Adam Bergman

Founder, Tax Lawyer, Author

If you are a founder, partner, fund manager, or key employee who has been granted a profits interest in an LLC or partnership, you may be sitting on one of the most significant tax planning opportunities available under the Internal Revenue Code.

When properly structured, a profits interest held inside a Self-Directed Roth IRA can allow decades of future appreciation and income to grow and ultimately distribute completely tax-free. For entrepreneurs and investment professionals who expect their profits interest to become highly valuable, this strategy can mean the difference between paying millions in taxes and keeping those gains entirely within a retirement account.

As a tax attorney who has spent more than 25 years helping business owners and investment professionals build retirement wealth, I believe this is one of the most underutilized planning strategies available today. The rules are complex, the execution must be disciplined, and the transaction must be structured carefully. But for the right person, the long-term tax savings can be extraordinary.

What Is a Profits Interest?

A profits interest is a type of partnership or LLC interest that entitles the holder to participate in future profits and appreciation of the entity but carries no right to receive any proceeds upon an immediate liquidation at the time of grant. In other words, if the business were sold the day after the profits interest was issued, the holder would receive nothing because there are no profits yet to share.

This definition comes directly from IRS Revenue Procedure 93-27, which established that a profits interest received by a service provider in exchange for services to a partnership is generally not taxable at the time of grant if two conditions are satisfied. First, the interest must not relate to a substantially certain and predictable stream of income. Second, the recipient must not dispose of the interest within two years.

Revenue Procedure 2001-43 further clarified that a profits interest can be structured so that its value at issuance is zero based on the current liquidation value of the entity. This means that under the right circumstances, someone can receive an interest in a business at effectively no tax cost simply because there are no current profits to share.

Founders, fund managers, real estate sponsors, key employees, and incentive compensation recipients commonly receive profits interests as part of their economic arrangement with a business or fund.

Why a Roth IRA Creates Such a Powerful Opportunity

The Roth IRA is one of the most powerful tax planning vehicles available under the Internal Revenue Code. Qualified distributions are completely tax-free, including all investment appreciation. There are no required minimum distributions during the account owner’s lifetime.

A profits interest fits this framework almost perfectly. At formation, a profits interest may have a near-zero fair market value. Years later, after the business or fund has grown significantly, that same interest may entitle the holder to millions of dollars in future distributions. If those economics accrue inside a Roth IRA rather than in a taxable account, the long-term tax savings can be transformative.

This is exactly the type of planning strategy I discuss in my book on Self-Directed IRAs. The concept is straightforward: identify an asset that has minimal current value but significant future growth potential, acquire that asset inside a Roth IRA at a low cost, and allow decades of tax-free compounding to work in your favor.

How the Structure Works

Step 1: Establish a Self-Directed Roth IRA. Traditional brokerage firms do not permit private partnership interest investments. A Self-Directed Roth IRA custodian such as IRA Financial is required to hold this type of alternative investment.

Step 2: Fund the Roth IRA. Depending on your income and prior Roth contributions, you may fund the Roth IRA through annual contributions, a Backdoor Roth IRA conversion, or by rolling over assets from an existing retirement account.

Step 3: Determine fair market value at issuance. This step is critical. The Roth IRA must acquire the profits interest at fair market value. Under Rev. Proc. 93-27 and Rev. Proc. 2001-43, a newly issued profits interest in a partnership or LLC often has a liquidation value of zero at issuance because there are no current profits to distribute. However, this does not mean the interest can be acquired for nothing. The fair market value must be documented and defensible.

Working with qualified tax counsel to prepare a valuation memorandum at the time of acquisition is a best practice. If the IRS were to challenge the transaction, the documentation prepared at the time of issuance will be the primary evidence supporting the value assigned.

Step 4: Issue or transfer the profits interest to the Roth IRA. Depending on the structure, the Roth IRA may receive a new class of interests directly from the entity, or it may purchase an existing profits interest from a current holder. Both approaches have different risk profiles under the prohibited transaction rules, which are discussed in detail below.

Step 5: Allow appreciation to accumulate tax-free. Once the profits interest is held inside the Roth IRA, any appreciation, distributions, and profits allocations generally flow into the retirement account. Those amounts grow tax-deferred in a Traditional IRA or potentially tax-free in a Roth IRA, depending on which account structure is used.

