Unrelated Business Taxable Income (UBTI) was defined by the Internal Revenue Code to ensure fair competition between businesses. It was based on the assumption that those with tax-exempt status would have unfair advantage over regular businesses without tax-exempt status. In order to level the playing field for all businesses, the IRS set a tax on income generated by a business activity that is separate from the tax-exempt purpose of the entity. This can also apply to qualified retirement plans such as the IRA and Solo 401k retirement plans.
What is UBTI?
UBTI is income generated by business activity that is unrelated to the main purpose of the plan. If the income generated by the business activity is both funded by the plan and unrelated to the purpose of the plan, that income may be defined as unrelated business taxable income. 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.
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
In other words, income from regular activity outside of the main purpose may be taxed.
The plan may enjoy tax-exempt status for activity related to its main purpose; unrelated business activity may be subject to taxation called Unrelated Business Income Tax (UBIT). UBIT is a compressed, complicated form of taxation.
How the UBIT applies to the IRA and Solo 401k retirement plans
With the IRA and Solo 401k retirement plans, UBTI may also apply to income that is unrelated to the plan’s tax exempt purpose. Any investment that uses debt financing and/ or is involved in business unrelated to the purpose of the plan can trigger UBIT. UBIT is proportional to the income that is debt-financed. Some examples of IRA investments that can generate income and trigger UBIT are ownership of limited partnerships and flipping properties using IRA funds. Income from dividends and interest are considered passive investments and are not subject to UBIT.
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.