In this episode of Adam Talks, IRA Financial’s Adam Bergman Esq. discusses how to “Peter Thiel” your Roth IRA, explain exactly what that means, and the benefits of doing so.

Peter Thiel Your Roth IRA

Hey, everyone, Adam Bergman here, tax attorney and founder of IRA Financial. Welcome to another episode of Adam Talks. Really excited about today’s episode. I got a bunch of emails over the last couple of weeks just from people, clients, some non-clients, saying, hey, Adam, you haven’t talked about Peter Thiel and Roth IRA in a while and, really interested in that subject. Want to figure out ways that I can kind of maximize the Roth IRA value, lock in tax-free gains. Can you go through kind of how Peter Thiel did it? And some strategies that more regular folks like you and me could potentially use similar strategies to boost and maximize Roth IRA. So, here I am. It’s a great topic and I spent some extra time researching Government Accountability Office reports from 2014, really digging through some of the details so I can give you, I think, some tips on what the IRS is looking at and some of the issues the IRS is having and actually trying to address a Peter Thiel-type Roth IRA transaction.

So, let’s start with the beginning. Let’s start with the man himself. So, who’s Peter Thiel? Smart guy, Stanford Law graduate. He’s a private equity guy that actually started three of some of the most successful companies in the world, from PayPal to first investor in Facebook to Palantir: three publicly traded companies. So, we’ll start at PayPal because that’s kind of where the story starts. The story Thiel and Elon Musk and a few tech folks started PayPal. And basically what he did, Peter Thiel, is he decided to use his Roth IRA to buy shares in PayPal – founder shares. And because they were founder shares, they were low in value. And something the IRS has an issue with, they felt they were below fair market value. But we’ll soon see that everyone, at least all founders, got to use the same value for the share. So, that is their first issue the IRS has is how do you value privately held shares, which we’ll talk about in a few minutes.

But, basically what happens is he took a couple thousands bucks and was able to buy 1.7 million shares for about $1,700 because the par value was so low. And essentially he turned that into $28 million. And then from there, he was able to buy Facebook, literally up front from Zuckerberg, one of the first outside investors, and made hundreds of millions of dollars there, and then was able to invest in Palantir.

So, his Roth IRA is believed to be in the billions, according to a pro publica article from last June 2021. And obviously, the IRS has been focused on this. We talked about Peter Thiel a lot during the Build Back Better bill, which was really the heart of Washington in last fall, September, October 2021 until Senator Manchin essentially just shut it down, saying he wasn’t going to vote for it. But, there were some provisions in the Build Back Better Act attempted to cap Roth IRAs, even potentially initially eliminate the ability for IRAs to invest in alternative-asset type of credit investor, private placement stuff, which ended up being kicked out of the bill. But this was all kind of focused on what Peter Thiel did – how he was able to take a couple thousand dollars and turn it into billions, tax free.

So, first of all, we’re not all Peter Thiels. There are some limitations on who actually can do this, right? Generally, you got to be in a situation where you’re going to be a founder of a billion dollar company, which I’ve started a bunch of businesses; not that easy. And number two, you have to be an accredited investor, right? Not everyone can buy private placement-type investments or invest in a private equity fund. And that’s not a rule I made up. That’s an SEC rule. So, in fact, the government is limiting who can invest in these investments and then getting mad when only certain investors are able to capitalize on these investments because they are accredited investors. So, it’s kind of circular argument, but that’s kind of where we’re at at this point.

So, what are the lessons from the Peter Thiel story? Right? How do you take $1,700 and turn into $30 million within a few years? Right? Number one, obviously, you gotta stay under the 50%, right? Section 4975 of the tax code is clear, is you need to stay under 50%. You cannot invest in an entity where you own more than 50%. So in this case, Peter Thiel clearly owned less than 50%. He only bought $1,700 worth of shares, 1.7 million shares, and there were lots of other founders and investors. So, he was able to stay under that 50%. Not everyone can, right? If you’re going to start a company with a couple of buddies, you may not be able to be under 50%, which is a problem. So, you want to be under that 50%, if possible.

