Over the last few years, Self-Directed IRA and solo 40(k) plan clients are using crowdfunding websites as a way to invest in small businesses. But what is crowdfunding? Crowdfunding generally refers to a financing method in which a large number of people raise money through soliciting relatively small individual investments or contributions. Before you elect to make crowdfunding IRA investments, it’s important to understand the various crowdfunding rules.
Rules of Crowdfunding
Title III of the JOBS Act established crowdfunding provisions that allow early-stage businesses to offer and sell securities. The SEC subsequently adopted Regulation Crowdfunding to implement the crowdfunding provisions of the JOBS Act.,
Under rules adopted by the SEC in 2015, the general public can participate in the early capital raising activities of start-up and early-stage companies/businesses through crowdfunding. This includes Self-Directed IRA and Solo 401(k) plan investors.
Anyone can invest in a securities-based crowdfunding IRA offer. Because of the risks with this type of investing, one is generally limited in their investments. For example, you are limited in how much you can invest during any 12-month period. Typically, limitations on how much you can invest depends on your net worth and annual income.
Generally, if your annual income or net worth is less than $107,000 during any 12-month period, you can only invest up to the greater of either $2,200. Or you can invest 5% of the lesser of your annual income or net worth. However, this will differ if both annual income and net worth are equal to or more than $107,000. If this is the case, during any 12-month period, you can invest up to 10% of annual income or net worth, whichever is lesser. You cannot exceed $107,000.
Early Stage Venture
Crowdfunding offers investors an opportunity to participate in an early-stage venture. However, be aware that early-stage investments may involve very high risks and you should research thoroughly before making an investment. Additionally, one can only invest in a crowdfunding offering through the online platform of a broker-dealer or a funding portal. This includes a website or a mobile app. Companies may not offer crowdfunding investments directly—they must use a broker-dealer or funding portal.
New Crowdfunding Rules Cover Three Broad Areas
The three areas the new crowdfunding IRA rules cover are:
- Limitations placed on the amount of money investors can invest
- Requirements on the form and mechanism for the transactions
- Offering limitations and disclosure obligations on companies
Under the new rules, the company raising the funds is required to disclose various company and business information to the investors. Additionally, the company must publicly file annual financial statements that, at a minimum, an independent accountant reviews. Whereas, in a Regulation D 506(c) investment opportunity anyone who is an accredited investor can invest.
Crowdfunding investments have become popular for retirement account holders either through a Self-Directed IRA or Solo 401(k). The advantage of using a retirement account to make a crowdfunding investment is that, generally, all income and gains the investment generates will be tax-deferred. In the case of a Roth IRA or Roth 401(k) plan, it’s tax-free. However, a lesser-known tax, the Unrelated Business Taxable Income tax (UBIT or UBTI) can apply. This turns a potential tax-deferred or tax-free crowdfunding investment into a very tax-inefficient investment.
In general, under the UBTI tax rules, if the crowdfunding investment operates through a passthrough entity, such as an LLC, engages in a trade or business, the retirement account investor may be subject to the UBTI tax. The tax is 37% if the IRA or solo 401(k) has allocated more than $1,000 of annual income. Whereas, in the case of a crowdfunding investment in a small business or start-up that is taxed as a C Corporation, the UBTI will not be taxed.