One of the more frequent inquiries we hear at New Direction regards the transacting of business between an IRA and a private company. For us to perform our jobs successfully for your IRA, we will often need a discussion with the account holder to discern whether the participation in the private company is a loan or a private stock (or equity) purchase. Both investments involve sending IRA money to the company with the expectation of a return, but the supporting documentation for the two types of investment is different.
A) “A loan”?
As you probably know, it is permissible for your IRA to loan money to a private individual, so long as that individual is not disqualified by virtue of IRS regulations. But an IRA can also lend moneys to a business – and this will also constitute the same sort of Private Lending. Companies will often need infusions of capital to “start-up” or fund their growth and development, and they may solicit potential capital infusions by offering attractive interest rates to Lenders (which could include an IRA).
The parties draw up a Promissory Note, spelling out the amount of funds to be loaned, and the terms of that Loan, and an inked signature of the Borrower on it — which the New Direction IRA client furnishes to us along with the Promissory Note Buy Direction Letter form.
The characteristic that most often indicates that the IRA’s asset is a loan (and not private stock) is that the return on the investment is agreed upon and fixed in the transaction documents. Remember, just as in the case of lending to an individual, lending to a company would only be prohibited if, for example, the IRA holder or other disqualified person is a majority owner or controlling officer of that company.
B) “Buying stock”?
Very often, smaller or growing companies elicit investment capital not only through acceptance of loans, but also by offering stock. In other words, though they’re still private, a company may sell stock shares to investors, giving those investors the opportunity to acquire equity in their enterprise. Since these companies are not publicly traded on stock exchanges, the only means to acquire a stock investment is through what is typically called a Purchase or Subscription Agreement, or Private Placement.
The company draws up their Agreement or Private Placement document, spelling out the number of shares to be purchased and price, which the IRA holder furnishes to us along with the Private Stock Buy Direction Letter and Disclaimer & Indemnity Agreement forms.
The characteristic that most often indicates that the IRA’s asset is private stock or private equity (and not a loan) is that the return on the investment is largely based on the performance of the company which is a variable.
C) “Convertible Notes”? (a kind of combo or hybrid)
It’s not uncommon for companies to also offer an investment opportunity which incorporates both the element of a Loan with that of Equity — by offering a Convertible Note. This is a kind of Loan, transacted as in the first example above, using a Promissory Note. The difference here is that the Note may provide an option at some point for the Lender to convert their creditor status for an actual ownership share (purchase of stock in the company), at some point in the future.
Once again, it is easy to see that there are a myriad of ways to exercise the freedom of your self directed IRA. However, because the supporting documentation for these types of investment are a little different, it is a good idea to decide the nature of the investment before beginning the acquisition process.