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What does 'private placement' mean?
"Private placement" is the term used in the securities
world to define a non-public offering of an investment vehicle.
Securities regulations allow exemption for selected types of private
placements. The primary classifications for these exemptions are
Rules 501-506 D. Smaller private offerings can be done where there
are less than 35 investors and when the public is not solicited
(e.g., friends and family rounds of financing). The most common
types of private placements are those involving closely-held private
companies. It is estimated that 75% of new businesses formed in
the United States are funded through such private placements.
Procedures: Investing IRA Funds
In Closely-Held Enterprises
IRA owners are often presented with opportunities to invest IRA funds
in an existing or new closely-held enterprise, such as an operating business,
a real estate venture or an investment partnership. Significant tax consequences
can occur if such an investment is a "prohibited transaction"
or generates "unrelated business taxable income." However, in
appropriate circumstances, an IRA's investment in a closely-held enterprise
can be structured to eliminate or reduce the risk of adverse tax consequences.
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Prohibited
Transaction Considerations
When IRA funds are invested in an enterprise in which the IRA owner has,
or will have, some other relationship - current owner, co-investor, employee,
creditor, director or officer - there is often an issue of whether the
investment will constitute a "prohibited transaction" under
the tax laws. A prohibited transaction between the IRA and IRA owner will
result in immediate taxation to the owner of the IRA's entire value. Prohibited
transaction issues may also arise after the IRA investment is made, usually
in connection with a transaction or service between the IRA and the enterprise
or the IRA owner (or related person) and the enterprise.
The government and the courts have provided only limited guidance regarding
when an IRA investment in a closely-held enterprise may give rise to a
prohibited transaction. Nevertheless, some general observations can be
made:
· In an advisory opinion, the Department of Labor (which
interprets the prohibited transaction rules) concluded that investment
by both an IRA and the IRA owner in a partnership was not a prohibited
transaction where the IRA owner and his family owned less than 50%
of the partnership, and the IRA owner derived no (or only an incidental)
benefit from the IRA's investment. Note: In all examples, the terms
'family' or 'related persons' does NOT include siblings (brothers
and sisters) of the IRA owner.
Thus, co-investment by an IRA and IRA owner in the same enterprise should be permissible
under some circumstances, as long as certain caveats noted in that opinion are heeded.
· An IRA's investment in an enterprise of which the IRA owner
and related persons already own 50% or more (in value or voting power)
is a prohibited transaction. However, many believe that a simultaneous
co-investment by an IRA and the IRA owner in the enterprise's initial
capitalization, resulting in their joint ownership of a majority interest
in the enterprise, is not a prohibited transaction.
· An IRA investment should not be made to facilitate or protect
the IRA owner's investment or interest. For example, an IRA's investment
for the purpose of ensuring the IRA owner's employment with the enterprise,
or preserving the IRA owner's investment in the enterprise, is likely
to be viewed as a prohibited transaction.
· The IRS appears to take the postion that if a transaction
between an IRA and a "disqualified person" would be a prohibited
transaction, then a transaction between that person and an entity
in which the IRA has an ownership interest would also be a prohibited
transaction if the IRA, alone or together with certain other "disqualified
persons," can require the corporation to enter into the transaction.
· If an IRA owner wishes to invest only some IRA funds in the enterprise,
it is advisable to first transfer the amount to be invested to a separate
IRA. Such separation may ensure that, if a prohibited transaction does
occur, any adverse tax consequences would impact only the separate IRA making
the investment.
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Unrelated Business Taxable
Income
If the enterprise is a pass-through entity (a partnership or a
limited liability company) which produces or sells goods or provides
services, the IRA's share of the enterprise's ongoing net income
likely will be "unrelated business taxable income" ("UBTI").
An IRA is required to pay income tax on UBTI
at the trust income tax rate. Also, if the business is a pass-through
entity which acquires any assets through loans or on margin, a portion
of the IRA's share of the income may constitute UBTI.
The IRA generally will not have UBTI on the sale of its equity interest in the
pass-through entity (except to the extent that interest was acquired through
debt which was still outstanding within twelve months of the sale).
Structuring the enterprise as a C corporation can avoid UBTI, although
the enterprise then will be subject to income tax in accordance with applicable
corporate taxation rules.
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Special Considerations for Roth IRAs
Transactions between a business of which a Roth IRA (or Roth IRAs
of related persons) owns substantially all the interests and the
IRA holder or related persons may be "listed transactions" which
may need to be reported to the IRS. The fact that the transaction
is "listed" or must be reported does not mean it is prohibited.
Please see IRS Notice 2004-8 or consult your tax advisor for further
details.
S Corporations
An IRA may not be an S corporation shareholder.
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In Summary
Careful planning will often enable an IRA to invest in a closely-held
enterprise with little tax risk. The transactions which might occur
after the initial IRA investment is made (such as, how and when the IRA
will ultimately dispose of its investment or future capital needs) should be taken into account
at the planning stage. An experienced attorney or tax practitioner familiar
with prohibited transaction and UBTI issues should be consulted when an
IRA owner is considering making such an investment.
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Plan Asset Regulations:
Even though IRAs which are not employer-sponsored are not subject to
Title I of ERISA, they are subject to the plan asset rules. The plan asset
rules, by their terms, cover any plan described in Internal Revenue Code
section 4975(e)(1), which defines "plan" to include an IRA.
At least one Department of Labor opinion letter (2000-10A) confirms
that IRAs are subject to the plan asset rules.
