How to Finance a New Business by Rolling Over Your Retirement Funds
In times of tight credit, you can finance a new business or franchise by rolling your retirement funds into your new company. You pay no income taxes or early withdrawal penalties, avoid debt and have money available immediately to rent a space, hire employees, buy equipment and pay yourself a salary. And this is all sound, the firms that arrange these rollovers say, because they’re “based on long-standing provisions of the Internal Revenue Code.”
For thousands of startups, these rollovers are working. Every year, thousands of businesses are launched with retirement rollover money. These new entrepreneurs create more than 60,000 new jobs and adding $8.3 billion to the nation’s economy.
Indeed, one of the early adopters, Gary Cote, used $60,000 from his 401(k) back in 2005 to start Sunray Technology Ventures, a California provider of high-speed internet access services for hotels (sadly, Mr. Cote passed away in 2012). “I didn’t want to borrow money or mortgage our home to the hilt,” Cote once said. “Using my retirement money gave me independence. We’ve been profitable since 2007. 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, founder and chairman of the board of Benetrends Financial of North Wales, Penn., and Steven Cooper, president of SDCooper 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 Great Recession, when credit was easily available.
Today, they’re so popular that Rosen estimates 35 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. But if you’re considering joining them, you should be aware that retirement rollovers aren’t as simple as they sound. Obviously, you’re putting your nest egg in jeopardy. Less obviously, you’re 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 not many rollover plans have been questioned until now, the IRS has signaled very strongly 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 -- 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 aren’t 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’re spending the money on your own corporation instead of on stock in 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 to 30 percent of their assets.
Compliance is easy when starting out, when you’re the only employee and the stock value is low. In the Benetrends survey, almost three-fourths of clients had only one to three employees. Of the rest, 14 percent employed seven or more, and 3 percent had 21 or more workers. Half of all clients’ employees participated or planned to participate in their employers’ retirement plans, and the IRS wants to make sure those plans are viable.
All the major plan promoters promise to help if you’re audited; one even guarantees it will pay all fines and legal fees should the IRS rule against you. So far, the ROBS (Rollovers as Business Startups) in existence have drawn only a handful of IRS audits, and most of those ended well for the business owners, the plan providers say.
Cote wasn’t worried, because his rollover started both a business and a rich new retirement plan. He opened his Sunray retirement plan to his employees and moved some of its funds into stocks and bonds. He hired professional appraisers to evaluate the assets in his plan, and every year his provider, Guidant, helped him file detailed reports with the IRS. “My own retirement plan,” Cote said, “is worth substantially more than the $60,000 that was in it five years ago.”