Self-managed IRAs offer the kind of benefits that many investors seek, such as tax-advantaged savings and flexibility. They also represent a vast source of capital that can be invested in several types of alternative and non-traditional assets, such as hedge funds and even Buying Gold with IRA. You can buy a hedge fund with a self-directed IRA. While the IRC doesn't describe what self-directed IRA can invest in, it describes what it can't invest in. Sections 408, &, 4975 of the Internal Revenue Code prohibit disqualified individuals from making certain transactions.
The rules on prohibited transactions tend to become more of a problem when the person using IRA funds or any disqualified person related to the owner of the IRA has a personal interest or relationship with investing in the hedge fund. What if Steve and his executives could exempt their IRAs from the management fee and accrued interest to fund A's general partner or they could purchase a different membership class from fund B, which didn't have to pay any commission to hedge fund A?. Most funds will analyze the IRA holder's personal income or net worth to determine if the IRA can make the investment. After examining the IRS's prohibited transaction rules to determine if an IRA investment can be made in a hedge fund, another set of IRS rules should be reviewed to see if a tax would be imposed on income allocated to the IRA for investment in hedge funds.
The key is to ensure that the IRA investment in the hedge fund does not directly or indirectly benefit IRA owners, since that type of investment would likely result in a prohibited transaction. Hedge funds don't offer IRAs on their own, and an IRA owner cannot invest directly in hedge funds. In other words, an IRA can generally make an investment in a hedge fund in which neither the IRA holder nor any disqualified person has any personal property or relationship with. The main question to be asked and answered positively is if the IRS analyzed the transaction, could you argue that the owner of the IRA has personally benefited in any way directly or indirectly from investing in the IRA?.
If the owner of an IRA cannot demonstrate that he did not receive any direct or indirect personal benefit from the IRA's investment in the hedge fund, the IRS is likely to argue that the investment caused a prohibited transaction. These include the IRA administrator himself, as well as the IRA owner's family members or business partners. Considering that, if you bought a stake in a transfer entity, such as an LLC, with funds from an IRA and the LLC participated in an active operation or business, used a margin or acquired a debt, the income allocated to the IRA could be subject to the UBTI tax. For example, if the only way Joe can attract investors to the fund is to demonstrate that he has also invested in the fund and that the only funds he had available to invest were IRA funds, the IRS could argue that using the funds from his IRA would benefit him personally, since without using the funds from his IRA he would not be able to attract investors to his fund and obtain a personal financial return by owning the fund.
Because of the severity of the tax consequences for potential investors in an IRA, contact your lawyer or hedge fund accountant if you have specific questions about your IRA investments in your fund. As noted in a previous article on hedge funds and ERISA, while IRAs are not specifically ERISA assets, they do count toward the 25% threshold and, therefore, the manager must know the amount of IRA and other ERISA assets in the hedge fund. Consequently, when it comes to using retirement funds to invest in a hedge fund with which the owner of an IRA has a personal relationship, issues such as management fee and accrued interest are elements that must be considered when structuring self-directed investment in IRA hedge funds. To begin with, the use of retirement funds cannot be invested in the GP entity, since it is the entity in which services are generally provided on behalf of the hedge fund and in which the management fee and accrued interest are usually used to invest IRA funds in a company in which the holder of the IRA is personally owned or provides services as an employee would likely violate the IRS's prohibited transaction rules.