What is UBTI?
Typically, a retirement plan or other tax exempt entity is not taxed on the income generated through its activities. This sheltering from taxation is one of the key advantages to investing with a tax-deferred or tax-free IRA or 401(k) plan.
An exception occurs, however, when a tax-exempt entity regularly engages in an activity that would be considered a trade or business. In this case, a tax is applied to what is referred to as Unrelated Business Taxable Income (UBTI).
Per IRS Publication 598:
“If an exempt organization regularly carries on a trade or business not substantially related to its exempt purpose, except that it provides funds to carry out that purpose, the organization is subject to tax on its income from that unrelated trade or business.”
The idea behind this law, which congress passed in the 1950’s well before IRA and 401(k) plans even existed, is that we do not want to create a competitive disadvantage for tax-paying businesses by allowing tax-exempt entities to compete with them on unequal terms.
When a tax-exempt entity has UBTI, the tax paid by the entity is referred to as Unrelated Business Income Tax or UBIT.
A sub-set of UBIT applies when a tax-exempt entity uses debt-financing such as a mortgage for a real estate investment property. This tax applies to Unrelated Debt-Financed Income or UDFI.
What Activities Generate UBTI?
UBTI only applies to certain types of activities that one might engage in with an IRA or 401(k) plan. Most retirement investments are passive in nature and therefore not considered subject to this tax. Examples of passive investments not subject to UBTI would include:
- Rent from real property
- The sale of an asset that has been held over time to produce passive income
The test for whether the tax applies in an IRA or 401(k) has to do with the following criteria:
- Is the income generated from a trade or business activity?
- Is the activity engaged upon on a regular or repeated basis?
Examples of investments that might fall under this category would include:
- Operating income from ownership in a business such as a LLC or limited partnership that is treated as a pass-through for purposes of taxation, when that entity is engaging in an active trade – a restaurant, bookstore, auto shop, etc. Income from a partnership that purely holds passive investments would not typically be taxed. Note that dividends from a C corporation are not taxed, since the corporation will already have paid taxes on the income.
- Earnings on a loan to a business where the terms of the loan include participation in the profits of the business.
- Purchasing real property with the intent to fix it up and re-sell, otherwise known as flipping.
- Construction of real property with the intent to immediately sell.
- Renting or leasing personal property (not real property).
- Any kind of “dealer” activity that simply consists of buying and then reselling an asset.
The calculation of UBTI taxation will vary depending on the type of activity being taxed. In general terms, the gross income produced by the activity will be subject to the tax. The taxable amount will then be reduced by allowable deductions for any costs directly associated with the production of income.
The tax is applied using trust tax rates, which range from 15% to 39.6% on various income brackets. The top 39.6% applies to income above $12,700 per year. In addition to the federal tax, many states have parallel tax.
Example – House Flipping
Assume you purchased a property using your IRA with the intent to have the house repaired and then resold for a profit. This is considered flipping, and the property is viewed as inventory held for sale in the normal course of business.
Let’s say you purchased the home at auction for $100,000 and then had repair work done prior to sale at a price of $200,000. This would result in a $100,000 gross gain on the transaction, which would be considered UBTI.
You would then be able to reduce the taxable income amount by the repair costs, as well as other expenses such as property taxes during the time the property was held, sales cost, etc. For sake of simplicity, let’s assume the total deductible expenses were $66,000, including $50,000 of rehab & holding costs and 8% for realtor commission and closing costs at the time of sale. This leaves a net taxable amount of $34,000.
Per the 2018 trust tax rate table for form 990-T, the tax amount would be $11,717. This leaves your IRA with $22,282 return on $150,000 invested. The project has produced a 13% net after tax return to your IRA. That is not bad, but there are probably less risky ways to generate a 13% return that do not have exposure to UBTI.
Example – Venture Capital
Venture Capital investments may have exposure to UBTI, but the impact may not diminish the appeal of the opportunity.
In a true venture capital play, the “prize” is the eventual sale of your IRA’s stake in a business at a higher price when the venture is sold or goes public. Only operating income is considered UBTI, not the gain in equity value. While there may be a UBIT component to the investment, it may not be significant. The start-up phase is not always profitable, and there may even be losses in the early goings that could be carried forward to offset UBTI in future profitable years. When the business hits the next level and you get to sell the shares your IRA purchased for $100 each at a price of $500, $1,000 or more, that gain in equity value is not taxed. Investing with IRA or 401(k) funds into such an opportunity can make a lot of sense.
If the primary motive for an investment in a business is the operating income the business will produce, however, the impact of UBIT may spoil the opportunity as an investment for a self-directed IRA or Solo 401(k) plan.
UBIT Blocker Strategies
If your self-directed IRA or Solo 401(k) strategy involves repeated trade or business activities that would generate UBTI, you essentially have three choices:
- Pick a different investment strategy that does not generate UBTI
- Engage in the activity, pay UBIT, and be satisfied with the net-after-tax returns
- Implement a UBIT blocker strategy to dramatically reduce the taxable impact
If the opportunities that are within your expertise and network are UBTI exposed – such as flipping houses – it may very well make sense to put your IRA to work in this fashion. A key benefit of a self-directed IRA or Solo 401(k) is to be able to “invest in what you know”, after all. With a UBIT blocker, you can have the ability to invest as you choose, but increase the profitability of the deals.
A UBIT Blocker is a taxable corporation inserted between a tax-exempt entity and a UBIT exposed transaction. This strategy does not eliminate tax exposure, but rather reduces the taxable rate. Instead of the gains from a transaction being taxed at the higher 39.6% trust tax rates, normal corporate tax rates of 21% will apply. The underlying IRA or 401(k) plan then receives the after-tax profits of the deal as tax-sheltered dividend income from the blocker entity.
Such structures have been around for a long time, but were not particularly beneficial when the top corporate tax rate was 35%. With the passage of the 2017 Tax Cuts and Jobs Act, the corporate tax rate has been lowered to 21%. This is a significant enough savings that the use of a blocker corporation may be beneficial for those investors wanting to engage in trade or business activities such as house flipping with their self-directed retirement plan.
Revisiting the Flip Example with a UBIT Blocker
If we take the prior home flip example and insert a UBIT Blocker between the IRA and the transaction, the resulting profitability of the deal is markedly improved.
By taking the net income of $34,000 and applying a 21% corporate tax rate instead of the effective UBIT rate, the taxable amount is reduced by over $4,500 to $7,140. This results in a net after-tax profit of $26,860 that can be issued by the blocker entity as a dividend to the underlying IRA or 401(k) plan. That changes the ROI for the deal from 13% to 18%, which is much more appealing. If you repeat the flip process multiple times per year, the savings generated by the blocker entity can be significant.
A return must be filed if the total income generated through a business activity exceeds $1,000 for the year. UBTI is calculated and reported by the IRA or 401(k) using IRS form 990-T, and is not associated with your personal return. This return has an April 15th filing deadline. If the total tax liability will exceed $500 for the year, quarterly estimated tax payments may be required.
At first blush, one might decide that exposure to taxation would rule an investment opportunity as unfavorable for your retirement plan. While this tax does generate additional overhead through both the tax itself and the costs of preparing a return, you need to keep an eye on the bottom line. If the after UBIT returns on a deal is superior to other opportunities available to your, it may still make sense to move forward. If you will be engaging in a series of UBTI exposed transactions over time, the use of a UBIT Blocker entity may be a viable strategy.
If you are considering making an investment that will have exposure to UBTI, you should consult with your tax advisor in advance to gain a clear picture of the impact the tax will have in your specific situation.
IRS Publication 598 – Tax on Unrelated Business Income of Exempt Organizations