Crowdfunding is the newest form of raising capital for small businesses and start-ups and it will eventually dominate as a primary method of raising capital in amounts under $1,000,000. In essence, Crowdfunding relaxes the current securities law restrictions, which make it nearly impossible for a small business or budding entrepreneur to raise capital from others. The basic premise of the Crowdfunding exemption to the securities laws is that the laws are loosened so long as the total amounts being raised are capped ($1M) and so long as each investor is only allowed to invest only a small portion of their income or net worth. For a breakdown on the details of the Crowdfunding rules, check out my prior article here. Keep in mind; the final rules still haven’t been put in effect so Crowdfunding hasn’t started yet. But we’re getting close.
Because the typical investor of a Crowdfunding company is likely to have more investible funds in their retirement account then in their personal account, it is my prediction, and this is shared by many, that self-directed IRAs will become a very popular investment vehicle and funding source for Crowdfunding deals. A self directed IRA is an IRA with a custodian or administrator whereby the IRA can invest into any investment allowed by law. The IRA is not restricted into only investing into publicly traded stocks, bonds, or mutual funds but can instead invest into real estate, private companies, or in a company via a Crowdfunding offering. The companies who offer these types of IRAs are referred to as self-directed custodians.
Before IRA money is invested in a Crowdfunding offering, the parties involved (investor, offering company, portal) should be aware of the following issues that are unique to Crowdfunding where an IRA is involved.
- UBIT Tax. There is a tax that can apply to an IRA called unrelated business income tax (“UBIT”). IRC 512. This tax doesn’t apply to IRAs in passive investments like rental real estate, capital gains, or on dividend profits from a C-Corp (e.g. what you get from publicly traded stock owned by your IRA) as those types of income are specifically exempt from UBIT tax. However, one situation when an IRA is subject to UBIT tax is on profits from an LLC or LP where the profits are derived from ordinary income activities like the selling of goods or services. So, for example, if my IRA bought LLC units in a company that manufactured and sold a new yard tool then the profits that are returned to my IRA is ordinary income (where no corporate tax was paid) and will be subject to UBIT tax. The UBIT tax rate is 39.6% once you have $12,000 of annual net profits. Being subject to UBIT tax isn’t the end of the world and there are some structuring options to minimize the tax such as a c-corp blocker company which can cut the tax rate in half in many instances.
- Avoid Perks. Many Crowdfunding offerings promise free products or special services to the shareholders/owners that invest through the Crowdfunding offering. Unfortunately, these perks to self-directed IRA owners will likely constitute a self-dealing prohibited transaction and will result in disqualification of the IRA. A self-dealing prohibited transaction occurs when and IRA owner receives personal compensation or otherwise personally benefits from an IRA’s investment. IRC 4975 (c)(1)(F). As a result, perks to self-directed IRA owners should be provided only when it has been determined that they would not result in a self-dealing prohibited transaction.
- No S-Corporations. An IRA cannot become a shareholder in an s-corporation because IRAs do not qualify as an s-corporation shareholder under the tax laws. IRC 1361 (b)(1)(B). Consequently, IRAs should not invest in companies that are s-corporations.
- Watch Out for Companies Owned or Managed by Family. The tax laws restrict your IRA from investing into companies where you or a family member (e.g., spouse, children, parents) are owners or members of management. IRC 4975(c). As a result, if the Crowdfunding offering is offered by a family member or if a family member is involved in management, make sure you consult with an attorney prior to investing your IRA into the Crowdfunding offering as it could result in a prohibited transaction for your IRA.
The rules regarding self-directed IRAs can be a little tricky at first, but once learned they can be easily applied to common Crowdfunding scenarios. In summary, before investing your self-directed IRA into a Crowdfunding offering, make sure you add the above items to your due diligence check-list. Failure to properly understand these rules can result in taxes (e.g. UBIT tax) or disqualification of your IRA (e.g. prohibited transaction).
By: Mat Sorensen, Attorney and Author of The Self Directed IRA Handbook.
