Can an IRA Invest in a Private Company?

Individual Retirement Accounts (IRAs) serve as a tool for many seeking to save for retirement, offering tax advantages that can help grow savings over time. While most IRAs hold common assets like publicly traded stocks, bonds, and mutual funds, some investors explore broader possibilities. A frequently asked question concerns whether these tax-advantaged accounts can include investments in private companies, moving beyond traditional market offerings. This inquiry highlights a less conventional, yet permissible, path for retirement savings under specific conditions.

Understanding Self-Directed IRAs

Investing in private companies through a retirement account involves a Self-Directed IRA (SDIRA), which differs significantly from standard IRAs offered by most financial institutions. Unlike traditional or Roth IRAs that restrict investment choices to readily marketable securities, SDIRAs provide account holders with greater control over their investment decisions. This flexibility allows for a wider array of alternative assets, including real estate, precious metals, and private company stock or debt.

The distinction of an SDIRA lies in the role of its custodian. While a traditional brokerage firm might limit investment options to its own product offerings, an SDIRA custodian primarily acts as an administrator, holding the assets and processing transactions as directed by the account holder. The custodian ensures compliance with IRS regulations but does not provide investment advice or conduct due diligence on the investment itself. This arrangement places the responsibility for investment selection and performance squarely on the account owner.

Traditional IRA custodians often avoid private company investments due to their illiquidity, valuation complexities, and the administrative burden associated with non-standard assets. They are set up to handle publicly traded securities efficiently, lacking the infrastructure for less conventional holdings. The specific framework of an SDIRA, with its specialized custodians, is designed to accommodate the unique administrative and reporting requirements of alternative investments.

Investment Rules and Prohibitions

Investing in a private company through an IRA is permissible, but it is subject to strict Internal Revenue Service (IRS) regulations designed to prevent self-dealing and conflicts of interest. An SDIRA can hold equity, such as stock, or debt instruments, like promissory notes, issued by a private company. The requirement is that the investment must be solely for the benefit of the IRA and its beneficiaries, not for the direct personal benefit of the IRA holder or certain related parties.

The IRS defines “prohibited transactions” as improper use of an IRA by the owner, a beneficiary, or any “disqualified person.” Disqualified persons include the IRA owner, their spouse, ancestors, lineal descendants (children, grandchildren), and their spouses. Entities in which the IRA holder or other disqualified persons have a 50% or greater interest are also considered disqualified.

Examples of transactions prohibited with disqualified persons include borrowing money from the IRA, selling property to the IRA, or using the IRA as security for a loan. The IRA cannot invest in a business owned or controlled by the IRA holder, nor can it make a loan to the IRA holder or other disqualified persons. These rules aim to prevent “self-dealing,” where the IRA is used for personal benefit rather than solely for retirement savings.

Beyond transactions with disqualified persons, certain assets are prohibited from being held within an IRA. These include life insurance contracts and most collectibles. Investing in such prohibited assets can result in the amount invested being treated as a taxable distribution to the IRA owner.

A consideration for private company investments is Unrelated Business Taxable Income (UBTI), which can arise if the SDIRA invests in an active trade or business, or if the investment involves debt financing. While IRAs are tax-exempt, income from such activities or from debt-financed property can be subject to tax within the IRA itself, even before distributions are taken. This tax, known as Unrelated Business Income Tax (UBIT), applies if the gross UBTI exceeds $1,000 in a given year. Passive income, like interest, dividends, or most capital gains, is not considered UBTI unless it arises from an active business or debt-financed property.

Making the Investment

Embarking on a private company investment through a Self-Directed IRA requires careful planning and execution. The first practical step involves selecting an SDIRA custodian experienced in handling alternative assets. Not all custodians support these types of investments, so it is necessary to perform due diligence to ensure the chosen provider has the expertise and infrastructure to facilitate private equity or debt transactions. This includes verifying their fee structure, administrative processes, and their comfort level with the specific type of private investment contemplated.

Once a suitable custodian is identified, the next step is to fund the SDIRA. This can be achieved through direct contributions, subject to annual IRS limits, or by rolling over funds from an existing retirement account, such as a 401(k) or another IRA. The rollover process involves instructing the current plan administrator or custodian to transfer the funds directly to the new SDIRA custodian, ensuring the tax-deferred status of the funds is maintained.

Before committing IRA funds, the account holder is solely responsible for conducting thorough due diligence on the private company itself. This includes evaluating the company’s business plan, financial statements, management team, and legal documents. Unlike traditional investments, there is no regulatory body or third party vetting private companies for SDIRA investors, placing the entire burden of research and risk assessment on the individual.

With the SDIRA funded and due diligence completed, the investment process involves instructing the custodian to execute the transaction. This requires submitting specific forms provided by the custodian, along with the investment documents from the private company, such as a subscription agreement for equity or a promissory note for debt. The custodian will review these documents to ensure they meet their internal compliance standards and align with IRS regulations. The investment must be formally titled in the name of the SDIRA, clearly indicating that the asset belongs to the retirement account and not the individual.

Ongoing Obligations and Tax Reporting

After a Self-Directed IRA invests in a private company, ongoing responsibilities and potential tax implications arise that require continuous attention. An obligation is the annual fair market valuation of the private company investment. SDIRA custodians require this valuation to accurately report the IRA’s asset value to the IRS, on Form 5498. The private company often provides this valuation, but for complex or illiquid assets, an independent appraisal may be necessary, the cost of which is borne by the IRA.

The concept of Unrelated Business Taxable Income (UBTI), introduced earlier, becomes relevant post-investment. If the private company generates income from an active trade or business, or if the SDIRA’s investment is debt-financed, the IRA may incur UBTI. If the gross UBTI for the year exceeds $1,000, the IRA itself is required to file IRS Form 990-T, Exempt Organization Business Income Tax Return, and pay any Unrelated Business Income Tax (UBIT) due. The custodian handles the filing of Form 990-T, but the responsibility to inform the custodian of potential UBTI and ensure proper reporting ultimately rests with the IRA owner.

Distributions received from the private company investment, such as dividends or interest payments, are deposited directly into the SDIRA. These funds remain tax-deferred in a Traditional SDIRA or tax-free in a Roth SDIRA, adhering to the standard tax treatment of IRA assets. When the IRA owner eventually takes distributions from the SDIRA in retirement, these funds will be taxed according to the rules governing traditional or Roth IRA withdrawals.

Maintaining accurate records is important for SDIRA owners with private company investments. This includes keeping all investment documents, annual valuation reports, and any communications with the custodian or the private company. Accurate record-keeping facilitates compliance with IRS requirements and provides a clear audit trail, which is important given the complex nature of these alternative investments.