The Effects of UBTI on the Solo 401k and IRA
Those with Solo 401k retirement plans or IRAs should be aware of Unrelated Business Taxable Income (UBTI) and how it might affect their investments.
What is UBTI?
Unrelated Business Taxable Income (UBTI) is a concept defined by the Internal Revenue Code. Its purpose is to ensure fair competition between businesses.
The assumption is that businesses with tax-exempt status have an unfair advantage over businesses without tax-exempt status. In order to level the playing field, the IRS established UBTI, a tax on income generated by “unrelated business activity.”
Unrelated business activity
The IRS defines unrelated business activity as meeting the following three requirements:
- It is a trade or business
- It is regularly carried on
- It is not substantially related to furthering the exempt purpose of the organization
Unrelated business activity is business activity that is separate from the main, tax-exempt purpose of the entity.
How UBTI applies to IRAs and Solo 401k retirement plans
For retirement plans, UBTI may apply to income generated by unrelated business activity. That is, income that is unrelated to the plan’s tax exempt purpose.
In other words, if there is business activity that is funded by the plan and unrelated to the purpose of the plan, UBTI may apply. This income can come from operating a business, owning or improving property using debt financing from the plan, or participating in partnerships in which the plan owns interest.
Activities of a plan are tax-exempt if they are related to their main purpose- passive investing. But unrelated business activity, as defined by the IRS, can be subject to UBIT.
Other examples
UBTI can also be triggered by any investment that uses debt financing. UBTI is proportional to the income that is debt-financed.
For IRAs, ownership of limited partnerships and flipping properties using IRA funds can trigger UBTI. Income from dividends and interest are considered passive investments and are not subject to UBTI.
UBTI requires an income tax return to be filed if the gross amount of unrelated business income is $1,000 or higher in a tax year. Form 990T must be filed on or before the April 15 deadline. Form 990T payments must be made from IRA assets. The account owner has final responsibility for the filing of this form, and the plan custodian must be directed to pay these taxes before the due date.