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Start-Up Founder Stock in a Roth IRA

Start-Up Founder Stock

Almost every entrepreneur that starts a business thinks that their new venture will be a smashing success.  The goal for every start-up is typically a big capital event that nets the business founders a big payday, by way of a sale of stock or the assets of the business. Start-up founder stock is crucial.

A growing number of savvy start-up business founders are looking to maximize the tax benefits of a Roth IRA by having the Roth IRA buy start-up company shares at fair market value at inception.  The strategy is that if the business is successful and seeks a later round of financing or a stock sale, the sale of the stock of the Roth IRA would be tax-free.  In other words, the Roth IRA would not pay any short-term or long-term capital gains on the sale of stock and all the gains could continue to grow in the Roth IRA tax-free.

Key Points
  • Every start-up needs capital
  • Funding a Business with a Roth IRA may work for some people
  • Be careful when mixing retirement and personal funds to start a business

For business owners thinking of having their Roth IRA buy stock in their new start-up, there are several important rules they must be aware of.

IRS Prohibited Transaction Rules

In general, retirement funds are permitted to invest in private businesses. The IRS prohibited transactions rules under Internal Revenue Code (“IRC”) Section 4975 do not state what a retirement plan can invest in – only what it cannot.  In general, an IRA cannot invest in life insurance, collectibles, such as art, and any transaction involving the retirement plan and a “disqualified person” as outlined under IRC Section 4975.

A “disqualified Person” is generally defined as the retirement plan holder and any of his or her lineal descendants, as well as any entity controlled by such persons (greater than 50%).  In other words, a business owner should not use a Roth IRA to invest in a start-up if the Roth IRA owner owns greater than 50% of the business interests or stock in the aggregate when combining personal and Roth IRA ownership.  That being said, even if the business owner will own less than 50% of the business, including personal and IRA interests, the IRS could still potentially argue that the Roth IRA investment was a self-dealing or conflict of interest prohibited transaction under IRC 4975. However, they may have a hard time making that argument if the Roth IRA paid fair market value for the stock and the investment was not significant.

For Example

If Founder X invested $200,000 of personal funds and $7,000 of Roth IRA funds in the start-up business for a 28% company interest in the aggregate, it would be quite difficult for the IRS to argue that the $7,000 Roth IRA investment in some way personally benefited the business owner, since the investment was so minimal and clearly the IRA owner or a third-party could have made that investment.

When thinking about the IRS prohibited transaction rules, it is important to remember that the IRA investment must always be made to 100% exclusively benefit the IRA and cannot directly or indirectly personally benefit the IRA owner or any of his or her lineal descendants.  Hence, in the example of Founder X, since he would own less than 50% of the business, the IRS would not be able to argue that he violated the direct prohibited transaction rules under IRC 4975. However, it would have to attempt to argue that the IRA investment was either a self-dealing or conflict of interest type of prohibited transaction, which is “fact-sensitive” and quite difficult to prove.  On the other hand, if the Roth IRA capital investment was significant in relation to the other shareholder investments and was needed in order for Founder X to reach his required capital commitment, then the IRS would potentially have a stronger argument that the Roth IRA investment in some way was done to personally benefit Founder X and was, thus, a conflict of interest prohibited transaction.

Conclusion

In summary, anytime one wants to use a Roth IRA to invest in a start-up business, it is crucial that the total ownership of the business by the IRA owner, their lineal descendants and all related IRAs, be under 50% of company’s stock of membership units/interests.  Additionally, even if the ownership if less than 50%, if the IRA investment was done for any other reason than to 100% exclusively benefit the IRA, then the transaction can still be re-characterized as a self-dealing or conflict of interest prohibited transaction under IRC 4975.

Fair Market Value

A 2014 Government Accountability Office (GAO) report on IRAs touches on certain scenarios involving founders who issued shares to their Roth IRA and the potential valuation issues that could arise.  Here is one example.

The example is based on Securities and Exchange Commission (SEC) filings detailing the transactions of a technology company founder and assumes the following:

  • In 2008, the founders of a newly created company authorize the issuance of up to 100 million shares with an initial value of $0.00125 per share.
  • One company founder opens a Roth IRA with an after-tax contribution of $5,000, and uses the Roth IRA to purchase 4 million non-publicly traded shares in the company.
  • The founders stipulate that they will retain an “additional consideration” in these shares if the outside investors can someday sell them for more than $30 per share. Specifically, the company founder will receive 20 percent of the profits above $30 per share.
  • In 2012, the company offers shares to outside investors through an initial public offering of shares at a price of $25 per share. By 2014, the company has enjoyed continuing success and its shares trade on public stock exchanges at $60 per share. The founder retires and sells the remaining shares in her Roth IRA. Additionally, the outside investors of the venture capital firm sell the shares they purchased in 2009 for $60 per share

Conclusion

According to the GAO report, this is why it is difficult for the IRS to pursue valuation cases in these type of IRA investments:

“It is often difficult for IRS to pursue cases of potential abuse based on inappropriately valued assets. First, in response to a congressional inquiry, IRS said it generally requires individuals to assess the FMV of assets in IRAs rather than use a liquidation value or other valuation method.

