Episode 6: Investing in a Private Company, Private Fund, or Small Business

Tax attorneys and hosts Mat Sorensen and Mark Kohler explain how your self-directed IRA or solo 401(k) can invest in real estate. Mat and Mark explain the process, rules, steps, and common real estate deals and investments made by self-directed investors (rentals, fix and flip, partnerships, wholesale/options).

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Mat Sorensen: Welcome, everyone, to the Directed IRA podcast, if you’ve been wondering about how the heck you can self-direct your IRA and buy cool stuff, well, you got the right podcast.

Mark Kohler: That was one of your most to the point good introduction, just like you just know right there.

Mat Sorensen: It’s the end of the day today when we’re recording. And I just want to cut to the chase.

Mark Kohler: It’s like you don’t pull any punches with that. Well, that was Mat Sorensen, the amazing CEO of Directed IRA, the fastest growing, highest customer service rated directed trust company in the country. How was that?

Mat Sorensen: Yeah, that’s all accurate. All accurate. We’re the best. I don’t want to say what we what we do with excellence. A little salty, but. Well, I’ll say, you know, Ricky, Bobby, I just piss excellence. You know, I’m the best. That’s all there is to it.

Mark Kohler: Complacent loser. Now I am the measly CFO of the Directed Trust company, but we are also both senior partners. Equally in the KKOS law firm, been around for 20 years, been helping clients with their small businesses and building their retirement accounts for 20 years. We love this space. We finally got around to a podcast on it just this year because we’re like, you know what? We’ve got to get some better, more info out there. Not taking a shot at anyone else out there in the space, just trying to be best we can and deal with it.

Mat Sorensen: And if you don’t like the podcast, we do give full refunds, whatever you’ve paid. If you don’t like it, 100% refund.

Mark Kohler: We will hook you up. So CPA and Mat’s a tax attorney, and Mat tell us the topic today,

Mat Sorensen: Like, yeah, this is cool. We’re gonna talk about investing in a private company, private fund or small business with your IRA. If you’ve listened so far to the podcast, you know anything about Self-directed IRAs, you know, you don’t just have to buy the big publicly traded companies, you know, that you can invest on Main Street. You can buy a small business, you can invest in a private fund. Would that be something to talk about?

Mark Kohler: Yeah, and I was going to ask is that would private equity?

Mat Sorensen: Private equity fund PPM private placement memorandum, a hedge fund? You could do a private REIT. We have clients that have done those, an LLC or a limited partnership real estate fund. That could be a private placement real estate fund. Now, there are other things you can do. You could there’s ways your retirement account can own a business that you’re kind of set up. But that’s we’re going to do that in another podcast we’re talking about. You just want to invest in some other cool business. You want to invest in the next Facebook. You want to invest in some private fund that’s doing cool things and getting good returns. Yeah, that’s what we’re going to hit today.

Mark Kohler: I would say, too in this typical scenario, you are not a manager or an officer of this operation. Right. You would be generally considered a limited partner or a passive partner or an investor if that term fits to where it. Because we’re normally and we’ve talked about this for years, we want to be careful of throwing the investor word out there, because if you’re out there raising money, you’re got to meet with a lot of requirements. If you’re going to call people investors. Well, a lot of these private equities and hedge funds and they’ve done that. So you are an investor, so that’s OK. But you’re not an officer or director of these businesses.

Mat Sorensen: Exactly. And so let’s focus on how you can use your retirement account to do this, because it’s kind of cool. And I want to give a few examples.

Mark Kohler: Let’s start with a cool example before we get into tech.

Mat Sorensen: Ok, let’s start with an easy example. Pandemic hit. There was a bar and restaurant owner also had some gentlemen’s clubs, Sam, that was part of it. And that shutdown, OK, they got shut down in the pandemic. I had a client’s IRA come in, buy up some shares in that in that business, gave him an influx of cash for that to help them get through the pandemic. Knew this business had been around for twenty-plus years before they were friends and said, hey, I just want to invest in your small business. And this was an existing business. OK, so we see that. We see transactions like that of I’m going to buy some stock in your small business. We’re going to talk about how you do that. But that be an easy example.

Mark Kohler: If I can play off that example, that would not be private equity registered security scenario. That was. This very, very combative, very OK, is your friend down the street says, I’ve got this business, I’m struggling right now or I want to expand it couldn’t be it. Maybe it’s not a crisis, but an opportunity. And they come to you say, hey, do you want to buy in now Guys! Gals! This is what we talk to our clients about all the time. It’s called opportunity shifting. When that person comes to you and says, hey, you want to buy in, you say, no, I don’t want to buy in, but my retirement account does. That’s the difference. And you have to use that nomenclature, that verbiage. You’ve got to remember, this is not you. This is your retirement account. So clients come to me especially I’m going to the more tax planner. I get them a podcast or webinars or lives all the time. And people like how I save taxes. I’ll say quit making money, let your retirement account make the money. And that’s the difference here in this wonderful example is his friend down the street, said I need some cash and he’s there to start particulars. You probably say, here’s my operating agreement. Go look at it with your lawyer, what would happen to next?

