Let’s say you have an opportunity to purchase a closely-held business. Perhaps you are a key employee in a business and the owner is looking to get out. Or perhaps you want to leave the corporate world and purchase a franchise. If, for example, the purchase price is $2 million and you can get SBA (Small Business Administration) guaranteed financing for 85% or $1.7 million you will still need $300,000 cash equity. The only cash you have is $400,000 in a qualified retirement account – a 401(k) or IRA. Depending on the terms of the plan, you might be able to borrow money from a 401(k), but this type of loan probably won’t qualify as “equity” for SBA financing purposes. For borrowed money to qualify as “equity” the repayment must be subordinated to the SBA loan and furthermore, no payment of interest or principal can be required to be made for at least two years after closing. It is unlikely that the 401(k) will make you a loan on these terms, so you probably can’t borrow the equity from your 401(k).
You could take a premature distribution (assuming you are not yet 59 ½) from your qualified retirement account, but there would be a prohibitive tax cost. The distribution would be subject to ordinary income tax plus a 10% penalty. This could easily eat up 40% or more of the distribution. Even if you are over 59 ½, you will still need to pay ordinary income tax.
Rollovers as Business Startups (ROBS) is a proven techniques for using qualified plan funds to purchase a business. It’s complicated and not for everyone, but in the right circumstances it can be a home run. Here’s how it works.
First, you must form a new corporation that will be the vehicle that you use to buy the business assets and establish a qualified plan in that new corporation – usually a profit-sharing plan that under the terms of the plan is allowed to hold employer stock. The corporation must be a so-called “C corporation”. Then, roll over your existing retirement funds into this new plan – this rollover is tax-free. These funds can be invested in the new corporation’s stock which in turn can be used to purchase the business assets that you want to acquire. (For more information about ROBS see “Can Your Retirement Plan Own Your Business?” at https://www.sba.gov/blogs/can-your-retirement-plan-own-your-business.) The rules for administering the pension plan must adhered to including filing an annual tax report. Make sure you consult with a tax advisor who is familiar with these techniques and use a firm that specializes in ROBS in order to set one up. These companies typically charge about $5,000 plus an annual maintenance fee of about two hundred dollars to set up the corporation and profit-sharing plan that will be the ROBS vehicle.
Using ROBS to buy a business has its own special risks – you are literally putting all of your eggs in one basket. But if the opportunity is too good to pass up, it might be worth it.
A self-directed IRA can also be used to invest in closely-held stock. But if you are not careful you will run afoul of the so-called “prohibited transaction” rules which can cause the entire value of the IRA to become immediately taxable. These transactions are not for the do-it-yourselfer; make sure you get competent advice.