One of the topics we discussed briefly at the past weekend’s seminar was the fact that you can start or invest in businesses using your self-directed pension plan. There was quite a bit of interest in the subject, so I thought I’d go through some of the details to give you an idea of how it’s done.
In all cases, the big issues are steering clear of disqualified persons and prohibited transactions. Get to know your self-directed pension custodian well – you’re going to need their information, referrals and assistance to make sure you stay within the rules.
A disqualified person is a lineal relative (parents, grandparents, children, grandchildren, etc.), you, your spouse, the spouses of your children, certain business trusts, and people connected to administering your pension (custodian, broker, fiduciaries). Note that your siblings, aunts and uncles aren’t included in this list, although all custodians are different – some may be more conservative than others and still disallow the transaction.
A prohibited transaction is one that involves disqualified persons, or one where your pension invests inappropriately. Yes, it’s a vague description! That’s because the rules aren’t crystal clear. One of the big things we do know is that you can’t invest pension money into a company you already own more than 50% of, either alone or with other disqualified persons. So if your new business venture needs more money to push it forward, and you own 100% of that business, you can’t bring in pension money. Even if you don’t own 50% or more of the business, you can’t invest pension money if the only reason is to save your business, or your investment in the business. It has to be an investment that makes sense for your pension.
Here are some things that you can do:
- You can begin a new business with pension funds, either alone or alongside you and other investors, but it’s essential to do it properly. For example, you’ve got to bring in your pension at incorporation, along with you and any other investors coming into the business. This is your one and ONLY shot at breaking through the prohibited transaction rule I just mentioned, but again, only if it’s done right.
- You can also buy an existing business (as a passive entity you own, not run) using your pension. In this case, instead of you buying an interest in the business, it would be your pension instead. This is like investing in a REIT, for example.
- You can invest pension money into your existing business, as long as you dilute your interest (and those of any disqualified persons) to less than 50% – but structure things carefully, with a good attorney.
Depending on the type of business and the degree of ownership and decision making power in the business by the you, your pension and any related parties you may be able to provide services to the business and pay yourself without it being a prohibited transaction. One of the keys here is to make sure that you have an unrelated partner in the business, and that person approves the payment, and that you and your pension don’t own a controlling interest overall in the business. The business needs to make/sell a product or provide a service to make this work. And, what constitutes a controlling interest isn’t clear. Generally speaking a controlling interest is more than 50%, but a recent court case reduced that to 33%. The case is under appeal, and isn’t atypical, but it’s out there so you need to be aware. Definitely talk to your custodian, and probably an attorney, to make sure you’re in line with the current “state of the nation” regarding this issue.
Play it Safe By Using a Separate Pension Fund
One of the best things you can do to protect yourself if you’re planning to start a business using pension money is to create a separate, small pension plan and use that one, instead of your main plan. Now if you get into trouble somewhere down the line the worst that can happen is your small plan is disallowed (taxed and penalized), rather than your entire pension fun.
Pension Investment Doesn’t Always Mean Tax-Free
Yes, there is tax involved. Think about it: if pension-owned businesses could earn money tax-free, then wouldn’t all businesses be owned by pensions? The tax assessed against pension-owned businesses is called UBIT (unrelated business income tax). You can escape UBIT by using a C Corporation, but the C Corporation will pay tax at its own rate. And remember, in both cases the profit from your business will flow back into the pension, where it will be treated like any other income. So if you’re investing with a Roth your profits will grow tax-free, and if you’re investing with a regular IRA they will be tax-deferred. Tom Anderson, the CEO of Pensco, likes to tell a story of a bunch of young people who funded an internet start-up with their Roths, to the tune of $2,000 each. The company took off, went public, and several stock splits later, the young owners sold their shares for millions of dollars … all of which went back into their Roth accounts, tax-free.