Mat Sorensen: Yeah. Yes. OK, so the first thing you do is you want to understand what type of businesses this. Is this an LLC? Is it an S corp? Is it a C corporation? Those there’s going to be your typical three businesses out there in the small business world. One of those is a problem. All right, let’s walk through that. OK, the first one. S corporation, if the person has an S corporation or the business is an S corporation, your IRA will not qualify to invest in it. IRAs just can’t buy the stock of an S corporation. Now, your IRA could loan them money. You could be a lender to an S corporation and maybe take, you know, get a lien on some assets the business owned. But you can’t buy the stock in an S corporation.

Mark Kohler: I got a backup plan, but go to go to the LLC and see corporate. Then let’s circle back.

Mat Sorensen: Ok, the next to be the C Corp. The C Corp is pretty easy. That’s basically when your IRA is buying Microsoft or Apple or General Motors. You know, if anyone buys that stock anymore when your IRA buys those, those are C Corps straightforward. IRA owns it. There’s nothing called UBIT tax you need to worry about and you’re in business. You own some of the stock.

Mark Kohler: And typically in that situation, your friend is not going to have a sequel that’s not cheap, but they could have the LLC. Is that OK?

Mat Sorensen: Yeah. Now, let me say on the C Corp, we see that a lot in the startups. So when you’re investing in a startup, that could be the next big thing. And there’s tons of these going on right now. Those are typically going to be C Corps. So you usually get there. But the existing small business down the street is going to be an S Corp or an LLC and the LLC, LLC. Now, here’s the way you need to when you’re messing with an LLC, your IRA can own an LLC, you’re going to be what’s called a member of an LLC. That’s like a shareholder of a corporation. You called a member in an LLC you’re the owner. You’ll negotiate whatever percent you can out of that, right. So think of this bar and restaurant that was shut down, needed an influx of cash. Was that you’re the retirement account investor. You’re like, can I get 20% ownership out of this for my $250,000? What’s the business worth? And so you’ve got to negotiate that. In this example, they negotiated the buyout so that the existing business owner could buy the client, the IRA, back out. But it was for like a three-time multiple. So the only way they could force him back out to buy them back out was a three-time return. So if I put in $250,000, that gets pay me $750,000 to get me back out to force me. I can always sell if I wanted to sell, but to force me back out. And you can negotiate terms like that. Now the LLC, one thing you need to know what these operating businesses.

Mark Kohler: Before you go there Mat. I know where you’re going and I know that’s going to take us to the level. I kind of like to dumb things down a little bit. Mat’s so smart. I’m the dumb guy. So it helps now in that after the negotiation stuff, typically this is where people screw up all the time. I don’t know why, because they’ve got their retirement account and their due diligent brain just is gone, you know, or because if I was going to go invest in this restaurant for some reason, I’m going to I don’t know why people in that situation are much more diligent to go in and look at the books and negotiate a good membership transfer agreement and look at non competes and all these things. People just they think it’s their IRA. So they throw a little more caution to the wind. You don’t want to do that. Step one’s negotiating. Step two is making sure that your retirement account, whether it’s an IRA or 401k or whatever, whatever your retirement account is, is getting a good document, a good legal document. Get your lawyer involved. Your lawyer brain might explode your retirement. It goes by unless you get just shut up and just look at the contract. So don’t let your attorney jack it up by getting freaked out that your retirement accounts doing call our law firm if you need to but negotiate well and then you’re going to get a membership certificate and buy into the LLC. Mat was okay?

Mat Sorensen: It will typically be a membership transfer agreement or purchase agreement to buy the units of the LLC in this small business case, you’re going to get added on to the operating agreement of the LLC generally when you’re going to have to know what the operation is and you want to know that do I have any voting power now if I’m an owner, what if I have voting rights? But I only own 40% of this company and the person I bought in with has 60%. I have a say of anything? Probably not. Negotiate that stuff. And you want to have that control because you’re going to be able to vote for your IRA and its position to say, yeah, we should take on debt, yes, we should open a second location, whatever it may be in the business you’re investing into.

Mark Kohler: And we’re going to come to the private equities, hang out, everybody. But let’s think through this a little more. See, hopefully we’re open your eyes now, okay? It’s just like me buying into a business and I’ve got to negotiate on behalf of my IRA. Yeah, I got to negotiate properly. I got to make sure the documents are done properly. Do I have a voting right? And again, in this situation, you’re not going to go bar tend. You’re not going to run the books. You’re not going to go run the show. Now you go patrĂ³n the gentleman’s club or the restaurant. Sure. But you’re going to pay the same as everybody else because you’re not an owner. Yeah. Your retirement account is. You’re going to negotiate and when this deal goes down, you want to talk about. Where’s the money going to go? A lot of times in a business sale, the money is going to go to the person selling the membership or the stock, not in this situation I suspect. You said, OK, if I’m going to put this money. I want the money to go in the business. So now the accountants have to be involved because you don’t want a capital gain for the seller. You want an infusion of cash going into the business. So it’s not a taxable transaction for the other owner. And accountants have to account for that differently on the tax return of the seller and the buyer. So these are little things you need to deal with. And if you’re going to spend a couple of grand in legal or accounting, it’s OK. This guy got a killer deal, it sounds like.

