The UBIT Rules and the Self Directed IRA
In general, when it comes to using a Self Directed IRA to make investments most investments are exempt from federal income tax. This is because an IRA is exempt from tax pursuant to Internal Revenue Code 408 and Section 512 of the Internal Revenue Codes exempt most forms of investment income generated by an IRA from taxation. Some examples of exempt type of income include: interest from loans, dividends, annuities, royalties, most rentals from real estate, and gains/losses from the sale of real estate.
However, the IRS enacted a set of rules in the 1950s in order to prevent charities and later IRAs from engaging in an active trade or business and, thus, having an unfair advantage because of their tax-exempt status. These rules can be found under Internal Revenue Code Sections 511-514 and have become known as the Unrelated Business Taxable Income rules or UBTI or UBIT. If the UBTI rules are triggered, the income generated from that activities will generally be subject to close to a 40% tax for 2017. Note – an IRA investing in an active trade or business using a C Corporation will not trigger the UBTI tax.
The UBTI generally 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.”
Trade or Business: In defining “unrelated trade or business,” the regulations 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. Because expenses incurred by individuals in profit-oriented activities not amounting to a trade or business are deductible under Internal Revenue Code Section 212, 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.
Regularly Carried On: The UBIT only applies to income of an unrelated trade or business that is “regularly carried on” by an organization. Whether a trade or business is regularly carried on is determined in light of the underlying objective to reach activities competitive with taxable businesses. The requirement thus 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.” Short-term activities are exempted if comparable commercial activities of private enterprises are usually conducted on a year-round basis (e.g., a sandwich stand operated by an exempt organization at a state fair), but a seasonal activity is considered regularly carried on if its commercial counterparts also operate seasonally (e.g., a horse racing track). Intermittent activities are similarly compared with their commercial rivals and are ordinarily exempt if conducted without the promotional efforts typical of commercial endeavors. Moreover, 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.
Before it can be determined whether an activity is seasonal or intermittent, the relevant activity must be identified and quantified, a step that is often troublesome.
The type of income that generally could 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 – i.e. a restaurant, gas station, store, etc
- Business income generated via a passthrough entity, such as an LLC or partnership
- Using a nonrecourse loan to purchase a property
- Using margin on a stock purchase