Baby boomers are proving more likely to launch businesses in their 50s and 60s than members of past generations, in some cases risking retirement savings on the ventures. A small but growing number have adopted a complex strategy to use their retirement nest eggs early to buy or launch businesses—while avoiding taxes and penalties for early withdrawal.
The IRS has repeatedly warned that the strategy—known by the unfortunate acronym ROBS, for Rollovers for Business Startups—lies in a murky area of the law. Two recent tax court decisions show that the federal government may be looking to go after millions of dollars in back taxes.
The ROBS strategy has been around for decades and has gained popularity in recent years, especially with entrepreneurs buying franchise businesses. Guidant Financial, a Bellevue (Wash.) company that specializes in the transactions, handled $232 million in such rollovers in 2012, according to the Franchise Times, which took a long, hard look at ROBS in an article last month. The outlet also reported that new players are emerging to process ROBS.
Here’s one way the maneuver typically works: A would-be entrepreneur creates a shell company and sets up a 401(k) plan for it. She transfers some or all the savings from her personal retirement account into the new company’s 401(k). She uses the new 401(k) to invest in the shell company through an employee stock ownership plan. That gives the shell company cash to buy an existing business or to cover startup costs. The entrepreneur owns the company through shares held in the new retirement plan.
If it sounds complex, that’s because it is. The IRS cast some doubt on ROBS in a 2008 memorandum (pdf) saying the strategy needed further study. “ROBS transactions may violate law in several regards,” the agency noted. In 2010, the agency called ROBS “questionable” but provided the basis for continued use.
Last year the IRS won decisions against entrepreneurs who were found to have misused ROBS. In Peek v. Commissioner, filed in May, the tax court said two Colorado entrepreneurs owed more than $560,000 after they used their company’s retirement plan to guarantee a loan. In Ellis v. Commissioner, filed in October, the court ruled against a Missouri man who used a ROBS transaction to rent space for his business and pay himself a salary.
Proponents of the strategy say those decisions show the importance of hiring a company that knows what it’s doing to manage the transaction. Some tax wonks have warned recently that the cases show the IRS is preparing a crackdown on ROBS and could soon seek back taxes from other entrepreneurs.
A bigger question: Should anyone devote retirement savings to the inherently risky act of launching a business? Michele Markey, a vice president at the Kauffman Foundation, says older entrepreneurs should be more cautious about taking the plunge. “Boomers don’t have time to recover from failure like a 20-year-old does,” she told me.