How SDIRA SPVS Can Value Pre-IPO Companies Such as SpaceX, OpenAI, or xAI

Currently, the top pre-Initial Public Offering (“IPO”) companies based on valuation, growth, and market activity are SpaceX, OpenAL, Anthropic, Stripe, Databricks, xAL, Revolut, Canva, and Lambda. These companies are considered highly anticipated for potential public listing due to their massive valuations and high revenue growth rates. Investing in pre-IPO companies involves purchasing shares of private companies before they list on public exchanges, typically requiring investor status. Investors often use Special Purpose Vehicles (“SPVs”) to invest in top pre-IPO companies. A SPV is a separate legal entity- often a Limited Liability Company (“LLC”) or partnership-created by investors to isolate financial risk, hold special assets, or pool capital for a single investment, such as a startup.

SPVs are often held with self-directed IRAs (“SDIRAs) to facilitate investments in the private markets. Investors often use pre-tax SDIRA funds to invest in pre-IPO companies and then transfer the high-growth asset to a Roth SDIRA. Transferring a potential high-growth shares of a pre-IPO company from a SPV contained in a SDIRA to a Roth SDIRA is a taxable event. Taxing a pre-IPO asset in a Roth conversion involves paying tax on the fair market value of the asset at the time of conversion. Because a pre-IPO asset is illiquid and difficult to value, this creates a high-tax risk event. The pre-IPO asset valuation is critical for tax purposes. The investor must establish the current fair market value of the pre-IPO asset at the time of the Roth conversion. This valuation can be conservative, but it must be defensible in a potential Internal Revenue Service (“IRS”) audit. This article discusses how a SDIRA can value a pre-IPO asset.

What is a Self Directed IRA

The appeal of investing retirement funds outside of the typical investments has driven a surge in the use of SDIRA investment structures. Investments within SDIRA frequently include closely held business entities. Since 1974, the IRS has permitted individuals to totally “self-direct” investments made within their SDIRA that are also authorized by federal law and are held by a trustee or custodian that permits investments in a broader range of assets than is permitted by traditional IRAs. See Levine v. Entrust Grp., Inc., 2012 WL 6087399 (N.D. Dec. 6, 2012). SDIRAs allow investors to invest in asset classes that are often deemed illiquid.

Most investors who fund SDIRAs do not realize that funding such a structure may trigger tax obligations and filing requirements. Anyone considering funding a SDIRA must understand the term unrelated business taxable income (“UBTI”). If a SDIRA earns UBTI, the IRA may need to file a Form 990-T and pay annual taxes. To calculate UBTI, the income from the business activity that is not passive in nature must be identified. Next, any business expenses must be identified. In addition, if the SDIRA utilizes non-recourse debt to acquire property, the SDIRA may be subject to Unrelated Debt Financing Tax (“UBFI”). Below, please find two illustrations which demonstrate how the aforementioned taxes and filing requirements apply to self-directed IRAs.

The Taxation of UBTI

An IRA is considered a tax-exempt entity, meaning that it generally does not pay taxes on interest, dividends, or capital gains within the account. As a tax-exempt organization, an IRA is subject to the tax-exempt rules stated in the Internal Revenue Code. Since 1950, exempt organizations have been taxed on unrelated business taxable income, which is defined as gross income (less directly connected expenses) derived from an unrelated trade or business. See IRC Section 512(a). If the property producing such income is acquired with borrowed funds, however, the debt-financed property rules of Internal Revenue Code Section 514 treat all or part of the income as unrelated business taxable income with the result that it is subject to tax.

An exempt organization is taxed on unrelated business taxable income which is defined as gross income (less directly connected expenses) derived from an unrelated trade or business. An unrelated trade or business is defined as: (a) any trade or business; (b) that is regularly carried on; and (c) is not substantially related, aside from the need of the organization for funds, to the organization’s exempt purpose.

In most instances, investment activities of exempt organizations would be regularly carried on and not substantially related to the organization’s exempt purpose, thus meeting the second and third prongs of the definition of an unrelated trade or business. It is less clear whether the conduct of investment activities constitutes a trade or business. The regulations of the Internal Revenue Code provide that, in general, the term “trade or business” has the same meaning it has in Section 162 of the Internal Revenue Code and generally includes any activity carried on for the production of income from the sale of goods or the performance of services. The Supreme Court held in Higgins v. Commissioner, 312, 217 (1941) that an individual’s management of his own investments was not a trade or business even though the individual’s activities were extensive enough to require an office and a staff. Congress ultimately overruled Higgins and enacted Section 212 of the Internal Revenue Code. Section 212 of the Internal Revenue Code allows individuals to deduct “ordinary and necessary” expenses for producing income, managing income-producing property, or handling tax-related matters.

