Funding Your Company

The Myth of the Self-Directed IRA
Funding Your Company

You resigned from the big company. You spent a few weeks relaxing. You unscrambled the insurance mess. Now you are ready to start your own company!

Of course there are many models of funding a venture with other people’s money.  You can find angel investors. You can look into small business loans. However, each of these approaches leaves you working for somebody else. If possible, it is much cleaner to fund the business with your own assets.

However, if you have spent most of your career working for a large company, chances are good that most of your liquid assets are tied up in IRAs and 401K accounts.  These have a complicated set of rules about withdrawals and taxes. What is the best way to move the money out of those accounts and into your new business?

As you start to scratch your head and think about that problem, you hear a noise: “Poof!” There is a bright flash, and a salesman is standing in front of you telling you all about the wonders of the “Self-Directed IRA”.  What exactly is he talking about?

Legitimate Self-Directed IRAs

Some people simply don’t trust the people on Wall Street. These consumers resent being forced to let some guy on Wall Street pick the stocks that their retirement fund will invest in. They feel that they can do a better job of identifying promising stocks than the guys on Wall Street. Self-Directed IRAs provide a legitimate and legal avenue for such consumers to have more of a say in how their retirement funds are being invested.

To address the needs of such consumers, financial institutions like Merrill Lynch provide a fiduciary service. Just as with a normal IRA, the fiduciary still holds the investment assets such as stocks, bonds or real-estate titles on behalf of the consumer. The consumer, however, gets to direct the fiduciary in selecting which assets to invest in.

Not surprisingly, without some strict legal limitations, such an arrangement could easily be abused. For example, I could direct the fiduciary running my retirement fund to invest in real estate by purchasing my home. Such a maneuver would be little else than a tax cheat. I would be abusing a law intended to incent people to save for retirement. Instead of saving for retirement, I would simply be avoiding paying tax on the portion of my salary needed to buy my home.

In order to prevent such abuse, the law has numerous arms-length restrictions concerning “prohibited transactions” and “prohibited persons”. If your Self-Directed IRA violates one of these restrictions the IRS can simply declare your entire Self-Directed IRA to be a taxable distribution and make you pay the 10% penalty and outstanding federal tax on all of it.

The Business Funding Grey Area

Not surprisingly, there are any number of individuals and businesses that chafe at the restrictions, even though the restrictions clearly support the intent of the law. Following a single court case in which the plaintiff Swanson managed to win a judgement against the IRS, a small industry has sprung up around using Self-Directed IRAs to fund your own business. Companies dealing in this sort of Self-Directed IRA typically have a sales pitch that includes a diagram that looks something like this:

Avoiding the 10% tax penalty
Typical Self Directed IRA Business Funding Concept

 

The general idea is as follows:

  1. The financial service company creates a new company on your behalf. This new company is probably a normal C-Corporation. S-Corporations and most LLCs will be too closely associated with you to pass the IRS requirements.
  2. The financial services company creates a Self-Directed IRA for you.
  3. The Self-Directed IRA buys stock in the new C-Corporation as an investment.
  4. The new C-Corporation hires you and pays you a salary.

The financial services companies claim that this sort of arrangement is acceptable and point to the single court case as proof. In the specific court case, an individual won a judgement against the IRS after the IRS pursued him over an arrangement somewhat like the one described above.  However, this legal implications of the actual case are controversial. See the Swanson Decision. It certainly doesn’t look like a closed topic to me. On the contrary, it looks like this sort of maneuver is simply asking to be the next test case for the IRS legal steamroller. My preference is to focus my energy on building my business, not on picking a fight with the IRS.

Taking a Closer Look at the Costs

Even if you accept that such arrangements are legal, the financial results are not necessarily as attractive as one might think.  In my case, almost all of the cost of running my business for the next year will simply be the need to cover my own living and household expenses.

Let us assume for the moment, that my household and living expenses for the moment will be $75,000. How much money will I need to withdraw from my 401K account in order to have that much money available after all taxes and other expenses?  I have prepared a side-by-side comparison below:

The Self Directed IRA is Actually More Expensive
Model of How Much You Would Need to Withdraw to Have $75k of Cash

The money that routes through the Self-Directed IRA and the C-Corporation is subject to Social Security and Medicare taxes. These total 13.3% for 2011 and will total 15.3% for other years. The money which simply comes out of the 401K fund and goes into my bank account is subject to a 10% penalty. In either case, I end up paying income tax on the money. As shown above, simply paying the penalty ends up being slightly cheaper and you and up with a less cumbersome business structure as well.

On the other hand, if you have a significant need to fund non-salary business expenses, the picture looks a little different. Let us assume that in addition to the $75,000 of cash you need for living expenses, you also need $100,000 of non-salary business expense money as well. A common example would be the fit up of a new fast food franchise restaurant. The revised calculation looks like this:

Significant business expenses make the Self-Directed concept more attractive
Model of How Much You Withdraw With Business Expenses

Clearly, the Self-Directed IRA approach looks more attractive in this case. If you have such a need, you might want to consider risking a battle with the IRS and go ahead and use one of these service companies.

I do not have such a need and it makes neither financial nor legal sense to risk battling with the IRS. I will simply do things the old-fashioned way: withdraw the money, pay the penalty, pay the taxes, and start my business.

Glossary for Overseas Readers

  • IRS – Internal Revenue Service. This is the department of the United States government that collects taxes.
  • IRA – Individual Retirement Account. This is a type of savings account that allows taxes on interest and capital gains to be deferred until the owner of the account retires. There are a number of rules surrounding such accounts including a 10% penalty for withdrawing funds before you reach retirement age.
  • 401K – A retirement fund similar to an IRA except that it is setup by your employer and your employer is allowed to match your contributions to the fund.

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