ROBS vs Self-Directed IRA

Welcome everybody to the Directed IRA Podcast. My name is Mark Kohler. I'm here with the amazing Matt Sorensen. An exciting topic today because I always learn something from Matt when we dive deep into an area that is a little controversial.

Today we have got to talk about this rollover on business startups called the ROBS 401, and we want to compare it to the self-directed IRA because it is getting getting messed up online, on AI, and with social media influencers. And I'm fielding way too many questions of people who are getting this wrong. So, we want to break down this ROBS strategy. What is it? Who should be using it? And then compare it to the self-directed IRA strategy. And again, what is it and who should be using that strategy?

Yeah. And I think what many of you that are our listeners here, already have a pretty good feel for the directed IRA concept. So we're going to start with ROBS. But I know we have always new listeners that are probably a ROBS fan.

Big fan.

And you're like, what the hell is this directed IRA option? I didn't know that was an option. So I don't know, we'll see how it goes. But we're going to talk about ROBS first. Why would you do a ROBS or why is it sold? What is the purpose of it? Then we'll get into how you do it. And it's— and I want to say right out of the gate, it's not illegal. It's not an IRS scrutinized top 10 dirty, top 12 dirty dozen thing. They're just technical and they come with a good and a bad, a lot of good and a lot of bad, you know, so you got to be careful there. So what the ROBS is, is for someone that has maybe a little good Oversized 401. I was going to say a little nest egg in their retirement account. They worked for a large company for years. They've put away their money in their 401, and they're in their 50s, maybe older, maybe a little younger. And they've got this money sitting in the 401, and they're like, oh, I want to use this to start a business, a business they want to run. So they want to go buy a job. Oh, did I say that? But they want to go buy a business and they want to buy this business with the money in their 401. And they think, oh, I should be able to do that. No, that's prohibited transaction to just buy a business with your 401 and start running it. But the ROBS strategy creates a technique of where that 401, that old 401 of yours, can buy a business or start a franchise or whatever. And you can work for the business. You got to follow a lot of rules along the way. But the theory is here and why you might be interested in it is it's not to invest the 401 creatively. It's to start or buy a business that you want to run. That's the ROBS strategy in a nutshell. What do you— Matt, did I summarize that well?

Yeah. And we're at the cross-section of this, of course, because we're working with clients every day using their IRA or 401s to invest in private assets. You're buying real estate. day, investing in private companies and small businesses, funds, crypto. I mean, we're knee-deep in that every day at our company, Directed IRA. But also in our law firm, KKOS Lawyers, we're advising clients, business owners, clients buying businesses, selling businesses, setting up businesses. And so, we've been down the road on this many times. I've even set up about 30 different ROBS structures for clients. Now, I compare that to 25,000 accounts that we have at Directed IRA. Okay, so that'll give you the fit that I think where it works. So, a little spoiler Yeah.

So the thing that I thought you were going to say, and I want to finish the sentence for you in there since we finished each other's sandwiches, is that you said we set up every day 401s and IRAs for people to buy businesses, but not businesses the owner of the IRA gets to work in. That's the big difference.

Yes. And this is where the ROBS came about, is people were like, well, I can't use a self-directed IRA because I want to own the business 50% or more with my 401, and I'm going to work in it and take a salary. And this is very popular in the franchise world. A lot of people are using this ROBS structure to buy franchises, which can be great. Okay. And this is, again, I'm not like, you know, I've had clients do that. We've had clients just buy existing small businesses from people selling and exiting a business. And so what I would say is it's very common as a funding mechanism to buy a franchise or an existing small business where you're going to be working in it, taking a salary, which you can't do with a self-directed IRA. That was a limitation that'll cause a prohibited transaction. Now, this loophole of the ROBS, and Mark said this earlier, comes with some baggage. Okay. So yes, I can use that 401 I've built up over the years in corporate America. And I can get it into this ROBS structure that buys a business that I'm working for and I'm taking a salary. But let me tell you what the big drawback is and then what this structure entails.

Matt, I love that summary 'cause that makes total sense as we explain it compared to the directed strategy, which we'll come to shortly. All right, so here's these steps real quick. You have to set up a C corporation, C as in Charlie. You're not going to be using an S corporation, which I Typically a person would do if they're setting up a franchise. Then you're going to take that corporation and form a new 401. Then you've got to roll over your old 401 money that's probably sitting in an IRA now into that new corporate 401. Then that 401 is going to buy the shares issued from the C corp. So now the 401 owns the same company that sponsored the 401. And there's a lot of technical terms in that process. But anyway, this 401 now owns the C corp, and that C corp hires you to go run the business and make it happen. And you get a salary which has to be reasonable. And gosh, from there, Matt, that's when the surprises really happen for people. Am I missing a step that you'd add to that too?

