Rules for Owning a Business In An IRA
Suppose you could run a small business without having to worry about taking a chunk of your profits out of it every year to pay income taxes. Suppose further that you could buy and sell property as much as you wanted, within your small business, and not have to worry about capital gains taxes.
Think you could make some money?
The surprising fact is this: It is quite possible to accomplish this by using a commonly used retirement vehicle – an IRA.
How It Works
While most people don’t realize that IRAs aren’t just restricted to stocks, bonds, annuities, CDs and mutual funds, when you think about the mechanics of it, it’s obvious that you can own a business in your IRA. After all, what is stock ownership but ownership of a fractional interest in a business? Owning a whole business in an IRA, then, is no different than owning all the stock of the business in the IRA. In fact, you can invest your IRA assets in nearly anything you can conceive, as long as it is not expressly prohibited by law. Ever since 2011, the list of prohibited investments is fairly narrow: You cannot invest directly in collectibles, art, rugs, antiques, metals other than gold, silver and palladium bullion, gems, stamps, coins (except certain U.S.-minted coins), alcoholic beverages, and a few other tangible items related to personal property. Before going forward with this type of planning we would want to discuss what the business will specifically be working with.
You can also use a Roth IRA to own a business. This means that provided you abide by certain rules, you can operate your business income and capital gains tax free for as long as you live!
That said, if you want to use your IRA assets to start or acquire a business you plan to operate yourself – including a small business that engages in buying and selling any of the above items, there are a couple of things you need to do differently.
Abide by Prohibited Transaction Rules
When you own a business in a retirement account, you can’t treat it the same way as you do the other entities you control. For example, you can’t have the company in your IRA hire your company to clean the air ducts, even if you pay market rates. Nor can you hire your wife or her company to manage the property. In fact, your IRA cannot buy from, sell to, lend money to or borrow from any of your ascendants, descendants, nor their spouses, nor any entities they control. The same applies to your financial advisors and attorneys and their businesses. IRS rules require you to keep a strict arms-length relationship between yourself, your family, and any businesses or entities they control.
Watch Your Cash Flows
Remember that as of January 1, 2021,you can only contribute a maximum of $6,000 to an IRA in any given year. That limit is increased to $7,000 for those over age 50, but that is still a very narrow window for the infusion of new capital. If your business needs additional capital, you will have to fund everything above that number from existing IRA assets. You may be able to roll over contributions to that particular IRA account from other IRA or 401(k) assets. However, you cannot contribute more than $6,000 in new money, plus allowable catch-up contributions, in any given year. Also remember that there could be limitations on your ability to even have an IRA or fund and IRA if you have other methods of donating to retirement funds.
Additionally, you cannot take money out of the business for your own use until you reach the age of 59½. If you do, your distributions will be subject to income taxes and penalties as they would be for any other IRA account. You must reinvest any earnings back into the IRA until you reach age 59½.
Don’t Pledge the IRA as Collateral for a Loan
This can be a problem for IRA owners whose IRA businesses need to raise capital, for whatever reason. Once the available rollover options and new money contributions are exhausted, then the IRA will have to borrow the money from some other source. However, the only loans IRAs are allowed are non-recourse loans: The bank or lender can have no claim on any assets, in the event of default, that are outside of the IRA.
Don’t Make Personal Use of IRA-Owned Property
You cannot use your IRA or property within it for your own personal enjoyment. For example, if your IRA has a real estate investment company inside it, and it owns a vacation property, you cannot stay in that property yourself, even for a night, and even if you pay fair market rates to the IRA for the use of the property.
Build a Team of Advisors
The rules governing self-directed IRAs are complex. Not every advisor understands the ins and outs of this very specialized area of financial planning. It is critical to get advice from a qualified expert who has experience specifically with self-directed IRAs, and who understands and follows the various court precedents, revenue rulings and other factors unique to this kind of investing.