What Type of IRA Business Trust Investment Transactions May Trigger the UBTI Tax?
If you are planning for your future, designating funds for your retirement is a great step. Most people have heard of a 401(k) or individual retirement account (IRA). These plans allow owners to invest in various stocks, bonds and mutual funds. While these options can promote financial growth, if you want more, you should consider opening a self-directed IRA (SDIRA). These plans, which can be traditional or Roth accounts, allow for much more diversified investments. In fact, you can invest is almost anything, including real estate, precious metals, renewable energy and private placements.
SDIRA’s and UBTI Tax
For many, establishing a limited liability company (LLC) in the name of your SDIRA makes sense. It helps to isolate and protect your investment funds. It also provides you with a level of anonymity that many owners find beneficial.
IRAs and SDIRAs are typically exempt from the Unrelated Business Taxable Income (UBTI) tax. This rule, as established by the Internal Revenue Service (IRS) in 1950, was introduced as a means of preventing tax-exempt businesses from unfair competition related to their profits.
Most passive investments made with your SDIRA LLC are considered tax exempt. However, real estate in particular can trigger the UBTI tax. Why? UBTI taxes are generally applied to incomes generated by “any unrelated trade or business” that is “regularly carried on” by an organization that would be subjected to the tax. To better understand this, let us take a look at the main components of this regulation.
“Trade or Business”
The Internal Revenue Code (IRC) Section 162 defines “trade or business” as profit-oriented activities that involve regular actions by a taxpayer. There are very few cases in which activity needs to be attributed to a trade of business, however. This is because most expenses that are incurred from the profit-oriented activities of a taxpayer can be listed as deductibles under IRC 212.
“Regularly Carried On”
For an activity to be considered “regularly carried on”, it is compared to those activities of a competitive, taxable business. There are some nuances to this. A short-term activity are typically tax-exempt if a similar commercial occurs all year. An example of this would be an ice cream stand operated by a tax-exempt organization during a state fair. Seasonal activities, however, are likely to be subjected to the UBTI tax. Intermittent activities are typically exempt if they are done so without the same type of promotional actions taken by a commercial enterprise.
UBTI Tax Triggers
It is important to identify and quantify the types of activities your SDIRA LLC has used to generate profits. This will help you to determine whether the activity and its profits are exempt or not. As previously stated, most passive transactions associated with your SDIRA LLC would not be subjected to the UBTI tax. However, there are several that could.
- Income generated by the actions of a trade or business that would be considered active but the IRS;
- Income that is generated by a convenient store;
- Income generated by a manufacturing company;
- Business income that is generated by an LLC that is used as a pass through entity;
- Income that is generated by a business that is owned by your SDIRA LLC and you, the plan owner, are an investor;
- Unrelated Debt Financed Income (as defined by IRC Section 514(e));
- When a nonrecourse loan is used to purchase property; or
- Income generated by a real estate investment, which is treated as a business inventory vice an investment.
There are plenty of examples of taxpayers and the IRS, referred to in court proceedings as the Commissioner of Internal Revenue, going to court over taxes. However, let us take a look at two similar examples that resulted in very different court rulings.
- Brown v. Comm., 143 F.2d 468 (5th Cir. 1944): In this case, the taxpayer (Brown) inherited 500 acres of land from a deceased relative. This land was used for grazing purposes only and, as such, was considered tax-exempt. After taking ownership of the property, the taxpayer decided to sell it. They listed it with a real estate broker. The broker was instructed to subdivide the property into lots and develop the land for sale by the tax-exempt organization. The broker did as directed. Streets were constructed, wells were installed, gas and electric lines were laid, and storm sewers were put in. Every year, between 20 and 30 lots were sold. In this ruling, the court found that the lot sales were being conducted regular course of business. The court ruled in favor of the IRS.
- Farley v. Comm., 7 T.C. 198 (1946): In this case, the taxpayer (Farley) owned a tract of land that was being used as a part of his nursery business. Without further developing the land, the taxpayer sold off 25 lots for residential development. Unlike the Brown case, the court ruled in favor of the taxpayer. Because the taxpayer did not further develop the land, the court viewed it as a “gradual and natural liquidation of an asset”.
Invest with a Professional
Finding the right plan can be hard. However, when you open an account with a reputable professional, like IRA Business Trust, our experts go to work for you. Not only do we handle any documents and tax forms you may need, but also as experts, we understand where the IRS draws a line. Your SDIRA is a vital part of your future. To find out more about opening a SDIRA, forming an LLC, or understanding UBTI, contact us today!