Investing in startups can be a way to create explosive capital growth for your self-directed IRA. If you can get in on the ground floor of a new business that makes it to the next level, the potential financial rewards can be tremendous.

When a company goes public or is acquired by another firm, the payoff for original investors is often significant. We speak with a good number of investors with the potential to participate in such deals.

Let’s look at some of the key considerations affecting startup investing in a self-directed IRA or Solo 401(k).

Startup Opportunities

You’ve certainly seen all the buzz about companies going public and big gains for investors on IPO day. The reality is, as an individual investor, you’re not invited to that party.

Large institutional investors dominate access to IPO’s. Where you can get involved in the exciting prospects of a company with a new idea is as a startup or early stage investor.

These opportunities are out there, and normally presented to friends and family and their associated sphere of influence. Networking in an entrepreneurial environment is usually how you can find out about these types of opportunities.

Whether a company is starting from scratch or has achieved proof of concept and is looking to scale up, the need for capital is there. Private investors are the fuel for innovation.

Avoiding Disqualified Persons

It’s important to keep in mind that your IRA can’t invest in certain businesses where you or close family have control. The IRS rules surrounding the tax-sheltered status of an IRA or 401(k) prohibit any direct or indirect benefit between a plan and a disqualified person.

The list of folks your IRA can’t interact with include:

• You
• Your spouse if married
• Lineal antecedents such as parents, grandparents, etc.
• Lineal descendants such as children, grandchildren, etc.
• The spouse of a descendant
• An entity such as a business or trust where one or more of the above have control via greater than 49% ownership or a directorial role
• A joint venture or business partner in a business that you or a disqualified person control
  What this means is that your IRA can’t invest in your daughter’s new startup. It also means that your IRA shouldn’t invest in a company if that investment will grant you the opportunity to become an employee of that company – or in effect, buying you a job.

Is Accreditation Required

Depending on the nature of the business, the opportunity to invest may only be available to accredited investors. In very small private placements, the possibility of friends and family to invest without the transaction being viewed as a security exists.

In any larger opportunity — or where involvement of investors beyond the company owner’s immediate circle exists — securities regulations may apply.

Depending on how the company has setup their offering, it may be limited to accredited investors only. Some types of arrangements allow for up to 35 non-accredited but “sophisticated” investors capable of understanding business and risk.

Be sure you understand and meet the requirements to invest before spending too much time analyzing an opportunity.

Avoid Subchapter S Corporations

Subchapter S corporations are limited to shareholders who are individuals and US citizens. Your IRA may not be a shareholder, and therefore can’t invest in any venture that is established as a S corporation.

Potential Tax Implications

An IRA or 401(k) is exempted from taxation on income that is passive in nature such as dividends, interest, and rents from real property.

If a startup is formed as a subchapter C corporation, then it will be issuing dividends to investors after paying corporate taxes. This type of income will be fully sheltered to an IRA, just like an investment into a large publicly traded company like Amazon or General Motors.

If the business is some other form of entity like a sole proprietorship, LLC or LLP, then it will be passing through income to investors without first paying taxes at the corporate level.

When a tax-exempt such as an IRA or 401(k) receives this type of trade or business income it can be subject to taxation on Unrelated Business Taxable Income (UBTI). Tax rates on UBTI top out at 37%. The concept behind this form of taxation is to protect tax-paying businesses from unfair competition.

When UBTI is Problematic

UBTI applies to operating income, not to the gain in equity an investor may receive if a business is sold or goes public.

In most true startup or venture capital type plays, this exposure to UBTI is certainly something to be aware of, but not likely to spoil the opportunity. Most startups operate in the red initially, allowing for losses that can be used to offset future UBTI obligations.

While there may be a period of time where positive operating income exists, the overall tax impact should be relatively modest.

When the company is sold, there is no tax on the gain in value. And if that gain is good, it will more than outweigh the small cost of UBTI taxation on the way there.

On the other hand, investing in a company for the long term with the operating income that company will produce being the primary incentive may not work out so well.

Diligence Considerations

We’ve covered the initial structural considerations that you’ll need to consider when investing in a startup with IRA funds.

These are a good starting point to determine if it even makes sense to look more closely at an opportunity.

If you choose to invest, be sure to perform thorough diligence on the company. This may involve reviewing financials and obtaining background checks on company principals.

You may also want to do your own research to corroborate any assumptions the company is making in pro-forma projections. Consider the following questions:

• Is the sector the business is looking to serve real?
• Who are competitors in the same field?
• Are there regulatory hurdles that need to be overcome, and does the leadership team have the necessary expertise to navigate these processes?
• What happens if the goals are not met?

Do You Need Checkbook Control?

If your only goal is one or two private placement investments totaling under $100K in value, a Checkbook IRA is going to be more tool than necessary.

The benefit of checkbook control is time efficiency and reduction of per-transaction and per-asset fees assessed by self-directed IRA custodians. These benefits will come into play pretty quickly with a moderate amount of activity in an account.

For one or two static assets, however, there may not be any real advantage.

Checkbook control plans will benefit investors who are either broadly investing in a number of startups, or for whom startup investing is just one aspect of a larger portfolio of alternative assets.

The Crowdfunding Option

It’s possible to participate in venture capital investing without a direct network to entrepreneurs. Subsequent to the 2012 JOBS Act, securities rules were relaxed so as to allow companies to attract a broader range of investors.

Crowdfunding platforms have become a popular way to make startup and angel investing opportunities more publicly available. Many of the same principals outlined above will still apply when investing on a crowdfunding platform.

Swinging for the Fences

The opportunity to “hit a home run” with a startup is certainly appealing. You also need to be cognizant of the fact that many startups fail or stall out and end up as a “strikeout”.

This type of investing leads to some pretty high risk-reward ratios, and isn’t for everyone.

Be sure that any amount you invest in a startup is money you can live without. If you have the opportunity to spread money around into multiple deals, that can provide some level of diversification.

If there are 3 strikeouts and one home run, you still end up ahead of the game.

Contact us with questions about investing in a startup with your self-directed IRA today »