The good news is that you can you use a Self-Directed IRA or other self-directed retirement plan (e.g. 401k) and invest it in a new or existing business or franchise. You cannot invest in a business in which you already have an ownership interest, but all other businesses are generally fair game. You can use your retirement funds without being taxed on the funds (except where an IRA is used to own the LLC – see below). The use of the funds would be considered an investment, not a withdrawal. This means that there are no early-withdrawal taxes or penalties. However, there are some plans and structures that work better than others for this purpose. These are examined below.
Using an LLC Owned by a Self-Directed IRA
Under this structure the Self-Directed IRA would form and own an LLC. The LLC would then use the funds from the IRA to purchase or invest in a business.
The main advantage is that the self-directed IRA provides a nontaxable source of funds. You can access your retirement funds without paying interest on borrowed funds if funds outside of retirement are insufficient. Also using an IRA is less complex and less expensive to establish and operate than a 401k plan.
Using the IRA to own the LLC, the LLC would incur UBTI on the operation of the business and the UBTI would be passed on to the Self-Directed IRA. The taxation of the income at the IRA level would off-set any tax-exempt advantage an IRA would normally have. Note: this tax does NOT apply to LLCs that hold property for investment or rental purposes (except if the level of activity meets the standard of operating a trade or business).
In addition, the owner of the Self-Directed IRA cannot take an active role in managing the business and cannot receive any compensation for managing the business (either one of these actions would constitute a “prohibited transaction’). So, if a salary is needed by the owner of the Self-Directed IRA, this structure would not meet the Self-Directed IRA owner’s needs. Moreover, even if the owner of the IRA did not receive any compensation, the mere fact of managing the business could also give rise to the need to report the transaction as a “listed transaction” and file Form 8886.
Using a C Corporation Owned by a Self-Directed IRA
Under this structure, the Self-Directed IRA would form a C corporation instead of an LLC. The IRA would then fund the C Corporation and the Corporation would invest in an existing or new business. A C Corporation is an entity established under state law (just like an LLC), but the major difference is that it is taxable as a separate entity. As such income earned by the corporation is taxable at the corporate level and taxed again when the income is distributed to the owners (shareholders) of the corporation.
As with an LLC owned by a Self-Directed IRA, you can access your retirement funds if funds outside of retirement are insufficient to invest in or purchase a business. There are two major advantages to this structure. The first is that by virtue of using a C corporation you avoid the UBTI. Since the C Corporation is taxed as a separate entity, the status of the IRA as an owner does not affect the tax treatment at the corporate level. The second is distributions to the C Corporation as dividends are not taxable to the IRA when received as the IRA is a tax-exempt structure.
Because of rules governing IRAs, a C corporation owned by a Self-Directed IRA still could not pay an owner of the IRA a salary or other compensation. Such a payment would be a Prohibited Transaction. In addition, a C Corporation has more formalities that must be adhered to than an LLC such as the requirements to create and maintain minutes and other records.
Using a 401K Plan Rather Than an IRA
Under this structure a 401k plan is used to own the entity rather than an IRA. In addition, a C Corporation is established rather than LLC and the C Corporation is owned by the 401k Plan. The prospective business owner then rolls all or part of their existing and eligible retirement funds (funds from either a former employer plan, an IRA, or 403b plan) into the new 401(k) plan. This 401(k) plan in turn invests in the stock of the new corporation. The corporation, now flush with funds, acquires a small business or franchise on behalf of the 401(k) plan.
If an investment in a new or existing business is what is intended as investment with retirement funds, this is probably the best structure to use for the reasons set forth below.
- It can be difficult and expensive to acquire capital for a new business or to buy an existing business. With this approach the aspiring entrepreneur can use his or her existing funds to buy the business and not have to borrow funds and pay interest on the loan.
- The owner of the 401k Plan can pay him or herself a salary without violating the Prohibited Transactions rules. In fact, payment of a “reasonable salary” may be required.
- If the new company has employees, the business now can also offer participation in the company’s 401(k) plan to his/her employees.
- You do not need a Custodian. The funds are held in a trust established for the 401k plan.
- Profits (what’s left after payment of expenses and the entrepreneur’s salary) is paid tax-free to the 401k plan as dividends.
- High contribution limits for future contributions to the plan (for 2018 you can contribute up to $18,500 in employee deferrals (the 401k feature), and age 50 or older you can make 401k contributions up to $24,500. If you combine the 401k with a profit-sharing feature, “employer” contributions can be made, which when combined with the 401k contributions an amount in contributions, up to $55,000 (or $61,000 if over 50) can be made.
- The cost of establishing the structure is higher (from $1,500 to $4,000) and annual ongoing costs are about $500 to $1,500 a year.
- It only makes sense if at least $50,000 is to be invested.
- Operation of 401k plans are more complex and tax and legal compliance can be more difficult. You will need professional tax and legal guidance to ensure compliance.
The attorneys at the law firm affiliated with IRA Village (irataxlawyers.com) are skilled and experienced in advising you on any of the above approaches to using your retirement funds to purchase or invest in a business. And if you decide to pursue this approach you can use their knowledge and expertise to successfully guide you through all the steps from forming the plans and entity to operating the plan – all to ensure you begin and stay in compliance with applicable laws.