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.

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