Using an IRA to Invest in a Closely-Held Business

We are often asked about using an individual retirement account (IRA) to purchase an interest in a closely-held business, whether that business is a corporation or a limited liability company (LLC).  This is a rather natural question for people to think about because when someone needs a fairly large sum of money for such an investment, he or she will think about that nest egg that is sitting in an IRA.

There are two fairly typical types of investments that people want to make with their IRAs.  One is the purchase of an interest in a business in which he or she will be employed.  The other is the purchase of an interest in a business that will own investment property, such as real estate.  Both scenarios share issues that need to be considered when deciding if that approach makes sense.

Before considering using an IRA to purchase an interest in a closely-held company, remember that the purpose of an IRA, and the reason it is given favorable tax treatment, is to provide a means of accumulating assets for your retirement.  That is important because the laws that apply to IRAs (and there are many of them) are based upon that proposition.  A more direct way of looking at this is that you are not permitted to use the assets of an IRA to benefit yourself or your family prior to retirement.

Let’s start with the proposition that an IRA is permitted by law to purchase stock of a corporation (except for an “S-corporation”) or a membership interest in an LLC.  So the answer to the question “may I do this” is a definite “yes.”  But running out and buying that stock or that LLC interest without analyzing the transaction a bit further is dangerous.

There are some fundamental rules that apply to any IRA.  One is that the owner of the IRA and his or her family members (e.g., spouse, parents, grandparents, children, grandchildren, spouses of children and grandchildren, entities owned by more than 50% of those individuals, and trusts under which those individuals have at least 50% beneficial interest), may not transact business with the IRA.  “Transacting business” means things such as selling or leasing property, lending money, furnishing goods and services, and transferring or using income or assets of the IRA.  Examples include the owner of the IRA (or one of the family members mentioned above) guaranteeing a bank loan to the IRA, a company owned by the owner of the IRA (and/or those family members) leasing property owned by the IRA, and the IRA owner (and/or those family members) using/renting a beach-front rental property owned by the IRA.  Keep in mind the proposition mentioned above: “You are not permitted to use the assets of an IRA to benefit yourself or your family prior to retirement.”  If you keep this in mind whenever you think about purchasing investment property using an IRA, you will be well on your way to making good decisions.

It would be bad enough if only one governmental agency issued these rules concerning IRAs.  Unfortunately there are two.  The IRS and the Department of Labor each has many regulations concerning retirement plans, including IRAs.  The rules are very much the same, but they are enforced separately.  So you can get into trouble with each agency for taking the same prohibited actions.

We will first look at how all of this applies to purchasing a business that will own investment property, such as rental property.  I will not go into all of the things that you should not do.  That would require a tome the size of War and Peace.  Instead, let’s look at a way of accomplishing such a transaction in a relatively safe manner.

The first thing that you need to know is that not all IRA custodians will participate in owner-directed investments in investments such as real estate and closely-held companies.  So you will need to find the appropriate custodian.  After you have accomplished that, you will need to rollover assets from a qualified plan or another IRA to that custodian.  I believe that you should only rollover sufficient funds to accomplish the transaction in question.  By keeping each transaction in a separate IRA, you minimize the damage that may be done if you do end up disqualifying the IRA because of any actions that you take that are determined to violate the applicable rules.

Once the cooperative IRA custodian has the funds, you can direct the custodian to purchase the business interest.  You may negotiate the terms, but the custodian should execute all associated documents and must take title to the ownership interest.

After the  business is acquired, it is important for the IRA owner and his or her family not to get involved with operating the business or transacting business with it.  The custodian should hire a manager for the business who, in the case of a real estate business, will be responsible for renting and maintaining the property.

The trap for some people who want to use an IRA to purchase investment property is that they think they can be involved in operating and maintaining the assets of the business in order to save money.  That kind of involvement, however, can violate the rules that prohibit IRA owners from currently benefiting from or transacting business with the IRA.

The other way that some people want to use IRA money is to purchase an interest in a company that he or she will control/operate and or for which he or she will work for compensation.  In other words, the person sees a great opportunity to buy an Arby’s franchise and the only source of funds for making that acquisition is in his or her IRA.  This type of transaction is especially fraught with danger.  At the risk of being repetitively redundant, “You are not permitted to use the assets of an IRA to benefit yourself or your family prior to retirement.”  If the purpose of the acquisition by the IRA is to secure a current job and income, then you may well be violating that rule.  If you own a minority interest in the company and have no management or operational control, you may be on safer ground.  But to the extent you are pulling the strings, you are putting yourself into a position of making decisions about what is the best interests of the company (and you) today and how you can ensure that you continue to feed your family today.  That position is contrary to the responsibility that the owner of a self-directed IRA has to protect the interests of the beneficiary of the IRA (you) upon retirement.

You might be wondering what the downside is of attempting, and failing, to properly use an IRA to purchase an interest in a closely-held company.  To the extent that you violate the rules discussed above, the IRS may conclude that the IRA is not a proper tax-favored vehicle and should, in essence, be treated as a bank account.  That means that the IRA assets used to purchase the interest in the company will be deemed to have been distributed to you in the year of acquisition and you will be liable for the income taxes owing on that deemed distribution, as well as income earned by the IRA in subsequent years.  If you are not yet age 59-1/2 at the time of the deemed distribution, an additional 10% early withdrawal penalty will be owing.

The proverbial bottom line on all of this is that using a self-directed IRA to acquire a closely-held company can be a good way to invest the IRA assets.  But it must be done properly and in compliance with the applicable rules.  We will be happy to discuss this with you further if you have questions or would like more information.

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