Mat Sorensen: That would be like, you know, the non-planning of I’ll just transfer half of my ownership and he’s got a capital gain instead of just selling new units and diluting yourself to 50% or whatever in the negotiation is.

Mark Kohler: And Mat, how many times does that happen? People just see somebody. You’re like, what are you getting? Well, I’m just buying part of this company. Where’s the contract? Well, here’s a napkin from Denny’s. No. Yeah. Oh, my gosh. Drives me insane. Private equity example. Give us a good private equity example.

Mat Sorensen: OK, let’s talk about private equity.

Mark Kohler: I said the S CORP thing we were going to circle back where we.

Mat Sorensen: UBIT. Well, we got to talk about UBIT actually. Because the S Corp.

Mark Kohler: Yeah. Let me just say the S-Corp thing because normally a restaurant owner like that is going to be an S Corp and if you don’t want a dumb accountant or lawyer to torpedo you buying in. So typically in this we do or we call it a reorg or reorganization. So what you do is create an LLC and you would inject your retirement account as a 40% owner and that’s a gamble. And the current owner would buy or contribute the assets of the business through his S corp as a 60% owner. So you end up with this new parent that would own and operate the business in your retirement account would own part of that LLC and the current owners, S CORP would own the 60%. So it’s doable. You just need good accountants and lawyers to bring it together. It is not terribly expensive, so don’t think you’re out of the cold if someone comes to you said you want to buy into my business, I got an S Corp, no, I can’t. My retirement can’t own an S Corp. No, we just reorg it and back door you.

Mat Sorensen: I love that. I didn’t even think of that. That was great. I just skip that. I think I loved it.

Mark Kohler: That’s why we’re partners and you know,

Mat Sorensen: Such a good team.

Mark Kohler: Ok, now, Mat, before you go to this, let’s get the private equity people in the mix. Is that OK?

Mat Sorensen: Let’s just call it the private fund. OK, private, because this could be a hedge fund, a private equity fund, you know. PPM. Any type of PPM. Limited partnership. Yeah. And that’s. Yeah. And so, so that structure is basically you have someone who’s raising money for investment purposes. They’re going to go out and buy and sell stock or do real estate deals or buy and sell small and medium sized businesses like a private equity fund. We’ve got a prospectus. Yeah, there’s a there’s a prospectus or an offering document. And what you’re doing in those is those people raising the money are have a management team that run the fund, that make decisions, that get a management fee. They get a share of profits. When the fund makes money, then they push down the rest of the profits, of course, to the investors. And it’s good, it’s great. It’s very common. And that’s, you know, like there are lots of famous hedge funds out there, for example, that are very exclusive. And who gets in is like, you know, you’ve got to like, know the right people and kiss the butts or whatever to get in. Now, there’s a number of funds out there that actually very famous, that have had ridiculous returns over the years that we have a couple of clients that that are in some of these funds that you can’t just call up and be like, I want to buy in. I feel like I got a million bucks. Can I buy into this fund? They’ll be like, nope, but you have to know someone, unfortunately. So now there are those types of funds and you can’t even get those types of funds that are very well known, but super exclusive. They’re not publicly traded. OK, these are private funds. And you use under what’s called Reg D under the securities rules, your IRA can just invest in those. And of course, you can open an account at Directed IRA to do it. Now, you’re the regular fund too that might just have one hundred investors in it and someone just out the raise in kind of a smaller fund and trying to raise maybe ten million bucks or one hundred million or five whatever, very, very common too.

Mark Kohler: Now, what’s good about these types of deals is it’s not John or Mary down the street. These have professional managers. They’re going to have a track record of some sort. They have a prospectus. So the nice thing about this is you have are going to have less stress and there’s not a lot of negotiation is a deal. Here’s the deal. Do you want in or do you want out? And their documents are going to be vetted 50 times over by all the attorneys involved.

Mat Sorensen: Well, let me say this. What, Marks saying, it’s your duty to make sure this is the case before you invest, that you have all the documents you want to look at the management background, OK, just because you got an email from someone or somebody told you to invest or you saw some workshop or something and they offer a fund, doesn’t mean you should you’re you know.

Mark Kohler: We’re not doing that for you either at directed IRA. That’s on you. Just like your buddy down the street. You’ve got to do your due diligence. But I would say Mat, don’t you? I mean, with these private funds, at least you’re going to have something to look at that’s a little more organized, right?

Mat Sorensen: Yeah, like yeah. Like the small business down the street, the bar-restaurant. I mean, you’re going to have to kick the tires and create the documents and get some financials out of the current owner. Right. The private fund is they have a whole packet typically of documents that the SEC requires. You generally want to search to make sure their funds registered at SEC.gov. There’s a research tool there. If this fund is big enough and most of the private funds we see through here are, some exceptions to it. But so there’s definitely more preparation in that. And the documentation, now someone could be a terrible fund manager and could lose your money. Right. So you want to, of course, get to know the people that are running it, talk to other investors, do the typical due diligence things you would do. But there’s it’s it’s a very popular world to be in right now in some of these private funds that are finding opportunities in the markets with all the volatility we’ve had.