When IRA-owned property is held for rent, the management of the rental property must be structured such that rental income is received by the IRA and expenses are paid by the IRA. The IRA owner and other disqualified persons (e.g. IRA owner, spouse, etc.) cannot personally be the “middle man” by paying expenses personally or by collecting the rent in their personal account and then forwarding the funds to the IRA. There are essentially three different methods whereby the IRA may be structured to properly collect rent and pay expenses.
Three Methods to Manage the Property
|1. Manage directly through the IRA. Money goes to the IRA custodian and expenses are paid by the custodian at the direction of the IRA owner.
|2. Property Manager. The IRA hires a property manager who manages the property and receives the income and pays property expenses. Cash flow is returned to the IRA.
|3. IRA/LLC. Under the IRA/LLC, the IRA owner is the manager of the IRA/LLC and receives income and pays expenses from an IRA/LLC checking account. The IRA/LLC structure is very common in IRA owned real estate investments.
First, the IRA may be receiving the income directly and paying the expenses. This method involves a lease between the IRA and the tenant directly. Under this method, the tenant pays rental income to the IRA (e.g. ABC Trust Company FBO Sally Jones IRA) and sends the actual payment to the IRA custodian and the custodian then deposits that income into the respective IRA. If expenses are due, the IRA owner will need to direct the custodian to pay them by completing a written form (e.g. payment authorization letter) and instructing the IRA custodian as to the expenses to be paid from the IRA. There is usually a fee each time an instruction letter is issued to a self directed IRA custodian. This method can be tedious and can be fee intensive and as a result is not the most common way of managing a rental property held by an IRA.
Second, the IRA hires a property manager who receives the rental income to the property and pays the expenses to the property. The property manager cannot be a disqualified person to the IRA owner and the property manager will typically take a percent of the rental income collected as payment for their services. Under this method the IRA enters into an agreement with the property manager and the property manager then enters into leases with respective tenants. The IRA receives rental income minus property expenses and fees charged by the property manager.
Third, many IRA owners with rental property decide to use a structure known as an IRA/LLC. Under the IRA/LLC structure, the IRA invests into a newly created LLC and the IRA’s investment is then the ownership of the LLC. The IRA will invest an amount designated by the IRA owner into the LLC, and then funds are typically deposited into an LLC checking account at a bank selected by the IRA owner.
IRA/LLC Structure for Real Estate
The IRA owner then, as manager of the LLC, signs the contract for the LLC to purchase the real estate. The property should close in the LLC name with funds from the LLC bank account and the LLC then in turn rents the property, receives the income and pays the expenses all from the LLC checking account. The LLC is entirely owned by the IRA and all funds in the LLC checking account must eventually be returned to the IRA when the IRA owner desires to take a distribution.
Regardless of the method used to own and manage the IRA owned rental property, the property cannot be leased to a disqualified person. So, for example, the IRA cannot purchase a property and allow the IRA owner’s son to lease the property as that lease would be a transaction with a disqualified person which results in a prohibited transaction.
In addition to prohibited transactions that are involved in leasing the property to family members, the IRA owner should closely analyze any leasing arrangement to a company where the IRA owner or other disqualified persons are owners of the IRA or company. For example, any lease to a company that is owned 50% or more by the IRA owner or other disqualified persons would constitute a prohibited transaction. IRC § 4975(e)(2)G).
In summary, there are many different ways to manage a rental property owned by your IRA. Make sure you are implementing one of these methods and that you are managing the IRA’s income, expenses, and properties properly.
This article is an excerpt from Mat Sorensen’s book, The Self Directed IRA Handbook.
