The IRS and Internal Revenue Code (IRC) offers IRA owners a wide latitude in the types of assets in which they can invest. The Code allows IRA owners to invest in publicly traded securities or assets in custody of a financial institution or non-publicly traded alternative assets, such as real estate and private placement stock. However, an IRA owner is not permitted to engage in certain prohibited transactions which generally involve life insurance, collectibles, and transactions involving the IRA and a “disqualified person.” These types of transactions are prohibited to prevent misuse of an IRA to benefit the owner or other disqualified persons in a way other than as a vehicle to save for retirement.
This article will explore how one could potentially use a Self-Directed Roth IRA to purchase a profits interest in an investment fund to shelter the gains from tax.
- Profits Interest from an investment fund are generally available to key employees and accredited investors
- Highly successful funds can generate large profits for investors
- Shelter the gains by investing with a Self-Directed Roth IRA
How are Investment Funds Structured?
An investment fund, such as a private equity fund, real estate fund, hedge fund, or venture capital fund are typically structured as a partnership or an LLC. Both a partnership and an LLC are taxed as a flow-through entity. Partnerships typically grant two types of partnership interests – capital interest and profits interest.
Capital interests are issued to outside investors, known as limited partners, generally in exchange for cash investments in the partnership. Whereas a profits interest is often granted to key employees in exchange for services, ideas, and expertise that benefit the partnership. In some cases, a profits interest is also referred to as a carried interest.
The initial value of a capital interest is typically higher than that of profits interest because it mirrors the limited partners’ cash investment in a fund. However, the owner of a profits interest has a right only to future profits generated by the fund if it is a success. In general, the IRS taxes a profits interest or carried interest as a capital asset subject to the lower capital gains tax regime and not subject to the ordinary income tax rules.
Who Can Invest in an Investment Fund?
Non-publicly traded shares and private placement partnership interests can generally only be offered to a small number of individuals, in part because all offers and sales of securities must be registered under the Securities Act of 1933, unless an exemption from registration is available. The most used exemption limits the investors who can purchase securities in the offering to accredited investors.
What is an Accredited Investor?
The SEC defines individual accredited investors as any person who comes within certain categories, or who the issuer of the securities reasonably believes comes within certain categories, at the time of the sale of the securities to that person.
Some of these categories include: (i) any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer; (ii) any natural person whose individual net worth, or joint net worth with that person’s spouse exceeds $1,000,000 (excluding the individual’s primary residence); and (iii) any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.
What is a Self-Directed Roth IRA?
The Relief Act of 1997 introduced the Roth IRA, which is an after-tax IRA which allows any US person with earned income under a set income threshold to make after-tax contributions up to annual limit. The limit for 2023 is $6,500, plus an additional $1,000 catch-up contribution if you are at least 50 years old. So long as the Roth IRA has been open for at least five years and the Roth IRA owner is over the age of 59 1/2, all Roth IRA distributions would be tax free. Plus, there are no required distributions for a Roth, meaning it can grow unhindered for as long as you like.
A Self-Directed Roth IRA is simply a Roth IRA that can invest in alternative asset investments, such as non-publicly traded securities or real estate, among a myriad of other asset classes. In order to self-direct your plan, you need to work with the right custodian, such as IRA Financial.
Using a Self-Directed Roth IRA to Acquire a Profits Interest
In general, a profits interest has the potential to provide key employees with large investment returns based on the amount of capital if the fund is a success. If, on the other hand, the fund does not generate a minimum rate of return for its outside investors, the profits interest may expire without generating any money for the key employee.
The following is a breakdown of how it works:
- Step 1. Establish a Self-Directed Roth IRA and fund the plan either by direct contributions, rollover/transfer of Roth funds, or a conversion of pretax retirement funds. The unique aspect of the profits interest Roth IRA strategy is that it requires a minimal amount of capital outlay.
- Step 2. The General Partner establishes an investment fund and invests around 5% of the capital and seeks outside investors (limited partners) to help raise the remaining 95%.
- Step 3. The general partner typically receives 20% as a profits interest in the fund for its management, wisdom, and success. The general partner grants the partnership profits interests to key employees at the fund, who are granted profits interest for a minimal amount.
- Step 4. The general partner uses the funds invested by the limited partners to make investments and works with the key employees to raise the value of the fund. After several years, the general partner sells the underlying fund’s investments.
- Step 5. The fund’s assets are then allocated to the partners based on the fund’s partnership agreement. In a typical fund arrangement, the limited partners would receive the capital they invested back and then an 8% rate of return. After that, the general partner typically takes 20% of the rest of the profits as a “profits interest” or “carried interest,” which are distributed to the key employees of the fund.
