What Self-Directed IRA Owners Need To Know About UBTI & UBIT Tax

Your friends at the IRS just love making new rules for us lawyers to learn. I decided to "share the love" and write this article for you. Don't panic--this is much more readable than the version I got.

While UBTI (Unrelated Business Taxable Income) and UBIT (Unrelated Business Income Tax) sound familiar, they apply in different investment scenarios and are certainly not the same tax rate.

Wait: Aren't IRAs Tax Exempt?

They are, most of the time.

When it comes to using your Self-Directed IRA, most of the investments you make are exempt from federal income tax. Some examples of exempt income include: dividends, royalties, most rentals from real estate and gains/losses from the sale of real estate.

But this doesn't mean you can't end up finding yourself in trouble with the IRS.

The UBTI/UBIT Income Rules.

The IRS enacted a set of rules in the 1950s in order to prevent IRAs from engaging in an active trade or business and having an unfair advantage because of their tax-exempt status.

These rules became known as the Unrelated Business Taxable Income rules or UBTI or UBIT. If the UBTI rules are broken, the income generated from your activities will be subject to a 40% tax for 2018.

Note: An IRA investing in an active trade or business using a C Corporation will not trigger the UBTI tax.

Where Does UBTI and UBIT Apply?

The UBTI/UBIT tax applies to the taxable income of “any unrelated trade or business…regularly carried on” by an organization subject to the tax. The regulations separately treat three aspects of the quoted words “trade or business” “regularly carried on” and “unrelated.”

Let's go over them.

What is "Trade or Business?"

The rules start with the concept of “trade or business” as used by Internal Revenue Code Section 162, which allows deductions for expenses paid or incurred “in carrying on any trade or business.”

Although Internal Revenue Code Section 162 is a natural starting point, the case law under that provision does little to clarify the issues. Expenses incurred by individuals in profit-driven activities not amounting to a trade or business are deductible under Internal Revenue Code Section 212. This means it is rarely necessary to decide whether an activity conducted for profit is a trade or business.

The few cases on the issue under Internal Revenue Code Section 162 generally limit the term “trade or business” to profit-oriented endeavors involving regular activity by the taxpayer.

What is "Regularly Carried On"?

Whether a trade or business is regularly carried on is determined based on intent. If the underlying objective is to reach activities competitive with taxable businesses, your business may meet this criterion.

The requirement is met by activities that “manifest a frequency and continuity, and are pursued in a manner generally similar to comparable commercial activities of nonexempt organizations.”

What About Short Term and Intermittent Activities?

Short-term activities are exempted if comparable commercial activities of private enterprises are usually conducted on a year-round basis. But a seasonal activity is considered regularly carried on if its commercial counterparts also operate seasonally.

Intermittent activities are similarly compared with their commercial rivals and are ordinarily exempt if conducted without the promotional efforts typical of commercial endeavors.

If an enterprise is conducted primarily for beneficiaries of an organization's exempt activities (e.g., a student bookstore), casual sales to outsiders are ordinarily not a “regular” trade or business.

What Type of Income Is Subject to UBTI or UBIT Tax?

The type of income usually subject a Self-Directed IRA to UBTI or UBIT is income generated from the following sources:

• Income from the operations of an active trade or business. (A restaurant, laundry mat, car wash, etc.)
• Business income generated via a pass-through entity, such as an LLC or partnership.
• Using a nonrecourse loan to purchase a property.
• Using margin on a stock purchase.

Internal Revenue Code Section 511 taxes “unrelated business taxable income” (UBTI) at the rates applicable to corporations or trusts, depending on the organization's legal characteristics.

What Are The Actual UBTI and UBIT Tax Rates?

A Self-Directed IRA subject to UBTI is taxed at the trust tax rate because an IRA is considered a trust. For 2020, a Solo 401k Plan or Self-Directed IRA is subject to UBTI is taxed at the following rates:

• Up to $2,600: 10% of the amount over zero
• $2,600 up to $9,450: $260 + 24% of the amount over $2,600
• $9,450 up to $12,950: $1,904 + 35% of the amount over $9,450
• $12,950 and over: $3,129 + 37% of the amount over $12,950

Meanwhile UBIT tax is levied based on corporate taxes.

I hope this article helped any answer questions you might have concerning your Self-Directed IRA and UBIT/UBTI tax. If you have any questions, feel free to ask in the comments below or contact us directly.