When Abdul Wahab lost his wealth management job in 2007 he began looking at franchises as a career alternative. When he couldn’t get financing to buy the pair of Quiznos sub shops he was eyeing on Long Island, New York, he turned to an obscure part of the tax code to enable him to use his retirement funds without paying a tax penalty. “They saved me a lot of money,” Wahab said of Benetrends, the Pennsylvania-based company that helped him use his 401(k) to buy the restaurants. “I was able to use more money to invest in my business.”

While the franchise sector has had some struggles over the past couple of years, Benetrends has been soaring. Tight credit has led more would-be franchisees to turn to their IRAs or 401(k)s to open up businesses. “We’ve enjoyed some significant growth over the last two years,” said company President Mark Nelson.

Yet that success is coming amid a backdrop of recent IRS hostility to retirement fund rollovers. In late 2008, the IRS issued a memo stating its concern about some of these rollovers and intends to scrutinize them on a case-by-case basis in the future. In other words, people who start a business with rolled-over retirement funds could face an audit. And those whose plans are drawn up poorly could face steep fines.

Benetrends is one of the largest and most well known marketers of these financing plans, which the IRS dubbed Rollovers as Business Startups, or ROBS. The company is thus getting aggressive in defending the rollovers.

It recently backed a pair of studies by the franchise information-gathering firm FRANdata. One study found the rollovers had an $8.34 billion impact on the economy in 2009, generating 32,603 direct jobs and another 29,342 indirect jobs.

A second survey of more than 3,000 Benetrends clients found they are for the most part educated, spend considerable time making their franchise buying decisions and use only a portion of their retirement accounts to invest in a business.

“We’re trying to be proactive,” Nelson said. “What we wanted to show was that this industry has real economic value to the country relative to the jobs it creates and the economic output.” Nelson added that his company has been meeting with congressional leaders to ensure they have this information.

How it works

The rollovers generally are structured like this: The prospective business owner creates a C Corporation, which crafts a 401(k) plan that enables its employees to roll over funds from an IRA or another 401(k). The corporation issues stock, and gives its employees the option to exchange assets in the 401(k) for stock. The employee is the owner, and the assets can be used as the initial investment. The rollover helps avoid taxes and penalties associated with early withdrawal from a retirement account.

Rollovers have become increasingly popular the past two years, as financing for startups has become almost non-existent. But their popularity has also led to some controversy. Darrell Johnson CEO of FRANdata, points out that much of the discussion thus far has not been backed by any data. The study, he said, “quantifies what really is happening with such transactions in the franchise space and in so doing, provides a means of objectively assessing the impact this form of capital in the creation of businesses and jobs.”

The IRS’s concerns about such plans are not about their legality, but the way that many of them are structured—its memo said the rollovers “could create a prohibited transaction.” And the penalty is steep. The owner or business could be forced to pay 115 percent of the amount involved.

In its memo, the IRS said some of these plans violate the IRS’s anti-discrimination code because other employees are often not allowed to acquire stock. The code is written so that benefits should not be structured in favor of highly compensated employees. In addition, the IRS claims the value assigned to the stock is not often backed by supportive analysis.

Nelson wants to see the IRS establish a set of formal standards to ensure all rollover transactions fall within the law and are done properly, “as opposed to people interpreting standards that don’t necessarily apply to us,” he said. “That would be a win-win-win: A win for the industry, a win for the government, and certainly a win for the people who start their business.”

The issue has particularly strong implications in the franchise sector—more than 60 percent of such transactions are used to invest in a franchise business, according to the economic impact study. Most of these funds are used to invest in lower-cost, mainly service-oriented franchises, including business services and commercial and residential services. More than half roll over between $75,000 and $200,000 of their retirement funds, though roughly a quarter will roll over between $200,000 and $500,000. Sixty percent needed additional funds to start their business.

The ROBS users tend to be older—84 percent are 45 to 65 years old, according to the FRANdata survey. They are well educated, with 89 percent having a college degree or more, and they’re overwhelmingly male (84 percent). They also spend time studying their decision—93 percent spend at least a month conducting research and 40 percent spend seven months or longer.

The demographics and investment information is important, Nelson said, “to dispel some misinformation that some of the people in the government agencies were thinking.” ROBS investors, he said, “know what they are getting into. They know the risks. People who are engaging firms like ours really do know what they’re doing. They’re educated. They’re doing their due diligence. They’re not risking every nickel.” Most investors, Nelson said, don’t use all of their retirement accounts to fund their business.

The economic impact study, meanwhile, found that every 500 ROBS transactions create 7,648 jobs. The number of direct jobs created in 2009, according to the study, meant that the average business started with such a transaction had eight workers. The Benetrends client survey, meanwhile, found that 74 percent of the businesses started had 1 to 3 full-time workers, and 66 percent had 1 to 3 part-time workers.

“These certainly are beneficial to the economy,” Nelson said. “The creation of 60,000 jobs is something that should not be taken lightly. In an economy losing jobs, our industry was creating jobs. And without government money.”

Wahab drained just about all of his 401(k) for his Quiznos franchises. The last couple of years haven’t been kind to the chain, and he admits that his stores’ sales struggles make him nervous because he has his retirement fed into the operation.

“It’s why I wake up every morning and start fighting,” Wahab said. He admits that, had he been able to get a loan back in 2007, “I might be out of business now.” Instead, he’s considering buying another store.