A properly structured s-corporation is utilized best when business owners adopt and contribute to a 401(k) plan. Whether the business has only one owner/employee (or spouses only) or whether the business has dozens or even hundreds of employees. Simply put, a 401(k) plan can be used as a tool for putting the income of the business owner (any applicable employees) away for retirement with the added benefit of a tax deduction for every dollar that can be contributed. There are so many neat things about 401(k) plans and there are so many options. For example, you can do Roth 401(k) plans, you can self direct a 401(k) plan, and you can even loan money to yourself from your 401(k) account. While books have been written about all of these options and benefits, one of the most misunderstood concepts of 401(k) plans is how s-corporation owners can contribute their income to the plan. That is the focus of this article.
Rules for 401(k) Contribution
In order to understand how s-corporations income can be contributed to a 401(k) plan, you need to understand the following three basic rules:
- Only W-2 Salary Income can be Contributed to a 401(k). You cannot make 401(k) contributions from dividend or net profit income that goes on your K-1. See IRS.gov for more details. Since many s-corporation owners seek to minimize their W-2 salary for self-employment tax purposes, you must carefully plan your W-2 and annual salary taking into account your annual planned 401(k) contributions. In other words, if you cut the salary too low you wont be able to contribute the maximum amounts. On the other hand, even with a low W-2 Salary from the s-corporation you’ll still be able to make excellent annual contributions to the 401(k) (up to $17,500 if you have at least that much in annual W-2 salary).
- Easy Elective Salary Deferral Limit of $17,500 or 100% of Your W-2, whichever is less. If you have at least $17,500 of salary income from the s-corporation, you can contribute $17,500 to your 401(k) account. Every employee under the plan is allowed to make this same contribution amount. As a result, many spouses are added to the s-corporation’s payroll (where permissible) to make an additional $17,500 contribution for the spouse’s account. If you are 50 or older, you can make an additional $5,500 annual contribution. Follow this link for the details from the IRS on the elective salary deferral limits. The elective salary deferral can be traditional dollars or Roth dollars.
- Non-Elective Deferral of 25% of Income Up to a $52,000 total Annual 401(k) Contribution. In addition to the $17,500 annual elective salary contribution, an s-corporation owner can contribute 25% of their salary compensation to their 401(k) account up to a maximum of a $52,000 total annual contribution. This non-elective deferral is always made with traditional dollars and cannot be Roth dollars. So, for example, if you have an annual W-2 of $100,000, you’ll be able to contribute a maximum of $25,000 as a non-elective salary deferral to your 401(k) account. If you have employees who participate in the plan besides you (the business owner) and your spouse, then the non-elective deferral calculation gets much more complicated. But for now, let’s assume there are no other employees and run through the examples.
Lets run through two examples. The first is an s-corporation business owner looking to contribute around $30,000 per year. The second is a business owner looking to contribute the maximum of $52,000 a year.
Example 1: Seeking a $30,000 Annual Contribution.
- S-Corporation Owner W-2 Salary = $50,00
- Elective Salary Deferral = $17,500
- 25% of Salary Non-Elective Deferral = $12,500 (25% of $50,00)
- Total Possible 401(k) Contribution = $30,000
Example 2: Seeking Maximum $52,000 Annual Contribution
- S-Corporation Owner W-2 Salary = $138,000
- Elective Salary Deferral = $17,500
- 25% of Salary Non-Elective Deferral = $34,500 (25% of $138,000)
- Total Possible 401(k) Contribution (maximum) = $52,000
As a result of the calculations above, in order to contribute the maximum of $52,000, you need a W-2 salary from the s-corporation of $138,000. Keep in mind that if you have other employees in your business (other than owner and spouse) that you are required to do comparable matching on the 25% non-elective deferral and as a result such maximization is often difficult to accomplish in 401(k)s with employees other than the owner and their spouse. Consequently, the additional 25% non-elective salary deferral is best used in owner only 401(k) plans.
While every self directed IRA investor enters into investments with high hopes and expectations of large gains, sometimes an IRA has to declare a loss on its investments and sometimes those losses are total losses. However, how does an IRA document a loss on a private partnership investment or an uncollectible promissory note investment? Two Tax Court opinions released today show us what not to do. Berks v. Commissioner, T.C. Summary Opinion 2014-2, Gist v. Commissioner, T.C. Summary Opinion 2014-1.
