Year-End Tax Planning for ROBS Users
If you utilize the ROBS structure for your business, there are several things you need to do before the end of the year. ROBS tax planning is an essential part of your business so that you remain IRS-compliant. In the following, we will discuss all the items you need to take care of before December 31.
ROBS Refresher
For those considering ROBS, let's take a brief look at exactly what it is. ROBS stands for Rollover for Business Startups. Basically, you can use your existing retirement funds to start a new business or bring in more capital for an existing one. Though it is IRS-approved, ROBS arrangements are generally more scrutinized. It's important that you work with a qualified provider, such as IRA Financial, when employing the structure.
How Does it Work?
First, you need to to ensure your business is set up as a C Corporation. This is because to use ROBS, you must be able to sell stock in the company, which a C Corp allows. Next, a new 401(k) plan is set up for this business. A custodian is chosen to manage the plan investments. Now it's time to rollover your existing retirement funds into the new 401(k). Stock in your company is then purchased by the retirement plan. Finally, your company can now use those funds to invest in your business.
Why Use ROBS?
There are many reasons to us the ROBS structure to fund your business. Here are the Top Three:
- You are in control - Instead of guessing on the stock market, you can use your retirement funds to invest in yourself.
- No debt - Since you are using your own money, there's no need to take out a loan and make high interest payments.
- 401(k) plan - The ability to offer prospective employees a retirement plan option will give you a larger pool of qualified workers.
Of course there are risks when using ROBS. The biggest one is the risk of failure. If your business fails, you risk putting your retirement in jeopardy. It's important to work with a financial planner to ensure the risk of your new business is mitigated.
ROBS Tax Planning
Just with any business, there are items that must be checked off at the end of the year. It's doubly important when using ROBS so that you stay within the rules set forth by the IRS. Don't forget these important steps, especially if this is the first year of your new business. It can be quite to forget about the reporting requirements while getting your business off the ground.
First thing's first, it's essential to work with your ROBS provider. They will take care much of the items needed for your ROBS tax planning. However, there are things you need to take care of personally. IRA Financial can help guide you every step of the way. You, as the business owner, are the plan administrator. IRA Financial (or another administrator if you have one) handles the plan administration. Only working in tandem will ensure you stay within the IRS and Department of Labor (DOL) rules.
The most important is IRS Form 5500. The size of your business will decide on which form you need to file. Assuming you have less than 100 employees, you can generally file Form 5500 SF, while others may have to file the general 5500 form. Usually, your provider will file this form on your behalf. You will need to provide them with the details of your 401(k) plan. These may include (but not limited to) employee information/number of participants, profit and loss, and balance sheets, and 401(k) contributions. Your provider will assist you in correcting and mistakes they may find with the form.
ROBS Tax Planning You Need to Take Care Of
Every year there are certain requirements for your 401(k) and C Corporation. First, your 401(k) is considered an Eligible Individual Account Plan. The plan must show that all eligible employees can share the benefits of the 401(k). For example, if you offer a match to employee contributions, every employee who contributes must receive this match.
As mentioned previously, the Form 5500 must be submitted to the IRS. This is an informational form to determine the value of the plan assets. This includes the stocks you purchased to start the business, in addition to any assets the corporation owns. Further, each participant of the plan must have a value of the assets he or she holds.
You, as the business owner using the ROBS structure, must take an annual salary. You must begin doing so as soon as the business can afford it. Also, you should work at least 1,000 hours per year and be paid at least minimum wage in your state. It's also wise to contribute at least one percent to your 401(k) plan. This serves as a "best interest" for the plan.
Next, you need to ensure you have an ERISA Fidelity Bond at all times. This provides insurance to losses to the retirement plan used with ROBS. Your bond, which is required by ERISA, must be the lesser of $500,000 or ten percent of your plan assets. This is an important ROBS tax planning requirement to ensure compliance.
C Corporation Requirements
In addition to the 401(k) plan requirements, there are certain things you must do with your C Corporation as well. Most importantly, you need to file taxes for your business. This is different than the Form 5500. Failure to file your taxes on time will lead to penalties from the IRS. Further, it's important to check your state laws in regards to your corporation. States require different rules for maintaining your C Corporation. Don't forget to sign all documents as well! Your provider cannot do this for you.
Next, you must ensure your business is an operating company. Essentially, you need to sell goods or a service to meet the definition. Day traders, investment advisors and some real estate investment companies are not examples of operating companies. It's crucial that the company you use your retirement funds to invest in fits the criteria.
Lastly, your ROBS business must always be a C Corporation. If you try to create another type of company, such as an LLC or S Corporation, you run the risk of a prohibited transaction which may disqualify the plan. Further, it could lead to stiff tax penalties. Always work with legal professionals, such as a lawyer and CPA, to make sure you are abiding all rules and laws.
ROBS Tax Planning - a Review
While many things do not have to be done by the end of the year (such as filing taxes), many items outlined should be done as quickly as possible. The rules of navigating the ROBS structure is quite complicated. You, as the owner of the business, have a lot of responsibilities. Neglecting any of these may lead to severe financial consequences. If you are working with IRA Financial, know that we are there every step of the way and are just a phone call away!
Please contact us @ 800.472.0646 if you any questions about your ROBS tax planning for the end of the year. We will help ensure that you stay within the rules and help your business thrive.
Backdoor Roth vs. Mega Backdoor Roth
Many retirement savers are not aware that that a massive Roth contribution option for the self-employed or small business owner known as the “Mega Backdoor Roth" is available and that is even more popular than the "Backdoor Roth IRA." This article will explore how the two types differ and explain how they each work. We'll also dive into the rules of the strategies which will ensure you understand what you need to do.
- The Backdoor Roth is a strategy that allows anyone, regardless of income, to get retirement funds into the popular after-tax plan
- While the Backdoor Roth IRA is good, self-employed individuals have an advantage of using the Mega Backdoor Roth 401(k)
- So long as you follow the rules, you can have a tax-free retirement
The Roth IRA vs. Mega Backdoor Roth IRA
In 2026, the most one can contribute to a Roth IRA is $7,500 or $8,600 if at least age 50. In general, if you are single and earn more than $168,000 or married and filing jointly and earn more than $252,000, you are not permitted to make Roth IRA contributions.
The main reason behind this rule change was to increase tax revenue after the financial crisis of previous years. Roth conversions generate immediate taxation on the amount of the conversion. Consequently, the Backdoor Roth IRA conversion strategy was born.
Why is the Roth IRA so Popular?
Three words: Tax-Free Retirement. If you like paying taxes, the Roth IRA is not for you. A Roth is funded with after-tax money. So long as you meet the requirements, you will never owe taxes on that money (or the income it generates) ever. This is the opposite of a traditional, or pretax, IRA. Contributions are made before your income is taxed. Therefore, you get an immediate tax break on whatever you contribute. However, distributions, including the earnings, will be taxable.
As mentioned, there are requirements to receive tax-free Roth money, but there are only two. First, you must be at least age 59 1/2. Easy enough, since retirement money shouldn't be touched until later in life. Secondly, any Roth must have been open for at least five years. You cannot fund a Roth and expect to pull the money out, tax-free, in a year or two. This shouldn't be an issue since time is on your side when accumulating retirement wealth.
Another great facet of the Roth IRA is that there are no required minimum distributions. Once you reach age 73, you must start withdrawing from your pretax IRA, no matter if you need the money or not. There is no such requirement for a Roth. It's not mandatory to ever distribute those funds. They can continue to grow for as long as you want. If you're lucky enough to not need those funds, you can pass them along to your beneficiaries, untouched.