Certain types of income, commonly referred to as “passive income,” are excluded from UBTI. See IRC Section 512(b). These include dividends, interest, payments with respect to securities loans, amounts received or accrued as consideration for entering into agreements to make loans, annuities, royalties, rents from real property and personal property leased with the real property if the rent attributable to the personal property is 50 percent or less of the total and the rent does not depend on income or profits derived from the leased property, and capital gains and losses. See IRC Section 512(b)(5). In addition to passive income, royalties are excluded in computing the unrelated business taxable of a tax-exempt entity. A “royalty” has been defined as any payment received in consideration for the use of a valuable intangible property right, whether or not payment is based on the use made of the intangible property. However, payments for services provided in connection with the granting of these types of rights are not royalties and are generally taxable as unrelated business income.

The UBTI for SDIRAs are taxed at progressive trust tax rates, which can reach up to 37% for income over $16,000 (as of 2026). If an IRA generates over $1,000 in annual gross income from unrelated business income, it can be subject to UTBI tax at a rate of 37%. As discussed above, deductions are permitted for expenses that are “directly connected” with the carrying on of the unrelated trade or business, and net operating losses are allowed to be carried forward and backward (with certain limitations). Losses from one unrelated business activity are not able to offset gains in another; profit and losses are determined per activity.

Below, please see Illustration 1 which provides an example as to how UBTI can be assessed against a self-directed IRA holder.

Illustration 1.

Jill invested $500,000 from her IRA into an LLC custom jewelry company. The investment gave Jill a 25 percent interest in an LLC. The LLC had three other owners, not related to Jill, and none of the other investors were co-owners with her in any other business entities. Jill was not involved in the LLC’s day-to-day operations and did not otherwise personally benefit from the investment.  The LLC recorded a significant profit on its annual Form 1065, U.S. Partnership Income Tax Return. In turn, each investor, including Jill’s self-directed IRA was issued yearly Schedules K-1, Partner’s Share of Income, Deductions, Credits, etc., which showed ordinary income. The Internal Revenue Code imposes a tax on income earned by a tax-exempt organization in a trade or business that is unrelated to the organization’s exempt purpose. This type of tax liability is known as UBTI and it became a large tax liability for Jill.

It should be understood that most IRA investments do not trigger current tax consequences, not because all income an IRA earns grows tax free, but because the types of income that an IRA typically earns are exempt from UBTI tax rules. For example, IRAs that invest in publicly traded securities (e.g., stocks, bonds, and mutual funds) do not owe current tax because gains from the sale of C corporation stock dividends, and interest income are exempt from UBTI. For this reason, most IRA investors are unaware that an IRA can require a tax return (Form 990-T Exempt Organization Business Income Tax Return) and pay taxes. Income from a business that is regularly carried on (whether directly or indirectly) can result in UBTI and filing requirements.

In this case, since the LLC Jill invested into conducted a regularly conducted business, the self-directed IRA had a tax consequence. To make matters worse, in Jill’s case, the self-directed IRA was taxed at trust rates. This resulted in Jill’s self-directed IRA realizing a far greater tax liability compared to an individual who is taxed at ordinary marginal tax rates. Jill may be shocked to discover that her self-directed IRA is subject to taxes on the LLC’s yearly profits, but also that the tax rate on income over $16,000 is a whopping 37 percent. To add insult to injury, there was an additional net investment income tax of 3.8 percent assessed on the trust income over $16,000.

