Angel investing: using an IRA or not using an IRA?

Now, not many people know that, but you can make investments in early stage companies, including through VentureSouth, using funds that are in retirement accounts.

How?

Step 1: Have cash in a self-directed IRA at a custodian that allows alternative investments.

That means you need to have money in an IRA at somewhere that lets you invest in things other than the stock market. (Generally large securities brokerage firms do not offer this; smaller IRA providers do.)

If you don’t have that, you can get it by rolling some of your existing IRA funds from your current custodian to one that does.

Step 2: Find some angel investments and make them!

This post discusses why you might consider using an IRA and some of the concepts you could think about evaluate the idea.

Why would you want to make angel investments through an IRA rather than just cash?

Tax efficiency: gains made in IRAs have favorable tax treatments.

Other things to buy: People have plenty of ways to use their cash, for both investments and consumption. Uninvested capital in an IRA has fewer options!

Patience: Angel investing requires patience and a reasonable timeframe — 3–5 years if your investment thesis is “early exits,” likely much longer if you’re swinging for IPOs. If you have a capital source that must be patient, it could be a good fit for angel investing.

But does it actually make sense to use your IRA?

1. Investment considerations

We’ll skip the general reasons for making early stage investments, from being not correlated with other asset classes, having the potential for outsized returns, and the local development, networking, and other ancillary benefits. Here we cover whether it makes sense to use IRA funds to make angel investments you are already planning.

First, how you view your IRA funds determines whether you think using them for angel investing is sensible.

· If they are absolutely critical to your retirement and you cannot afford to lose them, you should not use them for angel investing, because you could lose it all. Of course, you could lose it all investing in public equities too if picking individual stocks, and you can diversify in angel investing too; but, still, the chances of losing significant capital are real.

· If they are more discretionary — great to have, but available to be used to try to generate some investment returns on a higher-risk, higher-reward strategy — you might want to use them.

Second, timing and liquidity is important. Angel investments are hard to sell, with little you can do to create “liquidity” (i.e. turn them back into cash) if needed. That’s good: if you have a long-term horizon for these funds, an IRA is a good place to invest from; but it’s also bad, because you have to make required minimum distributions (RMDs), having assets that are hard to sell creates complications.

You can make distributions from IRAs as “in-kind” distributions (i.e. you can distribute the stocks rather than selling them). There is more planning you can do around this too. But still, it can be complicated to distribute shares at “market value” when that value is hard to judge.

(And risky: if a valuation has gone up from later rounds you might have to pay ordinary income on the phantom increase in value, only to see the value disappear if the company ultimately fails.)

So, with some careful planning, and especially if you have some time before RMDs (these, not this guy) kick in, using IRA funds you can afford to lose can make sense for angel investing.

2. Taxes.

The key benefit of investment through an IRA, of course, is that any gains have favorable tax treatments: in a traditional IRA, the gains are tax free when they happen and you pay ordinary income tax upon withdrawals; in a Roth IRA, the gains are entirely tax free.

This sounds like a slam-dunk positive in favor of angel investing through an IRA. However, the story is not quite that simple.

(A) In the traditional IRA, you do not pay capital gains when the assets are sold, but you will pay ordinary income rates when you come to make those distribution. The idea is your income will be lower after retirement, so the rate paid then will be less. (Assuming no changes to future tax rates, which seems a questionable assumption…)

(B) If you make a capital gain on an angel deal outside an IRA, there is a good chance the gain will not be taxable (a Section 1202 exemption), or can be deferred and eventually not be taxable (a Section 1045 rollover).

So the comparison is between (A) ordinary income taxes on a hopefully lower income bracket at distribution time or (B) potentially no taxes. (B) is not, of course, guaranteed; but it’s not obvious at all that (A) is better than (B).

If you can use a Roth IRA, the comparison would be easier: no taxes in the Roth IRA vs. potentially no taxes outside. That makes decisions like Max Levchin’s no-brainers!

