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UBIT Blocker Corporation & Your IRA Investment

UBIT Blocker Corporation & Your IRA Investment

Almost all retirement account investments generating passive income will not be subject to Unrelated Business Taxable Income (UBTI or UBIT) or Unrelated Debt Financed Income (UDFI) Tax The most popular forms of passive income earned by a retirement account that will not be subject to the UBIT tax are capital gains, interest, dividends, rental income, and royalties.

This article will detail the types of Self-Directed IRA investments that could trigger the UBIT tax.  More importantly, it will explore the various ways a Self-Directed IRA or Solo 401(k) plan can minimize or even eliminate the UBIT tax, which has a maximum tax rate of 37%.

Key Points
  • The UBIT tax can apply to certain retirement account investments
  • The tax can go as high as 37%
  • Using a corporation blocker can help reduce or even eliminate this tax

History of the UBIT Rules

A tax-exempt organization, such as a charity or an IRA, that generates unrelated business income from a trade or business, regularly carried on, that is not substantially related to the charitable, educational, or other purpose that is the basis of the organization’s exemption of over $1,000 would be subject to the UBIT tax.  The problem with retirement accounts is that, unlike a charity, an IRA does not have an exempt purpose.  An IRA’s sole purpose is to accumulate wealth for the IRA owner.  The problem with the UBIT rules is that they are deemed to apply to all tax-exempt organizations under Internal Revenue Code (IRC) Section 501, which includes retirement accounts.  Hence, since IRAs were created by ERISA 1974, the UBIT rules automatically apply to IRAs even though that was likely not the intent.

The intent of the UBIT rules when enacted was to stop for-profit businesses, such as McDonald’s, to open a charity and run their business through the charity and escape taxes.  Thus, Congress imposed the UBIT rules which taxed tax-exempt organizations that generated unrelated business income.  Unfortunately, since retirement accounts are treated as a tax-exempt entity, they became subject to the UBIT tax rules.

What IRA Income is Subject to UBIT?

In general, when it comes to using an IRA or 401(k) plan to make investments, most are exempt from federal income tax. However, in several instances, the UBIT tax could be triggered and turn a tax-exempt investment into a taxable investment.  In general, the UBIT tax is triggered in four types of investment categories involving retirement accounts:

  1.  Using a margin loan to buy an asset, such as stocks or securities
  2. Using a nonrecourse loan to buy real estate (there is an exemption for 401(k) plans under certain conditions)
  3. Investing in an active trade or business operated through an LLC or pass-through entity, such as a partnership.
  4. Investing in an investment fund that is a pass-through entity that uses leverage or invests in portfolio active businesses via a flow through entity, such as an LLC.

In the case of a loan used by an IRA to buy an asset or real estate, IRC Section 4975(c) requires that the loan be nonrecourse.  A nonrecourse loan is a loan not personally guaranteed by the borrower.

UBIT Tax Rate

For 2024, the maximum UBIT tax rate is 37%. It follows the trust tax rates and reaches the rate at a very low-income threshold (approximately ($15,000).  The UBIT tax is only generated if the investment generates at least $1,000 of attributable UBIT income.

The federal government taxes trust income at four levels:

  • 10%: $0 – $2,900
  • 24%: $2,901 – $10,550
  • 35%: $10,551 – $14,450
  • 37%: $14,451 and higher

Why Have I Never Heard of the UBIT Tax?

The majority of retirement account investments involve publicly traded securities, such as stocks, mutual funds, ETFs, or bonds.  Almost all publicly traded companies are structured as a C Corporation and, thus, are not treated as a pass-through entity.  A C corporation is an entity that has two layers of taxation, an entity level and a shareholder level.  Because a C corporation has an entity level tax, there is no reason to impose another layer of tax on corporation income.

