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How to Exit the ROBS Business Financing Strategy

October 25, 2019

We’ve done many articles in the past around initiating a Rollovers As Business Startups (ROBS) financing strategy to start a new business or grow an existing one, but what about when it comes time to exit said plan?

Why exit?

Typically, those partaking in the ROBS strategy that wish to exit it, do so to defer taxation on their company shares or to change their corporate entity to something other than a C-Corporation. If their company stock is valued at more than they want to pay to buy it back, there is a set of provisions in the Internal Revenue Code that permit tax deferral and capital gains tax treatment when utilizing certain methods of exiting a ROBS plan.

Main methods for exiting the ROBS strategy
  1. Full or Partial Redemption (e.g. buyback) of Stock
  2. Early Redemption (e.g. buyback) of Stock
  3. Distribution of Stock In Kind
  4. Required Minimum Distributions (RMDs)
  5. Net Unrealized Appreciation (NUA) Strategy
 
The Closure and Sale of the Business

The C Corporation needs to buy the stock back from the plan before the C Corporation can be dissolved and the can be plan terminated. Employer Securities (QES) - the private stock of the C Corporation that is held/owned by the 401(k) Plan - must be redeemed (e.g. bought back) and the sales proceeds allocated pursuant to ownership of the C Corporation. For example, if the plan is a 75% owner of the C Corporation, the 401(k) Plan is entitled to 75% of the proceeds of the sale. This requirement applies even if the value of the stock is now at $0, due to business closure. The Department of Labor still expects to see, before the 401(k) Plan is terminated, that the stock was removed from the plan.

Additional investments need to be transferred out of the plan. If any additional investments, assets, dollars (e.g. cash) are held in the name of the plan, those assets must be distributed or rolled/transferred out of the plan before the plan can be fully terminated and the final IRS Form 5500 filed.

Proceeds from the sale of the business should be returned to the C Corporation. The proceeds from the sale of the business should be allocated to the owners of the C Corporation, based on respective ownership. The proceeds from the sale of the business should NOT be allocated solely to the individual business owner, if the plan is also an owner of the C Corporation.

With stock bought back, investments transferred, and proceeds returned, the C Corporation can be dissolved and the plan can be terminated. If no further business is to be conducted, and the stock is redeemed, the C Corporation can then be dissolved and the plan can be terminated, pursuant to Department of Labor and Internal Revenue Service requirements.

 
Full or Partial Redemption of Stock

A redemption of stock occurs when the C Corporation buys some or all of its stock back from the plan. This exit strategy is most often deployed by an entrepreneur who wants to convert the C Corporation to S Corporation status.

The decision to have the C Corporation buy the stock back, from the 401(k) Plan, is often a very strategic one. This is a decision that should be made based on several factors including 1) priorities of the business, 2) priorities of the business owner(s), 3) retirement savings needs, 4) tax deduction needs, 5) business expansion/financing needs and more! Given the tricky nature of this strategy, it’s best to work with a Third Party Administrator, an ERISA attorney, and a tax advisor when exiting a ROBS business financing strategy.

Once the decision has been made to redeem stock, the C Corporation engages in a partial or full stock buyback from the 401(k) Plan. The C Corporation needs to come up with the money to buy a certain amount of stock/shares back from the plan at the current fair market value of the stock. It is a common misconception that the stock can be bought back for the original price that the plan paid for the stock. Full or partial redemptions are allowed however, the C Corporation cannot be converted out of C Corporation status until all stock has been redeemed from the Plan.

There are various ways a Corporation will generally raise cash for this kind of buyback, including, obtaining a traditional bank/SBA loan, retaining revenue, or accepting a loan from a third party (in limited instances the third party can be the same individual who runs the company). The actual buyback process is as follows:

Step 1: Stock valuation. The company stock should be valued by an outside, independent firm; this may generally include an informal valuation from your CPA, if he/she does them or a formal valuation from a valuation firm. 

Step 2: Stock redemption authorization. A corporate resolution should be drafted, authorizing the redemption of stock between the C Corporation and the Plan. 

Step 3: Return the proceeds. The proceeds from the redemption need to be returned back to the plan based on its rightful share, by sending the monies back to the plan account.

Step 4: Stock certificate redemption. Stock certificates should be “redeemed”, the stock that is purchased back usually becomes unissued stock for the time being.

Step 5: Stock ledger revisions. The stock ledger needs to be revised, reflecting the updated ownership (the plan is no longer a shareholder or has a lesser amount of ownership). The monies - including earnings that are returned to the plan - can be invested in more traditional investments like mutual funds. You could also use the monies and earnings for other non-traditional or business financing needs in the future.

Step 6: Conversion. Once all stock is fully redeemed by the C Corporation from the plan, the C Corporation can convert to S Corporation status and the plan can either continue to exist or it can be terminated.

 
Partial Redemption of Stock

A partial redemption of stock occurs when smaller amounts of stock are purchased back by the C Corporation, from the plan, in multiple transactions over time. For a partial redemption, if the company valuation is higher than cash on hand, the plan and C Corporation can enter into an amortized payment schedule to settle the buyout. This allows for a controlled distribution of the profts to the plan. It can also help mitigate the impact of being taxed as a C Corporation. This method extends the amount of time that the business remains a C Corporation, and comes with high costs from the administrator for the redemption. 

There are requirements related to valuing corporate stock each time a partial buyback is completed. Generally, you must value the stock each time you engage in a partial buyback although the facts and circumstances of your partial buybacks may allow for utilizing a prior or historical valuation. Partial buybacks can end up being a rather expensive approach to buying back the stock as additional costs apply each time there is a redemption and this approach is rarely utilized as a result.

