What is Unrelated Business Income Tax (UBIT)?
- Unrelated Business Income Tax (UBIT) must be paid by tax-exempt entities, including self-directed retirement accounts – SDIRAs, QRPs, Solo 401(k) Plans, & Defined Benefit Plans – on Unrelated Business Taxable Income (UBTI).
- UBTI is income generated from any trade or business in which it regularly engages that is not substantially related to the exempt organization’s tax-exempt purpose.
- UBIT is the tax, UBTI is the type of income that is subject to the tax.
- Checkbook IRA Accounts, Solo 401(k) Plans , Defined Benefit Plans and other QRPs are among the tax-favored investment vehicles that can be subject UBIT.
Why are tax-sheltered entities – including QRP, Solo 401k, & SDIRA – subject to UBIT tax?
To better understand UBIT and UBTI, it is helpful to know what Congress’s objective was in instituting this tax. As outlined in Section 1.513 of the Tax Regulations, “the primary objective of adoption of the unrelated business income tax (UBIT) was to eliminate a source of unfair competition by placing the unrelated business activities of certain exempt organizations upon the same tax basis as the nonexempt business endeavors with which they compete.” In other words, allowing Self Directed Retirement Plans to engage in trade or business tax-free in all circumstances would give them an unfair competitive advantage over other businesses in the marketplace.
To avoid UBIT and UBTI, Self-Directed Checkbook Control Retirement Plans, should not regularly engage in businesses that the IRS would consider to be generating active income, as opposed to passive income.
What is Unrelated Debt Financed Income (UDFI)?
Unrelated Debt Financed Income (UDFI), refers to income generated from debt-financed property. UDFI is a form of UBTI that is governed by Section 514 of the Tax Code and was enacted by Congress to keep tax-exempt entities from using leverage to purchase income–producing property and then using tax-free income generated by the property to service the debt.
When purchasing investment property in a Checkbook IRA using nonrecourse borrowing, the impact of UDFI on the investment returns must be considered.
One of the great features of QRPs, Qualified Retirement Plans, Checkbook Control 401k and Checkbook Control Defined Benefit Plan, as opposed to Self-Direct IRAs & HSAs, is that their real estate acquisition indebtedness does not generate UDFI in most circumstances. In other words, such plans are not taxed on debt-financed real estate income. Section 514(c)(9) of the internal revenue code specifically exempts QRPs, 401(k)s, Defined Benefit Plans and other “Qualified Organizations” from UDFI related to real estate acquisition indebtedness.
Note: QRPs – including 401k plans and defined benefit plans – can incur UBIT liability, as they have only a limited UDFI exemption for debt-financed real estate.
UBIT Tax Rates and Tax Return Filing
The tax rates that apply to UBTI and UDFI are those that apply to trusts, as specified in Section 511 of the Internal Revenue Code. Trusts are subject to compressed income tax rates and reach the maximum tax rate of 37% at UBTI of only $12,750. It’s important to note that those trust rates do not apply to capital gains, which are taxed at the lower capital gains tax rates.
Checkbook Retirement Plans that have UBTI of $1,000 or more must file Form 990-T with the IRS by the 15th day of the fourth month after the end of the taxable year, which will usually be April 15. IRS Form 8868 can be filed to request an automatic extension. Both the Form 990-T and any UBIT payable are the responsibility of the retirement plan, not the account-holder, and should be filed using an EIN obtained specifically for the retirement plan.The taxes must be paid from retirement plan funds.
What Types of Retirement Account Income Are Exempt from UBIT, UBTI, and UDFI?
Section 512(b) of the Tax Code lists types of income that do not create UBTI. Among those are interest income, dividend income, royalty income, real estate rental income, and capital gains. The majority of retirement plan investments are exempt from UBIT under one of the above.
In certain instances, advanced strategies that use blocker corporations can be used to eliminate UBIT.
- It is important to emphasize that Qualified Retirement Plans – which includes 401k plans – are, generally, subject to UBIT.
- QRPs – including 401k plans – do have an important but limited UDFI exemption with regard to debt-financed real estate.
- In addition, there are several exceptions to the QRP real estate UDFI exemption.
- Therefore, it should NOT be assumed that any QRP – including Solo 401k – has a blanket UBIT exemption.
UBIT, UBTI and UDFI FAQ