Introduction to Unrelated Business Income Tax (UBIT)
Unrelated Business Income Tax (UBIT) must be paid by tax-exempt entities on Unrelated Business Taxable Income (UBTI), which 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.
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 Checkbook Control Retirement Plans to engage in business tax-free in all circumstances would give them an unfair competitive advantage over other businesses in the marketplace. To avoid UBIT and UBTI, 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.
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 a Checkbook Control 401k and Checkbook Control Defined Benefit Plan is that they are not taxed for income generated by debt financed real property. Section 514(c)(9) of the internal revenue code specifically exempts 401(k)s and Defined Benefit Plans from UDFI related to 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 39.6% at UBTI of only $12,300.
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. 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.
Avoiding 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.
Using a Solo K or defined benefit plan to invest in leveraged real estate deals will avoid UDFI.
UBTI, UBIT, and UDFI FAQ
Will a self-directed 401k, self-directed IRA, or self-directed DB Plan generate taxable income if it invests in a business that sells goods or services?
It depends on whether that business is treated as a C-corporation for tax purposes. If that entity is a C-corp, the dividends paid to the Checkbook Control Retirement Plan will not be taxable. Otherwise, the pass-through income will represent UBTI to the retirement plan.