Investing in crowdfunding opportunities is a popular way for self-directed IRA and Solo 401(k) holders to diversify. The concept of crowdfunding has been around for a long time and is essentially raising capital for a venture by securing small amounts of capital from a large number of investors. With the passage of the JOBS act in 2011, and final SEC rules effective in early 2016, it became much simpler for businesses to pursue such a funding strategy. The rules enable businesses to solicit such investments from the public without the full level of regulatory requirements associated with a public stock offering or other forms of securities. There are now hundreds of crowdfunding platforms offering such investments.
Kinds of Crowdfunds
Crowdfunding opportunities abound in wide variety. There are online platforms specifically tailored to offer one or more fund opportunities associated with new product development, real estate, motion picture production and more. There are also standalone ventures that go directly to investors rather than through a platform.
There are 3 basic types of categories of funds, only one of which is beneficial for an investor using retirement funds.
- Donation funds generally seek small amounts of capital with no promise of return to the investor. These feel-good opportunities are not appropriate for an IRA or 401(k).
- Reward funds attract investors by offering early access to the resulting product of the venture. This is also an unsuitable type of investment for an IRA, as you could not personally use the resulting product and the IRA probably does not have a need for some new invention.
- Equity based funds are appropriate for retirement investing, and offer a ownership stake in the funded venture.
The Appeal of Crowdfunds
There are several advantages of investing in crowdfunds, including:
- One can typically participate with limited capital
- It is easy to diversify by investing in multiple funds
- Easy to manage
- Potentially good return on investment
- Leveraging the expertise of experts in a field
Before investing in a crowdfunded venture with your self-directed IRA plan, you will want to consider the following questions.
Is Accreditation Required?
Some funds are open only to accredited investors. Your self-directed retirement plan is viewed as accredited if you personally meet the annual income or net worth requirements associated with accredited status. If you are not accredited, your plan will not be able to participate.
Is Leverage Used?
Some funds may use investor capital as well as some form of debt-financing. This may create exposure to taxation on Unrelated Debt-Financed Income (UDFI). Basically, when a tax-exempt entity like an IRA or 401(k) plan is using borrowed – non-plan – capital as a lever to accelerate growth, this tax applies to the percentage of the gains the plan receives from the borrowed funds.
So, if an investment is 60% debt-financed, 60% of the income the IRA or 401(k) receives is considered taxable. 60% of any applicable deductions would then be used to reduce the taxable income amount.
IRA plans are subject to UDFI taxation in all debt-financing scenarios. Solo 401(k) plans are exempted from UDFI taxation when the debt instrument is used for the acquisition of real property. Other forms of debt-financing would expose a 401(k) plan to UDFI taxation.
If there will be UDFI exposure you should review the investment with your licensed tax advisor to gauge the impact. In some cases, the after-tax return on investment may still be quite worthwhile.
Will UBIT Apply?
If the underlying income producing activities of a venture are considered a trade or business, then an IRA or Solo 401(k) could have exposure to Unrelated Business Income Tax. Determining whether UBIT applies can be complicated as there are many variables. If a venture is a C-Corporation and investors own shares and received dividends, this is passive income not subject to taxation. If a funded entity is a pass-through such as a LLP or LLC, and produces income from providing a product or service, then an IRA investor could have exposure to UBIT on the operating income received.
Funds Typically Not Subject to UBIT
- Entities formed as subchapter C corporations where investors are shareholders. Corporate dividends are passive income to a retirement plan.
- Entities holding property to produce rental income.
- Entities that produce revenue through interest, dividend, or royalty arrangements, such as funds for investing in mortgages, commercial debt, etc.
Funds Typically Subject To UBIT
- Real Estate funds engaging in new construction or rehab of properties for immediate sale.
- Direct equity in a business that offers a product or service, if the business is not a C Corporation and therefore passes-though its earnings to stakeholders.
- Funds engaging in some form of dealer activity – buying and reselling.
Investing in crowdfunds can be a very hand’s off way to step into solid deals and leverage the expertise of professionals in a field. If you have an opportunity for such investments and want to discuss whether the use of IRA or 401(k) funds may be appropriate, please feel free to contact us.
As with any investment, there is risk associated with investing in crowdfunds. Before investing, you should ensure you have the investing experience to understand the risks associated with such investments 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.