The two most popular Self-Directed IRA investors are probably Mitt Romney and Peter Thiel. It is believed that Peter Thiel has a Roth IRA worth more than a billion dollars. Whereas Senator Romney is believed to have an IRA worth a few hundred million. However, in the case of Senator Romney, his IRA is pretax, while Mr. Thiel has a Roth IRA. Hence, it is not very controversial to make the case that Peter Thiel should be crowned alone as the king of the Self-Directed IRA. Nevertheless, understanding how Mr. Romney and Mr. Thiel built up their IRA wealth is a valuable exercise we can all learn from.
Romney’s Self-Directed IRA Story
Since 2019, Mitt Romney is a U.S. Senator from Utah. He served as the 70th governor of Massachusetts from 2003 to 2007 and was the Republican Party’s nominee for president of the United States in the 2012 election. Prior to entering politics, Romney was a successful businessman and private equity investor. In 1984, he co-founded and led the spin-off company Bain Capital, a private equity investment firm, that became one of the largest and most successful in the country. Mr. Romney’s leadership role in Bain allowed him the opportunity, along with other executives, to co-invest alongside Bain Capital in various fund investments. Mr. Romney is believed to have been one of the first private equity-type investors to use a tax-deferred retirement account, such as an IRA, to make these investments.
Of note, at the time Romney was making his IRA investments into Bain Capital deals, the Roth IRA was not yet created, which limited Mr. Romney to pretax IRA investments.
The Roth IRA was created in 1997 by Senator Roth. Unlike a pretax IRA which provides for a tax deduction when making a contribution, IRA distributions would be subject to ordinary income tax. Whereas in the case of a Roth IRA, after the after age of 59 ½ and the Roth IRA has been open at least five years, all distributions would be tax free.
As a result of information made publicly available concerning Mr. Romney’s wealth, Mr. Romney’s IRA value is estimated between $25 million and $125 million. With his wealth estimated to be at approximately $200 million dollars, his IRA investments make up a considerable percentage. The question then becomes, how was Mr. Romney able to increase his IRA wealth so considerably over the years.
Private equity firms, such as Bain Capital, typically act as the general partner for each fund they create. The firms collect an annual management fee equal to approximately 2% of the fund during the period it is buying and restructuring companies. When companies are resold, the firm’s partners also split a percentage of the profits, known as a carried interest, which is about 20% of the returns after certain thresholds have been met.
According to several articles that reported on Mr. Romney’s IRA wealth over several years, his IRA was able to take advantage of Bain Capital’s successes over the years. Romney and his co-workers invested their own money in most of the deals to increase their personal returns. Based on research performed by the Wall Street Journal, Bain Capital allowed its employees to co-invest in Bain deals with personal, as well as tax-deferred retirement accounts, such as an IRA. According to former employees, Bain Capital allowed certain employees to invest their tax-deferred IRAs into special share class that cost little but yielded much larger gains than other shares when Bain deals proved successful. According to another Wall Street Journal report, this unique investment structure allowed Bain employees to recognize a tax-deferred gain of approximately 583-fold compared to a 36-fold gain recognized by Bain over the same period.
According to internal documents and securities filings, Bain Capital investments that involved tax-deferred retirement accounts were typically structured as follows:
Bain Capital would offer two classes of stock, usually called Class L and Class A. Mr. Romney and Bain Capital would typically use their IRAs to purchase the Class A shares. Because Bain Capital controlled the investment companies, it had flexibility in assigning values to the classes. For example, Class L shares, akin to preferred stock, were safer and had a higher initial value. They had priority if the company paid dividends, and holders of these shares were the first to receive proceeds from a sale or liquidation. The shares also accrued interest, often at 10% to 12%. Whereas, Bain Capital assigned a much lower value to Class A shares, which were riskier but potentially more profitable.
If Bain Capital sold or liquidated a company it had taken over for less than was owed to Class L shareholders, the Class A shares lost all their value. But once Class L shareholders got their money, Class A shareholders received the bulk of additional gains, often as much as 90% of them, according to the documents and former employees. In successful deals, the A shares could skyrocket and if they were owned by a tax-deferred arrangement, such as an IRA, the gains would be tax-deferred.
