Our world is full of tax strategies that solve an immediate problem, but expose clients to possibly more expensive problems down the road. One of the challenges we as tax planners face is avoiding the temptation to get sucked into one of traps – or keep our clients from falling into them – when they can look so tempting and attractive.
Sometimes it’s hard to pass on a nice immediate savings that you can brag about! But you can’t just look at today’s victories. If your client is going to be subject to taxes tomorrow (and they are, of course), you have to take the long view.
Let’s say your client is a 45-year-old middle manager at the local paper mill or auto-parts manufacturer. He’s finally worked his way out of the cubicles and into a real office . . . just before learning he’s part of the latest “rightsizing.” He sure doesn’t want to go back to work for “the man”!
So now he’s looking at opening a franchise and building a sandwich/taco/salad bowl/muffler empire. He’s got the cash to buy the franchise and get started. Unfortunately, that cash is locked up inside his 401(k). Looting the account will mean paying a hefty tax bill, plus a 10% penalty for the early withdrawal.
But there’s an escape hatch – a tax-strategy that lets him get the money for the franchise out of the account without paying the tax or the penalty. It’s called a Rollover for Business Startup, or ROBS. Briefly, it lets him establish a C corporation, adopt a 401(k) plan for the corporation, roll assets from his old employer’s plan into the new C corporation’s plan, use it to buy stock in the C corporation, then finally use the money in the C corporation to finance the franchise.
Now, that sounds like a great solution. The client has a problem – he needs money to start his new business. He has the money, but he can’t use it without paying a huge tax bill. The ROBS lets him use the money without the tax bill. Everyone wins, right?
But here’s the problem. The ROBS creates a bunch of new problems down the road. And in apparently too many cases, those new problems outweigh the benefit the client gets from solving the initial tax problem:
- The ROBS has to operate as a bona fide retirement plan for all the company’s employees, with all the technical requirements and red tape that a qualified plan requires. If the ROBS fails that challenge, it can be disqualified, and the owner can be forced to pay immediate tax on the entire account balance. Ouch!
- The new business has to operate as a C corporation. If it loses money up front, like many startups do, those losses are locked inside the corporation until it shows taxable income to offset. The owner can’t use those losses to offset income from a spouse or another job.
- The owner can draw income from the new business only in the form of salary (taxed at the client’s top marginal rate and subject to FICA too), or dividends (subject to tax at both corporate and personal levels).
- If the business succeeds and the client eventually sells it, the gains that would have been taxed at lower capital gains rates (if the client hadn’t used the ROBS) go back into the retirement plan to be taxed at higher ordinary income rates. The client also loses the chance to benefit from stepped-up basis at death. (Well, his heirs do.)
- If the business eventually fails – like a majority of business startups – the client can’t take the capital loss because it’s locked inside the retirement plan. Even worse, there goes the client’s retirement savings!
So, what do you think? Yes, the ROBS can help clients solve the problem of finding money to start their business. But there are obvious pitfalls down the road. Plenty of TaxCoach members have run into clients who have been burned by these side effects, and generally they recommend staying as far away as possible!
This is actually a common problem that we face as planners. You don’t do clients any favors if solving today’s tax problem means creating bigger problems tomorrow. But the flip side of that coin is opportunity to show clients you’ve considered those dangers and made yourself even more valuable – even if it means sometimes shooting down an idea a client brings.
Tax planning is a wonderful superpower. But as with all superpowers, you have to be sure to use it for good, not evil!
Disclaimer: This blog was previously published at TaxCoachSystem.com. Tax Coach has become Tax Master Network. We didn't want our amazing clients, readers and interested tax friends to miss any of our archived content so please forgive any broken links or various referenced to Tax Coach options. update