Berks v. Commissioner and Gist v. Commissioner
In Berks and Gist, self directed IRA owners invested their IRAs into various real estate partnerships and had equity interests and promissory note interests. Approximately five years after the investments were made, the IRA owners sought to declare the values on all of the investments worthless as the partnerships were no longer in business and as the IRA owner was told by their friend who they invested with that the investments were worthless. The IRA custodian for Berks and Gist sought additional documentation before agreeing to write down the value of the investments. Writing down the value of an investment and closing an account is a red flag for the custodian and the IRS as both want to ensure that IRA owners are not unfairly writing down investments in an effort to avoid taking distributions from the IRA which are taxable. As a result, the IRA custodian sought documentation as to the valuation change and upon receiving no documentation; the IRA custodian distributed the account to the IRA owners with the original investment amounts made from the account.
The self directed IRA accounts were closed by the custodian and the IRA owners were responsible for the taxes due from the 1099-R as well as accuracy related penalties. Eventually the un-claimed 1099-R went into collections with the IRS and the IRS sought payment of the additional taxes owed. The taxpayers disputed the amounts owed and took the case to Tax Court. The case eventually proceeded to trial and the taxpayers both lost in separate cases because they went into the case with no documentation or evidence of collection attempts. Instead, there was only testimony from the IRA owner and from their advisor that assist them in the investments. In Berks, the Court stated, “…[the IRA owner] simply took Mr. Blazer [their friend they invested with] at his word, and they apparently never saw the need to request any documentation that would substantiate that the partnerships had failed or that the promissory notes in the IRA accounts had become worthless.” Accordingly, the Court ruled against the IRA owners and held that the investment values as reported by the custodian (the initial investment amounts) were the best representation of fair market value. As a result, the IRA owners were subject to taxes owed on the higher valuation amounts.
I handled a very similar case to this one in Tax Court myself. In my case, the case resulted in the IRS reducing the valuation of the distributed IRA down to the proper discounted fair market valuation the IRA owner was seeking. As a contrast to what the taxpayers did to document their losses in Berks and Gist (e.g., no documents or records), I have outlined the steps that should be taken to properly document a loss with your IRA custodian and/or with the IRS/Tax Court.
Documenting a Loss/Failed Investment
- Hire a Third Party to Prepare an Opinion as to Value. Your custodian, the IRS, and the Tax Court all want to see an independent person’s opinion as to the value of an investment.
- Provide Accounting Records Showing Losses and No Profits/Income. In my Tax Court case on the same issue (obviously different facts and investments), we were able to re-construct the accounting records and losses from the company that demonstrated the significant valuation change. These accounting records we assembled were accompanied by financial records and third party documents which supported our numbers. The IRS agreed with our decreased valuation before trial, and dismissed their case against our client.
- Document Fraud. If fraud was involved by persons receiving the income. Was a lawsuit filed? Were complaints made to regulatory bodies (e.g. SEC or state divisions of securities)? Provide those documents to your custodian.
- If the Investment Losses are from a Un-Collectible Promissory Note.
- Engage a lawyer or collection agency to make collection efforts. Keeps documents of their collection efforts.
- If the borrower filed bankruptcy, provide the bankruptcy documentation.
- If the loan is totally un-collectible, Issue a 1099-C (Forgiveness of Debt Income to the Defaulted Borrower, you’ll need the borrower’s SSN/EIN for this).
The best way to document an investment loss is to provide a third party valuation to your custodian. A custodian cannot accept an e-mail or letter from the IRA owner saying the investments didn’t pan out. If a third party opinion as to value cannot be produced, you’ll need to provide some of the records and documents I outlined above to demonstrate the loss. Remember, as Tom Cruise said in A Few Good Men, “It doesn’t matter what happened. It only matters what I can prove.” To prove an investment loss in your IRA, you’ll need documents and records showing what went wrong.