How to Exit The ROBS (Rollovers As Business Start Ups) Business Financing Strategy

Rollovers as a Business Start-Up: A 401(k) Business Financing Solution > ROBS Exit Strategies

HOW TO EXIT

the ROBS (Rollovers As Business Start Ups) Business Financing Strategy

 

Exiting the ROBS (Rollovers as Business Start Ups) business financing strategy can mean different things. Most often, an exit occurs because the business (C Corporation) ceases to exist.  There are other reasons why a business owner may wish to exit the ROBS business financing strategy including: getting out from under the C Corporation requirement in an effort to avoid double taxation, eliminating the required 401(k) Plan, reducing company and personal taxes and even selling the company.

 

Leading Retirement Solutions is equipped to lead these discussions with business owners, their attorneys and CPAs. Below are common examples of how an entrepreneur can exit the ROBS business financing strategy.

 

Summary of Exit Strategies

  • Closure of the Business
  • Full or Partial Redemption (e.g. buy back) of Stock
    • Partial Redemption (e.g. buy back) of Stock
  • Early Redemption (e.g. buy back) of Stock
  • Distribution of Stock In Kind
  • Required Minimum Distributions (RMDs)
  • Net Unrealized Appreciation (NUA) Strategy
  • Sale of your business & rollover of sales proceeds to an IRA
  • Sale of your business & rollover of Employer Securities to an IRA
  • Reinvest your 401(k) money into another business venture
  • Additional Requirements Related to Exit Strategies
  • Valuation of Corporate Stock Requirements
    • Allocation of monies to the C Corporation owner(s)
    • Termination of the 401(k) Plan

 

Closure of the Business

 

  1. Employer Securities (QES), the private stock of the C Corporation that is held/owned by the 401(k) Plan must be redeemed (e.g. bought back). This means that the C Corporation needs to buy the stock back from the Plan.
  2. This requirement applies even if the value of the stock is now at $0, due to business closure. The Department of Labor still expects to see, before the 401(k) Plan is terminated, that the stock was removed from the Plan.
  3. If any additional investments, assets, dollars (e.g. cash) are held in the name of the Plan, those assets must be distributed or rolled/transferred out of the Plan before the Plan can be fully terminated and the final IRS Form 5500 filed.
  4. The C Corporation can then be dissolved and the Plan can be terminated, pursuant to Department of Labor and Internal Revenue Service requirements.

 

Sale of the Business

 

  1. The proceeds from the sale of the business should be returned to the C Corporation.  The proceeds from the sale of the business should be allocated to the owners of the C Corporation, based on respective ownership. The proceeds from the sale of the business should NOT be allocated solely to the individual business owner, if the Plan is also an owner of the C Corporation.
  2. The Employer Securities, the private stock of the C Corporation that is held/owned by the 401(k) Plan should be redeemed and the sales proceeds allocated pursuant to ownership of the C Corporation. For example, if the Plan is a 75% owner of the C Corporation, the 401(k) Plan is entitled to 75% of the proceeds of the sale. 
  3. In the alternative, the business owner can leave the sales proceeds in the C Corporation and invest in a new/other business venture.
  4. If no further business is to be conducted and the stock is redeemed, the C Corporation can then be dissolved and the Plan can be terminated, pursuant to Department of Labor and Internal Revenue Service requirements.

 

Full or Partial Redemption (e.g. buy back) of Stock

 

A redemption of stock occurs when the C Corporation buys some or all of its stock back from the Plan. This exit strategy is most often deployed by an entrepreneur who wants to convert the C Corporation to S Corporation status.

 

The decision to have the C Corporation buy the stock back, from the 401(k) Plan, is often a very strategic one. This is a decision that should be made based on several factors including 1) priorities of the business, 2) priorities of the business owner(s), 3) retirement savings needs, 4) tax deduction needs, 5) business expansion/financing needs and more! Given the tricky nature of this strategy, it’s best to work with a Third Party Administrator, an ERISA attorney, and a tax advisor when exiting a ROBS business financing strategy.

 

  1. The C Corporation engages in a partial or full stock buy back from the 401(k) Plan.
  2. The C Corporation needs to come up with the money to buy a certain amount of stock/shares back from the Plan at the current fair market value of the stock. It is a common misconception that the stock can be bought back for the original price that the Plan paid for the stock.
  3. Full or partial redemptions are allowed however, the C Corporation cannot be converted out of C Corporation status until all stock has been redeemed from the Plan.
  4. There are various ways a Corporation will generally raise cash for this kind of buy back, including, obtaining a traditional bank/SBA loan, retaining revenue, accepting a loan from a 3rd party (in limited instances the 3rd party can be the same individual who runs the company).
  5. This buy back must be done based for the current fair market value of the C Corporation stock, not the value of the stock when the Plan originally made its investment(s) into the C Corporation.
  6. The company stock should be valued by an outside, independent firm; this may generally include an informal valuation from your CPA, if he/she does them or a formal valuation from a valuation firm.  
  7. A corporate resolution should be drafted, authorizing the redemption of stock between the C Corporation and the Plan.  
  8. The proceeds from the redemption need to be returned back to the Plan based on its rightful share, by sending the monies back to the Plan account.
  9. Stock certificates should be “redeemed”, the stock that is purchased back usually becomes unissued stock for the time being.
  10. The stock ledger needs to be revised, reflecting the updated ownership (the Plan is no longer a shareholder or has a lesser amount of ownership). 
  11. The monies, including earnings that are returned to the Plan can be invested in more traditional investments, like mutual funds.  You could also use the monies + earnings for other non-traditional or business financing needs in the future.
  12. Once all stock is fully redeemed by the C Corporation, from the Plan, the C Corporation can convert to S Corporation status and the Plan can either continue to exist or the Plan can be terminated.

