Holding Private Shares in an IRA
It is very common for founders or early employees to have an opportunity to buy a substantial amount of stock in a promising startup company at a very low price. If your company permits transfers to your own IRA, you can create an IRA account at a special financial institution such as Pensco and then move your private shares into it. However, you are limited to how much, if any, you can contribute to an IRA each year. The Fair Market Value (FMV) of your shares at the time of the transfer will count against that annual limit. As such, it is best to do this when your company is young and the stock has a very low value. Once you achieve this, all future gains on the shares will be tax deferred. This is especially valuable in a hot IPO market when your shares have run up in value. In this situation, it is common for employees to net exercise their options or sell their shares in order to capture value before a possible stock collapse. But by doing so, they trigger a lot of taxes on the profits in addition to raising their tax brackets on all sources of income including their base income. On the other hand, shares held in an IRA won't cause either problem and will benefit from compounding effects over the years since all profits can be reinvested instead of being used for taxes.
Purchasing Private Shares with an IRA
If your Pensco IRA is sufficiently funded from prior gains or contributions, you can purchase private shares from these funds as well. By doing so, all gains on this investment will accrue tax-deferred until you withdraw the money at age 59 1/2 or higher. Even if you need to withdraw the money sooner to cover an emergency, the 10% penalty and taxes might still be worth it considering how much was saved over the years. However, it is unlikely that you can exercise employee stock options directly from an IRA because of IRS rules relating to options granted in connection with employment. Options and warrants granted in non-employment situations such as investing are usually eligible though.
Normally, highly compensated employees at fast growing technology companies are not eligible to make Roth IRA contributions. However, the IRS frequently allows IRA conversions as a mechanism to generate near term tax revenue for the government. During such a window, you can convert your IRA into a Roth IRA by paying the taxes on the amount converted as if it was an authorized distribution. Although the taxes paid effectively increases the amount that you have invested in your stock, your return on investment can be enormous since the final proceeds will be tax free for the most part as opposed to merely tax deferred in the case of regular IRAs. Note that the amount of taxes you pay on your Roth conversion will be a function of the fair market value of your stock at the time of conversion, so it is best that you do it early on while the valuation is still low. Although Qualified Small Business Stock(QSBS) exemptions can be less expensive to execute, the tax savings is limited to federal tax for many states, the investment must be held at least 5 years, and the exemption on capital gains is capped at the higher of $10 million or 10x the invested capital. Although an investment using a Roth IRA doesn't have those QSBS limitations, it is subject to many other restrictions. Be aware that the rules governing IRA's outline a number of prohibited transactions including self dealing in situations where you control the asset in which you invested. That can be risky for founders who own a large percentage of their companies. Since this is a grey area of the law, it is highly recommended that you seek professional advice before doing this.If you hold employee stock options or restricted shares in a private company funded by institutional venture capital, feel free to contact us at the Employee Stock Option Fund for more information on how we can assist you. By doing so, you can not only avoid the risks associated with investing directly in a startup but possibly improve your taxes as well. For specific tax related support related to stock option exercises, please contact Scott Chou.