The Taxation of UDFI

The exclusion for passive income is not available for income derived from debt-financed property. Section 514(a)(1) of the Internal Revenue Code requires an exempt organization to include UBTI a percentage of income derived from “debt-financed property” equal to the “average acquisition indebtedness” for the taxable year over the average amount of the adjusted basis for the taxable year. A like percentage of deduction is allowed in computing UBTI. See IRC Section 514(a)(2). The straight-line method of depreciation must be used. See IRC Section 514(c)(3). Debt-financed property is defined in Section 514(b)(1) as any property held to produce income with respect to which there is an acquisition indebtedness at any time during the taxable year or, if the property is disposed of during the taxable year, at any time during the 12-month period ending on the disposition. The statute contains several exceptions to the definition of debt-financed property, which have the collective effect of limiting its application to investment income. Specifically, the following are excepted from the definition of debt-financed property: (a) any property substantially all of the use of which is substantially related to the organization’s exempt purpose; (b) any property the income from which is included in UBTI without regard to the debt-financed property rules, except that gain from the sale or disposition of such property is not excluded under Section 512(b)(5); (c) any property to the extent income is excluded under Section 512(b)(7) relating to government research, Section 512(h)(9) relating to college, university, and hospital research, and Section 512(b)(9) relating to fundamental research the results of which are made freely available to the public; (d) any property used in any trade or business described in Section 513(a)(1) relating to work performed by volunteers, Section 513(a)(2) relating to convenience of members, etc., and Section 513(a)(3) relating to selling of merchandise received as gifts; and (e) neighborhood land acquired with the intent of using it for exempt purposes within 10 years.

Acquisition indebtedness is defined as the unpaid amount of (a) indebtedness incurred by the organization in acquiring or improving debt-financed property; (b) indebtedness incurred before the acquisition or improvement of the debt-financed property if such indebtedness would not have been incurred but for such acquisition or improvement; and (c) indebtedness incurred after the acquisition or improvement of the debt-financed property if such indebtedness incurred after the acquisition or improvement of the debt-financed property if such indebtedness would not have been incurred but for such acquisition or improvement and, the incurrence of such indebtedness was reasonably foreseeable at the time of such acquisition or improvement. See IRC Section 514(c).

The statute excludes from the definition of acquisition indebtedness a number of transactions that relate to non-investment transactions common to exempt organizations. These include: (a) a 10-year exception if mortgaged property is acquired by bequest or devise and certain conditions are met; (b) liens for taxes and assessments that attach before the payment date; (c) extension, renewal, or refinancing of an obligation evidencing a pre-existing indebtedness; (d) indebtedness inherent in performing an organization’s exempt purpose such as indebtedness incurred by a credit union accepting deposits from its members; (e) charitable gift annuities; and (f) certain federal financing for low-and-moderate-income persons. The statute also excludes from the definition of acquisition indebtedness securities loans and real property acquired by pensions trusts and schools, colleges, and universities.

If none of the statutory exceptions is applicable, then, to determine whether there is acquisition indebtedness, one must first determine whether there is indebtedness and then determine the indebtedness is traceable to the acquisition or improvement of income-producing property.

Below, please see Illustration 2 which provides an example as to how UDFI can be assessed against a self-directed IRA plan holder.

Illustration 2.

Mark had $1.5 million in his 401(k). Mark decided to invest the $1.5 million in a SDIRA. Mark’s goal for his SDIRA was to invest in residential real estate through an LLC. Mark found a real estate investment group that frequently organized partnerships and promised “passive” investment (no direct involvement by Mark). The real estate partnership collected capital contributions from 20 investors and used the cash plus debt to purchase an apartment building. The apartment building was held as a rental property, with net income distributed to the investors, including Mark’s SDIRA.

As stated above, it is possible for a SDIRA to invest in a broad range of investments. Thus, real estate partnerships are acceptable self-directed IRA investments is technically correct. However, this does not answer the question of whether there are more difficult legal or tax issues. For example, “rent from real property” is normally exempt from UBTI, and thus currently not taxable when earned by a self-directed IRA or self-directed IRA LLC. However, income from debt-financed property (whether held directly or indirectly by the self-directed IRA or self-directed IRA LLC) is partially taxable under the  rules because the income generated from the investment is not earned by investment of the self-directed IRA capital, but rather by financing.

In this case, the yearly income that is allocated to Mark’s SDIRA is partially subject to tax under the UBFI rules. Income received from debt-financed property may be subject to the  UBFI rules. Because the property placed in the self-directed IRA was financed and subject to the UBTI rules, the SDIRA was required to file Form 990-T, annually. This was the case whether or not UBFI taxes were required to be paid. Failure to pay the UBFI taxes and file Form 990-T could subject Mark’s self-directed IRA to significant penalties and interest.

