Navigating the Legal Minefield: Founder Investments in Roth IRAs

Few things are better than hitting a home run with an early-stage investment through a Roth IRA. Under current law, Roth IRA investments grow tax-free (just as they do in the case of a traditional IRA). There is also no cap on value held in a Roth IRA, and in contrast to a traditional IRA, distributions from a Roth IRA are generally tax-free, provided they occur after the applicable retirement age (currently 59 ½). Thus, successful investing through a Roth IRA may result in substantial amounts of tax-free money in retirement.

Investing a Roth IRA in shares of a startup founded by unrelated third parties is relatively straight-forward. Under the Internal Revenue Code (“Code”), which governs Roth IRAs, there is no per se bar to investing in private companies. But many other requirements and restrictions do apply (these requirement and restrictions also apply to traditional IRAs).

One requirement under the Code is that the Roth IRA be custodied by a qualified IRA custodian (or trustee). While larger, established financial institutions tend to restrict private investments in the IRAs they custody, many smaller, specialty custodians do not, provided certain other requirements are met. Among other things, the latter custodians will require representations from the IRA owner as to the legality of all investment activity (e.g., investment is solely for retirement purposes and not for the owner’s personal benefit). They may also require expensive legal opinions or blanket indemnities, including, in some cases, from the issuer of securities in which the IRA intends to invest. These requirements may extend not only to the account opening and purchases, but also to liquidations/exits years down the road. An IRA owner should explore and fully understand all applicable requirements before engaging a particular custodian.

Investing a Roth IRA through a wholly owned LLC tends to simplify the requirements imposed by many custodians. Where an LLC is used, the custodian has to hold and otherwise deal solely with the LLC interests (and not the underlying securities and their issuers). Use of an LLC does not avoid the legal requirements and restrictions under the Code, however.

If an LLC is used, absent advice from qualified legal counsel, the Roth IRA generally should be the sole member of the LLC. Investing personal money in the LLC or allowing family members or third parties to invest in the LLC may give rise to prohibited transactions under the Code and highly unpleasant consequences (discussed further below).

The Code also requires that a Roth IRA be invested exclusively for the (retirement) benefit of its owner and any beneficiaries (and not the owner’s personal “today” benefit). Further, the Code generally prohibits a Roth IRA from engaging in related party transactions (e.g., sales or transfers of Roth IRA assets to the Roth IRA owner, close relatives or closely held entities). The Code also generally prohibits a Roth IRA owner from engaging in self-dealing with the Roth IRA, whether through a related party transaction or otherwise (e.g., investing IRA assets in exchange for personal benefits to the owner, such as a finder’s fee or more favorable terms for personal investments).

Navigating these “prohibited transaction” rules can be tricky for founders wishing to invest Roth IRAs in their own new company, whether held individually or with co-founders. A founder’s relationship with the company may render the company itself a related (and thus disqualified) party, precluding the founder’s Roth IRA from buying shares in the company. Even if that relationship does not cause the company to be a related (disqualified) party, it may effectively bar the Roth IRA from providing material seed capital (e.g., where it could benefit the founder’s personal interests in the company). A founder may not use a Roth IRA investment to satisfy personal capital commitments or other obligations to the company. A founder may not receive a salary, directors fees, insurance, loans, perquisites or any other benefits funded, even indirectly, by the founder’s own Roth IRA investment. A founder may co-invest personal money alongside the founder’s Roth IRA money, however, provided the Roth IRA and personal interests in the company remain aligned (e.g., the founder generally may not leave the Roth IRA invested while liquidating the founder’s personal interests in the company).

Violating the Code’s prohibited transaction rules carries stiff penalties. A prohibited transaction involving a Roth IRA owner may disqualify the Roth IRA and cause its assets to be deemed distributed, resulting in the loss of continued tax-free growth. Further, depending on the owner’s age, the owner could face early withdrawal penalties and, if not timely paid, additional penalties and interest. Related (disqualified) persons (other than the owner) involved in a prohibited transaction may incur punitive excise taxes on the amount involved in the transaction, and those taxes continue to accumulate until the transaction is corrected.

Founders can chart a path through this legal minefield under certain circumstances, however. But they must be flexible in their expectations. For example, they must invest their Roth IRAs solely for the purpose of generating investment returns for the Roth IRA, and not for personal (non-retirement) purposes. Further, their investments must be independently valued, fully vested and otherwise not tied to any personal relationship with the company, including any personal obligation to provide services or contribute capital.

Founders must also be careful in planning and timing. For example, trying to invest a Roth IRA after the company is formed and founders shares (or options) are issued may prove impossible. This is because the prior issuance of interests to a founder may have rendered the company a related (disqualified) person to the founder’s Roth IRA and thus unable to do business with the Roth IRA. This problem may not be solved by the company canceling shares (or options) previously issued to the owner of the Roth IRA and re-issuing them to the Roth IRA.

For further information, please contact Patrick Menasco at pmenasco@goodwinlaw.com, Bibek Pandey at bpandey@goodwinlaw.com, or Robert Kester at rkester@goodwinlaw.com.

This informational piece, which may be considered advertising under the ethical rules of certain jurisdictions, is provided on the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin or its lawyers. Prior results do not guarantee similar outcomes.