In this article, we will discuss the difference between debt and equity investments using an IRA. The topic of debt versus equity investments can be confusing for many people, including attorneys, accountants, and successful entrepreneurs. In this article, we will explain the key distinctions between the two types of investments and how they are treated by the IRS, specifically in regards to self-directed investments in an LLC.
An equity investment is similar to buying stock in a company. When you invest money in an equity investment, you receive an interest in the business, whether it is shares in a corporation, interest, or units in an LLC. The key distinction with equity investments is that there is no guaranteed rate of return. For example, if you invest $50,000 in Apple stock, there is no guarantee of how much you will receive in return. The value of your investment may increase or decrease, depending on the performance of the company.
On the other hand, a debt investment is a loan. You lend money to an individual or corporation, and in return, you receive a stated rate of return, typically with a maturity date of five, ten, or fifteen years. The main difference between a debt investment and an equity investment is that there is a guaranteed rate of return with a debt investment.
The Importance of Distinguishing Between Debt and Equity
The distinction between debt and equity investments is important when it comes to the application of Unrelated Business Income Tax (UBIT) rules. If your IRA is investing in an LLC and you make an equity investment, and there is more than $1,000 in net income, and it’s a business, that could be subject to UBIT, which has a tax rate of 37%. However, if you did a loan to that business, interest is not subject to UBIT. This is because interest is considered a passive form of income, similar to capital gains, rental income, dividends, and royalties.
It’s also important to note that corporations block UBIT, so whether you call it a debt or equity investment into a corporation, it doesn’t matter. However, when it comes to LLC investments, debt is not subject to UBIT, while equity investments into an LLC, if that LLC is a business, could trigger UBIT.
Another topic to consider is convertible notes. These are notes that start as debt and then convert to equity. When it’s a debt note, it’s not subject to UBIT. However, as soon as you convert it to equity, it becomes subject to UBIT, if the LLC is a business.
In conclusion, the distinction between debt and equity investments is crucial when it comes to the application of Unrelated Business Income Tax rules. If you are considering an investment in an LLC, it’s important to understand whether it is classified as a debt or equity investment to avoid any potential tax issues. If you have any further questions, our self-directed retirement experts are available to assist you.