With a self-directed IRA or checkbook IRA structure, you will have the ability to invest in almost any type of asset you wish including a private company or business. This post will detail what you need to know if you are thinking of using an IRA to buy or invest in a private company or business.
IRS Prohibited Transaction Rules
The IRS and the Internal Revenue Code do not describe what a self-directed IRA can invest in, only what it cannot invest in. Internal Revenue Code Sections 408 & 4975 prohibits Disqualified Persons from engaging in certain type of transactions, such as life insurance, collectibles, or any transaction directly or indirectly involving or benefiting a “disqualified person.” A “disqualified person” is essentially defined as the IRA holder and any of his or her lineal descendants, as well as any entities controlled by such persons.
How the Self Directed IRA Works
The main advantages of using a self-directed IRA to invest in a private company or business is that one has the opportunity to invest in assets one knows and understands as well as defer the taxes on the income or gains. In other words, as long as you or a disqualified person are not personally involved in the company or business directly or indirectly, the self-directed IRA will likely be able to make the investment without triggering the prohibited transaction rules.
In general, one has two options when using an IRA to buy or invest in a private company or business.
- Custodian Controlled: With the custodian controlled self-directed IRA, a special IRA custodian will serve as the custodian of the IRA and allow you to make alternative asset investments, such as a private business or a private company. The IRA custodian will then invest the IRA funds at the sole direction of the client. The investment will be held in the name of the IRA custodian, such as IRA Financial Trust Company FBO John Doe IRA. The IRA custodian will be responsible for making all payments regarding the IRA investment, including paying expenses.
- Checkbook Control: With a self-directed IRA with checkbook control, investing in a private company or business is as simple as writing a check. With a self-directed IRA with checkbook control, a special purpose limited liability company (“LLC”) is established that would be owned by the IRA and managed by the IRA holder (you). As manager of your self-directed IRA LLC, you have the authority to make real estate investment decisions on behalf of your IRA on your own without needing the consent of an IRA custodian. With a self -directed IRA LLC with “Checkbook Control’ you will be able to invest your IRA in a private company or business by simply writing a check. Since all your IRA funds will be held at a local bank in the name of the IRA LLC, all you would need to do to make the real estate transaction is write a check straight from the IRA LLC bank account or simply wire the funds from the IRA LLC bank account.The UBTI Self Directed IRA Rules
When it comes to using IRA or 401(k) plan funds to invest in a private company or business, other than the prohibited transaction rules, the one additional issue that must be addressed is whether the transaction would trigger a little-known tax known as the Unrelated Business Taxable Income tax (UBIT or UBTI). If the UBTI tax is triggered, an IRA investment into a private business or company can be subject to a tax as high as 37%.
In general, under the self directed IRA UBTI rules, if the private company or business is operated through a passthrough entity, such as an LLC or partnership, the income generated by the private company or business that is allocated to the IRA would likely trigger the UBTI tax if it exceeded $1000 for the year. Whereas, if the private company or business was operated as a C corporation, the UBTI tax would not apply as the c corporation in essence is blocking the application of the UBTI tax. This is the reason why when you use your IRA to invest in the public stocks, such as Apple or Google, the UBTI tax does not apply since almost all public companies are C corporations.