IRA Unrelated Business Taxable Income Rules
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 (individual retirement account) is exempt from tax pursuant to Internal Revenue Code 408 and Section 512. However, you should be aware of the UBTI rules.
The Internal Revenue Codes exempt most forms of investment income an IRA generates from taxation. Some examples of exempt income include:
- Interest from loans
- Most rentals from real estate
- Gains/losses from the sale of real estate
However, the IRS set forth rules in the 1950s to prevent charities, and later IRAs, from engaging in an active trade or business. Charities and IRAs had an unfair advantage due to their tax-exempt status.
IRA investors can find the UBIT rules under Internal Revenue Code Sections 511-514. These rules are classified as the Unrelated Business Taxable Income rules.
If you trigger the UBIT rules, the income you generate from activities will generally be subject to close to a 40% tax for 2019. Note – an IRA investing in an active trade or business using a C Corporation will not trigger the UBIT tax.
UBTI Rules (Unrelated Business Taxable Income Rules)
UBIT rules generally apply 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” by Internal Revenue Code Section 162. This 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. Expenses that individuals incur in profit-oriented activities not amounting to a trade or business are deductible under Internal Revenue Code Section 212. Therefore, 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 rules in connection with an IRA only apply 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 is then 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 exempt if comparable commercial activities of private enterprises are usually conducted on a year-round basis. For example, a sandwich stand that an exempt organization operates at a state fair would be exempt.
However, a seasonal activity is regularly carried on if its commercial counterparts also operate seasonally. For example, a horse racing track.
Intermittent activities are similarly compared with their commercial rivals and are ordinarily exempt if they don’t have promotional efforts typical of commercial endeavors.
Moreover, if an enterprise is conducted primarily for beneficiaries of an organization’s exempt activities (i.e., a student bookstore), casual sales to outsiders are ordinarily not a “regular” trade or business.
Before determining 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 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 non-recourse loan to purchase a property
- Using margin on a stock purchase
Contact IRA Financial
Do you still have questions regarding UBTI/UBIT rules in an IRA that were not covered in this article? We can answer your questions directly at 800-472-0646. You can also fill out the form to speak with a certified IRA specialist to answer any questions regarding UBIT and your individual retirement account. We’re happy to help.