Yeah. And I say the, keep in mind here, the 401, what it's doing is, is this is your account in the 401. So just like, you know, you had your 401 at your job at Microsoft and you had your account in the 401 plan. I mean, this is your personal account in this new C corp 401 that you just set up, you know, Vandelay Industries, all right, whatever you want to call it. All right. But it's your Art Vandelay and you have your account in the Vandelay Industries 401. Your account is going to buy the shares of the C corp and it— your 401 account owns the C corp. You don't own the C corp, 401 does. What does that mean, Matt? Well, that means like, you know, the income and profits are going to build up in your 401. This is an important point here. You can only take a salary that's reasonable. Let's say that this company starts doing amazing and you're making a million bucks a year. Maybe you can justify a couple hundred grand in salary that you're paying yourself, and then the other $800 grand is going to go down into your 401. You're going to pay corporate tax on it because you're in a C corp at 21%. Now it's going to go into your 401, no tax. But this is a traditional 401. It's building up. It's going to come out later at ordinary income rates, you know, and maybe you can Draw this out later in retirement. But what's happening is that income that starts building up in your 401, if this is traditional dollars, so I mostly see people using in the ROBS, is that creating this kind of ticking time bomb that you're going to be drawing out later. Where if I just owned it personally in an S corp structure, max rate's going to be 37%, right? I don't have a corporate tax. It's going to come out to me right now. And assuming, you know, you hit the highest bracket here at $600 grand or so. But when you run the math, it's not the best tax outcome in the ROBS structure. And there's a couple other problems and snags here. I just want to get in compliance on it. But I just don't— a lot of people are like, this is a great tax strategy. I'm like, is it?

Is it? Now, if my understanding is correct, you could use a Roth 401 to do it. You could, but most people don't. And you— and some of you may be like, well, why? Why wouldn't I just use my Roth? Because remember my example. You worked for this company for years and years. You did your contributions. The company did their match. 9 times out of 10, that's going to be a traditional 401. It's only been in the last few years you could have a Roth 401 feature, but this is going to be a traditional 401. So then you say, okay, I'm going to do the ROBS strategy. Oh, but I want to do it with Roth money. So now you've got to pay tax now out of personal funds to convert the 401 to Roth before you start the ROBS.

Yes.

Now, yes, it'd be nice if it was a Roth 401. So down the road when you sell the company or get out, finally, it would be— all those profits would be tax-free. But we don't see people do that. Because it takes such a huge hit upfront on that 401 money. You can't chunk at it like we normally teach. And so you just end up with this traditional 401 where you're pulling the money out later.

Yeah.

Yeah. And so I agree. Yeah, it's hard to make sense of it tax-wise.

And I— if you're doing the Roth 401, which you can do in the ROBS structure here, I can like it a little bit more. Definitely. Now it becomes a lot more tax efficient. All right, because now I'm building up this tax-free bucket of this income coming out of this business. It's making money. Now let's say you're like, all right, Matt, I'm going to be able to sell it now. I can sell this business for $5 million. Okay, let's say that that opportunity comes up. If you have the traditional 401 and now I'm selling the business, great. I'm selling the C corp stock, right? And now it's going into my Traditional 401, that's going to come out at ordinary income rates. It's not going to come out at capital gain. I could have just paid capital gains rate of 20%. I'm trading it for 37%, possibly, if I'm at the highest bracket, you know, as I'm pulling money out of retirement of this traditional 401. Now, if it's the Roth, like Mark was countering earlier, where this can— where I— if you're doing Roths and this business is going to be successful putting out cash-flowing income, or you're going to sell it for profit, Definitely love the Roth. But if it's the Roth, then of course the business sells, it goes into the 401, you sell the stock, and then when you're distributing it out later at 59 and a half and you're living off of this income, it's coming out tax-free, which is better than paying capital gains tax.

Mm-hmm.

So just know as you're getting into it, the real tax outcomes here. I just think the traditional is not a better structure. I think you'd better— you'd be better off just owning it personally. And not going through the gymnastics, in my opinion.