 

Partial Redemption (e.g. buy back) of Stock

 

A partial redemption of stock occurs when smaller amounts of stock are purchased back by the C Corporation, from the Plan, in multiple transactions, over time.

 

For a partial redemption, if the company valuation is higher than cash on hand, the Plan and C Corporation can enter into an amortized payment schedule to settle the buyout. This allows for controlled distribution of the profits to the Plan. It also can help mitigate the impact of being taxed as a C Corporation. This method extends the amount of time that the business remains a C-Corporation. 

 

There are requirements related to valuing corporate stock each time a partial buyback is completed. Generally, you must value the stock each time you engage in a partial buyback although the facts and circumstances of your partial buybacks may allow for utilizing a prior or historical valuation.

 

Partial buybacks can end up being a rather expensive approach to buying back the stock as additional costs apply each time there is a redemption and this approach is rarely utilized as a result.

 

Early Redemption (e.g. buy back) of Stock

 

The early redemption method tends to be utilized by entrepreneurs who need business financing for only a short period of time. The business owner invests 401(k) monies into the C Corporation and within 1-2 years, the C Corporation is able to raise enough funds to buy the stock back, in full, from the Plan. This allows for a quick exit and conversion to S-Corporation status. However, the amount returned to the 401(k) account of the participant may be less than that originally deposited depending on how the value of the company stock has fluctuated, if at all.

 

This method is not often utilized because most new businesses can’t raise enough capital, this early, to buy the stock back. Additionally, it is generally not recommended that you terminate the Plan, in conjunction with the early buy back.  A Plan must be established with the intent to be a "permanent" not "temporary" program (26 CFR 1.401-1(b)(2)). Federal regulations require, that when you establish a 401(k) Plan, you establish it with the intent of providing a “permanent” employee benefit to and for you and your workforce. Five (5) years is generally the minimum number of years you need to have a Plan operational to show that you intended to put in place and offer a permanent employee benefit. Exceptions can be made for business hardship necessitating an early termination of the Plan.

 

Distribution of Stock In Kind

 

Unlike the full or partial redemption strategy, the C Corporation stock does not need to be liquidated and can be distributed or transferred “in kind”.  An “in kind” distribution is a payment made in the form of securities or other property, rather than in cash. A distribution in kind may be made in several different situations, including a stock dividend, inheritance or taking securities out of a tax-deferred account. An in kind distribution or transfer avoids the requirement of liquidating the stock.

 

With the ROBS strategy, an in kind distribution or transfer means that the stock is transferred directly to an individual or another retirement account, without first liquidating the stock into a cash state. This works for individuals that are not ready to or can’t afford to pay the value of the stock to redeem it or want to continue to hold onto the stock for tax advantages and other beneficial reasons.

 

The retirement plan legal documents (e.g. Adoption Agreement) must allow for the “in kind” distribution or transfer of the Employer Securities (QES). If your retirement plan documents do not currently allow for this, we can generally amend your documents to allow for this in kind method.

 

Required Minimum Distributions (RMDs)

 

An additional option to consider, if the 401(k) accountholder invested in the Corporation is of an age to take Required Minimum Distributions (RMDs), RMD’s can be taken in the form of the Employer Securities (QES)/corporate stock or if the stock is liquidated and proceeds + earnings returned to the 401(k) Plan, taken in the form of cash.

 

RMDs are minimum amounts that a retirement plan account owner must withdraw annually starting with the year that he or she reaches 70 ½ years of age or, if later, the year in which he or she retires. However, if the retirement plan account is an IRA or the account owner is a 5% owner of the business sponsoring the retirement plan, the RMDs must begin once the account holder is age 70 ½, regardless of whether he or she is retired.

 

For RMD’s made from the QES/corporate stock, in kind, the retirement plan legal documents (e.g. Adoption Agreement) must allow for the “in kind” distribution or transfer of the Employer Securities. If your retirement plan documents do not currently allow for this, we can generally amend your documents to allow for this in kind method.

 

Net Unrealized Appreciation (NUA) Strategy

 

Typically, an entrepreneur who has engaged in the ROBS business financing strategy and has built a successful and profitable enterprise, but now wishes to exit the strategy, wants to do so with a goal of deferring or reducing taxation on their company shares.

