Think twice before investing in startups using an IRA

We frequently hear from high net worth individuals and family offices who are interested in investing in startups, either directly as angel investors, or indirectly as limited partners in venture capital funds. Often, we are asked about making these investments through an IRA account, prompted by media reports of vast riches accumulated inside an IRA by early investors in iconic technology companies.

Mainstream IRA custodians, like Fidelity and Schwab, are not set up to allow illiquid investments inside IRA accounts. Instead, investors need specialized custodial firms like Millennium, Pensco, or others. Setting up an account and funding an investment are more cumbersome processes than opening a regular IRA, so you should open your account and fund it before committing to a funding round with an imminent closing date.

So, the answer is that investing in startups with an IRA can be done, but should it be done? As with any tax-related advice, it depends. There are several factors to consider.

Minimum Required Distributions: If you’re required to take MRDs from your IRA, you need to base the amount of your MRD on the total value of your IRA holdings, across all accounts, including illiquid assets. So you must always keep enough liquid assets to meet the MRDs over the life of your illiquid investment, even if that’s a decade or more. The valuation of illiquid investments with asymmetrical upside can also be a problem. If you invest in the next Uber through an IRA and you are subject to MRDs, your MRDs could exceed the value of the liquid assets in your IRA as the value of your startup investment increases. Practically speaking, anyone subject to MRDs or close to the MRD age threshold should think very hard before investing IRA money in illiquid assets.

Unrelated Business Taxable Income: UBTI is income generated by a tax-exempt entity through active business activities. Investing in an active business structured as a pass-through entity, like a limited partnership or an LLC, can create UBTI for your IRA, which is a serious problem. Especially outside of California, startups are often organized as LLCs, so investors need to be careful about this issue. The easiest way to avoid this problem is to invest only in entities that do not have pass-through active business income, like startups organized as C-corporations, or venture capital funds.

Qualified Small Business Stock: Before 2015, the prospect of a tax-free windfall from investing in a startup via an IRA was a pretty good reason to consider the investment, even with all the inconvenience and caveats. But since Congress passed the Protecting Americans from Tax Hikes Act of 2015 (the PATH Act), the story has changed. Under the PATH Act, Congress amended §1202 and §1045 of the Internal Revenue Code to simplify the rules for claiming a tax exemption from an investment in qualified small business stock. A QSBS issuer must have gross assets below $50 million, must be a C-corporation, and must not engage in certain business activities (including financial services, professional services, real estate, hotels, restaurants, and resource extraction activities that can claim percentage depletion). Under §1202, an investor who buys QSBS stock from the issuer and sells the shares after five years to a third party can exclude from federal taxation 100% of their gain, up to $10 million or 10 times their investment, whichever is greater. For shares held for less than five years, §1045 allows rollover investments similar to §1031 for real estate investors.

The favorable tax treatment for startup investments now makes it much less attractive to hold such investments inside an IRA. A typical investor would maximize his or her after-tax returns by allocating to active public equity strategies and taxable bonds inside an IRA, and real estate, passive public equities, tax-free bonds, and startups with their taxable funds. Obviously, everyone’s situation is different, and anyone reading this blog post should not rely on it as investment or tax advice. Rather, consult with your financial planner and your tax advisor before making any decisions. When you do, ask whether your advisor is familiar with the recent changes to QSBS treatment. Many accountants and financial advisors we meet are unfamiliar with this tax break, so don’t be surprised if your advisor needs to read up on the topic before advising you. And as always, invest thoughtfully and carefully. A tax break is only valuable, after all, if you’re expecting a capital gain.