Related: The Roth IRA Five-Year Rule Explained
How Does the Backdoor Roth IRA Work?
As we stated in the opening, if you earn too much money, you cannot contribute to a Roth IRA. Let's amend that to: you cannot directly contribute to a Roth IRA. This is where the "backdoor" comes in. The Backdoor Roth IRA is a strategy that allows you to contribute to a pretax IRA, and then convert to Roth. Because of the income limitations of an IRA, you will not receive a tax deduction on these contributions. If you left those funds right there, your distributions would also be taxable. So why do it?
The only reason one would generally contribute after-tax funds to a traditional IRA is to convert them to Roth. With the Backdoor Roth strategy, you would immediately convert the contribution to Roth. Because there would be no earnings on those funds, no taxes would be due.
Here's how it works for someone just starting out:
- Open both a traditional and Roth IRA
- Make an after-tax contribution to the traditional IRA
- Work with your IRA custodian to complete the conversion
- The conversion would be reported on IRS Form 1099-R as a zero-tax conversion
The Backdoor Roth IRA can be done per person, so a married couple can go up to $13,000 or $15,000 if they are both age 50 or older.
Related: Can I do a Backdoor Roth every year?
The Mega Backdoor Roth 401(k)
The Mega Backdoor Roth 401(k) allows self-employed individuals to move significantly more money into a Roth account than a Roth IRA permits.
With a properly structured Solo 401(k), you can contribute up to $70,000 in 2025, or $77,500 if age 50 or older, depending on income.
A Solo 401(k) allows:
- Employee deferrals up to $23,500 ($31,000 if 50+)
- Employer profit-sharing contributions (generally up to 25% of compensation)
- After-tax contributions, which can be converted to Roth
The ability to make after-tax contributions and convert them to Roth is what makes the Mega Backdoor strategy possible.
This approach works best with a Solo 401(k) because these plans are not subject to certain nondiscrimination tests that apply to larger employer plans, making it easier for business owners to maximize contributions.
To qualify, you must have self-employment income and no full-time employees other than a spouse.
Solo 401(k) Plan After-Tax Contribution Mechanics
After-tax 401(k) contributions are separate from employee deferrals and employer profit-sharing contributions. Because of this, they allow you to contribute beyond the standard pre-tax or Roth limits, up to the overall annual cap. These contributions are not tax-deductible, but they can be converted to Roth under the Mega Backdoor strategy.
For example, in 2025, an individual under age 50 earning $90,000 in self-employment income could contribute up to the full $70,000 annual Solo 401(k) limit, if the plan allows after-tax contributions.
By contrast, if contributing only through traditional pre-tax or Roth employee deferrals and employer profit-sharing, the total would typically be significantly lower based on income and compensation limits.
How Does it Work?
IRS Notice 2014-54 opened the door to the Mega Backdoor Roth 401(k) strategy because it allowed for funds to be distributed from a 401(k) plan separately without a pro rata formula requirement. Below are the steps one can take to make these types of contributions:
- Establish a Solo 401(k) plan.
- Establish two bank accounts for the plan. In addition, if you expect to make pretax employee deferral contributions, it is suggested that a separate bank account also be opened for accounting simplicity purposes.
- Make a contribution into the plan’s after-tax bank account.
- Transfer those funds to the Roth plan bank account using the backdoor.
- (optional)You can then move those funds to a Roth IRA if you wish.
- The plan administrator will need to file IRS Form 1099-R in January of the following year to report the tax-free conversion.
Related: Beginner’s Guide to Alternative Investments
Deadline for making a Mega Backdoor Roth Contribution
The deadline for making a contribution is the date the adopting employer files its tax return, including extensions. Because the contribution is in after-tax funds, it does not impact the individual’s federal income tax return (IRS Form 1040).
Conclusion
Although both strategies share many similarities, do not get confused by the Backdoor Roth IRA and the Mega Backdoor Roth 401(k). The both seem almost too good to be true; thankfully they are 100% legal.
Anyone who is otherwise eligible can engage in Backdoor Roth IRA - even if you are over the income thresholds for directly contributing to a Roth. However, you must satisfy the eligibility requirements to open a Solo 401(k) and utilize the Mega Backdoor, which is the obvious winner here for the sheer amount of annual contributions you can make.
One thing to remember is where you open your Solo 401(k) matters. Not all providers will offer a way through the backdoor, so it's important to know the option is available if you need it.
Pay attention to the rules and work with the right professionals if you wish to employ either strategy. A tax nightmare can arise if you miss a step or try to withdraw funds too early. If you wish to learn more, please fill out a contact form with any questions and we can help you on your way to a tax-free future!
Tax-Deferral vs. Tax-Free - Which is Better?
Tax-Deferral vs. Tax-Free
When it comes to saving for retirement, there are two ways to fund the account(s). You either use pretax (traditional plans) or after-tax (Roth plans) funds. This is true for both 401(k) plans and IRAs. So, what's the difference between tax-deferred vs. tax-free retirement funds?
- Saving with a retirement plan come with certain tax benefits
- Traditional plans receive an upfront tax break, while Roth plans allow for tax-free distributions
- The younger you are, the more you can take advantage of the power of the Roth
Tax Deferral
When you invest in a traditional retirement plan, you are using pretax money. Essentially, your contributions are withdrawn before they are taxed. For example, if you have a workplace 401(k) plan, your contributions are taken out before you receive your paycheck. Let's say your gross income is $1,000 per week and you want to contribute $100 to your traditional 401(k). That $100 is sent to your 401(k) first (leaving you with $900 of taxable income). Now, that $900 is taxed based on your tax bracket and you then receive your paycheck, minus taxes and your 401(k) contribution. You receive an immediate tax break and the taxes are deferred until you withdraw from your 401(k).
Learn More: How do Self-Directed IRA's Work?
Advantages of Tax Deferral
Obviously, the main advantage of tax-deferred accounts is the ability to lower your tax bill in a given year. Since your tax bracket is based on your earned income for the year, any traditional contributions that lessen your income will be taken from the highest bracket. To simplify, let's say your annual salary is $100,000 and you are single. That puts you in the 24% tax bracket in 2023. Since the cutoff for the 22% tax bracket is $95,375, $4,625 of your income will be taxed at the 24% rate. However, if you were to contribute at least that much money into a pretax, or tax-deferred, account, you will fall back into the 22% bracket entirely.
The other significant advantage is the ability to pay taxes at a lower rate during retirement. This is especially true if you are at your peak earnings potential, in which you'll see your highest tax rates. With a tax-deferred account, you can hold off on paying those higher rates and wait until you start take distributions during retirement, when your tax hit will be significantly less. Note: you must wait until you reach age 59 1/2 to withdraw from your retirement plan to avoid the early withdrawal penalty.
Tax-Free
Who doesn't like the words "tax free?" When it comes to retirement accounts, tax-free refers to your withdrawals. As we stated earlier, you need to fund a Roth plan to reap the tax-free rewards. A Roth IRA or Roth 401(k) plan is funded with after-tax money. As opposed to a traditional plan, you don't get an immediate tax break. Using our example from above, if you earn $1,000 per week, the entire amount will be taxed. The Roth plan will be funded after the taxes are calculated. However, your retirement account will grow tax-free and you will never pay taxes on qualified distributions from a Roth plan.
To be a qualified distribution, the Roth must have been opened for at least five years, and you must be at least age 59 1/2. Withdrawals of earnings before both conditions are met will lead to tax and penalties. Note that contributions to a Roth can be withdrawn at any time without tax or penalty.
