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Caution! Using a 401(k) Rollover to buy a Franchise can be risky to your financial health?
Almost every week, someone calls The IRA Club asking if they can use their 401(k) rollover to buy a business. Even though the answer technically is “yes” The IRA Club has always discouraged this method of business funding and has declined to set up an IRA that would be used to fund a business if the IRA owner plans to earn their livelihood from that business.
Now, the IRS is catching on to this “to good to be true” funding method and has signaled their displeasure with the concept.
How do such plans work?
Example: Mr. “A” was recently severed from his employer. He has $275,000 in his 401(k) plan and would like to use that money to start a business. He finds a franchise he is interested in acquiring. The price of the business is $225,000. The proper way to proceed is: Mr. A should cash out his 401(k) and pay the income tax, and then buy the business with the remaining funds.
However, some IRA facilitators have constructed a series of steps whereby a 401(k) is rolled to a new “qualified retirement plan”. Then the new plan invests in the business. The final step is that Mr. “A” becomes an employee of the new business.
Until now, the IRS has gone along with such plans however, that may be about to change: What troubles the IRS is that Mr. A was able to buy a business using funds that otherwise would not have been available without first paying income tax.
On October 1, 2008, the IRS released a memo that acts as a shot across the bow for people considering this option. No, the IRS did not out and out prohibit such strategies however; they instead listed a series of provisions and regulations with which anyone involved in such a transaction must be careful to comply.
The IRS’ list of provisions runs almost 12 pages. The IRA memo makes two important comments which are very telling: 1) That upon a spot check the IRS found that none of the businesses they investigated met all the provisions and 2) They dropped a very broad hint that there will be more restrictions are to come.
One last clue about the IRS’ opinion: Their memo is titled “Guidelines Regarding Rollovers as Business Start-ups” which they abbreviate to ROBS. If calling these transactions ROBS isn’t a clue I don’t know what is.
We believe that by following the IRA Club’s suggestion to avoid ROBS, IRA Club members have been saved from costly and debilitating IRS audits of their retirement account.
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- Submitted by Dennis Blitz, The IRA Club
IRA Club, 333 N. Michigan Ave Suite 2220, Chicago, IL 60601
