Unrelated Business Taxable Income Explained
By Agatha Schmidt, CISP, SDIP, CHSP
What is unrelated business taxable income?
Earnings in an IRA generally are not taxed until an IRA distribution takes place. However, some earnings, referred to as “unrelated business taxable income” (UBTI), are taxable before a distribution occurs. This type of income generated in IRAs is most common in IRAs holding self-directed alternative assets, such as real estate, debt instruments, or an interest in privately-held companies. UBTI is income that is received during the ordinary course of commercial business activities; it is income that is not related to the purpose of the IRA’s tax-exempt status, which is to generate income for retirement.
For example, a self-directed IRA is invested in a local restaurant business. The business generates income by providing food, beverages, and customer service. The IRA, as an investor in the business, receives income from the business. Part of the income received by the IRA may be considered UBTI because it is related to the products and services provided by the restaurant, not to appreciation or growth in the market value of the business.
What types of income are exempt from UBTI?
Passive income such as interest, dividends, royalties, rental income, and most types of capital gains generally are not considered UBTI. However, capital gains from certain real estate investments may be subject to UBTI. Specifically, if property is acquired and held for the purpose of selling it in the short-term (generally, within 12 months) as part of its ordinary course of business. As a result, capital gains on the sale of the property may be subject to UBTI. For example, income generated by a real estate flipping business may be considered UBTI.
Who is responsible for determining whether an IRA has incurred UBTI?
The trustee or custodian of the IRA generally is not responsible for determining if an IRA has incurred UBTI; it is the IRA owner’s responsibility. An IRA owner who is not familiar with UBTI should work with a competent tax advisor who is well-versed in corporate and investment taxation, preferably before making the IRA investment. The IRA owner or her competent tax advisor should also determine if estimated tax payments are required to be made throughout the year. Estimated tax payments are required if the tax to be paid is expected to be $500 or more.
How is the UBTI tax filed and paid?
IRA trustees and custodians must file IRS Form 990-T, Exempt Organization Business Income Tax Return, if the UBTI is $1,000 or more. One Form 990-T must be filed, even if there are multiple investments that incur UBTI, but each investment must be reported on a separate Schedule M.
Form 990-T is filed in the name of the IRA trustee or custodian for benefit of the IRA owner. For example, “ABC Trust Company for benefit of Jane Doe IRA.” As for the tax identification number (TIN), the IRA trustee or custodian may require that the IRA owner obtain a separate TIN for her IRA for purposes of Form 990-T filing. Most financial organizations require that Form 990-T be prepared by the IRA owner or her competent tax professional, but it must be signed by an authorized representative of the trustee or custodian.
The tax must be paid when the form is filed. Financial organizations can make the payment either by electronic funds transfer via the Electronic Federal Tax Payment System (EFTPS) or via same-day wire through the Federal Tax Application (FTA) system. See IRS Publication 598, Tax on Unrelated Business Income of Exempt Organizations, for more information.
The tax payment is considered an expense or fee related to the investment; therefore, it must be paid directly from the IRA; the IRA owner cannot pay it out-of-pocket or with non-IRA funds. An IRA owner should ensure that he has sufficient liquid assets (cash) in his IRA to cover the tax payment. If he doesn’t, he should make a contribution to the IRA (if eligible to do so), transfer funds from another IRA, or roll over cash from a qualified retirement plan. If the IRA owner is not eligible to make a contribution or has no other qualified liquefiable assets to cover the tax payment, the financial organization may need to consult its legal counsel to determine how to handle. It may also want to consider having the IRA owner remove the investment if recurring issues are anticipated.
Taxes also may be due to a state taxing authority. IRA owners and their competent tax professionals should check with their state tax authority on procedures for determining and paying any state tax due.
