As a corporate attorney who has worked with many small business owners, I see all kinds of deals come across my desk. I never like to kill deals, but sometimes I have no choice but to advise a client not to move forward. Here’s an example.
At a conference where I was speaking, I was approached by a business owner who was doing pretty well with a local pest control business he had built up over time. One of his main competitors wanted to retire and asked him if he would like to buy his business. It was an enticing offer that would nearly double his client base. But despite his track record and experience, he wasn’t having success borrowing the cash he needed for the down payment the seller demanded. He didn’t have enough equity in his home, and there was little collateral in the new business to pledge.
So he started digging deeper and came across a company that told him he could use the funds in his individual retirement account to buy the business. Rather than having to cash in his IRA, and pay taxes as well as an early withdrawal penalty, he could move the money into a self-directed IRA, which could then purchase the business. He asked me what I thought of this approach. Unfortunately I had to burst his bubble.
To understand why, some background is in order. IRAs, as most people know, can offer significant tax deferrals, allowing retirement accounts to grow tax-deferred or tax-free over time. IRAs can also offer asset protection. If you must file for bankruptcy, the money in your IRA is usually protected from creditors.
The problem with using an IRA to make an investment that directly benefits you, however, is that it runs afoul of Internal Revenue Sercice rules against “prohibited transactions.”
On the surface it doesn’t make sense that you can’t use your IRA funds for any investment you choose. While Congress can borrow against the Social Security Trust Fund for unrelated purposes, it has expressly prohibited us from doing the same with our IRAs. However, when you take into account that the Social Security system is rapidly running out of money, it’s apparent that Congress is hoping investors will be more careful with their retirement funds than they have been with ours.
A recent Florida bankruptcy case illustrates the danger of using your IRA in a prohibited transaction. The owner of a self-directed IRA borrowed money from the account to pay off a mortgage on a property he later sold. This self-dealing (using the IRA to benefit him in a separate real estate deal) was deemed a prohibited transaction. As such, his IRA asset protection was lost and creditors were able to reach his retirement funds (which normally would be protected from creditors) and take his entire retirement account.
But it gets worse. Due to the self-dealing, his entire IRA account became taxable. He lost both the tax benefits of the IRA and the asset protection through one simple transaction.
What do you need to know here?
Literally hundreds of firms are encouraging retirement account holders to engage in prohibited transactions. Self-directed IRAs are being promoted as a way for entrepreneurs to buy franchises or other businesses or to raise capital for their existing firms. These sales pitches can appear quite sophisticated and legitimate. They have a strong incentive to sell you on the idea, since they charge thousands of dollars to show you how to use your self-directed IRA to invest in a business. What they don’t tell you is that you’ll leave your IRA completely exposed to creditors and the IRS.
These firms may provide you with convincing “proof” that their approach is legal. In another client’s case, he gave me a copy of an IRS letter the firm had given him to supposedly prove its approach was on the up and up. But that letter had to do with a completely unrelated transaction and in no way backed up the claims. (It’s important to understand that these opinion letters apply only to a specific situation.) Fortunately he had me review the deal before he moved forward, and I was able to help him avoid disaster.
The IRS is just starting to investigate these scams. And while running a business is stressful, triggering an IRS investigation is even worse. If you are thinking of using your IRA or other retirement funds to invest in a business, don’t just rely on the opinion of a firm that has something to sell you. Get advice from your tax professional or attorney, even if they can’t give you the answer you want to hear.