICE PROFESSIONALS | JANUARY 2016
27
EXECUTIVE COMPENSATION
of the capital contribution made by the 401(k)
plan. This may allow the IRS to argue that there
has been an overpayment for the C corporation
stock which could result in a prohibited transaction. In addition, in order to avoid securities
law issues, the C corporation stock is typically restricted in terms of sale and transferability. Finally, just because the qualified plan is investing in
qualifying employer securities does not make the
plan an employee stock ownership plan (ESOP),
subject to the additional requirements applicable
to such plans. An ESOP involves the purchase of
qualifying securities with a loan. That is not the
case in a ROBS transaction.
6. The C corporation then uses the funds transferred in exchange for its stock to purchase a
franchise or to purchase or fund some other form
of new or existing business venture.
This form of ROBS has been the subject of numerous IRS audits, but to our knowledge has not yet
been the subject of any judicial proceeding. It will
hereafter be referred to as a 401(k) ROBS.
poration would then purchase the business venture
in which the executive wanted to invest. The IRA
would then be the sole owner or majority owner of
the business venture through its status as a shareholder of the C corporation. Thus far, the courts have
only addressed this form of ROBS, which hereafter
will be referred to as an IRA ROBS.
In more recent years the ROBS structure has
evolved and has become more sophisticated. It now
takes the form of the following sequential steps:
1. An individual establishes a C corporation which in
turn sponsors a qualified retirement plan, usually a
401(k) plan or a profit-sharing plan. At this point,
the corporation has no employees, assets, or business operations. The reason a C corporation must
be used, as opposed to another form of business
entity, is to avoid the imposition of the tax on unrelated business income which is levied on unrelated
business income earned by a tax-exempt entity.3
2. The plan document provides that all participants
may invest the entirety of their account balances
in employer stock.
3. The individual becomes the only employee of the C
corporation and the only participant in the plan.
4. The individual then executes a rollover or direct
trustee-to-trustee transfer of available funds from
a prior qualified plan or personal IRA into the C
corporations newly created qualified plan. These
available funds might be any assets previously accumulated under the individuals prior employers qualified plan, or under a rollover IRA which
itself was created from those amounts. Because
assets have been moved from one tax-exempt accumulation vehicle to another, all income or excise taxes otherwise applicable to the distribution
have been avoided.
5. The sole participant in the plan then directs investment of his or her rollover account balance
into the purchase of employer stock at par value,
i.e., the stock of the C corporation. The employer
stock is valued to reflect the amount of plan assets that the taxpayer wishes to invest. This is a
critical part of the ROBS transaction. The C corporation arguably has no value prior to its receipt
Legal Framework
If you perform a Google search asking how to use
retirement funds as start-up capital, the results will
consist of many links to articles in the financial planning press, as well as to companies offering services
to IRA owners interested in using IRA balances as a
source of capital. However, until the court decisions
involving IRA ROBS were handed down during the
last few years, not many of these articles and Web
sites advised potential business owners of the tax and
ERISA complexities of investing IRA funds in such a
manner. This column is intended to address those tax
and ERISA complexities and to determine if, in light
of a recent federal court of appeals decision, ROBS
continues to be a suitable mechanism for the investment of an executives retirement funds.
Opinions about the legal validity of the ROBS
structure have ranged from clearly illegal to so complex that it should be avoided to straightforward
and legal as long as the right steps are followed. The
one thing that is clear, however, is that there is no
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EXECUTIVE COMPENSATION
single rule that can be identified which makes the
ROBS strategy legal. The ROBS strategy generally
relies on tax provisions and regulations from various
sources which, when pieced together, produce a rationale for allowing executives to invest their own
retirement funds into a corporation that sponsors a
properly drafted tax-qualified defined-contribution
plan which authorizes an investment in qualifying
employer securities. But, on the other hand, there is
nothing that absolutely prohibits its use.
In 2008 the IRS issued an internal memorandum directed to the Directors of Employee Plans
Examinations and Employee Plans Rulings and
Agreements setting forth certain guidelines regarding 401(k) ROBS (the 2008 IRS Memo). The IRS
believed that it was necessary to issue these guidelines
because the National Office was getting so many
questions from the field arising from audits of 401(k)
ROBS transactions that for the sake of efficiently disposing of these cases it had to provide guidance to its
field agents with respect to the common elements of
the 401(k) ROBS transactions.
The 2008 IRS Memo confirmed that the IRS did
not believe that the form of the 401(k) ROBS transaction was a per se violation of federal law. Instead the
IRS cautioned that each case had to be considered on
its own merits. In other words, the IRS acknowledged
that the form or structure of the 401(k) ROBS transaction was not necessarily noncompliant with federal
tax law, but that the operation and administration
of the 401(k) ROBS transaction should warrant increased scrutiny to determine if the qualified plan was
being abused. The tax issues that the IRS identified as
warranting closer scrutiny included the following:
1. violations of the nondiscriminations requirements. In particular, the participants right to
direct that his account be invested in employer
securities may not satisfy the benefits, rights, and
features test of the Treasury regulations if it is in
any way limited in its application.