Advantages of Tax-Free
Tax-free distributions is the number one advantage of Roth plans. Not only are withdrawals of your contributions tax-free, but also any earnings from your investments. For example, if you contribute $50,000 to a Roth IRA throughout your working years and it grows to $1,000,000, the entire million will be tax free, not just the $50k in contributions! Taxes must be paid on the entire balance of a traditional plan that are withdrawn.
While traditional plans offer you an immediate tax break, you might not need it when you first start working. Often, when you enter the workforce, you will be in a lower tax bracket. The tax break is not as important for you if this is the case. Rather, you can pay taxes now at a lower rate and then enjoy the tax-free benefits later in life. Generally speaking, a Roth plan offers greater benefits over the long run.
One last thing to consider is that you can choose to let the Roth grow for as long as you wish. However, traditional plans start requiring withdrawals once you reach a certain age. In 2023, if you are at least age 73, you must start taking RMDs, required minimum distributions. The IRS wants its cut after all. RMD rules do not apply to Roth accounts since no taxes are due to the IRS. Therefore, you can let the assets grows unhindered for as long as you wish.
Did you know that you can purchase Real Estate in a Roth IRA and move in the rental property at 59 1/2? Learn more: Using a Roth IRA to Invest in Real Estate
Tax-Deferral vs. Tax-Free: Which Should You Choose?
Everyone's situation and retirement goals are different, so there's no one right answer to this question. However, there are a few things you should consider:
- If you are younger and have not reached your earnings potential, a Roth plan is typically the better choice. On the other hand, if you're currently in a high tax bracket, the tax break of the traditional plan might be better.
- Required Minimum Distributions - You are required to take mandatory distributions from traditional IRAs and 401(k) plans once you reach age 73. If you plan on utilizing your retirement funds throughout your golden years, this is perfectly acceptable. However, if you are in a comfortable financial situation and don't really need those funds and wish to leave them to a beneficiary (such as your child), a Roth is much better. Roth plans are a great estate planning tool since you are never required to withdraw from the account.
- Since Roth plans are funded with after-tax money, you are allowed to withdraw contributions at any time, tax- and penalty-free. This can come in handy if you are in dire straights for some cash. You will be penalized most of the time when you withdraw funds from a traditional account before the age of 59 1/2.
- One last thing to consider is your adjusted gross income (AGI). If you earn too much money, you cannot directly contribute to a Roth IRA. However, you can use the Backdoor Roth solution to get money into a Roth.
Conclusion
Whichever route you plan on taking, it's imperative that you save for retirement. The earlier you start and the more you contribute, the better you will be in the long run. There really is no right or wrong answer when choosing between tax-deferred vs. tax-free savings. Saving is the real key here. If you have any questions about the differences laid out, please contact us @ 800.472.0646.
How to Make Crowdfunding Investments with Retirement Funds
Crowdfunding is an approach for entrepreneurs and small businesses to raise capital from a number of investors in order to fund their business. Traditionally, entrepreneurs and small businesses in need of capital would turn to banks and venture capital firms, a method that takes a lot of time and money to present the business plan, market research, etc. Also, there is no guarantee of success.
The traditional method was also quite limiting, as it forced entrepreneurs to rely on a handful of integral players, putting fewer eyes on their business and in some cases the wrong eyes. Today, crowdfunding platforms not only provide a vast resource of investors to fund their business but facilitates entrepreneurs in finding the right investors. It also helps the investor find the right business venture to fund.
- Crowdfunding is a popular way to gain capital for startups
- Investments can be risky, so it's important to do your due diligence
- Investing with retirement funds allows for tax-free gains from your investment
Considerations of Crowdfunding Investments
As with any investment, there are some risks to take into consideration prior to investing in a startup. It is possible for several years to go by before an investor sees a return on his/her investment. An even more unfavorable outcome is the investor may not yield any return on his/her investment if the business fails to perform. By receiving capital through equity crowdfunding, it is more likely for a business not to perform than through traditional means, such as a venture capital firm. Venture capitalists offer more than financial support but have business management experience to help guide startups toward success.
Of course, there are also the benefits to consider, such as the ability to invest modestly on a business or project that is of personal interest to the investor. Furthermore, if the startup grows, the investor's cut will most likely appreciate in value. If the business owner decides to sell to another firm, such as Facebook's acquisition of the virtual reality headset Oculus Rift in 2014, the investor may yield a return far more substantial than their original investment.
SEC Loosens Federal Restrictions
Today almost anyone can fund a startup through an equity crowdfunding platform. Back in 2015, the Securities Exchange Commission (SEC) loosened the rules with a regulatory amendment called Regulation A+. Prior to this, only accredited investors (an individual who owned more than $1 million in assets, excluding their place of residence, or has maintained an income greater than $200,000 for at least two years) were able to invest in equity crowdfunding startups. Regulation A+ allowed individuals with an annual income or net worth less than $100,000 to invest a maximum of 5% (or $2,000 - whichever is greater) of their yearly income or net worth. Individuals who earn greater than $100,000 were able to invest 10%.
Benefits of Crowdfunding for Investors
The most tax-advantageous method to purchase investments is with the use of retirement funds. A Self-Directed IRA or Solo 401(k) for self-employed or small business owners allows you to generate tax-deferred or tax-free gains on your investments. Additionally, the IRS only states the types of transactions you cannot make with your retirement account, which are very few.
Crowdfunding is a legal and lucrative investment when using a self-directed retirement plan.
1. More Stable than Traditional Investments
Investors who are intimidated by the stock market volatility can find more security in the crowdfunding sector, as it is not linked to the financial markets. Therefore, during times of economic instability, the crowdfunding sector remains stable and often performs better than traditional assets.
As previously stated, crowdfunding offers stability through diversification. Rather than making a huge purchase for one investment option, you can invest funds into multiple business ventures. In the event that one investment performs poorly, you have several more investments to fall back on.
Related: Beginners Guide to Alternative Investments
2. Profitable for Investors with Small Capital
If you are interested in using your funds, whether personal or with a retirement plan, but don’t have much capital to invest, crowdfunding is a good place to start.
Unless you are interested in funding a crowdfunding real estate investment which demands a high cost of financial support, you can invest as little as $20 to one or multiple business ideas that appeal to you. As a result, the crowdfunding sector may be good for Millennials who are just establishing their careers, interested in investing, but do not wish to invest in the stock market.
3. Retirement Portfolio Diversification
Most investors know of the risks associated with investing in one investment class, like the stock market. To mitigate risk, investors must allocate their funds in a variety of investments, which is more possible with a self-directed retirement plan, such as the Self-Directed IRA or Solo 401(k) if using retirement funds for investments.
The crowdfunding sector offers retirement portfolio diversification by allowing investors to fund multiple companies. As with any investment, crowdfunding for investors requires plenty of due diligence of the borrower and his/her business plan.
If you are an entrepreneur, crowdfunding is an excellent source to receive the capital required to get your business off the ground. For investors, it’s a low-risk investment with the potential to yield high returns and avoid getting involved in an investment you don’t know or understand.
Learn More: The Importance of Diversifying Your Retirement Fund
Benefits of Crowdfunding for Entrepreneurs
Over the years, hundreds of crowdfunding platforms (like Kickstarter) have emerged, reinventing how entrepreneurs reach out to investors to receive the funding and sponsorship needed to begin their business ventures or take it to the next level. All of this can be achieved without banks or venture funds. Additionally, crowdfunding does much of the work for entrepreneurs, as the platforms provide investor updates, bookkeeping and more.
