The Internal Revenue Code does not describe what a Self-Directed IRA can invest in, only what it cannot invest in. Internal Revenue Code Sections 408 & 4975 prohibits Disqualified Persons from engaging in certain type of transactions. In general, when it comes to using a Self Directed IRA to make investments most investments are exempt from federal income tax. This is because an IRA is exempt from tax pursuant to Internal Revenue Code 408 and Section 512 of the Internal Revenue Codes exempt most forms of investment income generated by an IRA 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. In the case of oil and gas investments, made with a Self-Directed IRA, if the investment is generating royalty income then the income and gains generated would typically be exempt from tax. However, if the investment will be generating business income, which is typical of most Master Limited Partnership (“MLP”) investment structures, then the unrelated business taxable income tax (“UBIT” or “UBIT”) rules would likely apply triggering a tax on the income generated.
The key in determining whether income from an oil and gas project would be subject to the UBIT tax is whether the income would be treated as royalty for income tax purposes. The IRS addressed this is IRS Revenue Ruling 69-179.
In IRS Revenue Ruling 69-179, a tax-exempt organization owned a working interest in oil and gas producing property. Under the terms of an agreement with an independent operator, it was relieved of any liability for the development costs associated with the interest but remained liable for operating expenses. The Internal Revenue Service held that the income from the mineral interest was not a “passive” royalty and therefore not excluded from unrelated business taxable income under the Section 512(b)(2) exclusion for passive royalty income.
Rev. Rul. 69-179, 1969-1 C.B. 158, describes an exempt organization that derives income from a working interest in an oil and gas property. In the situation described, although the organization is relieved of the development costs, it is liable for the operating costs associated with its interest. Under these circumstances the revenue ruling holds that the amounts derived from the mineral interest are not royalties under IRC 512(b)(2).
The general rule under Reg. 1.512(b)-1(b) provides that mineral royalties are excluded from the computation of unrelated business taxable income. However, mineral royalties are included in such computation if an organization (1) owns a working interest in a mineral property, and (2) is not relieved of its share of development costs. The revenue ruling notes that a royalty interest is a right to a mineral in place that entitles its owner to a specified fraction of the total production from the property free of expense of both development and operation. Although the regulations are silent as to the effect of liability for operating costs, the reference to relief from development costs is only by way of illustration, and to be a royalty interest, the right to payment must be free of both development and operating costs.
Hence, your self-directed IRA oil and gas investment will be exempt from the UBTI tax if the investment generates pure royalty income, whereby, the IRA does not own an interest in the mineral property and is not responsible for its share of any development or operating costs of the underlying mineral investment. As a result, most oil and gas investments, especially those structured as MLPSs tend to trigger the UBTI tax, which is approximately 35%.