Most people donât know that the number one way entrepreneurs fund their startups is via their personal savings. More often than not, you will find that most lenders (i.e. traditional banks) donât provide business loans to startups. The top 3 options that most entrepreneurs have to fund their startup business (without giving up equity) include personal savings (via a 401k or other qualified retirement plan), unsecured business lines of credit (i.e. credit cards) and microloans via SBA approved lenders or community based financial institutions. In this article we are focusing on 401k business funding (aka Rollover for Business Startups).
What is a Rollover for Business Startups (ROBS)?
TheÃÂ Rollover for Business Startups (ROBS) funding concept began in theÃÂ 1980s. ÃÂ And, throughout the next 30+ years, has been shown to be a legitimate,ÃÂ IRS-acceptableÃÂ financial interchange. A ROBS transaction offers entrepreneurs and business owners the opportunity to access qualified retirement funds without incurring Ã¢ÂÂ
- A penalty.
- Interest costs.
- The creation of debt.
- Upfront tax obligations.
It is important to emphasize that a ROBS transaction is NOT some newfangled form of debt. A Rollover for Business Startups (ROBS)Ã¢ÂÂ a viable method forÃÂ funding a business with aÃÂ 401KÃ¢ÂÂ is a somewhat complex financial maneuver that legally transfers eligible retirement funds from one custodial company to a brand-new custodian for the startup business.
Learning How a ROBS Works
There are 5 simple steps required for funding a business with aÃÂ 401K.
#1 Ã¢ÂÂ Create a C-Corp
In terms of legal entities, the new business you plan to start must be formed as a C-Corporation (C-Corp). This is the only legal entity that passes the legal muster of the Internal Revenue Service (IRS) requirements. Technically, a C-Corp is the only legal entity that permits the sale of shares of the new business by a retirement account lawfully. Therefore, it is noted that other popular legal entities like Ã¢ÂÂ
- A sole proprietorship,
- An S corporation.
- A Limited Liability Corporation (LLC), or
- A partnership cannot be the legal entity of the new business if you wish to complete a ROBS transaction that complies with IRS regulations!
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Recommended Provider for 401K Business Funding
Those interested in a ROBS transaction are advised to speak with a legal or tax expert to fully grasp the tax implications of a C-Corp. business identity. At Small Business Brain, we recommend Benetrends Financial, the leading small business lending group that has assisted entrepreneurs with completing ROBS transactions via their Rainmaker Plan for the last 35+ years.
#2 Ã¢ÂÂ Define the Startup BusinessÃ¢ÂÂ Retirement Plan
Next, a new retirement plan must be established for your new business. There are several retirement plan options that are eligible for a ROBS transaction. First, though, you must locate a financial custodial company to administer the new retirement plan. Available retirement plans include-
- ÃÂ TheÃÂ 401K.
- Profit Sharing.
- Defined Benefits, or any combination thereof.
The right plan is contingent on several business specific issues, which can be evaluated with the help of your new retirement account custodian.
#3 Ã¢ÂÂ Transfer Existing Retirement Account Funds to the New Retirement Plan.
Next, you need to transfer the funds to the new retirement account. Contact your current retirementÃ¢ÂÂs custodians. Transfer times vary and depend upon the custodianÃ¢ÂÂs processes.
#4 Ã¢ÂÂ Retirement Plan Purchases Stock in the Corporation
The 4thÃÂ Step is when you purchase stock in your new C-Corp business using the funds in the newly funded (and created) retirement plan. It is noted that a ROBS transaction can be combined with other business financing methods like the loan issued by the Small Business Administration or otherÃÂ small business creditors.
#5 Ã¢ÂÂ Funds Become Available to the Corporation
The last step ofÃÂ funding a business with aÃÂ 401K is when you begin to invest the monies in your new business. Note though, these transferred funds can only be used for a Ã¢ÂÂnormalÃ¢ÂÂ business (i.e. not personal) use.
