Invest in a Company the Peter Thiel Way with a Self-Directed Roth IRA

In June 2021, ProPublica released an article focusing on how Peter Thiel was able to amass a $5 billion Roth IRA over the years.  The article was based on leaked IRS documentation that were released unlawfully.  It was immediately cited by various Democratic members of Congress and the Senate to attack abuses involving the Self-Directed Roth IRA. 

I have written extensively in the past on the Peter Thiel Roth IRA story but wanted to write an article that discussed how a new business owner or entrepreneur could potentially use his model to develop a tax advantage exit strategy for their business holding.

Before I get into the Peter Thiel story, I just wanted to provide a quick overview of the Roth IRA.

Roth IRA

The Relief Act of 1997 introduced the Roth IRA. The Roth IRA is an is a type of IRA which allows any US person with earned income under a set income threshold (Under $144,000 if single and $214,000 if married and file jointly for 2022) to make after-tax contributions. For 2022, you may contribute $6,000, plus an additional $1,000 “catch-up” if you are at least age 50.

So long as any Roth IRA you own has been opened for at least five years and you are over the age of 59 1/2, all Roth IRA distributions would be tax free!  Also, with a Roth IRA there are no required minimum distributions, like a traditional, pretax plan.  In other words, if you made an investment into any capital asset, such as stocks, real estate, and even cryptos, all gains would be tax free. All qualified distributions would not be subject to tax ever. This makes it one of the most desirable retirement accounts around.

Related: How to Build up Your Roth IRA Fast

The Peter Thiel PayPal Story

Peter Thiel, a Stanford law graduate, ran a small hedge fund in the late 1900s. In 1999, single taxpayers were only allowed to contribute to a Roth if they made less than $110,000. Like many startups, PayPal offered its top executives low initial salaries and large stock grants.

Thiel’s income that year was $73,263, the IRS records show. While SEC filings describing that time don’t mention Thiel’s Roth, they show that he bought his first slice of the company in January 1999. Thiel paid $0.001 per share for 1.7 million shares. At that price, he was able to buy a large stake for just $1,700.

PayPal later disclosed details about the early history of the company in an SEC filing before its initial public offering. According to the ProPublica article, the filing reveals that Thiel’s founders’ shares were among those the company sold to employees at “below fair value.”

However, the record revealed that all employees got that same price, which is what the IRS acknowledged when they audited Thiel back in 2012. Soon after the company sold him the shares, investors invested millions of dollars into the company.

About a month after, PayPal opened up the company to more investors. In the summer, “$4.5 million poured in from the venture fund arm of telecom giant Nokia and other investors,” those records show.

All in all, in just one year, Thiel’s Roth jumped from $1,664 to $3.8 million! In ’02, eBay purchased PayPal. Later in the year, Peter Thiel sold his shares. Let us remind you that those shares were still held inside his Roth IRA. Because of that, all the gains from the sale of the company were tax free. By the end of the year, tax records show that his Roth IRA was worth approximately $28.5 million.

Thiel and colleagues in 2003 founded Palantir, a data analytics company, helped by an early investment from a CIA-backed venture fund. Again, Thiel used his Roth IRA to buy shares in the company. It was still private and well before its IPO.

Then, in 2004, Thiel met Mark Zuckerberg, a Harvard undergraduate who was developing the king of social media, Facebook. Thiel invested half a million dollars in the venture with his Roth. By the end of 2008, the Roth was worth $870 million.

Ironically, the IRS and many of Thiel’s opponents spent time focusing on his Papal investment. However, it was his Palantir and Facebook investments that generated the largest returns for his Roth IRA.

Related: The $5 Billion Roth IRA

Following the Thiel PayPal Playbook

Most of us not entrenched in the Silicon Valley social network will ever have the ability to be a seed investor in a multi-billion dollar company, such as Facebook.  However, many of us will have the opportunity to invest in a start-up that has the potential to be successful, and quite valuable. 

The following are the two keys to safely replicating Peter Thiel and structuring an investment into a start-up using a Roth IRA.

The IRS prohibited Transaction Rules

In general, one may use an IRA or Roth IRA to invest in a private business, including a start-up business. Internal Revenue Code (“IRC”) section 408 and Section 4975 do not state what a retirement plan can invest in – only what it cannot.  In general, an IRA cannot invest in life insurance, collectibles, such as antiques, and any transaction involving the retirement plan and a “disqualified person” as outlined under IRC Section 4975.

A business owner should not use a Roth IRA to invest in a start-up if the Roth IRA owner or any disqualified persons own 50% of the business interests. In the case of Peter Thiel & PayPal, Thiel owned less than 50% of the entity and thus, the entity was not deemed a disqualified person.

However, there are instances in where an investment into an entity where the retirement account owner owns less than 50% can still trigger a prohibited transaction.  In Rollins v. Commissioner, Mr. Rollins caused his 401(k) to lend funds to three companies, and in each of which he was the largest (9% to 33%), but not controlling, stockholder.

The IRS argued the loans violated the prohibited transaction rules under IRC 4975. The Court agreed with the IRS and concluded that the loan benefited Rollins as an owner of the entities since the entities were able to borrow money without having to go through independent lenders.

The court essentially concluded that because the loan benefited Mr. Rollins and the exclusive benefit from the loan transaction did not benefit the 401(k), the loan transaction were prohibited even though Rollins owned less than 50% of the entity.

Examining the Thiel PayPal transaction considering Rollins, it would have been difficult for the IRS to argue that Thiel personally benefited from the IRA transaction since the amount invested by the Roth IRA was so minimal.

Valuation, Valuation, Valuation

IRA custodians, such as IRA Financial Trust, are responsible for ensuring that all IRA assets are valued annually at their fair market value and are required to report the account’s fair market value at year-end to IRS. In general, an IRA’s fair market value includes any contributions, rollovers into the IRA, investment earnings, and any adjustment to the market value of IRA assets. According to the IRS, non-publicly traded assets do not have easily determined fair market valuations.

The following excerpt from the October 2014 GAO report on IRAs illustrates the difficulty the IRS has in showing a value paid by an IRA for a privately held stock is not its true fair market value:

It is often difficult for IRS to pursue cases of potential abuse based on inappropriately valued assets. First, in response to a congressional inquiry, IRS said it generally requires individuals to assess the FMV of assets in IRAs rather than use a liquidation value or other valuation
method.

However, IRS guidance implies that individuals can use the liquidation value of a profits interest for certain tax purposes. One industry stakeholder also noted that individuals can use case law to support very low valuations of nonpublicly traded shares and profits interests.

Second, according to IRS officials, valuation can be subjective and IRS may expend resources and ultimately conclude that the taxpayer’s valuation is reasonable. Third, the statute of limitations for IRS to pursue cases is generally only 3 years, which poses certain obstacles to pursuing noncompliant activity that spans years of IRA investment.

Therefore, before investing Roth IRA funds into a private start-up, make sure the IRA is paying the same price for the respective shares as all other investors. Investing in a start-up with no assets or business history can more easily support a low share price value.

Conclusion

Using a Self-Directed Roth IRA to buy start-up stock can prove to be very lucrative. Peter Thiel provided all of us with a blueprint on how to talk advantage of the Roth IRA tax rules in conjunction with a start-up business investment.

However, generating Thiel type returns is highly unlikely considering he was an early investor of three hugely successful publicly traded companies.  Regardless, ensuring that the company is not deemed a “disqualified person” as per IRC 4975 and that the IRA is paying fair market value for the shares is crucial in successfully structuring a Self-Directed Roth IRA investment into a start-up business.