The majority of investments you make with a Solo 401(k) plan will not be subject to tax. This is the beauty of investing in a tax-advantaged retirement plan: tax is either deferred in a pretax plan or eliminated with a Roth plan. However, some transactions made with a retirement plan are subject to a lesser-known tax called UBIT – Unrelated Business Taxable Income. Generally, investments that generate passive income will not be subject to the UBIT tax. Examples of exempt type of income include:
- Interest from loans
- Most rentals from real estate
- Gains/losses from the sale of real estate
- UBTI is a four-letter word you should know
- Although Solo 401(k) plans are tax-advantaged, there are some ways an investment may trigger a tax
- Be mindful of the UBTI rules to make sure an investment is in your best interest
Here, we’ll talk about the Solo 401(k) UBTI rules and how they come into play.
Internal Revenue Code 512(b)(5)(A)
When an exempt organization such as a 401(k) plan undertakes any development activities in connection with selling real estate that goes beyond passively placing the property for sale (directly or through a broker) the issue arises under Internal Revenue Code 512(b)(5)(A) whether the real estate is “property held primarily for sale to customers on the ordinary course of the trade or business.”
An organization that engages in the sale of property to customers in the ordinary course of the trade or business is characterized as acting as a “dealer.”
Fundamental to considering whether an exempt organization (i.e., a 401k Plan) is a “dealer” of real property is whether the property itself is held “primarily” for resale to customers in the ordinary course of a trade or business.
In Malat v. Riddell, 393 U.S. 569 (1966), the U.S. Supreme Court interpreted the meaning of the phrase “held primarily for sale to customers in the ordinary course of trade or business” under Internal Revenue Code Section 1221(1). The IRS has often applied the principles derived under Internal Revenue Code Section 1221 to rulings interpreting the language of Internal Revenue Code Section 512(b)(5). The Court interpreted the word “primarily” to mean “of first importance” or “principally.”
By this standard, ordinary income would not result unless a sales purpose is dominant. Both the courts and the IRS concluded that a taxpayer may make “reasonable expenditures and efforts” (such as subdividing land, construction of streets, the provision of drainage, and furnishing of access to such a necessity as water, as part of the “liquidation” of an investment asset without being treated as engaged in a trade or business.
Related: UBTI Tax Rate
When the UBTI Tax Applies
The UBTI tax for a Solo 401(k) 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.”
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.” Although Internal Revenue Code Section 162 is a natural starting point, the case law under that provision does little to clarify the issues.
Because expenses incurred by individuals in profit-oriented activities not amounting to a trade or business are deductible under Internal Revenue Code Section 212 , 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 UBTI tax for a Solo 401(k) only applies to income of an unrelated trade or business that is “regularly carried on” by an organization (Solo 401k Plan investment). 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 thus is 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 exempted if comparable commercial activities of private enterprises are usually conducted on a year-round basis (e.g., a sandwich stand operated by an exempt organization at a state fair), but a seasonal activity is considered regularly carried on if its commercial counterparts also operate seasonally (e.g., a horse racing track). Intermittent activities are similarly compared with their commercial rivals and are ordinarily exempt if conducted without the promotional efforts typical of commercial endeavors.
Moreover, if an enterprise is conducted primarily for beneficiaries of an organization’s exempt activities (e.g., a student bookstore), casual sales to outsiders are ordinarily not a “regular” trade or business.
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. The type of income that generally could subject a Solo 401(k) Plan to UBTI is income generated from the following sources:
- Business income generated via a pass-through entity, such as an LLC or partnership
- Income earned from a convenient store operated through a pass-through entity
- Income earned through an active business owned by an LLC in which the IRA is an investor
- Income from a real estate investment held through a pass-through entity that is treated as a business (inventory) instead of as an investment
Examples could include:
In Brown v. Comr, 143 F.2d 468 (5th Cir. 1944)
The exempt taxpayer owned 500 acres of unimproved land used for grazing purposes within its tax-exempt mission. Taxpayer decided to sell the land and listed it with a real estate broker. The exempt organization instructed the broker to subdivide the land into lots and develop it for sale. The broker had the land plotted and laid into subdivisions with several lots. Streets were cleared, graded and shelled; storm sewers were put in at street intersections; gas and electric lines were constructed; and a water well was dug. Each year 20 to 30 properties were sold. The court held that the taxpayer was holding lots for sale to customers in the regular course of business. The court identified the sole question for its determination as whether the taxpayer was in the business of subdividing real estate. The fact that the taxpayer did not buy additional land did not prevent the court from finding that the sales activities resulted in an active trade or business.
Farley v. Comr., 7 T.C. 198 (1946)
The taxpayer sold 25 lots out of a tract of land previously used in his nursery business but now more desirable as residential property. Because the taxpayer made no active efforts to sell and did not develop the property, the court described the sale as “in the nature of the gradual and passive liquidation of an asset.” Therefore, the income derived from the sales represented capital gains income, rather than ordinary income from the regular course of business as in the Brown case.
Additional Cases of Regularly Carried on Business
Dispositions of several thousand acres of land by a school over a period of twenty-five years does not constitute sale of land held primarily for sale to customers in the ordinary course of business and thus gains are excludable under Internal Revenue Code Section 512(b)(5) (Priv. Ltr. Rul. 9619069 (Feb. 13, 1996)).
Developing or subdividing land and selling a large number of homes or tracts of land from that development in a given period.
Buying a property/home rehabbing it and then selling it immediately thereafter when this was your sole intent (note: The activity must manifest a frequency and continuity, and are pursued in a manner generally similar to comparable commercial activities of nonexempt organizations). It is unclear whether the purchase and sale of one or two homes in a given year that were held for investment purposes would trigger UBTI.