Question: I am trying to use my Roth IRA to start a llc that will purchase shares of an income producing business. This is a great investment that I currently hold in a taxable account. My plan is to sell the shares back to the business and repurchase them through the llc that my IRA owns. The returns historically average between 30-45% per year. My problem is that I only have $34,000 in the Roth and I can shift from $33,000 to $250,000 worth of shares to the Roth owned llc. I’m just wondering what is the best way to finance this and if you have any recommendations on lenders. My brother is willing to lend a non recourse loan but that seems a little risky although my interpretation is that he is not a disqualified person. I appreciate any input that you have.
Answer: Unfortunately, there are a number of problems with what you propose. First of all, it is a violation of the prohibited transaction rules to, either directly or indirectly, sell or exchange the shares that you own in a taxable account to your Roth IRA. Just based on the brief description in your email, it seems almost certain that your plan would violate Internal Revenue Code Section 4975(c)(1)(A), which prohibits the direct or indirect “sale or exchange, or leasing, of any property between a plan and a disqualified person.” You will certainly want to get competent legal assistance from an attorney who is intimately familiar with the prohibited transaction rules to guide you.
As far as lenders go, the ones that I am familiar with loan against real estate assets, not shares of an LLC, so unfortunately I don’t have any lender recommendation for you. As you know, all loans must be non-recourse to any disqualified person and to the IRA itself as well. You are correct that your brother is not a disqualified person solely because of his status as your brother, but you are also correct in assuming that having your brother loan your IRA or your IRA owned LLC money is risky. The problem is that all IRA transactions are supposed to be on an arms-length basis. If the person you are dealing with is someone in whom you have an interest in which would affect your best judgment as a fiduciary for your IRA, then the transaction may still be considered to be prohibited because a benefit to that person may be deemed to be an indirect benefit to you. This area of the law is a bit tricky, so hopefully your legal counsel will be knowledgeable enough to guide you on this issue as well.
Finally, I assume that your goal is to avoid taxes on this wonderful investment you have found. Unfortunately, the method you have selected will not accomplish this goal, although it certainly may have other benefits. There are 3 circumstances when an IRA, which normally enjoys tax free treatment of its gains, must pay taxes. First of all, if the IRA owns or operates a business, either directly or through a non-taxed entity (the tax is avoided if the entity invested in is taxable). Second, if the IRA receives rents from personal property. And third, if the IRA owns debt-financed property. Your proposed solution may cause taxes to be due under the first and third scenarios, depending on how you structure the transaction. You may find out more about the topic of Unrelated Business Taxable Income (UBTI) in IRS Publication 598, or by referring directly to the Internal Revenue Code Sections 511-514. Also, I have written a few articles on the topic which may be found on our website at www.QuestIRA.com. If the profit from the venture is as high as you say it is, then the after tax returns should still make for a fantastic return for your Roth IRA, assuming you can overcome the other obstacles to the investment. Good luck!