AN INVESTOR S GUIDE. Private Equity Investing Using a Tax-Advantaged Account

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1 AN INVESTOR S GUIDE Private Equity Investing Using a Tax-Advantaged Account

2 Savvy investors realize that private equity can deliver significant rewards. When those investments are held in a tax-advantaged Individual Retirement Account (IRA), the returns can be even better. This paper explains how private equity investors can use a self-directed IRA and other types of retirement accounts to maximize their 14% vs. 7.1% Private Equity S&P 500 Average returns over the last 10 years* Statistics through December Source: Private Equity Growth Capital Council. investments in private equity. It also explains the prohibited transactions that can result in a loss of tax advantages and what to expect from a self-directed IRA custodian. Investing for the Long Term Private equity investments are highly illiquid. It can take years to achieve the desired outcome and a buyer may not be readily available because the asset is not traded on a public exchange. Since most people invest in their retirement accounts for the long-term, this lack of easy liquidity may not be an issue. Getting Started with a Self-directed IRA Private equity can potentially earn significantly greater returns than investments in other asset classes for investors who understand and are willing to accept the inherent risks. When held in a qualified retirement account, investors get the additional advantage of building wealth and generating income on a tax-deferred basis or enjoying tax-free growth if held in a Roth account. To make the most of this opportunity, investors first need to open what s commonly referred to as a self-directed IRA. This is because most financial institutions that act as IRA custodians limit the investments they offer to stocks, bonds and mutual funds that are traded on public exchanges. (Note that all IRA accounts must be held for the account owner by a custodian or trustee approved by the IRS in order to act in this capacity.) What makes self-directed IRAs unique is that their custodians permit investments in a broader range of assets. Otherwise, they perform like other IRAs, which offer tax advantages and have minimum distribution requirements (except for Roth accounts). A wider choice of assets allows individuals and their advisors to diversify their investment holdings outside of exchange-traded investments. However investors and their advisors should bear in mind the higher risk that comes with private equity investments, and manage their portfolios accordingly. *Past performance is not a guarantee of future returns. Investors should not assume that the future performance of any investment or strategy will be profitable or equal to past performance levels. Private Equity Investing Using a Tax-Advantaged Account 2

3 Private Equity Investments That Can Be Held in a Self-directed IRA There are two primary ways that a self-directed IRA can invest in private equity: Through a fund. This can include Private Equity (PE) funds, Venture Capital (VC) funds, and funds of funds. Directly in a company. Investors looking for opportunities outside of a fund can put their money into start-up companies, including their current employer, or make angel investments. Account owners can use their self-directed IRAs to purchase ownership in everything from micro-businesses to billiondollar global companies, to less conventional opportunities, such as land trusts and hybrid securities. 17,744 The number of private equity-backed companies headquartered in the U.S. As of June Source: Pitchbook, PEGCC Analysis. Private equity investments that can be held in a self-directed IRA include: C-corporations Limited Liability Corporations not traded on the exchanges, including single member and familycontrolled LLCs Limited Partnerships not traded on the exchanges, including single member and family-controlled LPs Private placements, including private investment in public equity (PIPE) deals and standby equity distribution agreements (SEDA) Private stock Private placements including: Private hedge funds Real Estate Investment Trusts (REITs) not traded on the exchanges Convertible notes Private Equity Investing Using a Tax-Advantaged Account 3

4 Prohibited Transactions That Negate Tax Protection Holding alternative assets in a self-directed IRA is not for everyone and there are certain rules and regulations that investors should understand before considering this type of investment. A key point to remember is that the IRS considers the retirement account not the account owner to be the investor. For this reason, the account owner cannot receive any direct or indirect benefit from the investment while it is held in the retirement account. This would be considered self-dealing, a prohibited transaction, which is described in detail in Internal Revenue Code Section Engaging in what the IRS deems to be a prohibited transaction even unintentionally can jeopardize the tax deferment or tax-free growth of a self-directed IRA, triggering an immediate distribution, as well as significant taxes, penalties and potential disqualification of the entire IRA. IRS prohibited transactions include those that would directly or indirectly benefit a disqualified person. Disqualified persons include: The account owner The account owner s spouse Lineal family members (parents, children, grandparents and grandchildren); this does not include siblings, aunts, uncles, nieces or nephews The spouses of lineal family members Fiduciaries of the account owner Another consequence of the retirement account itself being the investor is that all financial transactions associated with the private equity investment must first flow through the IRA for it to remain eligible for tax advantages. This includes income generated by the investment (e.g., dividends, cash or in-kind distributions), as well as profits generated through an increase in stock price or company value, sale of the company to another organization, initial public offering (IPO), or other liquidity event. Once in the account, the account owner can access the money through an IRA distribution. Due to the serious consequences of not complying with IRS regulations, investors are strongly encouraged to consult with a tax attorney and other financial advisors to structure their investments in a way that maintains the tax advantages offered by qualified retirement plans. It is also a considered a prohibited transaction if the IRA funds are used to invest in a business in which: The account owner holds a greater than 50% share A disqualified person holds a greater than 50% share Private Equity Investing Using a Tax-Advantaged Account 4