Overview of the Applicable Prohibited Transaction Rules

A key term governing SDIRA is “prohibited transactions.” If a SDIRA engages in a “prohibited transaction,” the “self-directed” IRA will lose its tax exempt status. Because of the importance of the “prohibited transaction” concept, individuals need to identify a prohibited transaction. Internal Revenue Code Section 408(a) provides the technical statutory definition of a “prohibited transaction” with respect to self-directed IRAs. For this purpose, a “prohibited transaction” is determined under the rules of Section 4975 of the Internal Revenue Code. The sanction for a prohibited transaction is the disqualification of the tax exempt status of the IRA account. In the event of a prohibited transaction, for income tax recognition purposes, the IRS will treat all the assets of the IRA as being distributed to its owner as of the first day of the year in which the transaction occurs. In many cases, the IRS will assess an additional 10 percent tax for premature distribution. In addition, the IRS could assess an additional 20 percent tax under Internal Revenue Code Section 6662. (The Internal Revenue Code imposes an additional tax of 20 percent on the portion of an underpayment attributed to: 1) negligence of federal tax law and 2) a substantial understatement of income tax).

In order for a prohibited transaction to occur, there must be a transaction involving a “disqualified person” with respect to the “plan.” A “disqualified person” includes: 1) a fiduciary; 2) a person providing services to the plan; 3) an employer any of whose employees are covered by the plan; 4) an owner, direct or indirect of 50 percent or more of: i) the combined voting power of all classes of stock entitled to vote or the total value of the shares of all classes of a corporation; ii) the beneficial interest of a trust or unincorporated enterprise which is an employer or an employee organization; 5) a member of the family including spouse, ancestor, lineal descendant and any spouse of a lineal descent; 6) a corporation, partnership, or trust or estate of which is 50 percent or more of the combined voting power of all classes entitled to vote of the total value of the shares of all classes of stock of such corporation; 7) the beneficial interest of such trust or estate or owned directly or indirectly or held by persons; 8) an officer, director, a 10 percent or more shareholder or a highly compensated employee. See IRC Section 4975(e).

A “prohibited transaction” with respect to a SDIRA includes:

1. sale or exchange, or leasing, or any property between a plan and a disqualified person;
2. lending of money or other extension of credit between a plan and a disqualified person
3. furnishing of goods, services, or facilities between a plan and a disqualified person;
4. transfer to, or use by or for the benefit of, a disqualified person the income or assets of a plan.
5. act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interests or for his own interests or his own account; or
6. receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.

The basic rule of a “prohibited transaction” is that a self-directed IRA holder cannot do the following:

1. The IRA owner cannot enter into a transaction between the IRA and his or her spouse, a lineal ascendant (parents) or descending lineage (children), or the spouses of descendants;
2. The IRA holder cannot make personal use of the IRA’s property;
3. The IRA holder cannot personally guarantee a loan from his or her IRA nor use the IRA as collateral for a personal loan;
4. The IRA holder cannot work for or take income from an IRA investment;
5. An entity, such as a partnership, that is at least 50% owned by any combination of disqualified persons cannot transact with the self-directed IRA;
6. A 10% owner, director or other highly paid employee of such an entity cannot transact with the self-directed IRA.

When properly operated and all of the above discussed rules are carefully followed, a self-directed IRA offers the IRA owner tax deferred growth. This is a significant tax advantage. However, there are times when assets placed in a SDIRA have significant growth potential and it may make sense to transfer the asset to a Roth SDIRA in order to avoid taxation on that growth.

What is a Self-Directed Roth IRA?

Roth IRAs are individual retirement accounts that an individual contributes into with after-tax dollars. With a Roth IRA, an individual can withdraw contributions from the Roth IRA with no additional tax or penalties. After an individual reaches age 59 ½, the participant can withdraw earnings from the Roth IRA with no tax on the IRA’s gains and earnings as long as the account was held by the participant for at least five years. The Roth IRA five year rule mandates that at least five years from January 1 of the year of the first contribution must pass from the first contribution before a Roth IRA holder can withdraw earnings and assets tax and penalty free. Thus, if an individual converted an asset from a SDIRA to a Roth SDIRA, a separate 5-year clock starts to run for each conversion in order to tax and a 10 percent penalty on the withdrawal. In addition, if an owner of a SDIRA is under 59 1/2, removing an asset from the IRA is subject to income tax and incurs a 10 percent penalty, unless an exemption applies. The IRS considers contributions to a Roth IRA to be withdrawn first, then conversions, and earnings last. A self-directed Roth IRA is subject to the same filing requirements and “prohibited transaction” rules discussed above that apply to SDIRAs.

