The Special Purpose Acquisition Companies (SPACs) marketplace, which has been very quiet in 2023, is coming off a period of robust growth from 2020-2021. A SPAC is a listed investment vehicle for taking private companies public via mergers, as an alternative to traditional IPOs. For promoters of SPACs, the ability to have a Self-Directed Roth IRA own the founder shares allocated in a SPAC deal is an enormous tax advantage that is not widely known. This article will explore how a SPAC works and focus on the structure of using a Self-Directed Roth IRA to purchase founder shares.
- SPACs are a way to go public with a private company
- The ability to invest in founders stock has the potential for a big payout
- Using a Self-Directed Roth IRA to invest could reap tax-free gains
What is a SPAC?
SPACs are exchange-listed shell companies with the sole purpose of targeting and merging with a private operating company, whereby the target becomes listed. The rationale for SPACs is that they offer private companies a quicker, easier, and more certain way to become publicly traded versus a traditional IPO.
How Big is the SPAC Market?
In 2020, 248 SPACs were listed on public exchanges for an average listing size of $336 million and a total amount of capital raised of $83 billion. In contrast, in 2021, 613 SPACs were listed at an average listing value of $265 million and gross proceeds of $162 billion. However, in 2023, the volume of SPAC IPOs and mergers has reverted to pre-COVID levels. One of the primary reasons for the lackluster market is that many investors experienced poor performance from SPACs listed during the COVID boom period.
How does it Work?
A SPAC is incorporated, listed on a stock exchange, looks for a target to merge, and negotiates a merger deal, which is then voted upon by the SPAC shareholders. If approved, the SPAC then merges with the target company. Once a SPAC closes its merger, the target company is listed, replacing the SPAC shell company on the stock market. Also once listed and prior to a merger with a target company, the SPAC has two years to merge with a target or it must be liquidated.
An Example
The first step in the SPAC life cycle is an IPO. The SPAC sells units at $10 each. A unit consists of one share of stock in the SPAC and typically a fraction of a warrant, which grants the owner the right to purchase a SPAC share at $11.50 after the SPAC merges with its target. After its listing, the SPAC simply holds the cash received from its IPO in a trust account for upwards of two years.
The trust cannot be drawn until closing its merger with a target company. After a merger deal is approved with a target company, if the SPAC shareholders do not like the deal, they can redeem their shares from the SPAC for $10, if they wish, while keeping their warrants, which they can exercise as the price of the stock increases.
SPAC Founder Shares
Each SPAC has a founder or group of founders who manage the SPAC from its start through the conclusion of the merger. The SPAC founder receives 20% of the outstanding shares of the listed SPAC for a minimal cost as compensation for creating and managing the SPAC. This is one reason SPACs continue to be a popular funding vehicle in the marketplace. The opportunity to receive up to 20% of an exciting target company for a minimal capital outlay is almost unfathomable.
There is a reason many SPAC founders have become exceptionally wealthy. In addition, founder shares are different from the listed SPAC shares sold to investors in that founder shares cannot be traded until a merger is consummated. Accordingly, because their shares do not pay off unless a merger closes, SPAC founders have a strong motivation to merge with a target company even if it is not an ideal fit, leaving those shareholders who do not redeem their shares with the liability.
Taxation of Founder Shares
The SPAC shares the founder receives for creating and managing SPAC is treated as a capital asset. Any gains from the sale of a capital asset is subject to the capital gains tax regime. A capital asset held for less than 12 months is categorized as short-term capital gains tax and is subject to ordinary income tax rates, which have a maximum tax rate of 37%. Whereas a capital asset held for greater than 12 months is subject to the long-term capital gains tax rate, which has a reduced tax rate of 15% or 20%.
The Self-Directed Roth IRA Solution
The Roth IRA is an after-tax IRA, which, unlike a traditional IRA, does not offer a tax deduction to the IRA holder for contributing. However, if the Roth is open at least five years and the Roth holder is over the age of 59 1/2, then all Roth distributions are tax-free. In addition, there are no required minimum distributions for Roth IRAs, allowing it to grow unhindered. Hence, if one owned company shares in a Roth IRA, all gains from the stock sale would flow back to the Roth IRA without tax. The Roth IRA owner would then be able to take distributions tax-free so long as they are qualified as explained above.
When a Roth IRA generates income or gains from the purchase and sale of a capital asset, such as stocks, mutual funds, real estate, etc., irrespective of whether the gain was short-term or long-term, the Roth does not pay any tax on the transaction itself or when the income is withdrawn. Thus, using a Self-Directed Roth IRA to invest in founder shares would eliminate any tax due from the investment.
Related: Tax free vs. Tax Deferred
How to Buy SPAC Founder Shares in a Self-Directed Roth IRA
Any SPAC founder who will receive shares should strongly consider using a Self-Directed Roth IRA to buy the shares. A traditional financial institution or bank generally does not allow an IRA to invest in non-publicly traded investments. A Self-Directed Roth IRA would need to be established at a company, such as IRA Financial, to use Roth funds to buy founder shares. Once established, you can roll over other Roth funds into the new self-directed account, convert traditional IRA funds, or directly contribute to the plan.
Since a founder is generally able to purchase up to 20% of the SPAC stock for a nominal amount of funds, the Roth can be funded with a minimal contribution to the plan.
The massive tax advantage of using a Self-Directed Roth IRA to buy SPAC founder shares is that all the gains from the founder stock sale after the SPAC IPO would go back to the plan without tax. One can then re-invest the stock sale proceeds in other investments, all while enjoying tax-free qualified distributions!