5 The Role of Self-directed IRA Custodians While private equity offers the potential for significantly greater returns, it can come with higher risk than exchange-traded equity investments. There are no SEC rules governing disclosure for private transactions, so it can be difficult to value private equity funds and the companies in which they invest. It s imperative that IRA account owners conduct their own independent and thorough due diligence. Investors and their advisors not the IRA custodian are solely responsible for evaluating the investment s merits and suitability. the extensive recordkeeping required by the IRS and handles the reporting (when warranted) of investment activity within the account. This responsibility can include quarterly reports, processing of annual asset valuations and other documentation. Private equity gives investors with sufficient funds and investment knowledge an opportunity to reap significant rewards. Because of the tax advantages, private equity held in retirement accounts is becoming increasingly popular among self-directed investors. What the self-directed IRA custodian does do for the investor is to hold and administer the assets in the account. A custodian manages Glossary of Investment Terms Account Owner The individual who holds title to the selfdirected IRA. Alternative Asset An asset which is not bought and sold (i.e., traded) through the various market exchanges. Disqualified Persons Those who are not allowed to benefit from the investment while it is held in the IRA. Investor Can refer to the person who is putting up the money for the investment or to the self-directed IRA, which is considered the investor by the IRS. IRA Custodian The entity that administers the retirement account. Non-exchange Traded Assets that are not available on public exchanges. Private Equity An asset class consisting of equity in companies that are not publicly traded on a stock exchange. private investors instead of to the public. Prohibited Transactions Transactions that are not allowed by the IRS and that can jeopardize the tax advantages of the retirement account. Refer to IRS Publication 590 or Code section 4975 for more information. Self-dealing Transactions that directly or indirectly benefit the account owner or any disqualified persons. Self-directed IRA An IRA that requires the account owner to make investment decisions and investments on behalf of the retirement plan. The custodian of this type of IRA allows for investments in a broader range of assets often referred to as alternative assets. Tax-advantaged Investing Holding assets in a qualified retirement account to gain tax deferrals or tax-free growth. Private Placement A round of funding in which the sale of securities are made available to a small group of Private Equity Investing Using a Tax-Advantaged Account 5

6 About PENSCO PENSCO Trust Company is the nation s premier alternative asset custodian specializing in retirement accounts. Founded in 1989, PENSCO provides investors and their advisors with a comprehensive suite of custody services for direct investments in real property, private equity, notes, precious metals and other investments not traded on public exchanges. At PENSCO, assets can be held in a Traditional IRA, Roth IRA, SEP-IRA, Solo(k) and other types of qualified plans. A regulated banking company, PENSCO has more than $10 billion in assets under custody and 50,000 client accounts (September 2013). In addition to serving individual investors, PENSCO works with Registered Investment Advisors, financial planners, family offices, accountants, attorneys, and others seeking a retirement custodian for their clients. To learn more about PENSCO services and investing in non exchange-traded alternative assets, please visit or call PENSCO Trust Company performs the duties of an independent retirement custodian, and, as such, does not provide investment advice, sell investments or offer any tax or legal advice. Potential clients are advised to perform their own due diligence in choosing an attorney, tax advisor or any investment opportunity. Alternative investments are not FDIC insured and are subject to risk, including the loss of principal. This information is for general purposes only and is not intended as an individual recommendation or to be a substitute for specific individualized tax, legal or investment planning advice. 14-PE-001-PPC1 Private Equity Investing Using a Tax-Advantaged Account 6