 

If the company stock is valued at more than an entrepreneur wants to pay to buy it back, there is a set of provisions in the Internal Revenue Code (IRS) that permits tax deferral and capital gains tax treatment when utilizing certain methods of exiting a ROBS Plan.

 

Are there certain conditions that must be met in order complete a NUA transaction?

 

When it comes to methods for exiting a ROBS Plan, such as a Net Unrealized Appreciation (NUA) transaction, there are certain conditions that must be met. In order to initiate an NUA Transaction specifically, these 5 conditions need to be fulfilled:

 

  1. The ROBS participant needs to be at least 59½ years old.*
  2. All other Defined Contribution retirement plan accounts (sponsored by the employer) of the ROBS participant are also distributed/rolled out of the plan in the same tax year.
  3. Employer securities must be distributed in-kind.
  4. Employer securities must be distributed in the same tax year.
  5. The shares should be valued by an independent, valuation firm prior to distribution.

 

*While it’s possible to do for those under 59.5, it would be complicated and expensive to do.

 

Once the above conditions have been met, a ROBS participant exit can be initiated. In the case of an NUA exit, the participant will owe only ordinary income tax in the year of distribution on the original rollover value of the shares, as of the date the original ROBS transaction (as opposed to the current value of the shares).

 

What would the tax impact look like if the same entrepreneur sold the C Corporation with the shares still owned by the 401(k) plan?

 

If the ROBS participant decided to sell the company, taking the cash proceeds and earnings back into the Plan, instead (as opposed to utilizing the NUA Method), when the ROBS participant took a distribution from the Plan, the distribution would be taxed like normal (income tax and capital gains), at the ordinary rate. This could lead to higher costs for the ROBS participant.

 

Sale of your business & rollover of sales proceeds to an IRA

 

Consider the timing of the sale of your business.  If you sell in the near-term, all the proceeds flow into the 401(k) plan.  If/when the plan is terminated, you are permitted to roll those amounts into a TRADITIONAL IRA (to distinguish between a ROTH 401(k) account or a ROTH IRA rollover);  the law doesn’t require you to take out any money from that traditional IRA until 70 ½ years old.  This forces you to consider what you think you will be making in income at that time (and at the time your spouse turns 70 ½).  Perhaps then your ordinary income tax rate will be lower than what you currently pay now, especially if you think you are retiring in the next 3-5 years (age 60-62, from what you told me).  It is possible that your income at 70 ½ will be so low that taking the required minimum distribution (that’s what you have to show as income for the year of distribution) won’t be so onerous in terms of taxes.  

 

Sale of your business & rollover of Employer Securities to an IRA

 

The termination of the 401(k) Plan and transfer of stock to an IRA with Promissory Note to the Corporation is a strategy available if the 401(k) accountholder will no longer be involved with the company as an owner, manager, employee or otherwise.

 

Reinvest your 401(k) money into another business venture

 

There are ways to further invest the redeemed amounts in your 401(k) Plan. We work with clients who sell all or part of their business and rather than returning the sale proceeds back to the 401(k) Plan they will use the money to finance another business venture.  Are there more entrepreneur activities that you contemplate in the future where (a) you work at the enterprise, or (b) where you don’t?  If so, those are priorities that should be considered.

 

Additional Information About Exit Strategies

 

Valuation of Corporate Stock Requirements

 

Any time there is a sale or exchange of the C Corporation’s stock with the 401(k) Plan, a valuation of the corporate stock is generally required. Although a formal valuation, by an independent, licensed 3rd party is not necessarily required by regulations, there are plenty of requirements around who should perform the valuation and how it should be performed. If you want additional information regarding valuation requirements, you can request additional information from our team.

 

Allocation of monies to the C Corporation owner(s)

 

With most ROBS structures, the 401(k) Plan is a sizeable owner of the C Corporation (95% is pretty typical) and an individual (usually the same individual who is the 401(k) accountholder) is a minority owner (5% is typical). In the event the C Corporation buys back stock from the 401(k) Plan or sells the stock to someone else, the proceeds from that sale  must be allocated to the owners of the C Corporation based on their rightful ownership. This means that, if the 401(k) Plan is a 95% owner of the C Corporation, the 401(k) Plan would be entitled to 95% of the proceeds from the sale of the stock. This is an important but often overlooked and misunderstood requirement.

 

Termination of the 401(k) Plan

 

Before a 401(k) plan can be terminated, all assets need to be removed from the plan, this includes the stock of the C Corporation.  In the case of a ROBS plan, that means having the corporation buy back the Employer Securities (QES), in entirety, from the 401(k) plan at fair market value. All other assets (cash, traditional investments, etc.) must be rolled out or distributed from the plan and then we can file the “final” IRS Form 5500 for the plan.

 

Leading Retirement Solutions regularly assists businesses and entrepreneurs who have engaged in the ROBS business financing strategy, with exiting that strategy.

 

Leading Retirement Solutions

(206) 430-5084 phone)
 (800) 974-2814 (toll free)
 service@leadingretirement.com

www.leadingretirement.com

 

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Article ID: 56, , Modified: 6/23/2021 at 11:39 AM

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