Number two is you got to buy early, right peter? Thiel was able to buy PayPal stock right at the beginning, as a founder, and then he was able to flip it when outside investors came in at a higher value. So, the strategy works. You got to buy in early. You can ask any smart investor, whether it’s a real estate investor, or an equity investor, you make money when you buy, not when you sell, right? Any idiot can sell; it’s when you make, smart people know when to buy. So, you got to employ the strategy early, right? As a founder, if you’re in a private equity fund, as a founder, get in and take a percentage of either the carry, and we’ll get into what private equity funds can do, some type of class, common, preferred, however, you classify units early on before the fund actually employs the money, because once the money has been allocated, valuations will technically be augmented and it will be hard to get the valuation you want. So, you want to do it early, you want to stay under 50%.

And the third and most important thing is you got to support your valuation. And that’s what I’m going to spend the bulk of my time on this. The 2014 Government Accountability Office report, God, I wish I can talk better, need more coffee, is probably really, I think, the best source for kind of examining how the IRS treats founder shares and carried interest in a private equity fund in a Roth IRA. You can Google it. It’s not super complicated. You can just do an edit find for founder stock and kind of read the 20-30 pages that address it. It’s actually quite interesting. So they kind of outlined a scenario here which kind of follows the Peter Thiel model.

You have a situation where someone pays a small amount for shares at a very low par value, like $0.00001; they use a Roth IRA to buy it. The company does really well. The company goes public at a $14 share price or so. And then those millions of dollars of shares you got for $400 or $4,000 is now worth $50, $60, $70 million tax free. So it’s kind of the Peter Thiel model, right? You start early, you’re under 50%, you buy early, and you support your valuation. Okay?

So, the big strategy that Peter Thiel used, and many, many private equity hedge fund investors use, and I’ve helped a number of them do this, is something called the cheap stock model or the cheap equity model. And what this is, is you basically create two classes. You can call it preferred or common, class A, class B, doesn’t matter what you can call it. You call it Sunshine and Snowflake. It doesn’t matter. The way it works is you have one class that essentially has a higher initial value and more guaranteed payout, right? So it’s kind of like, let’s say it’s a preferred. So, you’re guaranteed your return of capital, you’re guaranteed your money back, and you’re guaranteed, like the first tranche of cash that comes back. And then there’s the second class called the common, call it class B. That’s cheaper, but riskier because you only get paid back on a super capital event; like a super acquisition, super capital asset event where the fund or the business brings back a certain return. And that’s how the Mitt Romneys and Bain Capital and a lot of the private equity hedge fund models work. Okay? Some will just buy into the carry through the GP, which I think is a little bit risky because equity fund, private equity hedge fund, you have a GP and then LPs, or you have an LLC with a general partner that gets the management fee and the carry. And generally, if you are going to buy into that GP, it could be done. But if it’s closely held, where you’re going to own 50% or more, can’t be done. Right? But if it’s a larger fund where there’s 10, 15, 20 partners and you maybe only own 5-10% of the GP, then you can maybe potentially sell a slice off to your Roth IRA. But again, that’s based off facts and circumstances and will be based on how much you own.

But, what you can do from a stock standpoint is you can have two classes of shares. You can have common and preferred. Let’s say the preferred are less risky because you get paid back first and they may have a higher value, less risk. And then there’s the common, which Peter Thiel did, where, if there’s a sale, it will get a higher return. So, that is, to me, the most, I think, popular and I think the most successful way to structure these things is to use two classes, whether it’s common, preferred, Class A, Class B, however you classify them, but you make one safe, more expensive, and then you make the other one riskier and cheaper so that will let your Roth IRA buy-in cheap. And if there is a home run, you could hit a capital event and have a huge tax-free windfall.

