Prohibited Transactions and Excise Taxes—the Basics for ROBS Plans

All tax-qualified retirement plans, including those of a rollover business start-up (ROBS) plan, are subject to the prohibited transactions (PT) rules of the Employee Retirement Income Security Act (ERISA), which are enforced under Section 4975 of the Internal Revenue Code and related Treasury regulations. The purpose of the PT rules is to ensure that retirement plan assets are carefully safeguarded and used solely for the purpose of providing the retirement benefits to participating employees and their beneficiaries.

The law provides a list of individuals and entities that are disqualified to do business with a given plan (DQP), including the plan’s fiduciaries and participants, the plan sponsor and its employees, and all service providers. What transactions are prohibited? The PT rules mandate that any transaction in plan assets is prohibited unless expressly exempted in the statute (or through an individual exemption granted on a case-by-case basis). It is just such a statutory exemption that permits a C corporation to be funded by its own retirement plan using the ROBS stock purchase. As most ROBS owners are informed by their ROBS promoter, the corporation must observe several logistical requirements to qualify for the ROBS PT exemption.

However, even after the start-up, a ROBS company continues to face unique PT pitfalls. The difficulty lies in a special rule for ROBS plans—that the assets of a ROBS corporation are generally considered to be plan assets, especially during the period immediately following a ROBS funding transaction. This means that the Company’s bank account and other assets are covered by the PT rules. The rule, which does not apply to a non-ROBS company, can easily trip up an unwary ROBS plan sponsor, because it forbids many otherwise perfectly acceptable and common business practices.

For example, it is a PT for a ROBS corporation to lend money to any DQP, including the ROBS company, the ROBS participant, their family members and any other entity controlled by the participant/family member. In a non-ROBS business, such loans are commonplace; a CPA or other business advisor involved with a ROBS business may assume that such a loan is also permitted for a ROBS corporation. Unfortunately, however, the loan would likely be characterized by an IRS examiner or Department of Labor investigator to be a prohibited extension of credit by the plan to the DQP.

The consequences of a PT are often quite expensive

The prohibited transaction must be fully corrected and reported to the IRS on Form 5330 along with payment of an excise tax of 15% on the amount involved in the transaction. The party who must correct, report and pay the excise tax on the PT is the DQP who benefited from the improper use of plan assets. In case you’re tempted to ignore the PT rules, keep these 3 legal principles in mind:

• A PT can happen accidentally! That is, it arises without regard to the intentions of the parties involved, under a strict liability standard.

• The 3-year statute of limitations on a PT does not begin to run out until the breach is fully corrected, reported, and taxed.

• The excise tax imposed on a PT escalates rapidly if it remains uncorrected for more than a single tax year. Each PT generates a new PT on January 1 of each subsequent year until it is fully corrected, reported, and the tax is paid. Thus, a single PT in 2021 that remains uncorrected and unreported will become 2 PTs in 2022, 4 PTs in 2023 and 8 PTs in 2024. In this way, the initial 15% excise tax on the amount involved in the transaction rapidly escalates as the uncorrected years accumulate.

These harsh rules are designed to act as deterrents from committing a PT and also as incentives to correct a PT as soon as possible after it is identified.

Examples of common Prohibited Transactions in ROBS plan assets:

• The corporation lends money to the ROBS owner, another employee or a shareholder.
• The ROBS owner uses a corporate asset for personal use.
• A vendor of the corporation is an entity separately owned by the ROBS owner.
• The corporation pays for a redemption of the ROBS stock using a promissory note instead of cash.

Yikes! If you suspect you might have committed a PT with your ROBS plan assets, get knowledgeable legal advice as soon as you can. Prompt correction is the best way to handle an existing problem and good advice can help you structure prospective transactions in a way that will avoid future PTs.