UBTI stands for unrelated business taxable income. It’s the tax placed on the income earned from an unrelated business, regardless of the tax filing status.
How UBTI works
For our example, say an investor were to use their IRA to fund and start up a small business like a yoga studio. A yoga studio is a business not necessarily related to the primary principle of a traditional IRA. UBTI comes in at this point because the income earned from that yoga studio is considered unrelated business taxable income. Regardless of the fact that funds piping in are going into a tax-deferred, or tax-free account.
If an investor is qualified for a business loan through their IRA, any income or earnings that come as a result of the debt financing is also taxable. There are also certain tax deductions that can apply to UBTI, accordingly reducing tax liability. Eligibility for deductions has limits. The purpose of UBTI is to prevent tax-exempt accounts engaging with a business that is unrelated to their purpose. It includes most business operations’ income and excludes interest, dividends and capital gains from the sale or exchange of capital assets.
It’s important to note that UBTI isn’t illegal. You’re not breaking any laws if your IRA incurs UBTI, your IRA will just have to pay extra taxes. Investors everywhere miss out on opportunities because they don’t take their time to fully understand what UBTI is.
UBTI is reported on IRS Schedule K-1 and sent to investors once a year. Say an investor were to receive more than $1,000 of UBTI in one year. They generally must file additional paperwork with the IRS. On top of proving or disproving the intent of the retirement account investor, and whether or not the person was intending to engage in an active trade or business.