The beauty and I think the success of this structure is, if the IRS looks at it, you can show there’s economic risk here, right? There’s economic substance. There is no guarantee that your Roth IRA was going to hit it big, because if the business failed or the fund didn’t perform as well as it should have, then maybe the common or the Class B would get nothing, because the preferred, the safer class would get paid first. And probably there’d be nothing left if the business or the fund didn’t do very well. But if it did well, then the cheaper, riskier shares or units would do better. So, you can show economic risk and substance is what the IRS looks at. That’s very important to them. If they feel like there’s no risk of loss and it’s a sham, they’ll treat it as such. But, if you can show them there’s a real risk of loss, there’s a real risk that the investment would be lost; that will support your position, I think, in greater volume.

Of course, the more you invest, the better too. So investing $1,700 isn’t perfect. If I was advising Peter Thiel, I would say put in $50 grand, $30 grand, $100 grand. You want to show real money’s at risk, $1,500, $50, $100 – not good enough. Okay? So, you want to show that there’s more risk. So, a little bit more cash is an okay thing.

So, in the private equity world, and I’m kind of toggling between private equity and shares, it’s the same concept. So, there are some interesting facts on the GAO report that, they concluded that private equity firms currently use a ratio of about four to one to split the value of portfolio companies between preferred and commons, right? That means about 80% of the company’s value would be assigned a preferred class and the remainder to the common shares. Okay? So, that means you can still get a really, really big chunk of the company; could be allocated to the riskier shares. Some use ratios of nine to one, okay? Which could be pushing the envelope. So, the idea is you want to allocate more of the value to the riskier shares and thereby have a bigger potential payout. But that’s something that you just need to understand more of your risk appetite and how hard you want to push in terms of showing the value and how much you’re paying for the common or the preferred or the safe vs. risky shares.

So, how does all this work? Okay, kind of mention those two scenarios. You buy early, you, standard 50%, and then valuation, valuation, valuation. So, this is the last part I want to focus on. This is the most important; is how can the IRS tax these transactions? So if you’re under 50%, they’re going to have a tough time buying, employing 4975 and using that as a sword to target your transaction, because then they have to get into self dealing, conflict of interest; much more harder to prove in court, okay?

That’s obviously number one. Number two, the buy in early. Okay, you’re a founder. You have a right to buy these shares, just like any other founder. That leads to the third and that’s valuation. So really, the core, and probably easiest way the IRS could attack these transactions, is to argue it’s a sham value; that your IRA paid under market valuation for these shares and thus, we should ignore that transaction because it’s a sham transaction and either it’s prohibited, a self dealing, or we’re going to just treat it as an excess contribution because it’s not really an investment.

So, the problem the IRS has is, number one, they’re privately held shares, right? So, they’re not publicly traded. It’s difficult to, obviously, value private shares and they admitted to it. It’s something that two individuals could have two different values for the same shares. You can use liquidation values, right? There’s different methods to use for valuation. A lot of these startups have no good will, there’s no cash flow. It’s tough to value these startups. It is. I see in my industry where some companies claim they’re worth X and some claim they’re worth Y and almost the same company, but they get different valuations.

Again, not to say anything badly about accountants or appraisers, but you can find an account or appraiser that will give you the value you want. Put it that way. You can interview five, ten, 15 of them. Eventually, you’re going to find someone that’s going to agree with your valuation. So, you can always find someone that says, hey, my company’s worth X or my company’s worth Y. So that’s something the IRS has to contend with, because you will have someone that’s going to say to the IRS, hey, we think the shares are worth Y. Now the IRS can say, well, we don’t really care, we think it’s not worth that, but at least you have some support. And again, they have only three years to pursue it. The statute of limitation is three years. There is a six-year for substantial understatement; if there’s 25% or more understatement of your AGI. But, those are hard to go by because, again, the amount at issue, they’re putting in very small amounts of money. Right? So, it’s going to be hard to get the six years. So you have three years, you have evaluation of privately held shares, which is tough to do. You generally have a company that has a valuation already, and it’s expensive. This is litigation that cost the IRS lots of money to go and try to argue valuations, and now it’s up to a judge to determine what this is worth. And it’s not a slam dunk case, right? And the IRS generally doesn’t want to lose, and they don’t like trying to start and continue litigation where there’s not a sure thing of them winning. So, you add all that together, it’s tough for the IRS to enforce these valuation issues.

