Can founders hold shares in their own Startup through an IRA?
After reading about Peter Thiel’s IRA gymnastics, founders inevitably wonder whether or not they can use similar tactics to leverage the tax benefits associated with IRAs for the shares they hold in their own startup. We typically get this question at least once a month during Gust Launch office hours. While it’s technically possible to do it, there are important questions and serious potential consequences to consider before attempting. There are also other tax benefits available to startup founders that are considerably less difficult to navigate.
Why the heck would a founder even consider this?
IRAs, specifically Roth IRAs come with major tax advantages for appreciating assets. Money you put into a Roth IRA has already been taxed from an income tax perspective and gains within the Roth IRA are shielded from capital gains taxes (as long as you observe the holding period rules) so any gains in the IRA are essentially tax free. For a rapidly growing startup, avoiding income and capital gains taxes on rapidly appreciating shares can be really appealing!
What makes it tricky to navigate?
While it’s possible to hold startup stock in an IRA, there are a number of complications and consequences to keep in mind. For example, if you are a controlling shareholder of the company and also the owner of the IRA, you can run into trouble with prohibited transaction rules, since your startup–based on your controlling ownership–may be a disqualified person. Even if you’re not a controlling shareholder, your position as a founder (and likely an officer or board member of the company) may still establish you as a controlling member of your startup, complicating the type of work you can do for the company and whether or not you can be compensated for that work via cash or equity.
Violations of prohibited transaction rules can blow the tax benefits for the entire IRA.
You can find a thorough, point-by-point breakdown of all of these issues and the underlying statutes here.
What other tax benefits are available to startup founders?
As a founder, holding shares of your startup through an IRA you own can be complicated. Luckily, there are other avenues available to startup founders–and other holders of startup shares–to minimize both capital gains and income tax liabilities.
Minimize Capital Gains by maintaining QSBS
QSBS, short for Qualified Small Business Stock, allows holders of qualifying shares to write off 100% of capital gains on shares held for more than 5 years. Holders of qualifying shares can write off a maximum of $10M in gains or 10x the aggregate adjusted basis of the shares–whichever is greater.
The aggregate adjusted basis calculation doesn’t typically come into play for newly formed startups, but if you have questions or you’re converting an existing entity to a C-Corp talk to an accountant!
QSBS is a huge tax savings opportunity for founders, early team members, and investors in high-growth startups, so it’s important to maintain QSBS status for everyone’s shares. You may even be asked to assert in writing that your startup’s shares maintain QSBS status during fundraising diligence. While there are multiple rules governing whether shares qualify, here are a handful of high-level considerations to keep in mind:
– There are rules about how the stock is purchased. As always, cash is king, but there are some other acceptable methods of payment. Make sure you understand them before granting stock in kind for services.
– Qualifying shares must be held by the original grantee, so be careful shuffling shares around through stock transfers.
– Large repurchases of issued shares can qualify as a redemption and blow QSBS at a company level, so be careful when repurchasing substantial amounts of shares. Exceptions apply for termination and a handful of other cases.
– To maintain QSBS a company must be organized as a domestic C-Corporation for substantially all of the 5 year holding period of the shares so make sure you understand the ramifications of an early S-Corp election or starting as an LLC.
All of these and more are treated in much greater detail in this excellent article from Frost Brown Todd. Before you make any decisions that could affect the QSBS status of shares in your startup, talk to a startup-familiar accountant or attorney!
Minimize Income Tax with an 83(b) Election
All restricted shares issued to founders and early employees should have vesting associated with them. From the perspective of the IRS, vesting represents a substantial risk of forfeiture. Basically, that means the IRS does not recognize shares of restricted stock as income until they are fully vested. For startup shares that are rapidly growing in value this can create a large income tax burden for founders later in the vesting cycle, even if the shares can’t yet be exchanged for cash. Taking the 83(b) election allows founders to recognize all of the income up front, often reducing the income tax liability for a fully-paid grant to $0.
While this election is a must-consider for every startup founder, it’s easy to miss because of arcane filing requirements and a tight 30-day deadline. You can read more about it here.
Summing it all up
It can be complicated and risky to hold your founder shares through an IRA you own. If you want to explore that strategy, talk to a qualified professional! If you want to forego the complexity of navigating IRA rules, you can still minimize capital gains and income tax obligations by preserving QSBS and filing an 83(b) election. Digital platforms like Gust Launch can help keep you on the right track, understand when it’s time to tag in an expert, and introduce you to vetted professionals when the time comes.
A final note
In 2021, the US House’s version of “Build Back Better” included a proposed reduction of the QSBS exclusion. The final version of the legislation that passed the Senate did not include the reduction. You can find details here, but the important thing to note is that this stuff is constantly changing. This info is up-to-date as of February 2023, but make sure your information is current and that you’ve consulted an expert before making decisions that affect your company!
This article is intended for informational purposes only, and doesn't constitute tax, accounting, or legal advice. Everyone's situation is different! For advice in light of your unique circumstances, consult a tax advisor, accountant, or lawyer.