How to Fund Your Business With Self-Directed IRA and 401(k) Money

Do you have a small business or start-up that could use some funding? If so, you're in for some great news!

There's tens of trillions of dollars in retirement plans across the United States. But did you know that these funds can be invested into your business?

IRAs and 401(k)s can be used to invest in startups, private companies, and even real estate.

Most entrepreneurs and retirement account owners have no idea that retirement accounts can invest in private companies. And there's a good reason for that. (More on this later.)

And it's not just anyone who owns these retirement funds, it's EVERYONE! Literally. Have you ever asked anyone to invest in your business with their retirement account?

Probably not.

But why not? How much do you think they have in their IRA or old employer 401(k) and how attached do you think they are to those investments? Think hard on that one.

(The answer is they usually have lots of money and they probably don't even know anything about what it's invested in.)

Those two questions have paved the way for over a billion dollars to be invested in private companies and startups!

This kind of funding isn't as uncommon as you might think. Recent industry surveys show that there are over one million retirement accounts that are self directed. Those accounts invest heavily in private companies, real estate, venture capital, private equity, hedge funds, and start-ups.

How does it work?

So now you want to know how these funds be properly invested into your business. Well, if you ask your CPA or lawyer, the typical response is, “It’s possible, but we wouldn't recommend it.” Which probably means they don't know how.

What about you ask a financial adviser? If you ask a financial adviser, especially your own, they'll tell you it's a bad idea. Most likely because you won't be paying him or her fees like how you do with mutual funds, annuities and stocks.

There are "different" risk in private company or start-up investments, so self directed IRA investors need to be cautious and they shouldn’t invest everything into one private company or start-up. And yes, you will probably need some help regarding the tax and legal issues.

What is a Self Directed IRA?

A self directed IRA is a retirement account that can be invested into any investment allowed by law. In order to invest into a private company, start-up, or small business, the retirement account holder must have a self directed IRA.

If you have an account with a "typical" IRA or 401(k) company, such as Vanguard or Ameritrade, then you can only invest in investments allowed under their platform.

Usually these companies won’t allow your IRA or 401(k) to invest in private companies or start-ups. To do so, you would first need to rollover or transfer the funds to a self directed IRA.

For a detailed list of the companies that provide these types of accounts, check out the (RITA) Retirement Industry Trust Association’s website and membership list. RITA is the leading nationwide association for the self directed retirement plan industry.

How to sell corporation stock or LLC units to Self Directed IRAs

Are you seeking capital for your business in exchange for stock or other equity? You might consider offering shares or units in your company to retirement account owners. And no, you don't have to go public.

Companies who have had individuals with self directed IRAs invest in them before they were publicly traded include: Google, Facebook, PayPal, Domino’s, Sealy and Yelp.

There are many investment options available. Popular ones include:

  • An equity investment purchasing shares or units where the IRA becomes a shareholder
  • Note investment where the IRA becomes a lender.

Note: you must comply with state and federal securities laws when raising money from investors.

What You Need to Know: Prohibited Transactions

One of two important things to be aware of when someone invest their retirement account money into your business relates to what they can and can't invest in (prohibited transactions).

The tax code restricts an IRA or 401(k) from transactions with the account owner personally or with certain family members (parents, spouse, kids).

This is called the prohibited transaction rule. If you own a business personally you can’t have your own IRA or your parents IRA invest into your company to buy your stock or LLC units.

However, family members such as siblings, cousins, aunts and uncles could move their retirement account funds to a self directed IRA to invest in your company. Anyone else can invest into your company without worrying about that rule.Note: If a prohibited transaction occurs, the investors self directed IRA is entirely distributed. Make sure the rules are followed!

What You Need To Know: UBIT Tax

The second thing you need to be aware of is the tax known as Unrelated Business Income tax (UBIT). UBIT is a tax that can apply to an IRA when it receives “business” income. Generally, IRAs and 401(K)s don’t pay tax on the income or gains that go back to the account because they're considered "investment income".

Investment income would include rental income, capital gain income, dividend income from a c-corp, interest income, and royalty income. (e.g. income from a mutual fund).

However, when you go outside of these forms of investment, you may find yourself outside of “investment” income. Which means you might be receiving “business” income that is subject to the extremely costly “unrelated business income tax.”

This tax rate is at 39.6% at $12,000 of taxable income annually last time I checked. That’s steep. You want to make sure you avoid it.

When should an investor anticipate paying UBIT?

The most common situation where a self directed IRA will have to pay UBIT is when the IRA invests into an operational business selling goods or services who does not pay corporate income tax.

Let's say you own a new business that sells goods online, and is organized as an LLC and taxed as a partnership. This is a very common form of private business and taxation, but one that will cause UBIT tax for net profits received by self directed IRA.

On the other hand, if your new business was a c-corporation and paid corporate tax (that’s what c-corps do), then the profits to the self directed IRA would be dividend income, a form of investment income, and UBIT would not apply.

Self directed IRAs should expect that UBIT will apply when they invest into an operational business that is an LLC, but should expect that UBIT will not apply when they invest into an operational business that is a c-corporation.
Note: IRAs can own c-corporation stock, LLC units, LP interest, but they cannot own s-corporation stock.

Are you an LLC wanting to raise capital?

You should have a section in your offering documents that notifies people of potential UBIT tax on their investment. UBIT tax doesn’t your company any additional money or tax. But it will costs the retirement account investor since UBIT is paid by the retirement account.

If the investment from the self directed IRA was via a note or other debt instrument, then the profits to the IRA are simply interest income and that income is always investment income, which is not subject to UBIT tax.

Interestingly, many companies raise capital from IRAs for real estate or equipment purchases. These loans are often secured by the real estate or equipment being purchased and the IRA ends up earning interest income like a private lender.

Recap (because that was a lot!)

So, here’s a brief recap of everything you just read.

  • There’s trillions of dollars in retirement plans across the U.S.
  • These retirement accounts can be used to invest into your private company, start-up or small business.
  • You must comply with the prohibited transaction rules.
  • Anyone can invest into your company, except you & your close family members.
  • Depending on how a company is structured (LLC or C-Corp) & how the investment is designed (equity or debt/loan), there may be UBIT tax.
  • UBIT tax usually arises for IRAs in operating businesses structured as LLCs where the company doesn’t pay a corporate tax on their net profits. This income gets passed down to IRA owners & can cause UBIT tax liability.

The bottom line

Retirement account funds can be a huge source of funding and investment for your business, so it’s worth some time and effort to learn how these funds can be used. Just make sure you follow the rules.

Last Updated: 
November 17, 2017

Scott Royal Smith is an asset protection attorney and long-time real estate investor. He's on a mission to help fellow investors free their time, protect their assets, and create lasting wealth.

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