Using an individual retirement account (IRA) or 401(k) plan to make investments 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. News that Mitt Romney had tens of millions of dollars in his IRA generated from numerous Bain Capital investments over the years has many people in the hedge fund and private equity world buzzing about the potential of using a self-directed IRA to start or fund an investment fund.
When it comes to using retirement funds to invest in a hedge fund, it is important to be mindful of the IRS prohibited transaction rules under Internal Revenue Code Section 4975. In general, the IRS has restricted certain transactions between the IRA and a “disqualified person”. The definition of a “disqualified person” (Internal Revenue Code Section 4975(e)(2)) extends into a variety of related party scenarios, but generally includes the retirement account holder and any of his/her ancestors or lineal descendants of the holder (i.e. parents, children, spouse, daughter-in-law or son-in-law), and entities in which the retirement account holder or a disqualified person holds a controlling or management interest. Furthermore, Internal Revenue Code Section 4975(c)(1)(D) and (E) outlines rules that relate to self-dealing or conflict of interest transactions that involves an investment that could directly or indirectly personally benefit a disqualified person. The self-dealing or conflict of interest prohibited transaction rules have the broadest application especially when it comes to hedge fund type investments.
A hedge fund or private equity fund is an alternative investment vehicle available only to sophisticated investors, such as institutions and individuals with significant assets. In general, retirement funds are permitted to invest in hedge funds. 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 investment fund investment. In other words, a retirement account holder can generally make an investment into an investment 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, employee or, in some cases, has a professional relationship with the fund in question.
In general, if structured correctly, there may be a way for one to use his or her retirement funds to invest in a hedge fund that one is personally involved in. The key is to make sure that the retirement account investment into the fund will not directly or indirectly personally benefit the retirement account holder or any disqualified person since that type of investment would likely trigger a prohibited transaction. The analysis of whether the retirement account fund investment would trigger a prohibited transaction is based on the facts and circumstances involved. The onus would be on the retirement account holder to prove that he or she did not personally benefit from the retirement account investment, either directly or indirectly, with the failure to do so could trigger very steep taxes and penalties. In addition, on a side note, using retirement funds to invest in an investment fund, such as a private equity or hedge fund, operated through a pass-through entity (i.e. LLC or partnership) that either uses leverage or invests in active businesses operated via a pass-through entity, could trigger a tax called the unrelated business taxable income (“UBTI”) tax, which could go as high as 40%.
Whether one wishes to use retirement funds to start an investment fund or invest in an ongoing fund, the following are some helpful items to consider:
- Beware of receiving any personal benefit either directly or indirectly, from making the fund investment with retirement funds, such as management fees or a carried interest on the retirement account’s limited partnership interest. The retirement account holder or any disqualified person should not receive any personal benefit from the retirement account fund investment.
- Do not use retirement funds to invest in the general partner or management company of the investment fund if it involves disqualified persons
- The amount of the retirement account investment and percentage of the fund owned by the retirement account is relevant to determining whether a prohibited transaction occurred (the larger the fund is and the smaller the retirement account ownership interest is will typically be a positive fact).
- Beware of the impact of the UBTI tax if the fund will be using leverage or will be investing in active businesses through a pass-through entity (i.e. LLC)
- Retirement account holders seeking to invest in large established funds versus new or smaller funds may have an easier time navigating the prohibited transaction rules
- Even a very small ownership interest in an investment fund with retirement funds can trigger a prohibited transaction if not structured correctly
As Mitt Romney has revealed, using retirement funds to invest in a hedge fund or investment fund is not on its face a prohibited transaction, however, when the retirement account holder has some personal involvement with the fund, the IRS prohibited transaction rules must be closely examined to make sure the investment would not trigger a prohibited transaction.