Want to quit the rat race and start your own business? Or maybe you’ve lost your job and are eyeing franchise opportunities?

If funds are limited and credit is tight, you might consider using what’s left in your 401(k) to start a business or a buy a franchise.

Yes, it is possible. And proponents tout a method known as “a rollover as business startup” — or ROBS — as a tax-friendly way for budding entrepreneurs to tap their 401(k) accounts.

“This is clearly a permissible type of investment, permitted by the IRS code,” says Leonard Fischer, founder and CEO of BeneTrends, a financial services company specializing in ROBS located in North Wales, Pa.

But not everyone is sold on ROBS. In fact, some people maintain a ROBS is fraught with dangerous tax pitfalls.

“(A ROBS) strategy sounds amazing … it all sounds too good to be true because it is,” says Jeff Nabers, CEO of Nabers Group and founder of the IRA Association of America, a trade organization.

Starting up a business using this strategy immediately raises suspicions with the IRS, Nabers says.

“Anyone who (does a ROBS transaction) puts a target right on their back: ‘Audit me,'” Nabers says.

ROBS 101

ROBS plans are touted by franchise sellers all over the Internet and arranged by investment firms specializing in this practice.

ROBS firms charge a fee to walk clients through the process of creating a C corporation. The new corporation starts its own 401(k) plan, which must offer employees the option to purchase stock in the company. The new business owner then rolls over funds from an existing 401(k) into the newly created corporation’s plan.

Because the assets are moved from one tax-exempt vehicle to another, business owners avoid taxes and penalties.

The sole participant in the plan (e.g., the owner of the new company) can then direct the investment of the 401(k) account balance into a purchase of employer stock in the new corporation. The transferred funds are used to either purchase a franchise or fund the new business — essentially creating tax-free working capital.

Guidant Financial Group of Bellevue, Wash., has helped clients tap a total of $1.5 billion in 401(k) funds since the firm opened its doors in 2003. A large percentage of these clients use their funds for entrepreneurial ventures.

David Nilssen, CEO of Guidant Financial, says a major benefit of the ROBS approach is that clients start out a business relatively debt-free, increasing the chances of being profitable sooner.

“Profits made can be funneled into growing the business rather than paying off debt,” he says.

Too good to be true?

However, others — like Nabers — warn about the dangers associated with ROBS.

Martin Hauptman, an attorney specializing in Employee Retirement Income Security Act, or ERISA, law, says the ROBS approach may sound simple. However, it is actually a complicated process fraught with the potential to lose your whole retirement savings — and then some — to the IRS.

A ROBS may be legal, but it operates in a grey area of IRS codes and regulations, says Hauptman, principal with the law offices of Hauptman & Richmond, PA of West Orange, N.J.

To keep a ROBS transaction legal, the business owner must heed a slew of IRS regulations and avoid making certain prohibited transactions, Hauptman says.

The penalties for not complying with the rules are staggering.

For example, if the IRS determines the deal is a prohibited transaction, it can trigger excise taxes.

“If you run afoul of these prohibited transactions, you can run up 110 percent — or more — in penalties,” says Hauptman.

Hauptman has helped guide clients through using the ROBS method. He says he is careful to construct plans that work within IRS regulations.

ROBS deals must be done very carefully and no two cases are exactly the same, says Hauptman, who recommends first contacting an attorney who is well-versed in ERISA law before venturing into any ROBS deals.

“I wouldn’t recommend this as a do-it-yourself project, and it’s not for the faint of heart,” Hauptman says.

IRS weighs in

A memo issued by the IRS on Oct. 1, 2008, appears to cast a chill on the ROBS strategy. The 13-page memo concludes that:

ROBS transactions may violate the law in several regards. First this scheme might create a prohibited transaction between the plan and its sponsor. … Additionally this scheme may not satisfy the benefits, rights and features requirement of the Regulations. … For this reason employee plans specialists are directed to open ROBS cases as described herein.

Michael D. Julianelle, author of the aforementioned IRS memo and director of employee plans for the IRS, maintains that ROBS plan can be legal — if you’re careful.

“There are so many rules that need to be followed,” Julianelle says.

For example, the IRS looks closely to make sure companies that use ROBS funding offer stock ownership to all employees of the business, he says.

“That is one example of what is not happening in many instances, which violate nondiscrimination rules,” Julianelle says.

Another red flag is when the rollover amount equals the business’ stock value.

“That does raise an eyebrow for us. … It indicates that this is something we should be looking at,” says Julianelle, who says such math usually indicates the rollover’s intent is to be used as business seed money only, rather than to be used as a bona fide employee retirement vehicle.

To avoid running afoul of the IRS, prospective business owners should seek the professional advice of a benefits expert, Julianelle says.

Indeed, ROBS proponents such as Guidant’s Nilssen insist that rollovers performed by reputable companies operate under IRS guidelines and will not raise agency suspicions.

“I’ve heard of people using a rollover for business startup to buy a Mercedes-Benz for a company car of a business that is ‘to be formed later,'” Nilssen says. “Well, that individual never started a business. … That’s wrong and a transaction we’d never participate in.”

Fischer also believes in the ROBS approach. However, he cautions that a ROBS is not a strategy to be taken lightly.

“It does require a lot of thought and scrutiny because you’re putting your retirement plan at risk,” he says.

Putting retirement at risk

The risk of losing retirement money is the biggest drawback of a ROBS, says Michael Stamler, spokesman for Small Business Administration.

“We do not advise people to use their retirement funds to finance a startup business because there’s a great risk that it could consume those retirement funds,” says Stamler.

Jaime Raskulinecz, CEO of Entrust Northeast based in Verona, N.J., echoes those concerns.

“What if your business doesn’t become profitable and folds? You’re out of retirement money,” says Raskulinecz, whose firm manages self-directed retirement accounts.

Besides, there are other options to seed a startup business that will not put your retirement money at risk or incite the wrath of the IRS, Raskulinecz says.

They include:

  • Ask others to invest in your business. Others can legally use their retirement money to invest even if they will not be a principal in the business.
  • Ask for a loan. Loans are available from the Small Business Administration. You can also consider a home equity loan or cash loans from friends or family.
  • Borrow money from your 401(k). A 401(k) loan is an option, but IRS rules allow you to borrow only up to half of your vested balance, or $50,000, whichever is less. Some plans may even put restrictions on how you can use the money. So check to see if starting up a small business is allowed under your plan.