Financing a business start-up can be a challenge. Most traditional lenders require that a business be operational for at least a year before they will provide small business loans. Moreover, venture capitalists are quick to reject most start-up proposals and if the venture capitalist is willing to fund the start-up they typically demand a significant ownership stake in the business. This has caused many entrepreneurs to look for alternative means for financing business start-ups. The entrepreneur rollover stock purchase (ERSOP) plan is one such financing alternative.

The idea behind the ERSOP is to use the entrepreneur’s 401(k), IRA, or other qualified plans to fund the start-up. The ERSOP process looks something like this: establish a legal entity; get a taxpayer identification number and checking account for the entity; set up a trust and get a taxpayer identification number and a checking account for the trust; (hopefully) get a determination letter from the IRS specifying that the trust qualifies as an everyday employee stock option purchase plan (ESOP); roll the entrepreneur’s retirement accounts over to the trust checking account and then to the entity checking account; the entity transfers entity stock into the trust. At that point the money is in the business checking account and the business stock is in the ESOP. Most transactions such as this are disseminated via financial planners or via the large accounting firms; however, it appears that very few of those advisors are actively recommending the ERSOP. Instead the ERSOP seems to be being pushed by the professionals who help facilitate the transfer of franchise businesses. There are a number of businesses on the internet that claim to specalize in handling these types of transactions (see, e.g., http://www.ERSOP.com).

The main problem with the ERSOP is that it involves pulling money out of retirement accounts to fund speculative business ventures. This is a particularly risky undertaking given today’s diminishing government safety net and increasing government regulation.

Other problems involve violating the self-dealing rules required for ESOPs, volunteering for additional accounting and compliance requirements and costs, limiting future business structuring by creating a near permanent stock ownership arrangement, possibly limiting the entrepreneurs’ rights if the business goes under or if the entrepreneur wants to sell the business in the future, and placing the business in a vulnerable position with respect to future changes in the law.

While these drawbacks will probably preclude the use of an ERSOP in most cases, this does not mean that the ERSOP would never be appropriate. A client who is going to start a business using other risky financing methods (such as taking on credit card debt), who is fully advised of the consequences and requirements, and who is fully willing to comply with the requirements and willing to take the risk might be a viable candidate for the ERSOP. The ERSOP may be particularly attractive for clients who have significant wealth that is held outside of their retirement accounts, but it is currently illiquid.

A tight money supply and tougher underwriting mandates from Congress will probably help fuel the popularity of ERSOPs and other alternative financing arrangements in the near future. However, long-term, ERSOPs will probably be legislated out of existence or will continue to be passed up for simpler financing alternatives.

By: Kreig Mitchell
Law Office of Kreig Mitchell
1942 Broadway, Suite 314
Boulder, CO 80302
Ph. 303.521.0053
http://www.irstaxtrouble.com