Even though your Retirement Plan is generally recognized as tax exempt before making distributions, it still may be liable for tax on its Unrelated Business Income, which is income from a trade or business. If your retirement plan has $1,000.00 or more of Unrelated Business Income, either the Custodian, Trustee or you must file Form 990-T, Exempt Organization Business Income Tax Return.
The Form 990-T may need to be filed for an employee’s 401(k) Trustee, an IRA (including SEPs and SIMPLEs), a ROTH IRA, a Coverdell ESA, or an Archer MSA by the 15th day of the 4th month after the end of its tax year. Failure to file when due (including extensions of time for filing) is subject to a penalty of 5% of the unpaid tax for each month the return is late, up to a maximum of 25% of the unpaid tax.
For many years investors with qualified retirement plans have looked to reduce overall portfolio volatility and improve returns on their investments. This has led to an increased interest in the area of “Alternative Investments,” which include Direct Participation Programs (“DPP”) in oil and gas, hedge funds, real estate, private equity and venture capital funds. These investors have embraced the pros and cons of Unrelated Business Taxable Income (“UBTI”) generated by Alternative Investments for more attractive risk adjusted returns.
Oil and gas drilling funds structured through a limited partnership that holds working interests in oil and gas properties create UBTI when placed inside an IRA or other qualified retirement plan. So, do oil and gas investments belong in IRAs and qualified plans? This is not a black and white issue and the usual answer is no, but there may be exceptions. The nature of certain types of oil and gas DPP investments may have benefits created by the investment that more than offset the potential negatives, or exposure to UBTI. If the exposure to UBTI is insignificant or inconsequential to the total benefits from the investment’s non-UBTI returns, there may be a level of acceptability.
Other energy DPP investments, such as leasebank investments, may be more suitable to an IRA than a drilling fund. Typically, the majority of the returns to a leasebank fund come from capital gains created by the sale of lease assets and passive income from royalty interests. It is our belief that capital gains and passive income are exempt from UBTI, however, we encourage investors to consult their tax advisors for specific advice and guidance.
What is UBTI?
Unrelated Business Taxable Income in the U.S. Internal Revenue Code is the income that comes from an activity engaged in by a tax exempt entity or organization that is unrelated to the tax-exempt purpose of that entity or organization.
UBTI is a tax imposed by Congress on tax-qualified entities that produce profits through business activity instead of passive investments. Examples of passive investments include interest from loans, dividends and gains from private stock holdings, and returns from the purchase/sale of precious metals.
UBTI in an IRA or Qualified Retirement Plan
If an investor holds an Individual Retirement Account (IRA), and the Alternative Investment generates income that qualifies as UBTI, the Plan may be subject to taxation. When it comes to self-directed IRA investing, account holders often find out about prohibited transactions and disqualified persons before making investments; but fewer investors learn about (or even come across) UBTI before acquiring their DPP in a limited partnership or purchasing rental real property in their self-directed IRA or 401(k).
There are two scenarios that trigger UBTI for Retirement Plans:
- Profits generated from a business/trade.When an IRA or 401(k) derives profit from an operating business that has not paid business tax on those profits before distributing them to the retirement account, those profits trigger UBTI and are taxed at trust rates. This includes net taxable income from working interests in oil and gas properties. Taxable deductions from oil and gas properties can be used in computing net taxable income. (Generally Mineral Royalties are excluded from UBIT whether measured by production or by gross or taxable income from the Mineral Property).
- Leveraged Real Estate Investments. When an IRA purchases real estate using a non-recourse mortgage loan, the Debt-Financed portion of the property’s profits is subject to UBTI. Similarly, if an IRA-owned property is sold while a percentage of ownership is still debt financed, the profit derived from the debt financed percentage is subject to UBTI. (Generally rental income and Capital Gain are excluded in computing UBTI-property that is NOT Debt-Financed).
What is the tax rate for UBTI? How is UBTI Calculated?
UBTI rates for retirement account investments follow a schedule of “Trust Rates” provided by the IRS on an annual basis. Contact your Professional Tax Advisor about filing form 990-T as soon as you consider investing in an asset that may be subject to UBTI. Keep in mind that losses in some years may offset profits in subsequent years. Trust rates change from year to year, but slide from 15% to 39.6%.
If your IRA generates UBTI, it does not disqualify the IRA (like prohibited transactions would). It does, however, require your IRA to file an income tax return, which is unusual since an IRA is supposed to be tax-exempt. Since UBTI is generated, income tax will be owed on the income if it reaches certain levels.
Just like individual tax returns, if the IRA generates gross income of $1,000 or more during the tax year, the Retirement Plan must file Form 990-T. Issues that arise with this filing include:
- The IRA must have a federal tax ID (EIN).
- The custodian is considered responsible for filing Form 990-T, but most self-directed IRA custodians transfer this responsibility to the account owner.
- The IRA custodian may not have all of the information required to file the return, since much of the information in these privately-held investments is given directly to the account owner.
- The account owner ultimately has the final responsibility to file the Form 990-T, and a lack of an understanding of the rules can cause major issues for the account owner.
- The account owner will also be required to file quarterly estimated tax payments as long as the investment is in place. Every three months, a tax payment must be made to the IRS if the total tax for the year is expected to be greater than $500.
Note: UBTI may create one of those cases where income within an IRA is actually destined to be double-taxed. Even though you pay tax on the tax as it is earned within the IRA (at trust rates, not individual rates, which are more compressed), when you take the money out of the IRA, you will be taxed again. Paying tax on the UBTI doesn’t create non-taxable basis in the IRA.
Depending upon the nature of the IRA or qualified plan investment, UBTI may be:
Good – with limited exposure, the overall net investment benefits may be worthwhile using assets from this source.
Bad – the tax shelter on some or all investment earnings may be lost and some of the IRA/plan may wind up being double taxed.
Ugly – there are tax reporting and tax estimates that may come into play. Failure to take care of all of these duties could lead to adverse consequences.
Account Owners should not run away when they hear UBTI, but care and proper evaluation are definitely in order. When debating the pros and cons of UBTI in an IRA, the question shouldn’t be “How do I avoid UBTI?” but rather “What is the resulting net rate of return from the investment within my IRA that will generate UBTI”
Dismissing an investment because of the potential payment of taxes should never be a deal killer.
PLEASE CONSULT YOUR PROFESSIONAL TAX ADVISOR REGARDING THE POTENTIAL IMPACT OF UBTI ON AN IRA OR OTHER QUALIFIED PLAN.
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IRS regulations require us to advise you that, unless otherwise specifically noted, any federal tax advice in this communication (including attachments, enclosures, or other accompanying materials) was not intended or written to be used, and it cannot be used, by any taxpayer for the purpose of avoiding penalties; furthermore, this communication was not intended or written to support the promotion or marketing of any of the transactions or matters it addresses.