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IRA Tax on Non-Passive Income UBIT Tax Law & Cases

Statutes 

IRC § 408 (e). When retirement accounts were established, Congress decided that it was important to separate what income would be exempt from taxation in retirement plans and what income would still be subject to tax when earned in a retirement account.

IRC § 511, IRS Publication 598, pg. 2 (2012). Unrelated Business Income Tax (“UBIT”) applies to ordinary income received by an IRA.

IRC § 512(b). The exemptions to UBIT tax

UBIT TAX EXCEPTIONS

Income Type

Explanation

Interest Income 512(b)(1)

Interest income, such as interest payments on loans made from the self directed IRA are exempt from UBIT tax. 

Dividend Income 512(b)(1)

This is the most common exemption and applies to dividends/profits received by an IRA from a C corporation (e.g., most publicly traded companies). Real Estate Investment Trust (REITs) income may also be considered a qualifying dividend and exempt. IRS Revenue Ruling 66-106. 

Royalty Income 512(b)(2)

Royalty income is the income derived from intangible property rights such as intellectual property (e.g., use of name, software licensing, patent license). It also includes royalty income from certain oil and gas, and mineral-leasing activities. 

Rental Income 512(b)(3)

Rental income derived from real property is exempt from UBIT tax. Personal property that is leased in connection with real property is also exempt. Equipment leasing or other personal property leasing can be subject to UBIT tax unless the income can be considered interest income when the leasing is structured as a financing agreement. 

Capital Gains 512(b)(5)

Capital gains from the sale, exchange, or other disposition of property, except for “property held primarily for sale to customers in the ordinary course of the trade or business.” 

IRC § 512(b)(5)(B). The capital gain exemption for the sale of property does not apply when the property was “…held primarily for sale to customers in the ordinary course of the trade or business.”

IRC § 512(b)(5). The after-tax profits are then paid to the IRA (or other owners) as dividends. Dividends paid to an IRA are exempt from UBIT tax

IRC § 514(b)(1). UDFI tax is applied to income from “debt financed property” that is subject to “acquisition indebtedness.” Debt financed property is defined as property held to produce income that has acquisition indebtedness.

IRC § 514(b)(1). Additionally, debt incurred after the acquisition of property is acquisition indebtedness if such debt would not have been incurred without the property and if such debt were reasonably foreseen at the time of acquisition.

IRC § 514(9). 401(k) and other employer plans are exempt from UDFI taxes that arise from debt on real property.

IRC § 514 (9)(C)(ii). The tax code specifically exempts plans which are “qualified trusts” under section 401 from the tax code from UDFI tax.

Internal Revenue Manual, Part 2, 7.27.8.4. Unrelated Debt Financed Income, Gain From Sale or Other Disposition of Property, Treasury Regulations 1.514(a)-1(a)(v)(b), IRS Publication 598 (2012). UDFI tax at the time of sale works in a similar fashion to the example above, but the IRA is able to use the capital gain tax rate of 20% on profits subject to UDFI as opposed to being subject to the UBIT rate.

IRS Publication 598 (2012). The tax rates applicable to UBIT tax are the trust tax rates which cap out at a maximum rate of 39.6% at $11,950 of annual income subject to UBIT tax. The UBIT tax should be paid from the IRA’s funds and should not be paid with personal funds of the IRA owner.

Cases and Opinions

Adams v. Commissioner, 60 T.C.M. 996 (1973) 

In Adams, the U.S. Tax Court adopted a facts-and-circumstances test that is frequently used to analyze whether property is held for investment or held for sale in the ordinary course. The relevant factors are outlined below. 

Intent. Property bought and held for investment demonstrates that the property is not intended to be held for sale. On the other hand, property bought and immediately held for sale would demonstrate intent to hold for sale in the ordinary course.

Holding Time. If the property is held less than a year, it is more likely to be considered property held for sale as opposed to property held for investment. In sum, the longer the property is held the more likely it is to be deemed held for investment. 

Development, Construction or Improvements. Property which goes from land to fully developed homes or buildings will likely be deemed ordinary business activity and not property held for investment. Development, construction, and improvements make the property and profits from it appear to be conducted in the course of business as opposed to being held for passive investment. 

Number of Sales or Frequency of Similar Transactions. A large number of sales of property that are short-term in duration will likely cause an IRA to be deemed to be in the ordinary business or selling real estate as opposed to holding and selling for investment.

Misc. and Tables

IRS form 990-T. If UBIT tax is due, the IRA must file IRS form 990-T to claim and pay the UBIT tax.

UBIT TAX RATE (2014)

ANNUAL INCOME  UBIT TAX RATE
$0–$2,500 15%
$2,500–$5,800 $375 plus 25%
$5,800–$8,900 $1,200 plus 28%
$8,900–$12,150 $2,068 plus 33%
Over $12,150 $3,141 plus 39.6%

IRS Publication 542 (2012). CORPORATE TAX RATES (2014)

Income Corporate Tax Rate
$0–$50,000 15%
$50,000–$75,000 $7,500 plus 25% above $50,000
$75,000–$100,000 $13,750 plus 34% above $75,000
$100,000– $335,000 $22,250 plus 39% above $100,000
$335,000–$10,000,000 $113,900 plus 34% above $335,000
$10M – $15M $3,400,000 plus 35% above $10M
$15M – $18,333,333 $5,150,000 plus 38% above $15M
$18,333,333 35%

 

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