Mark Kohler: Now in both of these situations, correct me if I’m the wrong Mat, but as CEO of directed IRA, when you once you find the fund that you’re cool with and you’re stoked on or buddy down the street and you vet and you go over and look over his shoulder or her shoulder and you’re looking at QuickBooks and you’re happy you’re going to go to directed IRA and go. I opened my account here, I move my money from my IRA or my 401k rollover or whatever it is. Your money is at directed IRA. Now you’re going to say, what form do I use to get this done? And there’s going to be some specific forms that you fill out and submit so that we can do the deal and get that money where it’s supposed to go. Is that a fair way of saying it?

Mat Sorensen: You’re going to do the direction of investment. Private company. Private fund. You outline details how much you want to invest from your account, attach the documents, authorize us to sign them and execute it. Money goes out in a couple of days. So now here’s the critical thing on the docs. Yeah. On remember, you’re not investing in this fund. Your IRA is the documents do not say Mark Kohler is the investor. It says directed trust company FBO, Mark Kohler IRA. All right. And you sign the documents, read and approved to say, I approve you guys directed IRA, but we will actually sign for the IRA. Let me hit a couple of one other note. Oh, turn around time.

Mark Kohler: Be a little more clear on that, if you don’t mind. What should people expect process-wise? Because some people are like, can you do this today or sort of thing?

Mat Sorensen: Yeah, I probably say the average time is two to three days. The turnaround time to fund it. Now we’re generally funding within a couple of days, one to two days, just because we’re on our stuff. You know, we got our crap together over here. Once they submit everything, once you submit everything right. Now if you know what you’re doing, we’re going to process it fast. If it’s your first one and you blow up the documents, you don’t do it right. There might be some back and forth, but we’re going to help you through the process. Our investment team is very well trained. We’re doing a number of private funds every day. Like one I remember we did a couple of months ago now was a it was a men’s health, you know, medication and a medical company had a lot of doctors involved in helping for men’s health in the bedroom. Let’s just say that trying to solve some problems there. You know, say if it works, that is something people will pay money for. All right.

Mark Kohler: You know, usually I’m the one getting in trouble. We’ve got a gentlemen’s club example. And now Men’s Health.

Mat Sorensen: I don’t know. Yeah, I mean, I just I should get better examples.

Mark Kohler: The ladies on the show are like these guys are creeps. No no.

Mat Sorensen: Who are their customers over there? Why are those the funds that I remember? I just. Oh, what’s this one? Here’s another cool one that came through, though, a fund. A Netflix movie. So it’s kind of a Netflix movie. It is somebody who’s produced one before that’s had stuff get on Netflix and purchased. And so we had some clients. IRAs investing in a fund that was you’re buying shares in the company that’s going to own this Netflix movie. You get a share of the royalties. And so so that was cool. You know, we see stuff like that in these in these funds as well.

Mark Kohler: Ok, now, if I may say. What happens on day two, all this is done, your money is now invested in this deal, you’re going to have an account that you can view online and see, OK, my accounts there, it’s invested in X and then do you get the money Mat? Who gets any dividends or money? Are they going to send it to Mat Sorensen in your mailbox tomorrow and put it in your bank account?

Mat Sorensen: No. So when you complete the documents for the fund, most of these funds are going have a section that says, hey, where do we send the any distributions or any dividends?

Mark Kohler: All I’m trying to say, profits from this investment are not going to you. The person.

Mat Sorensen: Oh, I know. I just said, yeah, OK. I thought your distribution stepped down with the fund’s column distributions so that the fund is distributing proceeds out to the investors. So you call it dividends or profits. So when the fund’s cutting money out to the investors, there’s a section in your documents when you say, hey, fund, I’m investing called the subscription agreement, where you indicate where to send the money. Now, don’t put your address in your name. The directed trust company FBO Mark Kohler IRA, if it was Mark’s. And then you’re going to put our account number and information, which we provide you with on our forms, and our staff will do it for you if you miss it. And that way we’re going to receive the income into the IRA, just like when you’re IRA Owens Apple stock and Apple issued a dividend, they don’t send you a check. They send it to your IRA gets in your Schwab account or wherever your IRA is at. So similar thing with the private fund, they’re going to send the money back to us. It’ll get deposited in is cash in your account.

Mark Kohler: Now that and then you can look at your portal and go, oh, money showed up today and there it is.

Mat Sorensen: A lot of private funds do quarterly distributions. Some of them do an annual now with some of them don’t distribute at all. Some of them have kind of a lifespan of maybe it’s a seven year fund, like a private equity fund. And some of those even VC venture capital funds, those are kind of like we’re not really distributing the money necessarily. We’re going to keep it invested and distribute at the end of our time period.

