Adam Bergman

Founder, Tax Lawyer, Author

What Are the ROBS Prohibited Transaction Rules?

The IRS-prohibited transaction rules are not triggered in a rollover business start-up (ROBS) solution. The ROBS solution allows one to use their IRA or rollover 401(k) funds to purchase stock in a C Corporation that they are personally involved in, without triggering the IRS-prohibited transaction rules. A Self-Directed IRA doesn’t get that same treatment. If a Self-Directed IRA bought stock in the same company instead of a ROBS 401(k), that purchase would trigger the prohibited transaction rules the moment the retirement account owner or their lineal descendants controlled the company.

Before going further, it helps to take another look at what the prohibited transaction rules actually entail, since that’s what makes the ROBS exemption worth understanding in the first place.

If you have a retirement account, you’re probably already aware these rules exist. What’s less obvious is that they don’t describe what you can invest in, only what you cannot. The reasoning behind them is simple: the IRC doesn’t want you using retirement funds for personal gain today. The entire purpose of an IRA or 401(k) is to accumulate funds until retirement age, then make withdrawals, not to quietly benefit you or your family in the meantime.

Disqualified Persons

For the sake of clarification, what exactly is a disqualified person? Under IRC Section 4975(e)(2), a disqualified person includes:

• You, the IRA or plan owner
• Your spouse
• Your ancestors, such as parents and grandparents
• Your lineal descendants, such as children and grandchildren, and their spouses
• Any entity 50% or more owned or controlled by you or the people listed above
• Fiduciaries and service providers to the plan

The IRS treats you, your spouse, and your family line as effectively one and the same for these purposes, which is exactly why a Self-Directed IRA can’t buy stock in a company any of those people already control. You can review the complete list in more detail in Disqualified Persons and Retirement Accounts.

The prohibited transaction rules are also in place to protect the IRS’s revenue-generating rules. If you use retirement money to help your children or spouse, the IRS sees that as a way around the distribution rules, the minimum amount you’re required to withdraw from your account each year. You wouldn’t be paying tax on those funds while still benefiting your closest family members, which defeats the purpose of the rule entirely. The same logic applies if you tried to give IRA funds directly to a spouse: it would amount to using the funds now, without paying tax or the potential 10% early withdrawal penalty. If that were allowed, everyone would do it to avoid tax on their retirement savings.

How Does This Hurt the IRS?

Here’s an excerpt from Turning Retirement Funds into Start-Up Dreams that captures why this matters to the IRS specifically:

“…The IRS would be left with very little tax revenue from the IRA account, and it would also lose tax revenue because of the use of the IRS deduction in the year of contribution…So prohibited transaction rules are actually very important for the IRS.”

The Reason There Are No ROBS Prohibited Transaction Rules

As covered in What Is the Rollover Business Startup Solution? and How Does ROBS Work?, the ROBS structure is one of the few ways an individual can legally sidestep the prohibited transaction rules described above. That’s because ROBS takes advantage of the “qualifying employer securities” exception in the tax code, found in IRC Section 4975(d)(13). This provision works by importing an ERISA exemption, Section 408(e), that allows a qualified plan like a 401(k) to acquire employer securities under specific conditions: the price paid has to reflect adequate consideration, no commission can be charged on the transaction, and the plan has to be an eligible individual account plan. Doing so does not trigger the prohibited transaction rules the way the same purchase would inside a Self-Directed IRA LLC.

The distinction is worth sitting with for a second, because it’s easy to assume an IRA and a 401(k) work the same way here. They don’t. An IRA has no equivalent exemption for buying stock in a company its owner controls, which is exactly why that same transaction inside a Self-Directed IRA triggers the prohibited transaction rules while the identical purchase inside a ROBS 401(k) doesn’t. The exemption is also narrow by design: it applies to qualifying employer securities specifically, which is why a ROBS structure requires a C Corporation rather than an LLC or S Corporation. Stock in an S Corp or a membership interest in an LLC doesn’t qualify for the same treatment.

With so many advantages to the ROBS solution, it’s worth serious consideration if you’re looking to start or finance a business with retirement funds, provided you go in understanding both the exemption and its limits.

Did You Know?

The ROBS solution can allow you to use funds originating from your retirement accounts to purchase a business you can also earn a salary from, something a standard Self-Directed IRA investment never allows, since you can’t personally benefit from an asset your IRA owns. It’s the only legal way to draw a salary from a business your retirement funds financed. You’ll need a C Corporation, not an LLC or S Corporation, to set up a Rollover Business Start-Up.