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Investing in a Startup with a Roth IRA

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Adam Bergman here, tax attorney and founder of IRA Financial. Today, I’m going to give you some tips on how you potentially be the next Peter Thiel. Use your Roth IRA to maybe invest in the next PayPal or Facebook. Is it possible?

Yeah, of course, it’s possible. Could it happen to you? Who knows? But I’m going to explain to you the IRA rules you need to know about. So, first things first.

Why Invest in a Startup with a Roth IRA?

If you’re over 59 and a half, the Roths have been open for at least five years. All distributions from Roth IRA are tax-free. In 2022, you can put in 6000 or $7,000 in a Roth IRA.

You can also roll if you have a 401K Roth fund into a Roth IRA when you leave your job or you’re over the age of 59 and a half through your employer plan. How else do you fund a Roth IRA? Conversions. Let’s say you have a pretax IRA of $100,000 or $50,000 and you want to go Roth. Why?

Because you think you’re going to hit a home run and you want to lock in your tax-free gains. What you do is you do a Roth conversion. There are no income limitations for Roth conversions. You just pay tax on the value you convert. So, let’s say you have the potential to invest in a startup.

Maybe, as I said, the next PayPal. You probably want to consider using a Roth IRA. What are a few tips to think about? Number one, you got to know prohibited transaction rules.

Related: Can I still do a Backdoor Roth?

Prohibited Transactions & Investing in Startups with a Roth IRA

The IRS defines prohibited transactions as, “transactions between a plan and a disqualified person that is prohibited by law.” In the case of a startup, this means you cannot invest in a startup that you or any disqualified person are going to own more than 50%. Okay, so if you’re going to own 80% of the business, you should not use your Roth IRA to invest without it. If you’re going to invest in your Roth IRA, you’re going to own 20% or 30%. Honestly, you should be okay, right? It’s under the 50% threshold, which makes the entity not disqualified under 49. However, there’s a case I want to share with you called Rollins v. Commissioner. It’s a taxpayer case from 15 or so years ago and wanted to share it because it gives you some notion about how the IRS could potentially attack a transaction.

So, in this case, Rollins was an accountant. He owned less than 50% of a bunch of businesses. These businesses needed cash. He took his 401K and lent the money to the business at prevailing interest rates. The IRS argued and prohibited the transaction, and the taxpayer agreed.

Why? Because they said Rollins invested to also help himself out personally. Because of that loan may be his personal investment in these companies would have gone belly up. So again, he’s under 50% and the IRS still attacked the transaction. What I’m trying to get out is even if you’re under 50%, you want to be able to show that the investment is being done to exclusively benefit the IRA. However, if you’re only going to put in $5,000, $6,000, or $7,000 from your Roth IRA into a start-up for shares worth maybe a Penny, it’s hard to argue that $6,000 had a material impact on the business, right? So then how else could the IRS attack the transaction this is the most common way they can attack it.

The second way is called valuation. If they could show that your IRA is paying or your Roth IRAs paying below market value for the shares, they could attack the transaction. Now in the case of Peter Thiel and PayPal, his IRA paid for founder shares exactly what all other founders paid, whether they used IRAs or personal fun.

It was a start-up. The business had no goodwill. There were no assets in it. It paid exactly what all other founders paid. The IRS was not able to attack it.

If you want to try to mirror those facts, if there’s a start-up, very little assets, no business operations, no goodwill, you probably can get away with your Roth IRA paying pennies for those shares so long as it’s paying the exact amount of some other founders. So, a couple of things to consider. What I suggest is to make sure your Roth IRA is not the only party buying the shares at that time. Have other people come in, whether it’s friends, family, or yourself, you want to show everyone is paying the same amount for the shares. That will help you defend against valuation.

Number two, get an evaluation if you can. If it’s a start-up and you’re raising a million dollars and there’s no business activity, clearly the company is only worth a million dollars. It gets more complicated if the business has goodwill, operations, assets, or inventory. In that case, you need to get an appraiser. But for startups under 50%, you certainly have a viable option to use a Roth IRA to invest in the shares at par value or Penny as long again, as you can show valuation is accurate, you’re under the 50% and the investment is not being done to personally benefit you, you probably will be okay, right?

There’s no guarantee. If you see with the Rollins case, the key is building up a case. Good facts to show you paid fair market value and the transactions benefiting the Roth IRA and not you personally under the 50% and you will have good supporting facts to defend a Roth IRA investment into a startup.

Learn More: Buying a Business with Your Retirement Account


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