Like an IRA, the tax advantage of a Solo 401K Plan is that income is tax-free until distributed. In general, an exempt organization is not taxed on its income from an activity that is substantially related to the charitable, educational, or other purpose that is the basis for the organization’s exemption. Such income is exempt even if the activity is a trade or business. However, to prevent tax-exempt entities from competing unfairly with taxable entities, tax-exempt entities are subject to unrelated business taxable income (UBTI) when their income is derived from any trade or business that is unrelated to its tax-exempt status.
What is Unrelated Business Taxable Income?
UBTI is defined as “gross income derived by any organization from any unrelated trade or business regularly carried on by it” reduced by deductions directly connected with the business. The UBTI rules only apply to exempt organizations such as charities, IRAs, and 401(k) Plans. Congress enacted the UBTI rules in the 1950s in order to prevent charities from competing with for-profit businesses since charities do not pay tax giving them an unfair advantage over for- profit businesses. With the enactment of ERISA in 1974, IRAs and 401(k), who are considered tax-exempt parties pursuant to Internal Revenue Code Sections 408 and 401 respectively, became subject to the UBTI rules. As a result, if an IRA or 401(k) invests in an active business through an LLC or partnership, the income generated by the IRA or 401(k) from the active business investment will be subject to the UBTI rules. In other words, a 401(k) Plan that is a limited partner, member of a LLC, or member of another non-corporate entity will have attributed to it the UBTI of the enterprise as if it were the direct recipient of its share of the entity’s income which would be UBTI had it carried on the business of the entity. For example, if a Solo 401(k) Plan invests in an LLC that operates an active business such as a restaurant or gas station, the income or gains generated from the investment will generally be subject to the UBTI tax. However, if the Solo 401(k) Plan invested in an active business through a C corporation, there would be no UBTI since the C Corporation acts as a blocker blocking the income from flowing through to the Solo 401(k) Plan. This is why you can invest IRA and 401(k) funds into a public company, such as IBM without triggering the UBTI tax. Remember that if an IRA or 401(k) Plan makes a passive investment, such as rental income, dividends, and royalties, such income would not be subject to the UBTI rules.
UDFI and The Solo 401(k) Plan
However, unlike a Self-Directed IRA LLC, in the case of a Solo 401(k) Plan, UBTI does not apply to unrelated debt-financed income (UDFI). The UDFI rules apply when a 401(k) Plan uses leverage to acquire property such as real estate. Pursuant to Internal Revenue Code Section 514(c)(9), a 401(k) Qualified Plan is not subject to the UDFI rules and, thus, the UBTI tax if non-recourse leverage is used to acquire property such as real estate. With the UBTI tax rates at approximately 40% for 2017, the Solo 401(k) Plan offers real estate investors looking to use non-recourse leverage in a transaction with a tax efficient solution.
Exceptions to the UBTI Rules
There are some important exceptions from UBTI: those exclusions generally exclude the majority of income generating investment activities from the UBTI rules – dividends, interest, annuities, royalties, most rentals from real estate, and gains/losses from the sale of real estate.
What is an Unrelated Business?
For a Solo 401(k), any business regularly carried on or by a partnership or corporation of which it is a member/partner is an unrelated business. For example, the operation of a shoe factory by a pension trusts, the operation of a financial consulting business for high net worth individuals by a university, or the operation of an computer rental business by a hospital would likely be treated as an unrelated business and subject to UBTI.
UBTI & Real Estate Investments
Although there is little formal guidance on UBTI implications for Solo 401(k) Plans investing in real estate, there is a great deal of guidance on UBTI implications for real estate transactions by tax-exempt entities. In general, Gains and losses on dispositions of property (including casualties and other involuntary dispositions) are excluded from UBTI unless the property is inventory or property held primarily for sale to customers in the ordinary course of an unrelated trade or business. This exclusion covers gains and losses on dispositions of property used in an unrelated trade or business, as long as the property was not held for sale to customers. In addition, subject to a number of conditions, if an exempt organization acquires real property or mortgages held by a financial institution in conservatorship or receivership, gains on dispositions of the property are excluded from UBTI, even if the property is held for sale to customers in the ordinary course of business. The purpose of the provision seems to be to allow an exempt organization to acquire a package of assets of an insolvent financial institution with assurance that parts of the package can be sold off without risk of the re-sales tainting the organization as a dealer and thus subjecting gains on re-sales to the UBIT.
How Do I Avoid UBTI?
In general, if you make passive investments with your Solo 401(k) Plan, such as stocks, mutual funds, precious metals, foreign currency, rental real estate, etc the passive income generated by the investment will generally not be subject to the UBTI tax. Only if your Solo 401(k) Plan will be making investments into an active business, such as a retail store, restaurant, software company using a passthrough entity such as an LLC or partnership will your Solo 401(k) Plan likely be subject to the UBTI tax.