Using a Solo 401(k) Plan, what type of transactions may trigger the UBTI tax?

In general, most passive investments that your Solo 401(k) Plan might invest in are exempt from UBTI. 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.

When an exempt organization such as an 401(k) Plan undertakes any development activities in connection with selling real estate, beyond passively placing the property for sale either directly or through a broker, the issue arises under Internal Revenue Code 512(b)(5)(A) whether the real estate is “property held primarily for sale to customers on the ordinary course of the trade or business.” An organization that engages in the sale of property to customers in the ordinary course of the trade or business is characterized as acting as a “dealer.

Fundamental to considering whether an exempt organization (i.e. a 401(k) Plan) is a “dealer” of real property is whether the property itself is held “primarily” for resale to customers in the ordinary course of a trade or business. In Malat v. Riddell, 393 U.S. 569 (1966), the U.S. Supreme Court interpreted the meaning of the phrase “held primarily for sale to customers in the ordinary course of trade or business” under Internal Revenue Code Section 1221(1). The IRS has often applied the principles derived under Internal Revenue Code Section 1221 to rulings interpreting the language of Internal Revenue Code Section 512(b)(5). The Court interpreted the word “primarily” to mean “of first importance” or “principally.” By this standard, ordinary income would not result unless a sales purpose is dominant. Both the courts and the IRS concluded that a taxpayer may make “reasonable expenditures and efforts” (such as subdividing land, construction of streets, the provision of drainage, and furnishing of access to such a necessity as water, as part of the “liquidation” of an investment asset without being treated as engaged in a trade or business.

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 (Solo 401(k) Plan investment). 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 Solo 401K Plan to UBTI is income generated from the following sources:

Examples could include:

Please contact one of our Solo 401(k) Experts at 800-472-0646 for more information.

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