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5500 Preparer's Manual for 2012 Plan Years
The premier resource in the field of Form 5500 preparation, 5500 Preparer's Manual will help you handle the required annual Form 5500 filings for both pension benefits and welfare benefit plans.
The Treasury and the IRS have identified tax avoidance transactions using plan assets as start-up business capital, whereby prospective business owners access tax-deferred retirement funds and avoid applicable distribution taxes by rolling the funds over into a new plan that is established to invest in employer stock. The information has been released in the form of a Memorandum of Understanding, providing initial guidelines for IRS technical specialists on the acceptability of arrangements denoted as “rollovers as business start-ups” (ROBS), currently being marketed to entrepreneurs. Under a ROBS plan, a prospective business owner acquires business capital by withdrawing money from his or her existing retirement accounts and channels the funds into a new retirement plan. While not stating that such transactions are noncompliant per se, the IRS has indicated that it will carefully scrutinize these plans on a case-by-case basis.
The plan created by a ROBS transaction is typically set up as a proprietary defined contribution plan, generally established in the form of a profit-sharing plan coupled with a cash or deferred arrangement (CODA). ROBS plans are questionable because they may allow the principal establishing the business to exchange tax-deferred assets for currently available funds by using a qualified plan that authorizes investment in employer stock, thus avoiding otherwise assessable distribution taxes. Because the plans generally benefit only the principal who set up the business and do not allow rank-and-file employees to acquire employer stock, they may violate nondiscrimination requirements and not satisfy the benefits, rights and features test of Reg. §1.401(a)(4)-4 . Such plans may also create a prohibited transaction between the plan and its sponsor, due to deficient stock valuations.
Progressive steps in a ROBS transaction
The following progressive steps make up a ROBS transaction:
(1) An individual establishes a shell corporation sponsoring an associated and purportedly qualified retirement plan. At this point, the corporation has no employees, assets or business operations, and may not even have a contribution to capital to create shareholder equity.
(2) The plan document provides that all participants may invest the entirety of their account balances in employer stock.
(3) The individual becomes the only employee of the shell corporation and the only participant in the plan. At this point, there is still no ownership or shareholder equity interest.
(4) The individual then executes a rollover or direct trustee-to-trustee transfer of available funds from a prior qualified plan or personal IRA into the newly-created qualified plan. These available funds may be any assets previously accumulated under the individual’s prior employer’s qualified plan, or under a conduit IRA which itself was created from these amounts. Note: Because assets have been moved from one tax-exempt accumulation vehicle to another, all assessable income or excise taxes otherwise applicable to the distribution have been avoided.
(5) The sole participant in the plan then directs investment of his or her account balance into a purchase of employer stock. The employer stock is valued to reflect the amount of plan assets that the taxpayer wishes to access.
(6) The individual then uses the transferred funds to purchase a franchise or begin some other form of business enterprise. Note: All otherwise assessable taxes on a distribution from the prior tax-deferred accumulation account are avoided.
(7) After the business is established, the plan may be amended to prohibit further investments in employer stock. This amendment may be unnecessary, because all stock is fully allocated. As a result, only the original individual benefits from this investment option. Future employees and plan participants will not be entitled to invest in employer stock.
(8) A portion of the proceeds of the stock transaction may be remitted back to the promoter, in the form of a professional fee. This may be either a direct payment from plan to promoter, or an indirect payment, where gross proceeds are transferred to the individual and some amount of his gross wealth is then returned to the promoter.
Nondiscrimination violations
Because ROBS transactions generally benefit only the principal involved with setting up a business, and do not enable rank-and-file employees to acquire employer stock, the IRS believes that some of these plans violate the anti-discrimination provisions of the Code and Regulations. Code Sec. 401(a)(4) provides that, under a qualified retirement plan, contributions or benefits provided under the plan must not discriminate in favor of highly compensated employees (HCEs). Furthermore, Reg. §1.401 (a)(4)-4(e)(3) provides that the plan’s benefits, rights and features (BRFs) must be tested to see if they are nondiscriminatory in effect. BRF testing considerations can arise in many forms, including as here, the right to make investments in employer securities.
Even if the ROBS initiator is an HCE, in many of the identified cases, there are no other employees in the initial year of the transaction or for some number of future years thereafter. Therefore, as no finding regarding discrimination can be made in absence of NHCEs in the transaction year, the current availability testing standard for plan BRFs is satisfied. Given that ROBS arrangements are designed to take advantage of a one-time only stock offering, the investment feature generally would not satisfy the effectively available benefit requirement. The issue of discrimination arises because the plan is designed in a manner that the BRF will never be available to any NHCEs. For this reason, ROBS cases should be evaluated for discrimination issues whenever a given plan covers both HCEs and NHCEs, and no extension of the stock investment option is afforded to NHCEs.
Stock appraisal prohibited transactions
In all ROBS arrangements, an aspiring entrepreneur creates capital stock for the purpose of exchanging it for tax-deferred accumulation assets. The value of the stock is set as the value of the available assets. An appraisal may be created to substantiate this value, but it is often devoid of supportive analysis. This potentially creates prohibited transaction issues under both Code Sec. 4975 and ERISA §408(e) . Since the company is new, there could be a question of whether it is indeed worth the value of the tax-deferred assets for which it was exchanged. Although most of the assets involved in these cases were used for business purposes, the IRS discovered one case in which the plan assets were invested in an RV for personal use, rather than a business purpose.
CCH Note: Code Sec. 4975(f)(1) provides that where more than one person is liable for prohibited transaction excise taxes, all persons are jointly and severally liable for any deficiency. Therefore, assessments against promoters for direct receipt of plan assets may be made even where assessments are proposed against the corporation or individual for invalid appraisal of the underlying stock.
Current and projected enforcement
The IRS has been alerted to these transactions through its regular compliance processes, such as determination letter submissions and project examination activity, as well as through practitioner queries. So far, the IRS has identified nine promoters of these transactions. Most of these are actively promoting the use of ROBS at seminars that are held to assist individuals to purchase business franchises. The IRS has is also coordinating its consideration of ROBS plans with the Department of Labor (DOL). The transfer of enterprise stock within a ROBS arrangement could also raise ERISA Title I prohibited transaction issues.
The IRS has specifically considered whether the form of the plan, as presented, is entitled to a favorable determination letter ruling. It has concluded that there is no inherent violation in the form of a plan containing a ROBS arrangement that would otherwise prevent a favorable ruling. The issues raised by ROBS plans are inherently operational, and beyond the scope of a determination letter ruling, the Memorandum of Understanding concluded. Therefore, determination letter applications for plans with ROBS features can be reviewed and approved as appropriate. However, the IRS plans to monitor the volume of approval letters issued to these plans in a manner similar to those issued to Code Sec. 412(i) arrangements.
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