ROBS: Tap into retirement funds for real estate financing

Real estate investing is awesome. Buying a tangible asset that you can drive by, walk through, modify, and be proud of is quite satisfying. Of course, the major downside is that real estate investing requires capital. If you don’t have capital available, you will be forced to save after-tax dollars in hopes of one day applying them to real estate.

Many of my clients at The Real Estate CPA have been contributing to their retirement plans for years. After seeing the less-then-stellar returns their retirement accounts were bringing in, they decided to switch investment strategies. Real estate investing was their next option.

But they found themselves in a dilemma – they don’t have the necessary capital readily available. By readily available, I mean in an accessible equity portfolio or in the bank.

What they do have, however, are large retirement accounts. Some of these clients rolled their accounts into SDIRAs and Solo-401(k)s. Others used a more exotic strategy; something known as the Roll Over Business Start-up (ROBS).

What is the ROBS?

On a sky high level, the ROBS strategy is one that allows you to roll your 401(k) plan into a C-Corporation that you establish. You, the entrepreneur/real estate investor, are then free to use the funds. You may pay yourself a salary or dividends using the capital the 401(k) contributed to the business.

How can this be? The 401(k) purchases shares of the C-Corporation. In exchange for providing the 401(k) with shares, the C-Corporation receives the 401(k)’s capital contribution. The C-Corporation is then able to use those funds in its business operations.

The 401(k) is now a shareholder of the C-Corporation and has provided you, the entrepreneur, with necessary funds to start your business. Hence the “Start-Up” portion of Roll Over Business Start-Up.

Steps in a ROBS

A valid ROBS strategy requires that the entrepreneur uses the funds for legitimate business operations. A pension plan sponsored by the C-Corporation must be permanently formed and administered. It must also be demonstrated that the 401(k)’s purchase of the C-Corporations securities was an appropriate investment of the 401(k)’s capital.

Setting up the ROBS strategy usually requires the following:

1. Create a C-Corporation;
2. (You) Get on the C-Corporation’s payroll as an employee;
3. The corporation adopts a 401(k) plan that permits participants to direct the investments of their plans, including into employer stock;
4. (You) As the employee initiate a direct rollover of retirement funds from your 401(k) plan into the newly established plan;
5. (You) As the employee then direct the investment of your 401(k) plan account to purchase the C-Corporation’s stock;
6. (You) Personally invest in the C-Corporation and acquire corporate stock; and
7. The C-Corporation uses the proceeds from the sale of stock to your 401(k) to purchase an existing business or to begin a new business.

Downsides

Obviously, the upside to using a ROBS strategy is that you make your retirement funds readily accessible for use in your real estate ventures. You may use them how you please (as long as you have a business purpose) and you don’t have to wait until you are 59.5 years old. Having access to those funds will allow you to maximize the use, and therefore the return of those funds. If done correctly, a real estate venture will completely annihilate the non-real estate returns you are used to seeing.

But with any exotic strategy, there are many downsides. If you mess up, you could be in deep trouble. And be very careful with anything you read on the ROBS strategy online – some people make it seem much easier than it actually is, others make it seem much more complicated than it actually is.

The first major issue is that the ROBS must be for a business purpose. If an operating business is not established, then the ROBS plan can be disregarded pending an IRS audit. It should be stressed that you cannot avoid paying tax on early distributions from qualified plans by funneling these distributions through a C-Corporation if that corporation is acting only as a shell. The corporation must have a business purpose and need for the retirement funds.

The second major issue is that the ROBS strategy forces the use of a C-Corporation. C-Corporations can be strategically used in your ventures, but if the entity doesn’t make sense for use in your business, the ROBS strategy may not be for you.

The third major issue is that the corporation must sponsor a 401(k) plan for the benefit of, and extend rights to, each and every one of its employees; not just for you. This also includes employees of the corporation’s subsidiaries, if applicable. The 401(k) plan itself has numerous administrative and filing requirements. Often times, because you likely don’t understand the ins and outs, you will hire a trustee to handle everything which adds an additional expense to your fledgling business.

The fourth issue revolves around your ability to invest in the C-Corporation. You must first be an employee of the C-Corporation prior to investing qualified funds. Additionally, you will absolutely need to invest in the C-Corporation yourself as for a ROBS to work, the C-Corporation needs one additional investor aside from the 401(k) plan. The IRS has set statutory thresholds for the minimum amount you must invest alongside your 401(k) plan. Lastly, as long as the 401(k) plan is a shareholder, you have a duty to ensure that equity transactions for the corporation meet the “adequate consideration” rule. This rule essentially says that the 401(k) is making a solid investment in the corporation.

Key IRS Issues

As you can see, there are many downsides to the ROBS strategy. Many downsides stem from the many issues the IRS has raised over the years. It doesn’t mean that we can’t utilize the strategy, it just means we must tread with caution.

I’m not going to cover all of the IRS hot button issues surrounding the ROBS strategy today. Instead, I’ll touch on the main two.

Company valuation. You must demonstrate that the 401(k) made a sound investment in your C-Corporation. You must show that the 401(k) will earn solid returns on its investment and that the 401(k) bought your corporation’s shares for a reasonable price. This of course can get dicey because the obvious question is: how do I value my C-Corporation’s shares? That depends on the facts and circumstances and is beyond the scope of today’s post. But it’s important to note that valuing your company is not as easy as some people make it out to be.

Nondiscrimination.  The plan that the C-Corporation established (not your 401(k) plan investing in the C-Corporation) must meet the nondiscrimination requirements as laid out in IRC Section 401(a)(4). The IRC’s nondiscrimination rules are designed to ensure that highly compensated employees (HCEs) do not benefit in any extreme manner from the established plan. Some trustees will consider the owner of the C-Corporations (you) to be an HCE. If you are the only HCE, you’ll not have to worry about the nondiscrimination rules as they will be automatically satisfied. There are also issues with coverage and benefits, but we’ll get into those another time.

Conclusion

So there you have it. A sky high overview of the ROBS strategy. While it is certainly complicated, it’s also completely legitimate. If executed in concurrence with a CPA and attorney, you’ll be safely on your way to building a new business.

Keep in mind that I didn’t mention feasibility from a financial perspective. I also didn’t mention what types of businesses you can and cannot start via a ROBS. I did this intentionally, to allow your brain to digest these topics at a high level. Later on, I’ll write in more detail about the technicalities.