When it comes to making investments with a self-directed IRA LLC, the IRS generally does not tell you what you can invest in, only what you cannot invest in. The types of investments that are not permitted to be made using retirement funds is outlined in Internal Revenue Code Section 408 and 4975. These rules are generally known as the “Prohibited Transaction” rules.
In addition, to the Prohibited Transaction rules, the IRS imposes a levy or tax on certain transactions involving IRA funds. In general, when one uses IRA funds to invest in an active business, such as a restaurant, store, factory that is operated through a passthrough entity such as a Limited Liability Company or Partnership or used non-recourse financing, such as a non-recourse loan or margin in a stock or trading account, a percentage of net profits or income generated by that activity could be subject to a tax. The tax imposed is often referred to as Unrelated Business Taxable Income or UBIT or UBTI. The UBTI rules are generally outlined in Internal Revenue Code Sections 512-514.
The reason the UBTI tax rules do not impact most retirement investors, is that Internal Revenue Code Section 512(b) provides a general exemption for the following categories of income generated by a retirement account: dividends, interest, royalties, rental income, and capital gain type transaction,. As a result, since the majority of retirement investors purchase publicly traded company stock, which is exempted from the UBTI tax pursuant to Internal Revenue Code Section 512,, the UBTI tax rules are not widely known.
When it comes to using margin with a self-directed IRA, the rules surrounding the taxation of the use or margin or leverage is found in Internal Revenue Code Section 514. The taxation of margin or non-recourse financing is subject to the Unrelated Debt Financed Income rules under Internal Revenue Code Section 514. If one uses retirement funds with non-recourse real estate financing or in a transaction involving margin, the Unrelated Business Taxable Income would be triggered and a tax would apply on a portion of the income.
How Does One Calculate the UBTI Tax For Using Margin?
IRS Form 990-T, specifically Schedule E, is the tax form where a charitable organization of retirement account, such as an IRA or Roth IRA would report income that would be subject to the Unrelated Business Taxable Income (also known as UBIT or UBTI) or Unrelated Debt Financed Income tax. In general, only income generated from an active trade or business via a passthrough entity, margin, or real estate acquisition indebtedness would be subject to the UBTI/UBIT tax.
In general, when debt-financed property is held for exempt purposes and other business purposes, the organization must allocate the basis, debt, income, and deductions among the purposes for which the property is held. One would not include in Schedule E amounts allocated to exempt purposes
What is Acquisition Indebtedness?
Any property held to produce income is debt-financed property if at any time during the tax year there was acquisition indebtedness outstanding for the property.
As used in Internal Revenue Code 514, “acquisition indebtedness” means “the unpaid amount of . . . indebtedness incurred by the organization in acquiring or improving [debt-financed property].” Acquisition indebtedness does not include “indebtedness the incurrence of which is inherent in the performance or exercise of the purpose or function constituting the basis of the organization’s exemption, such as the indebtedness incurred by a credit union described in section 501(c)(14) in accepting deposits from its members.”
In Henry E. and Nancy Horton Bartels Trust for the Benefit of Cornell University et al. v. United States; No. 2009-5122 (7 Sep 2010), the issue of whether the use of margin to buy securities by an exempt organization under Internal Revenue Code Section 501 would be subject to the unrelated business income tax.
The case was a tax refund suit. It was filed by a taxpayer that qualifies as a tax-exempt organization under I.R.C. § 501(c), The Henry E. and Nancy Horton Bartels Trust for the Benefit of Cornell University (“Cornell Trust” or “Trust”). The court was asked to decide whether this tax-exempt organization owed unrelated business income tax (“UBIT”) on income resulting from the sale of securities it purchased on margin. After paying the UBIT, the Trust filed this refund claim in the United States Court of Federal Claims. The Court of Federal Claims denied the claim, concluding that the proceeds from the margin-financed trades were taxable as income from debt-financed property and thus income from an unrelated trade or business, which is subject to the UBTI.
This case arises from some of the Trust’s investment activities during the 1999 and 2000 tax years. During those years, the Trust invested in stocks purchased “on margin.” In other words, the Trust used money borrowed from its broker to complete the stock purchases. The Trust subsequently sold the stocks.