So, how do you make sure it’s even tougher? A couple of things we learn from the GAO report is when your IRA buys founder shares or private equity interest, class B or carried, make sure it’s paying the same amount as everyone else, right? So, you want to have IRAs, Roths there. You also want to have individuals. You want everyone paying the same amount. So, even if you have to find people – brothers, sisters – you want to bring them in and show that, hey, everyone’s paying a cent per share or everyone’s paying $100 per unit. Not just my Roth IRA. There’s Joe, there’s Jane, there’s Jimmy, there’s all the founders here, plus outside investors get to also use this valuation. That’s super important. It’s not a good fact if your Roth IRA is paying a penny a share and then a day later everyone, investor is paying $5,000 a share. Not good.

So, you want everyone, the founders, to start early. Come in at the same price, whether it’s a Roth IRA or an individual. The more that come in at that same price, the better it is and the better support you’re going to have that this valuation is actually legitimate and should be respected by the IRS, okay? So that’s important. The more people that come in, the better.

What else does the IRS look at? They look at the time – when did they buy the shares, how quick did you sell them, and who else was buying shares around the same time? So again, going back to my three factors: standard at 50%, buy early, the earlier the better; the minute you think of a business and you want in, have your Roth IRA buy-in with the founders. Okay? Because, if you buy in on May 1 for a dollar share and then May 10, you’re selling it for $1,000 a share. Tough! You can buy it at May 1 at a dollar share, and in October, you’re selling for $1,000 a share. Okay? Things happen in four or five months. That’s fine. Ten days, not a lot happens.

So, if you think about all this together and you want to maximize and “Thiel-asize” your Roth IRA, I should say, then this is what you want to do. Not everyone can do it right? You need to have a company that you think is going to blow up and be a huge hit. Or you need to have a private equity, hedge fund, venture capital fund, real estate fund, that you think is going to be super successful. You buy early, okay? You have other people come in at the same time, and by using the same value. You stay under 50%, so you and your IRA and all lineal descendants own less than 50% of the GP or 50% of the company. And what else you need to do is you have to support your valuation. So, if you can get a third party to attest what it’s worth and hey, these shares are worth a penny a share, even better, support your valuation. That’s how the IRS will come in. If they attack it, it will be for the valuation.

And then you have to decide, kind of how you want to classify it, how you want to structure it. You want to call them common or preferred shares, which in companies, that’s what they do. The preferred are the safer, more expensive; common are the cheaper and the riskier. You want your Roth IRA to be allocated more common, because it’s cheaper and riskier, because if it doesn’t hit a home run, okay, your Roth IRA loses $1,700 or $5,000 or $30. Who cares? But if it hits home run, I can turn that into million, $10 million, $50 million. That’s what you’re after.

If it’s a private equity, venture capital fund, then you have to decide, is it a Class A, Class B. Do you want your Roth IRA just buying into the GP? Again, that will depend on how much you own of the GP and how your fund is structured. I like doing the Class A, Class B; Class A’s are for the LPs. They’re the run of the mill, whether it’s the 20 and 2 and then the 80/20. Or, do you want the preferred to have a kicker? Like, for example, in a private equity, venture capital, hedge fund model, the LPs come in, they get their return of capital, they get an 8% preferred return, and then they get, it goes 80/20, the rest of the waterfall. So, what you can do for the Class Bs is say, okay, the Class Bs are going to buy a percent of the 20% carry from the GP, and it only is going to collect if there’s a super capital event. So, let’s say not only is it 8% return, return of capital, but there’s a, instead of 8%, maybe it’s a 10% or 15% threshold to show that, hey, this Class B is cheap. But the reason it’s cheap because it has to satisfy a very difficult threshold and there’s a strong chance that Class B will never hit. And that’s why the risk/reward scenario is so divisive, because there’s a small chance it hits. But if it does hit, it’s going to get a good payout. It’s riskier because there’s no preferred return. There’s no return of capital. It only gets paid on, instead of an 8% return, maybe a 15% return. So, you can do different things.

