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With IRA Financial Trust’s Self-Directed IRA, you are permitted to purchase an interest in a privately held business that is engaged in any type of business activity. The business can be established as any entity other than an S corporation (i.e., LLC, C corporation, or partnership) When investing in a private business using Self-Directed IRA funds, it is important to keep in mind the “Disqualified Person” and “Prohibited Transaction” rules under IRC 4975 and the Unrelated Business Taxable Income rules under IRC 512. It is a good idea to consult a retirement tax professional to develop the most tax-efficient structure for using your Self-Directed IRA.

Before electing to invest in a private business with a Self-Directed IRA, it is important to consider the application of the IRS prohibited transaction rules and the Unrelated Business Taxable Income (UBTI or UBIT) rules.

The IRS Prohibited Transaction Rules

In order to avoid triggering the prohibited-transaction rules when making investments into a private business, you should be careful to not invest any retirement funds in any business in which you have a direct or indirect benefit in, including ownership, serving as officer or manager, and even being an employee in some cases.

Certainly, using a Self-Directed IRA to invest in a friend’s private business—so long as you have no involvement in it and the investment is 100 percent passive—would not violate the IRS prohibited-transaction rules.
But what about a private company in which you already own a small percentage or are an employee of? Would that violate the IRS prohibited-transaction rules? Unfortunately, there is no clear answer to this and you must examine the facts and circumstances in relation to the prohibited-transaction rules under IRC 4975 to see if a prohibited transaction would occur. Even if you own less than 50 percent of the private business and on its face the entity does not seem to be a disqualified person under IRC 4975, the self-dealing and conflict-of-interest prohibited-transaction rules could still trigger a prohibited transaction.
It is highly advisable to consult with a tax attorney or tax professional, specifically one with a strong understanding of the IRS prohibited transaction rules, before using a Self-Directed IRA to invest in a private business.

The Unrelated Business Taxable Income Rules

One of the advantages of using retirement funds through a Self-Directed IRA to make investments is that, in most cases, all income and gains from the investments flow back to your Self-Directed IRA without tax. This is because a Self-Directed IRA is exempt from tax, pursuant to Internal Revenue Code 408. Pursuant to Internal Revenue Code 512, most of the popular forms of income generated by a retirement income will be exempt from tax. This is why most American investors look at you funny when you start telling them about the Unrelated Business Taxable Income (UBTI) rules.

History behind the UBTI rules

The IRS enacted a set of rules in the 1950s to prevent businesses from creating charities and then engaging in active trade or business via the charity to gain an unfair advantage through their tax-exempt status. The IRS did not want a for-profit company like McDonalds setting up a charity and running its business through that charity to generate tax-free profits. These rules, found in IRC 511–514, have become known as the UBTI rules. When UBTI rules are triggered, the income generated from those activities are generally subject to a maximum tax rate of 40 percent.

The good thing about the UBTI rules is that they won’t apply to over 90 percent of American retirement investors because most types of income and gains generated by a retirement account are exempt. The Internal Revenue Code exempts dividends, interest, capital gains, royalties, and rental income from being subject to the UBTI tax rules. In general, the UBTI tax is essentially triggered in three main types of Self-Directed IRA investments:

  1. Investing in an active trade or business via a pass-through entity, such as an LLC
  2. Using margin when buying stock
  3. Using a Nonrecourse Loan to buy real estate

Putting it all together

With the IRA Financial Trust you will be able to use your retirement funds to make private business investments. It is important to keep in mind the IRS prohibited transaction rules and the potential application of the UBTI rules if the business will be operating through a pass-through entity, such as LLC or partnership (a C Corporation will not trigger the UBTI tax rules).

It is highly advisable to consult with a tax attorney or tax professional, specifically one with a strong understanding of the IRS prohibited transaction rules, before using a Self-Directed IRA to invest in a private business.

To learn more about using a Self-Directed IRA to invest in a business, please contact a Self-Directed retirement expert at 1-800-472-1043.