In this article we’ll look at the problem of Unrelated Business Income Tax in an IRA. Here’s how to define Unrelated business Income Tax and how to avoid UBIT in your IRA through the use of an offshore UBIT blocker structure.
Yes, certain types of income earned by your IRA can be taxable. Not only is Unrelated Business Income in an IRA taxable, it’s taxable at the very highest rate. That’s about 39.6% for the Feds, plus your state.
Unrelated Business Income Tax in an IRA Defined
When an IRA earns UBI, it must pay tax on those profits before they are deposited in to the retirement account. The most common examples of Unrelated Business Income in an IRA are 1) active business profits and 2) income from the use of leverage or loans in a retirement account.
Other examples of transactions that can generate Unrelated Business Income Tax in an IRA include:
- Buying and selling a large amount of real estate in a year and thereby being classified as a real estate dealer or professional.
- Making a large number of private loans out of your IRA.
- Using margin to purchase stocks or FX
- Any ordinary income generating business that passes income to you tax free.
Income from an active business is usually untaxed profits passed through by a limited partnership, limited liability company, disregarded entity, general partnership, or master limited partnership. Basically any income that flows out of the business tax free to be taxed on the shareholders return.
And it makes sense that untaxed income can’t flow into an IRA to be held tax free (ROTH) or tax deferred (traditional). Of course Uncle Sam wants his cut before the money gets to your retirement account. If this were not the case, all small businesses could operate nearly tax free.
Keep in mind that we’re talking about flow-through businesses here. If you invest in a C Corporation, this company pays tax on its profits before making a distribution to you as a dividend. These dividends are not UBI. They are standard forms of investment returns, a concept that will be important later.
What’s less logical is the fact that income from leverage or a mortgage is taxable before it reaches your retirement account. This rule for Unrelated Business Income Tax in an IRA was put in place to prevent investors from using leverage and loans in their retirement accounts.
For example, you buy a rental property in Nevada with your IRA and a mortgage. 50% of the money for the property comes from the IRA and 50% from a non-recourse mortgage.
In this case, half of the net rental profits are taxed and half flow tax free into the account. Likewise, 50% of your capital gain when you sell the property are taxable and 50% flows into your IRA tax free.
Unrelated Business Income Tax in an IRA is reported to the IRA on Form 990-T. Reporting is required if you receive UBI of $1,000 or more in the year. These taxes are paid by your custodian and reported as a distribution on IRA Form 1099-R.
Unrelated Business Income Tax Blocker Corporations
As stated above, dividends from a corporation do not generate UBI. Only income from a disregarded or flow through structure is creates UBI. So, if you can convert income from UBI to a dividend, you can eliminate UBIT.
US corporations pay US tax on income before making a distribution. If you put a US corporation between your IRA and an LLC, the corporation will pay 21% after President Trump’s tax plan passed this year. Then the corporation can pass on remaining profits to your IRA as a dividend.
If you set up an offshore UBIT blocker corporation, you can eliminate US tax entirely. Invest in a foreign business and earn UBI. Place an offshore blocker corporation in-between an offshore IRA LLC and your investment, to convert UBI to dividends.
That is to say, a UBI blocker corporation effectively converted UBI to ordinary investment income, avoiding UBIT. If this transaction is in the United States, you pay US tax at the corporate level. If this transaction is in a tax free offshore jurisdiction, you pay no US corporate tax.
Of course, this offshore UBI blocker structure only works with offshore transactions. You can’t invest into a US partnership through an offshore UBI blocker and get the same benefit. The IRS thought of this loophole years ago and closed it.
I hope you’ve found this article on Unrelated Business Income Tax in an IRA Defined to be helpful. For more information on moving your IRA offshore or forming a UBIT blocker corporation, please contact us at firstname.lastname@example.org or call us at (619) 550-2743. All consultations are free and confidential.