There’s a broad belief that the law prohibits self-directed IRA’s from purchasing shares in an S-corporation. This is untrue, but it is based in the truth.
A bit of background will help to explain:
An “S” Corporation is a corporation, and there’s simply no questioning the legality of purchasing shares of a corporation in an IRA. Indeed, it’s arguable that the one asset class that’s most common in IRA’s is shares of corporate stock traded on Wall Street.
However, every publicly traded company on Wall Street is a “C” corporation rather than an “S” corporation.
The distinction between the two is all about taxes:
The “C” corporation is its own distinct legal entity in terms of taxation. C-corporations – like those traded on Wall Street – file their own tax returns and pay their own taxes. If any post-tax profits are distributed in the form of dividends, those dividends are taxable a second time, this time taxable to the shareholder receiving the dividends.
That’s where an “S” corporation is different. It’s designed for small (thus the “S” designation) businesses with a maximum of 75 owners.
The biggest difference between “C” and “S” corporations is the way taxes are handled.
Unlike C corporations, S corporations are not liable to pay tax as a corporate entity. Instead, the income and expenses flow through to the owners of the S corporation, who report and pay those taxes on their own tax returns. In effect, S corporations eliminate the “double taxation” that happens with C corporations.
Clearly, this is a very attractive situation.
But here’s where the complication with self-directed IRA’s rears its head: While the law that created IRA’s – the Employee Retirement Income Security Act of 1974 (ERISA) – does not include “S” corporation shares in its list of prohibited assets for IRA’s, the law that created “S” corporations stipulates that (in general) all S-corporation shares must be owned by natural persons who are U.S. Citizens or Residents.
Unfortunately, your IRA is not a natural person. As if there was any doubt, IRS Revenue Ruling 92-73 provides conclusive evidence of that fact.
Nevertheless, it is still incorrect to say that an IRA is not able to purchase shares in an S corporation. However, if that happens, the result can be very painful, as the corporation is quite likely to lose it’s status as an “S” corporation. As such, it will again be subject to double taxation, with the financial ramifications being predictably very, very bad.
It may be tempting to classify this distinction as purely semantic, since the net effect of Revenue Ruling 92-73 is that IRA’s should not purchase shares of S-corporations. But the distinction is far more substantial than that.
If S Corporations were actually prohibited assets under ERISA – a distinction reserved only for two asset types: life insurance and collectibles – the net effect of your purchasing S-corporation shares in an IRA would extend beyond the loss of the “S” status. Your IRA would additionally face taxes, penalties and interest because the IRS would classify the capital used to purchase your S-corporation shares as “distributed.”
However, that’s not what happens because the purchase of S corporation shares in an IRA is not prohibited by law. But the tax ramifications for the S corporation itself can be very, very bad.