The Employee Retirement Income Security Act of 1974 (otherwise known as ERISA) and the Internal Revenue Code clearly allow for the use of retirement funds to acquire or invest in a new or existing business as long as the transaction complies with IRS and ERISA rules and regulations.
Business owners have been using retirement funds to help acquire or invest in a business for a number of years. A number of promoters have promoted these types of transactions under the name “ROBS”. Even though this type of transaction is permitted under IRS and ERISA rules, the IRS believed a significant number of the promoters were not taking the necessary steps to structure a transaction that is in full compliance with IRS and ERISA rules.
The October 1, 2008 Memorandum
On October 1, 2008, Michael Julianelle, Director, Employee Plans, signed a “Memorandum” approving IRS ROBS Examination Guidelines. The IRS stated that while this type of structure is legal and not considered an abusive tax avoidance transaction, the execution of these types of transactions, in many cases, have not been found to be in full compliance with IRS and ERISA rules and procedures. In the “Memorandum”, the IRS highlighted two compliance areas that they felt were not being adequately followed by the promoters implementing the structure during this time period.
The first non-compliance area of concern the IRS highlighted in the “Memorandum” was the lack of disclosure of the adopted 401(k) Plan to the company’s employees. The IRS believed that in too many instances the promoter was establishing a 401(k) Plan that was not adequately disclosed to all employees. Internal Revenue Code Section 401(a)(4) provides that under a qualified retirement plan, contributions or benefits provided under the plan must not discriminate in favor of highly compensated employees. In addition, the promoters were encouraging the business owner who had used their retirement funds to purchase company stock to not provide the same benefit to their employees.
The second non-compliance area of concern the IRS highlighted in the “Memorandum” was establishing an independent appraisal to determine the fair market value of the business being purchased.
Internal Revenue Code Section 4975(c)(1 )(A) defines a prohibited transaction as a sale, exchange or lease of any property between a plan and a disqualified person. Internal Revenue Code Section 4975(d)(13) provides an exemption from prohibited transaction consideration for any transaction that is exempt from ERISA Section 406, by reason of ERISA Section 408(e), which addresses certain transactions involving employer stock. ERISA Section 408(e), and ERISA Regulation Section 2550,408e promulgated thereunder, provides an exemption from ERISA Section 406 for acquisitions or sales of qualifying employer securities, subject to a requirement that the acquisition or sale must be for “adequate consideration.” Except in the case of a “marketable obligation”, adequate consideration for this purpose means a price not less favorable than the price determined under ERISA Section 3(18). ERISA Section 3(18) provides in relevant part that, in the case of an asset other than a security for which there is no generally recognized market, adequate consideration means the fair market value of the asset as determined in good faith by the trustee or named fiduciary pursuant to the terms of the plan and in accordance with regulations.
An exchange of company stock between the plan and its employer-sponsor would be a prohibited transaction, unless the requirements of ERISA Section 408(e) are met (the acquisition or sale of the qualifying employer securities must be for adequate consideration).
Therefore, valuation of the purchase corporate stock is a relevant issue. Since, in some cases, the company may be newly established, there could be a question of whether the stock is indeed worth the value of the purchase price exchanged. If the transaction has not been for adequate consideration, it would have to be corrected, for example, by the corporation’s redemption of the stock from the plan and replacing it with cash equal to its fair market value, plus an additional interest factor for lost plan earnings. In addition, the IRS asserts that a valuation-related prohibited transaction issue may arise where the start-up enterprise does not actually “start-up.” Many promoters have been advising clients that they do not need to secure appraisal which would seemingly contradict the IRS’s position outlined in the “Memorandum”. In addition, the promoters who have provided clients with a valuation have been providing clients with a single line valuation statement generally approximating available retirement funds, which the IRS considers inadequate.
The August 27, 2010 IRS Public Phone Forum
On August 27, 2010, almost two years after publishing the “Memorandum”, the IRS held a public phone forum open to the public which covered transactions involving using retirement funds to purchase a business. Monika Templeman, Director of Employee Plans Examinations and Colleen Patton, Area Manager of Employee Plans Examinations for the Pacific Coast spent considerable time discussing the IRS’s position on this subject. Monika Templeman began the presentation reaffirming the IRS’s position that a transaction involving the use of retirement funds to purchase a new business is legal and not an abusive tax-avoidance transaction as long as the transaction complies with IRS and ERISA rules and procedures. The concern the IRS has had with these types of transactions is that the promoters who have been offering these transactions have not had the expertise to develop structures that are fully compliant with IRS and ERISA rules and regulations. The IRS added that a large percentage of the transactions they reviewed were in non-compliance largely due to the following non-compliance issues: (i) failure by the promoters to develop a structure that requires the new company to disclose the new 401(k) Plan to the company’s employees and, (ii) the failure to require the client to secure an independent appraisal to determine the fair market value of the company stock being purchased by the 401(k) Plan. The IRS concluded by stating that a transaction using retirement funds to acquire a business is legal and not prohibited so long as the transaction is structured correctly to comply with IRS and ERISA rules and procedures.
The IRA Financial Group’s Solution
In light of the 2008 “Memorandum” and the most recent IRS comments outlined on the August 27, 2010 public phone forum, the IRA Financial Group’s in-house tax and ERISA professionals spent the better part of two years studying IRS materials and guidance in order to design an IRS and ERISA compliant structure for using retirement funds to acquire or invest in a business tax-free! Unlike our competitors who have been offering this type of structure for many years, which according to the IRS, a significant portion have been found to be non-compliant, the IRA Financial Group has patiently waited for clear IRS guidance before offering a structure that would be fully compliant with IRS and ERISA rules and procedures.
BACSS was developed to specifically address and solve each of the non-compliant areas addressed by the IRS creating a business acquisition and funding solution that is in full compliance with IRS and ERISA rules and procedures. Because the IRS has stressed the importance of compliance when using retirement funds to purchase a business, it is crucial to work with a company that is operated by a team of in-house tax and ERISA professionals who have worked at some of the largest law firms in the United States, including White & Case LLP and Dewey & LeBoeuf LLP to ensure the structure satisfies IRS and ERISA rules and procedures.