1. Financial Protection
Starting a business is a difficult process that comes with many financial challenges. Crowdfunding offers a form of financial protection, first through the process of market validation. It helps entrepreneurs and small business owners better determine whether the target market will like the product/service they are offering.
Furthermore, entrepreneurs with a good business idea in need of capital can utilize crowdfunding platforms to avoid using personal funds and potentially going into debt. It also protects them from giving up a part of their business to cover expenses to stay afloat. Through reward-based crowdfunding, entrepreneurs simply have to offer rewards to investors rather than shares in their company.
2. Better than Banks
Securing a loan through a bank is one of the most difficult challenges entrepreneurs faces. Securing a bank loan has become less frequent, and even if entrepreneurs are approved for a loan, they do not always receive the maximum funds they applied for. Through crowdfunding, you can choose a platform for your particular niche, ultimately increasing the chances of obtaining funds.
For example, Kickstarter allows you to choose from a variety of categories to share your business idea. Many platforms allow you to get creative in how you share the message behind your business, which is key in finding investors. A good presentation helps them relate to your message.
Let’s not forget, this approach is duplicates as a marketing strategy, as it brings more eyes to your business, thus the potential for more referrals through social media channels and unique visitors to your website.
3. It’s Completely Free to Use
This is a crowd favorite among entrepreneurs and small businesses: there is no fee to participate, and no risk for entrepreneurs who set goals they may not reach. If you are unable to reach your goal, simply return the funds to the donors without receiving a penalty.
How to Make Equity Crowdfunding Investment
If you are interested in equity crowdfunding, also known as investment crowdfunding, you can get started by establishing a Self-Directed IRA. This individual retirement account allows investors to diversify their asset investments by purchasing alternative assets. The Internal Revenue Code (IRC) does not describe what you can purchase with this type of retirement plan, only the investments you cannot make. These are known as the prohibited transaction rules. You can find more information on the IRC prohibited transaction rules by downloading our free Self-Directed IRA info kit, but prohibited transactions include life insurance and collectibles (art, stamps, etc.). Outside of these few prohibited assets, retirement investors can invest in virtually anything, like funding a startup through an equity investment platform.
Self-Directed IRA Provided by Banks
Most banks and financial institutions that claim to sell Self-Directed IRAs do not allow clients to purchase alternative asset investments. They limit investors to the investments they sell, such as bank CDs, stocks, mutual funds, etc. However, a Self-Directed IRA custodian permits both traditional and alternative asset investments. Most financial advisors will recommend that you diversify your investments, so they do not move in the same direction, which makes the Self-Directed IRA the perfect solution for retirement investors.
Using a retirement plan to make investments, such as a Self-Directed IRA is more advantageous than using personal funds. With an IRA, you can defer taxes on the income and gains the investment yields until you take a qualified distribution. This allows the investment to grow unhindered over the years.
At IRA Financial, we do not offer investment advice. We do not tell clients what they should or should not invest in, such as equity crowdfunding, only the types of investments that are possible with a Self-Directed IRA. However, equity crowdfunding can offer investors the ability to grow retirement wealth through alternative means. As with any investment, it is important to perform due diligence on the startup of interest as well as the entrepreneur's background.
The Corporate Transparency Act & Impact on Your Self-Directed IRA LLC
The government wants to learn more about your business or entity. This article will explore the new Corporate Transparency Act (CTA) and its impact on millions of entities operating in the US, including the Self-Directed IRA LLC.
- The Corporate Transparency Act seeks to garner information about a business's beneficial owners
- The CTA will go into affect beginning on January 1, 2024
- Those who utilize the Self-Directed IRA LLC structure will have to comply
What is the Corporate Transparency Act?
Beginning on January 1, 2024, a considerable number of companies in the United States will have to report information about their beneficial owners (the individuals who ultimately own or control the company). The beneficial owners will have to report the information to the Financial Crimes Enforcement Network (FinCEN). FinCEN is a bureau of the U.S. Department of the Treasury.
The primary purpose of the CTA is to stop the use of entities for money laundering and other criminal enterprises. The Treasury is attempting to gather more detailed information on individual owners with control or at least 25% ownership in entities with activities in the United States. The CTA follows a recent trend by the IRS and US governmental agencies to gain greater disclosure on individual ownership of cryptos and U.S.-focused entities.
The U.S. government believes there is a significant amount of under-reporting of income taxes and possible criminal activity by some entities that they are currently not able to uncover. They are hopeful that the CTA’s requirement for certain beneficial ownership information (BOI) will help them in this regard.
When is the CTA Starting?
The CTA is going into effect on January 1, 2024, and will require the disclosure of certain information related to beneficial owners and controllers of most US domestic entities and certain non-US entities doing business in the United States. These rules will likely impact investment funds and Self-Directed IRA LLCs by requiring the reporting of beneficial ownership information for certain individual owners and control persons. The identifying information will need to be reported to FinCEN.
How Many Entities Will Be Impacted by the CTA?
As first stated in the FinCEN September 2022 regulatory impact analysis, they said it is difficult to estimate the number of entities that are reporting companies and will be subject to the CTA. The analysis assumed that all entities created or registered before the effective date of Jan. 1, 2024, that are subject to the BOI reporting requirement — 32.6 million entities — will submit initial BOI reports in the first year.
In 2025 and beyond, FinCEN estimates that almost 5 million initial BOI reports will be filed each year, the same estimate as the number of new entities per year that meet the definition of a reporting company and are not exempt. The total five-year average of expected BOI initial reports is about 10.5 million.
FinCEN estimates that about 6.6 million BOI update reports will be filed in 2024, and about 14.5 million such reports will be filed annually for 2025 and beyond. The total five-year average of expected BOI update reports is almost 12.9 million.
The primary issue with the CTA from a FinCEN oversight standpoint is manpower. In 2023, they have less than four hundred employees. With an average of 10 million BOI reports filed in the coming years, the question is how will they handle the sheer volume of reports and whether will they have the capacity to do much with the data.
What Companies Need to File a BOI Report?
All entities formed or registered to do business in the United States will need to either (i) confirm they qualify for an exemption from the CTA’s reporting requirements or (ii) timely submit a BOI report to FinCEN.
Which Entities are Exempt from the CTA BOI Requirement?
Exemptions may apply to certain entities, including the following:
- There is an exemption for entities already subject to other federal reporting, so registered investment advisers under the Investment Advisers Act of 1940.
- Large operating companies have several requirements including a threshold of at least 20 full-time employees, a physical US office, and more than $5 million of gross receipts.
- Tax-exempt entities such as private foundations are exempt from reporting.
- Certain inactive entities do not need to be reported.
- Certain types of trusts that are not created by a filing with a Secretary of State or similar office.
Who is a Beneficial Owner?
Under the CTA, a “Beneficial Owner” is any individual who either:
- Directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise, either exercises substantial control over the Reporting Company, such as a senior officer, or the ability to appoint a senior officer. A decision maker on the business, finances, or structure of the company; or
- Owns or controls at least 25% of the ownership interests of the Reporting Company.
There is always at least one beneficial owner, and there can be more than one beneficial owner, even if no one owns at least 25% of the entity.
It is important to note that a “Beneficial Owner” needs to be a person (not a company or legal entity).
When is BOI Reporting Due?
Reporting for the LLC’s will be due:
- If the LLC was established on or after January 1, 2024, 90 days from creation to reporting the BOI with FinCEN.
- If the LLC was established prior to January 1, 2024, the BOI report will be due on or before December 31, 2024.
