Self-Directed IRA - investment in a franchise

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I was wondering if anyone has bought a franchise using a self directed IRA and what some of the limitations are. Could you do work there? I have a self directed I use for other investments, and I have read a little about investing in real estate, and the "sweat equity" issue. I assume it applies in a similar way where it might conflict, but what if it's paid?

My thought is to purchase a franchise with a partner, I bring the money, they run the day-to-day. Would I be in a danger if I took a pay check from the franchise to do the books or as an hourly employee? I have a feeling that's not a good idea. Is there a clear directive on the issue? Would it be different if I made a loan to the partner in return for a percentage of the business? I guess what I want to do is separate the money earned as an investor, from some money earned hourly as a service provider or employee. 

Just looking for ideas. Thanks in advance for thoughts and advice. 

Hey @Robert Taylor  

Investing into an operating business with an IRA is completely alright but as you mention, there are some specific rules that need to be followed.

First and foremost, IRA investments should always be arms length from personal endeavors. This protects you from accidently commiting any prohibited transactions. Others may have a differing opinions but this is the cleanest and safest approach.

That being said, you could be the "money" as long as you or other disqualified persons don't get involved. The concern would be incurring a "self-benefit" like pay, work, etc. If you limit yourself to a passive role as both an investor and as a manager, you can stay well within the boundaries of the IRS guidelines.

One important consideration when investing in an operating business is the additional taxation you'll be subjected to. It's called UBIT or unrelated business income tax. All of the profits that your IRA gains will be subject to UBIT (ranges from 15% to 39.6% tax). These brackets follow the "Trust and Estate" rates published by the IRS. Check out my BP blog for additional UBIT information.

@Loren Whitney does the UBIT occur whether your funding from a traditional IRA or a ROTH? I understand the UBIT consequences of having a traditional SDIRA acquire a loan for real estate, but didn't know that this also applied to the purchase of a business. Thanks for the info.

@Barrett Dunigan  

Happy to help. There are no differences between IRA accounts as it relates to UBIT subjectivity.

UBIT is triggered two ways:

  1. 1. UBTI - Unrelated business taxable income
  2. 2. UDFI - Unrelated debt financed income

I just wrote a Bigger Pockets blog on this exact topic that I think you'll appreciate. Check it out!

Investing with an SDIRA - Understanding UBIT, UDFI, and UBTI

Let me know if I can help with anything else!

Thanks Loren, great info!

If your goal is to open a franchise, specifically, and aren't just looking for an investment for your IRA and your IRA is not a ROTH, you might research doing a different arrangement known as ROBS (RollOver as a Business Startup). This has been a controversial deal and the IRS has reviewed it to determine if it was an abusive tax shelter. It has determined that it is not inherently, but if that it isn't arrange correctly and that strict operational rules are not followed, it is a problem. So there's some guidance now on how to stay within the lines. And since they're watching it, it needs to be done carefully. You'll see it advertised a lot in the context of franchise funding. Here's the summary info from the IRS:

It basically involves the formation of a new C-Corp that has a 401(k) plan. You rollover your IRA funds into the 401(k) plan and the 401(k) purchases company stock, funding the corporation. There are a bunch of rules: you must pay yourself a salary once the business becomes profitable, allow eligible employees to be able to participate in the 401(k) and also allow them to purchase company stock, etc.

You definitely need good advisors to tackle this.

Thanks Phil, that's a pretty interesting approach. I'll see if I can make sense of the summary. Appreciate the info!

This is the exact process I followed. Created a self-directed 401k and then directed it to invest in a c-Corp that bought 2 franchise areas.  There are many rules and filings to follow to be in compliance.  Sold the franchises back at a 40% profit and have now opened a real estate brokerage and property management firm so I could be active in the business.  Same rules for filing and reports as well as employees qualifications, but allows me to manage the day in an industry with a lot of variety and opportunity.

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