IRA - investing in my own company

[Guest irenes]

Currently I am a participant in an employer sponsored 401(k) plan. I am interested in buying this company's assets - I do not want to take the plan on also. Therefore, the current company will terminate it. Can I rollover my distribution from my current employer's plan and invest in my new company through my IRA?

Specifically, can my IRA own shares of my new company? Is there any limit on what percentage owner I can be before it becomes a prohibited transaction?

[Dave Baker]

The Internal Revenue Code, which supplies most of the rules that apply to IRAs, has no direct prohibition against an IRA owning a piece of a company in which the IRA owner also owns a piece. So my IRA can invest in IBM common stock even though I also own some shares of IBM common stock.

But as an IRA owner (which makes me a "fiduciary," due to my ability to decide how to invest my self-directed IRA), I am prohibited from "dealing" with the assets of my IRA in way that is "in my own interests or for my personal account" -- basically I'm supposed to invest my IRA with nothing but the IRA's long-term retirement investment interest in mind (not whether I am able to get some current side benefit personally from the way the IRA invests).

IRC 4975© provides:

© Prohibited transaction

(1) General rule

For purposes of this section, the term "prohibited transaction'' means any direct or indirect--

(A) sale or exchange, or leasing, of any property between a plan and a disqualified person;

(B) lending of money or other extension of credit between a plan and a disqualified person;

© furnishing of goods, services, or facilities between a plan and a disqualified person;

(D) transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;

(E) act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interests or for his own account; or

(F) receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.

Could you purchase all of the assets of the company using your own personal funds (or funds you borrow personally), without using any of the IRA's funds (which I understand would come from a rollover of your 401(k) account in the terminating plan)? If you would have a hard time making the purchase without the IRA's help, then it would seem that you are "dealing" with the IRA's funds in a way that bootstraps you into being able to make the personal investment.

If you could somehow prove that you could purchase the assets entirely on your own and that hence the use of the IRA's funds to invest in the new company is just a shrewd investment on the part of the IRA, then maybe the IRS would be less likely to question the transaction.

Still, I worry about your being the majority owner of the company. That gives you certain abilities with respect to how the company uses the capital that would be invested in the company by the IRA (e.g., the ability to appoint the directors who decide how to spend the money), which might be considered an indirect use by you personally of the IRA's funds. This is probably especially so if you are going to be compensated by the new company as an employee or as a director -- the IRA's funds would be enabling you to get a new job or earn some self-employment income.

[John G]

I can't comment on the technical or IRS limitations on the IRA owning part of your own company, but I could see a lot of abuses if this was allowed. I am sure someone would find a way to funnel money into the IRA shelter by exagerating the performance of the stock, that is favoring the stock over perhaps payroll or bonuses. I also know there are required annual valuations for IRAs that become extremely difficult if not impossible when there is no active market to price the stock.

From a more practical point of view, having your life and retirement assets both bet on the same enterprise puts you at a great risk if the business fails to thrive. I would not recommend this. It is the same as a couple that both work for the same firm and have most of their assets in company stock... there is not diversification to protect you in the even of a downturn, hostile acquisition, downsizing, etc. I have friends who thought this was not a realistic risk that are now eating their savings while they are both on the job market. Ouch.

One of the major reasons for business failure is undercapitalization. If you are severely stretched to buy this business, you may want to think twice about the timing or how you are financing the purchase or even if you should proceed. You need more than just the front end money, you need operating capital and reserves for the unexpected.

[Steve72]

What percentage ownership would the IRA have? If it rises to the level of a "significant plan investment" (basically, 25%), you may have a plan asset issue as well.