Life and Death Planning for Retirement Benefits

Chapter 8: Investment Issues; Plan Types

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8.2 IRAs and the Tax on UBTI

Normally, IRAs are tax-exempt entities; however, like other tax-exempt entities, IRAs are subject to tax under § 511 on “unrelated business taxable income” (UBTI). § 408(e)(1) . This ¶ 8.2 provides , for the estate planner, CPA, or financial planner who is advising an individual participant or beneficiary, an overview of the tax, emphasizing rules that personal advisers may not be aware of. An IRA owner and his adviser must seek UBTI-expert help (or become UBTI experts) if the IRA invests in nontraditional investments. For more on UBTI, see IRS Publication 598, Tax on Unrelated Business Income of Exempt Organizations. The idea of the UBTI tax is that a tax-exempt organization (such as a charity or retirement plan) is granted its tax exemption to foster its exempt purposes, not to enable the entity to compete with tax-paying businesses. Reg. § 1.513-1(b) . If the tax-exempt entity has UBTI, it must pay income tax on that income. § 511 . However, despite this rationale, an IRA does not have to actually operate a business to become subject to this tax; see ¶ 8.2.03 . The UBTI tax can require not only the complications of figuring out the tax, and filing returns (Form 990-T, 990-W) but also paying estimated taxes (if “adjusted” UBTI exceeds $500), with associated penalties if any of these filings or payments are late. If the UBTI for the year is under $1,000 there is no tax, because there is a $1,000 deduction. § 512(b)(12) . Form 990-T must be filed if gross unrelated business income is $1,000 or more. The IRA custodian or trustee is supposed to file the return. Strangely, it is not clear whether an individual’s IRAs are aggregated for purposes of applying the $1,000 deduction. Nothing in the Code gives the IRA owner any “basis step-up” or tax credit to reflect the fact that some of the IRA’s income has already been taxed as UBTI. An IRA or Roth IRA distribution will be taxable (or not) under the usual rules for taxation of such distributions (see ¶ 2.2 , ¶ 5.2 ) without regard to howmuch if any UBTI tax has been paid on the IRA’s internal income. UBTI: Rationale, exemptions, returns, double tax, etc.

The UBTI tax is not a concern if the IRA invests only in publically-traded corporate stocks and bonds and bank deposits, and never borrows money. However, UBTI can be generated by certain publically-traded securities; see ¶ 8.1.05 (A).

Income from an IRA-operated trade or business

UBTI includes gross income (minus permitted deductions) from the conduct of an “unrelated trade or business” that is “regularly carried on” by the exempt organization. § 512(a)(1) . § 513(b) provides that, for a QRP, “unrelated trade or business” means “any trade or business regularly carried on by such [plan] ...or by a partnership of which it is a member.” Emphasis added. Though there is no comparable specific rule for IRAs, which are tax-exempt under § 408(e)(1) not § 401 , it appears prudent to assume that any “trade or business” conducted by an IRA (or by a partnership or LLC of which it is a member) is unrelated to its exempt purpose. Under § 513(a)(1) , unrelated trade or business “does not include any trade or business— (1) in which substantially all the work in carrying on such trade or business is performed for the organization without compensation ....” This might make it appear that, if the IRA owner is the