However, what about the individual who works for a corporation that is not publicly traded? Is it possible for these individuals to purchase employer stock in an IRA?

The answer is, "Yes, but..." The "but" is that he or she will probably have to do some additional work to establish an acceptable account since most IRA trustees only allow publicly traded securities to be included in the portfolios held by them.

Also, the individual is more likely to incur a fee to open an IRA account that allows such an investment because the trustee is not as likely to generate revenue from commissions or investment advisory services as is usually the case with publicly traded investments. The large trustees offer free IRA accounts as an inducement because of these other fees offset the costs of administering the accounts.

The Basics
IRAs, which permit individuals to contribute up to $2,000 per year to retirement savings accounts, have always been a good way for individuals to save for retirement. The "traditional" IRA may be either tax-deductible or non-deductible, depending on the individual's circumstances.

To be eligible to deduct contributions to a traditional IRA, a taxpayer must meet certain income limitations and other requirements. As a result of changes to the law made about two years ago, however, more employees than ever are eligible to participate in deductible IRAs.

In addition, the new law created a new type of IRA called the "Roth." Contributions to the Roth IRA are non-deductible but have the advantage that income earned is not taxed when withdrawn as a qualified distribution. Eligibility for the Roth IRA is subject to certain income limitations, which gradually phase out the benefit as income increases. Eligibility for the Roth ends completely at Adjusted Gross Income (AGI) of $110,000 for single taxpayers and $160,000 for joint tax return filers.

While there are certain limitations on the kinds of investments permitted to be held in an IRA, individuals are allowed more freedom of choice in their investments than is commonly perceived. The lack of knowledge in this area probably stems from the fact that most large IRA trustees only advertise or market the types of investments that they normally sell and hold in their non-IRA accounts. As you would expect, consumers get their IRA education more from advertising and marketing than reading the Internal Revenue Code.

Actually, the tax laws specify only a very limited set of investments as being prohibited to IRAs. Two of the prohibited investments are life insurance and collectibles (not including certain gold and silver coins and any coins issued by states). Importantly, the stock of privately held U. S. companies is not among the prohibited investments. There may nevertheless be reasons for some individuals to avoid investing their IRA savings in such stock, which will be discussed later.

Search for a Trustee
An IRA must be held in a trust or a custodial account that can be treated as a trust. The trustee must be a bank or a person whom the IRS accepts as a trustee. A custodial account is treated as a trust if a person who can qualify as a trustee holds it and it meets all the other requirements to be an individual retirement arrangement.

IRA trustees and custodians are not prohibited from holding stock of privately held companies. Most of the traditional IRA trustees or custodians (i.e. banks, brokerage houses and mutual funds) nevertheless have policies against acting as trustees for what they consider to be unorthodox investments. As a practical matter, therefore, the individual taxpayer desiring to hold the stock of a privately held company in an IRA will normally be required to seek out an independent trustee that is willing to offer such a service.

This search can proceed in several ways. A tax advisor, CPA or attorney may serve as a good source of leads since he or she may have other clients with self-directed IRAs using trustees that accept such investments. An Internet search may result in good information. Other employees or the employer may be a good source, especially if they have done a similar transaction in the past.

While some bank trustees may be willing to accept these investments, the most likely source of a willing trustee lies with smaller securities firms or brokers who wish to distinguish themselves from the competition. If a banker or broker is unwilling to hold the stock of a privately held company in an IRA, he or she may be willing to give a reference to another firm that would.

Since a willing trustee is likely to be a firm that is previously unknown to you, proceed with caution and with appropriate due diligence as in any other financial transaction. A careless, incompetent or dishonest trustee can put IRA assets at great risk. Therefore potential clients should carefully confirm the professionalism, reputation and financial stability of the trustee before turning over cash or other assets.

Some investment firms are more likely to open IRA accounts holding non-publicly traded securities if they feel that the company is likely to become publicly traded in the near future.

Prohibited Transactions and Self-Dealing
IRA trustees are prohibited from engaging in certain kinds of transactions involving plan assets even if the transaction is perfectly fair and appropriate. One prohibited transaction is the sale or exchange of any property between a retirement plan (including an IRA) and a "disqualified person."

ERISA specifies a number of types of people or entities who are disqualified persons. It would be prohibited for an IRA trustee to purchase stock directly from the employee or to purchase stock from a closely held corporation at which the IRA owner is an officer or has a controlling equity position. If the prohibited transaction rules are violated, the IRA might lose its tax-free status, so it should be avoided. IRA trustees may, however, purchase shares from current or former employees or other investors.

Employer Perspective
Under the proper circumstances, employers should encourage this type of employee ownership for the same reasons they encourage other forms of employee ownership.

Some large privately held corporations now operate their own "internal" markets that permit employees to purchase and sell stock on a periodic basis. These employers are especially well situated to permit employees to purchase stock for their IRA accounts. These employers should facilitate the ability of IRA trustees to make purchases on behalf of current employees in the internal market.

If there is no formal internal market for closely held shares, employees might still direct their IRA trustee to purchase shares from stockholders who are willing to sell on an informal basis. Also, the IRA vehicle would seem to be appropriate in the fast growing pre-IPO situation where the company wants to have significant employee ownership and the employees need a tax efficient way to invest. In these situations the company itself may sell stock to the employee's IRA.

Some of the employees may be new hires that just left another company. These individuals may have significant amounts in a 401(k) plan being eligible for a rollover into an IRA. Some employees may have had their IRA accounts for several years and $2,000 a year compounding tax-free adds up to a nice sum in a relatively short time.

Employers must remember to be conscious of the federal and state securities laws when selling securities to an employee and/or his or her IRA. The securities must either be registered or an applicable exemption must be found. The good news is that unless there are a lot of sales and as long as the purchaser is a fairly sophisticated investor, an exemption is usually available. However, employers should seek legal advice before engaging in this type of activity.

As stated above, IRA trustees are prohibited from purchasing stock from closely held companies where the IRA owner is an officer or has a controlling equity position. Therefore, employers should avoid those transactions.

It would certainly be advantageous for an employer interested in using the IRA vehicle to encourage employee ownership to help employees seek out a willing and qualified IRA trustee. The company may have a long-standing relationship with an investment firm that does not normally hold non-publicly traded stock, but could be convinced to do so if assured that it would be worthwhile to do so in a particular situation.

Employee Perspective
Employees wanting to save for retirement, outside of the employer provided qualified plans and have an equity stake in their employer should consider employer stock in their IRAs as a tax efficient manner to achieve both objectives.

One way that employees wind up with privately held stock in their IRAs is that their employer was formerly a publicly traded company that is now privately held as a result of a leveraged buyout (LBO). Employees may have had the publicly traded stock in a qualified plan such as an ESOP or 401(k) that has been terminated as a result of the corporate transaction. These individuals may continue to be eligible to hold the stock now that the employer is privately held but they do not wish to pay the tax on a premature distribution from a qualified plan. In this situation the employees can roll the distribution over to an IRA if a willing and able trustee can be located.

Conclusion
IRAs are relatively simple and cost effective, both for employees and for employers that want to encourage employee ownership. If the circumstances are right, companies and employees ought to consider the IRA possibility even though finding an suitable trustee might not be easy or quick.

Originally published by SmartPros on June 12, 2000

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