Financial planning knowledge to help you better serve your clients.

For entrepreneurially minded individuals, the potential to generate investment returns and wealth creation through the founding and growth of a business is often unrivaled. The caveat, of course, is that rapid growth businesses also face substantial taxation on that growth when they are eventually sold. Accordingly, when such individuals have retirement account assets – effectively legal tax shelters – the question arises: “How can I shift some of the value of my fast-growing business into my retirement account?” or better yet “Can I use my tax-free Roth IRA to invest into early stage growth companies?” (as was highlighted in a recent ProPublica article about Peter Thiel’s early stage investments into PayPal and Facebook to create a whopping $5 billion Roth IRA).

Because the reality is that while a Roth IRA can certainly own shares of stocks – including privately held companies that are not (yet) publicly traded – there are limitations on who an IRA can buy shares from, and who can be compensated by an IRA-owned company, under the so-called “Prohibited Transaction” rules.

At the highest level, the Prohibited Transaction rules restrict an individual from using their (Roth) IRA to engage in various types of transactions with certain “Disqualified Persons”. Which is important because, in the case of an IRA owner, failure to abide by these rules results in a deemed distribution of the entire IRA in which the transaction occurs as of January 1 of the year in which the Prohibited Transaction occurs (causing a forced liquidation of the entire retirement account and forfeiting its tax-preferenced status altogether!).

Among the Prohibited Transaction rules outlined in IRC Section 4975, IRAs are prohibited from buying/selling property to/from, lending/borrowing to/from, or furnishing/receiving goods, services, or facilities to/from, a Disqualified Person. Disqualified Persons are also prohibited from using IRA assets for their own personal benefit. Finally, Disqualified Persons who are also fiduciaries must avoid dealing with the income or assets of an IRA for their own account, or (in general) receiving any consideration from the IRA.

Critically, an IRA owner is always a Disqualified Person, and fiduciary with respect to their own IRA. Other Disqualified Persons, with respect to an individual’s IRA (who may or may not be fiduciaries), are the individual’s spouse, ancestors, lineal descendants, and any spouse of a lineal descendant. In the event an IRA owner, along with those related Disqualified Persons owns 50% or more of a business, then the business, itself, also becomes a Disqualified Person, along with its officers, directors (and persons with similar responsibilities), 10% or greater owners, and employees earnings 10% or more of its total wages.

The end result of these rules is that in order for a Roth IRA to invest into an early stage growth business, it must have someone besides the IRA owner (or his/her family members) to buy the shares from (as they cannot be contributed in-kind to an IRA). Which means businesses that are fully owned by the founder (and/or their family members) are effectively ineligible to be purchased inside of an IRA! And even if the business isn’t fully owned by Disqualified Persons, if the IRA owner (and other family members) own 50% or more of all shares, the business cannot even issue new shares to the IRA and must find other non-Disqualified-Person owners to buy from (and even then, there is a risk that the IRS will scrutinize the transaction further under the self-dealing rules for IRAs).

Interestingly, though, for individuals who want to start a new business owned by an IRA, 100% IRA ownership is achievable. As the Tax Court has repeatedly determined that since prior to the formation and capitalization of a company, it has no owners and thus, cannot yet be a Disqualified Person! Accordingly, the company can issue 100% of its shares/interests to an individual’s IRA.

However, even when a business is fully owned by an IRA, entrepreneurs must still be cautious with respect to their compensation. Because in situations where the business is owned 50% or more by an individual’s IRA, “control” essentially always exists (either directly or indirectly), and thus receipt of compensation personally should be universally avoided (to avoid running afoul of the self-dealing rules for IRAs). Though at the same time, absent the receipt of compensation, an individual can still create a Prohibited Transaction through the provision of services (‘sweat equity’) to their IRA-owned business. As while an IRA owner can perform certain administrative and decision-making duties on behalf of an IRA-owned business (e.g., paying bills of the IRA-owned business with IRA money, deciding on investments to be made by the company), it cannot do the work of the business.

Ultimately, the key point is that while IRAs can be used to purchase private, non-public companies, the Prohibited Transaction rules significantly restrict both who can sell shares to the IRA, what compensation the entrepreneur can receive when working for an IRA-owned company, and even the ability to contribute sweat equity to an IRA-owned company. Which is important to navigate, given the harsh tax consequences associated with the Prohibited Transaction rules!

Read More...