How does a ROBS 401(k) plan differ from a traditional 401(k) when it comes to tax implications?

Introduction

A Rollovers as Business Start-ups (ROBS) arrangement is not a distinct type of 401(k) "product," but rather a specific transaction structure used to fund a new business. While it utilizes a standard 401(k) plan, the tax mechanics, entity requirements, and compliance risks differ fundamentally from a traditional 401(k) used solely for passive retirement investing.

The primary distinction is the investment target: a traditional 401(k) invests in public market assets (stocks, bonds, mutual funds), whereas a ROBS 401(k) invests its assets into a single, private C Corporation controlled by the taxpayer. This triggers a unique set of tax rules under IRC § 4975 (prohibited transactions) and creates "double taxation" implications that do not exist in standard retirement investing.

Core Explanation: Tax Differences & Structural Implications

The following breakdown outlines the specific tax divergences between a ROBS arrangement and a Traditional 401(k).

1. Entity Structure and "Double Taxation"

• Traditional 401(k): Typically holds assets like mutual funds or public stock. These investment vehicles generally do not pay entity-level tax on their income before passing it to the plan (e.g., Regulated Investment Companies). The growth within the 401(k) is tax-deferred.
• ROBS 401(k):
  • C Corporation Requirement: To satisfy the "Qualifying Employer Securities" exemption under IRC § 4975(d)(13) and IRC § 409(l), the business must be a C Corporation. It cannot be an S Corporation or LLC because an IRA/401(k) generally cannot hold S Corp stock without triggering unrelated business income tax (UBIT) or voiding the S election.
  • Tax Drag: The C Corporation pays a flat corporate tax rate (21% federal + state) on its profits before any value accrues to the stock held by the 401(k). This creates a layer of tax friction that traditional 401(k) investments avoid.

2. The "Prohibited Transaction" Exemption

• Traditional 401(k): The account holder is a "disqualified person" and generally cannot sell property to, buy property from, or lend money to the plan.
• ROBS 401(k): The ROBS structure relies entirely on a specific statutory exemption. The plan purchases stock in the new company. Normally, a plan buying stock from a disqualified person (the owner) or investing in a company the owner controls would be a prohibited transaction.
  • The Exemption: The transaction must strictly qualify as an acquisition of "Qualified Employer Securities". If the business fails to operate as a legitimate operating company, or if the stock valuation is manipulated, the exemption is void.
  • Consequence: A failed ROBS transaction is treated as a prohibited transaction, resulting in the entire rollover amount being treated as a taxable distribution (subject to income tax + 10% penalty) plus a 15% to 100% excise tax under IRC § 4975.

3. Operational Tax Deduction vs. Plan Assets

• Setup Costs:
  • In a Traditional 401(k), fees paid by the employer are deductible business expenses.
  • In a ROBS, promoters often charge large fees to set up the structure. Warning: These fees generally cannot be paid out of the rollover funds. Using plan assets to pay the promoter for the individual's benefit (establishing the corporation) is a prohibited transaction. These must be paid from personal funds.

4. Filing Requirements (Form 5500)

• Traditional 401(k) (Solo/Owner-only): If assets are under $250,000, the owner may often file Form 5500-EZ or potentially no return at all.
• ROBS 401(k): The "EZ" filing exception generally does not apply. Because the plan assets are "non-qualifying assets" (private stock not readily tradable) or because the business often has (or intends to have) other employees, a full Form 5500 is almost always required annually, regardless of asset value.

Audit and Practitioner Consideration

The IRS maintains a specific compliance project regarding ROBS ("Project DO IT"). If you are advising a client on this structure, you must document the following to survive scrutiny:

1. Valuation of Stock (The #1 Audit Trigger):

   • The Risk: The plan buys stock in the C Corp. If the price paid is higher than fair market value, the owner has effectively "drained" cash from the tax-advantaged plan into the business for personal use.
   • Requirement: An independent, qualified appraisal is required to establish the share price at the time of purchase. "Par value" is rarely acceptable for this purpose.

2. Promoter Fees:

   • Challenge: The IRS frequently challenges whether fees paid to ROBS providers were paid with plan assets.
   • Guidance: Ensure setup fees are paid from the business's operating funds (post-funding) or the individual's personal funds, never deducted directly from the rollover amount before it hits the corporate account.

3. Benefits, Rights, and Features (Discrimination):

   • Disqualification Fact: The ROBS plan is a qualified 401(k). If the business hires employees, they must be offered the right to participate in the plan and purchase stock on the same terms as the owner.
   • Trap: Many owners set up ROBS and fail to notify eligible employees of the plan. This violates IRC § 401(a)(4) (nondiscrimination), potentially disqualifying the entire plan.

4. Permanent Establishment:

   • The business must be a legitimate operating company. If the entity is a shell used merely to access retirement funds for personal use, the IRS will collapse the transaction under the "step transaction" doctrine.

Summary

• Entity: ROBS requires a C Corporation, subjecting the business to corporate income tax rates (21%) before value grows in the 401(k). Traditional 401(k)s often avoid this layer.
• Investment: ROBS relies on the "Qualified Employer Securities" exemption; failure to strictly adhere to valuation rules results in prohibited transaction excise taxes (up to 100%).
• Compliance: ROBS plans usually require an annual Form 5500 regardless of asset size, unlike many solo-401(k)s.
• Employee Rights: The plan must be offered to eligible employees; it cannot be an exclusive vehicle for the owner.

Suggested Next Steps

1. Review Valuation: Secure an independent appraisal for the initial stock purchase price; do not rely on the "promoter's" valuation.
2. Verify Entity Selection: Confirm the C Corporation status and analyze the long-term tax drag compared to an S Corp or LLC (which might be funded via a loan rather than a ROBS).
3. Check TPA Status: Ensure a Third-Party Administrator (TPA) is engaged to handle the annual Form 5500 filing, as this is frequently missed in year 1.
4. Legislative Check: While the One Big Beautiful Bill Act (July 2025) made changes to ABLE accounts and "Trump Accounts" (child IRAs), it did not explicitly ban ROBS; however, strict adherence to IRC § 4975 remains critical as enforcement has tightened.