In this episode of Adam Talks, IRA Financial’s Adam Bergman Esq. discusses the Unrelated Business Taxable Income tax rules and how you can avoid them with your Self-Directed IRA or Solo 401(k) plan.
How Do You Avoid Unrelated Business Income Taxes?
Hey everyone, Adam Bergman here, tax attorney and founder of IRA Financial. On today’s Adam Talks going to be talking about, based off a request from a special client who said Adam can’t you do one Adam Talks on UBIT. It drives me crazy. It’s such a complicated area. I know you’ve done blogs and you’ve done some other podcasts, but I listen to Adam Talks every week. Do you mind just doing one on how people who have Self-Directed IRAs can avoid this four letter ugly word, UBIT. So I said, of course, your wish is my command. So on today’s episode, how you can avoid the unrelated business income tax if you are an IRA or 401(k) investor.
So, this is going to be somewhat technical, but I will keep it fun and simple. At least I’ll do the best I can so that everyone comes away from this podcast totally understanding how the unrelated business income tax works.
So, let me start at the beginning. Let’s go all the way back into about the 1950s and when the unrelated business income tax rules were coded and became law; and just when you’re thinking about the unrelated business income taxes, the history is a good way of understanding it. So, what was the point of these rules? The point of these rules is that Congress did not want companies, like McDonald’s, to set up charities and just run their business through a charity and never, ever pay tax. So they set these rules up to say, hey, if you’re a tax exempt charity, 501, and you have income that’s unrelated to your exempt purpose, i.e. you are a hospital and you sell donuts, or you are a school and you sell, I don’t know, T shirts, that income could be unrelated to your exempt purpose and therefore, we should tax it because that would be the only way we could stop companies from setting up charities running their business through charities and never, ever paying federal income tax.
So that’s what those rules essentially are intended to do. And they could be found under a section 512, 513 and 514 of the Internal Revenue Code. And essentially, that is the heart of the provision. Okay? It is there to stop tax exempts, like charities, from generating unrelated activity and not paying tax on it. So, the unrelated income tax follows the trust tax rates, which have the highest maximum tax rate of 37%. But the threshold for getting to 37% is quite low.
So, once you’re approximately $20,000 or so of net income, you’re going to hit the max rate, which is a very low threshold considering if you are an income taxpayer, you’re not going to hit that rate until you’re making almost $500,000 or so. So, a very, very low threshold.
So, what are the types of income that are exempt from UBIT? It’s basically all the passive forms of income, like dividends, interest, royalties, rental income and capital gains. So that’s why most investors, most retirement account investors never have to deal with UBIT, because let’s say 90% to 95% of retirement accounts are invested in equities, whether it’s mutual funds, ETFs or stocks.
So, almost all publicly traded companies are C corporations. So think of a C Corp as a big box, right? It has a corporate level tax, and then there’s a shareholder level tax. There are two levels of taxes. So the UBIT tax does not need to apply to the corporate level, because there’s already a corporate level tax. So there’s no need to impose the UBIT tax on a C Corp. So that’s why you and me, before we got into the self-directed retirement world, never heard of UBIT.
If you go and talk to sophisticated investors that are in the financial world, they probably have never heard of UBIT or UBTI or unrelated business income tax because it really doesn’t apply if you’re just doing traditional investments. And when I mean traditional investments, I mean stocks, mutual funds, ETFs, okay?
So, how does it get triggered? So, number one, you need to be tax exempt. So we know charities are tax exempt under 501. We also know, or we should know, that IRAs and 401(k)s are also treated as tax exempt trust under 501. Now, they have different intentions than a charity, right? Their exempt purpose is different than a charity. An IRA is different than the Red Cross, but they’re taxed the same. They’re both tax exempt.
Now, the rules pertaining to IRAs can be found in Section 408, and the rules pertaining to 401(K)s can be found in Section 401. But, from a tax foundation standpoint, they’re both treated as tax exempt, just like a charity. Therefore, when IRAs and 401(k)S were created in 1974 by ERISA, they, just by becoming tax exempt and being treated as tax exempt, trust under 501, are now subject, or became subject, to the unrelated business income tax.
The only difference is IRAs and 401(k)s do not have an exempt purpose, right? Whatever the IRA does, its intention is to grow and generate income or gains. Whereas a charity, like the Red Cross, has an exempt purpose. So, that means that essentially anything the IRA does could be deemed unrelated to its exempt purpose. Or on the flip side, some people would argue that nothing should be deemed unrelated to its exempt purpose because its purpose is to make money. So, it shouldn’t be even tied into these UBIT rules. I kind of agree with the latter. I really don’t think IRAs and 401(k)s should be subject to UBIT and we’ll get into some of the purposes of UBIT and how it gets triggered. So that’s something if I was able to wave a magic wand or had some power in Congress or was on the Ways and Means Committee, I would push for IRAs and 401(k)s not be subject to UBIT because they don’t have an exempt purpose. It’s not like a charity, like the Red Cross.
