As many entrepreneurs understand, taxes on gain from investment in a private company are mainly treated as Long Term Capital Gain if shares are held for more than a year. This tends to be the case in most startups as they generally last multiple years. While there are many ways to fund your startup using personal funds, friends and family, VC money, retirement savings etc., according to Hiren Modi, Partner at EisnerAmper LLP in San Francisco, funding your company through Roth could help you potentially avoid taxes on the gain from money used from Roth IRA. You would specifically have to hold the investment in a Self-Directed IRA account through custodians, such as PENSCO, which would allow you to invest in the private company stock. Tax experts put private investments held in retirement accounts in the gray area of the law. There are many restrictions such as self-dealing which would make this a disqualified transaction so working with your tax adviser to structure it right would be the key. This type of investment could potentially work well in a scenario where there are multiple founders, each owning less than 50% of the company and where each founder uses part of their Roth IRA to contribute to the startup.
As an example, startup capital is $75K and each cofounder contributed a 1/3rd of the capital. Founder A chooses to fund 50% of his $25K contribution through Taxable account and 50% through his Roth IRA. Founders B & C do not use a Roth for their initial contributions of $25K each. Assuming at exit, each founder nets $5 million in gain, here is the difference between using part of the investment from ROTH versus fully funding through your taxable account:
As you can see from the above example, the entire gain for stock held in Roth IRA could be tax free and can result in significant tax savings if structured properly. If the idea is really big and the founding team is really strong with history of successful and repeated execution, it may be worthwhile for the founders to work with their tax advisor and structure the investment correctly as the benefit of doing this right could be huge. For those who don’t have a Roth IRA should consult their tax advisor for converting their traditional IRA into a Roth IRA. Tax paid on conversion to Roth, would be a lot less compared to the potential upside from tax savings. One big caution is given the high risk of investing in a private company, one needs to be extra careful in using retirement savings to fund your startup. For more information regarding tax on prohibited transactions, readers can refer to IRS code 4975.
Disclaimer: Information contained here is for information use only and is not a solicitation for services. Neither Sanjeev Sardana nor BluePointe Capital Management provide tax advice. Please consult with your tax advisor for further information.