Yeah. And I want to summarize it with this again, kind of public service announcement. When you hear someone on social media, watch them on social media or hear them on stage, whatever, and they're talking about, oh, there's this unique strategy and you can buy a business and sell it tax-free. And it's, you know, and they talk about your 401 owning and they just hit the highlights. Gosh darn it, it sounds pretty freaking awesome. It does. It sounds sexy. I get it. Regrettably, they aren't giving you the details of that baggage that comes along with it. And so I want to affirm they work, and a lot of people have done this, and they've done it successfully. But a lot of clients we talk to get into the maintenance of this, which, Matt, I know you wanted to comment on too.

Yes.

And they realize, oh my gosh, this thing is actually not as flexible as a typical business owner's used to. This is not owned by you. It's owned by a 401. The rules regarding your salary are stringent. You've got to do a C corp tax return. You've got to do your 401 tax returns, probably an extensive 5500.

Yep.

You've— the maintenance on this is not fun. And clients go, wow, if I would have known about self-directing, I think I would have taken a different route. And so just do your research when someone's selling you on this. But Matt, again, you wanted to comment, I know, on that maintenance.

Yeah, I think it's way more complicated, especially compared to a self-directed IRA, because you are going to be spending maybe $5,000 a year in accounting and just reporting fees on that structure. Keep that 401 plan is a little complex because it's not just a regular 401, by the way. It has an employee stock purchase plan option in it. It's got that, which is the way you're getting around this loophole where you can still work in the business, by the way. So it's a little, it's a complicated 401. And you need someone that really does this. So there are companies that really do this day by day. We don't do it anymore. When I said I've set up 30 of them, I probably had, of those 30 clients that I set up the ROBS for, I'll bet 20 of them didn't like it.

Hmm.

It was the most of the people that set that up were just like, uh, this, I wish I just would've done this personally. This was way too much gymnastics. I feel bottled up here on what I can and can't do and how I take the money out of the business, how much I can take as salary versus, which is not the most efficient way to get money out of your business, by the way, is salary. You're paying self-employment tax on all of it. The rest is going down to my 401, and that's traditional with most of these people. It's growing tax deferred. Great, but it's going to come out at a higher rate. I can't touch it now until I'm 59 and a half. It's just like, it's a little clunky. Now, there are people that it can work for, and I want to say it's legitimate. And if you're like, this is how I'm going to buy this business, this is the only funding way to get there, and I need to work in the business, I get it. I can see it being a use case, but don't think it's a great tax strategy. I would use it more because It's the way I can make this thing happen and pull off this deal that I want to do.

Yeah, no, that's an excellent point. Well, I want to try to provide the transition here with a couple of thoughts. If you're, if you're listening to this podcast, watching us on YouTube, you're— there's a good chance you're looking at buying a business or starting a business from scratch. Please get over to our Main Street Business Podcast. We've done several shows in the last year on due diligence and buying a business, when to buy a business, how to buy a business, and having your eyes wide open to that experience. The ROBS is a piece of this. There's a lot to consider if you're buying a business. So please get over there. And are we saying you can't have your 401 buy a business? No, your 401 can buy a business. Let's transition to that. I would love to self-direct and have my 401 buy a business. Okay. We've just got some prohibited transaction rules about you personally working in the business. And you might go, that sounds great. I didn't want to work in the business anyway. Okay, well, now we're at the right time.

Yeah, I think let's hit a couple of things here because Mark and I have done some episodes on this about how to buy a business with your IRA or 401. And the ROBS is like one of a few strategies here. That's probably the least likely one that we see used. So if you're like, all right guys, what can I do? Let me go through the first one. That's actually the easiest. It's not even a self-directed IRA. It's just establishing a new S corp for the new business, adopting a solo 401, rolling over your IRA or 401 dollars, and taking a loan of $50K. So you can have a 401 where you can lend yourself half the balance of the 401, not to exceed $50 grand. You got $200 grand in a 401. You can take out $50 grand that you loan to yourself that you can use to buy the business. The other $150 goes and stays invested in your 401. But I can access $50K for any purpose. I could pay down high-interest credit cards. But of course, here for our purposes now, you can use it to buy the business. You pay that loan back over 5 years. The interest you're paying back to your own 401, by the way, is tax deductible because it was used for for business purpose here. So we can, so we can use IRA or 401 dollars to help you just buy it personally and just use the regular S corp and at least get $50K.