2. a prohibited transaction arising from defective
valuations of the employer securities. In particular, this could occur if the true operating value
of the business proves to be substantially differ-
ent from the value of the funds transferred. This
would be the case when a valuation fails to apply
appropriate discounts for lack of marketability
and other factors affecting the true operating
value of a closely held company.
3. a prohibited transaction arising from the manner
in which promoter fees are paid. The promoter
may be considered to have rendered investment
advice and if so, it is a prohibited transaction to
pay the promoter a commission in connection
with a transaction involving plan assets.
4. violation of the permanency requirement applicable to all qualified retirement plans.
5. violation of the exclusive benefit requirement applicable to all qualified retirement plans where the
purpose of the qualified plan to provide retirement
benefits is only incidental to the other purposes to
be achieved through the adoption of the plan.
6. failure to communicate the terms of the retirement plan to all employees.
In conclusion, the 2008 IRS Memo directed
the field agents to concentrate their review of ROBS
transactions on the enumerated tax issues related
to the 401(k) plans compliance with the qualification requirements and on the failure to file annual
returns. On the positive side, the 2008 IRS Memo
did not give any indication that ROBS transactions
would be banned completely. Furthermore, it did
provide a road map for how to establish a properly
structured 401(k) ROBS transaction that will withstand IRS scrutiny.
In 2013 the Tax Court decided the first of two
cases to consider the compliance of an IRA ROBS
transaction with the prohibited transaction rules. In
Peek v. Commissioner, 140 T. C. 216 (2013), two Colorado taxpayers, Lawrence Peek and Darrell Fleck, were
found to have engaged in a prohibited transaction
when using their self-directed IRA assets to purchase
the assets of an existing business (the target company). Under the facts of the case, the two business
partners formed a C corporation and directed their
personal rollover IRAs to use the amounts rolled over
from a prior employers retirement plan to purchase
100 percent of the corporations newly issued stock.
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EXECUTIVE COMPENSATION
The cash in the IRAs was not sufficient to finance the purchase of the assets of the target company so the corporation borrowed money from various
sources, one of which was a note to the seller, personally guaranteed by the taxpayers. After the transaction was complete, the taxpayers owned the IRAs
and the IRAs owned 100 percent of the stock of the
corporation that was now operating the target companys business. The corporation owed money to the
seller of target companys assets and the taxpayers
had personally guaranteed that debt. Several years
later the taxpayers converted their rollover IRAs to
Roth IRAs. Thereafter, the taxpayers IRAs sold their
interests in the corporation and took the position that
no gain was reportable when amounts were distributed from the Roth IRAs.
The Tax Court held that the personal guarantees constituted an indirect extension of credit to the
IRAs, which was a prohibited transaction. Under the
Internal Revenue Code (the Code), any extension of
credit directly or indirectly between an IRA and
a disqualified person, which includes an owner of
the IRA with the authority to direct investments, is
treated as a prohibited transaction. Once an IRA engages in a prohibited transaction, it ceases to qualify
as an IRA throughout the time that the prohibited
transaction is in effect. In Peek that meant that the
taxpayers IRAs ceased to be IRAs during the period
that the loan guarantees were in effect and that the
gains realized on the sale of the corporation were not
exempt from tax. In addition, the taxpayers became
liable for a 20 percent accuracy-related penalty because their underpayment of tax constituted a substantial understatement.4
Less than a year later the Tax Court in Ellis v.
Commissioner, 2013 T. C. Memo 245 (2013), was
again called upon to decide another case involving
an IRA ROBS transaction. In this case the taxpayer
rolled over proceeds from a prior employers 401(k)
plan into an IRA which then purchased 98 percent of
the membership units of a limited liability company
(LLC) organized to operate a used car business. The
LLC then elected to be treated as an association taxable as a corporation. The taxpayer was also the gen-
eral manager of the business and was paid a modest
compensation for those services, i.e., $9,754 in 2005
and $29,263 in 2006. The compensation was paid
from the LLCs checking account and was reported as
income on the taxpayers joint tax return for each year.
The Tax Court left little doubt about its view of
the transaction. The court said that:
In essence, Mr. Ellis formulated a plan in which he
would use his retirement savings as startup capital
for a used car business. Mr. Ellis would operate
this business and use it as his primary source of income by paying himself compensation for his role
in its day-to-day operation. Mr. Ellis effected this
plan by establishing the used car business as an
investment of his IRA, attempting to preserve the
integrity of the IRA as a qualified retirement plan.