 
Early Redemption of Stock

The early redemption method tends to be utilized by entrepreneurs who need business financing for only a short period of time. The business owner invests 401(k) monies into the C Corporation and within 1-2 years, the C Corporation is able to raise enough funds to buy the stock back, in full, from the plan. This allows for a quick exit and conversion to S-Corporation status. However, the amount returned to the 401(k) account of the participant may be less than that originally deposited depending on how the value of the company stock has fluctuated, if at all.

This method is not often utilized because most new businesses can’t raise enough capital, this early, to buy the stock back. Additionally, it is generally not recommended that you terminate the plan, in conjunction with the early buyback. Federal regulations require, that when you establish a 401(k) Plan, you establish it with the intent of providing a “permanent” employee benefit to and for you and your workforce. Five (5) years is generally the minimum number of years you need to have a plan operational to show that you intended to put in place and offer a permanent employee benefit. Exceptions can be made for business hardship necessitating an early termination of the plan.

 
Distribution of Stock In Kind

For this method, unlike the full or partial redemption strategy, the C Corporation stock does not need to be liquidated and can be distributed or transferred “in kind”.  An “in kind” distribution is a payment made in the form of securities or other property, rather than in cash. A distribution in kind may be made in several different situations, including a stock dividend, inheritance, or taking securities out of a tax-deferred account. 

With the ROBS strategy, an in kind distribution or transfer means that the stock is transferred directly to an individual or another retirement account, without first liquidating the stock into a cash state. This works for individuals that are not ready to or can’t afford to pay the value of the stock to redeem it or want to continue to hold onto the stock for tax advantages and other beneficial reasons. The retirement plan legal documents (e.g. Adoption Agreement) must allow for the “in kind” distribution or transfer of the Employer Securities (QES). If your retirement plan documents do not currently allow for this, LRS can generally amend your documents to allow for this in kind method.

 
Required Minimum Distributions (RMDs)

Required Minimum Distributions are minimum amounts that a retirement plan account owner must withdraw annually starting with the year that he or she reaches 70.5 years of age or the year in which he or she retires (if over 70.5). However, if the retirement plan account is an IRA or the account owner is a 5% owner of the business sponsoring the retirement plan, the RMDs must begin once the account holder is age 70.5, regardless of whether he or she is retired.

If the 401(k) accountholder who invested in the Corporation is of an age to take RMDs, they can be taken in the form of the Employer Securities (QES)/corporate stock. If the stock is liquidated and proceeds/earnings returned to the 401(k) Plan instead, RMDs can be taken in the form of cash. For RMDs made from the QES/corporate stock, in kind, the retirement plan legal documents (e.g. Adoption Agreement) must allow for the “in kind” distribution or transfer of the Employer Securities.

 
Net Unrealized Appreciation (NUA) Strategy

Typically, an entrepreneur who has engaged in the ROBS business financing strategy, that has built a successful and profitable enterprise, and now wishes to exit the strategy, wants to do so with a goal of deferring or reducing taxation on their company shares. If the company stock is valued at more than an entrepreneur wants to pay to buy it back, there is a set of provisions in the Internal Revenue Code (IRS) that permits tax deferral and capital gains tax treatment when utilizing certain methods of exiting a ROBS Plan. The main method used is called the Net Unrealized Appreciation (NUA) transaction.

When it comes to the NUA transaction, there are certain conditions that must be met. These 5 conditions include:

  1. The ROBS participant needs to be at least 59.5 years old.*
  2. All other Defined Contribution retirement plan accounts (sponsored by the employer) of the ROBS participant are also distributed/rolled out of the plan in the same tax year.
  3. Employer securities must be distributed in-kind.
  4. Employer securities must be distributed in the same tax year.
  5. The shares should be valued by an independent, valuation firm prior to distribution.
      * While it’s possible to do for those under 59.5, it would be complicated and expensive.

Once the above conditions have been met, a ROBS participant exit can be initiated. The participant will owe only ordinary income tax in the year of distribution on the original rollover value of the shares, as of the date of the original ROBS transaction (as opposed to the current value of the shares).

What would the tax impact look like if the same entrepreneur sold the C Corporation with the shares still owned by the 401(k) plan?

If the ROBS participant decided to sell the company, taking the cash proceeds and earnings back into the Plan, instead (as opposed to utilizing the NUA Method), when the ROBS participant took a distribution from the Plan, the distribution would be taxed like normal (income tax and capital gains), at the ordinary rate. This could lead to higher costs for the ROBS participant.

 
Sale of your business and rollover of proceeds/QES to an IRA

When implementing a ROBS exit strategy, be sure to consider the timing of the sale of your business. If you sell in the near-term, all the proceeds flow into the 401(k) Plan.  If/when the plan is terminated, you are permitted to roll those amounts into a Traditional IRA instead. For comparison, the law doesn’t require you to take out any money from that traditional IRA until 70.5 years old. This forces you to consider what you think you will be making in income at that time; perhaps your ordinary income tax rate will be lower than what you currently pay now. If the 401(k) accountholder will no longer be involved with the company as an owner, manager, employee or otherwise, the termination of the 401(k) Plan and transfer of stock to an IRA with Promissory Note to the Corporation is also an available strategy.

If you’re looking to exit a ROBS plan effectively, the Leading Retirement Solutions team are experts in nontraditional investing and funding strategies, including ROBS business financing, and can help every step of the way. If you have questions you can get in contact with us here.

If you’d like to learn more about other strategies for financing your business, including the ROBS strategy, check out our friends over at Frank Selden Law!

For more tips and information regarding retirement plans, contact us.

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