However, IRS guidance implies that individuals can use the liquidation value of a profits interest for certain tax purposes. One industry stakeholder also noted that individuals can use case law to support very low valuations of non-publicly traded shares and profits interests.

Second, according to IRS officials, valuation can be subjective and IRS may expend resources and ultimately conclude that the taxpayer’s valuation is reasonable. Third, the statute of limitations for IRS to pursue cases is generally only 3 years, which poses certain obstacles to pursuing non-compliant activity that spans years of IRA investment.

For example, as we have previously found, the long-term nature of private equity investment requires lengthy financial commitments and delayed financial returns. A private equity fund may not begin making profits for 4 or more years.

Treasury regulations generally define FMV for the purposes of valuation of plan assets as, “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.” 26 C.F.R. § 1.412(c)(2)-1(c). For examples of the time that may in some cases be needed to realize disproportionately large investment returns from such investments.”

For reference, the above can be found in this PDF.

The 2014 GAO report offers a clear illustration of the structure several start-up founders have used to generate large tax-free returns in a Roth IRA.  The IRS is clearly aware of these types of transactions, however, it is evident that the IRS is unclear on how they wish to address these transactions.

Avoid Roth IRA “Stuffing”

This scheme involves shifting value through transactions that disguise Roth IRA contributions exceeding annual IRA limits, such as selling receivables at less than fair market value to a Roth IRA. In 2004, IRS determined that this abusive tax avoidance shelter is a listed transaction that taxpayers must report to IRS.

In Notice 2004-8, the IRS highlights the following type of transaction involving a Roth IRA that they have listed as abusive. In general, these transactions involve the following parties: (1) an individual (the Taxpayer) who owns a pre-existing business such as a corporation or a sole proprietorship (the Business), (2) a Roth IRA maintained for the Taxpayer, and (3) a corporation (the Roth IRA Corporation), substantially all the shares of which are owned or acquired by the Roth IRA. The Business and the Roth IRA Corporation enter into transactions as described below. The acquisition of shares, the transactions or both are not fairly valued and thus have the effect of shifting value into the Roth IRA.

Hence, it is imperative that if a founder is seeking to have its Roth IRA purchase shares in the start-up, that the investment be for fair market value.  This is the main reason why a Roth IRA investment will typically be made in a start-up business where there could be very little risk of shifting income as described in IRS Notice 2004-8.  In other words, a start-up will likely have very low value since it is most likely a quasi-shell company at inception, hence, the investment would most likely not be deemed abusive and violate IRS Notice 2004-8. 

Unrelated Business Taxable Income

If the start-up business you will be investing is structured as a passthrough entity, such as a partnership or limited liability company, it is important to be aware of the unrelated business taxable income (UBTI) rules.  Unknown to many, when a retirement invests in a passthrough entity that either engages in a trade or business or uses leverage, the investment could trigger the UBTI tax.  The UBTI tax could go as high as 37% and could make a highly profitable investment highly tax inefficient. Therefore, if one is considering using IRA funds to make a start-up investment in an LLC, it is important to remember the tax implications of the UBTI tax.  Note, investing in a business set-up as a C Corporation would block the application of the UBTI tax and it would not apply to the IRA investment.  

Tips to Consider

If you are considering investing your Roth IRA in a business, here are a few key tips to keep in mind:

  • Make sure the aggregate business ownership is less than 50%, when including the stock ownership of the IRA owner personally, his or her lineal descendants, and their IRAs.
  • Be cautious if your IRA will be investing in a mature company. It is imperative that the IRA pay fair market value for the stock or membership interest. Beware of IRS Notice 2004-8.
  • The Roth IRA must be making the investment for the exclusive benefit of the IRA and the investment cannot be made to personally benefit the IRA owner or any of his or her disqualified person.
  • Investing the Roth IRA in a start-up for fair market value where the overall personal and IRA ownership is low is the best and safest option.

Start-Up Founder Stock in a Roth IRA

In conclusion, anytime one uses personal and IRA funds in the same transaction there is always the risk that the IRS could argue prohibited transaction.  That being said, the 2014 and 2020 GAO report demonstrates that the IRS has a significant amount of work left to do before they have a plan for addressing these type of Self-Directed IRA transactions.

Always consult with tax professionals before using retirement funds to invest. This is imperative when co-mingling Roth IRA funds along with personal money. The IRS rules can get quite complicated, therefore you should get all the help you can.

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