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Investing in Businesses

We receive a lot of phone calls each month from individuals wanting to invest in a business.  The very first thing we ask is; “your own business or someone else’s business?”

Both approaches are possible, but require very different plan structures in order to preserve the tax-sheltered status of your retirement funds.

Let’s take a big picture look at these two very different approaches.

Investing in Yourself

organized finance planIRS rules prohibit an IRA or Solo 401(k) from engaging in any self-dealing or dealing with disqualified parties.  You and close family, or family held businesses are disqualified to your IRA, and as such a conventional self-directed IRA or Solo 401(k) may not invest in your business.

For investing in a business in which you will be directly involved, you must use the Business Funding IRA approach.

With this plan type, you can use existing tax-deferred retirement savings to capitalize your business while remaining in compliance with the provisions of the tax code.  There are no taxes or penalties for using retirement funds in your current IRA or 401(k) to fund your business, but the business itself will operate in the taxable realm. The retirement plan becomes a shareholder of your corporation.

The Business Funding IRA is more than an IRA.  It is a specially constructed union of a subchapter C corporation, a qualified 401(k) or Profit Sharing Plan, and an employee stock option purchase (ESOP) of parent company shares via the retirement plan.

For more information, see our Business Funding IRA page.

Investing in Other People’s Businesses

You can use a self-directed IRA or Solo 401(k) to invest in a business owned and operated by someone who is not a disqualified party.  In this case, your plan is simply an investor in that unrelated party’s business.

When investing in privately held business, there are several factors to consider to ensure the investment will both be compliant with the IRS rules and tax-favorable to your self-directed IRA plan.

Avoiding Disqualified Parties

It is important to ensure that your IRA is not dealing with disqualified parties when investing in closely held businesses.

If the team leading the business includes one or more disqualified parties to your IRA, then your IRA may not be able to participate. Disqualified parties include you as the account holder, lineal family like parents/children, as well as fiduciaries to your account or a business/joint venture partner.

S Corporations are not Suitable

S Corporations are restricted to having US citizens and certain forms of trusts and estates as shareholders.  An IRA or 401(k) plan may not be a S Corporation shareholder.

Will UBIT Apply?

taxes paperworkUnrelated Business Income Tax (UBIT) applies when a tax-exempt entity is engaging in or receiving the un-taxed profits from a trade or business activity.  The purpose of this tax is to protect tax-paying businesses from unfair completion stemming from tax-exempt entities when they act like a commercial enterprise.

If your IRA is investing in the stock of a C Corporation, then UBIT is not a concern. The business income will be taxed at the corporation level before income is issued to the IRA as tax-sheltered dividends.  This is much like investing in the stocks of publicly traded companies.

If your IRA is investing in a pass-through entity such as a sole-proprietorship, LLP or LLC, then taxes are not paid at the entity level and the tax liability flows to the owners. If the income producing activity of the business is a product or service, then the IRA will likely be subject to UBIT. If the nature of the income produced by the entity is passive, such as rent from real property, royalties, or interest, then UBIT will not apply. So, investing in a LLC that operates a restaurant will have UBIT exposure. Investing in a partnership that owns an apartment complex for rental will not.

UBIT is not Always a Deal Killer

Exposure to UBIT is not a universal reason to avoid an investment.  Whether such an investment may make sense depends on the scale of UBIT and where the return is generated.

If operating income is the “prize” then UBIT will likely spoil the party. UBIT is taxed to the IRA at trust rates, which can be as high as 39.6%.  Since this is a higher tax rate than you would pay personally on the same income, it probably does not make sense to use IRA dollars for such a venture.

In a true venture capital play, the “prize” is the eventual sale of your IRA’s stake business at a higher price when the venture is sold or goes public. Only operating income is subject to UBIT, not the gain in equity value.  While there may be a UBIT component to the investment, it may not be significant.  The start-up phase is not always profitable, and there may even be losses in the early goings that would offset UBIT exposure in future profitable years.  When the business hits the next level and you get to sell the shares your IRA purchased for $100 each at a price of $500, $1,000 or more, that gain in equity value is not taxed.  Investing with IRA or 401(k) funds into such an opportunity can make a lot of sense.

In Summary

If you have an interest in using retirement funds to capitalize your own business or take a stake in someone else’s business venture, please feel free to Contact Us.  There are a lot of factors to consider and we can help by educating you so you can ask the right questions before deciding whether the use of retirement funds will be appropriate.

Disclosures

As with any investment, there is risk associated with investing in closely held businesses.  Before investing, you should ensure you have the acumen and experience to gauge and understand the risks and perform the necessary diligence required for such ventures.

Safeguard Advisors, LLC is not an investment advisor or provider, and does not recommend any specific investment.  We provide properly structured self-directed retirement plan platforms that provide you as the investor with full control over investment decisions.  The information above is educational in nature, and is not intended to be, nor should it be construed as providing tax, legal or investment advice.