Karen Blumenthal for the Wall St. Journal writes: For those looking to buy a business or invest in a startup, it is a tempting thought: Why not tap money accumulated in retirement funds, so that any gains can rise tax-deferred or tax-free?
Tax rules allow retirement accounts to make nontraditional investments in startups and private-company stock, and those have become more popular in recent years. But they are also rife with potential troubles.
In a May, a U.S. Tax Court ruled that two people who bought a business through their individual retirement accounts had engaged in a prohibited transaction when they personally guaranteed a loan for the business.
The men had set up IRAs in 2001 and then used their IRA money to buy the stock of a company providing fire alarms and other fire-protection services. The two later rolled over the traditional IRAs into Roth IRAs, which are funded with after-tax money and rise tax-free. After the business appreciated in value, the Roth IRAs sold the stock in 2006.
The participants erred, however, when they personally guaranteed a loan at the outset. The tax court ruled that the move caused their IRAs to lose their status as tax-deferred accounts back in 2001. The court assessed each man more than $225,000 in taxes and more than $45,000 in penalties.
Tax lawyers say the ruling is significant because there is little case law to draw on regarding retirement-fund investments in startup or private companies. Further, only a few items are banned as IRA investments, notes Amiram Givon, a San Francisco benefits attorney. Those include life insurance and collectibles, such as art or antique cars.
As a result, some advisers and firms recommend that those looking to buy a small business or start one tap retirement funds rather than take on debt. Roger Murphy, chief executive of Murphy Business and Financial Corp., a business broker based in Clearwater, Fla., says at least 10% of his firm's sales of businesses and franchises include some of the buyer's retirement funds. "We tell everybody about this," he says. "I look at it as, 'I'm investing in me.' "
Mr. Murphy encourages buyers to consider a transaction known as "rollovers as business startup," or ROBS. To do it, the business buyer forms a separate corporation and hires an adviser or a firm to set up a qualified employer 401(k) plan for the new company. The buyer then rolls over all or part of his IRA or old 401(k) into the new 401(k) and uses that to buy the stock of the new business.
Any future employees should have the option to participate in the 401(k), though they may not be able to buy company stock.
Guidant Financial, the biggest provider of ROBS-related services, has done about 8,500 such transactions over a decade and is growing about 20% a year, says David Nilssen, chief executive. The Bellevue, Wash., firm also handles record keeping for the new 401(k)s.
The upfront transaction costs about $5,000. The typical user is 40 to 60 years old and invests less than 75% of his retirement funds in the new business, Mr. Nilssen says. IRAs also may be used to acquire businesses. But "there are more ways for individuals to get themselves in trouble on the IRA side" than with a 401(k), says Brian C. McManus, a tax litigation lawyer at Latham & Watkins LLP in Washington.
Tax lawyers say another fairly common strategy is to buy founder's shares or a startup company's stock with funds from a Roth IRA. If the business is successful, the gains can continue to grow and can be withdrawn tax free after the investor reaches 59½.
There are income limits on who can open a Roth IRA, but anyone can roll over a traditional, tax-deferred IRA to a Roth, though taxes are owed on the amount rolled over.
Using your retirement funds in these ways, however, involves significant risks. The biggest, of course, is that the business fails and you lose that retirement nest egg. The IRS said it looked at a sample of ROBS-financed businesses in 2009-10 and many of them had gone out of business within three years.
While there are many investment options for retirement accounts, they come with some limits and requirements. For instance, IRA rules ban so-called self-dealing, such as buying your home using IRA funds or borrowing money from your IRA. A 401(k) must be managed for the benefit of all the plan participants and must issue annual reports.
In addition, even among reputable tax lawyers, advice about these transactions may vary, because the guidelines are murky. One tax lawyer may warn against a ROBS, while another is comfortable with it.
Last, IRS and federal rules could change. The IRS's main discussion of ROBS came in 2008 guidelines, in which it noted some questionable issues, such as how the new stock is valued and whether people who used them were avoiding the taxes they would have to pay if they withdrew retirement funds to buy a business.
More recently, the Obama budget for fiscal 2014 recommended capping savings in tax-advantaged retirement accounts—a proposal that could directly affect those looking to reap big gains from startup-company stock.
All of that points toward proceeding cautiously and seeking expert advice before making such an investment. "If you're the kind of person who doesn't want any trouble, why go there?" says Robert A. Green, a certified public accountant and chief executive of GreenTraderTax.com, which advises traders.
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