With over 25,000+ self-directed retirement clients, I have seen a number of taxpayers over the years accumulate massive Roth IRAs by investing in non-publicly traded company stock or an LLC interest, which was initially valued very low, and generating huge tax-free returns on a sale. This article will explore how one can use a Self-Directed Roth IRA to invest in start-up stock to generate tax-free gains on a sale. In addition, we will cover the various IRS rules that must be followed in order to avoid triggering an IRS prohibited transaction.
- Investing in start-up stock is a low-risk, high-reward proposition
- When using a Roth IRA to invest in founder stock, you can reap tax-free benefits in the future
- Be mindful of the prohibited transaction rules and pay fair market value to avoid IRS scrutiny
The Start-Up Roth IRA Strategy
The basics of the start-up Roth IRA strategy is quite simple. Invest in an asset that has a low value with a tax-exempt retirement plan and then sell the investment at a higher value.. Because it is held inside a Roth, the gains from the sale would be tax free. The use of a Roth is the key to taking advantage of the opportunity to shelter all investment gains from tax. This assumes the Roth IRA has been opened for at least five years and the IRA owner is at least 59 1/2 years old; this is known as a qualified distribution.
The following is a common way to use the start-up Roth IRA strategy:
- Step 1: A new private corporation or LLC, issues shares or membership units for a very low value, typically less than a penny. One or more founders uses a Roth to purchase the newly issued shares or LLC membership interests.
- Step 2: To raise money, the founders sell some of the shares/membership interests to private investors for a higher price that replicates the start-up increased value. Some or all of the proceeds from the stock sale would go back to the Roth IRA tax free.
- Step 3: After years of growth, the company has a liquidity event or goes public. All proceeds from the sale of stock/membership interest would flow back to the Roth, again, without tax.
The example above can be employed in various ways, whether it is for a start-up company, private equity fund, or other entity type. In addition, whether the stock price is initially issued for a penny or several thousand dollars, the key to the Roth IRA start-up strategy is to use the plan to acquire low-value shares with high upside.
Key Components of the Strategy
The following are the key components that are required to properly implement the start-up Roth IRA strategy:
Access to start-up investment opportunity: Whether you are a founder of a start-up or an investor in a founder, the first key component of the strategy requires that one has the opportunity to buy start-up company stock or receive a profits interest/carried interest in an investment fund. In other words, this strategy is perfect for an entrepreneur or start-up investor. Another advantage is that, typically, the risk of loss is quite small since the initial investment required from a start-up investor is quite small. In most cases, the founders will acquire shares in the start-up company when the company is a shell with no real assets. The founder can then sell the shares owned in a Roth IRA in subsequent series funding rounds or during a liquidity event. Hence, even if the start-up falters, the risk of loss to your retirement savings is generally quite negligible.
The Roth IRA: The backbone of the strategy is the Roth IRA. It is an after-tax account, which does not receive an immediate tax break (like a traditional plan). However, all qualified distributions from the plan are tax free. One can directly contribute to the plan up to the annual limit, or convert pretax retirement plan funds to a Roth.
Own less than 50% of the start-up: IRS rules provide IRA owners with great flexibility in the types of assets in which they can invest in including the opportunity to invest in publicly traded securities or assets in custody of a financial institution or custodian. As a way to gain greater investment diversification, a growing number of IRA owners choose to invest in non-publicly traded alternative assets, such as real estate, private placement stock, precious metals, investment funds, cryptos, and much more. However, you must be mindful of the prohibited transaction rules which are in place 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.
An IRA owner is not permitted to invest in a start-up company where he or she or any disqualified person will own 50% or more of the fund. This same 50% rule applies to LLC membership interests, or a carried interest received from a general partner entity. Accordingly, the start-up Roth IRA strategy can be used for start-ups where there are multiple founders or, at least, the founder that is considering using a Roth to invest will own less than 50% of the company shares or membership interests. The same applies for a hedge fund or other investment fund where the general partner will need to own less than 50% of the general partner entity in order to receive a share of the carried interest.
Paying fair market value for start-up stock: In addition to the IRS prohibited transaction rules outlined in IRC Section 4975, the only other way the IRS can “attack” a Roth IRA start-up strategy is if the valued paid is not fair and below market. By attempting to purchase undervalued start-up shares, the IRS could attempt to make the argument that the IRA owner is manipulating the contribution limits. Hence, it is crucial that when one uses retirement funds to purchase start-up shares or LLC membership interests, you are paying fair market value and the same price at which other investors, either IRA or non-IRA, are paying for the shares at the time of the offering.