Two other small things on taxes:

We looked at gains, but we shouldn’t forget the flip-side — losses. Capital losses are “useful” in either case — a loss in an IRA will reduce the amount of income on which you pay taxes; a loss from a cash investment can be used to offset capital gains too. The extra benefit of Section 1244 (which lets you offset a capital loss on an early angel deal against ordinary income) provides an extra boost outside of IRAs.

Similarly, at the state level in South Carolina, if you invest through an IRA, you can’t get the benefit of the South Carolina angel investor tax credit. This is not a trivial loss — potentially 35% of the invested capital amount taken off your taxes in cash, but lost in an IRA — when investing in South Carolina.

3. Admin and fees

There are a couple of other administrative considerations.

First, tracking: investments, especially if you do them on your own, is likely easier in the IRA as the custodian should have good tracking set up.

Second, tax tracking: similarly, dealing with the tax implications from investments outside of IRAs requires constant monitoring as the tax implications happen continuously (as things happen to the companies or they exit) — but you just have to worry about taxes at distribution time in the IRA.

On the other hand, “fair market value” statements each year from the assets in your self-directed IRA have to be corralled each year. It’s actually your responsibility to collect those, and that can take some time and attention.

Thirdly, documentation complexity: IRA custodians are not generally famous for the speed and simplicity of their document flows. Actually filling out the forms to make an investment can take much longer in an IRA than just doing it directly. (Even with VentureSouth’s admin team helping!)

Lastly, of course, IRA custodians aren’t charities — they charge fees. Those can be based on cash in the account, or on transactions, or both. If you are making a large number of small investments (which is the generally recommended practice for angel investing) those transaction fees can add up.

So what can I do to optimize?

There is nothing stopping you angel investing from both cash and IRA. You can, and many VentureSouth members in fact do, carefully plot what investments are made from which source.

If you’re investing in a C-Corp raising a priced equity round, the base positive outcome would be no ordinary income, a Section 1202 exemption, and a SC angel investor tax credit; and the base negative outcome a Section 1244 loss — all excellent treatments.

If the company is a South-Carolina headquartered, maybe cash investment is better to get the credit?

If you’re investing in an LLC which is going to pass along passive income losses. Might be more useful outside the IRA?

Maybe the IRA advantages are even greater if the company is outside South Carolina is raising a convertible note or a revenue-based financing and so there is a higher chance of taxable income and no angel credit.

Maybe investments in very early deals (the first $1M into companies) are better in cash for the Section 1244 benefits, but later rounds (after $1M) in the IRA?

Obviously angel investing is unpredictable, so what actually happens on a given company might (will!) be quite different from prediction. But small things can tilt returns in your favor, and our most sophisticated investors at least consider these nuances.

Can I “angel invest” in my own business through an IRA?

Oh, heck no. You can’t using your IRA to invest in anything that you “control”. Definitely do not do that. Look at using a ROBS instead.

“Family and friends” rounds are mixed — but broadly you can’t invest in family members’ businesses but friends’ might be OK. Your IRA custodian will have clear rules to help there.

Also note that if you’re angel investing with a potential view to being involved in the company, you might want to avoid using your IRA, so that the investment doesn’t become a “prohibited transaction” in retrospect! And similarly, don’t be on the board of a company you’ve invested in through an IRA.

I’m ready to invest through my IRA. Who do I call?

At VentureSouth, we have members that have invested using several different custodians. American IRA in Asheville is an excellent local provider; Pacific Premier Trust (formerly PENSCO), Equity Trust, Quest Trust, New Vision Trust, Millennium Trust, and others feature on our cap tables.

We have recently been particularly impressed with Alto IRA, which is a new-generation custodian focused specifically on making the process of investing in early stage companies easier and cheaper. You might want to give them a try. There are others too, of course, like Strata.

And for making angel investments, you know who to call!