Whereas, an LLC is taxed as a pass-through entity and, thus, has only one layer of tax at the owner level.  In other words, an LLC does not have an entity level of tax.  Therefore, if a business is structured as an LLC owned by a retirement account, the LLC would not be subject to any federal income tax at the LLC level, only the owner would.  However, since the owner of the LLC is an IRA, which is tax-exempt, the UBIT tax would apply to impose a tax on the LLC business income. Whereas, if the business was structured as a C corporation, the C corporation would block the application of the UBIT tax rules and no tax would apply to the C Corporation.

Domestic C Corporation Blocker

The prime way self-directed retirement investors have tried to limit the reach of the UBIT tax is by using a strategy known as a “C Corporation Blocker.”  The strategy comprises of a retirement account holder establishing a C Corporation and then investing the retirement funds into the C Corporation before the funds are ultimately invested into the planned investment.

For example, if a retirement account investor is seeking to invest into an active business operated through an LLC, such as a bakery, he or she can establish a C Corporation, invest the IRA funds through the C Corporation, and then have the C Corporation invest the funds into the bakery LLC.  The “C Corporation Blocker” strategy will not eliminate all the UBIT tax because the business income would be subject to corporate tax, which is 21% in 2023.  However, the 21% corporate tax rate is less than the 37% maximum UBIT tax rate. Because the UBIT tax rates follow the trust tax rates and have such a low-income threshold, even a few thousand dollars of UBIT tax can trigger a tax above the 21% corporate tax rate.  Therefore, the domestic C Corporation Blocker strategy is a popular option for a Self-Directed IRA investor seeking to limit the application of the UBIT tax.

In sum, a domestic C corporation blocker will shield Self-Directed IRA and 401(k) investors from directly incurring UBIT in respect of operating partnerships or funds using leverage as well as shield non-U.S. persons from directly incurring U.S. effectively connected income and, thus, limiting U.S. tax filing requirements.

U.S. Withholding Tax Regime

Under U.S. tax laws, a foreign person generally is subject to 30% U.S. tax on the gross amount of certain U.S.-source income. All persons, including funds or businesses (‘withholding agents’) making U.S.-source fixed, determinable, annual, or periodical (FDAP) payments to foreign persons generally must report and withhold 30% of the gross U.S.-source FDAP payments, such as dividends, interest, royalties, etc.

Withholding agents are permitted to withhold at a lower rate if the beneficial owner properly certifies their eligibility for a lower rate either based on the operation of the U.S. tax code or based on a tax treaty. Information reporting of the US-source payments is always required even if no withholding applies.  Whereas, with certain exceptions, capital gains income is not usually taxable to a foreign person. The United States has entered into various bilateral income tax treaties to avoid double taxation

Foreign Corporation Blocker

For tax-exempts that wish to invest in investments involving investment funds that will use leverage or an active business operated via an LLC, the use of a foreign blocker corporation strategy could have a major tax benefit.  The most common foreign jurisdictions for a foreign blocker strategy are tax-exempts counties, such as the Cayman Islands and the British Virgin Islands.

In general, when a foreign entity invests in a U.S. operating and there is no treaty that applies, a 30% withholding tax would generally apply.  There are certain exceptions, such as interest under the portfolio interest exception, and capital gains.  Whereas dividends and rental income that comes from a U.S. investment fund or U.S. business would be subject to a 30% withholding tax.

The United States is very aggressive in taxing any income of a foreign person that is connected to the country.  This is especially true for real estate.  Foreign corporations are also taxed on gains from the sale of real estate situated in the U.S. under FIRPTA. The Foreign Investment in Real Property Tax Act of 1980 is designed to ensure that a foreign investor is taxed on the sale of a U.S. real property interest, which includes an interest in U.S. realty and an interest in a U.S. corporation that was a U.S. real property holding corporation at any time during the five-year period before the disposition.

In addition, IRC Section 884 imposes a 30 percent “branch profits tax” on any earnings received from a U.S. trade or business carried on by the foreign corporation or through a U.S. branch of the foreign corporation. The branch profits tax can apply to the gains received from the sale of U.S. real estate.  The branch profits tax can potentially be avoided if the foreign corporation liquidates its U.S. property holdings prior to transferring proceeds offshore.

