Posts tagged individual retirement account

By Amy Feldman

May 27 (Bloomberg) — Hal Mottet, a Lake Oswego, Oregon,
businessman bought a family-owned packaging company for $3.5
million in late 2007, and he and a partner financed 40 percent
of the sales price with their retirement money.

Mottet and his partner used a loophole in U.S. tax law to
roll over $1.4 million from their existing 401(k) retirement
plans to finance the purchase of Carson, California-based Empire
Container Corp. The strategy saved them taxes and penalties they
would have faced for cashing out the plans.

“If we hadn’t done it this way, we would have had at least
$1 million more debt, and we wouldn’t have made it through the
recession,” said Mottet, 51, who’s now chief executive of the
firm. “It’s been a fantastic investment.”

Transactions like Mottet’s let entrepreneurs access their
retirement funds without tax consequences. Withdrawals from
401(k)s are generally subject to income taxes on the proceeds,
and cashouts done before age 59 1/2 incur a 10 percent penalty,
according to the Internal Revenue Service.

Here’s how it typically works: An investor sets up a
corporation, establishes a new 401(k) plan there, rolls over his
or her existing 401(k) or Individual Retirement Account, and
then uses part or all of the plan’s assets to buy shares of the
new company. This funds the new business, while keeping the tax-
advantages of the retirement plan.

The transactions have drawn the scrutiny of the IRS, which
dubbed them ROBS, for Rollovers as Business Startups, and said
in an October 2008 memo that some may run afoul of the law. The
IRS is coordinating efforts with the Department of Labor because
these rollovers may also raise issues under the rules that
govern retirement plans, according to the memo.

Not ‘Home Free’

“Like many other recently marketed tax savings strategies
that appear to have been designed to take advantage of the law,
ROBS arrangements, designed to fit within existing law and
guidance, do not present a ‘home free’ result,” the IRS said in
a November 2008 newsletter. “In fact, they may violate the
law.”

Among the issues the IRS found were prohibited
transactions, questionable valuations of the company stock, and
a failure for the rollover retirement plans to be available to
employees other than the principal owner. In a few cases the IRS
reviewed, retirement funds were used to purchase personal
assets, like recreational vehicles, according to the memo.

Monika Templeman, acting director of employee plans for the
IRS, said the agency would be reviewing these rollover
transactions, and auditing them on a case-by-case basis over the
next few years.

“It can be done just right, but we’re seeing problems,”
Templeman said. “It’s open to abuse because of the structure,
and the promoters are taking advantage of that.”

‘Saber Rattling’

In cracking down on tax shelters, the IRS generally goes
after the promoters of a shelter, she said. She declined to say
if the IRS was targeting any rollover promoter.

Stephen Dobrow, president of Primark Benefits, a
Burlingame, California-based benefits consulting firm, called
the IRS memo “saber rattling,” and said he expected increased
IRS auditing of the transactions.

The credit crisis has made the 401(k) rollovers more
attractive for small business financing. The Federal Reserve
Board said in its April survey of senior loan officers that
credit to businesses would “likely remain quite stringent
following the prolonged and widespread tightening that took
place over the past few years.”

The rollovers are a relatively inexpensive way to finance a
new business, said Jeremy Ames, chief executive of Bellevue,
Washington-based Guidant Financial Group, which advised Mottet
on the process. Fees are $4,995, with another $800 a year
minimum to administer the new plan.

Cashing Out

Cashing out a 401(k) early, by comparison, can eat up half
the balance or more, depending on an individual’s federal and
state income tax rates and age. Tax-free 401(k) rollovers also
cost less than small-business financing, while freeing
entrepreneurs from loan payments that can squeeze cash-flow
especially in a startup’s early days, said Ames.

“These people have 700-plus credit scores and own their
own homes; they can get loans if they need to,” said Ames.
“When you compare it with a 15 percent to 20 percent interest
rate on a loan, or look at the amount of equity you’d have to
give up in this investment climate, people are saying ‘I’d
rather be my own investor.’”

Joanna and Frederick Neubert, of Cleveland, South Carolina,
used a 401(k) rollover to buy a residential cleaning franchise
in 2004, after both were laid off from corporate jobs. The
Neuberts used the entire $118,000 proceeds from their 401(k)
plans, Joanna Neubert said. Last December they closed the
business.

Risking Future

The result for the Neubert’s retirement savings: The
business was valued at zero, and their 401(k) savings are gone,
according to Joanna Neubert.

Of the rollovers that the IRS has reviewed, many of their
sponsors had gone bankrupt, Templeman said.

“Our thinking tends to be that if you can’t raise enough
money with friends and family and people who find your business
compelling, it may not be a business that should be started,”
said Dan Rosen, a principal in the Lexington, Massachusetts,
office of venture capital firm Highland Capital Partners.

“There are a lot of ways to get a business funded without
risking your future,” he said.

Investors using this strategy also may face risk of an
audit. If a rollover transaction is deemed to be a tax shelter,
its plan sponsor or manager may be subject to excise taxes, in
addition to regular taxes and penalties, according to IRS
regulations.

Compliance with Memo

“We make sure our clients comply with that memorandum to
the semicolon and comma,” said Leonard Fischer, an employee
benefits attorney, who said he’s been doing rollovers for nearly
two decades and is founder of North Wales, Pennsylvania-based
BeneTrends Inc., which advised the Neuberts.

Executives at Guidant, Fort Worth, Texas-based FranFund
Inc., and Huntington Beach, California-based SDCooper Co., which
also advise clients on rollovers, said their transactions
complied with all regulations.

“It’s become a very hot issue,” said Richard Matta, an
employee benefits attorney at the Groom Law Group in Washington,
whose client is considering an investment in a rollover adviser.
“We’re worried about the entire industry being blindsided.”

To contact the reporter on this story:
Amy Feldman in New York at
afeldman16@bloomberg.net.