Again, the most important thing is show the risk reward. Show the valuation is real. Buy early. Okay? If you satisfy those three things and your company or fund is successful, you can legitimately allocate a huge percentage of the cash or the gains, I should say, to your Roth IRA and have it tax free. Now, the one last thing to remember, in order for your Roth IRA to be tax free, you got to be 59 and a half and you got to wait five years to cash out of your Roth, okay? So, it’s 59 and a half and five years, and then it’s all tax free. Never pay tax on any of the money you pull out of the Roth.

So, a lot of cool stuff; this topic I could talk about for hours. It’s interesting. I’ve helped structure many transactions with huge hedge funds and large companies and small funds and small companies. It could work in both cases. Again, it’s too late, if you started the company six months or a year ago and you did your first round, it’s too late. You got to do this early for your fund or your business because you got to buy early at a low valuation. You got to make sure you’re under the 50% threshold and you want to make sure there’s all the founders or all the people that are buying at that value; you have IRAs and non-IRAs, everyone buying at the same point, same value, and I suggest having a Roth put in real money, not just 1,500, but, real money, where there’s real risk of loss and then making that class B or that common, however you want to call it, risky, real risky, where it’s not just a slam dunk that you’re going to get paid. Show real risk. So, if your fund or the business does really well, it gets paid. Otherwise the Roth doesn’t win.

If you show those things and the IRS attacks you, I believe you’ll be successful and able to deflect or defend any type of IRS audit because it’s going to be super difficult for them to attack valuation, especially if you have an independent party. valuing it. It’s going to be costly and expensive and they’re going to lose, probably. So, it’s an area, and it takes three years, in a lot of cases, they’re going to find you after three years and it’s too late. And that’s what actually happened with Peter Thiel. They figured out Peter Thiel because the IRA figures out valuations. Each year, the 5498 they receive from the custodian. So, they know what your IRA is worth. So, they can see your IRA going from $5,000 to $25 million.

Generally, they only have three years to audit you, and in some cases that valuation doesn’t hit that point for two or three years. And at that point it’s too late because the three year statute already hit. Statutes start when you make the investment with your Roth. So, three years from that day. And again, even if they catch you and audit you, if your valuation is legit, you have independent source for that, you can show that other people bought at the same value. You’re under 50%. It’s going to be tough and costly for them to attack you.

So, there you go. That’s how you will Thielasize your Roth IRA. Yeah, Peter Thiel’s kind of a taboo topic and I’m not saying I don’t think what he did was wrong, clearly because the IRS couldn’t attack it. They claimed he paid under market, but they weren’t able to prove that. So, not everyone could be Peter Thiel. There’s less than, probably 100 people, that have more than $100 million in an IRA in the whole country. So, it’s clearly not that easy to be done. But, you can turn $20 grand into $100 grand, or $20 grand into  $600 grand. It still works, right? Even if you don’t make $100 million or a billion. Being able to invest in a successful business in a Roth IRA or a private equity fund. Even if you’re able to double, triple, quadruple your money. What’s wrong with that, right? Don’t have to be Peter Thiel to be successful.

So, I think there’s some really good strategies. I hope you guys enjoyed it. I’ll probably do more of these topics because I got a lot of questions about them. And this is the kind of stuff that if you tax plan early for you can have, I think, a real chance of some tax-free success.

So, thank you for listening, if you’re watching on YouTube, thank you as well. Don’t forget to check out Adam Talks each Wednesday. You can check it out anytime or everywhere you pick up your podcast – Spotify, Apple, SoundCloud and, you can always watch on YouTube anytime. So don’t worry, if you’ve you miss an episode. Otherwise, have a great day and talk to everyone again next week. Take care.