From an investment standpoint, there is a sense of confusion among many American investors on the difference between investing in private equity versus a venture capital fund. This article will explore the characteristics of private equity and venture capital investments and then explain how one can use a Self-Directed IRA to invest.
- The major difference between private equity and venture capital is the type of businesses you invest in
- With a Self-Directed IRA, you can use retirement funds to invest
- Pay attention to the IRS rules and beware of any tax consequences
What is a Private Equity Investment?
Private equity is a type of investment that involves pooling money from numerous investors that are established through a pass-through entity, such as a partnership or LLC, that are then used to acquire stakes in companies. In general, with private equities, the companies receiving the investment are generally mature with a history of revenues and profits.
Private equity investment funds typically raise money from wealthy accredited investors, family offices, banks and financial institutions, other investment funds, pension funds, and even IRAs.
The funds make money by charging a small fee for managing the fund, typically around 2%, and then taking a cut of the gains from the investments above a certain set threshold. This is known as the carried interest, and is typically 20%. The fees associated with investing in a private equity are steeper than investing in a mutual fund or ETF, but the hope is that the returns will more than make up for the associated costs.
What is a Venture Capital Investment?
Venture capital is a type of investment that investors provide to new start-ups and small businesses that are believed to have great potential. Venture capital generally comes from well-off investors (accredited investors), family offices, investment banks, and any other financial institutions. They are typically in very early-stage companies with little to no revenues.
Private equity and venture capital investments are quite similar. The main distinction is that private equity typically invests in mature types and revenue-generating companies in need of some revitalization, whereas, venture capital typically invests in very early-stage companies with little to no revenues.
Like private equity funds, venture capital funds generally make money by charging a management fee and then taking a cut of the gains from the investments above a certain set threshold. Just like private equity, it’s generally around 20%.
How Does it Work?
A Self-Directed IRA is a type of vehicle that allows one to use his or her IRA funds to invest in private equity or venture capital transactions. It can be used with a pretax IRA, Roth, SEP, or SIMPLE IRA. There are two types structures that can be used.
First, is the custodian-controlled approach. One can open an IRA at a special custodian, such as IRA Financial Trust, who will help facilitate the investment for you. Once contributions are made to the plan, those funds will generally be held with the IRA custodian. At your direction, the custodian will make the investment on your behalf. It can be private equity, venture capital, or any type of investment not prohibited by the IRA, such as collectibles.
With a custodian-controlled IRA, you have the freedom to invest how you want, with your custodian doing the bulk of the work. It’s the perfect solution for those who don’t have a high number of annual transactions.
Next, is the Checkbook Control IRA. If you prefer to be hands-on with your investments, you can gain total control with a Self-Directed IRA LLC. An LLC is created, which is owned by the IRA. You, as the IRA holder, will manage that LLC. By doing so, you now have “checkbook control” of your IRA, allowing you to be in charge of the entire investment process.
The funds are usually held at a local bank in the name of the IRA LLC. You will have access to those funds via a checkbook, debit card or electronic transfers. You never need consent from your custodian before making an investment. Simply choose the investment and do it!
For the most part, checkbook control is only needed for those who make frequent IRA investments during the year. Real Estate investors prefer it because of the number of times one interacts with the IRA. Of course, if you want the added protection and privacy an LLC gives you, it’s always an option, no matter your investment types.
Because both private equity and venture capital investments are so passive in nature, a “regular” Self-Directed IRA is all you need. This is because there are typically only a few transactions over a period of several years. However, you are not limited to one investment type with an IRA Financial Self-Directed IRA. If you plan on making other investments, the Checkbook IRA may be better for you.
Major Pitfall with a Self-Directed IRA
In general, one can use a Self-Directed IRA to make a private equity or venture capital investment. However, you must be aware of a couple of IRS rules before doing so. First, is the prohibited transaction rules. Investments held in your IRA must exclusively benefit the IRA. The investment cannot benefit any disqualified person, including you, the IRA owner, or any of your lineal descendants or descendants. For example, you cannot invest in a private equity fund managed by your father.
Secondly, you must be aware of the UBTI rules that could impose a tax on your investment. In the case of a Self-Directed IRA investment into a private equity or venture capital fund, the UBTI rules can be triggered in two primary instances:
- The fund will be investing in a business operated through a pass-through entity, such as an LLC, or
- The fund used leverage to invest in the pass-through entity.
If the UBTI rules are triggered, the income from the business generated by the fund could trigger the UBIT tax. For example, if the private equity fund invests in a bakery that is operated through an LLC, the income from the bakery allocated to the private equity fund could be subject to the UBTI tax, which can be as high as 37%.
Note – if the underlying business owned by the private equity fund is operated by a C Corporation, such as Apple or Google, the UBTI tax would not apply.
As with the fees being paid for the investment, the income generated by the fund may be enough to warrant the extra tax expense. It’s up to you and your financial advisor to decide if the investment makes sense from a tax standpoint.
Conclusion
Private equity and venture capital investments are one or the more popular investment options for Self-Directed IRAs. They are generally very passive and do not trigger many prohibited transaction risks, assuming you nor any disqualified person is actively involved in the fund. However, in some instances, certain investments could trigger the UBTI tax. It’s up to you to decide if the investment makes sense for your personal situation.
For additional information on using a Self-Directed IRA to make private equity or venture capital investments, please fill out the contact form below.
