Funding a New Business with a 401K

A few years ago, Intuit did a study showing that 72% of people would prefer to be self-employed. (1)

But, starting a business is costly. According to Forbes, the cost of starting one of the 20 top franchises ranges from just over $60K to almost $1.5M. (2)  Such figures are staggering for most  aspiring entrepreneurs and cause the idea of opening an independent business to be quickly dismissed.  However, there are options open to many people.

One of these options is using an existing 401K from your employer to fund the start-up or acquisition costs of a new business.  This option is called a Rollover as Business Start-up, or ROBS.   Here’s how it works:

  1. Form a Corporation.  In order to meet IRS requirements, the corporation must be a C Corporation – not a Limited Liability Corporation (LLC) or S Corporation (S Corp).  For sake of example, let us call the corporation “VCSCO, Inc.”
  2. New Corporation Sponsors a 401K Plan.  A CPA or an expert in setting up a ROBS creates a 401K for VCSCO, Inc., and agrees to be the plan administrator.
  3. Rollover Your Existing 401K Plan.  Rollover the funds from your present 401K plan into the new VCSCO, Inc., 401K plan.  Rolling funds from one 401K to another creates no tax liability.
  4. New 401K Plan Invests in the New Corporation Stock.  VCSCO, Inc., issues shares of stock and your new 401K plan buys them.  The proceeds from the sale of the stock to your 401K plan is deposited into the VCSCO, Inc., bank account.  It can be used to pay for franchise fees, start-up costs, and working capital to start a business or purchase an existing business.

When applying for bank or SBA loans, lenders consider such cash to be unencumbered funds.  In other words, there are no loans made against it and no debt associated with it.   Since business loans for many types of businesses are routinely made with 25% down payment, an entrepreneur can realistically afford to purchase a business that costs 3 or 4 times as much as the value of the 401K.   With average 401K balances of over $75K, a surprisingly large number of people have access to the money needed to start an average franchise with initial investments of $300K.

What kind of franchise can a person purchase for $300K?  A tax service like Liberty Tax.   A Merry Maids franchise.  A Supercuts franchise.  Or a fitness center franchise like Anytime Fitness.  For the more confident entrepreneur, $300K is more than enough to buy a small car wash, a dryer cleaners, or a laundromat.

In order to use a ROBS for funding, the entrepreneur must be a salaried employee of the business.  The salary that the entrepreneur makes should not come from the ROBS funding – but only from operational revenues generated once the new business opens its doors.

Drawbacks

The biggest drawback of using a ROBS for funding a new business adventure is that there is significant risk of losing retirement savings.  The entrepreneur is solely responsible if the business spirals into bankruptcy.

Other drawbacks include the IRS requirement that all full time employees of the business be offered the same 401K plan.  In other words, if your new business has full time employees, you will be required to offer them shares in the venture.  Obviously, if this is undesirable or unfeasible, only part-time workers can be hired.

Finally, the IRS wants to make sure that ROBS are not used as a backdoor method of withdrawing money tax-free from a 401K.  Therefore, it is important that your business opportunity be valued by a professional appraiser before the ROBS funding is secured as well as on a yearly basis thereafter.  And be prepared for an IRS audit – especially if your new enterprise is a cash business where money laundering could be a concern for the government.

(1)   http://usatoday30.usatoday.com/money/smallbusiness/columnist/abrams/2007-10-11-workers-survey_N.htm

(2)  http://www.forbes.com/sites/jjcolao/2012/02/08/top-20-franchises-for-the-buck/

(3)  http://money.usnews.com/money/blogs/planning-to-retire/2012/11/09/average-401k-balance-reaches-new-high

 

 

 

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