Unrelated Business Taxable Income (UBTI)
You may believe that the only time taxes are levied on an IRA or another form of retirement plan is when you take withdrawals or distributions. However, it is likely that certain income received in retirement accounts, which are tax-exempt entities will be taxed before that.
When tax-exempt charitable nonprofits make revenue from a source unrelated to their exempt purposes (for example, a commercial activity, such as sales of goods) and the activity is regularly carried on and it is not significantly connected to the charitable, educational, or other purposes that are the basis of the organization's exemption than the revenue from the activity will be taxable income under Internal Revenue Service (IRS) rules for "unrelated business income tax" also known as "UBIT."
Tax-exempt organizations often operate for charity or other beneficial purposes, and so the majority of their revenue is tax-free under the Internal Revenue Code (IRC). However, revenue-producing activities that are "unrelated to their exempt purposes" can result in taxable income.
How do you know if your earnings are taxed as unrelated business taxable income? Read on to learn more about what is unrelated business income tax, tax implications, and things to know about UBTI.
What is Unrelated Business Taxable Income (UBTI)?
The majority of not-for-profits (NFPs) are created to benefit the public. Tax-exempt status refers to the federal income tax exemption provided for certain types of income under Section 501(a) of the Internal Revenue Code (IRC). NFPs that have received IRS tax-exempt status is known as tax-exempt organizations or simply exempt organizations (EOs).
Federal law allows an NFP to participate in income-producing activities unrelated to the EO's exempt purpose, which may be subject to unrelated business income taxes (UBIT). Unrelated business taxable income (UBTI) is income that is subject to federal taxes.
For example, assume you own an oil drilling partnership in your IRA, and the drilling equipment held by the firm is leased to another corporation. This rental revenue would be termed UBTI.
The following categories of investments typically create UBTI:
- Limited partnerships (LPs) - enterprises held by more than one individual, with the owners having limited liability for business debt;
- Master limited partnerships (MLPs) - a form of LP that is publicly traded and commonly seen in the energy industry.
When an IRA invests in an MLP or LP, it becomes a partner in the partnership. This is a partnership ownership stake. Becoming a part- or full-owner of a business (such as an MLP or LP) does not fall under the IRA's exempt purpose. If the partnership borrows money, often known as utilizing leverage, it can create taxable income in a retirement plan.
Organizations that are not normally subject to UBIT regulations include:
- Companies formed under Acts of Congress that are instrumentalities of the United States, and
- Certain charity trusts are exempt from the tax on private foundations.
Tax Implications
An IRA is a tax-exempt entity that can be taxed independently of the IRA's beneficial owner. UBTI is subject to tax in all types of retirement accounts, including IRAs, Keogh plans, and health savings accounts (HSA). When the total positive UBTI across all applicable investments held in a retirement account exceeds $1,000, Form 990-T must be filed.
Things to know about UBTI
1. How can I determine whether I have an unrelated business taxable income (UBTI) of at least $1,000?
Check the following details on your Form K-1 to see if you've earned UBTI:
- UBTI from operating outcomes of the MLP or LP (typically reported on line 20-V of Form K-1).
- Ordinary profits from the liquidation of a partnership interest are 100% reportable as UBTI on Form 990-T (MLPs only).
- Unrelated debt-financed income (UDFI). UDFI is the share of the profits associated with the sale/liquidation of a partner's stake in a partnership or revenues from a taxable corporate action that is due to the acquired indebtedness, also known as debt-ratio gain (this information is obtained directly from the partnership).
- Debt cancellation income.
2. What information will be reported on the 990-T?
The 990-T will include information about the total amount of positive unrelated business income (UBI) that the retirement or health savings account generated. Allowable deductions, including the $1,000 special deduction, the 199A qualifying business deduction, and net operating losses are subtracted from this amount. The permissible deductions from UBI result in UBTI. More information is included in the Form 990-T instructions.
3. Does this have an impact on my non-retirement account(s)?
No, your non-retirement accounts will not get 990-T reports.
4. How is the tax liability calculated?
The unrelated business income tax (UBIT) amount is calculated using many data variables, including total UBTI, deductions, and the trust tax rate. The most recent trust tax table is available at IRS.gov. These computations are complicated, and you should consult with your tax expert before completing Form 990-T.
5. How will I know if a tax payment is due?
If it is determined that there is a tax payment obligation owed on your retirement account, you will be sent a letter stating the amount of tax that must be paid along with a copy of the IRS Form 990-T that will be sent to the IRS.
Bottom Line
Even though an organization is tax-exempt, it may still be required to pay taxes on unrelated business income. The filing of Form 990-T is in addition to the filing of the annual information return.