My guidance
1. Compliance
1.1.
In the context of a self-directed IRA (SDIRA), compliance primarily means avoiding prohibited transactions.
IRC §4975 establishes a strict prohibition on most transactions between an IRA and a «disqualified person» (hereinafter DP).
1.2. Investing in private companies involves specific risks:
1.2.1. Existing ownership.
If the aggregate DP ownership in the company is 50% or more before the transaction, the company itself is a DP.
Any direct or indirect sale or exchange of property between an IRA and a DP is prohibited.
Therefore, the IRA cannot acquire stock (e.g., in a new issuance) directly from such a company.
The acquisition of stock in such a company from an unrelated third party does not formally constitute a direct transaction with a DP.
However, such an investment poses extremely high risks described in point 1.2.3.
1.2.2. Initial capitalization
The status of a DP is determined immediately before the transaction.
A new company that has no shareholders before the IRA's investment is not a DP at the time of the initial stock issuance.
Consequently, the initial acquisition of stock by the IRA from such a company is not formally prohibited, even if the IRA will own 100% of the stock as a result.
The company becomes a DP only after the completion of this transaction.
Any subsequent transactions between the IRA and this company will be prohibited.
1.2.3. Self-dealing and conflict of interest
Even if a transaction is formally permitted, extremely high risks of violating other provisions of IRC §4975 persist.
These include prohibitions against the use of plan assets for the benefit of a DP and acts by a fiduciary involving a conflict of interest.
If the IRA owner (hereinafter O) holds a position (director, employee) in the company in which the SDIRA invests, this may be construed as receiving an indirect benefit or a conflict of interest.
O must act solely as a passive investor.
2. Tax implications
2.1.
The Unrelated Business Income Tax (UBIT) is levied on Unrelated Business Taxable Income (UBTI).
The definition of UBTI: law.cornell.edu/uscode/text/26/512#a_1
IRC §512(b) provides for a number of modifications to the definition: law.cornell.edu/uscode/text/26/512#b
2.2. The IRA's income is subject to UBIT in 2 primary scenarios:
2.2.1. Unrelated Trade or Business Income
If an IRA participates (directly or through pass-through entities) in an active trade or business, the income received constitutes UBTI.
The exceptions for passive income do not apply to such income.
2.2.2. Unrelated Debt-Financed Income (UDFI)
If an asset is acquired with acquisition indebtedness, the income from that asset (even if it is passive) is included in UBTI in proportion to the share of the debt financing.
2.3.
The legal structure of a company is of critical importance when investing in its equity, as it determines the form of ownership (stocks or interests):
2.3.1.
Investments in entities taxed as C-Corporations (including LLCs that have elected this status under the «Check-the-Box Regulations») generally do not trigger UBIT.
Such an entity pays income tax at its own level (acting as a «blocker»).
Dividends and capital gains received by an IRA are considered passive income and are generally exempt from UBIT.
2.3.2.
If an IRA acquires membership interests or partnership interests in pass-through entities (such as partnerships or LLCs taxed as partnerships or disregarded entities) engaged in an active trade or business, the income passed through to the IRA is subject to UBIT.
3. Some additional remarks
3.1.
An IRA cannot own stock in an S-Corp.
The investment will result in the loss of S-Corp status for the company.
3.2.
O is required to provide the custodian annually with the Fair Market Value (FMV) of the stocks for reporting to the IRS (Form 5498).
This often requires a costly independent valuation.
3.3.
All investments must belong to the retirement plan.
This is achieved by titling assets directly in the name of the IRA (direct ownership) or in the name of a legal entity (e.g., an LLC or partnership) in which the IRA is a member (indirect ownership).
With direct ownership, all funds must pass through the custodian.
With indirect ownership, the IRA can be either the sole member (e.g., in a Single-Member LLC) or one of multiple members (e.g., in a Multi-Member LLC or a partnership).
A structure where the IRA is the sole member and O acts as the manager allows O to conduct transactions directly from the legal entity's bank account after its initial funding by the custodian.
Regardless of the structure, any commingling of personal and retirement funds is prohibited.