Self-Directed IRA to Self-Directed Roth IRA Asset-to Asset Conversion

If a SDIRA account holder expects an asset in his or her SDIRA to appreciate significantly in the future, transferring the asset to a Roth SDIRA may permit that asset’s growth to become tax-free. Below are the steps to convert an asset of a SDIRA to a Roth SDIRA.

1. A SDIRA account holder cannot move an asset to a Roth SDIRA without liquidating the asset for income tax purposes. A SDIRA asset-to-asset conversion is when the account owner moves investments such as real estate, business equity, or cryptocurrency directly from a SDIRA to a Roth SDIRA without selling the asset. This is a taxable event that requires a fair market value appraisal to determine the income tax consequence of the asset transfer.
2. The asset being transferred from a SDIRA to a Roth SDIRA is taxed during the year of the transfer. Transferring a SDIRA to a Roth SDIRA is a taxable conversion. This transfer is a taxable event to the SDIRA holder. The SDIRA will owe income taxes on the pre-taxed funds and earnings converted to the Roth SDIRA. In certain cases, a fair market valuation must be obtained for specialized assets (securities) before the SDIRA is converted to a Roth SDIRA.
3. The SDIRA holder must obtain the fair market value of the transferred asset by a certified appraiser.
4. If a Roth SDIRA does not exist, a Roth SDIRA must be established with a custodian.
5. The SDIRA owner must provide instructions to the SDIRA custodian to move the asset from the SDIRA to the Roth SDIRA.
6. The SDIRA holder will pay income tax on the value of the asset transferred from the SDIRA to the Roth SDIRA.

The Importance of Proper Valuation

An asset being transferred from a SDIRA to a self-directed Roth SDIRA must be valued at its fair market value on the date of transfer. Treasury Regulation Sections 20.2031-1(b) and Treasury Regulation Section 25.2512-1 define the fair market value standard as “the price at which the property would change hands between a hypothetical willing buyer and a hypothetical willing seller, neither being under compulsion to buy or sell, and both having reasonable knowledge of the relevant facts.”

1. State law generally determines the property rights being transferred.
2. Federal tax law determines how those rights will be taxed.
3. General standard presumes hypothetical and willing seller and buyer. Actual buyer and seller are irrelevant to valuation analysis. See Est. of Bonner v. United States, 84 F. 3d 196 (5th Cir. 1996); LeFrak v. Commissioner, 66 T.C.M. (CCH) 1297, 1299 (1993). Nonetheless, the collateral consequences of the hypothetical ownership transfer are to be taken into consideration, such as the effect of a controlling or minority ownership interest.
4. No compulsion to buy or sell: not an emergency need to buy or desperation “fire sale.”
5. All relevant facts are to be considered, including those directly related to the asset to be valued, the market in which the asset is available (e.g., private sale, publicly traded, retail, or wholesale), and the general economic condition (e.g., depression, recession, modest growth, or boom times).

Although the goal in valuation for IRA tax purposes is an objective determination of the value of the self-directed IRA’s assets as of the date of the conversion, the hypothetical willing buyer/seller standard necessarily results in a subjective analysis, methodology and expert opinion play a major role. If a valuation of an asset transferred from a SDIRA to a self-directed Roth SDIRA exceeds its fair market value, the SDIRA holder will pay more in taxes than he or she reasonably should. On the other hand, an understatement of an asset transferred from a SDIRA to a Roth SDIRA can trigger additional tax, interest, and valuation related penalties. Section 6662 of the Internal Revenue Code provides a 20 percent penalty for the underpayment of the federal tax of $5,000 or more when the underpayment is attributable to valuation understatements. If a gross-valuation understatement occurs, the Section 6662 penalty can increase to 40 percent.

