Data from the US Census Bureau shows that an average of 4.4 million businesses are started every year. That average is from the past five years of business formation data in the United States.
The most common obstacle facing new businesses is how to raise sufficient cash to get the business off the ground. With interest rates skyrocketing and a shaky economy, more and more businesses and entrepreneurs have looked to tap into their retirement account to help fund their business. With over $13 trillion in IRA funds and over $32 trillion in retirement funds, there is a huge pool of cash available for business owners and entrepreneurs.
This article will explore how one can fund a Self-Directed IRA to invest in a business or start-up. In addition, it will detail the most important IRS rules that an IRA investor must consider before making a business investment using an IRA. Finally, the article will cover other tax-efficient options for funding a business.
- One can use a Self-Directed IRA to invest in a new or existing business
- You must be wary of the prohibited transaction rules, as well as the application of UBTI
- There are alternatives for using retirement funds for a business, including the 401(k) loan and the ROBS solution
Self-Directed IRA Overview
The term, Self-Directed IRA, has been adopted by specialized IRA custodians who simply administer and/or custody the retirement plan. It gives one the freedom to invest in whatever you want, so long as it’s not prohibited by the IRS (more on that later). Traditional financial institutions may offer a Self-Directed IRA, but generally do not give you that freedom. You are limited to the investments they offer. However, when you use the right provider, such as IRA Financial, your options are limitless, which includes the ability to invest in a private business.
Just like a regular IRA, you can opt for a traditional or Roth Self-Directed IRA. The former allows for pretax contributions affording you an upfront tax break, while the latter is funded with after-tax money; there is no immediate tax break, but all qualified distributions from the plan are tax free.
The primary issue of solely relying on IRA contributions to fund a business is that the annual contributions are so low – $6,500 plus an additional $1,000 if you are at least age 50 for 2023. Therefore, unless you have been investing with an IRA for awhile, it might not be enough capital. Enter the rollover.
A rollover is the process of moving funds from one retirement plan to another. When moving funds between the same type of plan (i.e. IRA to IRA), it is referred to as a transfer. Either way, the end result is the same – getting more funds into the plan you want. In this case, it is a Self-Directed IRA. This allows you the ability to go above and beyond the annual limits since there is no cap on the amount you are allowed to rollover. This is the best way to have access to enough funds for your business investments. There are approximately $500 billion dollars of IRA rollovers a year. You just need a fraction of that to get going.
Can I Buy a Business with My Self-Directed IRA?
Yes, in most cases you can in fact buy a business with a Self-Directed IRA. However, there are certain rules that must be followed. The next section will cover prohibited transaction rules, which prevent certain types of investments in an IRA.
The IRS Prohibited Transaction Rules
Now that you understand what a Self-Directed IRA is and how to fund it, it is vital that you confirm that the investment will not violate the IRS prohibited transaction rules. When the IRA was created in 1974 by ERISA, the IRS tax code did not specify the type of IRA investments that were permitted, but simply outlined the categories of investments that were prohibited. In general, there are three category of transactions that are not permitted to be made with a Self-Directed IRA:
- Life Insurance Policies
- Any Transaction involving a “disqualified person”
When it comes to using a Self-Directed IRA to make an investment in a new or existing business, there are several important prohibited transaction rules that must be followed:
- The IRA should not invest in an entity, business, or fund where it is 50% owned or controlled by a disqualified person.
- The IRA owner should not work or receive compensation from a business which is 50% owned or controlled by a disqualified person.
- The IRA owner should not lend money to a business which is 50% owned or controlled by a disqualified person.
- The Self-Directed IRA should make the investment into the business so that the IRA receives 100% of the benefit. No benefit should be derived by the IRA owner or any disqualified person.
Minority Ownership in a Business via a Self-Directed IRA
The IRS prohibited transaction rules are quite clear that an IRA cannot invest In any business that is 50% owned or controlled by one or more disqualified persons (including the IRA owner). However, what about a situation where your IRA will invest in a business and own less than 50%? Is such a transaction always permitted or could the IRS still attempt to argue the business investment is a prohibited transaction?
As a general rule, if the IRA invests in a business that is not 50% or more owned by a disqualified persons, the investment will likely not be treated as a prohibited transaction. However, in cases where the IRA will own a minority interest in a business, the IRS could still try to argue based on the facts and circumstances involved in the transaction that the investment was done to benefit the IRA owner or another disqualified person and was not done to exclusively benefit the IRA. Pursuing such a course of action is quite rare for the IRS, but it has been done.
The Rollins Case
In Rollins v. Commissioner, T.C. Memo 2004-60, the Tax Court ruled that a retirement account loan to a company that was owned less than 50% by the retirement account owner was a prohibited transaction.
The IRS argued that the plan loans were prohibited transactions under Code Section 4975(c)(1)(D) (transfer or use of plan assets by or for the benefit of a disqualified person) and Code Section 4975(c)(1)(E) (dealing with plan assets for the fiduciary’s own interest). Mr. Rollins stated that, although he himself was a disqualified person, the borrowers were not disqualified persons and therefore no prohibited transactions occurred as there were no transactions between the 401(k) and a disqualified person.
