Posted Sunday, October 22, 2023
Since this chapter is about unique or custom entity structures, there’s no better place to talk about self-directed IRAs. What the heck is a self-directed IRA? Just because you make investment choices within your retirement accounts, does not mean they are self-directed. Sure, in a practical sense they are. But a self-directed IRA in the context of this section is about a very specific investment vehicle.
Why would you consider this option? Let’s assume that you want to invest into rental properties (which is a great augmenting retirement strategy by the way… we are huge fans), but all your money is tied up in an IRA. You are 50 years old and can’t touch it without penalty. The bank won’t let you borrow against it. You might be hosed.
However, if you set up a self-directed IRA and roll your existing IRA into it, you can have the IRA invest into the rental property. But there is another reason why this might make sense. The S&P 500 index for the past 20 years has returned 9.22%. Not bad. Yet in some situations, rental properties might beat or in some cases, crush, the returns of the stock market. And it creates some diversification within your financial planning.
The other option with a self-directed IRA is to start or purchase a new business. A new business might need cash to invest into equipment, franchise fee, marketing, operational cash, etc.
If you want to expand your horizons into real estate notes, equipment leasing, livestock, private debt and equity placements, and oil and gas you can also use a self-directed IRA. Be careful here. Suitability might be your biggest hurdle. Talk to your financial team before squandering your life savings on ocean front property in Arizona.
A 401k may be used as well but it is slightly more complicated. At times you might hear the term ROBS (rollover business startup) plan. Here is a blurb from the IRS website-
A ROBS transaction therefore takes the form of the following sequential steps:
An individual establishes a shell corporation sponsoring an associated and purportedly qualified retirement plan.
The plan document provides that all participants may invest the entirety of their account balances in employer stock.
The individual becomes the only employee of the shell corporation and the only participant in the plan. Note that at this point, there is still no ownership or shareholder equity interest.
The individual then executes a rollover or direct trustee-to-trustee transfer of available funds from a prior qualified plan or personal IRA into the newly created qualified plan.
The sole participant in the plan then directs investment of his or her account balance into a purchase of employer stock. The employer stock is valued to reflect the amount of plan assets that the taxpayer wishes to access.
The individual then uses the transferred funds to purchase a franchise or begin some other form of business enterprise.
After the business is established, the plan may be amended to prohibit further investments in employer stock. This amendment may be unnecessary, because all stock is fully allocated. As a result, only the original individual benefits from this investment option. Future employees and plan participants will not be entitled to invest in employer stock.
A portion of the proceeds of the stock transaction may be remitted back to the promoter, in the form of a professional fee. This may be either a direct payment from plan to promoter, or an indirect payment, where gross proceeds are transferred to the individual and some amount of his gross wealth is then returned to promoter.
The IRS is also quick to point out that self-directed IRAs and 401k plans including ROBS face a lot of compliance concerns and are generally very risky. The funded businesses also have a high failure rate.
These steps all seem straightforward. What’s the catch? There’s always a catch. Here are the things to look out for.
No S Corps or Partnerships
The way these entities are structured, business profits are returned to the shareholders. Profits cannot fall into the hands of the IRA account owner or 401k plan participant (you). Tainting of retirement dollars is the big thing here.
Prohibited Transactions
The business cannot invest directly in collectibles, art, rugs, antiques, metals other than gold, silver and palladium bullion, gems, stamps, coins (except certain U.S.-minted coins), alcoholic beverages, and a few other tangible items related to personal property. Ok- there goes half your list for sure. Yup, cross palladium off your list.
In addition, friends, business associates and siblings may invest in the business via a self-directed IRA or 401k plan, but your parents, children or spouse may not. The strict arms-length perspective of the business dealings must be maintained.
Key Employee / Investor
You cannot be the key employee and key investor in the business. Nor can you own a controlling interest of the business. Basically, someone else has to have the right to hire or fire you such as a Board of Directors. The “someone else” is the grey area in all of this and warrants more discussion.
Having said all this we must fully disclose that WCG are not experts. While we could be, we choose not to and leave a ton of room for exceptions and other workarounds to these rules. There are several wealth and trust advisor firms who do this work all day every day, and are full of competent people. We have worked with Equity Trust and New Direction Trust in the past.
As you work through all this, the net-net is that the IRS does not allow you personally to receive money that was slated for retirement (at least without penalty until you are 59.5 years old).
To reiterate, a self-directed IRA or 401k is very cool. It allows you to move money you normally could not use into an account that can now be used to get yourself into a rental or a hot franchise. All without having to find cash elsewhere.
Not to throw a big wet blanket on your dreams, but we also see a high failure rate. It is a combination of many things; business ownership is tough. Period. But! There is also a feeling generated from using your IRA or 401k funds where the money doesn’t seem real… like it is Monopoly money or something. Regardless of where your money is coming from, your business always needs a solid plan, a budget and a little bit of good fortune.
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