Almost all retirement account investments generating passive income will not be subject to Unrelated Business Taxable Income (UBTI) or Unrelated Debt Finance Income (UDFI) taxes. In 2022, the maximum UBTI tax rate is 37%. Essentially, most of the income generated by a retirement account is exempt from UBTI. What if there is a tax? Is there a way to avoid UBTI?
- When you self-direct your IRA, you can use those funds to invest in a business
- Depending on the type of business, your investment may be subject to the UBTI tax
- No one likes to pay extra taxes, but there are some ways to avoid them
This is the reason why most Americans have never heard of UBTI. Passive forms of income, such as dividends, interest, annuities, royalties, most rental from real estate, and gain/losses from the sale of real estate are typically not subject to the tax. Note – rental income generated from real estate that is “debt-financed” loses the exclusion.
What Self-Directed IRA Investments Trigger the UBTI Tax?
In general, only three types of Self-Directed IRA investment categories will trigger the UBTI tax:
- Using margin to buy stocks or securities
- Using a nonrecourse loan to buy real estate
- Investing in an active trade or business operated through an LLC or pass-through entity, such as a partnership.
This article will focus on how the UBTI tax will be triggered by an IRA investing in a trade or business.
Investing in a Company That Sells Goods & Services
Income from the operations of an active trade or business through a pass-through entity (LLC/partnership) that is allocated to a Self-Directed IRA would be subject to the UBTI tax. For example, income earned from a convenience store or a manufacturing business allocated to a Self-Directed IRA would be subject to the tax.
In addition, the UBTI tax can be triggered if the income is earned through an active business owned by an LLC in which an IRA is an investor, such as a private equity investment owned by an IRA into a pass-through business.
Note – IRS Form 990-T, which is where the UBTI income is reported is only required if the annual net UBTI income is above $1,000.
What is a Pass-through Entity?
It is important to understand the distinction between a corporation and a pass-through entity. The UBTI tax is not triggered when a Self-Directed IRA invests in a C Corporation, as a corporation is taxed as an entity, separate from its shareholders. Since most publicly traded companies, such as Apple or Tesla, are C Corporations, most American IRA investors have no reason to worry about the application of the UBTI tax.
However, if a Self-Directed IRA elects to invest in a private business operated via a partnership or LLC, an allocation of business income above $1,000 could be subject to the UBTI tax.
For example, if one invests their Self-Directed IRA into a friend’s LLC that owns a restaurant, if the IRA was allocated more than $1,000 of net business income from the LLC, the IRA would be required to file a 990-T and potentially owe UBTI tax on the income.
Beware of the IRS Prohibited Transaction Rules
The IRS prohibited transaction rules under IRC Section 4975 prevent an IRA owner from engaging in any business that directly or indirectly involves a disqualified person. A “disqualified person” is generally defined as the IRA holder, any ancestors, or lineal descendants of the IRA holder, and entities in which the IRA holder holds controlling equity or management interest.
In the case of a Self-Directed IRA contemplating an investment in a business, it is important that the IRA owner nor any disqualified person owns, in the aggregate, more than 50% of the business entity so the investment does not trigger the IRS prohibited transaction rules.
How to Get Around the UBTI Tax?
If you will be using a Self-Directed IRA to invest in an active business operated via an LLC or other pass-through entity, below are the two most common solutions to circumventing the UBTI tax rules:
Use of a C Corporation Blocker
If a Self-Directed IRA invests in a business operated via a C Corporation versus an LLC, the UBTI tax will not apply to any dividends issued to the IRA. Hence, by an IRA selecting a business investment that is operated via a C Corporation versus an LLC, the IRA owner can sidestep the application of the UBTI. Of course, this option may not be available depending on how the business has been established. But, if your IRA has the choice between two business investments, investing in the business set up as a C Corporation will block the UBTI tax.
Loan vs. Equity Investment
If your Self-Directed IRA investments can be structured as a loan versus an equity investment, the interest received from the loan would be exempt from the UBTI tax. The downside of a loan investment is that it would only provide a stated rate of return, whereas an equity investment has no limitation on the investment upside.
However, structuring the IRA investment as a loan versus an investment into the LLC would allow you to generate returns without triggering the UBTI tax. This may be useful depending on your investment
Using a Self-Directed IRA to invest in a business that sells goods and services that is operated via an LLC or other pass-through entity could trigger the UBTI if the IRA is allocated more than $1,000 of net annual income. Whereas, if the IRA invested in a business that sells goods and services that is operated as a C Corporation, such as Tesla or Netflix, the IRA investment would not be subject to the UBTI tax as the C Corp blocks the application of the tax.
Before investing in any business, it’s important to do your due diligence and be aware of the important IRS rules surrounding the UBTI tax. Work with a financial advisor before engaging in any asset.