Uncle IRA, the Venture Capitalist
By: Ben Brazda
While the average IRA holder trades public stock and mutual funds, it’s the sophisticated, self-directed investor who also keeps an eye open for growing, private companies. Every public company started out as a private business and almost all used investors’ capital to get off the ground. Could you imagine if in the early 80′s your IRA invested in a private company called Microsoft? Unfortunately, that opportunity is long gone, but there are thousands of new businesses started each year and many will need seed capital to grow.
It just so happens that on your way to work tomorrow, your friend Kevin gives you a call. He started a business a few years ago and is now looking for investors to expand the company. You meet with him several times over the next few weeks and run the concept by your CPA. Ultimately, you decide that this would be an excellent investment for your currently idle Roth IRA account. Your CPA informs you that you need a specialized IRA administrator to process these types of investments and suggests that you give New Direction IRA a call.
You call New Direction the next morning and connect with Tina Garland. You tell her about the company and explain that you would like to use your Roth IRA for the investment. The first thing Tina asks is what type of business the entity is as some types do not allow IRA investors and others require the IRA to be a specific type of owner.
General Partnership (GP) - An IRA cannot invest into a GP because administrators will not allow an IRA to be a general partner. (All owners in a GP are general partners.)
Limited Partnership (LP, LLP, LLLP) - An IRA can invest into an LP as long as the IRA is listed as a limited partner.
Limited Liability Company (LLC) - An IRA can be a member in an LLC.
S-Corporation (S-Corp.) - S-Corp. rules do not allow IRAs to be shareholders.
C-Corporation (C-Corp.) - An IRA can purchase stock in a C-Corp.
The next question Tina asks is if there are any disqualified persons (DQPs) involved in the business. This is important because if the entity is currently managed by, or has a controlling interest held by DQPs, then it would be deemed a disqualified entity and is thus a prohibited investment.
Disqualified Persons (DQPs)
DQPs include the IRA holder, their spouse, lineal ascendants (parents, grandparents) lineal descendants (children, grandchildren) and their spouses as well as some business partners and financial advisors. Any entities owned by DQPs are also disqualified.
Tina follows up by asking if the entity will generate operating income or if it will have earnings from debt. The purpose of this question is to determine whether or not income from the entity would be subject to tax within the IRA.
Earnings from Debt
If the entity uses debt, net earnings from that debt would be subject to Unrelated Business Income Tax (UBIT). (i.e. an entity that purchases a mortgaged rental property.)
Income from the sale or lease of goods or services, or income from the sale of personal property is subject to UBIT. It is also important to know that the sale of real estate could also be deemed operating income in some cases.
In pass-through entities (LPs and some LLCs), it is the IRA’s responsibility to file a 990-T and to pay UBIT (if it applies). This tax still needs to be paid even if the entity does not distribute it’s earnings during the year. Therefore, it is wise to keep additional funds in the IRA to cover this expense.
C-Corps. and UBIT
C-corps. (as well as some LLCs) pay their own taxes before earnings are paid out to investors. If this is the case, the IRA does not need to worry about filing a 990-T.
At this point, you may be asking yourself, “Why invest a tax-free Roth IRA into a company where the income would be taxable?” Well, if you’ve ever invested that Roth IRA in the stock market, you’ve done just that. Most publicly traded companies are C-corps and therefore earnings are taxed before they are sent out as dividends to investors.
Tina goes on to explain that if you had your heart set on investing in a General Partnership or S-Corp, or you really opposed UBIT, you could always structure the investment as a promissory note instead. A promissory note is a loan to the company, and therefore the entity type is irrelevant. Then, because the note has a fixed rate of return independent from the company’s earnings, it is not subject to UBIT.
Finally, Tina leaves you with a few helpful reminders. First, IRAs have contribution limits and required minimum distributions (RMDs), both of which could pose challenges if not planned for in advance. Second, for IRA transfers and distributions, it is important the company allows the ownership to be re-titled.
Some companies require additional capital down the road through mandatory capital calls. It is critical you plan for such events well in advance. For example, if you used every penny in the account for the initial investment and the capital call is more than your plan’s yearly contribution limit, you will have a problem.
Required Minimum Distributions
Traditional IRA accounts require that the IRA holder start taking distributions at age 70 ½, and there is a 50% penalty if they are not taken. It is a good idea to ask the company about their liquidation policy, especially if you plan to hold the investment for that long.
Transfers and Distributions
If you ever decide to transfer your account to another administrator, distribute the investment, or in the event of your death, the account is inherited by your beneficiaries. It is important the company allows the ownership to be renamed accordingly.
After giving it some thought, you decide to move forward and you ask what the process is. Tina explains that the first step is to open an account with New Direction and to initiate a funds transfer. Once the account is established and funded, the investment can be made by sending in the required investment paperwork and forms. Tina sends you detailed instructions and forms as well as the IRA application, and thus, your journey into the world of self directed IRA investing begins.
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