So, the only exempt purpose the IRA has is to make money. So, it should be given the flexibility to make investments in the widest range possible in order to maximize its returns. But, we’re stuck with the UBIT rule.
So, let’s start with IRA and 401(k) investors. How does UBIT get triggered? Three ways: use margin to buy stock, two, non-recourse loan to buy real estate (there is an exemption for 401(k)s under 514(c)(9)), and thirdly, if an IRA or 401(k) invests in an active trad or business that operates through a pass-through entity, like an LLC.
Remember I said C Corps have their own entry level tax, so there’s no reason to impose the UBIT tax at the corporate level because there’s already a corporate level tax. However, LLCs are flow-throughs. They don’t have an entity level tax. There’s only one level of tax with an LLC. It’s the member level or the shareholder level.
So, by that purpose, there is seemingly a need to impose a tax at the entity level, and that’s where the UBIT tax pops up. So, again, just to summarize, only three ways UBIT gets triggered: margin to buy by stock, nonrecourse loan to buy real estate in an IRA (there’s an exemption for 401(k)s). I mentioned nonrecourse because Internal Revenue Code Section 4975 does not allow you to personally guarantee an obligation of your IRA. That’s deemed a prohibited transaction. That’s why the loan must be nonrecourse. And then thirdly, invest in an active trad or business, a restaurant or a hotel, that operates through a pass-through entity, like an LLC, partnership, not a C Corp. Remember, C Corp will block UBIT and the UBIT tax will not apply to C Corp.
So, how do you get around UBIT? Right? That’s the whole point of this podcast. Probably like Adam, get to the point already. I’ve already listened to you for a couple of minutes. How do I get around this thing? So a couple of ways.
Number one, set up a C Corp. Right? We know C Corps are not subject to UBIT, so if you want to invest in an active business, like a restaurant, or you’re going to invest in an investment fund or enterprise that has leverage, you can always set up a C Corp. Now, sounds easy, sounds great. What’s the downside? Tax!
Corporations now pay 22% maximum tax rate; it certainly could go up. The Democrats tried to increase it in the past. Biden administration is still keen on increasing corporate tax. Even Senator Manchin has said he would be okay with that, so it’s possible corporate level tax can go up, even in light of a potential economic downturn and inflation, it’s still possible. So, 22% is still 22%. It’s still 22% more than you would pay if you just bought stocks or you invested in a transaction without UBIT. So, the C Corp is the most common way to block UBIT.
A lot of large pension funds or a lot of large investment funds that want IRA investors, accredited investors, IRA investors to invest, will set up either a foreign blocker, so they’ll have you go into a Cayman Corporation. Some will set up a US blocker, but it’s more common to set up a foreign blocker. Why? Because Cayman Islands has no corporate level tax and IRAs don’t pay tax. So, generally your IRA needs to be an accredited investor in order to do various private placement or investment fund investments.
Who’s an accredit investor? It’s an individual that makes more than $300,000 if they’re married, filed jointly for consecutive years, or has a net worth above a million dollars, not including primary residence. So, if you are deemed an accredited investor, and you want to invest in a big hedge fund, private equity fund, venture capital fund, who will have UBIT, or will trigger UBIT. Why? Because either they’re going to use leverage, right? Every hedge fund in the world uses leverage. A lot of private equity funds use leverage, and a lot of private equity and venture capital firms will invest in portfolio companies that may be LLCs. So, in that case, it could trigger the UBIT. Plus, they’ll also probably use debt as well, at least private equity firms.
So, you would invest through a foreign blocker like a Cayman Corp and then the Cayman Corp would invest in the US fund. So, that’s one way of getting around UBIT. There’s potential some issues with holding taxes from the US Corp to the Cayman Corp, but that’s a topic for another podcast. But, generally the blocker is the most common; I’ve had clients do it in the US where they’re buying real estate with leverage or they’re going to invest in a US business, and they say, well, 22% is less than 37%. It’s not ideal. I’d rather pay zero, but 22% is still better than 37%. Therefore, I will set up a C Corp. On top of that, some states do impose a state level corporate tax. You have to keep that in mind, as well.
