One of the advantages of using retirement funds, such as a 401(k), Solo 401k or an IRA to make investments is that in most cases all income and gains from the investment will flow back to the Solo 401k tax-free. This is because a 401(k) is exempt from tax pursuant to Internal Revenue Code 401 and Section 512 of the Internal Revenue Codes exempt most forms of investment income generated by a 401(k) and a Solo 401k from taxation. Some examples of exempt type of income include interest from loans, dividends, annuities, royalties, most rentals from real estate, and gains/losses from the sale of real estate. The following will teach all about the Solo 401k and UBIT rules.
However, the IRS enacted a set of rules in the 1950s in order to prevent charities and later 401(k) and IRAs from engaging in an active trade or business and, thus, having an unfair advantage because of their tax-exempt status. These rules can be found under Internal Revenue Code Sections 511-514 and have become known as the Unrelated Business Taxable Income rules or UBTI or UBIT. If the Solo 401k UBIT rules are triggered, the income generated from that activities will generally be subject to close to a 40% tax for 2022. Of note, a 401(k) or Solo 401k investing in an active trade or business using a C Corporation will not trigger the UBIT tax.
The Solo 401k and UBIT generally applies 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.”
Related: Solo 401(k) Investments
Solo 401k and UBIT
Trade or Business: In defining “unrelated trade or business,” the regulations start with the concept of “trade or business” as used by Internal Revenue Code Section 162, which allows deductions for expenses paid or incurred “in carrying on any trade or business.”
Regularly Carried On: The UBIT only applies 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. Short-term activities are exempted if comparable commercial activities of private enterprises are usually conducted on a year-round basis.
Before it can be determined whether an activity is seasonal or intermittent, the relevant activity must be identified and quantified, a step that is often troublesome.
Interestingly, unlike an IRA, using non-recourse financing to purchase real estate will not trigger the UBIT/UBTI tax since it will not be treated as Unrelated Debt Financed Income (exception exists for 401(k) qualified retirement plans but not IRAs under Internal Revenue Code Section 514(c)(9).
The type of income that generally could subject a 401(k) or Solo 401k to UBIT is income generated from the following sources:
- Income from the operations of an active trade or business through a passthrough entity (i.e. LLC or partnership). For example, a store, restaurant, manufacturing business, real estate development company.
- Using margin on a stock purchase.