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.