AN INVESTOR S GUIDE: Tax-Advantaged Private Equity Investing

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1 AN INVESTOR S GUIDE: Tax-Advantaged Private Equity Investing

2 Tax-Advantaged Private Equity Investing Institutions and financial professionals have long realized that private equity can deliver significant rewards. Private equity can also be beneficial for individual investors, especially when those investments are held in a tax-advantaged Individual Retirement Account (IRA). This guide is aimed at helping investors learn how to use their Individual Retirement Accounts (IRAs) to invest in private equity and will cover topics including: What types of investments are permitted Understanding prohibited transactions How to purchase private equity within a self-directed IRA What investors should expect from a self-directed IRA custodian Average returns over the last 10 years* 10% Private equity 5.8% Public equity 6.6% Fixed Income * Statistics through December Source: Private Equity Growth Capital Council The Rise of Self-Directed IRAs In 1974, Congress enacted the Employee Retirement Income Security Act (ERISA) to shift the responsibility of retirement savings away from the employer and put employees in greater control of how their funds were invested. Individual Retirement Accounts (IRAs) were created the following year, ushering in a new era of retirement planning. Since then, the popularity of IRAs has grown exponentially, in large part because they offer tax advantages for investors in nearly every income bracket. The ability to invest IRA funds in stocks, bonds and mutual funds is understood by most investors. What s less well known is that the Internal Revenue Service (IRS) allows investors to use IRA funds to invest in alternative assets, including real estate, private stock, LLCs, precious metals, mineral rights and more. Most large financial institutions that act as IRA custodians limit the types of investments they offer to those traded on the exchanges, which may explain the lack of knowledge surrounding alternative asset IRA accounts. Custodianship of retirement accounts that hold non-traditional assets is a more complicated process that generally involves significantly more paperwork and administration. For this reason, alternative asset custodianship has always been limited to a smaller number of entities who specialize in self-directed IRAs. After years of market instability, self-directed IRAs are attracting greater attention as investors search for additional ways to manage risk and meet return objectives with their retirement funds. 2

3 Turn Your Passion for Pre-IPOs into Growth Account owners can use self-directed IRAs to purchase ownership in everything from micro-businesses to billion-dollar global companies, to less conventional opportunities, such as land trusts. What Kind of Private Equity Investments Can My IRA Hold? Limited liability companies (LLC) and limited partnerships (LP) 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, hedge funds, and funds of funds. Directly in a company Investors looking for opportunities outside of a fund can put money into start-up companies, including their current employer, or make angel investments. Private common stock, preferred stock, options, rights, and warrants Private hedge funds and funds of funds Private and non-exchange traded real estate investment trusts (REITs) Foreign private equity Exchange traded funds or funds of funds investing in privately-held companies Convertible notes 17,700 The number of private equity-backed companies that are headquartered in the U.S.* *Source: The Private Equity Growth Capital Council 2013 Annual Report, as of 12/2013 5,008 The number of public companies listed on the U.S. stock market. Source: World Federation of Exchanges, as of 12/2013 Is your time horizon right for including private equity in your IRA? One consideration for private equity investing is that private transactions are not traded on an exchange, and these types of investments can often be difficult to sell on short notice. Since most people invest their retirement accounts for the long-term, this lack of liquidity may not be an issue. 3

4 Make the Most of Your IRA by Understanding IRS Rules 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 IRA 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, which is a prohibited transaction, 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, for example triggering an immediate distribution, as well as significant taxes, penalties and potential disqualification of the entire IRA. Another important rule to note is that all financial transactions associated with the private equity investment must first flow through the IRA in order 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 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. *Distributions may incur penalties please consult a professional before taking any distribution. Disqualified Person = Deal Buster IRS prohibits IRA investments from which disqualified persons would directly or indirectly benefit. Disqualified persons include: The account owner The account owner s spouse Lineal family members (parents, children, grand- parents and grandchildren); this does not include siblings, aunts, uncles, nieces or nephews The spouses of lineal family members Fiduciaries of the account owner 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 What is Self-dealing? When the IRA account owner or disqualified party personally benefits from the investment held in the IRA. 4 4

5 Purchasing Private Equity in a Self-Directed IRA Private equity can potentially earn 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 taxfree growth if held in a Roth IRA. Funding Your Self-Directed IRA Because most private equity investments have investment minimums, self-directed IRAs are usually funded by transferring cash from an existing IRA or rolling a 401(k), referred to as a rollover, into an IRA. Remember that it can take significantly longer to roll a 401(k) into a selfdirected IRA. Taking a distribution from a 401(k) can often take many steps, and the actual process is highly scrutinized by the IRS. However, a cash transfer from an IRA at a broker-dealer to a self-directed IRA custodian can usually happen in 2-3 business days. To make the most of this opportunity, investors first need to open a self-directed IRA. Self-directed IRAs and other retirement accounts differ with respect to who controls the investment decisions and what type of investments can be made. 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 and may not have the expertise, record keeping systems, or regulatory authority to allow alternative investments. It is important to note that all IRA accounts must be held for the account owner by a custodian or trustee approved by the IRS to act in this capacity. You can also make annual contributions to your self-directed IRA up to the limits established by the IRS. As of 2014 that limit is $5,500 per year and $6,500 if you are 50 years old or older. A wider selection of assets allows individuals and their advisors to diversify their investment holdings outside of exchange-traded investments. However, investors and advisors should bear in mind the higher risk that comes with private equity investments, and should carefully assess suitability. What makes self-directed IRAs unique is that their custodians permit investments in a broader range of assets. In all other respects they are like other IRAs, which offer tax advantages, in the case of traditional IRAs, and have minimum distribution requirements. 5

6 Understanding the Role of a Custodian All IRA accounts are held for investors by a custodian or trustee, which may be a bank, trust company or other entity approved by the IRS to act in this capacity. Custodians of self-directed IRAs differ only in that they allow investments in a broader range of asset classes. Since these generally require less disclosure and oversight than traditional assets held in IRAs, it s important for investors to understand the role of the self-directed IRA custodian. 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. Your self-directed IRA custodian s role is to determine if the investment can be held in a self-directed IRA and help you meet the IRS reporting requirements over the life of the investment. The custodian does not approve of or endorse the actual investment. Self-directed IRA custodians are responsible only for holding and administering the assets in the account. They manage the extensive recordkeeping required by the IRS and handle the reporting of all investment activity within the account, including quarterly reports, processing of annual asset valuations and other documentation. Self-directed IRA custodians also work directly with the IRA account holders and investment sponsors to provide the IRS with annual valuations and other necessary tax reporting. A self-directed IRA custodian: Offer the possibility of a broader range of investments Does not evaluate the merits of an investment beyond its ability to be held within an IRA Provide extensive recordkeeping Monitors for prohibited transactions and ensures IRS compliance Assumes responsibility for the administration process and documentation required to buy, hold and sell alternative assets while in an IRA PENSCO Makes It Possible TM PENSCO Trust Company has been helping investors use their retirement account funds to invest in real estate, private equity and other non-exchange traded assets since As the trusted custodian of over $10 billion in assets on behalf of more than 50,000 clients, PENSCO works with asset sponsors, financial institutions, and financial advisors, as well as selfdirected investors who typically have a point of view about alternative investment opportunities based on their own knowledge or expertise. To learn more about PENSCO services and investing in non-traded alternative assets, please visit or call PENSCO Trust Company - InvestorsGuide_PrivateEquity_0514 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 loss of principal. 6