Joe Kristan is a CPA at Roth & Company P.C.
Equity is to startups like kindling is to a good campfire. You might not get anything started without it.
For many would-be entrepreneurs, retirement savings in an individual retirement account are the biggest potential source of startup funds. Yet getting money out of a traditional IRA triggers tax, and unless you are age 59 1/2 or older, a 10% early withdrawal penalty.
Some folks try to get around this problem by having the IRA itself be the equity investor. That can be a little like kindling a campfire with dynamite, as a Missouri man recently learned in Tax Court.
The taxpayer, a Mr. Ellis, took about $320,000 from his 401(k) plan and rolled it into a self-directed IRA. He then had the IRA invest almost all of the funds in a new corporation (technically, an LLC that elected to be taxed as a corporation) in exchange for 98% ownership interest of the corporation. The corporation then went into business as a used car dealership, with the IRA owner as the general manager of the dealership.
The IRS said the result was a "prohibited transaction" that terminated the IRA, making the entire $320,000 of IRA assets immediately taxable. The Tax Court agreed:
In essence, Mr. Ellis formulated a plan in which he would use his retirement savings as startup capital for a used car business. Mr. Ellis would operate this business and use it as his primary source of income by paying himself compensation for his role in its day-to-day operation. Mr. Ellis effected this plan by establishing the used car business as an investment of his IRA, attempting to preserve the integrity of the IRA as a qualified retirement plan. However, this is precisely the kind of self-dealing that [the prohibited transaction rule] was enacted to prevent.
The results are hugely unpleasant: $163,123 in taxes and penalties.
The tax law is not generally friendly to retirement plans investing in active businesses. There are cases where it can be done -- ESOPs, for example -- but it requires careful and well-advised planning, as the consequences of doing it wrong can be catastrophic.
The tax laws are this way for a good reason: that money is supposed to be a nest egg, your cushion to land on when you stop working. Startups aren't exactly a widows-and-orphans kind of investment. If your retirement-funded start up goes bad, so do your retirement plans. They are at best a startup funding source of last-resort -- and if your business plan requires them, you might want to reconsider your business plan.