In order to avoid the overpayment of taxes or penalties for the underpayment of taxes, SDIRA holders that transfer assets to a self-directed Roth SDIRA should be a competent and professional appraiser to value the asset or assets being transferred. If the self-directed IRA owner wants the valuation of an asset to be given credence (by the IRS, the Tax Court, etc.), it is imperative that the SDIRA owner retain a qualified appraiser. The appraiser should maintain membership in at least one of the following professional organizations.

1. American Society of Appraisers- an independent multi-disciplinary appraiser organization whose goal is to maintain and elevate the standards of the appraisal professional.
2. Institute of Business Appraisers, Inc- a testing and certifying organization for appraisers in the valuation of smaller closely held businesses.
3. American Institute of Public Accountants- established standards which generally apply to all services provided by CPAs, including valuation engagements.

Although membership in a professional appraisal organization may be indicative of a qualified appraiser, it is not the only determining factor. The following questions should be asked of any potential appraiser:

1. How many appraisals were challenged by the IRS.
2. How many appraisals have resulted in settlements with the IRS.
3. How many litigation appearances has the appraiser and the appraiser’s form made and with what results.

Overview of Valuation Approaches and Methods of Pre-IPO Companies

There are three generally accepted approaches used to determine the fair market value of a pre-IPO asset: the Income, Market, and Asset Approaches. Depending on the facts and circumstances of a particular appraisal, applying the three approaches independently of each other can yield conclusions that are substantially different. The strengths of each individual approach should be considered by an appraisal in determining the valuation of a pre-IPO asset. In some valuation cases, all three approaches should be considered.

Below, are a brief description of the three valuation approaches.

1. Income Approach. The Income Approach is based on the expected risk/return relationship of an investment. It measures the present worth of anticipated future economic streams of income generated by a subject entity or interest. Net earnings, cash flows, revenues or other streams of economic income are identified or forecasted for a represented period, then discounted to present value using an appropriate discount rate based upon the associated risk of the income stream.
2. Market Approach: The Market Approach is based on the economic principle that similar assets should sell at similar prices. It is defined by the American Society of Appraisers as “a general way of determining a value indication of a business, business ownership interest, security or intangible asset using one or more methods that compare the subject to similar businesses, business ownership interests, securities, or intangible assets that have been sold.”
3. Asset-Based Approach: The Asset Based Approach assumes that a prudent investor will pay no more for an asset or group of assets (less liabilities) than the amount for which the investor can replace or recreate such net assets. This approach is often appropriate when the current or expected future operating earnings of a subject entity are insufficient to generate a return greater than that which could be generated through the sale of the underlying net assets. This approach calculates the total value of all the company’s assets (equipment and inventory) and subtracting liabilities to determine the net asset value.

In the case of stock or securities of a corporation the value of which, by reason of their not being listed on an exchange and by reason of the absence of sales thereof, cannot be determined with reference to bid and asked prices or with references to sales prices, the value thereof shall be determined by taking into consideration, in addition to all other factors, the value of stocks or securities of corporations engaged in the same or a similar line of business which are listed on an exchange. See IRC Section 2021(b).

Treasury Regulations Section 20.2031-3 and 20.2031-2(f) and (h) contain special requirements for the valuation of interests in business. All relevant factors must be considered, including:

A fair appraisal of all the tangibles and intangible assets of the business, including goodwill;

B. The demonstrated earning capacity of the business;

C. To the extent applicable, other relevant factors, including:

1. The company’s net worth;

2. Its prospective earning power;

Its dividend-paying capacity;4. The economic outlook in the company’s industry;

5. The company’s position in its industry;

6. Its management;

7. The degree of control of the business represented by the block of the ownership interest to be valued;

8. The values of securities of companies engaged in the same or similar lines of business that are listed on a stock exchange;

9. Nonoperating assets, including proceeds of life insurance policies payable to or for the benefit of the company (to the extent not already taken into account in determining net worth, earning capacity, and dividend-paying ability); and

10. The impact on the value of the value of the IRA’s interest in the business of an option or contract to purchase the interest owned by the IRA.

The IRS has issued a number of Revenue Provisions for the valuation of nonpublicily traded stock and closely held corporations. Below is a list of Revenue Rulings that may assist in valuing corporate stocks in the context of a transfer of a self-directed IRA to a self-directed Roth IRA.