Both parties moved for summary judgment. In a clear, thorough, and insightful opinion, the Court of Federal Claims granted the government’s motion. It ruled that the Trust’s income from securities purchased on margin was by definition unrelated business taxable income under Internal Revenue Code Section 514. The Trust timely appealed.
Organizations otherwise exempt from federal taxation pursuant to § 501(c) remain subject to tax on their “unrelated business taxable income.” Internal Revenue Code Section 511(a). Unrelated business taxable income is generally defined as “the gross income derived by any organization from any unrelated trade or business (as defined in section 513) regularly carried on by it, less the deductions allowed by this chapter which are directly connected with the carrying on of such trade or business, both computed with the modifications provided in subsection (b).
When the Trust filed its “Exempt Organization Business Income Tax Return” for the 1999 tax year, otherwise known as its Form 990T, the Trust reported the income from the sale of the margin-financed securities as capital gains, without reporting any associated income tax liability.
On appeal, the crux of the dispute is whether the Trust’s income from its securities purchased on margin is subject to the UBIT. The Trust argues that the UBIT does not apply because: (1) doing so is contrary to congressional intent; and (2) investing in securities is not a “trade or business” under the tax code.
The case centered on Internal Revenue Code Section 514 and Code Section 512(b)(4), which modify the computation of “unrelated business taxable income” under Code Section 512(a)(1) when income is from a particular source, namely “debt-financed property. Internal Revenue Code Section 514 provides that “[t]here shall be included with respect to each debt-financed property . . . an item of gross income derived from an unrelated trade or business.”). Moreover, Internal Revenue Code 512(b)(4) requires that “in the case of debt-financed property (as defined in section 514) there shall be included, as an item of gross income derived from an unrelated trade or business, the amount ascertained under section 514(a)(1), and there shall be allowed, as a deduction, the amount ascertained under section 514(a)(2).”
“Debt-financed property” is defined as “any property which is held to produce income and with respect to which there is an acquisition indebtedness (as defined in subsection (c)) at any time during the taxable year.”
The court disagreed with the Trust’s argument that the UBIT does not apply because: (1) doing so is contrary to congressional intent; and (2) investing in securities is not a “trade or business” under the tax code. The language of Internal Revenue Code Section 512(b)(4) and Section 514 is plain and unambiguous. It is undisputed that to purchase securities on margin, the Trust borrowed funds. “Indebtedness [was thus] incurred by the organization in acquiring” these securities. Accordingly, under Internal Revenue Code Section 514(c), these securities were subject to acquisition indebtedness and constitute “debt-financed property” within the meaning of Internal Revenue Code Section 514(b)(1).
The court concluded that Internal Revenue Code Section 514(a) and Code Section 512(b)(4) treat income the Trust derived from selling these securities as “an item of gross income derived from an unrelated trade or business,” and therefore unrelated business taxable income under Internal Revenue Code Section 512.
The court also held that it does not matter whether the Trust’s investments in securities on margin satisfy the definition of “unrelated trade or business” in Internal Revenue Code Section 513 because separate provisions – Internal Revenue Code Sections 512(b)(4) and 514 – explicitly classify income from debt-financed property as income from an unrelated trade or business.
The Taxation of Using Margin with a Self-Directed IRA
When any property held for the production of income by an organization is disposed of at a gain during the tax year, and there was acquisition indebtedness outstanding for that property at any time during the 12-month period before the date of disposition, the property is debt-financed property. Securities purchased on margin are considered debt-financed property if the liability incurred in purchasing them remains outstanding. Note – a 401(k) Plan is exempt from tax on income attributable to acquisition indebtedness. Thus, no UBTI or UDFI tax would apply in the case of a Solo 401(k) Plan that used a non-recourse loan to purchase real estate. The tax would, however, apply if margin was used, which is not treated as acquisition indebtedness.
In sum, the use of margin by a retirement account, such as a self-directed IRA LLC would trigger the UBTI tax, which is approximately 35%.