However, this is precisely the kind of self-dealing
that section 4975 [the prohibited transaction provision] was enacted to prevent.
Thus, the court did not accept the taxpayers
argument that the used car business was merely a
company in which the taxpayers IRA invested. It
considered the corporation operating the used car
business and the taxpayers IRA as substantially the
same entity. In causing the corporation to pay the
taxpayer compensation, the court concluded that the
taxpayer engaged in the transfer of plan income or
assets for his own benefit in violation of Code Section 4975(c)(1)(D). Furthermore, in authorizing and
effecting this transfer, the taxpayer was found to have
dealt with the income or assets of his IRA for his own
interest or for his own account in violation of Code
Section 4975(c)(1)(E).
When an IRA engages in a prohibited transaction, the entire value of the IRA becomes taxable to
the IRA owner. If the owner is not yet age 59, then
the owner must also pay the premature distribution
penalty of 10 percent. These taxes and penalties, as
well as an understatement penalty of 20 percent, were
imposed on Mr. Ellis in this case.
The taxpayer in Ellis appealed the Tax Courts
decision to the Eighth Circuit Court of Appeals.
In an opinion filed on June 5, 2015 the Court of
Appeals affirmed the Tax Courts decision.5 The
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EXECUTIVE COMPENSATION
appeals court did not write a lengthy opinion, but
clearly found that the taxpayer engaged in a prohibited transaction by causing the used car business to
pay him a salary. Similar to the reasoning of the Tax
Court, the appeals court argued that [b]y directing
CST to pay him wages from funds that the company received almost exclusively from his IRA, Mr.
Ellis engaged in the indirect transfer of the income
and assets of the IRA for his own benefit and indirectly dealt with such income and assets for his own
interest or his own account.
ual account plans to acquire, hold, and sell qualifying employer securities as long as the transaction
is for adequate consideration and no commission is
charged. A 401(k) plan is an individual account plan
and thus can qualify for this exemption. By contrast,
an IRA is not an individual account plan and is not
eligible for this exemption.6
In other words, the protection afforded by ERISA
Section 408(e) should be considered to be sufficiently
broad to shield routine corporate transactions involving a disqualified person and the plan sponsored by
the corporate employer from being characterized as
technical violations of the prohibited transaction rules
due to the plans ownership of employer securities. If
the routine corporate transactions of the corporate
employer owned by the 401(k) plan are not spared
from prohibited transaction treatment by reason of
ERISA Section 408(e), the prohibited transaction
rules would needlessly prohibit a number of legitimate
business transactions and would ultimately nullify the
exemption that Congress intended to provide.
However, the prohibited transaction exemption
of ERISA Section 408(e) does not get the 401(k)
ROBS home free. Although the 2008 IRS Memo
does not address the prohibited transactions that were
the subject of Peek and Ellis, the memorandum does
address a number of other valid issues to which anyone who wants to adopt a 401(k) ROBS strategy must
pay attention. As previously noted, a 401(k) ROBS is
not per se noncompliant, but it is not a strategy for
the faint of heart or for someone who is not equipped
to pay attention to detail.
Applicability of Peek and Ellis to
the ROBS Strategy
The holdings of Peek and Ellis clearly have direct applicability to IRA ROBS. As a practical matter
those holdings put a crimp in the manner in which
executives can now implement that strategy. To effectively utilize the IRA ROBS strategy the executive and his IRA must remain passive investors in the
business and the operations of the business must be
carried on without the economic backing of the executive (or any related party) and without any economic benefit being paid to the executive (or any related
party) from the business. This could be a problem
for many executives, but for the fact that the 401(k)
ROBS strategy has effectively replaced the use of
IRA ROBS. Accordingly, the more critical question
is whether the holdings in Peek and Ellis have any
applicability to 401(k) ROBS.
On its face the 401(k) ROBS strategy bears some
similarities to the IRA ROBS strategy utilized in Peek
and Ellis. In both a business is purchased by a retirement plan; the newly formed business may also borrow from third parties, may pay salaries to employees
(including disqualified persons), and may engage in
other routine business transactions with disqualified
persons. The crucial distinction between the two
forms of ROBS is that the 401(k) form which offers
employer securities as an investment option under
the 401(k) plan operates under a specific statutory exemption from the prohibited transaction rules. This
exemption is found in ERISA Section 408(e) [as well
as Code Section 4975(d)(13)] which permits individ-
Conclusion
Even though applicable to an IRA ROBS, Peeks
prohibition of indirect extensions of credit to an IRA
by a disqualified person and Elliss prohibition of the
payment of compensation to a disqualified person
from an IRA for services rendered to a corporation
owned by the IRA should not apply to a 401(k) ROBS
which involves a 401(k) plan that qualifies for the statutory prohibited transaction exemption under ERISA
Section 408(e). Moreover, given the fact that since
2008 IRS officials have acknowledged that executives
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EXECUTIVE COMPENSATION
Mr. Schneider is a graduate of Lehigh University, Columbia University School of Law (JD), New York University (LLM in Taxation), and LaSalle University (MBA). Mr.
