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Unrelated Business Income Tax (UBIT) was created by the congress to level the playing field for businesses established under the umbrella of a tax-exempt entity, not to have a competitive advantage over other businesses outside of a retirement plan.
UBIT income comes from a trade or business, regularly carried on (showing frequency and continuity), that is not substantially related to the purpose of a retirement account. Both should shoulder their tax responsibility.
The Basics of Establishing a Retirement Plan
In order to establish a retirement plan there must be an entity that must hold or “custody” the assets in order for the account to remain tax-deferred. Custodians could be banks, trust companies, brokerage firms, to name a few examples. The custodian may also play the role of record keeper and must adhere to the IRA reporting requirements mandated by Treasury Regulations.
As part of the retirement program, custodians may provide retirement plan documents and updates, tax reporting and access to customer information. In most organizations that sell investments, they offer these services to make it easy to access the investments they sell, and typically limit the investments they hold under their program.
However other platforms, such as Self-Directed IRAs, do not offer investments, but instead provide a platform that will custody investments, provide the tax reporting and client access.
Self-Directed IRA administrators do not sell, endorse, nor give investment and tax advice. Instead, their main service offering is providing a path to the IRA of one's choice and holding investments in IRAs that wouldn't typically be accepted at other financial institutions.
There are only a few limitations as to the type of investments legally allowed. There are transactions that are considered prohibited-self-dealing. Self-directed retirement plan administrators typically provide general information and education to help investors navigate this new and expanding opportunity for retirement plan investing.
Unrelated Business Income Tax (UBTI)
IRAs are tax-deferred, which means that earnings are not taxed until distributed, so IRAs are treated the same as tax-exempt entities when it comes to the earnings it receives. Typical earnings received by IRA investments such as interest, dividends, rents and royalties are not taxed until distributed.
However, investment incomes that are derived from a Trade or Business are subject to a tax called Unrelated Business Income Tax (UBIT). The intent of this tax is not to disadvantage for-profit entities in comparison to for-profit entities held by an IRA.
The taxation of income received from IRA investments such as partnerships and LLCs derived from a trade or business will be taxable to the IRA. The tax rates will be based on trust tax rates since IRAs fall under the category of trusts.
The IRS form that will need to be filed for the IRA is called the IRS Form 990-T and is only required if the IRA receives taxable gross income of $1,000 or more. The IRA holder must acquire an EIN for their IRA and prepare this form to be filed by the 15th day of the fourth month following the tax year.
Unrelated Debt Financed Income (UDFI)
There are IRAs that avail of the use of loans to purchase certain investments such as real estate. Incomes from the investment associated with the portion borrowed are considered taxable. As an example, although rental income in an IRA is typically not taxable, if the IRA borrowed 50% of the funds to purchase a property, 50% of the income will be taxable. The tax is a type of UBIT called Unrelated Debt Financed Income (UDFI). This income is reported on the IRS Form 990-T.
As individuals expand their investing preferences, they must be aware of additional requirements that come into play with such investments.To read a case study and more information on calculating UDFI, read Understanding UBIT and UDFI.
Be sure to speak with a financial professional if you are considering an investment that may be subject to UBIT.
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