Having to explain to a Self-Directed IRA investor that there is potentially a tax that you may be hit with depending on the investments you make is not very enjoyable. That tax stems from Unrelated Business Taxable Income, UBTI, also referred to as UBIT, Unrelated Business Income Tax which may turn a tax-free investment into something much worse – taxable! The majority of investments one can make with retirement funds grow without tax so long as they are held in the IRA, but there are a handful of instances where taxes are due. The good news is that the UBTI tax only applies in very narrow circumstances for investors and the concept of a tax distribution could potentially eliminate the impact of the tax on your Self-Directed IRA investment.
What is UBTI?
In general, when it comes to using a retirement account to make investments most investments are exempt from federal income tax. This is because a retirement account is exempt from tax pursuant to Internal Revenue Code Sections 401 and 408. IRC Section 512 of the Code exempt most forms of investment income generated by an IRA from taxation. Some examples include interest from loans, dividends, annuities, royalties, most rentals from real estate, and gains/losses from the sale of real estate. Income generated from the following sources could subject the IRA to UBTI:
- Business income generated via a passthrough entity, such as an LLC or partnership
- Using a nonrecourse loan to purchase a property
- Using a nonrecourse loan to buy an asset, such as a stock purchase
If the UBTI rules are triggered, the income generated from those activities would generally be subject to a maximum tax rate of 37% tax for 2024. If the UBTI tax is triggered, a tax efficient investment that would typically be made in an IRA would become taxable at that rate. Thankfully, the tax only applies in the three investment categories mentioned above and typically does not get triggered when the IRA generates passive income, such as capital gains, interest, dividends, rental income, and royalties.
The Tax Distribution
A tax distribution provision in a limited liability company (LLC) operating agreement assists the members in meeting their federal and state income tax obligations with respect to their allocated net profits. In general, an LLC member pays tax on the amount of net profits allocated to him or her, not on the receipt of distributions of available cash. In certain circumstances, net profits are allocated to the LLC members, but the corresponding cash is withheld for operational reasons (i.e., establishing company reserves) resulting in “phantom income” to the members, including the Self-Directed IRA. In that case, the LLC may provide members with a tax distribution sufficient to cover their federal and state income tax liability.
A tax distribution is generally helpful in cases where a member does not have alternative sources of income apart from income generated by the LLC. Thus, if an IRA makes an investment into a private businesses or investment fund that is operated via an LLC, and the LLC generated net profits but did not make a corresponding distribution of cash to the IRA, the IRA would have a problem coming up with the funds to pay the UBIT on the phantom income generated by the investment.
For example: Steve and Joe each contribute $100,000 from a Self-Directed IRA to the LLC in exchange for a 50% interest in the LLC respectively. In year one, the LLC generates $40,000 of net profits. If management decided to reinvest the $400,000 in the business rather than distributing it to the members, Steve and Joe’s IRAs would still be forced to pay the income tax on their allocated share of net profits ($20,000 each). A tax distribution provision would allow the LLC to distribute enough money to Steve and Joe’s IRA, 37% of the $20,000 each or $7400 (37% is the maximum trust tax rate for 2024) to cover their tax tax liability resulting from an allocation of net profits without a corresponding distribution of cash.
Therefore, having a tax distribution provision in the LLC operating agreement can help eliminate the negative impact the UBTI tax can have on an IRA investment. Before making a Self-Directed IRA investment into an LLC investment that could trigger UBTI, it is important to have a tax professional review the tax distribution provision language in the LLC operating agreement. As an example, the language may call for tax distributions to be determined on a cumulative basis, implying that prior-year losses allocated to LLC members are taken into consideration when determining if the LLC members need cash for income in subsequent tax years.
Furthermore, another important consideration is whether or not tax distributions are treated as advances against regular non-tax distributions of the return on investment, which can have an economic impact on the overall business deal.
In general, tax distributions are treated as advances for other non-tax distributions, however, there are instances when the tax distributions are not treated as advances against the distribution waterfall and, hence, do not impact future LLC distributions.
Conclusion
The tax distribution option can be an important way to minimize or even eliminate the impact the UBTI tax can have on a passthrough business or investment fund transaction involving a Self-Directed IRA. It can help solve the problem of an IRA experiencing phantom income by providing a cash distribution to cover the tax, which is paid by the IRA using Form 990-T. In addition, in some instances, the tax distributions may not be taken into account for any future LLC cash distributions. Overall, the tax distribution is a very useful solution for combating the negative impact the UBTI tax may have on your investment.
