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Private Placement Investments and the Self-Directed IRA Rules

Private Placement Investments and the Self-Directed IRA Rules
5 Minute Read

Over the last several years, for many start-ups and still maturing companies, the idea of turning to the private markets versus the public markets to raise capital has become the standard mode of operation. Private placement are essentially a way for companies or investment funds to raise capital through private offerings, largely to friends, family, and accredited investors, without going through the public markets.

Private placement is a funding round of securities which are sold not through a public offering, but rather through a private offering, mostly to a small number of chosen investors.  According to a report by the leading consulting firm McKinsey:

“..private placement fundraising in 2021 was up by nearly 20 percent year over year to reach a record of almost $1.2 trillion; deal-makers were busier than ever, deploying $3.5 trillion across asset classes; and assets under management (AUM) grew to an all-time high of $9.8 trillion as of July, up from $7.4 trillion the year before.”

Who is an Accredited Investor?

As you will lean from reading this article, the majority of the most popular types of private placement investments typically require the individual to be an accredited investor. The reason for this is that the Securities Exchange Commission (SEC), which regulates the sale of private and public type securities, believe only certain group of investors with a set of minimum income levels or net worth are in a position to require less protection provided by regulatory disclosure filings. 

In general, one would satisfy the definition of an accredited investor if any of the following are true:

  • An annual income of at least $200,000 for an individual or a combined annual income of $300,000 for a couple.
  • A net worth of least $1,000,000 either for a single individual or combined with its spouse, excluding the value of its primary residency
  • A trust that manages at least $5,000,000 in total assets, that is operated by a sophisticated individual (business-savvy)
  • A legal entity whose shareholders are all accredited investors

In the case of a Self-Directed IRA, if the individual IRA or Roth IRA owner satisfies the SEC accredited investor definition, the Self-Directed IRA would then be permitted to make a private placement investment.

Types of Private Placements

The most common type of private placement investments are structured as Regulation A and Regulation D.  The primary reason businesses, and funds seeking to raise capital, are committed to complying with either the Reg A or Reg D SEC regulations is because it offers less restrictive SEC regulatory requirements and offers a high level of comfort that the offering will comply with all applicable SEC rules.

Regulation A

According to the SEC, Regulation A allows companies to offer and sell securities to the public, but with a reduced level of disclosure requirements than what is required for publicly reporting companies.

Regulation A allows companies to raise money under two different tiers.

Tier 1

Under Tier 1, a company can raise up to $20 million in any 12-month period. The financial statements disclosed in a Tier 1 offering do not have to be audited. 

Tier 2

Under Tier 2, a company can offer up to $75 million in any 12-month period. Financial statements disclosed in a Tier 2 offering must be audited by an independent accountant. In a tier 2 offering, if an investor, including a Self-Directed IRA, is not an accredited investor and the securities are not going to be listed on a national securities exchange upon qualification, there are some investment limitations.

Regulation D

In general, a Reg D offering does not have any monetary limit on the amount of the offering. Companies that satisfy the requirements of Reg D do not have to register their offering of securities with the SEC, but they must file electronically “Form D” with the SEC after they first sell their securities.  Reg D can b broken down further into two categories: Reg D – 506(b) and Reg D 506(c).

506(b)

Under paragraph ‘b’, a Reg D company can’t solicit or advertise the offering, but it can sell the offering to an unlimited number of accredited investors and up to 35 non-accredited investors, as long as they proved to be sufficiently knowledgeable of business matters to the extent that they understand the risks associated with investing in the business.

506(c)

Paragraph ‘c’ allows a Reg D business to solicit and advertise its offering, if all the parties investing in it are considered ‘accredited investors’.

Keys to Investing in a Private Placement with a Self-Directed IRA

Understand the UBTI Rules: If a Self-Directed IRA invests in a private placement and the underlying company or investment fund is structured as a pass-through entity, such as an LLC or partnership, and not a C Corporation, the UBTI rules could be triggered

In other words, if the private placement involves investing in a business or fund that is operated via an LLC or a partnership, and the income generated by that business or fund is over $1,000 annually on a net basis, then the UBTI tax would apply.  The highest UBTI tax rate is 37%, which is triggered at a low annual income threshold, approximately $15,000.

In the case of a Self-Directed IRA, even though the IRS itself will not be the direct investor in the underlying business, if the private placement investment is operated as a pass-through vehicle, the income from the underlying business or investment fund would be attributable to the Self-Directed IRA investor and could trigger the application of the UBTI tax. However, if the underlying business associated with the private placement is set-up as a C Corporation, the UBTI tax rules will not apply.

Do Your Research: Anytime one makes an investment into a private placement investment, it is important to do your research on the underlying business or fund.  It is advisable that, before investing your hard-earned retirement funds in a private placement that is not public, you should examine the investment documentation, the company’s management, and the financial terms of the investment.

Consider the Prohibited Transaction Rules: Internal Revenue Code Sections 408 & 4975 prohibits disqualified persons from engaging in certain types of transactions. A “disqualified person” is generally defined as the IRA holder, any ancestors or lineal descendants of the IRA holder, and entities in which the IRA holder holds a controlling equity or management interest.

In the case of most private placement investments, the IRS prohibited transaction rules typically do not play a major role since it typically involves hundreds of shareholders, which makes the likelihood of an IRA owner owning more than 50% of the entity or fund not very likely. 

Although, if the IRA owner and any disqualified person owned more than 50% of the underling business or fund associated with the private placement investment, the IRS prohibited transaction rules could kick in and prevent the IRA investment.

Conclusion

Private placement investments continue to be the most popular way for private businesses and investments funds to raise capital. With over $13 trillion dollars of IRA funds, Self-Directed IRAs will remain an important source of capital for these investments. It is important for Self-Directed IRA investors to appreciate the accredited investor rules, while concurrently understanding the far reach and potential impact of the UBTI rules before electing to invest in a private placement investment.

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[10:44 PM] Valerie Marszalek-Boik