November 25, 2020 How one founder could pay no taxes on a $196M gain with a ROTH IRA
When it comes to the topic of wealth preservation, there is no shortage of strategies. One method startup founders could take involves putting a percentage of their startup stock into a ROTH IRA retirement account to create a tax-advantaged nest egg.
What is the ROTH IRA?
The ROTH IRA allows you to put up to $6,000 in 2021 ($7,000 if you’re 50 or older) into an account which grows tax-free and can be removed without restriction or taxes due starting at age 59 ½.
There is no cap to the amount of money one can accumulate in a ROTH IRA, making it a popular vehicle for any investment that you want to grow without penalty and without any tax consequences when you withdraw.
Founder’s stock and potential pitfalls
The ROTH IRA is permitted to invest in private businesses not controlled more than 50% by the plan holder, so what about using the ROTH IRA to invest in your startup’s stock?
As long as you control less than 50% off the company, the IRS has no restrictions on investing in a business you partially own.
Real world ROTH IRA success stories
Forbes.com reported that in 2010 the chairman of Yelp sold 3.1 million shares of Yelp stock held in his ROTH individual retirement account, receiving around $10.1 million in profit, tax-free. Assuming he did not withdraw early, there are no taxes on that gain.
In 2014, the Government Accountability Office (GAO) released a report discussing the impact on the federal government from the revenue loss that occurs with this “circumvention of the longstanding rationale for IRA contribution limits.”
The report included an example in which one company’s shares were valued at $0.00125 each in 2008 and 4 million shares were placed in a Roth IRA. The company eventually got a venture capital investment, went public, and saw its share price go to $60. The founder could end up with $196 million in the IRA, according to the GAO. (The company and founder were kept anonymous.)
What to consider before investing
If you’re considering pursuing this strategy with your own startup, here are some guidelines you need to follow regarding restricted transactions with ROTH IRA’s before investing in your company’s stock.
- Make the investment as early on in the company life as possible, so no arguments can be made that the stock has experienced an appreciation in value.
- Control less than 50% of the company at the time of investment.
- Get a valuation done immediately before the investment to ensure the FMV of stock is what your ROTH IRA pays for it.
- There should be no mismatch with the value vs. purchase price. This will keep the IRS from looking at the investment as “abusive.”
- Be sure to hold your founder’s stock in multiple investment vehicles, so it is not concentrated in one account.
If this tax-saving method worked for the founders of Yelp and other successful startups, there’s a good chance it could work well for you.