And to juxtapose that to the self-directed format, the steps are so much, they're so much easier and fewer. You're rolling over that same old 401 that's now in an IRA somewhere from that job. And you know that you can invest it somewhere more wisely. So you open an account, a directed IRA. It could be a traditional or Roth or a combination of the two of them. And you roll that money in. There's no penalties, there's no taxes. And you start thinking about my options and your options. And you can say, well, I'm going to start converting some of it to a Roth or I would like to invest in a new startup and your retirement account will be buying shares in an LLC or maybe forming an LLC to go do a real estate deal or some type of business. And as long as you realize you're not going to be running the day-to-day operations in the business, but able to make decisions regarding the investment and the overall oversight of the project, You find out that that's where you wanted to be anyway. And the tax benefits can be significant because you're not dealing with the C corp in the middle and a salary and all those moving parts.

Yeah. And I think the self-directed IRA, like if you're thinking of funding the business and you're— especially if you're not going to work in it, that's the easiest. Just have— I would do a Roth IRA, particularly if you think this business is going to be great. Let it own a share of the company. This could be an LLC typically is what it would need to be here. It could be a C corp too, if that's, you know, whatever. But, but the Roth IRA is going to own the company or your share here. Maybe you own a third of it or you own 40% or 1/10, whatever, you know, in the situation here. And there's someone else who's more the work partner that's going to put in the work and the sweat equity and, and maybe they're putting in some cash too. But, but if you're not working in it and you're, you're like the cash investor, this is where I love your IRA to come in. And that's what we see a lot of times with clients at Directed IRA. They're investing in small businesses. And this is what you've, you know, you've heard in the headlines is like, this is what Peter Thiel did. I've seen so much of this influencer stuff out there saying, oh, Peter Thiel did the ROBS. No, he didn't. He did a self-directed IRA. He was like one of 6 different founders in PayPal. And that's how he invested his IRA in there. He didn't own 50% or more. His IRA was early. So it got in at a very low discounted price when Who knew if PayPal would even work, right? But his Roth IRA owned it. And you know, he has this $6 billion Roth IRA now, but there was other people involved where he didn't have control. And so it didn't cause this prohibited transaction issue. So there's nuances here on how you structure this. And I'll just say, if you're planning to use an IRA to invest in a business where you're going to work, you need to get an attorney, tax attorney, CPA, someone that's knowledgeable on these rules helping you. Our lawyers at KQS Lawyers help advise clients on how to structure this using their Roth IRA. What's the right LLC or entity structure? Can I work in the business or not? If, you know, and that's a little more nuanced, complex thing as well. If you want to keep it simple though, it's just like invest your IRA in small businesses and just don't work in it. I don't care what percent you own or what, doesn't matter. You can own 100%. You could own 1%, just don't work in it and it doesn't cause an issue. It's where you're physically working, providing services, taking a salary, where your IRA is invested, it causes a problem, which is where this ROBS structure came from because it solved that limited issue of you want to work in the business and take a salary. That's where you need to go. ROBS, get the C corp, get the more complicated 401, the more complicated reporting, the more complicated tax outcome. And so, but I just don't think most people need to go there.

So, I want to just say this in summary because I felt this talking through all of these points today is that there are so many options for you out there with a retirement account. In fact, many times, we don't even know what to ask when we're in an area that we're not familiar with. And I really want to encourage you to to meet with one of our lawyers at KKOS Lawyers. This is our firm that Matt and I have had for over 20 years, helping small business owners all over America start their own businesses and/or use their retirement accounts. And we can suggest ideas and options you may not even be thinking about. But take the notes from today and bring it. Well, what about this? Well, can I do that? Can I do this? Push, you know, ask those tough questions and we would love to answer them. And so I think this is a great conversation starter on your dreams of better using your retirement account, because if you're listening to the show, you already know your retirement account can do a lot more than just a Wall Street product. So let's find a solution for you. So down below is a link to KQSLayers. At least book a discovery call and, and see where we could be of service.

Yeah. And if the self-directed IRA works for you, we can set those up, of course, at Directed IRA. There are limited situations for ROBS. We can refer you to people that do set those up if that is— you're in that little sweet spot where it does make sense. So thanks, everyone. Hopefully this is helpful in illustrating the differences between ROBS and self-directed IRAs. Make sure you're subscribed however you're consuming this, on the podcast, on YouTube. Make sure you're subscribed so you get updates on future shows. Thanks for being here. Till then, stay calm, self-directed on.