In the case of a real estate fund, which will typically generate rental income or capital gain returns, the use of a foreign blocker could have mixed results.  In the case of a sale of U.S. real estate which triggers a capital gains tax, the FIRPTA could apply and impose a withholding tax on the sale of the real estate as well as the rental income could be subject to a withholding tax.  Whereas, in the case of a hedge fund or private equity fund with no real estate holdings, a foreign blocker would provide a greater tax benefit as it could limit withholding tax on any capital gains tax

Leveraged Blocker Solution

The “Leveraged Blocker” is a Delaware (or other US) corporation that is capitalized with a mix of loans and equity from its investors. The goal of this structure is to reduce the effective rate of U.S. tax on retirement accounts and non-U.S. investors on their investment as well as shield non-U.S. persons from the U.S.-tax filing requirement that FIRPTA imposes.  For IRA or 401(k) real estate investors, only  the Leveraged Blocker solution or the high-yield leverage structures can potentially reduce their U.S. tax obligation significantly, while also eliminating the U.S. tax return filing requirement.

The main issue with using a Leveraged Blocker is that it needs to be customized and could be expensive to implement.  The following is a short example of how the structure would work for Self-Directed IRA, 401(k), or foreign investors. Keep in mind, the two main purposes behind using a blocker is for a retirement account to reduce the UBIT tax and to limit filing requirements.

  • Non-U.S. investors or retirement accounts invest in a BVI or Cayman entity
  • The foreign entity then invests in a Delaware Corporation blocking the FIRPTA tax and U.S. tax filing requirements for the investors
  • Non-U.S and retirement account. investors capitalize blocker with debt and equity — a 4:1 ratio is common
  • Interest repayment on debt reduces net taxable income of blocker. For example, 80% of the capital is lent at a 12% interest rate and utilizes the portfolio interest exception to reduce tax to zero on the interest received.  Any return over the 12% return would be subject to a withholding tax.

In sum, the primary goal of the Leveraged Blocker is to take advantage of the portfolio interest exception so that the interest deduction associated with a leveraged investment that the Leveraged Blocker will reduce the amount of the Leveraged Blocker’s income that is subject to U.S. tax on dividends. 

High Yield Leverage Investment

The UBIT rules will not apply to leveraged transactions.  For example, if a Self-Directed IRA lends money to a U.S. fund or active business, the interest received would not be subject to UBIT.  However, the loan must be a real loan and cannot be deemed equity. For example, the instrument cannot be economically equivalent to an equity investment, so some (generally significant) upside will not be retained by the non-U.S. investors or a retirement account.  The downside to using a high yield leverage structure versus an equity investment is that the return on the debt is fixed whereas the equity investment could potentially have a greater upside.

The FIRPTA rules do not apply to interests in U.S. real estate that constitute “debt investments.” Real debt for this purpose means in general that

(i) the debt is not convertible into an equity interest in the underlying property,

(ii) the interest rate on the debt is not tied to the performance of the underlying property, and

(iii) the upside is capped.

Hence, if an IRA or 401k) investor structures a real estate investment as debt versus equity, they would be able to escape the reach of the UBIT and FIRPTA tax.


It is a real shame that the UBIT rules apply to IRAs and 401(k) plans.  Based on the history of the UBIT rules, it does appear that retirement accounts were not intended to be the targets for the UBIT tax regime.  Nevertheless, Self-Directed IRA and 401(k) investors are stuck with trying to navigate the reach of the tax.

For real estate investors seeking to limit the application of the UBIT tax, a foreign blocker would seem to have minimum value.  Whereas, a leveraged blocker solution or high yield loan structure would seem to be more tax efficient.

For non-real estate investments, such as hedge funds or venture capital funds, a foreign blocker could help block the UBIT tax and could eliminate any tax on capital gains.  Although, any dividends or other passive income could be subject to a withholding tax, which could go as high as 30% for entities established in counties with no tax treaties with the U.S., such as Cayman.  Hence, it is important to work with your tax advisor and the fund manager to understand the tax implications, and potential workarounds, for an IRA or 401(k) investment involving UBIT.


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