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Private Placement Investments and the Self-Directed IRA Rules

Private Placement Investments and the Self-Directed IRA Rules

In general, a traditional financial institution will not allow investors to use their IRA to invest in private placement investments.  The reason for this is that a financial institution or brokerage firm does not make money when clients invest in alternative assets, such as private placements. 

Whereas, a self-directed IRA is a type that allows IRA investors to make alternative investments, such as private placements. A self-directed IRA is not a legal term that you will find in the Internal Revenue Code.  Today, the Retirement Industry Trust Association (RITA) estimates anywhere between 4-7% of all IRAs are invested in alternative assets.  Accordingly, the self-directed IRA is the only way one can purchase alternative assets in an IRA.

What is a Private Placement?

private placement is an investment opportunity that is not available to the general public. It is only offered to a selected group of people, typically high net worth individuals or institutional investors. This type of investment generally offers a higher rate of return than what is available to the average investor.

Private placements are usually reserved for companies with a long-standing reputation and proven track record. This implies that securities offered through the private placement market carry less risk than those available to retail investors through crowdfunding platforms.

Private placement pros and cons

The benefits of private placements include:

  • Assured returns – Private placements offer a fixed return, which can be appealing to investors who are looking for stability.
  • Reduced risk – Private placements are considered less risky than investments available to the general public because they are only offered to a limited number of people.

However, private placements also have some drawbacks:

  • Lack of liquidity – These types of securities can be difficult for investors to sell. It may take several weeks or months to fetch an acceptable price for them on the market.
  • Upper investment thresholds – Private placements require investors to have a significant amount of funds available for investment.

While private businesses and private placements are a common investment held in retirement accounts, many Self-Directed Custodians do not allow you to invest in private placements or businesses. Instead, some will limit you to purchasing precious metals or cryptocurrencies. IRA Financial believes in investment diversity and the right to invest in what you know. We offer a wide range of investments that Self-Directed account holders can pursue.

Learn More: Alternative Investments with Retirement Funds

Why Invest in Private Businesses or Private Placements

In order to grow a company and raise additional funds, many large companies go the initial public offering (IPO) route. An alternative way to raise capital for a small private business is known as a private placement. A private placement involves the sale of securities or membership interests to a relatively small number of select investors. Investors targeted include wealthy accredited investors, large banks, and pension funds. A private placement is different from a public issue in which securities are made available for sale on the open market to any type of investor.

Private placements can be used for a range of purposes. A company may utilize a private placement to raise capital for its business.

The SEC regulates how securities are sold to the public through the Securities Act of 1933. If a company wants to issue stocks or bonds to the public, it must register with the SEC and sell the security using a prospectus.

Regulation D of the 1933 Act provides a registration exemption for private placement offerings. Regulation D allows an issuer to sell securities to a targeted group of accredited investors that meet specified requirements. Instead of a prospectus, private placements are sold using a private placement memorandum (PPM) and cannot be broadly marketed to the general public.

Private placements are a popular way for companies to raise funds for a number of reasons. The private placement regulations allow an issuer to avoid the time and expense of registering with the SEC. The process of underwriting the security is faster, which allows the issuer to receive proceeds from the sale in less time. If an issuer is selling a bond, it can also avoid the time and expense to get a credit rating from a bond agency. A private placement issuer can sell a more complex security to accredited investors who understand the potential risks and rewards, and the firm can remain a privately-owned company, which avoids the need to file annual disclosures with the SEC.

Related: What is a Disqualified Person?

Advantages of Investing in Private Placements in an IRA

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, of 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 prohibit 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 involve hundreds of shareholders, which makes the likelihood of an IRA owner owning more than 50% of the entity or fund very likely.   However, if the IRA owner and any disqualified person owned more than 50% of the underlying 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 investment 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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