Mark Kohler: I like it now where I thought Mat was going when he said distribution is Mat knew this. Well, now the money’s in your IRA. How do you get it? The investor, the person? Well, that depends on what type of IRA you have. Is it a Roth? Is it SEP? Is it as simple? Is it an IRA? Is it a Coverdale? Is it a 401k? What is it? Well, you may be young, you may be old. And that’s a topic for another plan on how to get money out of your retirement account after it’s grown to a million dollars, right? It is. So we want to we’ll talk about distributions from the retirement account to you. But what Mat was talking about was distributions from the fund to your retirement account. There’s two steps. It’s just like your IRA bought Apple stock. The money goes into your retirement account and then someday you’re going to call up and go. I’m ready for distribution for my IRA. We’ll go cool. We have a process for that. That’s another podcast for another day. But is that fair to say?

Mat Sorensen: Yeah, exactly. So and of course, you know that cash is building up in your account. And, you know, once you have enough more money, you make another investment in something else. And so or if you’re 59 1/2 Or older, you just can start pulling it out. You take a distribution from your retirement account to you personally. Now, I want to say one other thing. I mentioned the subscription documents are a subscription agreement. When you’re investing in a private fund, that is the key document that’s basically saying, all right, I read all the due diligence documents I want to invest. Here’s how much money I want to give you. Here’s where that send the profits back or any dividend income that the funds making money send it back to me here to my IRA. There’s also a section that where you going to certify a lot of these funds that you’re an accredited investor. Any of these private funds. Not all of them, but many of them require you to be what’s called an accredited investor, which means as an individual, you have a million-dollar net worth, not including your home equity in your in your personal residence or you make two hundred fifty-thousand annual income single or three hundred fifty thousand annual income married. And so you can qualify either by because you have high income or you have a million dollars net worth. Now, if you personally qualify as an accredited investor, your IRA does in that subscription agreement. When you check, even though the document set in your IRAs name, you’re going to check. I’m an accredited investor because I have the net worth or I have the income.

Mark Kohler: I like that because a lot of people go, well, am I saying my accountant is an accredited investor or me the person that question is on you, the person that’s the one box where it’s not your retirement account, it is you behind your retirement account. Now, some people say, why is this? Why do I have to do this? Why is this required? Well, this is actually goes back to the 1933-34 Securities Act when. All these little grandmas lost their stock in the stock market crash of the 20s and they started to impose these securities laws and they’ve evolved over the years and it started in 1933 and 1934. And what the SEC Securities and Exchange Commission has done.

Mat Sorensen: That’s not the Southeastern Conference where like Auburn and Alabama that we all hate, not the SEC. Alabama’s in the SEC, right.

Mark Kohler: Oh, he said sorry, I love real football. Our producer here, kind of a crazy guy. He’s here in the studio and he’s like he’s a huge Alabama fan. Some makeup or a bandwagon fan of LSU or Alabama. OK, sorry, LSU, whatever is that in the SEC? I watch. OK, no distractions here.

Mat Sorensen: Why did I break that up?

Mark Kohler: What the SEC does, the Securities and Exchange Commission, they’re trying to protect the little people that don’t have a lot of money to invest and they’re worried that they might lose everything they have on this one investment. And so does the SEC said, hey, if you’re going to have a fund in some situations, not everybody. Some of you may go, well, I never got asked that. Depends on the fund. But in this fund, they said we need to have accredited investors’ form signed. What they’re trying to do is say this person knows enough there and they’ve got enough money that they’re not idiots. They’re only allowed to invest because we consider them to be smarter or more substantiated investors. That fair to say that? That’s why it’s so don’t hate it. Just sign the dumb thing if you qualified. But don’t lie. Don’t lie. Right. Make sure you.

Mat Sorensen: Yeah, good advice. Yes, there is one other variety of the private fund out there called crowdfunding. All right. So we’ve had lots of clients with IRAs investing in crowdfunding. The last one I did just recently, a few days ago as a client’s IRA was investing into a video game.

Mark Kohler: Ok, this video, you’re going to give some of the salacious examples, right? OK, you’re OK with a video game. This wasn’t like it was a PG video game, too. It was. OK, take good. OK right now.

Mat Sorensen: But this was a video game company that has made many successful video games already. And they that’s one way they raise money, they crowdfund it amongst their fans to go do all the work to make it. And so these crowdfunding offerings can usually raise a million. That was actually just increased last month, up to five million. So eventually crowdfunding offerings are going be able to get five million. But these are clients. We’ve seen them invest a thousand bucks, two thousand bucks, five hundred bucks in these crowdfunding offerings through their IRAs, many of them using Roths because they’re hoping these are going to be kind of the moon shot deals. That could be big, but that’s a crowdfunding offering. So it’s going to have similar documents like a subscription we’ve talked about and a similar process of how you’re going to invest through the fund. And of course, the fund is going to send money back to your retirement account as there’s profits or distributions to be made.

