April 20, 2019

Creating Value: The Tax Implications of Starting a Business With Retirement Money

Creating Value

Are you getting the most out of your business?

Last week I wrote about the risks of using retirement money to finance your business. I spent some time looking at a strategy called ROBS — rollover as business start-up — and came to the conclusion that although it is being done by thousands of businesses, it has yet to receive the full blessing of either the Internal Revenue Service or the Department of Labor. As a result, I would advise my clients to stay away from the strategy.

But there is another reason to be wary, and it might be even more important — it’s about how you will be taxed if you do manage to build a company using ROBS and sell it at a profit. The tax implications are significant, and I think the lessons are important regardless of how you choose to finance your business.

If you are going to use ROBS to finance a business, you must file taxes as a C corporation, and that is where the tax issue comes into play. That’s because when it comes time to sell the company, you will be taxed twice — first at the corporate level and then at the personal level. And this, of course, is why most closely held small businesses are subchapter S corporations, whose structure allows income to flow untaxed to the owners of the company, who then pay taxes individually but only once.

Here’s an example. Let’s look at what happens if you sell a C corporation for a $1 million gain without using a ROBS strategy.

Gain……………………………………………………………………. $1,000,000

Corporate taxes @ 35%…………………………………………….. 350,000

Gain after corporate taxes ………………………………………..   650,000

Personal taxes @ 20% (capital gains)…………………………. 130,000

Cash left after taxes…………………………………………………..  520,000

Thus, if you were the owner of this corporation you would have paid 48 percent in total taxes. Now, if this company had been financed through ROBS, you would not have paid 20 percent capital gains taxes at the personal level. Instead, the stock would have been owned through a 401(k) and you would have had to pay 39.6 percent ordinary income taxes. Here’s what that would have looked like:

Gain……………………………………………………………………. $1,000,000

Corporate taxes @ 35%…………………………………………….  350,000

Gain after corporate taxes…………………………………………   650,000

Personal taxes @ 39.6%……………………………………………  257,400

Cash left after taxes…………………………………………………… 392,600

As you can see, using a ROBS strategy increases the tax bite from 48 percent to a little more than 60 percent. And that’s my point: even if ROBS transactions are legal, the tax implications are significant.

Now, a ROBS promoter might object to this example and argue that the seller should do a stock sale rather than an asset sale. (Here’s the difference: with a stock sale, the buyer purchases the owner’s share of a corporation; with an asset sale, the buyer purchases individual assets of the company but the seller retains ownership of the legal entity.) And it’s true that with a stock sale, the taxes would be the same as they are on any stock that is bought and sold inside a qualified retirement plan. No taxes would be paid until money is withdrawn from the retirement plan, when the maximum rate would be 39.6 percent.

This might be a great idea except for one thing: buyers generally do not like stock sales. Buyers do not want to buy your liabilities, and they do not want to buy surprises that might not show up for years. If you insist on a stock sale, you may have a difficult time selling your business.

But again, the main thing I want to emphasize is that it makes sense to think about how you are going to get out of a business before you decide to get in. Seemingly small decisions can have big consequences down the road.

What do you think? Would you still do a ROBS transaction knowing what the tax cost is likely to be?

Josh Patrick is a founder and principal at Stage 2 Planning Partners, where he works with private business owners on creating personal and business value.


This post has been revised to reflect the following correction:

Correction: April 17, 2013

In a previous version of this post, I mistakenly suggested that an alternative to a ROBS strategy would be to roll the funds from an existing retirement plan into a new company and then borrow up to 50 percent of your retirement account balance to finance the new business.

But this actually won’t work. The reason it won’t work is that there is a limit to how much you can borrow from a retirement plan at one time. The most you can borrow in any calendar year is $50,000, which makes this an impractical way to start a business. I apologize for the error.

Article source: http://boss.blogs.nytimes.com/2013/04/17/the-tax-implications-of-starting-a-business-with-retirement-money/?partner=rss&emc=rss

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