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Invest in an S Corp with a Self-Directed IRA

Invest in an S Corp with a Self-Directed IRA

The most popular reason millions of American IRA holders have turned to the Self-Directed IRA is to gain more control and investment options.  The ability to gain investment diversification and invest in a wide variety of assets in a tax-deferred or tax-free manner, is very attractive. However, are you allowed to invest in an S corp with your IRA funds? Read more to find out.

Key Points
  • A Self-Directed IRA allows one to diversify their retirement portfolio
  • S Corps are a type of business entity that is taxed at the shareholder level
  • An IRA cannot directly invest in an S Corp, but there are some workarounds

Investments Allowed with a Self-Directed IRA

The Internal Revenue Code do not describe what an IRA can invest in, only what it cannot invest in. It boils down to three types of investments you can’t do with IRA funds. Number one, you cannot invest in life insurance. Secondly, you cannot invest in collectibles, including art, stamps, and antiques. Lastly, you cannot invest in a transaction that includes a disqualified person.

To the last point, essentially, any investment made with IRA funds must “exclusively benefit” the IRA itself. A disqualified person, which includes you and your spouse, any lineal descendants and ascendants, their spouses, and any entities controlled by such, cannot benefit from the IRA-held investment.

Therefore, so long as no disqualified person is involved, and the investment is not prohibited by the IRS, you can do it. Investments include real estate, precious metals, and even S corps.

What is an S Corp?

S corps are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S corps report the flow-through of income and losses on their personal tax returns, and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income at the entity level.

C Corp vs. S Corp

A corporation (sometimes referred to as a C corporation) is an independent legal entity owned by shareholders. This means that the corporation itself, not the shareholders that own it, is held legally liable for the actions and debts the business incurs.

One of the major disadvantages of a C Corp is taxation. C Corps are required to pay federal, state, and in some cases, local taxes. When you form a corporation, you create a separate tax-paying entity. C Corps are known has having two layers of tax: (i) a corporate level, which is currently 21%, and (ii) a shareholder tax, which is subject to tax on corporate dividends received.

Whereas, an S corporation is treated as a pass-through entity, such as an LLC, for federal income tax purposes. All S corp items of income, loss, deductions “pass through” to the shareholders and reported on their federal income tax returns.

S Corp Requirements

To qualify for S corporation status, the corporation must meet the following requirements:

  • Be a domestic corporation
  • Have only allowable shareholders
  • Have no more than 100 shareholders
  • Have only one class of stock
  • Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).

In sum, the S Corp have very specific shareholder restrictions.  For example, corporations, foreigners, and only certain trusts can be shareholders of an S corp.  Unfortunately, an IRA is not a permitted shareholder of an S corp.  In addition, a single member LLC, owned by an IRA, is also not a permitted S corp shareholder since the LLC is a pass-through entity. 

However, a 401(k) plan is technically a permitted trust that can be a shareholder of an S corp.  Although, the issue with a 401(k) plan owning S corp stock is that any pass-through income exceeding $1,000 could trigger the UBTI tax, which has a maximum tax rate of 37%.

Unlike an S Corp, C Corps, LLCs, and partnerships do not generally have any shareholder restrictions.

How can a Self-Directed IRA Invest in an S Corp?

Now that we know that an IRA cannot be a shareholder of an S corp, what can an investor do who wants to use an IRA to buy S corp stock?  Here are a few options:

Revoke the S Corporation Election

A C corp may revoke the S election. To revoke a sub-chapter S election/small business election that was made on Form 2553, submit a statement of revocation to the service center where you file your annual return. The statement would need to include certain information about the corporation.

If revoking effective the first day of the tax year, the revocation is due by the 16th day of the third month of the tax year. Whereas, if revoking effective any day other than the first day of the tax year, the revocation must be received by IRS by the requested effective date.

By revoking the S election, the corporation reverts back to a C Corp and the two layers of taxation.

Debt vs. Equity Investment

An IRA investor can elect to lend funds to the S corp versus making an equity investment. The downside of a loan investment is that the IRA will simply be a lender to the S corp and not a shareholder.  Hence, the IRA will not share in any of the upside equity value of the corporation.

However, a loan with favorable rates could yield a decent return for your IRA. Of course, the profits will be limited.

Conclusion

The S corp shareholder limitation rules are often viewed as irrational as well as frustrating.  The fact that an IRA can invest in a C Corp or an LLC, but not an S corp, often infuriates investors.  Nevertheless, it is important to remember that these S corp shareholder restrictions are based on rules in the tax code and not IRA tax rules.

You do have options when it comes to investing in an S corp with a Self-Directed IRA, however, they are limited. Before investing, speak with a financial advisor to see if it’s the right deal for you. Never settle when it comes to investing in your future!

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