Number two, how else can you get around UBIT? You can structure investment as in debt versus equity investment. So what’s a debt investment? Debt investment is a loan. So, if you lend company X money and they give you a stated rate of return plus principle interest, as I mentioned, is not subject to UBIT. So, if you are a lender and you lend money to a borrower, the interest and principle you receive back as part of the loan, is not subject to UBIT. What’s the downside? The downside is you are only able to receive, and generate the interest on the note. That is your maximum upside. Whereas, if you invested in a startup or a business, things got really good and valuations got goofy and wacky, like they have been in the last two years, you may have been able to make 10, 15, 50, even 500%. Whereas with a loan, you’re capped at the interest rate.
So, some people don’t really want to structure their investments. Some IRA investors are not keen on structuring the investment as debt versus equity because they are not going to be able to capitalize on the upside of the investment. So, that generally is not really an interesting option for them.
What else can you do? Well, if you’re a real estate investor and you want to use leverage by real estate, you could set up a 401(k). Now who can set up a 401(k)? Assuming you have no employees, you have to satisfy two eligibility requirements under the 401(k) rules. Number one, you got to be a business, so that’s not going to be that hard to say I’m in the real estate business. Number two, you need to have no full-time employees, other than the owners or their spouses. And a full-time employee is someone who works more than 1000 hours, non-owner, non-spouse. So, if you have any business, you can sell widgets, you can provide services, anything, just has to have some anticipation of revenue; the intent needs to be to generate some type of income, you don’t have to have a billion dollar business. In fact, you don’t even have to have any income. It just needs to be the anticipation or the intent to derive income or gains from the business activity.
If you can satisfy those requirements, you can therefore set up a Solo 401(k) plan, roll your IRA funds tax-free into the 401(k). The 401(k) could buy the real estate and you can use leverage (it has to be a nonrecourse loan), but you’re not going to trigger UBIT. So, for real estate investors, the 401(k) is certainly the ideal structure and certainly more, I would say, definitely more, tax advantageous than the IRA, especially if you’re using leverage. Now, the 401(k) is not going to help you block UBIT if you’re investing in an active business or a fund that is not buying real estate, because the exemption under 514(c)(9) for leverage in a 401(k) only applies to real estate acquisition indebtedness. It doesn’t apply to just leverage to buy stocks or other types of trading solutions or trading activity. So, it’s really just for real estate acquisition indebtedness. So, just be cautious of that.
But UBIT’s tough. I can’t tell you how many times I speak to people who’ve used other companies and said, Adam, I saw one of your videos or I read one of your blogs, saw a podcast, listened to a podcast, and I just did this real estate deal four years ago, three years ago, and Holy cow, I never even knew about UBIT. I never filed the 990-T, which is the form that needs to be filed to report the UBIT. In fact, I had no idea there was even leverage. So, this is generally how I address those questions.
Number one, I said, well, if you didn’t know about it, the IRS is not going to know about it. So, you’re probably okay in terms of statute of limitations, which is generally three years. How is UBIT reported if you’re an investor, if you’re an IRA investor or 401(k) investor in a fund or a private placement, in a pass-through entity, how is it reported? It’s generally reported on a K-1. There’s a specific code for UBIT, which, if the code is not on the form, and there’s no number that is represented by that code, which is, I believe, V, then you’re not going to know, right? How are you supposed to know there’s leverage, right? If the fund manager is not reporting to you, how are you going to know? And then how is the IRS going to know if it’s not on the K-1? So, in many, many cases, it goes unreported because the IRA investor’s not even aware that UBIT exist.
But, if it’s just you, if your 401(k) or IRA bought the home, let’s say your IRA bought the home, borrowed $100k, nonrecourse from a bank, you can’t argue, you can’t use the excuse I didn’t know about it, there was no K-1 because you’re the manager of the LLC, or at least the trustee of the plan or the IRA owner. So in that case, again, it’s something that you should report if there’s more than $1,000 in net income. So, this is the rule for 990-T: if you have less than $1,000 in net income, including expenses, depreciation, you don’t have to report the UBIT. If it’s more than $1,000, you have to report it on a 99o-T. Now, the good news is you can take into account your pro rata share depreciation deductions, and other expenses. On top of that, if you have losses from prior years, you can carry them forward and use them to offset gains.
UBIT sounds horrible., And in some cases it is, but in other cases, it’s actually minimized. And how’s that? Well, it’s minimized because for a lot of real estate investors, the way real estate generally materializes is there are lots of losses upfront because there’s lots of depreciation, lots of deductions, lots of expenses, whether it’s improvements, build-outs, whatever it is, there’s lots of losses upfront. So, there’s generally not net income. So, if there’s no net income of over $1,000, there’s no UBIT. Plus, you can use those losses to offset any future UBIT. The only problem is if there’s a loan is still outstanding within twelve months of the sale, a capital gain sale of that real estate could still trigger UBIT. That is the wrinkle that you need to think about. So, you may be able to, on an annual basis, really minimize or reduce UBIT because of the net losses or the low net income, but if you want to sell that building and a loan is still outstanding, the UBIT could be triggered by on a capital gains transaction. Now, this could be removed if you have it in a 401(k). But if it’s an IRA, it’s not.