Penalties for Failure to File BOI Report
The BOI reporting is free but if one is late or fails to file a BOI report, the penalty is $500 a day up to $10,000. In addition, criminal penalties of up to two years of imprisonment may apply for a failure to file the BOI report.
What Type of Information Must be Reported on the BOI?
For reporting companies, the following information will need to be provided on the BOI report:
- Legal Name of individual
- Date of Birth of individual
- Current Address of individual
- Identifying Number (Passport, Driver’s License, State ID) of individual
Any changes to the BOI need to be reported to FinCEN within 30 days of the change. In addition, corrections need to take place within 30 days of learning of the error.
The Self-Directed IRA LLC and the BOI Report
A Self-Directed IRA LLC, also known as a Checkbook Control IRA, involves the establishment of an LLC that is wholly owned by one or more IRAs and managed by the IRA owner. Under the CTA rules, a Self-Directed IRA LLC would be deemed a reporting company and would, thus, be required to file a BOI report with FinCEN. Since the BOI report must be completed by an individual and an IRA is not an individual, the report would need to include the information for the IRA owner, who is the person in control of the LLC as the manager.
IRA Financial has been working with its internal compliance team to develop a program that will allow it to file the BOI reports for the plan. Each BOI report must be submitted directly to FinCEN and the person submitting must have a FinCEN filing number. To relieve our clients of the stress and responsibility of acquiring a FinCEN number and filing a BOI report, we will be offering this service to all our clients who have elected to join our annual consulting/compliance program.
It is possible that some investors may look to establish a trust, instead of an LLC, to circumvent the BOI reporting rules. IRA Financial is one of the few Self-Directed IRA custodians that does offer clients the ability to use a trust as a checkbook control vehicle to make investments.
Does a Self-Directed IRA or Solo 401(k) have to File a BOI Report?
A full-service Self-Directed IRA that invests directly in the name of the IRA without the use of an entity, such as an LLC, would not be treated as a "reportable" company under the CTA regulatory framework. The same goes for a Solo 401(k) plan since, in both cases, they are retirement trusts that are not entities formed or registered to do business in the United States.
Conclusion
If you do utilize the Checkbook IRA LLC structure, there will be extra reporting requirements starting next year. For most investors, this shouldn't be worrisome. In fact, if you are an IRA Financial client and take advantage of our compliance service, we'll do all the work for you. The CTA is just another way for the government to catch bad actors and those looking to cheat the system. Stay tuned as we see what happens in the new year.
How to Shelter a Profits Interest from Taxation
The IRS and Internal Revenue Code (IRC) offer IRA owners a wide latitude in the types of assets in which they can invest. The Code allows IRA owners to invest in publicly traded securities or assets in the custody of a financial institution or non-publicly traded alternative assets, such as real estate and private placement stock. However, an IRA owner is not permitted to engage in certain prohibited transactions which generally involve life insurance, collectibles, and transactions involving the IRA and a “disqualified person.” These types of transactions are prohibited to prevent misuse of an IRA to benefit the owner or other disqualified persons in a way other than as a vehicle to save for retirement.
This article will explore how one could potentially use a Self-Directed Roth IRA to purchase a profit interest in an investment fund to shelter the gains from tax.
- Profits Interest from an investment fund are generally available to key employees and accredited investors
- Highly successful funds can generate large profits for investors
- Shelter the gains by investing with a Self-Directed Roth IRA
How are Investment Funds Structured?
An investment fund, such as a private equity fund, real estate fund, hedge fund, or venture capital fund are typically structured as a partnership or an LLC. Both a partnership and an LLC are taxed as a flow-through entity. Partnerships typically grant two types of partnership interests - capital interest and profits interest.
Capital interests are issued to outside investors, known as limited partners, generally in exchange for cash investments in the partnership. Whereas a profits interest is often granted to key employees in exchange for services, ideas, and expertise that benefit the partnership. In some cases, a profits interest is also referred to as a carried interest.
The initial value of a capital interest is typically higher than that of profits interest because it mirrors the limited partners’ cash investment in a fund. However, the owner of a profits interest has a right only to future profits generated by the fund if it is a success. In general, the IRS taxes a profits interest or carried interest as a capital asset subject to the lower capital gains tax regime and not subject to the ordinary income tax rules.
Who Can Invest in an Investment Fund?
Non-publicly traded shares and private placement partnership interests can generally only be offered to a small number of individuals, in part because all offers and sales of securities must be registered under the Securities Act of 1933, unless an exemption from registration is available. The most used exemption limits the investors who can purchase securities in the offering to accredited investors.
What is an Accredited Investor?
The SEC defines individual accredited investors as any person who comes within certain categories, or who the issuer of the securities reasonably believes comes within certain categories, at the time of the sale of the securities to that person.
Some of these categories include: (i) any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer; (ii) any natural person whose individual net worth, or joint net worth with that person’s spouse exceeds $1,000,000 (excluding the individual’s primary residence); and (iii) any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.
What is a Self-Directed Roth IRA?
The Relief Act of 1997 introduced the Roth IRA, which is an after-tax IRA which allows any US person with earned income under a set income threshold to make after-tax contributions up to annual limit. The limit for 2023 is $6,500, plus an additional $1,000 catch-up contribution if you are at least 50 years old. So long as the Roth IRA has been open for at least five years and the Roth IRA owner is over the age of 59 1/2, all Roth IRA distributions would be tax free. Plus, there are no required distributions for a Roth, meaning it can grow unhindered for as long as you like.
A Self-Directed Roth IRA is simply a Roth IRA that can invest in alternative asset investments, such as non-publicly traded securities or real estate, among a myriad of other asset classes. In order to self-direct your plan, you need to work with the right custodian, such as IRA Financial.
Using a Self-Directed Roth IRA to Acquire a Profits Interest
In general, a profits interest has the potential to provide key employees with large investment returns based on the amount of capital if the fund is a success. If, on the other hand, the fund does not generate a minimum rate of return for its outside investors, the profits interest may expire without generating any money for the key employee.
The following is a breakdown of how it works:
- Step 1. Establish a Self-Directed Roth IRA and fund the plan either by direct contributions, rollover/transfer of Roth funds, or a conversion of pretax retirement funds. The unique aspect of the profits interest Roth IRA strategy is that it requires a minimal amount of capital outlay.
- Step 2. The General Partner establishes an investment fund and invests around 5% of the capital and seeks outside investors (limited partners) to help raise the remaining 95%.
- Step 3. The general partner typically receives 20% as a profits interest in the fund for its management, wisdom, and success. The general partner grants the partnership profits interests to key employees at the fund, who are granted profits interest for a minimal amount.
- Step 4. The general partner uses the funds invested by the limited partners to make investments and works with the key employees to raise the value of the fund. After several years, the general partner sells the underlying fund’s investments.
- Step 5. The fund’s assets are then allocated to the partners based on the fund’s partnership agreement. In a typical fund arrangement, the limited partners would receive the capital they invested back and then an 8% rate of return. After that, the general partner typically takes 20% of the rest of the profits as a “profits interest” or “carried interest,” which are distributed to the key employees of the fund.
How to use a Self-Directed Roth IRA to Acquire a Profits Interest
The IRS is clear that an IRA or 401(k) plan is permitted to invest in a profits interest. “As with non-publicly traded shares, key employees at private equity firms and hedge funds may use IRAs to purchase profits interests from the general partner.” According to the IRS, there are two ways for a retirement account to invest in a profits interest:
- Profits Interest Purchased by an IRA: The general partner grants or sells profits interest in the fund to key employees making them eligible to share in the general partner’s profits interest in the fund. The key employees use a Roth IRA, either via a contribution, rollover, or conversion, to buy the interests in the entity holding the profits interest.
