What is crowdfunding and how can you take part in a crowdfunded investment using a self-directed solo 401(K)? Crowdfunding, in simple terms, consists of a large number of individuals investing a relatively small amount of money, each, towards a large investment opportunity.
There are 4 main types of crowdfunding that could make sense as an investment in a self-directed solo 401(k):
1) Rewards-based – as an investor, your solo k could be offered different tiers of rewards that directly correspond with the amount pledged. This kind of funding is typically used for products that require funding to fully produce them.
2) Equity-based – this is often used to fund a start-up business and receive an equity interest, such as stock, in the company.
3) Debt-based – this is similar to the person or entity seeking funding taking out a loan. They look for investors to raise (typically) large amounts of money and they pay it back with or without interest.
4) Royalty-based – this form of crowdfunding provides the investor with a small percentage of revenue that is generated by the project or service once it’s successful.
No matter the type, you will want to ensure that the return on investment received can go back into the solo k account.
Before investing, there are 2 main questions to consider:
1) Can I invest in this particular crowdfunded investment?
· Generally speaking, the answer is yes so long as you are not on both sides of the investment/transaction. For example, you cannot personally be invested in or work for the company that is pursuing the crowdfunded investment. Doing so would be a Prohibited Transaction since you are a Disqualified Person.
2) How is the crowdfunded investment structured?
· If the crowdfunding investment is structured as equity, such as stock in a corporation or membership interest in an LLC, the investment may be subject to UBIT (Unrelated Business Income Tax) which can be high and could greatly reduce the investment’s rate of return. UBIT could apply if (1) the entity is an “active” business (provides goods or services) or (2) the entity is taxed as something other than a C Corporation. Alternatively, if the underlying investment is simply a passive investment, such as a long-term rental property, the UBIT issue should not apply.
· If the investment is structured as debt, the UBIT issue should not exist so long as it is TRUE debt. Some debt could be considered equity, such as debt that is a convertible note.
As with any investment held within a self-directed solo 401(k), there are the standard rules that must be followed, including:
· The investment must be held/titled in the name of the solo 401(k).
· The funds (gain, expenses, etc.) must flow into and out of the solo 401(k) account.
Crowdfunding, and similar alternative investments held within a self-directed solo 40(k), provide the opportunity for greater asset class diversification. Proper due diligence should always be performed, and appropriately licensed/certified advisors should be consulted.