Internal Revenue Code Section 512 outlines the rules regarding the taxation of charities and retirement accounts, such as a self directed IRA or Solo 401(k) Plan when engaged in an “unrelated trade or business”. The purpose of the UBTI or UBIT rules is to treat tax-exempt entities, such as charities, IRAs, and 401(k)s as a for-profit business when they engage in active business activities or use leverage. If the UBTI tax applies to IRAs and there are over 47 million IRAs, why has so few people heard about it? The answer is that the majority of retirement account holder purchase mutual funds and public stocks, which generally consist of public companies organized as a C Corporation.
A C corporation is a corporation which offers limited liability protection but also imposes a double tax – one tax paid by the entity – the other by the shareholders on any dividends received. Because of the entity level tax, any income generated by the C Corporation business is subject to corporate level tax before it is passed on to the shareholders. This is contrary to an LLC, which is not subject to an entity level tax, as the income passes through to the members (owners) which pay the tax o the income received – not the entity. As a result, a C Corporation has been also known as a “blocker” corporation since it blocks the income, include any unrelated business taxable income from flowing through to the shareholders. In contrast, income generated by an LLC or partnership, would pass-through or flow through to the owner and not be subject to tax at the corporate level. As result, a charity or retirement account, such as a self-directed IRA or Solo 401(k) Plan which purchases stock of a C Corporation would not be subject to any UBTI tax since the C Corporation would block the income from flowing through the charity or retirement account owner. This is why most Americans with retirement funds have never heard of the UBTI tax before. It just never applies to them since they are generally purchasing public companies stock with retirement funds and almost all public companies are set-up as C Corporations. So when do the UBTI tax rules apply?
The UBTI or 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.”
In general, when a charity or retirement account generates passive sources of income, such as dividends, interest, royalties, capital gains and rental income the income is not subject to tax. . For example, when a charity or retirement account, such as an IRA or 401(k) Plan invest in income producing real estate, the rental income attributable such activity is generally exempt from tax.
However, there a several types of transactions that generate rental streams of income that are not considered “rental income” for purposes of the rental income exception to the UBTI rules.
Treas. Reg. § 1.512(b)-1 sets forth guidance with respect to what types of income falls under the rental income exception for UBTI:
Whether a particular item of income falls within any of the modifications provided in section 512(b) shall be determined by all the facts and circumstances of each case. . . . [I]f a payment termed “rent” by the parties is in fact a return of profits by a person operating the property for the benefit of the tax-exempt organization or is a share of the profits retained by such organization as a partner or joint venturer, such payment is not within the modification for rents.
Treas. Reg. § 1.512(b)-1(c)(5) is the most important regulation in this area and provides:
Payments for the use or occupancy of rooms and other space where services are also rendered to the occupant, such as for the use or occupancy of rooms or other quarters in hotels, boarding houses, or apartment houses furnishing hotel services, or in tourist camps or tourist homes, motor courts or motels, or for the use or occupancy of space in parking lots, warehouses, or storage garages, does not constitute rent from real property.
Although, payments for the use or occupancy of entire private residences or living quarters in duplex or multiple housing units, of offices in any office building, etc., are generally treated as rent from real property.
Accordingly, when buying real estate with a self-directed IRA or Solo 401(k) Plan, whether one uses a C Corporation or LLC as the investment vehicle shouldn’t matter since, in general, the rental income should be exempt from the UBTI tax. However, if the activity generating the rental income would not satisfy the definition of the rental income exception under Internal Revenue Code Section 512, such as rental income from a storage facility of warehouse, using a C Corporation would block the income from being subject to the UBTI tax. Note – using a C Corporation would impose a corporate level tax on the rental income received by the C Corporation. If the annual rental income received by the C Corporation would not exceed $50,000, then using a C Corporation as a blocker corporation would reduce the overall tax liability associated with that income. A Corporation that generates under $50,000 annually of net income would pay tax at approximately 15%, whereas, the UBTI tax rate mirrors the trust income tax rates which are approximately 35%.
When engaging in a transaction with retirement funds, especially an investment that could be classified as a business and be subject to the UBTI/UBIT tax rules, it is vital that one works with a tax attorney with experience in the area.