- Profits Interest Put Directly into the Employer Sponsored Retirement Plan: The general partner puts the profits interests directly into the employer sponsored retirement plan in Roth or pretax. The profits interests are then allocated to the retirement plan when the fund matures without tax. In general, so long as the plan does not relieve the employer of any present or future obligation to contribute that is measured in terms of cash amounts, an in-kind contribution, such as a profits interest, can be made without triggering the IRS-prohibited transaction rules. The in-kind profits interest can then be rolled into an IRA or Roth IRA.
Key Items to Consider When Structuring a Profits Interest-Self-Directed Roth IRA Transaction
When contemplating using a Self-Directed Roth IRA to purchase or be allocated a profits interest, it is important to keep in mind that the IRS is typically concerned with three issues: (i) value of the profits interest, (ii) the statute of limitations, (iii) Identification.
Valuing the Profits Interest Received
According to the IRS, it is often difficult for IRS to pursue cases of potential abuse based on inappropriately valued assets, such as a profits interest. The IRS is clear that it generally requires individuals to assess the value of assets in IRAs rather than use another valuation method. However, IRS guidance infers that individuals can use the liquidation value of a profits interest for certain tax purposes.
Based on the liquidation value method, there is ample case law to support very low valuations of profits interests. Under this method, so long as the entity that holds the profits interests is liquidated based on positive capital accounts, the profits interests would have a zero balance since all funds would be allocated to any investors that have invested funds providing them a positive capital account.
In other words, if the entity that holds the profits interests is liquidated, all funds in the entity would be sent first to the investors who contributed funds, and since no funds would remain, the liquidation value method would treat the profits interest as having a zero value.
Moreover, under Campbell v. Commissioner, the Eighth Circuit Court of Appeals overturned a decision by the U.S. Tax Court and held that an individual who is granted a profits interest does not need to recognize any income if the profits interest does not have a readily ascertainable value.
The Statute of Limitations
In general, the statute of limitations for the IRS to pursue cases is generally only three years, which poses certain difficulties to the IRS for pursuing prohibited transactions involving IRAs. Generally, the IRS has three years from the date a return is filed (whether the return is filed on time or not) to assess tax liability. The statute of limitations may be extended in certain situations, such as submitting a false or fraudulent tax return or otherwise engaging in a willful attempt to evade a tax.
The long-term nature of private equity, real estate, or hedge fund investments typically involves a long-term lock-up period, such as four to seven years. This poses an issue for the IRS to uncover any problematic investments involving IRAs and investment fund profits interests.
Identification
The IRS admitted that due to a lack of information in publicly available filings by private equity firms and hedge funds, it could not determine the extent to which key employees use 401(k) plans or IRAs to invest in profits interests.
Profit sharing and 401(k) plans governed by ERISA and the IRC may generally satisfy annual reporting requirements by filing a Form 5500 Annual Return/Report of Employee Benefit Plan and its accompanying schedules. Form 5500-SF filers generally are not required to file schedules or attachments, such as Schedule H, which is required to be filed for plans with more than 100 participants.
However, small plans that directly invest in or allow participants to invest directly in non-publicly traded shares or profits interests would be required to file Form 5500 and Schedule I. Schedule I does not directly request information on participants that have invested in a profits interest or carried interests, but only seeks information on investments in “Partnership/joint venture interests."
Conclusion
The IRS is clear that key employees at investment funds may use IRAs or 401(k) plans to purchase profits interests from the general partner. The most important items to consider when contemplating using a Self-Directed Roth IRA to acquire a profits interest in the fund are the following:
- Plan before your fund has been established or has not received any funds allocated to the profits interest.
- Make sure the profits interest does not have a readily ascertainable value.
- Acquire the profits interest directly from the company and not from yourself personally.
- If you are involved with a real estate fund, consider using a 401(k) because of the UBTI tax on leverage for IRAs.
If you have any questions, feel free to contact us to discuss.
Solo 401k Eligibility & Plan Setup
Solo 401(k) Eligibility
If you’re a business owner with no full-time employees, or you earn self-employment income, you can establish a Solo 401(k). It is perfect for independent contractors, such as consultants, home businesses, and real estate agents. If you qualify, your spouse can also contribute as long as he or she is an employee of the business.
As long as self-employment income exists, you can establish a Solo 401(k). If you have a side gig, you can establish a Solo 401(k), even if you have a full-time job. Use your plan as a vehicle to save more money, generate greater tax deductions, or simply as an investment vehicle for real estate or other investments.
The Solo 401(k) plan may be adopted by an individual sole proprietor, or any other business entity, such as an LLC, corporation, or partnership. In general, in order to be eligible to benefit from the Solo 401(k) plan, one must meet just two eligibility requirements:
To be eligible to benefit from the Solo 401(k) plan, investors must meet two eligibility requirements:
- The presence of self-employment activity.
- The absence of full-time employees.
A Solo 401(k) is an IRS-approved retirement plan that is well-suited for businesses that either have no employees or no full-time employees, therefore are excluded from coverage. A Solo 401(k) plan is perfect for sole proprietors, consultants, or independent contractors. Individuals who have a full-time job are also eligible to open a Solo 401(k).
The Presence of Self-Employment Activity
Solo 401(k) eligibility includes the presence of "self-employment activity". This refers to the ownership and operation of:
- A sole proprietorship
- Limited Liability Company (LLC)
- C Corporation, S Corporation
- Limited Partnership where the business intends to generate revenue for profit and make significant contributions to the plan
Related: Solo 401(k) Rollover vs. Contribution
Generate Revenue for Profit
IRS will consider you eligible for the plan if the business is legitimate and is run with the intention of generating profits.
Self-employment activity can be part-time, and it can be ancillary to full-time employment elsewhere. A person can even participate in an employer’s 401(k) plan in tandem with their own Roth 401(k) retirement plan. In such a case, the employee elective deferrals from both plans are subject to the single contribution limit.
There are no established thresholds for:
- Profit the business must generate
- How much money must be contributed to the plan
- When and how quickly the profits and contributions must occur
Related: Beginner’s Guide to Alternative Investments
The Absence of Full-Time Employees
Unlike a regular 401(k) plan, a Solo 401(k) retirement plan can be implemented only by self-employed individuals or small business owners with no other full-time employees. Additionally, they must not be employed by any business owned by them or their spouse. An exception applies if your full-time employee is your spouse.
The business owner and their spouse are technically considered “owner-employees” rather than “employees."
*Did you know that individuals who participate in the Gig economy are eligible for a Solo 401(k)? Learn more about different side-jobs individuals can do to open a Solo 401(k).
Employees who are Excluded from Coverage
To maintain Solo 401(k) eligibility, the following types of employees may be generally excluded from coverage:
- Employees under 21 years of age
- Employees that work less than 1,000 hours annually
- Union employees
- Nonresident alien employees
Do you have full-time employees aged 21 or older (other than your spouse)? Do your part-time employees work more than 1,000 hours a year? If yes, you must typically include them in any plan you set up. However, a business eligible for the plan can have part-time employees and independent contractors.
Learn More: Solo 401(k) Prohibited Transaction Rules
*Did you know IRA Financial Solo 401(k) comes with a loan feature. While many 401(k) plans enable individuals to take loans, some providers exclude this feature from their Solo 401(k) plan. Many individuals have recently started a new business use a Solo 401(k) loan to invest in their new business venture.
