Is the rollover business start up technique legal?Article added by Nicholas Paleveda MBA J.D. LL.M on May 17, 2012
Nick Paleveda MBA J.D. LL.M

Nicholas Paleveda MBA J.D. LL.M

Sanford, NC

Joined: March 27, 2012

A client is considering the purchase of a new business with a preexisting 401(k) plan and wishes to do so using a rollover business start up (ROBS) technique. The technique consists of:

1.The creation of a business, either as an LLC or C-Corporation

2. The setup of a retirement plan by the corporation for its employees

3. The rollover of Client A’s previous 401(k) funds into the new plan.

Once this is accomplished, the plan will purchase corporate stock and the exchange of funds will be put towards the operation of the business.

When confronted with this plan, the legal issue involving purchasing a business with a 401(k) plan utilizing a ROBS program needs to be addressed.

Two issues with ROBS

There are two primary issues raised by ROBS arrangements:

1. Violations of nondiscrimination requirements, in that benefits may not satisfy the benefits, rights and features of Treas. Reg. §1.401(a) (4)-4 and;

2. Prohibited transactions, due to deficient valuation in stock.


The first issue deals with violation of IRC §401(a) (4), which states that a plan will be qualified if the contributions or benefits provided under the plan do not discriminate in favor of highly compensated employees (HCE). IRC §414(q) (1) (A) provides that an HCE is defined as either (1) a 5 percent owner or (2) an employee who had compensation in excess of $80,000. Although in the beginning stages of a business, no employee may meet the requirements of an HCE except by way of ownership.

Treas. Reg. §1.401(a) (4)-4 and §1.401(a) (4)-5 continue to explain discrimination further. Treas. Reg. §1.401(a) (4)-4 provides the rules for determining whether the benefits, rights and features provided under a plan are made available in a nondiscriminatory manner.

To be made in a nondiscriminatory manner, the benefits, rights and features must be “currently available” to non-highly compensated employees (NHCE) and “effectively available” to the NHCE. Further, 1.401(a) (4)-5 requires consideration as to whether the timing of plan amendments serves to preclude other NHCEs from receiving stock.

In a typical ROBS scenario, a shell corporation is set up and sponsors a qualified retirement plan documenting that all participants may invest. During the initial stages of set-up, the creator of the business is the sole employee. At this time, the employee executes a rollover of funds from a previous qualified plan into the new plan. With these funds, a purchase of employer stock is made and then the desired business is established, having capital to operate with.The plan is then amended to prohibit further investments in employer stock and therefore future employees and participants are not entitled to invest in employer stock.

Because Client A would be the only individual benefiting from the employer stock, the issue of discrimination arises because the plan has been designed so that the benefits, rights and features to invest in employer stock will never been available to any later hired employees.

The second biggest issue is one of valuation. There are many questions as to whether a new company is worth the value of the tax-deferred assets for which it was exchanged and therefore, the need for valuation is presented.

If the true enterprise value does not qualify as adequate consideration under ERISA §408(e), then a prohibited transaction may occur. In instances where a valuation approximates available funds, consideration needs to be given to whether inherent value in the plan-acquired entity exists.

Another situation that may result in a prohibited transaction is where the plan purchases stock of the employer and the employer immediately pays professional fees to the promoter out of the proceeds. IRC §4975(c) (1) (E) prohibits a fiduciary from dealing with the assets of the plan in his own interest or his own account.

If either of these situations resulted in a prohibited transaction, IRC §4975(a) imposes a 15 percent tax on the amount involved in the transaction. IRC §4975(b) imposes a tax equal to 100 percent of the amount involved in any case where a prohibited transaction is not corrected within the taxable period, as defined by §4975(f).

Other issues

Other issues raised by ROBS are the permanency, plan not communicated to employees, and inactivity in cash or deferred arrangement.

Permanency is a qualification requirement for all retirement plans and due to the nature of ROBS a benefit
occurring once, permanency is questioned. In most cases, ROBS do not violate permanency rules because when coupled with a cash or deferred arrangement (CODA) feature, contributions are received only if made and the issue of permanence is resolvable in favor of the employer.

The second issue that arises is that although the plan may pass the nondiscriminatory test, all employees must be made aware of the plan. Treas. Reg. §1.401-1(a) (2) requires that a plan be a definite, written program communicated to the employees. Failure to do so violates the regulation and disqualifies the plan.

Lastly, a CODA feature is often present in many plans within ROBS; however, not many participants make elective contributions to the plan. It is important that all procedures for allowing employees to participate in such an arrangement are followed and that employees are actually permitted to make elective deferrals to the plan. If not, there is a violation of IRC §401(k) (2) (D).


The use of ROBS is permitted, however, there are many obstacles along the way that if not mastered, can put the plan in violation to several laws. Proper administration is crucial because the IRS is skeptical about this method and is continuously monitoring it.
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