Rollovers for Business Start-ups (ROBS)
Rev. 09/03/09, E-mail Alert 2009-14

Background
The IRS is always watching for abusive or non-compliant transactions. On October 1, 2008, Michael D. Julianelle, IRS Director of Employee Plans, SE:EP, issued a memorandum to the Director, Employee Plans Examinations, and Director of Employee Plans Rulings and Agreements, on the subject of guidelines regarding rollovers as business start-ups. Although the transaction described below and in the memorandum may not be non-compliant as to the form of the transaction, it may very likely fail qualification rules in a number of ways and also it may be a prohibited transaction. Thus, the memorandum alerts the IRS agents performing audit reviews and determination letter approvals to study each of these on a case-by-case basis to verify if rules are being violated.

The primary purpose of ROBS is to provide the necessary funding to establish a business, with franchises often being the business of choice. The typical individual who makes the ROBS transaction accumulates the funds as an employee under a defined contribution account (or possibly a defined benefit plan with a lump-sum option) under a prior employer’s plan. The employee leaves the firm and funds a new business with the tax-deferred distribution of funds from the prior employer’s plan. These funds are rolled into the new business’s 401(k) or other profit-sharing plan and are used to purchase the new firm’s stock.

Thus, the new business is capitalized with tax-deferred money, avoiding any taxes that usually apply to a retirement plan withdrawal, ROBS typically exist as a defined contribution profit sharing plan with a 401(k) [cash or deferred arrangement (CODA)]. By the way, the acronym ROBS was created by the IRS.

Document Form Usually Not the Issue
Usually, the ROBS arrangement is set up on a prototype document and the document is theoretically in compliance. It is in the operation of the plan that may be found non-compliant.

Nondiscrimination Issue
The timing of a plan amendment to add and remove the opportunity to invest in the employer security can be viewed as benefiting only the person setting up the business, which would discriminate in favor of highly compensated employees (HCEs) and violate IRC Sec. 401(a)(4).

In many ROBS arrangements, there is no one who initially meets the HCE definition since the stock is considered a trust asset and is not attributed to the participant. The person who starts the business also may not earn enough compensation to be considered an HCE in the initial years.

The regulations provide that a plan’s benefits, rights, and features (BFR) be “effectively available” to a group of non-highly compensated employees (NHCEs) that satisfies coverage testing.  While a company only has NHCEs, the plan automatically satisfies coverage testing requirements. However, the determination requires consideration of factors or conditions precedent that must be satisfied in order to accrue a benefit, including timing elements and whether the transaction was structured to intentionally avoid BRF testing issues. Furthermore, Treas. Reg. Sec. 1.401(a)(4)-(5) requires consideration as to whether the timing of plan amendments serves to preclude other NHCEs from receiving stock allocations. Given that ROBS arrangements are frequently designed to take advantage of a one-time only stock offering, the investment feature generally would not satisfy the effectively available benefit requirement. The issue of discrimination arises because the plan may be designed in a manner that the BRF, to invest in employer securities, will never be available to any of the later hired NHCEs. For this reason, ROBS cases should be examined for discrimination issues whenever ROBS arrangements are designed to take advantage of a one-time only stock offering, as this could be viewed as discriminating against NHCEs.

Value of assets and other rules
There may be a question as to whether the new company is worth the value of the tax-deferred assets for which it was exchanged. A valuation would need to be done. ERISA Sec. 408(e) provides that an acquisition or sale must be for “adequate consideration.” A prohibited transaction would exist if this requirement were not met. Thus, if the transaction had not been valued accurately, a prohibited transaction requiring a penalty would have occurred if a correction were not made within the taxable period under Section 4975(f). The memorandum explains in-depth what a prohibited transaction is and shows how this transaction may be a prohibited transaction. 

Promoter Fees
Where the plan purchases the stock of the employer, and the employer immediately pays professional fees to the promoter who helped the employer in designing their arrangement out of the proceeds, prohibited transactions may occur.

Prohibited transactions are classifiable into either "discrete" one-time transactions, or "continuous" recurring transactions.  ROBS arrangements fall into the former. In a discrete transaction, a taxable event occurs in the initial or "source" year when the prohibited exchange of stock occurs, and it is deemed to be carried forward into later taxable periods until corrected.

OTHER ISSUES

Permanency
ROBS benefits are designed only to be used once, so whether they can be considered a “permanent” retirement program has to be considered. Permanency is a qualification requirement for all retirement plans. The IRS has yet to find that all ROBS violate this rule, and they are reviewing them on a case-by-case basis.

Exclusive Benefit Rule
In some cases, the new business purchased assets that were essentially personal assets for the benefit of the individual. This may well violate the "exclusive benefit" requirements of the Code. Code Sec. 401(a)(2) provides, in relevant part, that a plan is not qualified unless it is impossible, at any time prior to the satisfaction of all liabilities with respect to employees and their beneficiaries, for any part of the corpus or income to be used for or diverted to purposes other than for the exclusive benefit of employees or their beneficiaries.

Plan Has Not Been Communicated to Employees
After the business has been established and is up and running, the plan must be communicated to all new employees. Failure to do this is a violation of Treas. Reg. Sec. 1.401-1(a)(2). The IRS has found cases in which the plan was not communicated to employees.

Additionally, if employees meet the eligibility requirements and do not enter the plan as of the required entry date, the plan will fail IRC Sec. 410(a) requirements.

Inactive 401(k)
Upon examination, the IRS noticed that many ROBS contain CODAs, yet have a low number of participants making elective contributions to the plan. After raising the issue, the response the IRS received was that the CODA was “inactive.” There is no such thing as an “inactive” CODA. The IRS asks its reviewers to see if the participants were permitted to make elective deferrals to the plan. If not, there would be a violation of IRC Sec. 401(k)(2)(D).

Although the use of ROBS arrangements is permitted, it is clear there are many instances where a plan sponsor can fail to properly administer the operational requirements, allowing for various violations. The IRS will continue to examine this unique method of plan design and has also engaged in ongoing coordination with the DOL on monitoring these types of plan. The IRS has noted that at least one of the promoters has requested its own prototype plan and, thus, the IRS will be able to use the list of clients using that prototype to examine ROBS plans.

“ROBS transactions may violate law in several regards. First, this scheme might create a prohibited transaction between the plan and its sponsor. At the time of the exchange between plan assets and newly-minted employer stock, the value of the capitalization of the entity is equivalent to the value of all plan assets, when in reality, the entity may be valueless and asset-less for an indefinite period of time. Additionally, this scheme may not satisfy the benefits, rights and features requirement of the Regulations. The primary utility of the arrangement may only be available to the business's principal individual."

“Specific facts will need to be evaluated on a case-by-case basis in order to make a proper determination as to whether these plans operationally comply with established law and guidance. Technical advice requests may be submitted after consultation with group managers. For this reason, employee plans specialists are directed to resolve open ROBS cases as described herein.”

 

For much more on ROBS, the HEART Act, EESA, WRERA, and the final automatic contribution regs, click here for information on our recently recorded eSeminar entitled 401(k) Update, or click here for information on our Retirement Plan Insights Class.