Having your IRA act as a lender and receive interest income can be a great way to diversify and create predictable returns. We’ve written about investing in real estate notes, where the debt is secured by real property. But your IRA can also lend to businesses.
The fact is, a lot of businesses are in situations where obtaining bank financing may be difficult or just too expensive. Self-employed persons with limited business history, or small dollar loans that may not be attractive to a bank are some cases where your IRA can fill a need.
For a lot of investors, the ability to lend locally in opportunities they can personally evaluate is appealing. Business lending can be that type of opportunity.
What is a Small Business Loan?
A business loan is a lending arrangement wherein a lender provides capital to a borrower for the purposes of starting, operating, or expanding a business. The borrower agrees to pay back the loan with interest, and that interest represents the tax-sheltered gain the IRA will receive from the investment.
The lending transaction is documented with a promissory note, which is a contract outlining the terms of the arrangement such as how long the loan repayment will be and the interest rate. The note also conveys the borrowers promise to repay the debt.
Securing the Loan
A loan may or may not be secured by a hard asset such as business inventory or equipment. It’s also possible to secure a loan by financial assets of a business such as accounts receivable.
Sometimes, a borrower will pledge non-business assets as security for a loan to be used for business purposes. This is referred to as cross-collateralization.
Whether the loan is secured or un-secured isn’t critical for IRA compliance reasons, but does factor into the level of risk one is taking on.
When a loan is secured by an asset with value it reduces the risk, as the IRA can take possession of the asset if the borrower defaults. When a loan is unsecured, there is no remedy in the event of a default, and a higher risk of total loss in value.
The interest rate for unsecured loans is typically higher than for secured loans.
The terms of a loan should be in-line with the needs of the borrower and the level of risk to the lender. Any loan made by an IRA should also be at what would generally be considered market rates.
Loan terms such as the length of the loan, interest rate, loan setup fees and the like are all negotiable. A longer-term loan with a solid underlying security might have a lower interest rate. A shorter-term or higher risk loan may merit a higher interest rate.
IRS Rules Considerations
As with all investment transactions made with a self-directed IRA or 401(k), operating within the IRS rules is critical to protect the tax-sheltered status of your retirement plan.
Your IRA may not lend in a fashion that creates a direct or indirect benefit to a disqualified person. Those disqualified persons include, you, your spouse, and lineal family like parents and children, or entities controlled by a lineal family member.
Lending to your child or your child’s business would be prohibited and forfeit the tax-sheltered status of your IRA. Similarly, lending from your IRA to an associate, who then reciprocates by lending from their IRA to you or your business would be a violation, as you’re indirectly using your IRA to benefit yourself.
You must always invest an IRA with the best interests of the IRA in mind. While it’s permissible to lend to certain family members such as a sibling, you wouldn’t be acting in the best interest of the IRA if you were to make a higher risk business loan at a very low interest rate. Any loan to any allowable party should be done at market rates for similar types of loans.
From an IRS perspective, you only need to be concerned about avoiding self-dealing or dealings with disqualified persons. However, as a lender, your IRA also needs to operate within state lending laws – often referred to as usury laws.
Work with a local expert or attorney to ensure that the terms of the loan are in line with the law, and that any necessary disclosures are provided.
Any time your plan hires a professional for services such as legal review — with the review being exclusively for the use of the plan — fees for such services should be paid from the plan.
When your IRA or 401(k) is acting as a lender, you are the loan underwriter. This is a great amount of flexibility, but also means you need to do your homework.
Any time you are considering a loan transaction you need to fully evaluate the risk factors to determine the likelihood the loan will be repaid. The factors you will want to consider vary based on the borrower and type of loan, but would include some of the following:
- Who is the actual borrower; an individual, partnership, business entity, etc.?
- What is the security for the loan? What is the real, fair market value of that security?
- Does the borrower have experience in the line of business they are operating?
- Does the business have financials that can be reviewed?
- Can you run a credit check on the borrower, and determine what other debt obligations they may have?
- Can you run a background check on the borrower?
- What happens in the event of a default? How would your IRA take control of and draw value from the security backing the loan?
Lending vs Equity
In many cases, using your IRA to lend to a business can be a better option than having the IRA take an ownership stake in the business. When an IRA owns a portion of an operating business that is not a shareholder corporation issuing dividend income, then the pass-through income of that business will be considered Unrelated Business Taxable Income.
This means the IRA will pay taxes on the business income received. However, a loan receives interest income which is passive in nature, and not considered UBTI. All of the gains will be entirely tax-sheltered to the IRA.
Following this line of thinking, it’s important that any loan to a business be a true loan, and not a way to try and mask business profits in a lending vehicle. The terms of the loan cannot be variable based on the performance of the business. The loan must be for a set interest formula.
It’s possible to provide capital to a business in the form of a note that has the option to convert to equity in the future. This can be advantageous in a venture capital environment, where the purpose of the loan is to facilitate the growth of the business in anticipation of a sale.
Just ahead of that sale, the option to convert the note to ownership can be exercised. Since UBTI only applies to operating income and not to a gain on sale of equity in a business, the IRA can then reap a benefit if the business plan succeeds, without any significant exposure to taxation on UBTI.
Being the Bank Can be a Good Thing
For those investors with the right connections and the ability to analyze lending opportunities, lending to businesses can be a great way to diversify and create consistent, predictable returns.
Business lending is also a type of investment that can provide the personal satisfaction of investing locally and helping the success of others in your community.