Mark Kohler: Ok, now now I’m going to pose the question that Mat has been dying to get to. When you invest in these this little LLC down the street with the restaurant or these funds of any sort, you’re typically going to get what’s called a K1. This K1 tells you at the end of the year how much profit you made. Now you may say, wow, this is going into my retirement account. It’s nontaxable because this is my IRA. This is my Roth or this is whatever. So K1 goes to directed IRA, I don’t care. Whatever. Should they care? Mat what’s this tax you were going to call it the UBIT tax that we might need to worry about.

Mat Sorensen: unrelated business income tax. UBIT. Now, this is a tax that can apply to your IRA when it receives business income. So Mark mentioned a K1. When you’re in a private fund, it’s usually a limited partnership or LLC, or maybe it’s the small business that the bar and restaurant that’s an LLC let’s say. When you get a K1, it’s going to tell you what type of income you received. Box one of the K1 is not the one you want, box one is ordinary income. When an IRA gets ordinary income from box one on a K1, it’s going to have to pay this tax called UBIT. That’s and it’s a 37% tax rate. And there are some strategies we’ll do a later podcast on. UBIT. Another tax called UDFI, but I just want to flag it here. And this is something if you have a knowledgeable accountant or tax lawyer, that’ll kind of walk you through it. So that’s what to look out for. Now, the restaurant, the bar and restaurant is probably going to have it, let’s say the hedge fund out there. It may not have it. The private equity fund or even VC fund may not have it because they’re going to be pushing through capital gain income.

Mark Kohler: So if I may Mat a good example is the restaurant is an operational business now and the congressional or the. I guess the reason for this tax from a policy standpoint is the government said, hey, if you don’t get taxed on this, it’s not fair to the other restaurants in town. So you and John down the street need to pay taxes on this profit because it’s ordinary business income and everybody needs to pay their fair share tax when it’s operational. But if you invest in a fund that’s doing rental, real estate, commercial real estate, some sort of drilling or natural resource mining or something, it’s going to pay and probably be passive. And so when it’s creating rental income or capital gain income, the government says, OK, that’s OK, that’s investment income. And so we want you to get a big number in box one or big number and box two or three. We want big numbers. You all want big numbers, but we want to understand that, well, if it’s box one, I might have to pay some tax or my retirement account might have to. Or if it’s passive in box two, three or four or five, whatever, you’re going to have passive income that’s not subject to UBIT. Is that OK Mat? That’s kind of why that happens. And so when you’re looking at funds, you may want to think. Is this passive or is an operation am I buying into a bunch of Chick fil A’s or am I buying into a commercial belly built? Yeah, Netflix movie,

Mat Sorensen: Yeah, the Netflix movie. The profits are royalties so that the income from that is royalty income, which is exempt from UBIT.

Mark Kohler: Commercial real estate?

Mat Sorensen: Commercial real estate, if you have debt on it, this is where the problem that causes this tax called UDFI, but that’s only on the profits from the debt piece. A little complicated for today. Well, we want to hit, but so if you’re buying a fund that’s a commercial real estate fund that uses debt to buy assets, you’ll have this type of UBIT. But it’s because of the debt you’re getting rental income, which is exempt from UBIT. But there’s this tax on it. If you’re the investment entity you’re investing into, uses debt to leverage their purchasing power of assets.

Mark Kohler: Ok, so what about land speculation?

Mat Sorensen: Totally fine. Again, unless there’s debt used. So these private funds we want to look at in general, look, and if I’m advising a client as Mat, the tax lawyer, like Directed IRA, you’re supposed to be looking at this and any self-directed investors out there, you know, it’s on you to kind of know what’s going on in these funds. Like, we don’t know what’s going on. I mean, we’re looking at paperwork. So you’ve got to ask the questions. And even when I’m an attorney and I’m advising a client reviewing documents. I’m asking a lot of times you can’t tell from the documents. It’s a real estate fund. They don’t say that they’re going to use debt. They say they might, but they don’t say they are. Now, a lot of them are now. There are some funds out there in the real estate space and Real Crowd is one of the companies. They’ve been on our podcast, the mainstream business podcast. They’re probably one of the biggest funders of private real estate deals online doing like apartment buildings and commercial deals, real crowd. But they have a number of funds on there that are no debt funds, that the people who do the real estate deals, they use all cash and they really attract a lot of IRA investors. So sometimes you can look for specific funds. If you’re into real estate, find the right operator. And many times there’s some no debt funds out there.

Mark Kohler: And now a couple of things. Is this a deal killer? No, it’s you just want to know that it’s there. And we’ve got, again, another podcast talking about strategies of how to get around it. It’s not smoke and mirrors, regressive stuff. There’s just different ways to deal with it. And really, you’re looking at the overall net return in this fund is going to good management team it’s got a good track record. I’ve got some other buddies or gals or friends that are in on this. They’ve had a good experience. OK, now in the prospectus or some Q&A, you might point out, oh, there might be a little UBIT or a little UDFI OK, well, overall return kicks butt, if the retirement account owes a little tax, the retirement account can pay that tax and it can cover it in possibly the distributions, which is typical. So it’s not the end of the world. You just want to be savvy enough to go. There are some moving parts here.

