New SEC Rules Kickstart Crowdfunding

On October 30, 2015, federal regulators finalized crowdfunding rules under the JOBS Act, giving issuers access to a much larger group of investors — but under certain conditions. Companies will be able to gather up to $1 million in crowdfunding cash per year without registering with the Securities and Exchange Commission. The issuer will have to provide investors details about their business, how they’ll use the money, a list of officers and directors, and disclose anyone who owns at least 20 percent of the company.

Before the new rules, private companies could seek money only from “accredited investors,” defined as individuals who own more than $1 million in assets, excluding their primary residence, or have maintained an income of more than $200,000 for at least two years.

Under the new rules, those with more modest wealth will be able to invest in startups, with limits. People with annual income or net worth less than $100,000 will be allowed to invest a maximum of 5 percent of their yearly income or net worth, or $2,000 if that is greater. Those with higher incomes can invest up to 10 percent. An individual can’t invest a total of more than $100,000 in all crowdfunding offerings during a 12-month period. Investors generally couldn’t resell their crowdfunding securities for one year. The SEC also specified that crowdfunding must go through an intermediary, either a broker-dealer or a registered funding portal. Offerings need to be checked by outside accountants, and, in some cases, fully audited.

Crowdfunding is an evolving method of raising capital that has been used to raise funds through the Internet for a variety of projects. Title III of the JOBS Act created a federal exemption under the securities laws so that this type of funding method can be used to offer and sell securities.

While individual investors may dream of getting in on the ground floor of the next big start-up, like Snapshot or airbnb, investing in a start-up is highly risky as the majority of all small business start-ups ultimately fail. Nevertheless, the new crowdfunding rules will help start-ups, investments funds, and many more projects seek financing for projects of less than $1 million dollars from a much larger segment of the population, including retirement accounts.

The Internal Revenue Code does not describe what a retirement can invest in, only what it cannot invest in. Internal Revenue Code Sections 408 & 4975 prohibits Disqualified Persons from engaging in certain type of transactions. The purpose of these rules is to encourage the use of IRAs for accumulation of retirement savings and to prohibit those in control of IRAs from taking advantage of the tax benefits for their personal account. The definition of a “disqualified person” (Internal Revenue Code Section 4975(e)(2)) extends into a variety of related party scenarios, but generally includes the IRA holder, any ancestors or lineal descendants of the IRA holder, and entities in which the IRA holder holds a controlling equity or management interest.

Start-ups and private investment funds have always been popular investments for retirement accounts largely via a self-directed IRA or Solo 401(k) plan. However, there is an important but often overlooked tax that could potentially impact that financial viability of the investment for a retirement account. The Unrelated Business Taxable Income rules, also known as UBIT or UBTI, is a tax imposed on tax-exempts, such as retirement accounts, that generate income from the following sources:

Income from the operations of an active trade or business – i.e. a restaurant, gas station, store, etc., made via a passthrough entity, such as a limited liability company (“LLC”) or partnership

Using a nonrecourse loan to purchase a property

Using margin on a stock purchase

The UBTI tax rates follow the trust income tax rates and for 2015 can go as high as 39.6%. Therefore, if a retirement account wishes to make an investment in a start-up or investment fund, which are often set-up as a LLC, the income generated by the investment could trigger the UBTI tax and impose a potentially high tax rate on the income generated by the retirement account, greatly impacting the financial viability of the transaction.

The new crowdfunding rules could be a great boon for the economy, including allowing for high risk-high reward projects to get funded or helping a real estate investment fund raise quick cash to flip homes. It also can offer potential investment diversification to ones personal or retirement portfolios, keeping in mind the potential for the application of the UBTI tax rules. However, crowdfunding is not without risk, including business failure and the potential for fraud. Yet, the new crowdfunding rules will undoubtedly provide smaller companies and various investment projects with innovative ways to raise capital from both taxable and retirement sources while providing investors with a relatively high degree of protection.

Source: Forbes, Adam Bergman
Photo: Fundable
Adam Bergman is a tax partner with the IRA Financial Group and founder of the Bergman Law Group, LLC. Contact him via email at [email protected] or call him at 800-472-0646 Ext. 12.