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What Investors Need to Know About Unrelated Business Income Tax (UBIT)

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. In this article, we provide further information on the topic of UBIT:

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 the Treasury Regulations. As part of the retirement program, custodians may provide the 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 will hold under their program. There are other platforms however, that do not offer investments, but instead provide a platform that will custody investments, provide the tax reporting and client access. This open architecture model of  IRA investing is called “self-direction”.

Self-directed IRA administrators do not sell, endorse, nor give investment and tax advice. Instead, their main service offering is proving a path to establishing the IRA of choice and holding investments in an individual’s IRAs that normally would not be accepted at other financial institutions. There are only a few limitations on the type of investments allowable by law. There are also transactions that are considered prohibited-self-dealing. Self-directed retirement plan administrators typically provide general information and education to help investors navigate and point them to the right direction in this new and expanding opportunity for retirement plan investing.

Unrelated Business Income Tax (UBTI)

Since IRAs are tax-deferred meaning earnings are not taxed until distributed, 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, there are other investment incomes that are derived from a Trade or Business that are subject to tax.  This tax is called Unrelated Business Income Tax (UBIT). The intent of this tax is not to give for profit entities a disadvantage from for profit entities held by an IRA. The taxation of income received from IRA investments such as partnerships and LLCs that are 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.  This form 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.

No copyright infringement intended. This article was originally published at by John Paul Ruiz, QKA, CISP

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