Never heard of unrelated business income tax (UBIT)? Neither have most IRA account holders. It’s a tax with a particularly nasty rate if you fall afoul of it. Keep reading to learn if you have cause for concern.
How an IRA Works
Before we delve deep into the unrelated business income tax, let’s explore how an IRA works. Think of an IRA as an investor—not an account. Think of it as a person who wants to make you a lot of money.
Although most people use their IRA to invest in stocks, bonds and mutual funds, your IRA (especially if it’s a self-directed IRA) can invest in many other ways—real estate, precious metals, investments in private companies, energy sources and even a startup that your best friend has dreams of launching. These investments will produce income that is paid into the IRA.
But keep this in mind: The only reason the federal government created IRAs is to help people save for retirement. It’s not a tax-free way to make money. When people started finding loopholes back in the 1950s, the IRS created the tax.
Unrelated Business Income Tax
Now that you understand how an IRA works, what is this strange tax? UBIT is a tax on income produced by investment activities for which an IRA shouldn’t be used. The tax is reported on IRS Schedule K-1 and sent to the investor each year.
The IRS covers this with all kinds of big words in IRS Publication 598, but here are a few examples. If you’ve always wanted to open a motorcycle shop, you can’t use your IRA to fund the business. Other business activities that could trigger UBIT could include:
- Buying and selling a large amount of real estate in a year
- Making a large number of private loans out of your IRA
- Using margin to purchase stock
- Certain types of investments, such as master limited partnerships
In general if the IRA’s investment is in a trade or business—an entity that conducts business and regularly produces an income—it’s against the rules and will trigger the tax. The IRS doesn’t provide the most cut-and-dried guidelines on what creates the tax, because most people investing in such advanced ways have complicated ventures that require a judgment on the part of the IRS if it disagrees with how the IRA holder chose to categorize the investing activity.
As the maximum tax is 39.6 percent, investors who use their IRA in such advanced ways should check for tax consequences before moving forward with investing activities. In the case of UBIT, professionals are almost always required to determine the tax treatment.
But IRAs are full of assets that would seem to trigger UBIT. They hold stock in companies that produce income. It’s the same with bonds, and mutual funds profit by investing in companies that produce income, so what’s the deal?
Most publically traded companies, about 99 percent, are set up as C corporations. All C corporations are exempt from UBIT, making your stock purchases inside an IRA totally legit. That goes for most of the other investments you get through a normal IRA account. The financial institution that holds your IRA probably has rules in place keeping you from using your IRA to trigger UBIT.
Who Pays UBIT?
Using an IRA to invest in these “alternative” investments is normally reserved for “accredited investors”—often investment professionals themselves or those wealthy enough to have professionals acting on their behalf. If you didn’t know before today that you could use your IRA in such advanced and complicated ways, you’re probably safe.
Unrelated business income tax probably doesn’t apply to you, but if it does you have to become well-read in something that gets pretty complicated. Even if it doesn’t apply now, it may someday, when you’re super wealthy. Or maybe you can advise the super-wealthy on this subject and make a couple hundred per hour as a high-priced tax expert.