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Q: I read about something called an "ERSOP" process that claims to help people take money from their pension plans or IRAs without penalty and use it to finance a small business. Is this something that's "too good to be true"?
-- P.S., Boca Raton, Fla.
A: Get ready for a little alphabet soup. A handful of firms are heavily promoting the Entrepreneur Rollover Stock Ownership Plan (ERSOP) on Web sites. In this process, your current retirement funds are rolled over into an ESOP (a defined-contribution benefit plan) that the firm establishes for your new C-corporation. The ESOP then buys up the stock, thereby funding your new corporation. Firms charge around $800 for the transaction.
In case you're a little confused, an ESOP (Employee Stock Ownership Plan) is a type of benefit plan that allows employees to buy stock in their own companies, making them partial owners. ESOPs are well-established and often used in closely held outfits to buy part or all of the shares of existing owners. They're particularly popular with entrepreneurs who don't want to sell their businesses outright but are seeking liquidity as they get closer to retirement. When used as part of an ERSOP program, the ESOP allows new entrepreneurs to fund their companies by buying stock in them, since they're the only employees at that point.
POTENTIAL PROBLEMS. Be aware that ERSOP is a marketing phrase, rather than an Internal Revenue Service term, and most of the business and estate-planning experts we talked to weren't familiar with the plan. While the promoters assure potential investors that they have obtained favorable IRS "determination letters" about the plans' legality, critics point out that determination letters can be challenged. No binding IRS ruling for or against this kind of plan seems to exist. A search of "ERSOP" at the IRS website, www.irs.gov, turns up no results.
Experts who evaluated the ERSOP process identified several potential problems. "The dollars paid for the purchase of stock by the retirement plan of the new company needs to be for value, and therefore a valuation of the new company is required," says Donald Lucove, a CPA at Lucove, Say & Co. in Calabasas, Calif. "Since the company is new, there could be a question of whether it's indeed worth as much as the retirement plan will pay."
He also worries about the owner's dilution of control over the outfit and possible conflicts of interest as employees are added or if the business is eventually sold. That's because the ERSOP holds the stock, rather than the individual who started the concern. Other experts cite potential difficulties with estate planning and business-succession planning.
HIGHER STAKES. Perhaps the biggest drawback is that ERSOPs are a gamble. People who are planning for retirement should invest their funds wisely for the long term in a diversified portfolio, not a startup venture. "There's a huge risk for the individual putting his or her retirement funds into a new corporation," says Elaine Bedel of Bedel Financial Consulting in Indianapolis. "If the new corporation fails, they lose all their retirement funds," as well as their immediate income, she says.
If you're interested in learning more about ERSOPs, the best first step is to hire a business attorney or accountant to advise you about IRS rules and the potential benefits and drawbacks of these plans. Do not rely on plan promoters' advice alone.
Have a question about your business? Ask our small-business experts. Send us an e-mail at Smart Answers, or write to Smart Answers, BW Online, 45th Floor, 1221 Avenue of the Americas, New York, N.Y. 10020. Please include your real name and phone number in case we need more information; only your initials and city will be printed. Because of the volume of mail, we won't be able to respond to all questions personally. Karen E. Klein is a Los Angeles-based writer who covers entrepreneurship and small-business issues