Based on the above structure, Mr. Romney and certain Bain executives were able to use their IRA to invest in low-valued Class A shares that had very high upside on a capital or liquidation event. This structure allowed Mr. Romney to generate significant IRA returns in conjunction with the investment into Class A shares. Mr. Romney reportedly used this type of structure in multiple occasions, which contributed to the surge in value of his IRA.
Thiel’s Self-Directed Roth IRA Story
Peter Thiel, a Stanford law graduate, ran a small hedge fund in the late 1900s. In 1999, single taxpayers were only allowed to contribute to a Roth if they made less than $110,000. Thiel’s income that year was $73,263, IRS records show. Like many startups, PayPal offered its top executives low initial salaries and large stock grants. While SEC filings describing that time don’t mention Thiel’s Roth, they show that he bought his first slice of the company in January 1999. Thiel paid $0.001 per share for 1.7 million shares. At that price, he was able to buy a large stake for just $1,700 of Roth IRA funds.
According to a Pro Publica article on Mr. Thiel’s IRA, all PayPal employees got the same “below fair market value” pricing which is what the IRS acknowledged when they audited Thiel in 2012. And soon after the company sold him the shares, investors invested millions of dollars into the company. In just a month’s time, the company sold a slice of itself to investors for $500,000. That June and August, another $4.5 million poured in from the venture fund arm of telecom giant Nokia and other investors, those records show.
In just a year’s time, the value of his Roth jumped from $1,664 to $3.8 million — a 227,490% increase. Then in 2002, eBay purchased PayPal. That same year, Thiel sold the shares, still inside his Roth. The tax-free proceeds poured into his account. By the end of 2002, Thiel’s Roth was worth $28.5 million.
In 2003, Thiel and colleagues founded Palantir, a data analytics company. Thiel used his Roth to buy shares of Palantir when it was still a private company, years before it was listed on the New York Stock Exchange, according to a ProPublica analysis of tax records.
In 2004, Thiel met Mark Zuckerberg, a Harvard undergraduate who had come to Silicon Valley for the summer to work on growing the company that would become Facebook. Thiel invested $500,000, Facebook’s first large outside infusion of cash. Thiel invested in Facebook using his Roth IRA. By the end of 2008, the Roth was worth $870 million.
Ironically, the IRS and many of Thiel’s adversaries spent time focusing on his PayPal investment, however, it was his Palantir and Facebook investments that generated the largest returns for his Roth IRA.
Did Romney or Thiel Violate the IRS Prohibited Transaction Rules?
An IRA is an individual retirement account taxed under Internal Revenue Code Section 408, when it comes to using IRA funds to invest in transactions involving a “disqualified person,” one must first examine the prohibited transaction rules. In general, these rules state that the IRS has restricted and imposes a penalty on certain transactions between the IRA and a disqualified person. The rationale behind these rules was a congressional assumption that certain transactions between certain parties are inherently suspicious and should be disallowed.
The definition of a disqualified person extends into a variety of related party scenarios, but generally includes the IRA owner, any ancestors or lineal descendants of the IRA holder, and entities in which the IRA holder holds a controlling equity or management interest. To trigger the prohibited transaction rules, a direct transfer of funds between the IRA and a disqualified person need not occur. A disqualified person could trigger a prohibited transaction by either engaging in a self-dealing or conflict of interest transaction.
In the case of a transaction involving private stock, based off the GAO Report from 2014, there are essentially only two ways the IRS can attack the transaction and argue it violated the IRS prohibited transaction rules. The first is if the company is controlled 50% or more by the IRA owner of any disqualified person. The second is if the price paid for the shares by the IRA was below market.
The Case for Mr. Romney
Mr. Romney was a disqualified person with respect to his IRA because he was a fiduciary of his IRA. The question then becomes was Romney’s use of his IRA funds to co-invest with Bain Capital as a self-dealing or conflict of interest transaction under the rules. It is believed that he owned less than 50% of Bain Capital and, thus, Bain Capital or any of its controlled companies would likely not be considered a disqualified person.
Bain Capital allowed certain employees to invest their tax-deferred retirement accounts (IRA) into special Class A shares that cost little but yielded much larger gains than other shares when Bain deals proved successful. Could this investment structure be construed by the IRS has creating a conflict of interest for Mr. Romney since the Class A shares would benefit at the expense of the Class L shareholders.
