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This white paper interprets the recent IRS memorandum on qualified plan structures that allow participants to invest in business startups. The IRS memorandum confirms that these plans can receive a favorable determination letter but highlights several operational issues that can violate basic plan qualification rules. Key issues identified by the IRS include one-time stock purchases followed by plan amendments, lack of communication to participants, misuse of plan funds for personal asset purchases, and plans that solely execute stock transactions without other activities.

Qualified retirement plans must adhere to all applicable rules and regulations. They must allow for self-direction and investment in employer securities. Entrepreneurs must understand the complexity and value of this planning technique and structure, ensuring both the establishment and ongoing operation of the plan are compliant to avoid unexpected tax consequences.

Background

The purpose of the IRS memorandum is to provide technical advice to IRS field agents regarding qualified plan rollovers involved in business start-ups. IRS agents encountering new transactions, structures, or issues often seek guidance from the central authority on how to address these matters. The memorandum was developed to offer such guidance. While the memorandum confirms the compliance of ROBS structures with the law, it raises concerns about their operation and administration. This paper outlines these concerns and the necessary steps for maintaining compliance from inception through ongoing operation.

The IRS memorandum indicates that the form of ROBS transactions is not inherently noncompliant. Plans containing ROBS arrangements can receive favorable determination letters. However, the issues identified are operational and fall beyond the scope of determination letter rulings. The Treasury can review and approve such plans as appropriate, provided they comply with operational requirements.

Issues Raised

  1. Benefits, Rights & Features (BRF): A fundamental principle of qualified retirement plans is fair and non-discriminatory treatment of all participants. Contributions or benefits must not favor highly compensated employees (HCEs), defined as individuals owning 5% or more of the plan sponsor or earning compensation above a specified threshold. The IRS assesses BRF availability in two ways: current availability (can all participants access the benefit) and effective availability (do the plan’s conditions favor NHCEs). Concerns arise when only HCEs can invest in employer stock, typically available only at a company’s inception. To pass the effective availability test, employer securities must be available for purchase by all plan participants, with this option disclosed in the Summary Plan Description and acknowledged by employees during enrollment.
  2. Valuation of Company Stock: Accurate valuation of assets in a qualified plan is crucial for tax compliance, especially for non-marketable assets like private company stock. ERISA section 408(e) provides an exemption from prohibited transaction penalties if adequate consideration is ensured. Adequate consideration means a fair market value determined in good faith by the trustee, often relying on independent appraisers. Treasury emphasizes that the capitalization valuation is vital to avoid prohibited transactions. Compliance requires an initial and annual valuation of company stock by an independent firm.
  3. Promoter Fees: Treasury identifies potential self-dealing prohibited transactions if fees to promoters are paid from plan assets. Promoters could be deemed plan fiduciaries if they provide ongoing investment advice and control over plan assets. To mitigate this, policies include:
    • Using an independent valuation firm to establish corporate stock value initially and annually.
    • Appointing an independent, licensed money manager to advise plan participants.
    • Ensuring promoter fees are paid from the entrepreneur’s personal funds, not reimbursed by the corporation.
  4. Permanency: Treasury requires that qualified plans be permanent and primarily for providing retirement benefits. Plans must demonstrate ongoing intent through substantial and recurring contributions. Establishing the plan solely as a funding vehicle, without genuine retirement benefit intentions, fails the permanency requirement. It is recommended that the founder contribute at least 1% of their compensation annually to demonstrate this intent.
  5. Exclusive Benefit: Qualified retirement plans must exclusively benefit participants and beneficiaries. The typical ROBS design does not inherently violate this rule, but misuse of funds for personal asset purchases is prohibited. The plan’s purpose is to accumulate assets for retirement, not for immediate personal use. Compliance requires strict adherence to this principle, investing for the future rather than consuming in the present.
  6. Employee Communication: Effective communication of the plan to all employees is mandatory. This includes distributing a Summary Plan Description upon hiring, sending a notice letter 30 days before the plan entry date, and providing an enrollment/participation form. These steps ensure employees are informed and have the opportunity to participate.
  7. Inactivity in 401(k) Arrangements: Some plans fail to offer participants the opportunity to make 401(k) contributions. Compliance involves addressing this through proper documentation and communication, ensuring all employees are aware of and can participate in the 401(k) arrangement.

Final Thoughts

Strict compliance with tax law is essential for creating and operating a compliant ROBS structure. This requires regular monitoring and reporting. The IRS memorandum highlights the complexity of ROBS structures and the need for accredited professionals to design, establish, and administer these plans. The IRS’s increased scrutiny emphasizes the importance of professional guidance in maintaining compliance and avoiding non-compliant practices.

Given the IRS’s heightened scrutiny, it is crucial to have accredited professionals design, create, and administer your plan. Accredited professionals can help navigate the complex requirements and ensure ongoing compliance. Whether establishing a new retirement plan or seeking answers to specific questions, professional assistance is vital for successfully managing a ROBS structure.

For further assistance or questions about establishing a new retirement plan, consult with accredited professionals. Properly navigating these complex requirements will ensure your plan remains compliant and avoids the pitfalls identified by the IRS.

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