How to Invest A Roth IRA In Early Stage Growth Companies Without Violating Prohibited Transaction Rules

For ambitious individuals with an entrepreneurial mindset, the potential to create wealth and generate investment returns through starting and growing a business is unmatched. However, when it comes to rapidly growing businesses, substantial taxation on that growth can become a concern when they are eventually sold. This is where retirement account assets, acting as legal tax shelters, come into play, and the question arises: "How can I shift some of the value of my fast-growing business into my retirement account?" or even better, "Can I use my tax-free Roth IRA to invest in early-stage growth companies?" As highlighted in a recent ProPublica article about Peter Thiel's early investments in PayPal and Facebook, which helped him create a whopping $5 billion Roth IRA. While Roth IRAs can own shares of stocks, including privately held companies, there are limitations on who an IRA can buy shares from and who can benefit from IRA-owned companies, governed by the "Prohibited Transaction" rules. These rules restrict an individual from using their (Roth) IRA to engage in certain transactions with specific "Disqualified Persons." Violating these rules leads to the entire IRA being deemed distributed, causing a forced liquidation of the retirement account and the forfeiture of its tax-preferenced status. Among the Prohibited Transaction rules outlined in IRC Section 4975, IRAs are prohibited from buying/selling property to/from, lending/borrowing to/from, or furnishing/receiving goods, services, or facilities to/from a Disqualified Person. Furthermore, Disqualified Persons are not allowed to use IRA assets for their personal benefit. When a Disqualified Person is also a fiduciary, they must avoid dealing with the income or assets of an IRA for their own account, or in general, receiving any consideration from the IRA. An IRA owner is always considered a Disqualified Person and fiduciary with respect to their own IRA. Other Disqualified Persons, in relation to an individual's IRA, include the individual's spouse, ancestors, lineal descendants, and any spouse of a lineal descendant. If the IRA owner, along with these related Disqualified Persons, owns 50% or more of a business, the business itself becomes a Disqualified Person, along with its officers, directors (and persons with similar responsibilities), 10% or greater owners, and employees earning 10% or more of its total wages. These rules create challenges for Roth IRAs seeking to invest in early-stage growth businesses. To invest in such companies, an IRA must have someone other than the IRA owner or their family members to buy the shares from, as they cannot be directly contributed to the IRA. Consequently, businesses fully owned by the founder and/or their family members become ineligible to be purchased inside an IRA. Even if the business is not fully owned by Disqualified Persons, if the IRA owner (and other family members) own 50% or more of all shares, the business cannot issue new shares to the IRA and must find other non Disqualified Persons to buy from. However, even in such cases, there is a risk of scrutiny by the IRS under the self-dealing rules for IRAs. A viable option for entrepreneurs who want to start a new business owned by an IRA is to achieve 100% IRA ownership. Before the formation and capitalization of a company, it has no owners, and thus, it cannot yet be a Disqualified Person. As a result, an IRA can own 100% of a new business by issuing shares/interests directly to the individual's IRA. Even in cases where a business is partially owned by an IRA, entrepreneurs must be cautious regarding their compensation. If a business is owned 50% or more by an IRA, "control" essentially always exists, either directly or indirectly, and the individual should avoid receiving compensation personally to avoid violating the self dealing rules for IRAs. Although an IRA owner can perform certain administrative and decision-making duties for an IRA-owned business, they cannot do the actual work of the business. In conclusion, IRAs can be used to invest in private, non-publicly traded companies, but the Prohibited Transaction rules significantly restrict the purchasing process, compensation for the entrepreneur, and the contribution of sweat equity to an IRA-owned company. Navigating these rules is essential due to the harsh tax consequences associated with violating them. Although IRAs are powerful tax shelters, strict compliance with the various rules is necessary to reap their benefits fully.

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