Unrelated Business Income Tax (UBIT) is the tax on Unrelated Business Taxable Income (UBTI; IRC Section 501), which comes from an activity engaged in by a tax-exempt organization or entity which is not related to its tax-exempt purpose. UBTI is a concept more broadly related to not for profit entities and certain trusts. But it becomes a retirement plan issue because of the trust-like features that arise since plan money has been legally set aside for the benefit of the account holder after he/she retires.
The rules on this kind of tax are in section 408 of the code.This topic is also addressed in the first few paragraphs of Chapter 1 of the November 2007 revision of Publication 598, which states that IRAs are “subject to the tax on unrelated business income.”
For qualifying entities there will be UBTI if ALL of the following are true:
- Income is derived from “trade or business” activity (i.e., sale of goods and services).
- Business activity is not substantially related to furthering the exempt purpose. (and with IRAs there aren’t any businesses which could be related to its purpose)
- Business is regularly carried on by the entity.
Income which could subject an IRA to UBTI include:
- Income from operating an active trade or business – (i.e. a restaurant, gas station, store, etc)
- Business income generated via a pass-through entity, such as an LLC or partnership
- Borrowing money to purchase real estate
- Purchasing stock in a margin account
Most passive investment income – including dividends, royalties, and rent – does not create UBTI. However, an investment that generates income with debt financing (e.g., purchasing real estate with a non-recourse loan in an IRA) will create UBTI in direct proportion to the gain/income that’s debt financed. Essentially, borrowing money to create leveraged returns is seen as a business activity.
In most cases, IRAs that receive more than the current $1,000 UBIT exclusion must file Form 990T with the Internal Revenue Service on or before the April 15th deadline. Form 990T payments must be made from the IRA’s assets.