Critical Tax Issue: Valuation

The IRS has repeatedly scrutinized Roth IRA transactions where taxpayers attempted to shift future value into a retirement account without paying fair market value. The legal framework governing these challenges is built primarily around the economic benefit doctrine and assignment of income principles.

If the Roth IRA receives a profits interest for less than fair market value, the IRS can argue that the difference constitutes a contribution in excess of the annual limits or a taxable distribution to the IRA owner. In extreme cases, the entire Roth IRA could be treated as invalidated.

The best time to implement this strategy is at formation, when the business or fund is new and no profits have yet been generated. At that point, under the liquidation value analysis of Rev. Proc. 93-27, the fair market value of a newly issued profits interest may be minimal or zero. As profits accumulate and the entity grows in value, the fair market value of the interest increases. Once the interest has substantial value, transferring it to a Roth IRA becomes significantly more expensive and may trigger taxable income.

Timing matters. The earlier this strategy is implemented, the greater the potential benefit.

Prohibited Transaction Rules

Before implementing any profits interest Roth IRA strategy, the prohibited transaction rules under Internal Revenue Code Section 4975 must be carefully analyzed.

These rules restrict transactions between a retirement account and certain related parties called disqualified persons. Disqualified persons generally include the IRA owner, their spouse, parents, grandparents, children, grandchildren, spouses of those descendants, entities controlled by those individuals above the 50% threshold, and fiduciaries of the retirement account.

The key issue is whether the entity issuing or transferring the profits interest is controlled by disqualified persons. If the IRA owner and other disqualified persons together own more than 50% of the entity, significant prohibited transaction concerns arise. The transaction could be treated as a self-dealing prohibited transaction under IRC Section 4975(c)(1)(D) or (E), which could result in the Roth IRA being treated as distributed.

Two structural approaches can reduce prohibited transaction risk. First, if the profits interest is issued directly by the entity to the Roth IRA as part of a new class of interests at formation, rather than purchased from the IRA owner directly, the analysis is generally more favorable. Second, careful attention to the ownership structure can help keep disqualified person aggregate ownership below the 50% threshold.

This is an area where working with qualified ERISA and tax counsel before implementing the strategy is essential. The rules are technically complex and the consequences of a prohibited transaction are severe.

UBIT Considerations

Investors should also evaluate whether income allocated to the Roth IRA from a profits interest could be subject to Unrelated Business Income Tax.

In general, passive income such as dividends, interest, rents, and capital gains is excluded from UBIT. However, if the Roth IRA’s profits interest receives income that is characterized as ordinary business income from an active trade or business conducted through a pass-through entity, UBIT could apply. The analysis depends heavily on the nature of the underlying business activity.

For many fund structures, particularly those where the IRA holds a limited partnership or limited membership interest that is not engaged in the active conduct of a trade or business, UBIT may not be an issue. However, for management company or general partner interests that are treated as engaged in the active conduct of a business, UBIT exposure should be carefully evaluated before implementation.

Why This Strategy Works Best at Formation

The most significant limitation of this strategy is timing. The optimal window for transferring a profits interest to a Roth IRA is at or near entity formation, when the fair market value is minimal and the future growth potential is greatest.

Once a business has generated significant profits, accumulated substantial assets, or experienced meaningful appreciation, the fair market value of a profits interest increases accordingly. At that point, the Roth IRA must pay a higher acquisition price, which reduces the potential tax benefit and may require a larger retirement account contribution or conversion to fund the transaction.

Founders and fund managers who want to take advantage of this strategy should consider implementing it at the time they establish their business or launch their fund. Waiting until the business becomes successful significantly reduces the opportunity.

Final Thoughts

The ability to shelter a profits interest inside a Self-Directed Roth IRA represents one of the most sophisticated and potentially valuable tax planning strategies available to entrepreneurs, fund managers, and investment professionals. When properly structured and implemented at the right time, it can allow decades of business appreciation and profit distributions to accumulate and ultimately distribute completely tax-free.

The strategy requires careful attention to valuation, prohibited transaction compliance, UBIT analysis, and timing. It is not appropriate for every situation, and it must be implemented with the guidance of qualified tax and ERISA counsel. But for the right person, at the right time, with the right business structure, the long-term tax savings can be extraordinary.

If you want to understand whether a profits interest Roth IRA strategy could work for your situation, IRA Financial’s team of in-house tax and ERISA specialists is available for a free consultation.