Now, that’s only with leverage. If it’s an active trade or business again, a lot of startups, even some private equity funds, there’s no distributions until there’s a capital event. So, if there’s no leverage. So, let’s say you’re investing in a startup. There’s no leverage. There’s losses, losses, losses. And then in year five, someone comes out and buys the company, the sale of the membership units is capital gains, and it’s not subject to UBIT because there’s no leverage in the business. But, if there was leverage, then even if there’s a capital gain, it still could be subject to UBIT.
So there is some complications when you’re investing in pass-through businesses. If they don’t have leverage, you may be able to skirt the UBIT taxes on a capital gains sale. If there’s leverage in the business, maybe not. This is why it’s so important to work with a company like IRA Financial, that has the expertise that can help you navigate these rules. Listen, sometimes it may be better off not to do the investment in the IRA, right? You may be able to do it with personal funds and actually be in a better tax position because of UBIT. UBIT could impose a 37% tax on income that potentially could be tax deferred or tax-free if it was invested in another type of investment. So, it’s better to know this upfront.
That’s why I’m happy I’m doing this podcast. I’ve talked a lot about UBIT; in the eight books I’ve written, I probably mentioned UBIT in every book. Same with blogs and podcasts. I don’t love kind of confusing people upfront, but it’s important that people have information at hand before they engage in an investment so they can make a wise decision, because once the investment is done, it’s much harder to back out of it than restructure once you’re planning on doing it before the transactions actually materialize. Whether it’s using a blocker, whether it’s debt, whether it’s structuring it differently, whether it’s maybe getting into a Solo (k) versus an IRA, if there’s leverage, or maybe it’s just decided not to do it and do that investment with personal funds and then taking your IRA and doing other things with it. So, it’s better, as I mentioned, to plan ahead. That’s something my wife always tells me, be patient. Take your time, plan, think about it, and then execute.
So, hopefully, if you take away anything from this, take away that; that if you’re doing an investment, obviously you need to do your research, do your diligence, make sure you’re comfortable with it. Also, if it’s going to be leverage or there’s an investment in the pass-though business, you should be thinking UBIT/UBTI in your head. Now, a lot of people say, well, what’s UDFI? ,So unrelated debt financed income is Section 514, which is the real estate acquisition. That just means it triggers the UBIT tax. So unrelated debt financed income is just income that is triggered by the UBIT tax. It’s really all the same thing. Some people get caught up in the acronyms and the different definitions of unrelated business taxable income; unrelated debt finance income.
Just know this: if you use margin to buy stock, nonrecourse loan by real estate in an IRA, or you invest in an active trad or business that operates through a pass-through entity, like an LLC, partnership, then you could be subject to UBIT on income over $1,000.
What about S Corps? S Corps are pass through? The problem with S Corps is an IRA cannot invest in an S Corp. That’s not an IRA rule. That is an S Corp rule. Only individuals can be shareholders. A 401(k) could technically be shareholder, a single member LLC could technically be a shareholder, but not an IRA. So, that’s why IRAs don’t invest in S Corps. If they do, they’ll blow the “S” election and the S Corp will then become a C Corp.]
So, that’s it. I hope I didn’t scare people away from doing self-directed investments. Again, this only pops up in very specific investments. But again, full disclosure, it’s better to know upfront and then you can plan. Give us a call if you have questions. If you’re a client of IRA financial, then definitely use our compliance department. We are here to help.
If you are thinking of doing an IRA, let us know. We’d love to talk you through the UBIT rules and we’ll be honest, if it doesn’t work out; if the investment just doesn’t make sense using retirement account, we’re going to tell you that. I’m going to say, you know what, 37% tax is a killer – don’t do it. Just use personal funds or we may have ways to minimize it based on our experience and based off the facts of your transaction.
So there you go. That is the unrelated business income tax rules and now you know. So, thanks for listening. If you’re watching on YouTube, thank you. And other than that, check us out again next week. This is a weekly podcast. It drops every Wednesday. If you have questions, comments or criticisms of the podcast, let me know. You can email at [email protected], hit us up on social media at IRA Financial.
Otherwise, have a great day and talk to everyone again soon. Take care.