When a ROBS owner is ready to transition out of a ROBS arrangement, it can be very expensive for the company to accomplish the exit by buying the stock back from the retirement plan, a transaction known as a stock redemption. The plan’s stock, also known as qualifying employer securities (“QES”), must be redeemed in cash, at the current appraised value. A redemption may be prohibitively expensive when the plan owns a large percentage of the company, especially if the company has appreciated substantially in value since the original QES funding transaction.
Fortunately, ROBS owners who are at least 59½ years old have another choice: a net-unrealized appreciation (“NUA”) transaction.
The NUA Transaction is a Distribution of the Stock to the ROBS Owner
Upon reaching age 59½, a ROBS owner may elect to receive a distribution of their QES from the plan. The stock will then be held by the ROBS owner as an individual, outside the plan. In this way, the plan is “de-ROBSified” without costing the company any money at all.
Like all plan distributions, this is taxable to the ROBS owner as an individual, at ordinary income tax rates. However, thanks to special provisions in the Internal Revenue Code, the owner may elect to be taxed only on the amount of their original QES purchase.
Down the road, when the company is sold, the former ROBS owner (now individual shareholder) will owe tax on the difference in value from the original QES purchase and the value of the stock upon sale; and, they will be taxed at a generally more favorable capital gains rate.
Example
In 2015, Robert directed his 401(k) plan to purchase 100% of the common stock of his new company, Quality Engineering Services, Inc., for $100,000.
In 2025, Robert wants to exit the ROBS arrangement, but his company has done very well and his QES is now worth $1,000,000. Quality Engineering does not have that much cash available to redeem the QES. Robert is now 60 years old, and he works with his ROBS attorney to carry out the NUA transaction.
In 2035, Robert will retire and sell the company for $1,500,000.
The tax effects of this scenario would be:
- Robert includes the $100,000 of his original QES investment in income and when filing his Form 1040 for 2025 (in 2026); he pays ordinary income tax on this amount, which comes to $30,000.
- The additional $900,000 in value of the stock in 2025 is not taxed at this time.
- In 2035, he pays taxes on the increased value of his stock ($1,500,000 minus $100,000) at a capital gains rate.
The obvious benefits of an NUA transaction are:
- Getting out of the ROBS arrangement without having to come up with the current value of the stock in a redemption.
- It converts the stock from an ordinary asset into a capital asset, which tends to be taxed at a lower rate.
The potential downsides should also be considered:
- Removing the stock from the plan will reduce the amount of tax-deferred savings held for the ROBS owner’s retirement.
- It will require the ROBS owner to come up with the cash to pay the taxes for the year in which the NUA transaction occurs.
The decision whether to engage in an NUA transaction should be made in consultation with both a personal tax advisor and a benefits attorney with significant ROBS experience. In addition to the tax considerations, the NUA rules require a number of additional compliance tasks that vary depending on the facts of each individual situation.
More Tools for the ROBS Owner
The option to eliminate the ROBS arrangement from the retirement plan through an NUA transaction gives ROBS owners more opportunities to get out from under the restrictions of such an arrangement. If you are a ROBS owner over age 59½, or are approaching that age, it may be something for you to explore. For more information on ROBS plans, see our other blog posts on this topic, including Exit Strategies—Part 1: Options for Divesting the Plan of Stock Ownership.