The mere fact that an IRA's assets are plan assets does not create adverse
consequences; it just means that the entity's assets are treated as IRA
assets for purposes of applying the prohibited transaction rules and therefore
restricts the types of dealings which the IRA holder can have with those
assets and/or the entity. For example, if an IRA invests in an LLC, and
the LLC's assets are deemed to be plan assets of the IRA, then the IRA
holder's purchase of assets from the LLC would be a prohibited transaction.
If an IRA, together with other "benefit plan investors," owns at least 25% of
any class of the entity's equity interests, the entity's assets are treated as the
IRA's assets, unless an exception applies.
If a person has discretionary authority or control over assets
of the entity, that person's interests are disregarded in determining
whether the 25% threshold is met. For example, if person 'A' manages
the LLC, A's IRA owns 23% of the LLC, A owns 10% of the LLC and
individuals independent of A own the remaining 67% of the LLC, then
the IRA is treated as holding 25.6% (i.e., the ratio of 23% to 90%)
of the LLC.
Subject to the exception discussed in the following point, the
assets of an "operating company" are not plan assets,
even if the 25% threshold is met. The applicable regulations define
an "operating company" as either (1) an entity that is
engaged primarily, directly or through a majority-owned subsidiary,
in the production or sale of a product or service other than the
investment of capital; (2) a real estate operating company; or (3)
a venture capital operating company.
The plan asset regulations provide that if an IRA or related group of
IRAs own 100% of any entity, the entity's assets will be treated as plan
assets, even if the entity is an operating company. The regulations do
not indicate whether the same result follows if the entity's only owners
are the IRA and the IRA holder. It therefore would appear advisable for IRA clients
who are investing in an operating company to have an independent, minority
investor (with a non-trivial interest) to insure that the 100%
rule will not apply in their situations.
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Some examples
Example 1: IRA owns 100% of an operating company
(a company that provides goods or services, or a real estate operating
company). Can the IRA owner or any other ascending/descending family
members draw compensation?
Example 2: Bed and Breakfast
owned 100% by IRA. IRA owner cannot get compensation, but the IRA can earn
income on the business and when it's sold to an unrelated 3rd party, the
IRA gets the profit.
Example 3: Bob's IRA owns 60% of a hedge fund.
His sister privately owns 30% and his brother privately owns 10%.
Bob can take a 40% management fee (the portion of the company that
is NOT owned by his IRA).
Prohibited transactions
as defined in IRC 4975
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Example 1: IRA
owns 100% of an operating company (a company that provides goods or services,
or real estate operating company). Can the IRA owner or any other ascending/descending
family members draw compensation?
Answer 1: No, the IRA owner cannot be compensated but the IRA can
earn dividends (or get profits from sale of assets).
back to examples
Example 2: Bed and Breakfast owned 100% by IRA. IRA owner cannot
get compensation, but the IRA can earn income on the business and
when it's sold to an unrelated 3rd party, the IRA gets the profit.
back to examples
Example 3: Bob's IRA owns 60% of a hedge fund.
His sister privately owns 30% and his brother privately owns 10%.
Bob can take a 40% management fee (the portion of the company that
is NOT owned by his IRA).
back to examples
Prohibited transactions
as defined in IRC 4975
(These examples involve transactions
between the IRA and the company)
Prohibited Transaction Example 1: An IRA (alone or together with
certain related persons) owns at least 50% of a company. Can further
IRA investments be made with the same company?
Prohibited Transaction Answer 1: NO - no further investments, capital contributions, loans, stock
purchases can be done with IRA funds, but IRA ownership of over 50% with
no further transactions is fine. The IRA can continue to earn dividends
and may sell to an outside buyer and earn profits.
Prohibited Transaction Solution 1: Less than 50% ownership
If the IRA (alone or together with certain related persons) owns less than 50% of a company, then further sales or exchanges
at arms-length terms are allowed.
Prohibited Transaction Example 2 (Involving the 50/50 Rule): An IRA owns 70% of a
corporation or LLC. Can the IRA owner
add more money PERSONALLY if the company needs capital?
Prohibited Transaction Answer 2: Probably, if an independent person
approves the additional contribution.
Prohibited Transaction Solution 2:
Use a LOAN from an outside source. This way, the IRA's percentage of ownership
remains unchanged and company gets working capital it needs.
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Restricted Stock
Restricted Stock Example:
An IRA owns
a 10% share in a company with Restricted Stock, with the restrictions based
on the IRA owner's continued employment. Is this prohibited?
Restricted Stock Answer: Unclear (but very possibly) prohibited,
so it's not prudent to have the IRA's interest vest upon the individual's
non-IRA actions. If the IRA is benefiting from the individual's
effort for the company, (i.e., getting better terms or a special
deal on subsequent stock offerings based on the individual's performance
within the company), then it can be suspect - IRA impermissibly
benefiting from IRA owner's actions - a version of "self-dealing".
Restricted Stock Solution:
a) Have the IRA's stock restriction be based on a time-period that is
unrelated to continued employment.
b) Personally own stock that has less favorable restrictions and request
that the IRA's stock be vested immediately.
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(The foregoing is a general discussion. It is not intended, and may not
be relied upon, as an opinion or advice on any legal, tax or investment
aspects of IRAs. An IRA owner considering an IRA investment in a private
placement or closely held business should consult with his or her attorney,
tax advisor or CPA before making such investments. PENSCO Trust does not provide
tax, legal or financial advice.)
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