Learn More:
Why Choose a Solo 401(k) vs. a SEP IRA?
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ROBS Solution: How to Determine a Reasonable Salary
You are now working in a business funded by the Rollover Business Startups (ROBS) structure and it's up to you to determine a reasonable salary for your position. While you do not want to be underpay yourself for any services performed, if you pay yourself excessively, the excess pay will not be allowed as a deduction. In this article, we provide a few strategies to ensure that your salary is considered reasonable by the IRS.
ROBS Solution
The Rollover Business Startup solution is an avenue many entrepreneurs take in order to fund a new or existing business with their retirement funds. Furthermore, the structure (ROBS for short), allows individuals to participate in the business and even earn a salary. Entrepreneurs can do all of this without triggering the IRS prohibited transaction rules.
What Makes ROBS So Special
Here is a little background information on the ROBS structure for those who are learning this term for the first time:
The rules under Internal Revenue Code (IRC) section 4975 disallow individuals from investing in transactions with disqualified persons, which includes themselves. The rollover business startup solution is so attractive among entrepreneurs due to an exception to the prohibited transaction rules, which allows a 401(k) plan to purchase stock in a C corporation. This is the only legal way that an individual can use his/her retirement funds to invest in a business he/she will be personally involved in. There is the Solo 401(k) loan, however the loan limits individuals to $50,000 or half of their account value (whichever is less). So, if you need more than the Solo 401(k) loan permits, you will have to find the money elsewhere.
Read More: What is Rollover Business Startups?
Factors to Determine a Reasonable Salary
You have to ensure that your business is IRS compliant and one of the ways to do this is to be an employee of a business that provides a legitimate service. Once the business generates compensation, you can earn a salary. You have to prove to the IRS that the pay is reasonable depending on the circumstances that existed when you contracted the services - not the circumstances when the reasonableness of the salary was in question.
Look at the following facts to determine if the pay is reasonable:
- Duties you perform
- Type/amount of responsibility
- Complexity of your business
- Time required to complete tasks
- Cost of living in the area
- Pay policy for your employees
- Inflation
- Education and/or experience required for the position.
Do a Market Salary Comparison
Of course, you can perform a market salary comparison to find out the salary for similar positions. You can easily do this by going to a salary website, such as salary.com, glassdoor.com or indeed.com. This will help you see the salary of similar roles at other companies (in some cases, it also gives you a good idea of the employee benefits).
Work with a ROBS Provider
Finally, you can work with a ROBS provider. You should generally work with the provider who established your ROBS structure and provides ongoing assistance, such as IRA Financial. One of the main concerns the IRS has with the ROBS structure is the lack of compliance among participants. In order to truly ensure compliance, work with a ROBS provider to determine a reasonable salary for your position.
Key Takeaways
Determining a reasonable salary for your position after employing the ROBS structure is just one of the many steps to staying IRS compliant.
The ROBS structure is a great way for entrepreneurs to see their business ventures come to fruition. However, it is very complicated to navigate, which is why you should always work with a trusted ROBS provider who has had years of industry experience and can provide ongoing maintenance.
Can I Use the Real Estate Owned by a Self-Directed IRA?
Unlike stocks and other passive investments, real estate is a tangible asset that can provide real value to an investor. This article will explore the rules on using a Self-Directed IRA to buy real estate and will also cover, what, if any, benefit, the IRA owner can gain from the IRA-owned asset.
What is a Self-Directed IRA?
When IRAs were created in 1974 by ERISA, the Act did not distinguish between an IRA that invested in stocks and other traditional investments, and a Self-Directed IRA that invests in alternative assets. Essentially, a Self-Directed IRA is an IRA that can invest in almost any asset without restriction. Generally, traditional financial institutions will place limitations on the types of investments you can make. However, when working with the right plan administrator/custodian, such as IRA Financial, no such limitations are in place. Therefore, you can invest in anything you choose, so long as it is not prohibited by the IRS.
For the most part, the only things you can't invest in are collectibles, life insurance, and transactions involving a disqualified person, which we will discuss below.
Self-Directed IRA Prohibited Transactions
The IRS has always permitted alternative investments to be held inside IRA accounts. However, IRA providers have the option to only offer investments they so choose. Real estate is arguably, the most popular Self-Directed IRA investment. However, there are specific rules that need to be followed to make sure your plan remains compliant with the IRS.
What is a Disqualified Person?
The term “disqualified person” includes virtually anyone having a direct or indirect relationship to the plan other than as a participant or beneficiary. Under Internal Revenue Code (IRC) Section 4975, the principle categories of disqualified persons are:
- The IRA participant (holder)
- The IRA’s participant’s ancestors and lineal descendants (spouse, mother/father/daughter/son)
- Spouses of the IRA participant’s lineal descendants (son/daughter’s spouse)
- Fiduciaries of the plan (custodian or trustee)
- Investment managers and advisors
- Any corporation, partnership, trust, or estate in which the IRA holder has a 50% or greater interest
- 10% or more shareholder, highly compensated employee, or director of an entity that is 50% or more owned by a disqualified person.
- 10% or more owner of an employer with a 401(k) plan
Siblings, aunts, uncles, cousins, friends, neighbors, coworkers etc. are not included in the definition of disqualified persons.
What is a Prohibited Transaction?
IRC Sections 4975 & 408 prohibit fiduciary and other disqualified persons from engaging in certain types of “prohibited transactions," which are any direct or indirect:
- sale or exchange, or leasing, of any property between a plan and a disqualified person;
- 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;
- transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;
- 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
- 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.
Fiduciary prohibited transactions appear to be the most common in the Self-Directed IRA context. The IRA owner is a fiduciary to the plan and cannot use his or her IRA to directly benefit him or herself.
Investing in Real Estate with a Self-Directed IRA
The two most common ways to purchase real estate with a Self-Directed IRA is either having the IRA custodian purchase the asset directly or via the use of an LLC where the IRA owner serves as manager, which then owns the real estate. In both cases, the IRS prohibited transaction rules under IRC Section 4975 apply and dictate what level of activity the IRA owner or any disqualified person can have in relation to the IRA asset.
Using Real Estate Owned by a Self-Directed IRA
In general, the intent of the IRS prohibited transaction rules is that an IRA owner should make investments to exclusively benefit the IRA. To this end, IRC Section 4975(c)(1)(D) is clear that a prohibited transaction occurs when the income or assets of a plan are transferred to a disqualified person. Hence, if an IRA owned 100% of a real estate asset and the IRA owner used the real estate for any personal purpose, the IRS would have a strong argument that the personal use of the real estate violated the rules. The same goes if the real estate is owned 100% by an LLC.
Therefore, if the IRA owns at least 50% of an asset, a disqualified person should not have any direct or indirect benefit from said asset. This can include staying at an IRA-owned property, or utilizing raw land held in the plan.
On the other hand, an argument can be made that if your IRA owns less than 50% of a real estate investment, the underlying investment or LLC would not be treated as a disqualified person. This is somewhat of an aggressive position since the IRS would argue that, as the IRA owner, you are receiving a direct benefit from your IRA asset in violation of IRC 4975. However, if the real estate is owned by an LLC, which is not controlled by a disqualified person, the IRS may have more difficulty making the argument.
The Plan Asset Rules
Taking this argument, a step further, under the “plan asset rules," if an LLC is owned less than 25% by IRAs, the owners of the LLC (the IRAs) are not deemed to have a direct ownership in the LLC’s assets – i.e. the real estate. An argument can be made that if the real estate is owned in an LLC that is less than 25% owned by retirement accounts, the plan asset rules would not treat the IRA as a direct owner. Therefore, the owner could gain some personal benefit from the asset, so long as he or she can show the investment was not made for any personal benefit.