1. Revenue Ruling 59-60, 1959-1 C.B. 237, contains the basic guidelines for valuing closely held stocks.

Revenue Ruling 65-193, 1965-1 C.B. 370, modifies Revenue Ruling 59-60 somewhat in the context of intangible assets of a business.3. Revenue Ruling 77-287, 1977-2 C.B. 319 amplifies Revenue Ruling 59-60 by providing guidelines for discounts to be applied to publicly traded stock the transfer of which is restricted under federal securities laws.

Valuation Discounts

For purposes of an SDIRA in the context of valuing a pre-IPO asset, a “valuation discount” is not really a discount in the sense that the SDIRA holder is receiving a bargain at the expense of the IRS. Rather, the valuation discount is an appropriate factor in determining the fair market value of the asset held by the SDIRA. A valuation discount can be thought of as one or more factors that a hypothetical willing buyer would consider in determining a fair price to pay for an asset that is taxed in an IRA conversion. That is, if certain factors exist that would affect the hypothetical buyer’s use and enjoyment of such an asset, the hypothetical buyer would demand some sort of discount to compensate him or her for purchasing such an asset. A valuation discount can be contrasted with valuation “premium.” That is, if one or more factors exist that would enhance a hypothetical buyer’s use and enjoyment of an asset, the hypothetical seller would demand an increased purchase price. An example of such a premium is a control premium for a majority interest in a business entity. Theoretically, the fair market value of a controlling interest in a business is greater than the net asset value of the business represented by the shares of stock. This is so because, an individual with a controlling interest in a business may direct the day-to-day affairs of the business.

Lack of Marketability Discounts

The amount of discount for a pre-IPO stock is determined under a lack of marketability discount test or (“DLOM”). DLOM is based on the principle that, because the shares are not actively traded or otherwise readily marketable, an adjustment should be made per share value. A discount for lack of marketability in pre-IPO stock is calculated by comparing private, illiquate share prices to public market prices, often resulting in a 20% to over 50% discount. It is done using empirical studies.

DLOM is a relative measure of illiquidity. The IRS defines lack of marketability as “the absence of a ready or existing market for the sale or purchase of the securities being valued” See IRS Valuation Guide for Income, Estate and Gift Taxes. It equates the value of a closely-held investment (not publicly-traded) to the value of a comparable publicly-traded minority interest. The U.S. equity markets are the recognized benchmark for marketability, given that an investor can readily and inexpensively sell a publicly-traded stock for cash at a known, publicized price. Any circumstances short of this liquidity standard form a basis for a DLOM. Any closely-held enterprise that is not sold on the U.S. equity markets is subject to DLOM. Based on these considerations, pre-IPO assets held by a SDIRA that are in need of valuation it is necessary to apply DLOM to determine its fair market value. Two published series of empirical studies are widely recognized as providing market evidence for the quantification of DLOMs: restricted stock studies and pre-initial public offering studies.

Restricted Stock Studies

An SDIRA owner of a restricted stock, also known as letter stock or Securities and Exchange Commission (“SEC”) Rule 144 stock, is restricted from selling stock in a public market until a certain period lapse, at which time the stock becomes marketable under certain volume restraints. The restricted stock studies examine the difference in prices for restricted shares and their unrestricted, freely traded counterparts. In general, the restricted stock studies indicate that restricted states trade at a discount from the prices of their freely traded counterparts due to their restricted marketability. The SEC Institute Investor Study examined discounts of a number of restricted securities transactions under Rule 144 and observed a mean price discount of 25,8%.There are a number of other studies which have reported discounts as high as 60%. Any SDIRA that holds restricted Rule 144 stock should have an appraiser utilize a restricted stock study to determine the appropriate discount to the pre-IPO asset.

Pre-Initial Public Offering Studies

A separate series of studies provide strong direct empirical evidence for DLOM. These pre-IPO studies observe transactions in privately held companies that eventually completed an IPO. In each study, the private transaction price of a stock was compared to the subsequent public offering price on a minority ownership basis. The percentage discount from the public offering price is a proxy for the DLOM. A number of studies conducted over 20 years that have observed hundreds of private stock transactions comparing the prices of stock transactions that occurred up to 5 months prior to the IPO determined that the average discount ranged from between 27% to as high as 73%.

