Designating funds for your retirement is a great step if you are planning for your future. You probably already know about the 401(k) and the individual retirement account (IRA). These plans allow owners to invest in various stocks, bonds and mutual funds.
But for those of us who want a little more, there's another option: 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.
Establishing a limited liability company (LLC) in the name of your SDIRA makes a lot of 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.
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.
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.
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.
There are plenty of examples of taxpayers butting heads with the IRS. Let us take a look at two examples that resulted in very different court rulings.
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!
Scott Royal Smith is an asset protection attorney and long-time real estate investor. He's on a mission to help fellow investors free their time, protect their assets, and create lasting wealth.
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