BORSAs and ERSOPs and ROBS…Oh My!

Are these scary names for 3 new genetically engineered carnivores replacing the traditional "lions and tigers and bears?"

No...These three acronyms all refer to an arrangement under which a prospective small business owner uses his rollover account to finance a start-up business.

BORSA = Business Owner’s Retirement Savings Account
ERSOP = Entrepreneur Rollover Stock Ownership Plan
ROBS = Rollover Business Start-ups

The first two acronyms were coined by private vendors who provide assistance to business owners with this type of transaction. The IRS came up with “ROBS” and it is indicative of their perception of these types of arrangements.

So how do they work? Usually something like this:

An individual with a substantial retirement account wants to start a business and needs financing. Cash distributions from her retirement account would be subject to income tax and potentially an early withdrawal penalty. So, instead of a direct distribution, she establishes a “C-corporation” and creates, but does not issue, any number of corporate shares. This corporation then establishes a qualified profit sharing plan, and the “owner-employee” rolls over her retirement account into the qualified plan. Then the plan exchanges the cash from the rollover with the newly issued company stock and…Viola! The entrepreneur now has cash to finance her business without incurring a taxable event.

Like many things in life these arrangements look good in theory, but in practice have lots of problems. In October 2008 the IRS issued a memorandum, Guidelines regarding rollovers as business start-ups, in which it states: “Although we do not believe that the form of all of these transactions may be challenged as non-compliant per se, issues such as those described within this memorandum should be developed on a case-by-case basis.”

The IRS memo discusses 7 potential issues for these arrangements:

• Benefit Rights and Features Discrimination: Stock investment is not “effectively available” to all participants
• Prohibited Transactions – Stock Valuations: Initial valuation cannot be substantiated based on fair market value of start-up business
• Prohibited Transactions – Promoter Fees: If promoter is a fiduciary the “diversion” of plan assets to pay promoter fees may be a prohibited transaction. (Promoter may be giving investment advice by recommending investment in company stock. Because they are getting paid this makes them a fiduciary and potentially leads to a claim of self-dealing.)
• Permanency: If the plan doesn’t have substantial and recurring contributions then the IRS can challenge whether it was ever intended to be a qualified plan.
• Exclusive benefit: In some cases the proceeds from the ROBS transaction are used for personal non-business items (e.g. recreational vehicles). This would violate the exclusive benefit rule (i.e. that assets must be used exclusively to pay retirement benefits to participants).
• Plan not communicated to employees: May violate requirement that plan be definite written program communicated to employees.
• Inactivity of 401(k) arrangement: Plan may include a 401(k) provision, but participants have not been allowed to make a deferral.

Interestingly, this memo may have consequences not intended by the IRS. Instead of acting as a deterrent, the memo is being used as “a road map of the late-stage procedural issues brokers need to monitor closely in order to keep ROBS compliant” (at least according to sources referenced in this Forbes.com article: The IRA Job Machine).

Despite these potential issues, the recent credit crunch and increase in unemployment makes dipping into retirement savings look pretty appealing to many would be entrepreneurs.

We are definitely not in Kansas anymore.