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Self-Directed IRAs: An Untapped Source of Capital for Start-Up Entrepreneurs

NEW YORK (MainStreet)—Raising capital for a new business venture is not always easy – and certainly has not become easier in the last few years. The entrepreneur's business idea may be an exciting one, with tremendous upside potential. Nevertheless, traditional banks will likely shy away, especially initially, when the business has no track record and the person seeking the capital does not have the sort of personal wealth to offer an ironclad guaranty.

Likewise, competing for venture capital funds of "angels" will typically involve a lot of time and expense just gearing up for the presentation. The competition will be stiff. Even if the funds are obtained, the conditions may be severe. Often, tight controls are imposed on the deployment and reinvestment of venture capital. The entrepreneur may have to contend with heavy-handed oversight of day-to-day management and intrusion into overall governance. Indeed, the standard venture capital route carries with it the not inconsiderable risk that the entrepreneur will be eventually shunted aside if things go well or that the business will be forced to shut down prematurely if targets are not met.

Obviously, the public markets for raising the necessary capital will not be a viable option. So what is the start-up entrepreneur to do? One option that is too often overlooked, but might provide the perfect solution is the self-directed IRA. In other words, the IRAs of certain family members, friends, business associates, and other persons already seeking to invest IRA funds in a start-up may, in the aggregate, represent a substantial pool of readily available capital. An appealing pitch can be made to these potential investors.

The traditional IRA is invested by brokers and other investment managers in exchange-traded assets and funds. However, there is no requirement under the law that this be the case. Other than prohibitions regarding a few categories of assets, such as life insurance, collectibles, and interests in Subchapter S corporations, the IRA owner has a wide variety of alternative investments that can be made. One such option is a private placement acquisition of shares or units in a start-up company. Any dividend distributions received by the IRA will be tax-free. Upon ultimate disposition by the IRA of what, hopefully, will prove a hugely successful investment, the gain distributed in exchange for its interest will also escape taxation. The reinvested proceeds from the disposition will build in the IRA with the benefits of deferral and without the drag of income taxation. Ultimately, the time will come for distribution to the IRA owner or the owner's successor beneficiaries. Here is where Roth IRAs prove particularly appealing for investing—whether they are voluntary or mandatory, the distributions from the IRA will be entirely tax free.

As with any investment there are tax considerations, including some major pitfalls that must be avoided. For example, IRA ownership of an interest in a pass-through entity such as an LLC or partnership may result in unrelated business income tax ("UBIT"). Because the IRA is tax-exempt, there are also certain prohibited transactions, essentially transactions between the IRA and the IRA owner, the IRA owner's spouse, ancestors, or descendants. Nevertheless, that still leaves siblings, other relatives, friends, and business associates and acquaintances as potential investors. Even with permissible investors, great care must always be exercised to avoid conflict of interest situations and to maintain arm's length distance between the IRA and the persons mentioned.

Assuming that the tax and Department of Labor rules and regulations are scrupulously observed, the potential investor might still wonder – isn't this a pretty risky deployment of my retirement funds? Very possibly not. Obviously, asking someone to risk his or her entire IRA on a start-up is, in almost every instance, not likely to fly. Nor should it! It would be a high-risk move that should not be recommended. But as a component of a diversified IRA portfolio, ownership of stock or other interest in a promising start-up may be easily justified and have real appeal. The experience of the past several years suggests a very difficult investment environment. In the case of public equities, it has been a real roller coaster ride. Many other interest-based investments have shown meager returns.

But isn't any start-up a pretty risky investment for an IRA? Well, that depends. Fundamentally, most investors rely on investment advisors to invest their assets. As almost any investor will testify, the results can be mixed at best. With a self-directed IRA, the investor is essentially taking a piece of the IRA and saying, "let me handle this part." Acting for his or her own benefit, the diligent investor will be able to get to know personally all there is to know about the start-up, the market niche, and the entrepreneur(s) who have conceived the business plan and will be running the operation. Importantly, the investment in the start-up can safely be a percentage of the overall IRA portfolio that is substantially less than the entire portfolio. It can bring true diversification to the portfolio and, potentially, an asset that does not necessarily track public market cycles.

So let's assume that an individual investor is persuaded to invest a portion of his or her IRA in our entrepreneur's start-up. Can the investor hold title to shares or other ownership interests directly? The answer is "No." Unlike a 401k, in which the business owner can serve as trustee of the plan, in the case of an IRA there must be an independent custodian. Any number of trust companies specialize in providing this service. Because the custodian is not actually doing the investing, the fees charged tend to be quite reasonable. In addition, the custodian handles all the administrative and compliance aspects of the investment.

For the serious start-up entrepreneur, self-directed IRAs represent a source of capital that to date remains underutilized. For the IRA owner tired of the tepid and/or cyclical returns of an IRA funded exclusively with traditional investments, using a self-directed IRA to invest in a promising start-up may prove just the right move.

No doubt, the start-up entrepreneur will wish to invest in his or her concept as well. Unlike the outside investor, the start-up entrepreneur will be more prepared to risk a greater portion of the IRA on his or her "dream." But here is where a heavy dose of caution is in order. The fact is that the prohibited transaction rules previously mentioned are so complex and ambiguous that an inadvertent violation can easily occur. This is not to say that the investment in the start-up by the entrepreneur must be avoided at all costs. Rather, it should not be undertaken without the guidance of a professional who is expert in the tax and Department of Labor regulations and rulings. Obviously, compliance costs associated with any such investment will reduce the benefits of the self-directed IRA. Note should also be taken that the same risks and complexities must be considered whenever the owner or certain related persons invest his or her own funds in the same enterprise as the IRA, engage in a loan transaction with, or are compensated for services by the enterprise.

--Written by Theresa Fette, CEO of Provident Trust, for MainStreet

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