In general, almost all retirement account investments generating passive income will not be subject to Unrelated Business Taxable Income (UBTI), such as capital gains, interest, dividends, royalties, and rental income. However, in the case of option trading involving puts, calls, and other securities lending transactions, a question arises as to whether those type of transactions will trigger the UBTI tax.
- UBTI tax is triggered for specific retirement account investments
- In determining if the tax applies, you must distinguish between the purchase of securities using margin, and options and other lending transactions
- The borrowing of cash to make a stock investment will trigger UBTI
What is UBTI?
There are essentially only three types of transactions that could trigger the UBTI tax. Because the maximum UBTI tax rate is 37%, it is important to determine whether your self-directed investment will trigger the tax before making the investment.
UBTI is triggered when one:
- uses margin or a nonrecourse loan to buy stock or an investment asset;
- invests in an active business through a pass-through entity, such as an LLC; and
- uses a recourse loan to purchase real estate (exemption for 401(k) plans). This is known as Unrelated Debt Financed Income (UDFI), which triggers the same UBTI tax
Internal Revenue Code Section 511 taxes UBTI at the rates applicable to corporations or trusts, depending on the organization’s legal characteristics:
For 2023, a retirement plan subject to UBTI is taxed at the following rates:
- 10%: $0 – $2,900
- 24%: $2,901 – $10,550
- 35%: $10,551 – $14,450
- 37%: $14,451 and higher
If one triggers the UBTI tax, the IRA must file IRS Form 990-T by April 15 and pay the tax due from the retirement plan.
Security Lending Transactions
It is well established that the purchase of securities on margin gives rise to UDFI income (Henry E. & Nancy Horton Bartels Trust for the Benefit of the University of New Haven v. United States, 209 F.3d 147, 156 (2d Cir. 2000)). However, in Rev. Rul. 95-8, 1995-1 C.B. 107, the IRS has stated that neither the gain attributable to the decline in the price of the stock sold short nor the income earned on the proceeds of the short sale held as collateral by the brokerage firm constituted debt-financed income.
In addition, section 514(c)(8) provides that payments with respect to securities loans are deemed to be derived from the securities loaned, not from collateral security or the investment of collateral security from such loans and would not constitute debt-financed income. Furthermore, an obligation to return collateral security is not treated as acquisition indebtedness.
In GCM 39615 (March 12, 1987), the IRS reviewed purchases and sales of stock index futures and the underlying stock pursuant to a stock arbitrage investment program. The IRS held that the futures contracts, some of which constituted short sales, were “themselves property, albeit intangible.” Hence, the IRS concluded that the trading gains and losses from the stock index futures would be excluded from UBIT under Section 512(b)(5). In addition to the potential for gain from short sales, institutional short sellers are often entitled to interest income earned on the investment of short sale proceeds. This interest income, however, is unambiguously excluded from UBTI under Section 512(b)(1).
The IRS also held that income or gain connected with short sales does not become subject to tax by virtue of the “acquisition indebtedness” rules contained in Section 514. The IRS ruled that the borrowing of securities by the short seller does not create an indebtedness for federal income tax purposes. Similarly, the cash sale proceeds arising from the short sale are treated as sales proceeds and do not arise from an indebtedness. Hence, the short seller has borrowed securities and engaged in a property transaction and has not created an indebtedness for Federal income tax purposes.
In the case of a lapse of termination of an option, Section 512(b)(5) excludes from UBTI all gains or losses recognized from the lapse or termination of options to buy or sell securities.
In G.C.M. 39620 (Apr. 3, 1987), the IRS ruled that gains and losses from commodity futures contracts are excluded from UBTI under Section 512(b)(5). The IRS held that the obligation of a holder of a long position to pay for the commodity on delivery did not constitute indebtedness because neither the seller for the buyer held the property at the time of entering into the contract. In essence, the purchase of a long futures contract entailed no borrowing of money in the traditional sense.
Interest Rate Swaps
Pursuant to Treas. Reg. § 1.512(b)-1(a)(1), the IRS has held that interest rate swap transactions, known as notional principal contracts, shall not be subject to the UBTI tax rules.
When it comes to determining whether the UBTI tax would apply to a securities lending transaction, it is important to distinguish between a transaction involving the purchase of securities, such as stocks, on margin, versus options and various other lending transactions. The borrowing of cash to purchase stock will be deemed margin and will trigger the tax. Whereas Section 512(b)(5) excludes from UBTI all gains or losses recognized, in connection with the lapse or termination of options to buy or sell securities. This includes transactions involving short sales and commodity futures contracts.