The Case of the Rich Uncle

(While the following narrative reflects actual facts and events, the client’s names are withheld to protect their privacy.) 

For many years this candidate was a very successful small business owner. He operated a large wholesale distribution business. His top competitor was an even bigger company with a regional footprint that desired to buy his business. After a few years of courtship, he finally agreed to sell out to the bigger company. The multi-million-dollar transaction closed during summertime. 

By the fall the client was bored. He really liked being in business and sought out his local FranNet consultant for introduction to franchise opportunities. However, after just a little bit of research, the client would come to the same conclusion regardless of the opportunity. That is, he could do it better than the franchisor if he set his mind to it. This process went on every fall for eight (8) years. 

At a big, extended family gathering, one year, the candidate learned that one niece was unemployed and the other was underemployed. He sought them out and boldly offered to bankroll a business for the sisters if they were up to it. However, he wouldn’t fund an independent startup for them. He was a Rich Uncle, not a Crazy Uncle. They had to start a franchised business and the candidate knew just who to call. 

The FranNet consultant used the Entrepreneur Profile process with the sisters to determine their business owner profiles and transferable business skills. The FranNet consultant was able to match the sisters to an opportunity in an industry that they were familiar where the introverted, organized sister could fill the inside management position and the extroverted sister with successful sales experience could fill the outside sales role. 

It turned out that the sisters really did have a Rich Uncle, and smart, too. He was happy to fund the franchise business but wanted to mitigate risk and receive a return on his investment. The transaction was structured so that the Rich Uncle was the franchisee and controlled the business. The sisters would be hired for their respective positions with employment agreements and they would run the company. If things went well, then they would have the option to purchase the business based on a pre-determined formula. If the business ‘went south’ based on pre-determined operating and financial metrics, then the sisters could be fired and lose their option to purchase. 

The service franchise had a total initial investment required of $200,000. The Rich Uncle had the resources to pay cash or borrow or any combination of funding strategies. The FranNet consultant introduced him to the ROBS program concept to fund the franchise. ROBS is an acronym for Roll Over for Business Startup. This is a 40-year-old funding strategy known to experts whereby a business can be funded with retirement account assets without causing early withdrawal penalties or current year tax consequences. However, in this case, a ROBS program with a Roth component made the most sense. 

Part of the plan was for the sisters to buy the business after five (5) years. If they had the ‘normal’ amount of success as any typical franchisee (based on the Financial Performance Representation shown in the franchisor’s Franchise Disclosure Document and the sisters’ personal research gathered by speaking directly with existing franchisees) then the purchase price for the business five years hence should be $500,000. Capital gains taxes were an issue to consider. 

The client established a new Roth retirement plan and transferred $20,000 of existing non-Roth retirement assets into the new Roth plan. This transfer generated current year income tax consequences of a few thousand dollars. A regular C-corporation was created as the legal entity to operate the franchise business. The Roth retirement plan purchased the common stock of the new C-corporation for $20,000. The client then made a personal loan to the C-corporation for $180,000 to be amortized over ten years but with a balloon payment due after five years. 

The sisters’ wages are paid from the operating funds of the business. So too are the loan payments. The C-corporation files its own tax return and pays taxes due to its profit. Excess profits are paid as a dividend to the Roth plan. 

If things go as planned, after five years, the sisters will refinance the balance due on the $180,000 loan then buy 100% of the outstanding common stock for $500,000 less than the payoff amount of the loan. The sisters will own the franchise outright and the Rich Uncle will be completely cashed out. By refraining from taking any distributions from the Roth plan for five years the future withdrawals will be completely tax-free. 

If plans come to fruition, then the sisters will own their business outright and be in control of their futures. The Rich Uncle will have made a very significant return on his investment and be able to use the return without tax consequences. Most importantly, he’ll have the satisfaction of helping his nieces improve their lives through franchise business ownership. 

Jun 24, 2020