Using Retirement Account Funds to Start a Business: A Case Study

Date February 18, 2024
Authors Tyler G. Tomalavage, CPA, MT

Owning your own business: it’s one of the greatest of American dreams. It certainly was for one of the families we’re proud to call our clients. Let’s call them Joe and Jane, two office workers who decided they wanted to be their own bosses.

Joe and Jane contacted a business broker who put them in touch with a franchisor, and they soon became franchisees. They didn’t have much in the way of savings to use as startup funding, but Joe did have a few hundred thousand dollars in his 401k. They engaged a firm that specializes in helping aspiring entrepreneurs use funds from their retirement accounts to start their businesses, a process called Rollover for Business Startup (ROBS).

One of the nuances of the ROBS process is that, for the retirement plan to own the business entity, it should be formed as a C corporation. The “C” designation is generally not a tax-efficient form of ownership as income is taxed twice, once as corporate income, then again as shareholder dividends when the earnings are distributed to owners, or in Joe’s case, withdrawn from the retirement account as distributions, which are taxable as ordinary income. On top of the additional layer of taxes, there are also the administrative costs of maintaining the plan itself. These factors combined to make it cost-prohibitive for Joe and Jane to access the wealth they were building in their business.

Using the retirement funds as seed money, along with some expensive loans, Joe and Jane made it through the difficult first few years of their business, losing money as they were establishing a foothold in their industry. After a few years of effective management and excellent customer service, their business became profitable. Now they faced another challenge: Their oldest daughter would start college soon and they needed money for tuition, not to mention to cover steadily increasing living expenses. But they couldn’t take money from their business without losing a significant portion of it to taxes.

Ownership transfer

In order for Joe and Jane to gain access to the equity within their business, we knew that they would need to have ownership of the company directly, outside of the retirement account. So we developed a plan for transferring ownership from Joe’s retirement plan to Joe personally. After considering several options, the approach that we settled on with Joe and Jane involved the retirement plan issuing an in-kind distribution of all the corporate stock to Joe, just like a retiree taking a distribution from an IRA. We chose this approach because it minimized the cost of the transaction to Joe and Jane and it allowed the transfer to be completed in a relatively short timeframe.

The final part of the plan, now that the ownership had been transferred, was to elect S corporation status for the business. This made the corporation a pass-through entity, which allows the owners to draw on their equity from the business tax-free. It also gives Joe and Jane more flexibility when it comes to tax planning, as the business income is combined with their personal income.

It’s important to note that timing is a key element here. Once a business becomes profitable, the value of that business begins to increase rapidly. This means that the longer the owner waits, the more expensive it is to accomplish the ownership change, because the price of the corporate stock continues to rise. Timing is also important when it comes to flipping the business from C Corp to S Corp, as the S-election must be filed by March 15 of the year it takes effect.

While there are several options for exiting the ROBS structure, they all involve significant costs. Working with a knowledgeable CPA will help business owners accomplish the transaction in the way that makes the most sense for the business and the owners.

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