Can an investor make an investment in a startup through an IRA?
The short answer to this question is yes, but (and there almost always seems to be a “but”) doing so could result in taxes and penalties if the investment is deemed a “prohibited transaction.”
It is not uncommon for a startup founder or a founder’s family member to want to invest in a startup using assets from an individual retirement account (IRA). Prior to doing so, however, the founder or family member must determine whether making the investment with funds from an IRA would be a prohibited transaction in order to avoid adverse tax consequences.1
What Is a Prohibited Transaction?
The use of the assets of an IRA, including a ROTH IRA, to make an investment in a private company can result in what the IRS refers to as a prohibited transaction under the Internal Revenue Code (the Code).2 A prohibited transaction generally arises if there is a transaction between an IRA and a disqualified person.
Specific examples of prohibited transactions include:
- Selling or exchanging property between an IRA and a “disqualified person” (more on this term below);
- Lending money or extending credit between an IRA and a disqualified person;
- Furnishing goods or services between an IRA and a disqualified person;
- Transferring to or allowing the use by or for the benefit of a disqualified person of the IRA assets;
- An act by a fiduciary whereby the fiduciary deals with the IRA assets in its own interest or for its own account (including the use of authority by a fiduciary to enter into a transaction where the fiduciary has an interest which may affect its best judgment as a fiduciary); or
- Receiving any consideration for the personal account of a fiduciary from any party dealing with an IRA in connection with a transaction involving the IRA assets.
Who Is a Disqualified Person With Respect to an IRA?
The IRS considers each of the following a disqualified person:
- An IRA fiduciary which includes an IRA owner who directs the investment of his/her IRA;
- A person providing services to the IRA (“service provider”);
- A family member (spouse, ancestor, lineal descendant, or spouse of lineal descendant) of an IRA fiduciary or a service provider;
- A corporation, partnership, trust, or estate of which 50 percent or more of the stock, capital or profits interest, or beneficial interest, respectively, is owned by an IRA fiduciary or a service provider (“50 percent owned entity”); or
- A 10 percent or more capital or profits partner or joint venturer of a 50 percent owned entity.
What Are the Tax Consequences of a Prohibited Transaction?
The Code provides that an IRA ceases to be treated as an IRA if the IRA owner engages in a prohibited transaction. This means the entire IRA is treated as having been distributed so the full value of the IRA becomes taxable to the IRA owner (i.e., no further tax deferral on contributions or earnings) and the 10 percent early withdrawal penalty may apply (e.g., if the IRA owner has not attained age 59½). For a ROTH IRA (where contributions are made on an after-tax basis), the earnings become taxable and the 10 percent penalty may apply.
Under What Circumstances Could a Prohibited Transaction Arise?
Assessing the potential for a prohibited transaction requires a thorough analysis of the facts and circumstances to determine the existence of any disqualified person(s) and whether the transaction falls within a prohibited category. Whether a prohibited transaction will occur is not always obvious, especially if it is not clear whether a conflict of interest exists (or could exist) or whether an IRA owner will receive a benefit from the transaction.
While not laying out bright-line rules, Department of Labor (DOL) Advisory Opinions suggest that under the following circumstances, a prohibited transaction would likely occur:
- The transaction is part of an agreement by which an IRA owner causes IRA assets to be used in a manner designed to benefit the IRA owner (or any person in which the IRA owner has an interest) such that it would affect the exercise of the IRA owner’s best judgment as an IRA fiduciary.
- The IRA owner receives or will receive compensation from the subject company.
- By the terms or nature of the transaction, a conflict of interest exists between the IRA and the IRA owner (or persons in which the IRA owner has an interest).
- The IRA owner will be relying upon or otherwise be dependent upon the IRA investment in order for the IRA owner (or persons in which the IRA owner has an interest) to undertake or to continue the investment (e.g., minimum investment to be satisfied jointly by the IRA and IRA owner).
When Would an IRA Owner Have an Interest That Could Affect the Exercise of the IRA Owner’s Best Judgment as a Fiduciary?
This is important because, as noted above, a transaction that affects the IRA owner’s judgment would be a prohibited transaction. Some factual examples taken from DOL Advisory Opinions include:
- An IRA owner’s officer status with a company may be enough to affect the best judgment of the IRA owner with respect to an investment in the company.
- An IRA owner’s officer status plus 1.17 percent ownership, with his spouse, of an entity might affect best judgment of the IRA fiduciary.
- An IRA owner’s ownership of 46.04 percent of total voting power and 48.14 percent of total shares of a company might affect best judgment of the IRA owner.
- An IRA owner’s employee status plus less than 1 percent ownership of a company would not seem to affect best judgment of the IRA owner.
If the Initial Investment Is Not a Prohibited Transaction, Is There Anything Else to Consider?
Even if the initial investment is not a prohibited transaction, the analysis is not over. The facts could change such that an IRA owner could later develop a conflict of interest that might affect best judgment, resulting in a prohibited transaction, such as if:
- An IRA owner later becomes officer or director of a company that is the subject of the investment.
- An IRA owner later increases its ownership percentage in the subject company.
When Is It Unlikely That a Transaction Will Be Deemed a Prohibited Transaction?
- If the IRA owner is not currently (and is not likely to become) an employee, officer, director, or 10+ percent shareholder of the subject company.
- If the IRA owner is not making the investment to satisfy an obligation imposed by the subject company.
- If the IRA investment plus any non-IRA investment of the IRA owner does not total 50 percent or more of the equity of the subject company.
Even if a transaction is not prohibited under the Code, some other considerations are:
- An IRA investment is not allowed in an S-Corp and IRA investment in a partnership or LLC can raise unrelated business income tax issues.
- The IRA document should be reviewed to determine whether it permits an investment in non-publicly traded stock.
- The IRA custodian should be consulted to confirm the IRA can hold an investment in non-publicly traded stock.
- Some IRA custodians that allow investments in startups through IRAs require the startup to provide an annual valuation of the startup’s shares held by the IRA and certain other information. Most startups do not assign value to preferred stock once it is sold, so this can add to the startup’s administrative burden.
While an infusion of cash is often exactly what a startup needs, care must be taken to ensure that using IRA assets will not trigger a possible prohibited transaction. While the tax consequences apply to the owner of the IRA and not the startup, dealing with an unhappy investor who finds out they owe money for taxes due to an IRA investment they made in a startup is not ever rewarding for the startup.
1 This post does not address a Rollover for Business Startup (ROBS) which involves a startup establishing its own retirement plan into which other retirement plan funds are rolled over and then used to invest in employer stock.
2 Investing assets of a self-directed qualified retirement plan account may raise similar prohibited transaction concerns under the Code and under the Employee Retirement Income Security Act of 1974 (ERISA).