For thousands of startups, these rollovers are working. Last year, 4,050 businesses--60 percent of them franchises--were launched with retirement rollover money, according to FRANdata, an independent research firm. These new entrepreneurs started ventures that range from data processing companies to flower shops, created more than 60,000 new jobs and added $8.3 billion to the nation's economy. And the lingering recession, says Steve Rosen, CEO of FranNet, a franchise broker firm based in Louisville, Ky., is only making retirement rollovers more attractive.
"Bank credit is tight," Rosen says, "and housing values have dropped so much you can't get a home equity loan. These rollover plans let you invest in yourself instead of investing in the stock market."
Indeed, one of the early adopters, Gary Cote, used $60,000 from his 401(k) in 2005 to start Sunray Technology Ventures, a Palm Desert, Calif., provider of high-speed internet access to hotels. "I didn't want to borrow money or mortgage our home to the hilt," Cote says. "Using my retirement money gave me independence. We've been profitable since 2007 and had revenues of $2.2 million last year. I have 10 employees, and I can't say enough about the scenario that allowed us to provide for all these people."
Although the mechanism for rolling retirement funds into business startups has been available for decades, the practice began in earnest in 2000, when industry founders and former business associates Leonard Fischer, now CEO of BeneTrends Inc. of North Wales, Penn., and Steven Cooper, now CEO of SDCooper Co. of Huntington Beach, Calif., introduced the concept at the annual convention of the International Franchise Association. "We were the hit of the show," Cooper says. Rollovers gained momentum during the early 2000s but fell out of favor during the boom years before the current recession, when credit was easily available.
Today, they are so popular that Rosen estimates 35 percent to 40 percent of all new franchisees recruited through his broker network last year tapped some or all of their retirement funds to get started. So far, an estimated 10,000 small businesses and franchises have been launched nationwide with retirement money.
But if you're considering joining them, you should be aware that retirement rollovers are not as simple as they sound. Obviously, you are putting your nest egg in jeopardy. Less obviously, you are also agreeing to pay a rollover plan provider an annual fee for the life of your business and, some tax experts warn, risking increased scrutiny from the Internal Revenue Service. Although few rollover plans have been questioned until now, the IRS has signaled that it may begin looking at them more closely.
The "long-standing provision" behind these plans is ERISA, the extremely complicated and easy-to-violate Employee Retirement Income Security Act of 1974, which enables employees to be responsible for their own retirement plans.
The three main administrators of rollover plans--SDCooper, BeneTrends and Guidant Financial Group Inc., of Bellevue, Wash.--have tweaked ERISA rules into a neat three-step program. You pay one of them a fee of about $5,000 and it'll do the rest: Move your current 401(k) or IRA (self-directed IRAs are not eligible) into an ERISA profit-sharing plan, which then becomes the retirement plan for your new company. That plan buys up the stock of your new C-corporation. Once the funds have transferred, they become tax-free capital for your business. In essence, you are spending the money on your own corporation instead of for stock of another company, such as General Electric or Goldman Sachs.
"You then open a corporate checking account," Cooper says, "and pay yourself back for whatever you've spent money on and pay our fees." Like the other providers, Cooper charges an annual fee--$800 to $1,440 a year--to file documents required by the IRS to make sure your new "retirement plan" remains safely qualified.
Because maintaining the plans is complicated and expensive, you may think that only people who have no other options for financing a business are using them. But a FRANdata survey of about 500 of BeneTrends' 3,077 active clients shows that many of them are far from desperate. In fact, 89 percent of respondents have college or postgraduate degrees, and 60 percent of them used other sources in addition to retirement money to fund their businesses. Almost half of them were able to finance their investments by using only a portion of their retirement plans, and one-third tapped into only 10 percent to 30 percent of their assets.
But a contingent of CPAs, tax attorneys and pension experts, including Stephen Dobrow, immediate past president of the American Society of Pension Professionals and Actuaries and president of Primark Benefits in San Francisco, is concerned that the IRS is about to crack down on both rollover plan promoters and their clients.
"These plans are operating in a gray area, and I'm afraid they'll come back to bite their users in the butt," Dobrow says. He points to an IRS memorandum, issued in October 2008 by Michael Julianelle, director of employee plans, that calls such plans "ROBS" (Rollovers as Business Startups) and begins, "Although we do not believe that the form of all these transactions may be challenged as non-compliant per se, issues such as those described within this memorandum should be developed on a case-by-case basis."
The 15-page memorandum shows IRS auditors the ways ROBS plans can slip out of compliance. These rollovers are legal only because they exchange one type of retirement plan--your 401(k)--for another, the profit-sharing plan set up in your new business. You are the custodian of that plan and, therefore, must follow strict ERISA rules, which you can violate by not offering eligible employees participation in your new retirement plan, not filing proper reports with the IRS, filing a report with an improper valuation of the stock owned by your corporation's retirement plan, or by not diversifying the plan's investments. If the IRS finds you have violated ERISA rules, you could have to pay taxes and penalties on the money you took out of your 401(k), plus additional fines.
Compliance is easy when starting out, when you are the only employee and the stock value is low. In the BeneTrends survey, almost three-fourths of clients have only one to three employees. Of the rest, 14 percent employ seven or more, and 3 percent have 21 or more workers. Half of all clients' employees participate or plan to participate in their employers' retirement plans, and the IRS wants to make sure the plans are viable.
Melissa Labant, tax technical manager for the American Institute of Certified Public Accountants in Washington, D.C., says the memorandum "is as strong a warning as the IRS can give. They don't come out with this type of guidance often and it could mean they are preparing to audit many of these plans."
Dobrow notes that the IRS expressed concern about another ERISA twist a few years ago involving insurance policies, "then threw the book at everyone and imposed fines of hundreds of thousands of dollars. I believe ROBS are in the next wave."
But BeneTrends co-founder Fischer calls that IRS memo "the best thing that ever happened to us."
"It showed us how to comply with the law," he says. "Our business doubled the following year."
Benetrends' outside attorney, Kathleen Nilles of Holland and Knight in Washington, D.C., says she, too, sees the memo "as a road map for how to do this right. Although it's stated negatively--'This is how we catch people'--it lays out what i's to dot and t's to cross in this very complicated area of the law."
All the major plan promoters promise to help out if you are audited; one even guarantees that it will pay all fines and legal fees should the IRS rule against you. So far, the 10,000-plus ROBS in existence have drawn only a handful of IRS audits, and most of those ended well for the business owners, the plan providers say.
But Randy Gegelman, a tax attorney with Faegre and Benson in Minneapolis, Minn., warns, "The IRS goes in waves. When they find a practice, they spend time understanding the scope of it and then begin active challenges, which I expect will be their next step. These arrangements are intended to be used for retirement investment, not seed money for your business."
The IRS would not comment directly on whether it anticipates a crackdown on ROBS. "I can say the memo is still on our website and we point people to it," says IRS spokesman Dean Patterson.
Cote isn't worried, because his rollover started both a business and a rich new retirement plan. He opened his Sunray retirement plan to his employees (six of the 10 contribute) and moved some of its funds into stocks and bonds. He hires professional appraisers to evaluate the assets in his plan, and every year his provider, Guidant, helps him file detailed reports with the IRS. "My own retirement plan," Cote says, "is worth substantially more than the $60,000 that was in it five years ago."
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