One of the more popular questions from first-time Self-Directed IRA investors is can I invest in a business or company that I am personally involved in. The good news is that the IRS prohibited transaction rules are quite simple, especially when it comes to investing in a business where the IRA owner personally serves as a director.
- One can use IRA funds to invest in a business
- You must be aware of the prohibited transaction rules
- Facts and circumstances will determine if you can invest in a particular business
Self-Directed IRA in a Nutshell
There are several types of Individual retirement accounts, or IRAs. In general, if one has income from working for yourself or someone else, you may set up and contribute to an IRA. Most of the more than $12 trillion held in IRA accounts are controlled by the major brokerage firms and invested in stocks, bonds and mutual funds. Alternative investments, such as real estate, have always been permitted in IRAs, but few people seemed to know about this option – until the last several years.
The large financial institutions have little incentive to recommend investments other than their traditional offerings which bring in extremely profitable commissions and fees. A Self-Directed IRA is essentially a type of IRA that allows you to invest in alternative assets (non-publicly traded investments).
IRC 4975 – The IRS Prohibited Transaction Rules
The Internal Revenue Code (“IRC”) does not describe what an IRA can invest in, only what it cannot invest in, which is outlined in IRC Section 4975(c). Other than life insurance and collectibles, one can generally invest in anything that doesn’t involve a disqualified person.
In general, the IRS prohibits certain transactions involving “disqualified persons.” The definition of a disqualified person (Internal Revenue Code Section 4975(e)(2)) extends into a variety of related party scenarios, but generally includes 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
Therefore, an IRA investment cannot include you, your spouse, parents, grandparents, children and their spouses. Other relatives, friends, coworkers and neighbors are allowed.
Investing in a Business with a Self-Directed IRA
When using an IRA to invest in a business the IRA owner will be personally involved in, it is important that the IRA owns less than 50% of the entity. For example, if an IRA owner or any disqualified person will own more than 50% of an entity, that individual should not use IRA funds to invest into that entity, as it would trigger a prohibited transaction under IRC 4975.
On the flip side, an IRA can own more than 50% of an entity so long as the IRA owner nor any disqualified person owns any interest in the entity, or is personally involved in the entity.
Serving as Manager/Director of a Self-Directed IRA-Owned Business
The Court case, Swanson V. Commissioner 106 T.C. 76 (1996), confirmed that an IRA could capitalize a new entity and the entity can be managed by the IRA owner, (who is a disqualified person) without triggering the IRS prohibited transaction rules. The Swanson Case was later affirmed by the IRS in Field Service Advice Memorandum (FSA) 200128011.
However, what about the case where the IRA wishes to make an investment into an existing company where the IRA owner or a disqualified person will serve as manager or director? The answer generally depends on the facts and circumstances of the investment.
In the simplest case, if the IRA will owns less than 50% of the entity and the IRA owner will not earn any compensation from the entity, then the transaction would likely not trigger the prohibited transaction rules. However, where the IRA will own more than 50% of the entity and the IRA owner will be a paid employee or director, the transaction could be deemed an indirect, self-dealing, conflict of interest prohibited transaction.
The key point to remember is that the Self-Directed IRA investment must be one to exclusively benefit the IRA and not to directly or indirectly benefit the IRA owner personally.
Interpreting the IRS prohibited transaction rules under IRC 4975 tends to boil down to the specific situation. In the case of a Self-Directed IRA investment into an entity managed by the IRA owner or another disqualified person, below are a few key points to consider:
- An IRA investment of 50% or greater into an entity adds greater prohibited transaction risk, especially if the IRA owner or a disqualified person will be personally involved in the entity
- If the IRA will own more than 50% of the entity, the IRA owner, nor any disqualified person, should receive compensation from the entity as manager/director
- If an entity is owned 50% or more by the IRA owner or a disqualified person, the Self-Directed IRA should be cautious of investing into that entity
- If the Self-Directed IRA will be owning less than 50% of the entity, there is more flexibility for the IRA owner or any disqualified person to have a personal interest/compensation relationship with the entity
Get in Touch
The experts at IRA Financial can help you navigate the prohibited transactions rules. If you have any questions, please reach out to us @ 800.472.0646 today.