If you own a business or are thinking of starting one, raising capital continues to be key challenge. Lending requirements remain stringent, home equity is no longer a quick source of cash and equity investors continue to be very selective.
At the same time, the Investment Company Institute, the national association of investment companies, estimates that there are over $4.2 trillion in assets being held in Individual Retirement Accounts (IRAs). Many business owners and entrepreneurs are frustrated by the anemic returns they are earning on their IRA investments while at the same time lamenting their inability to raise money. There is a way to investment IRA assets penalty-free in your business: The self-directed IRA.
What is a self-directed IRA?
With non-self-directed IRAs, investment choices are limited to the options provided by the financial institution where the IRA is held. Typically these options include an assortment of stocks, bonds, mutual funds, exchange-traded funds, money market instruments and cash. The self-directed IRA allows you to go beyond that and invest in any investment type permitted by the IRS. This opens the door to IRA investments in real estate, franchises, private equity or even your own company.
The IRS does prohibit using self-directed IRAs to invest in collectibles, life insurance or what they term “prohibited transactions with disqualified persons”. Additionally, if you plan to invest in real estate, it has to be truly an investment property. You can’t use a self-directed IRA to buy your primary residence for example.
Funding your business from a self-directed IRA
A common method of setting up self-directed IRAs for entrepreneurs is as follows:
1. Establish a self-directed IRA, adhering to all of the necessary requirements and working with an experienced administrator and custodian.
2. Execute a roll over from the existing IRA, 401(k), 403(b) or Keogh, to the self-directed IRA.
3. Establish a Limited Liability Company (LLC) to be managed by the IRA’s owner. This is the legal entity for your business.
4. Execute the purchase of membership units in the LLC by the self-directed IRA using the funds in the self-directed IRA.
By structuring the investment in this way, the owner is able to use the money in their IRA to fund their business without taking an early withdrawal which would trigger taxes and penalties. The LLC can also borrow money, thereby using leverage to enhance returns. It also minimizes the number of transactions that need to be executed by the trustee, lowering the overall cost of owning a self-directed IRA.
Get help setting up a self-directed IRA
The IRS is vigilant with regards to self-direct IRAs. If you make a mistake with the setup or management of the account, the consequences could be expensive in terms of taxes and penalties. The regulations also require the use of a custodian to hold the assets. There are a number of firms around the country that offer self-directed IRA setup, administration and custodial services. They typically charge a low annual fee and a per transaction fee. Make sure you go with a firm that has setup at least several hundred self-directed IRAs, manages significant amounts of assets (over $100 million) and meets all IRS requirements. As with any decision that involves accounting and taxes, consult with your accountant and your lawyer before taking action.
Mike Periu is the founder of EcoFin Media, LLC an independent producer of financial, economic and entrepreneurial content for television, radio, print and the internet. Over the past ten years he has started three companies and advised over 50 companies on financial strategies including fundraising. Mike also hosts regular small business webinars on a range of topics relevant to business owners.