The Tax Court agreed with the IRS and stated that Mr. Rollins had the burden to prove that the transaction did not enhance or were not intended to enhance the value of his investments in the borrowers. In sum, the Tax Court felt that Rollins did not prove that he did not benefit personally from his 401(k) loan.
The Rollins case is a good example that highlights that even if your Self-Directed IRA investment makes a minority interest investment into an entity, if the facts and circumstances hold that the investment is in some way personally benefiting the IRA owner or any disqualified person, the transaction could be deemed prohibited.
Overall, the Rollins case is an outlier and not the norm. But it should be considered when investing your Self-Directed IRA into a business.
Be Wary of UBTI
Another IRS pitfall you must consider is Unrelated Business Taxable Income, or UBTI. For our purposes, one way this tax applies is when a retirement account invests in an active business through a pass-through entity, such as an LLC.
Essentially, an IRA investment into a business that is operated as an LLC, will trigger this (up to) 37% tax if the business generates more than a $1,000 of net income. Investing in a C corporation instead will block the application of UBTI.
No investor wants to trigger additional tax, especially in a tax-advantaged retirement plan. If you do, you must file IRS Form 990-T by April 15.
Business Investing Alternatives
If you have been reading this article and are now concerned that utilizing a Self-Directed IRA for your business investment may not be worth it, there are other options. You can still make use of your retirement funds, and possibly have more freedom for the business you want to invest in, especially if it’s your own.
The 401(k) Loan
Any business can establish a 401(k) plan. A sole proprietor can establish a Solo 401(k), assuming one doesn’t have any full-time employees. In today’s age, the majority of 401(k) plan documents contain a loan provision. You are generally allowed to borrow up to $50,000 or 50% of the account balance, whichever is less. The remaining funds in the plan are used as collateral for the loan.
That loan can be used for any purpose on a tax- and penalty-free basis. It must be paid back with a payment frequency no greater than quarterly. Interest rates are usually lower than a loan you may receive at a bank and the interest gets paid back into the plan. However, if you fail to pay the loan back, it will be treated as a taxable distribution.
Taking a loan is a better alternative than withdrawing from the plan. Not only will taxes be due in most cases, you would be subject to an early withdrawal penalty if you are under age 59 1/2.
The downside of borrowing right now is the high interest rate environment. This may be one too many hurdles for a new business owner. It is an option since it allows for that $50,000 limit, plus, there are no prohibited transactions to worry about, since you are in personal possession of the loan proceeds and not using a retirement plan to directly invest.
The ROBS Solution
For investors that are worried about the reach of the IRS prohibited transaction rules, the UBTI tax, or need more than the $50,000 a loan offers, another popular option is ROBS, or Rollover for Business Startups.
There are some exemptions to the prohibited transaction rules. Specifically, Code Section 4975(d)(13) lists an exemption for any transaction “which is exempt from section 406 of the Employee Retirement Income Security Act of 1974 (ERISA) by reason of section 408(e) of such Act.”
In other words, under the ROBS solution, an investor can form a C corporation which adopts a 401(k) plan. The owner will then perform a tax-free rollover of his or her IRA funds to the new 401(k) plan. The plan will then invest those funds in return for fair valued stock in the corporation, also known as “qualifying employer securities.” The 40(k) plan will own a percentage of the business.
There is no limit as to how much can be rolled over into the new plan. If you need more than the $50,000 a loan will allow for, you can utilize ROBS. Again, the IRA is not investing directly in the business; the money from the plan is used to fund the new 401(k) plan. Therefore, you don’t need to worry about majority ownership, prohibited transactions or UBTI.
ROBS is the only way you can gain access to more than $50K of retirement funds and be fully involved in the business. Plus, as part of ROBS, you are required to earn a salary from the business. This may be your best option if you want to be hands-on in the business.
Both the 401(k) loan and ROBS options can not only be used to start a new business, but they can help fund an existing business.
S Corporation Investment
Just a quick note that due to the very restrictive S Corporation shareholder rules under IRC Section 1361, an IRA cannot be a shareholder of an S corporation. If this should happen, the corporation would lose its “S” election and the business would revert back to a C corporation.
As highlighted above, there are many exciting ways to use a Self-Directed IRA to invest in a new or existing business. However, it is important to consider the IRS prohibited transaction rules, especially the requirement that an IRA not invest in any entity 50% or more owned or controlled by disqualified persons, including the IRA owner. Even minority investments by an IRA into a business must be carefully examined. Don’t forget about UBTI if you invest in a pass-through business!
The 401(k) loan feature and the ROBS structure are two useful ways to use retirement funds to invest in a business. Each option has its pros and cons and must be weighed before diving in.
Using retirement funds to invest in a business can be double-edged sword. If the business fails, not only will you be hurting now, but also in the future. It’s imperative that the business succeeds. All due diligence must be done before deciding to dip into your retirement savings to make your business ownership dreams come true.