Schneider frequently writes articles and lectures on tax
and employee benefits-related topics, and is coeditor of
ERISA: A Comprehensive Guide, 4th Edition (Aspen, 2011).
may use 401(k) ROBS to serve legitimate business,
tax, and retirement planning purposes, it is not likely
that the IRS will now begin to argue that the Ellis
appellate decision should be applied to 401(k) ROBS.
However, for the reasons stated in Peek and Ellis, the
IRA ROBS is no longer an acceptable approach to establishing a business which is to be owned by an IRA.
The strategy of choice to accomplish that result is now
the utilization of a 401(k) ROBS.
However, the implementation of a 401(k) ROBS
strategy is not a guarantee of a favorable tax result. The
2008 IRS Memo documents all of the matters that
could go wrong with the 401(k) ROBS strategy. That
ROBS transaction is quite complex, requires ongoing
administration, and can be expected to draw IRS and
Department of Labor scrutiny. In particular, there are
several potential operational defects to which executives should pay specific attention. These potential defects include: (i) utilizing plan documents that do not
meet the requirements for qualified plans; (ii) making
sure that the plan does not provide benefits or features
that discriminate in favor of highly compensated employees; (iii) making sure that the plans acquisition of
the employer securities does not run afoul of the requirements of ERISA Section 408(e); and (iv) neglecting to take seriously the executives responsibilities as
an administrator and as a fiduciary of the plan.
Finally, professional guidance remains an essential
part of the implementation process. Such guidance is
required to determine when it is appropriate and advisable to employ the 401(k) ROBS strategy and how to
do so in a manner most likely to withstand IRS scrutiny and to avoid unintended tax consequences. n
He may be reached at pschneider@[Link].
(1) Firms such as Benetrends, Guidant Financial Group, and SDCooper Co. have promoted rollovers from retirement accounts as
readily accessible sources of funding for new franchisees or for other
business ventures. Moreover, experts have estimated that prior to
2014 retirement savings have funded about 10 percent of the more
than 600,000 new businesses that are started each year.
(2) Other names that have been used for this strategy are a Business
Owners Retirement Savings Account (BORSA) and an Entrepreneur Rollover Stock Ownership Plan (ERSOP).
(3) In order to level the playing field between for-profit businesses
and businesses operated by tax-exempt entities, the Internal Revenue Code imposes a 35 percent tax on unrelated business taxable income. Such income consists of any revenue that is not related to the
exempt purpose of the entity. If the IRA or retirement trust holds
membership interests in a disregarded entity, the income of such
entity is subject to the UBTI tax because the businesss activities are
considered to be carried on by the IRA or the plan trust itself. See
Rev. Rul. 79-222, 1979-2 C.B. 236.
(4) More than 20 years before the Tax Court addressed the issue
in Peek, the Department of Labor was presented with an almost
identical fact pattern in DOL Advisory Opinion 90-23A. In that
opinion, the DOL concluded that an IRA owners personal guarantee of a loan to a company of which his IRA owned a 50 percent
interest and the IRA of an unrelated individual owned the remaining interest would be a prohibited transaction under Code Section
4975(c)(1)(B). Advisory Opinion 90-23A was not cited by the Tax
Court in its opinion.
(5) Ellis v. Commissioner, 787 F. 3d 1213 (8th Cir. 2015); accessed
at: [Link]
(6) Another distinction between an IRA ROBS and a 401(k) ROBS
relates to the consequences of the existence of a prohibited transaction. In the case of an IRA a prohibited transaction causes the
entire balance in the IRA to become taxable in the year in which the
transaction occurred. On the other hand, a prohibited transaction
involving a 401(k) plan results in the prohibited transaction having
to be undone. In addition, the amount involved in the transaction
is subject to a 15 percent penalty tax. The tax qualification of the
401(k) plan remains unaffected. Thus, the latter is much less financially costly than the former.
Paul J. Schneider, JD, LLM, is senior counsel to Paisner~
Litvin, LLP, Bala Cynwyd, Pennsylvania, where he has advised clients on taxation and employee benefit matters for
more than 30 years. He is a charter fellow of the American
College of Employee Benefits Counsel and has served as
chairman of the Important Developments Subcommittee
of the American Bar Association Tax Sections Employee
Benefits Committee. Mr. Schneider is also a member of the
Board of Editors of the Journal of Taxation.
JOURNAL OF FINANCIAL SERVICE PROFESSIONALS | JANUARY 2016
32
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