However, for most founder share Roth IRA scenarios, the share price of the start-up is close to zero since the company is essentially a shell with no assets. The same goes for using a Roth IRA to acquire a carried interest in an investment fund as part of the general partner arrangement since case law is clear that one can use the liquidation value of the entity as a basis for value. For example, if the general partner LLC operating agreement is drafted correctly, liquidation will go first to the members with a positive capital account: the members that contributed capital. Hence, the carried interest/profits interest in the general partner entity is worth zero at the time of grant.
The IRS Frustration with the Roth IRA Start-Up Stock Strategy
There are several reasons why the IRS has become frustrated with its ability to examine and, in some cases, audit the founder stock Roth IRA strategy. A number of these concerns were outlined in a 2014 Government Accountability Office report on Self-Directed IRAs.
Lack of Coordination Between the IRS & DOL
Multiple IRS units are responsible for enforcing IRA tax laws and conducting outreach activities to increase taxpayer understanding of the laws. Even more frustrating is that the IRS and Department of Labor (DOL) share responsibility for overseeing prohibited transactions relating to IRAs. The DOL defines the prohibited transactions and may grant exemptions, whereas, the IRS is responsible for the auditing of IRS prohibited transactions. It is fair to say that governmental organizations are not typically very good at coordinating and sharing resources.
IRS Audit Limitations
The IRS Small Business/Self-Employed (SB/SE) division conducts field examinations targeting more complex individual tax returns. Field examinations are the IRS’s most costly form of examination. They do not have a specific audit division for IRAs, as the SB/SE division is indirectly responsible for the audit of such. Whereas SB/SE examines individual tax returns, the IRS Tax Exempt/Government Entities division (TE/GE) has jurisdiction over employee plans (including employer-sponsored SEP and SIMPLE IRA plans) and requirements for rollovers from qualified employer plans into IRAs. Hence, because no specific IRS audit division is responsible for audits, typically the responsibility falls on the shoulders of the SB/SE division which are topically focused on more traditional audit items, such as business income and deductions.
In addition, because the Tax Form 1040 will not disclose any IRA transaction or value data, other than an IRA contribution (pretax), taxable distribution, or RMD, it is almost impossible for an IRS auditor in the SB/SE division to uncover a potential IRS prohibited transaction. This is why the majority of IRAs that are audited involve IRA owners over the RMD age to confirm that the IRA value they are using to calculate their RMD is accurate.
Three-Year Statute of Limitations
The three-year statute of limitations for assessing taxes owed can pose an obstacle for IRS pursuing non-compliant activity that spans years of IRA investment. For example, the long-term nature of start-up and private equity-type investments which requires lengthy financial commitments and delayed financial returns can be difficult to assess. A start-up company or a private equity fund may not see a liquidation event for four or more years. The IRS has three years from the date a return is filed (whether the return is filed on time or not) to make an assessment of tax liability based on IRC Section 6501(a).
The statute of limitations is extended in certain situations. For example, if a taxpayer submits a false or fraudulent tax return or otherwise engages in a willful attempt to evade a tax, the tax may be assessed at any time after the return is filed. Additionally, extensions are authorized when the taxpayer fails to file a tax return, omits a certain amount of gross income from the return, or fails to report a listed transaction. Therefore, the three-year statute of limitation significantly limits the IRS’s ability to examine most start-up and carried interest-type transactions.
Limitation on IRS Ability to Block Transactions
As we mentioned earlier, there are essentially two ways for the IRS to attack the start-up Roth strategy: invoke the prohibited transaction rules or argue an inaccurate valuation. The former can only be argued if a disqualified person owned more than 50% of the company issuing the shares (or the general partner entity issuing the carried interest).
In the case of valuation, so long as the price paid by the Roth IRA for the founder stock was the same as all other investors at that time, both IRA and non-IRA, and the company has little to no assets, contesting the low value of the newly issued shares would prove extremely difficult for the IRS. This is especially true for a general partner that issues a carried interest/profits interest to a Roth IRA, since IRS guidance implies that individuals can use the liquidation value of a profits interest for certain tax purposes.
The Roth IRA founder stock and carried interest strategy can be a great way to boost the value of your tax-free retirement plan. It is a low-risk, high-reward strategy that just about anyone can utilize. A small initial investment could reap huge returns in the future. Even if it doesn’t pan out, you won’t be out a large chunk of change. You may even want to explore multiple investments and if one hits big, you’re set!
Of course, not all start-ups or investment funds are successful; there is no guarantee that the strategy will be a home run for everyone. Although, for entrepreneurs and passive investors, the Roth IRA founder stock strategy could be the best thing your Roth IRA ever did! Just pay attention to the prohibited transaction rules, and ensure you pay fair market value as to not get on the IRS’s radar. Lastly, remember that you must wait to withdraw funds from your Roth or you’ll end up owing taxes (and penalties if you are under age 59 1/2).