The key analysis here is whether all investors paid the same price for Class A shares. Based on the information reported, the Class A shares had different economic terms than the Class L shares, including higher risk, but also higher upside, and the Class L shares were structured more like preferred shares. Preferred shares have a higher initial value because holders of this share class are more likely to be repaid if the portfolio company is not successful. Additionally, holders of preferred shares are the first to receive proceeds from the private equity fund’s sale of the portfolio company. In contrast, the riskier common shares can end up worthless if the private equity fund sells the portfolio company for less than it paid. But if the portfolio company is sold for a higher price than expected, holders of the riskier common shares may receive the bulk of any additional proceeds once preferred shareholders have received their proceeds.
That being said, it would seem plausible that if the IRS was able to audit the Romney IRA transactions within the three-year statute if limitations, an argument could have been made that the Class A shares were structured to provide Mr. Romney’s and other IRA holders’ a financial advantage at the expense of Bain Capital investors, which could be considered a conflict of interest. Thankfully for Romney, the IRS apparently did not have the opportunity to audit those transactions.
The Case for Mr. Thiel
In general, an IRA should not be used to invest in a business if the IRA owner or disqualified person owns greater than 50% of the business interests or stock. Although, even if the Roth IRA owns less than 50% of the business, including personal and IRA interests, the IRS could still potentially argue that the Roth IRA investment was a self-dealing or conflict of interest prohibited transaction under IRC 4975. However, that would be highly difficult in the case where the IRA was investing a trivial amount of money into a company with numerous founders and investors. In the case of Thiel, based on the information reported by Pro Publica, he owned less than 50% of the shares of PayPal, Facebook, and Palantir. In addition, the amount invested in all three companies were relatively minor.
In Notice 2004-8, the IRS highlighted a type of transaction involving a Roth IRA and company stock that they have listed as abusive. In general, the transactions were structured as follows: an individual owns a preexisting business and sells substantially all the company shares to a Roth IRA owned by the business owner. The acquisition of shares is far below fair market value and thus have the effect of shifting value into the Roth IRA. The IRS is very concerned with a taxpayer’s ability to shift taxable assets into a tax-free account and, thus, shielding the gains on the stock appreciation from tax.
For Mr. Thiel’s acquisition of PayPal shares, the ProPublica article stated that the SEC filings revealed that his PayPal founders’ shares were among those the company sold to employees at “below fair value.” However, the record revealed that all employees got the same “below fair market value” pricing which is what the IRS acknowledged when they audited Thiel in 2012. Hence, since all employees were able to buy the PayPal shares at that time for the same price, Thiel’s Roth IRA did not get a below market deal on the investment.
In the case of his Facebook investment, his Roth IRA paid the fair value price offered by the company at that time. Since Mr. Thiel’s Roth IRA invested into companies, he, nor any disqualified person, owned more than 50%, and paid value for the shares purchased, like any other employee/investor at that time, his Roth IRA investments into PayPal, Facebook, and Palantir were likely not prohibited transactions under the Code.
Mr. Romney and Mr. Thiel are surely two or the ore prominent members of the Self-Directed IRA Hall of Fame, but they are not alone. More than 28,600 taxpayers held IRAs larger than $5 million in 2019, according to a Joint Committee on Taxation analysis published in July, although they account for less than a tenth of 1% of the roughly 70 million taxpayers with a traditional or Roth IRA, according to most recent IRS figures. Almost 500 people have IRAs larger than $25 million in which the accounts average about $150 million.
Understanding how Romney and Thiel built up their IRA values is a worthwhile experience. This is especially true of Mr. Thiel who used the power of the Roth IRA to build a billion-dollar tax-free dynasty. In contrast, since Mr. Romney is now over the age of 73, he is obligated to take required minimum distributions on his pretax IRA, which would be subject to ordinary income tax. However, Thiel’s Roth will enjoy tax-free distributions and no RMD requirement.
Overall, Peter Thiel is the king of the Self-Directed IRA for understanding the enormous tax benefits of using a Roth for private stock investments. Imagine being a founder or early investor into three successful publicly-traded companies, including Facebook, and making all these investments with a tax-free retirement account. Pretty amazing!
Mr. Romney still has a lot to be proud of. He was one of the first private equity investors to use a tiered class structure that potentially could create extraordinary upside to its IRA class investors. Unfortunately, Mr. Romney has the misfortune of making most of his IRA investments prior to the creation of the Roth IRA. Nevertheless, all IRA investors can learn a lot from both Mr. Romney and Mr. Thiel.