How to use a Self-Directed Roth IRA to Acquire a Profits Interest
The IRS is clear that an IRA or 401(k) plan is permitted to invest in a profits interest. “As with non-publicly traded shares, key employees at private equity firms and hedge funds may use IRAs to purchase profits interests from the general partner.” According to the IRS, there are two ways for a retirement account to invest in a profits interest:
- Profits Interest Purchased by an IRA: The general partner grants or sells profits interest in the fund to key employees making them eligible to share in the general partner’s profits interest in the fund. The key employees use a Roth IRA, either via a contribution, rollover, or conversion, to buy the interests in the entity holding the profits interest.
- Profits Interest Put Directly into the Employer Sponsored Retirement Plan: The general partner puts the profits interests directly into the employer sponsored retirement plan in Roth or pretax. The profits interests are then allocated to the retirement plan when the fund matures without tax. In general, so long as the plan does not relieve the employer of any present or future obligation to contribute that is measured in terms of cash amounts, an in-kind contribution, such as a profits interest, can be made without triggering the IRS prohibited transaction rules. The in-kind profits interest can then be rolled into an IRA or Roth IRA.
Key Items to Consider when Structuring a Profits Interest-Self-Directed Roth IRA Transaction
When contemplating using a Self-Directed Roth IRA to purchase or be allocated a profits interest, it is important to keep in mind that the IRS is typically concerned with three issues: (i) value of the profits interest, (ii) the statute of limitations, (iii) Identification.
Valuing the Profits Interest Received
According to the IRS, it is often difficult for IRS to pursue cases of potential abuse based on inappropriately valued assets, such as a profits interest. The IRS is clear that it generally requires individuals to assess the value of assets in IRAs rather than use another valuation method. However, IRS guidance infers that individuals can use the liquidation value of a profits interest for certain tax purposes.
Based on the liquidation value method, there is ample case law to support very low valuations of profits interests. Under this method, so long as the entity that holds the profits interests is liquidated based on positive capital accounts, the profits interests would have a zero balance since all funds would be allocated to any investors that have invested funds providing them a positive capital account.
In other words, if the entity that holds the profits interests is liquidated, all funds in the entity would be sent first to the investors who contributed funds, and since no funds would remain, the liquidation value method would treat the profits interest as having a zero value.
Moreover, under Campbell v. Commissioner, the Eighth Circuit Court of Appeals overturned a decision by the U.S. Tax Court and held that an individual who is granted a profits interest does not need to recognize any income if the profits interest does not have a readily ascertainable value.
The Statute of Limitations
In general, the statute of limitations for the IRS to pursue cases is generally only three years, which poses certain difficulties to the IRS for pursuing prohibited transactions involving IRAs. Generally, the IRS has three years from the date a return is filed (whether the return is filed on time or not) to assess tax liability. The statute of limitations may be extended in certain situations, such as submitting a false or fraudulent tax return or otherwise engaging in a willful attempt to evade a tax.
The long-term nature of private equity, real estate, or hedge fund investments typically involves a long-term lock-up period, such as four to seven years. This poses an issue for the IRS to uncover any problematic investments involving IRAs and investment fund profits interests.
The IRS admitted that due to a lack of information in publicly available filings by private equity firms and hedge funds, it could not determine the extent to which key employees use 401(k) plans or IRAs to invest in profits interests.
Profit sharing and 401(k) plans governed by ERISA and the IRC may generally satisfy annual reporting requirements by filing a Form 5500 Annual Return/Report of Employee Benefit Plan and its accompanying schedules. Form 5500-SF filers generally are not required to file schedules or attachments, such as Schedule H, which is required to be filed for plans with more than 100 participants.
However, small plans that directly invest in or allow participants to invest directly in non-publicly traded shares or profits interests would be required to file Form 5500 and Schedule I. Schedule I does not directly request information on participants that have invested in a profits interest or carried interests, but only seeks information on investments in “Partnership/joint venture interests.”
The IRS is clear that key employees at investment funds may use IRAs or 401(k) plans to purchase profits interests from the general partner. The most important items to consider when contemplating using a Self-Directed Roth IRA to acquire a profits interest in the fund are the following:
- Plan before your fund has been established or has not received any funds allocated to the profits interest.
- Make sure the profits interest does not have a readily ascertainable value.
- Acquire the profits interest directly from the company and not from yourself personally.
- If you are involved with a real estate fund, consider using a 401(k) because of the UBTI tax on leverage for IRAs.
If you have any questions, feel free to contact us to discuss.