Mat Sorensen: Yeah. Let me give you another example. I had a client investing in a tech software startup and it was an LLC. And so I was looking at this investment and the company was raising money from a little fund. They were doing a raise of 10 million bucks, maybe small for Bay Area Tech Company now, but they stayed an LLC. They did not do a C Corp. And the client’s question was, well, am I going to have UBIT? And we looked at I said, well, what is the goal of this company? Well, my goal is that this company is going to take off, get a bunch of users and some other big tech companies going to buy them out and I’m going to sell all my shares and make profits. I’m like, OK, so your goal is to make capital gain income, because this is a highly appreciating, hopefully investment. Your goal is not to sit there and cash flow it as a partner in the LLC, getting ordinary income every year is it? He’s like, no. And in fact they lose money for years. They in fact, they get bought for tens, hundreds of millions of dollars and they have even made a cent yet. So I’m never going to see ordinary income coming through on a K1, even if it is just an LLC. And so many times you want to look at the investment if it’s and more in the startup or venture capital space, even if it is an LLC, you’re not trying to cash flow the business and hold it as a business. Your goal is is going to sell to someone else or it’s going to go public and you’re going to get cashed out and which is capital gain, which you would have no UBIT.

Mark Kohler: So it’s what’s hard here is I’m sure a lot of you are going, OK, that’s cool, guys. I get it. How do I figure this out. I’ve got a day job. I work 60 hours a week. I don’t have time to figure this out. So what’s going to happen is and I hate to say this, you might call your accountant, go, hey, I’m Self-directing, it’s a great idea. I like it. I vetted this. I vetted the company. I’m investing in the fund. I love directed IRA. They’ve been really supportive. Can you help me out with UBIT? And you hear crickets in the background? Yeah, maybe even the person you called falls over his chair is passed out because they’d never heard of UBIT, they don’t know what UDFI is. They don’t even know that you’re self-directing or figured that out. That’s very common. I’m a CPA. I’m a partner in an accounting firm. We do tax work around the country. I’ve worked at KPMG and the Big Five back then was Big Five. And so but most accountants don’t know this conversation. They don’t and they don’t. And that’s okay. It is a unique area. That doesn’t mean your accountants bad or dumb, but if you’re an accountant and you that’s the way I’d start up called your accountant and go to what UDFI is and have you ever heard of Self-directing, No. OK, thanks. You know, and then you want to reach out. And this is where our law firm, a sister company to Directed IRA, might be a big help. You might say, hey, I’d like to kind of know what the tax ramification of this project is. I know I’m going to do it. I got directed IRA on the case. We’re going to pull the trigger, loving it. But I needed some tax advice on what the ramifications might be. Cool retain a tax law firm or for a couple hours. It’s not going to be the end of the world or an accounting firm that knows this and say, well, you look at this, what are my options? And you’ve listen to our podcast on how to get around UDFI or UBIT. And you’re like, I just need some advice on if I’m going to have this and what to do were there for you. So we’re not going to throw you to the wolves or directed IRA, but you’ve got to have a third party accounting or law firm.

Mat Sorensen: Yeah, we have a ton of resources, too. And there’s my book, the Self-directed IRA Handbook, that’s got a whole chapter on UBIT and UDFI, it’s got a chapter on investing in such a good partner. It’s got a chapter on investing in a private company where we flag some of these issues. So but yeah, I think this is a growing area. If you look at the amount of money invested in what is quote unquote alternative assets, which basically means not big publicly traded companies, we’re talking about small business and real estate and these private funds. This is one of the fastest growing categories out there that’s actually seen amazing returns. And because the stock market just gets everybody just throws their money into it. But if you’re really strategic and know, like can find the good funds, can find the good small business opportunities, can find the good real estate deals, that’s what Self-directing is all about. And I see it from clients that, you know, like if you let’s say you’re at a biotech client that was used a Roth IRA and a really cool deal investing in a startup, they had it made a million multimillion dollar returns and that he was a he was a doctor in that space. And he’s like, this is a new company doing this cool thing he invested his money in it. And I had one even just a couple of weeks ago. There’s a mouthwash company that a client who’s a dentist invested his retirement account into this startup that he’s like, this is going to be I know this is going to be the cool thing. And so they’re seeing the opportunities in what they already know and investing into them at the ground level. Not once the company goes public. And, you know, investors on Wall Street and the investment banks, that has already made a ton of money off of it. Now it goes out to everyone else to pick up the crumbs.

