A common retirement / employment technique that looks enticing is to rollover your substantial 401(k) account after terminating employment to an IRA and then use the IRA to purchase or start up a business for you to run. What could be better? A job for you, a profitable investment for your IRA that you control, and the investment funds remain tax deferred in the IRA. What an excellent idea! No, not so much!
While this business start-up technique may look like the perfect use of your accumulated retirement funds, there are a lot of technicalities that can cause the arrangement to blow up, triggering huge taxes and penalties. The 8th Circuit Court of Appeals (in Ellis v. Commissioner) recently confirmed that such an arrangement done through an IRA disqualified the entire IRA (making the entire IRA taxable). The taxpayer owed taxes and penalties amounting to more than 50% of the IRA’s value.
In the case reviewed by the court, the IRA owner caused the IRA to purchase 98% of a used car sales business and then used his control of the company to have the company pay him compensation for his services running the business. The court held that the IRA owner’s exercise of control over the company causing the company to pay him compensation violated the tax law’s prohibited transaction rules for the IRA. The holding resulted in the IRA’s loss of tax deferred status as to all funds in the IRA. The prohibited transaction rules that the court said were violated was direct or indirect use of the plan’s income or assets for the benefit of the IRA owner as well as dealing with the IRA’s income or asses for his own interest.
The 8th Circuit case involved investment in the business start-up by the taxpayer’s IRA. Similar techniques are offered through C corporation business start-ups.
While it is clear that an IRA investment of this nature is extremely dangerous, often destroying the tax deferred status of the IRA, the same technique can be successful if done in a C corporation using the corporation’s qualified plan instead of the IRA. But there are significant expenses and dangers involved. Individuals should not consider this technique unless the investment funds involved are large enough to justify the expense and risk, and the individual has a high tolerance for details and complications.
To use the this business start-up technique in a C corporation, the typical approach is first transfer the rollover funds into a qualified plan established by the new start-up business and then have the qualified plan purchase stock in the business that is sponsoring the qualified retirement plan. The IRS and DOL calls these types of transactions “ROBS” for “rollover business startup”. While we do not assist clients in creating ROBS arrangements we routinely assist clients in understanding the risks and rewards inherent in the arrangements.