Last Updated on February 7, 2020
The advantage of purchasing venture capital funds with retirement funds is the ability to gain tax-advantages, such as tax-deferral or tax-free growth on income or gains the investment generates. A self-directed retirement plan, such as the Self-Directed IRA, gives you the freedom to purchase venture capital funds with a custodian control or checkbook control structure.
Buying Venture Capital Funds with Retirement Funds
Some of the most successful companies in the world, such as Google, Uber, and Amazon have been funded and grown as a result of venture capital investments. Venture capital investments can be best summed up as high reward/high risk investments. Venture capital firms may fund ten companies, but only need one or two of the acquisitions to work out to have a very successful fund. For example, Facebook’s $22 billion acquisition of WhatsApp in 2014 was (and still is) the largest private acquisition of a venture capital-backed company ever. It was also a big win for Sequoia Capital, the company’s only venture investor, which turned its $60 million investment into $3 billion.
Using an individual retirement account (IRA) or 401(k) plan to make a venture capital investment is seen as a tax attractive option because the gains from the investment would generally flow back to the retirement account without being subject to tax. Additionally, in the case of a self-directed Roth IRA, the income or gains have the potential to fully be tax exempt.
What is Venture Capital?
Venture capital is financing that investors provide to new start-up and small businesses that are believed to have great potential. Venture capital generally comes from well-off investors (accredited investors), family offices, investment banks and other financial institutions. Venture capital investments are typically into very early stage companies with little to no revenues.
What is the difference between venture capital and private equity?
Venture capital and private equity are very similar, but the main difference is, venture capital typically invests in very early stage companies with little to no revenues, whereas private equity invests in mature companies that generate revenue but need revitalization.
Venture capital funds generally make money by charging a small fee for managing the fund (typically around 2%) and then take a cut of the gains from the investments above a certain set threshold. This is known as the carried interest and is typically 20%. The fees associated with investing in a venture capital fund are steeper than investing in a mutual fund or ETF, but the hope is that the returns will more than make up for the associated costs.
Venture Capital Investments with a Self-Directed IRA – How does it Work?
A self-directed IRA is a retirement vehicle that allows investors to use their IRA funds to invest in private equity or venture capital transactions. A self-directed IRA can be used with a pre-tax IRA, Roth IRA, SEP IRA, or SIMPLE IRA.
There are two types of self-directed IRA structures that can be used to make a venture capital investment:
Custodian Controlled Self-Directed IRA
A custodian controlled structure allows you to invest in alternative assets, such as venture capital funds, but with the consent of a Self-Directed IRA custodian. With a custodian controlled self-directed IRA, the IRA funds are generally held with the IRA custodian. At the IRA holder’s sole direction, the IRA custodian will then invest the IRA funds into a venture capital fund. This is a popular structure for retirement investors who wish to make alternative asset investments that do not involve a high frequency of transactions.
Checkbook Control Self-Directed IRA
With a checkbook controlled structure, a special purpose limited liability company (LLC) is established, which the IRA owns and the IRA holder (you) manages. As manager of the LLC, you have full authority to make IRS approved alternative asset investment decisions on behalf of your IRA. No custodian consent is necessary. All of your funds will be held at a local bank in the name of the IRA LLC. As a result, simply write a check or wire funds directly from the IRA LLC bank account to make an investment.
The custodian controlled Self-Directed IRA is more popular for venture capital investments. The investments are so passive in nature and generally require a few transactions over a period of several years.
Self-Directed IRA Prohibited Transaction Rules
It is legal to use your Self-Directed IRA retirement funds for venture capital investments. However, you must be aware of the IRS prohibited transaction rules under Internal Revenue Code Section 4975. In general, the IRS has restricted certain transactions between the Self-Directed IRA and a “disqualified person.” Disqualified persons include, but are not limited to the IRA holder and any of his/her lineal descendants.
The prohibited transactions rules tend to become more of an issue when the person using the retirement funds or any disqualified person related to the retirement account holder has a personal interest or relationship with the venture capital fund investment. In other words, a retirement account holder can generally make an investment into any venture capital fund in which neither the retirement account holder nor any disqualified person has any personal ownership or relationship with. The issues begin to arise from an IRS prohibited transaction standpoint when the retirement account holder wishes to use retirement funds to invest in a fund where her or she or a disqualified person is either an owner, executive or, in some cases, has a professional relationship with the fund in question.
In general, if structured correctly, there may be a way to use your retirement funds to invest in a venture capital that you are personally involved in. The key is to make sure that the retirement account investment into the fund will not personally benefit you (directly or indirectly) or any disqualified person since that type of investment would likely trigger a prohibited transaction.
Triggering a prohibited transaction is based on the facts and circumstances involved. You must prove that you did not personally benefit from the retirement account investments (directly or indirectly). Failure of proof can trigger very steep taxes and penalties.
Unrelated Business Taxable Income (UBTI)
Retirement investors can use a Self-Directed IRA for venture capital investments if the IRA owner or another disqualified person does not benefit from the transaction in any way. However, if the venture capital fund will be invested in a business operated through a passthrough entity, such as an LLC, the income from the business generated by the venture capital fund could trigger an unknown tax called the unrelated business taxable income tax or UBTI or UBIT.
For example, if the venture capital fund invests in a restaurant that is operated though an LLC, the income from the restaurant allocated to the venture capital fund could be subject to the UBTI tax, which can be as high as 37%. Note – if the underlying business owned by the venture capital fund is operated by a C Corporation, such as Apple or Google (almost all public companies are C Corporations), the UBTI tax would not apply.
The good news for self-directed IRA investors is that most venture capital firms prefer the company be a C Corporation versus an LLC, thus, preventing the application of the UBTI tax. However, it would be wise to speak to the general partner of the prospective venture capital firm about the potential application of the UBTI tax before investing.
Putting it All Together
Venture capital investments are one of the more popular investment options for Self-Directed IRAs. Venture capital investments are generally high risk/high reward investments, but typically do not involve much prohibited transaction risks, assuming you or any disqualified person is actively involved in the fund. However, one should make sure that the companies the venture capital firm will be investing in will be structured as C corporations versus LLCs in order to prevent the application of the UBTI tax.
Why IRA Financial
IRA Financial has helped over 15,500 self-directed IRA investors invest over $4.5 billion in alternative assets. IRA Financial has significant experience assisting venture capital clients navigate the IRS rules in connection with all types of domestic and foreign investments.