UBIT (Unrelated Business Income Tax)
Even though an organization is recognized as tax exempt, it still may be liable for tax on its unrelated business income. Unrelated business income is income from a trade or business, regularly carried on, that is not substantially related to the charitable, educational, or other purpose that is the basis of the organization’s exemption. An exempt organization that has $1,000 or more or gross income from an unrelated business must file Form 990-T. An organization must pay estimated tax if it expects its tax for the year to be $500 or more.
The obligations to file Form 990-T is in addition to the obligation to file the annual information return, Form 990, 990-EZ or 990-PF. Each organization must file a separate Form 990-T, except title holding corporations and organizations receiving their earnings that file a consolidated return under Internal Revenue Code section 1501.
For more information on unrelated business income tax, see Publication 598, Tax on Unrelated Business Income for Exempt Organizations.
See Unrelated Business Tax Exceptions and Exclusions for a description of exceptions and exclusions from the unrelated business income tax applicable to tax-exempt organizations.
UBIT in an IRA
There is a commonly repeated view on Internet discussion groups, that “If your IRA invests in things that produce Unrelated Business Income (UBI), and the net income from these investments exceeds $1,000, your IRA could be subject to the Unrelated Business Income Tax (UBIT)”. This is possibly a myth. The 2006 Tax Information packet for Hugoton Royalty Trust states, in page 9, “In the opinion of the trust’s tax counsel, Winstead Sechrest & Minick P.C., the income of the trust will not be unrelated business taxable income so long as the trust units are not ‘debt-financed property’ within the meaning of section 514(b). In general, a trust unit would be debt-financed if the trust unitholder incurs debt to acquire a trust unit [...]“.
However, the IRS does unequivocally state in the first few paragraphs of Chapter 1 of the November 2007 revision of Publication 598 that IRAs are “subject to the tax on unrelated business income.”
With certain investments, IRA owners face other risks. The IRS can use portions of the IRC (sections 511–514) to tax a not-for-profit or a tax-exempt entity that conducts business unrelated to its original purpose. The rules cover income-producing “businesses” in tax-exempt entities, including trusts (IRA trusts under section 408(e)(1) that are considered businesses). Investments can lose their tax-exempt status and be taxed as business entities even though they operate in a tax-exempt environment. These rules relate only to investments the IRS considers “profit- producing” and camouflaged by tax-exempt entities such as using IRA funds to buy an interest in a cattle-breeding operation or to invest in a hedge fund that uses leverage to purchase securities. Both transactions generate unrelated business taxable income (UBTI).
Rents from real property are excluded in the definition of income under unrelated business income, so purchasing rental real estate in an IRA and collecting rents is an acceptable investment. Under section 512(b)(3), however, taxpayers must exercise caution if the rental property is leveraged. In such instances the net rents are limited to a $1,000 exemption.
The CPA should recommend restraint when an IRA client wants to make nontraditional investments, such as in a mutual fund owned or managed by the IRA owner, in an active marina or in a commercial building where an outside third party—not the seller—holds the mortgage. The IRS may consider all to be separate business enterprises.
Offbeat investments are at risk in two ways:
- Being construed as a prohibited transaction so the IRA risks its entire tax-exempt status.
- Contributing UBIT, which generally is taxable.
Unconventional investments must surmount both hurdles so they are sure not to jeopardize the IRA’s tax-exempt status.
Please check with your CPA or Tax Professional for additional information.