Mark Kohler: And let’s talk resources here for those that were on YouTube. I was playing around Mat was talking about Mat best selling book, the number one in the industry with this new cover pointing out highest customer satisfaction survey on directed IRA services. This is the Self-directed IRA handbook, and it really is a handbook people. Now to buy the book, get over to directed IRA SDIRAHandbook.com. Now there are links at Directed IRA, but if you want to just check out the book that’s got some good videos there, go to SDIRA Self-direct IRA handbook dot com. Pick up a copy of the book. Also a fun fact on this. The reason why I love what I’m saying here is that you’ve got some insider knowledge in the industry. I’m not saying insider trading. I’m saying that some inside knowledge on an industry and you’re going to invest in something you know, oftentimes in these funds you’re getting double digit returns, which is outperforming Wall Street dramatically in the S&P 500 because you know something that, you know, here’s what’s cool. You’re building million-dollar retirement accounts, multimillion dollar accounts. Get over to YouTube and type million dollar IRA, even throw in the word Kohler just to get there a little quicker, I hope. Popped up in the top two to three videos. I’ve got a million views on a video on how to build a million dollar Roth IRA, and it all comes down to these double-digit returns. So check that video out. You hit subscribe to hit the bell icon. Every time I go live or have a video, you’ll get a little ping and you’ll just be like, oh, but building a million dollar Roth IRA is so doable, guys. Here’s what why don’t you pool some of your family’s Roth fund, form an LLC and then do the private fund investment? See, some people are like, well, that’s nice. If I had a two hundred and $250,000 Roth, well, maybe you do. If you pooled you and your spouses and your kids, Roths formed an LLC. Now you can get a two hundred and fifty thousand dollar position in a fund through an LLC owned by seven Roth IRAs. Yeah, never pay tax on it. On Mat.

Mat Sorensen: Yeah. The Mat of water there. If you didn’t know what I was talking about, we did the multimember IRA LLC that’s what that structure is called a couple of podcast’s episodes ago about the IRA/LLC. And if you’re also like, how do we even get a Self-direct account? I’ve just stumbled into this podcast episode. Go back to episode one here. And we’ve kind of started in order here of like easy to complex. So we’re already at the different investment types or so and private companies and funds being one of them. Again, do your due diligence on them, but invest in the things that, you know, that’s what Self-direct is all about. Don’t give up. And just by, you know, boring stuff on Wall Street and just kind of like put it in a mutual fund, you don’t even know what the heck is in it. Just be more engaged with your money. I think that’s the best advice for any of us out there, no matter what we’re doing.

Mark Kohler: And this is fun. This is like a rabbit hole. I’ve had clients go, oh, my gosh, you said Self-directing. And then I got Mat’s book and I’ve been on a roller coaster for three weeks learning and not even know and never knew this world existed. Yeah, the Merrill Lynch’s and the Oppenheimer’s and the Smith Barney’s. They don’t want you to know about this because you’re going to take the money, pull it out of your old 401k or your old IRA and go, oh my gosh, I can self-direct this and invest in what I know. Oh, my gosh. Now this whole world’s open up to you and it’s exciting and it’s legit. There’s millions, billions of dollars in Self-directing out there and it’s been there for years. It’s just we can’t afford a Super Bowl commercial and so we can’t compete against Merrill Lynch to let you know about it. So you’ve stumbled upon us, soak it up, subscribe. Give us five stars if this blows your mind, please give us a good rating. That way, more people can hear about this. Yeah, love it.

Mat Sorensen: Yeah, of course. You can always learn more about the podcast, too at DirectedIRA.com/podcast. We’re on all the channels. You can find the video on YouTube. If you’re listening and you want to kind of see the video, it’s not that exciting. It’s just Mark’s and I’s faces. But you know.

Mark Kohler: Well, no, you’re going to see. Some tan good looking guy here in Idaho where it’s three degrees in some pasty white guy in phoenix, and.

Mat Sorensen: I was just thinking that man, I don’t know if I got the lighting wrong or what, but I’m like looking pretty pasty white compared to you.

Mark Kohler: Mat is a good looking guy, you’ve got a new haircut today. He looks like yesterday, but was it just two days ago actually put your hand up like that. Do that. Do that one more time. OK, now. Oh, see, you saw the masked man come out with his hat since the webcam. See right there. See, there is a little bit of camera tricks. Yeah, the camera picked up Mat. You know, you got all the you’ve got all the pieces and parts, but you’re the full metal jacket. The real deal. I don’t know what you say. You’re stuck.

Mat Sorensen: Well, I appreciate the confidence boost. All right. Well, thanks, everybody, for hanging in there on the podcast. We appreciate you being on how for your finding this to be helpful. We’ll be back next week to actually talk about two upcoming topics about how to start your own business with a retirement account. Pretty complicated strategy, but there are some options that will walk through them. And then we’re starting open forum too on the podcast as well. We’re fielding a lot of your tax or excuse me your Self-directed IRA questions on what you can and can’t do and some of the cool things people are doing.

Mark Kohler: So with our tax-related activities, we’ve got to talk about O.J. Simpsonising you’re retirement accounts. We’ll talk about the asset protection of your retirement accounts. And we do hope by the time Open Forum hits, there’ll be a little comment section where you can leave your questions and get some community there, people to comment. We’re going to reply. We’re let you know what episode we commented on the question and maybe say a few words. We’ve got six attorneys in our law firm that can take a call any time, make an appointment and get to counsel and learn more about this. So that’s the beauty of this. We’ve got the sister law firm and the sister accounting firm that you can go to is resources if you need it. So, again, don’t be dismayed if your professional is not up to speed on this some aren’t. But we got those firms if you need it. And thanks, everybody.

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