The IRS has recognized the restricted stock studies as empirical evidence of DLOM in Revenue Ruling 77-287. The pre-IPO studies are also recognized in the IRS Valuation Training for Appeals Officers Coursebook. In addition, the Tax Court has recognized utilizing pre-IPO studies for valuation of pre-IPO stocks. In the Estate of Davis v. Commissioner, 110 T.C. 530 (1998), the Tax Court determined that the expert for the IRS should have considered pre-IPO studies because they, together with the restricted stock studies, would have provided a more accurate base range and starting point for determining the appropriate lack of marketable discount. In Bernard Mandlebaum, et al. v. Commissioner, T.C. Memo 1995-255 (June 2, 1995), the Tax Court identified the restricted stock and pre-IPO studies as a starting point of reference and cited nine factors to consider when deciding on the magnitude of DLOM.

Financial Statement Analysis: Other things being equal, the better the company’s financial condition and performance, the stronger the demand for ownership and the lower the DLOM.

Dividend-Paying Policy and Capacity: Stocks with no or low dividends tend to have higher DLOMs than stocks with high dividends.

Nature of the Company and its History, Industry Position and Economic Outlook: The greater the risk associated with an investment, the greater the return required by investors. The fundamental characteristics of an entity, its strengths, weaknesses, opportunities and threats, and the predictability and stability of its financial performance and future prospects, can all affect the extent of the DLOM applicable to a particular entity.

Analysis of Management: The quality, experience and stability of management are also considered by investors when they evaluate the risk associated with an investment and the DLOM required.

Amount of Control in Transferred Shares: Marketability is significantly enhanced when a block of interests. Elements of control increase an investor’s ability to direct the operation of a business.

Holding Period: Market risk increases as the anticipated holding period of an investment gets longer. Owners of interests in privately-held entities tend to have indefinite holding periods, which can significantly increase the DLOM.

Restrictive Transfer Provision: Closely held ownership interests may be subject to provisions restricting the right of an investor to transfer interests. Such provisions tend to raise the DLOM by increasing the anticipated holding period of the investment. Alternatively, organizational documents or agreements among owners can contain certain “put rights”.” These are contractual rights that guarantee an investor a market for his or her interests under specified circumstances. Put rights can significantly decrease a DLOM.

Redemption Policy: Stocks with shorter anticipated restriction periods generally have lower DLOMs. It follows that restrictions on the marketability of ownership interests imposed by a particular company’s redemption policy can decrease the marketability of an investment. Some entities have owner agreements giving the entity a contract right to purchase an ownership interest before it is sold to an outsider, which can increase the DLOM.

Costs: Associated with a Public Offering: Significant costs are associated with taking a private company public. Such costs often range between 10% to 15% of the aggregate initial public offering price. The expected costs tend to increase the DLOM required for a private company’s ownership interests.

Any SDIRA holding pre-IPO stocks that needs valuation should have an appraisal properly apply the pre-IPO studies along with the above discussed nine factor test to determine a proper DLOM discount range.

Conclusion

The foregoing discussion is intended to provide the reader with a basic understanding of the different theories involved in the valuation of pre-IPO companies held in a SPV through a SDIRA. It should be evident from this article that it is crucial for a SDIRA investor to retain the services of a qualified tax attorney and appraiser. Because the quality of the appraiser’s report is significantly affected by the quality of the factual information the appraiser receives, the tax attorney involved in the pre-IPO company must work closely with the appraiser in obtaining the information that will serve as the basis for the appraiser’s report. The tax attorney should not expect the appraiser to go off and do his or her work without significant input from the tax attorney and the IRA account holder. The tax attorney is often the SDIRA investor’s adviser in the best position to have an overall understanding of the factual information supporting the valuation determination. The tax attorney must be prepared to convey it to the appraiser and to the IRS or the courts if a dispute arises. In general, the tax attorney needs to be the quarterback to make sure the appraisal process proceeds in an orderly and efficient manner. The tax attorney often has the closest relationship with the self-directed IRA account holder and other account holder advisors. This means that the appraiser typically will depend on the tax attorney for assistance in moving things along with the tax attorney for assistance in moving things along with the account holder.

Anthony Diosdi is a tax attorney at Diosdi & Liu, LLP. He has significant experience defending private clients before the IRS in difficult and complex tax disputes. Anthony counsels clients through examinations and liability disputes and, when necessary, takes disputed issues to court. Anthony has advised a number of SDIRA investors that use SPVs that invest in private companies.

Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.