Eligibility Requirements for Funding a Business with aÃÂ 401K
A ROBS transaction can be accomplished with personal funds held in a tax-deferred, qualified retirement account. Essentially, though, this requirement precludes the use of money held in a RothÃÂ 401K or a Roth IRA. Tax-deferred retirement accounts that are used most often for a ROBS transactionÃÂ would include Ã¢ÂÂ
- AÃÂ 401k.
- A SEP Ã¢ÂÂ known as a Simplified IRA.
- AÃÂ 403b.
- A traditional IRA.
- ÃÂ A Keogh.
- A TSP Ã¢ÂÂ a Thrift Savings Plan.
- Funding a Business with aÃÂ 401KÃÂ Requires Minimum Retirement Funds of $50K to be Cost Effective.
- Be a Legitimate Employee of the New Business.
Benefits & Concerns when Funding a Business with aÃÂ 401K
As with any financial transaction, a ROBS transaction has both benefits and areas of concern. These are discussed below.
- Retirement funds are available without incurring taxes or penalties.
- Your available investment funds are being used as Ã¢ÂÂpre-taxâ earnings.
- Funds can be used to pay yourself a salary when opening the business, given certain limitations.
- A ROBS transaction is typically completed in a matter of weeks, not months.
- Your business equity and company value become optimized.
- A ROBS transaction is a proven funding method that complies with IRS rules.
- The Possibility of Losing your Retirement Money.
- You could be tagged for an IRS audit.
- You must Administer a Retirement Plan.
A ROBS transaction needs to be proactively managed as there are reporting tasks and administrative duties required to maintain a compliant account.
ROBS Prohibited Transactions
A ROBS transaction requires strict adherence to its rules, which means proactively avoiding ROBS prohibited transactions. Using the funds obtained through a ROBS transaction for one of the specifically disallowed purposes will likely exposeÃÂ a business owner to penalties and/or unexpected tax obligations. Remain vigilant and avoid the following â
Personal Use of Business Property â IRS Section 4975ÃÂ adds a 15% tax to monies involving disqualified people.
Unsuitable Owner Compensation â When funding a business with aÃÂ 401K, you are tasked with a fiduciary responsibility managing the use of the retirement funds.
Comparing ROBS & Startup Business Loans
Historically, the most popular method to fund a new business (or aÃÂ business expansion) was unsecured lines of credit or business loans. Despite that fact that the business loan often caused a strain on the businessÃ¢ÂÂ cash flow (due to the monthly payment obligation of the loan), it remained the only option for a long time.
A ROBS transaction is NOT a loan so there are no monthly payments to disrupt the businessÃ¢ÂÂ cash flow stream. However, both a business loan and a ROBS transaction have benefits and concerns that should be evaluated carefully. Consider the following â
The Ease of Use â A ROBS transaction tends to be a more complex transaction and requires a business to be set up as a C-Corp. However, the additional work required for a ROBS pays off, as there are no fees or interest due.
The Cost â A ROBS transaction requires the payment of expenses to accomplish the transaction and to maintain the new retirement account. Despite these costs, a ROBS transaction tends to be more cost-effective when considering the significant interest paid for a business loan.
The Flexibility â Each type of funding offers differing types of flexibility. A ROBS transaction allows you to decide how to use the available funds for any business purpose. Both types of financing set restrictions on a case-by-case basis.
The Accessibility â A ROBS transaction, with all criteria met, is more easily accessible than a business loan because business owners can obtain the money without having to apply for financing approval.
It is noted that a ROBS transaction is often used in conjunction with a business loan.
Each investment, by definition, is defined by the amount of risk it carries. It is up to you to decide which financing method will work for your startup business. Either way, an investor should always be cognizant of the fact that there is something on the line for every investment.
She has spent the last 11+ years helping aspiring entrepreneurs start new businesses, raise capital and get connected to the resources they need to grow and thrive. She also spent this time helping B2B and B2C companies generate more leads and sales for their businesses via web development and the implementation of various digital marketing and advertising strategies.
She enjoys writing about her experiences as an entrepreneur and using data and information from reliable sources to back up what she writes about. Through her writing she aims to educate other entrepreneurs on how to build successful businesses doing what they love.
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