This post is the second of a two-part post on ROBS exit strategies.
The expenses and tax effects of the various paths of ROBS exit are generally outlined as follows:
A stock redemption is a cash sale of the stock by the plan back to the corporation, at fair market value. This requires a written professional appraisal to determine what price the company would fetch on the open market. The company uses this appraised value to price the stock to be redeemed in cash paid by the corporation. In exchange for the cash, which is paid into the ROBS owner’s retirement plan account, the plan returns its stock to the corporate treasury. The end result is that the (now former) ROBS owner becomes a regular plan participant, with new cash in their plan account, which can be invested in traditional plan investments, such as mutual funds.
Example – John used $150,000 of retirement funds in his ROBS plan account to fund his franchise acquisition in 2015. Now, John wants to divest his plan account of all company stock (QES) so that the corporation can take the S election starting in 2023. He hires a professional business appraiser, who prepares a report stating that the stock in John’s plan account is now worth $300,000. Therefore, to redeem all of the QES, the corporation would pay John’s plan account $300,000 cash. To pay for this expense, the corporation could use its available cash, borrow the funds, and/or receive new investment funds from someone other than the plan.
- Cash expense to the ROBS corporation: $300,000
- Income tax owed by John and the corporation as a result of the redemption: $0
Distribution of the QES costs the corporation nothing, and has no tax effect on the corporation, because it is a transaction between the ROBS plan and the ROBS owner. Without liquidating the stock, the retirement plan simply distributes it to the ROBS owner as a benefit (assuming that the plan permits in-service distributions or can be amended to do so). The end result is that the stock is out of the plan, and the ROBS owner is an individual shareholder of the corporation; however, it is a taxable event for the ROBS owner. The amount of tax owed depends on the age of the ROBS owner. For those under age 59½ at the time of distribution, ordinary income tax is due on the value of the stock at distribution; and an early distribution penalty of 10% is also owed.
Example – John, the only ROBS owner in his corporation, has QES now valued at $300,000 in 2022; he elects to take an in-service distribution of all QES in his plan account at early retirement age, 55. After the corporate and plan paperwork is concluded to carry out this election, he will owe a 10% pre-payment penalty of $30,000 and will have to report $300,000 as ordinary income tax on his personal tax return for 2022. John is now an individual shareholder of the corporation outside the plan, and the plan is no longer a ROBS plan.
- Expense to the ROBS corporation: $0
- Income tax owed by John: his ordinary tax rate on $300,000, plus $30,000 penalty
- Income tax owed by the corporation: $0
However, ROBS owners who are at least 59 ½ years old may avail of the following tax treatment –
- There is no pre-payment penalty;
- The ordinary income tax owed at distribution is based on the original value of the QES (not the current value);
- Tax on any increase in value is deferred until the ROBS owner eventually disposes of the stock; and
- At that future date, the tax rate will be at the capital gain rate not as ordinary income.
This tax treatment, for those old enough to elect it, is known as the Net Unrealized Appreciation (“NUA”) treatment of an in-kind distribution of QES.
Example – John used $150,000 of retirement funds in his ROBS plan account to fund his franchise acquisition in 2015; a professional valuation of the corporation in 2022 reports that the QES in ROBS plan is now worth $300,000. John, age 60, elects to take an in-service distribution of all QES in his plan account in an NUA transaction that will be effective in January 2023. After the corporate and plan paperwork is concluded to carry out this election, he will have to report $150,000 as ordinary income tax on his personal tax return for 2023 (payable in April 2024). John is now an individual shareholder of the corporation outside the plan, and the plan is no longer a ROBS plan. When John eventually sells his stock to a buyer, in 2028, for $1M, he will owe capital gains tax on the difference between his basis of $150,000 and the $1M sale price, or $850,000.
- Cash expense to John’s ROBS corporation: $0
- Income tax owed by John for the NUA transaction: his ordinary tax rate on $150,000 (subject to later taxation at capital gains rate on the additional value of $850,000)
- Income tax owed by the corporation: $0
Sale of the entire company. At any time, a ROBS owner may sell the company to a third party, either in a stock sale or an asset sale. There is no requirement for an appraisal for a third-party sale, as the negotiation determines the price to be paid. (It is also permissible for the ROBS owner to sell QES to a related person or company, but it would require an appraisal.)
Stock Sale – is a transaction between the Buyer and all shareholders of the corporation, including the plan, as the Seller(s). A stock sale has no legal effect on the corporation’s assets or its operations; rather, the buyer simply steps into the shoes of the selling shareholders and carries on with corporate business just as before the sale.
With regard to the ROBS owner’s stock, the Buyer pays the plan account directly for the stock, in an amount that corresponds to the number of shares owned by the plan account. For example, if a plan account owned 75% of the corporation’s outstanding shares, the plan account would receive 75% of the sale proceeds directly from the Buyer. The plan’s sale proceeds continue to be tax deferred until the former ROBS owner (now regular plan participant) takes a distribution from the plan account at some point in the future.
- Cash expense to the (former) ROBS corporation: $0
- Income tax owed by the ROBS plan and ROBS owner: $0 [deferred]
- Income tax owed by the corporation upon sale of its stock: $0
- Income tax owed by any non-ROBS shareholders: at individual capital gains rate
- Status of the plan: usually negotiated in the stock purchase agreement
Asset Sale – is a transaction between the Buyer and the corporation itself, as the legal entity that owns the assets being sold. After closing, the cash proceeds of the sale remain a corporate asset and the corporation continues to exist; the plan also continues to exist and the corporation is still the plan sponsor. At this point, the corporation’s board of directors must decide either to begin to operate a new business or to settle the corporate finances and dissolve the corporation under state law.
To formally dissolve, a corporation must pay all of its outstanding debts and liabilities, collect whatever revenues remain to be collected, and file a final income tax return. (There may be additional state law requirements for dissolution, which is beyond the scope of this blog.)
At the same time, the plan must be formally terminated and its benefits completely distributed to all plan participants. The ROBS stock, which still exists in the plan, will be redeemed as one of the last acts of the dissolving corporation, which pays cash (known as a liquidating dividend) to the ROBS owner’s plan account in exchange for cancellation of the QES. The plan then distributes the cash in accordance with the plan participant’s (i.e., the former ROBS owner’s) election to receive a taxable distribution or to get a tax-deferred rollover into an IRA or another qualified employer plan.
Example – Let’s say that our friend John sells 100% of his ROBS corporation’s assets, to an unrelated third party, for a total of $1,000,000. John, the sole director of the corporation, decides to dissolve the corporation. After paying a few outstanding debts and obligations, including corporate income tax, the corporation has $700,000 left in the bank. If John’s plan account owns 90% of the corporation, then the corporation pays the account a liquidating dividend equal to 90% of its cash, or $630,000; for the plan, this payment is not taxable. John (now just an ordinary retirement plan participant) may roll that plan account balance into an IRA or receive a taxable distribution to himself.
- Cash expense to the (former) ROBS corporation: $0
- Income tax owed by the ROBS plan and ROBS owner: $0 [deferred]
- Income tax owed by the corporation upon sale of its assets?: Yes, on net proceeds,
- Income tax owed by any non-ROBS shareholders: at individual capital gains rate
- Status of the plan: not usually negotiated in the asset purchase agreement
Every business is different, every ROBS owner is different. As you see, there is plenty to think about in deciding when and whether to divest one’s plan of Qualifying Employer Securities. Understand your options, get advice if you need it, and plan for your desired outcome.