In such a case, where the IRA owner paid for value for the use of the property, i.e. renting a cabin, and the IRA owned less than 25% of the asset, an argument can be made that because the plan asset rules do not treat the IRA owner of the LLC as a direct owner of the LLC’s real estate, use of the real estate would not trigger a prohibited transaction.
Please note – anytime an IRA owner gains any personal benefit from the use of an asset owned by an IRA, there is a string risk that the IRS could argue that a prohibited transaction occurred. Clearly, the lower percentage of IRA ownership coupled with the level of use will be an important determination of the IRS’s inclination to fight the transaction. For example, if your IRA owns 1% of a real estate fund that owns a hotel and you go on vacation and pay fair value for a hotel room, I believe the IRS would be hard pressed to argue a prohibited transaction occurred. Whereas if your IRA owns 75% of a real estate asset and you use the property for three months, the IRS would be far more motivated to argue that a prohibited transaction occurred.
Conclusion
When it comes to gaining some personal use of a real estate asset owned by your Self-Directed IRA, the safest approach is to not derive any personal benefit from the asset. This is especially true when the IRA will own more than 50% of the LLC and/or the asset itself. However, in the situation where a real estate asset is owned in an LLC where the total IRA ownership is less than 25%, the plan asset rules may provide some cover for an IRA owner to gain some personal use of the real estate asset on the same economic terms as a third-party. While you may be able to benefit from an IRA-owned asset, it's generally not worth the risk of losing the tax benefits of the plan. Tread carefully, and always speak to a professional before making any investment.
Capital Gains Tax and the Self-Directed IRA
The capital gains tax regime has been one of the key factors for the growth of the U.S. economy. By providing investors with the ability to benefit from a lower tax rate for holding an investment greater than a year, the capital gains tax has functioned to encourage savings and increase economic growth. The capital gains tax regime only applies to capital assets.
This article will describe, in simple terms, how the capital gains tax regime works, as well as explain how using a Self-Directed IRA or Roth IRA can prove even more tax advantageous.
- Most holdings, such as stocks and real estate, are considered capital assets
- Capital assets are subject to either short- or long-tern capital gains tax
- Using a Self-Directed IRA to invest shelters you from the tax as long as the asset remains in the plan
What is a Capital Asset?
According to the IRS, almost everything you own and use for personal, or investment purposes is a capital asset. Examples include a home, car, and stocks or bonds held as investments. A capital asset is property that is expected to generate value over a long period of time. In essence, from a tax perspective, a capital asset is all property held by a taxpayer, with the exceptions of inventory and accounts receivable.
Taxation of Capital Gains
Federal tax law apportions capital gains into two different classes determined by the calendar.
Short-term gains come from the sale of property owned one year or less; long-term gains come from the sale of property held more than one year. Short-term gains are taxed at your maximum ordinary income tax rate, where the maximum tax rate in 2025 is 37%. Whereas most long-term gains are taxed at either 0%, 15%, or 20%. For most people, you will be in the 15% bracket if your income falls between roughly $48,000 and $533,000.
In order to determine whether your capital gains transaction will be subject to the short-term or long-term capital gains tax rules depends on the period of time the taxpayer held the asset. When figuring the holding period, the day you bought the asset does not count, but the day you sold it does. So, if you bought a capital asset, such as a piece of real estate, on August 1, 2024, your holding period began on August 2nd. August 1, 2025 would mark one year of ownership for tax purposes. If you sold the asset on that day, you would have a short-term gain or loss. A sale of the asset one day later, on August 2nd, would produce long-term tax consequences, since you would have held the asset for more than one year. The federal income tax rate you pay depends on whether your gain is short-term or long-term.
Related: Self-Directed IRA Real Estate vs. Capital Gains
Capital Losses
A capital loss is a loss on the sale of a capital asset such as a stock. As with capital gains, capital losses are divided by the calendar year into short- and long-term losses and can be deducted against capital gains, but there are limitations. Losses on a capital investment is first used to offset capital gains of the same type. Hence, short-term losses are first deducted against short-term gains, and long-term losses are deducted against long-term gains. Net losses of either type can then be deducted against the other kind of gain.
So, for example, if you have $4,000 of short-term loss from a stock investment and only $1,000 of short-term gain from a stock investment, the net $3,000 short-term loss can be deducted against your net long-term gain (assuming you have one).
If a taxpayer engages in numerous capital asset transactions in a particular year, the end result could be a mix of long- and short-term capital gains and losses If you have an overall net capital loss for the year, you can deduct up to $3,000 of that loss against other kinds of income, including your salary and interest income, for example. Any excess net capital loss can be carried over to subsequent years to be deducted against capital gains and against up to $3,000 of other kinds of income. If you use married filing separate filing status, however, the annual net capital loss deduction limit is only $1,500.
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When Do you Owe Capital Gains Tax?
The federal income tax rules do not tax all capital gains. Rather, gains are taxed in the year an asset is sold, regardless of when the gains accrued. Unrealized, accrued capital gains are generally not considered taxable income. For example, if you bought a capital asset for $10,000 five years ago, and it’s worth $30,000 now and you sell it, your taxable capital gain would be $20,000 in the current year, and zero in the previous years.
Capital Gains and Mutual Funds
A mutual fund is a professionally managed investment fund that groups money from many investors to purchase securities. Based on the mutual fund rules, mutual funds that accumulate realized capital gains throughout the tax year must distribute them to shareholders.
Many mutual funds distribute capital gains right before the end of the calendar year, even if they are short-term capital gains. For tax conscious investors, owning a mutual fund in an IRA or 401(k) plan would prove more tax advantageous because a retirement account does generally not pay any tax on income or gains generated on a capital asset investment.
The Self-Directed IRA & Capital Gains
One of the primary tax advantages of using a Self-Directed IRA to make investments is that, in general, all income and gains are tax-deferred or tax-free in the case of a Roth IRA. In other words, an IRA would not be subject to ordinary income tax or any capital gains tax on income or gains allocated to an IRA, irrespective of holding period.
For active stock or crypto traders, using a Self-Directed IRA is a huge tax advantage. Most active traders will not hold the underlying asset for longer than twelve months, meaning the gains from the capital investment would be subject to short-term capital gains, which is taxed based on the taxpayer’s ordinary income tax rate. Whereas, if the investor used an IRA to make the investments, no tax would be due on any of the trading gains, The same principles would apply if the IRA invested in real estate.
The one drawback for using a Self-Directed IRA versus personal funds to make a capital investment, such as real estate, is that by using personal funds one can benefit from depreciation and other deductions, as well as pass-through tax losses. Although, depreciation recapture could be owed on a sale.
In addition, the sale of the asset would be subject to capital gains. Versus, owning the real estate in an IRA, where the IRA would not benefit from any losses, and IRA distributions are subject to ordinary income tax. Though, an IRA would be able to take advantage of the power of tax deferral and defer all income and gains until a later time when a taxable distribution is taken. Of course, a Roth IRA would trump the pretax IRA option and likely also the personal fund option since all qualified Roth IRA distributions are tax-free.
Conclusion
Making an investment that generates long-term capital gains versus ordinary income is considered tax savvy. Using a Self-Directed IRA to make that same investment could be considered ingenious since you could potentially defer or eliminate any future tax on the asset.
Whichever way you decide to invest, you should know the ramifications of both types of capital gains, and you can potentially use losses to offset any taxes incurred.