The Tax Implications of Starting a Business With Retirement Money

Josh Patrick for the NY Times writes: Last week I wrote about the risks of using retirement money to finance your business. I spent some time looking at a strategy called ROBS — rollover as business start-up — and came to the conclusion that although it is being done by thousands of businesses, it has yet to receive the full blessing of either the Internal Revenue Service or the Department of Labor. As a result, I would advise my clients to stay away from the strategy.

But there is another reason to be wary, and it might be even more important — it’s about how you will be taxed if you do manage to build a company using ROBS and sell it at a profit. The tax implications are significant, and I think the lessons are important regardless of how you choose to finance your business.

If you are going to use ROBS to finance a business, you must file taxes as a C corporation, and that is where the tax issue comes into play. That’s because when it comes time to sell the company, you will be taxed twice — first at the corporate level and then at the personal level. And this, of course, is why most closely held small businesses are subchapter S corporations, whose structure allows income to flow untaxed to the owners of the company, who then pay taxes individually but only once.

Here’s an example. Let’s look at what happens if you sell a C corporation for a $1 million gain without using a ROBS strategy.

Gain……………………………………………………………………. $1,000,000

Corporate taxes @ 35%…………………………………………….. 350,000

Gain after corporate taxes ………………………………………..   650,000

Personal taxes @ 20% (capital gains)…………………………. 130,000

Cash left after taxes…………………………………………………..  520,000

Thus, if you were the owner of this corporation you would have paid 48 percent in total taxes. Now, if this company had been financed through ROBS, you would not have paid 20 percent capital gains taxes at the personal level. Instead, the stock would have been owned through a 401(k) and you would have had to pay 39.6 percent ordinary income taxes. Here’s what that would have looked like:

Gain……………………………………………………………………. $1,000,000

Corporate taxes @ 35%…………………………………………….  350,000

Gain after corporate taxes…………………………………………   650,000

Personal taxes @ 39.6%……………………………………………  257,400

Cash left after taxes…………………………………………………… 392,600

As you can see, using a ROBS strategy increases the tax bite from 48 percent to a little more than 60 percent. And that’s my point: even if ROBS transactions are legal, the tax implications are significant.

Now, a ROBS promoter might object to this example and argue that the seller should do a stock sale rather than an asset sale. (Here’s the difference: with a stock sale, the buyer purchases the owner’s share of a corporation; with an asset sale, the buyer purchases individual assets of the company but the seller retains ownership of the legal entity.) And it’s true that with a stock sale, the taxes would be the same as they are on any stock that is bought and sold inside a qualified retirement plan. No taxes would be paid until money is withdrawn from the retirement plan, when the maximum rate would be 39.6 percent.

This might be a great idea except for one thing: buyers generally do not like stock sales. Buyers do not want to buy your liabilities, and they do not want to buy surprises that might not show up for years. If you insist on a stock sale, you may have a difficult time selling your business.

But there is an alternative, another way of using retirement funds if you really want to start a business and have no other way of getting capital. You can establish a retirement plan in your new company, roll your existing retirement plan into the new company, and then borrow up to 50 percent of your account balance.

So, if you need, say, $250,000 to start a new business, and you have an I.R.A. with $500,000, you could establish a subchapter S corporation, create a new retirement plan in the new company, transfer your I.R.A. balance of $500,000 to the new plan and then borrow half of it to finance the company.

You would have to repay the loan with interest over the following five years. If you failed to repay the loan, you would be presented with a tax bill at ordinary income rates for the amount of the loan that had not been repaid. If you were under 59.5 years old, you would have to pay income taxes, and you would also have a 10 percent penalty for early withdrawal.

Before borrowing money from your retirement plan, you will want to think long and hard about whether you want to risk retirement savings on a business that could fail. If it does fail, and you cannot repay the loan, the tax consequences will be serious.

But let’s say that you borrow the money and you do make a go of it. When it comes time to sell, because you established a subchapter S corporation, you will have preferential tax treatment.

Gain…………………………………………………… $1,000,000

Individual capital gains @ 20%……………….. $200,000

Cash left after taxes ……………………………….. $800,000

Obviously, from a tax perspective, this is an attractive option (although I urge you to talk all of this over with a tax adviser before doing anything). But again, the main thing I want to emphasize is that it makes sense to think about how you are going to get out before you decide to get in. Seemingly small decisions can have big consequences down the road.

What do you think? Would you still do a ROBS transaction knowing what the tax cost is likely to be?