Private Placements Overview

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.

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 position 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.

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 UBTI (Unrelated Business Taxable Income). 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.

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
1. Have the IRA's stock restriction be based on a time-period that is unrelated to continued employment.
2. Personally own stock that has less favorable restrictions and request that the IRA's stock be vested immediately.

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.

Plan Asset Regulations

IRAs that are not employer-sponsored are not subject to Title 1 of ERISA. However, 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" personally 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.

Examples of Ownership/Compensation Rules

Example I

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?

No, the IRA owner cannot be compensated but the IRA can earn dividends (or get profits from sale of assets).
Example II

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 III

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).

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.

The foregoing is a general discussion. It is not intended, and should 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 real property should consult with their own advisor.