The Initial Formation of a Self-Directed IRA Structure
The landmark case of Swanson v. Commissioner, 106 T.C. 76 (1996) confirmed that an IRA can purchase the stock of a newly-formed business entity (an S Corporation) without running afoul of ERISA’s prohibited transaction restrictions (specifically, ERISA’s Title II prohibitions, which are contained in the Internal Revenue Code). More recently, the U.S. Tax Court in T.L. Ellis, TC Memo. 2013-245, October 29, 2013, held that establishing a special purpose limited liability company to make an investment did not trigger a prohibited transaction, as a newly established limited liability company cannot be deemed a disqualified person pursuant to IRC §4975. Clearly, it's well settled that an IRA owner can direct her IRA to purchase the initial ownership interests of a newly-formed business entity without worrying about ERISA.
However, immediately after the IRA capitalizes the new business entity, the IRA owner must keep ERISA’s prohibited transaction restrictions in mind when she interacts with either the IRA or the newly-formed business entity. Depending on the application of the Plan Asset Regulation (as discussed in Part 1 of this two-part article), the IRA owner may need to treat the activities/transactions of the new business entity as if they are business activities of the IRA itself when considering ERISA’s prohibited transaction restrictions. In addition to the application of the prohibited transaction restrictions and related Look-Through Provision under ERISA, if the IRA capitalizes and becomes the owner of a pass-through entity (e.g., a limited liability company), the IRA will be subject to unrelated business income tax (UBIT).
In Part 1 of this two-part article, we reviewed the general prohibited transaction provisions, and considered the application of the Plan Asset Regulation in the context of non-traditional IRA investments. In this second part, we discuss the application of UBIT to IRAs.
Unrelated Business Income Tax (UBIT)
When an IRA either (i) invests in pass-through business entities or (ii) regularly engages in a trade or business (i.e., the IRA itself is acting similar to a sole proprietorship in operating a business), the profits gained from the operations of the business entity or the IRA’s “business operations” will likely be subject to UBIT. If an IRA earns more than $1,000 of unrelated business income per year, it must pay income taxes on that income. The purpose of UBIT is primarily to prevent tax-exempt entities from unfairly competing with businesses that are subject to taxation but UBIT also applies to IRAs. Generally, an IRA is a tax-deferred vehicle—it will not be taxed on its capital gains or income as long as the profits from investments stay in the IRA account. An IRA can easily avoid UBIT by (i) not investing IRA funds directly into pass-through business entities, and (ii) not engaging in a trade or business.
According to IRS Publication 598, unrelated business income is the income from a trade or business “regularly conducted” by the IRA. The concern for UBIT for IRAs typically arises when the IRA invests in an entity that passes through its income to be taxed at the shareholder or member level (e.g., S corporations, limited liability companies, etc.). However, UBIT may also apply to an IRA if it is “regularly” engaged in a trade or business. For example, UBIT may arise if the IRA regularly purchases homes for rehabilitation and then sale. The IRS may consider this activity to be a trade or business conducted by the IRA. There are several modifications, exclusions, and exceptions to the definition of unrelated business income and they will need to be considered before an IRA is directed to invest in a pass-through business entity or decides to conduct a “trade or business” with its assets.
UBIT generally applies to revenue generated from a trade or business, whether through a business entity or by the IRA itself. According to IRS Publication 598, “all dividends, interest, annuities, payments with respect to securities, loans, income from notional principal contracts,” and other income that is substantially similar to these types of income are excluded in computing UBIT. If an IRA is subject to UBIT, such amounts are taxable at corporate rates (corporate rates were reduced to 21% in 2018 by the Tax Cuts and Jobs Act); however, an IRA may be liable for alternative minimum tax.
If an IRA owner directs her IRA to invest in pass-through business entities, she may want to consider directing her IRA investment into a C-corporation which then invests directly into the pass-through entity (a C-corporation Blocker). Any revenue that is passed through to the C-corporation will not be subject to UBIT because this revenue will be subject to corporate level tax. Arguably, the C-corporation Blocker structure has more tax benefits than having the IRA invest directly into the pass-through entity because the C-corporation will not be subject to an alternative minimum tax which was eliminated by the Tax Cuts and Jobs Act. In other words, if the IRA uses a C-corporation Blocker (i) the IRA avoids UBIT and the related alternative minimum tax, and (ii) the C-corporation would only be subject to the reduced corporate level tax rate—because there is no longer an alternative minimum tax on C-corporations.
Whether an IRA owner chooses to use the C-corporation Blocker when directing her IRA investments, or simply chooses to direct IRA investment into a pass-through entity, the IRA owner must also understand how the Plan Asset Regulation and prohibited transaction provisions apply to each IRA investment. If the C-corporation Blocker is used, the C-corporation’s assets will be considered the IRA’s assets because the C-corporation would be a holding company, not an operating company. However, the Look-Through Provision may not apply as to the pass-through entity because that entity is likely to be considered an “operating company” under the Plan Asset Regulation—depending on the business operations of that entity. Nevertheless, the IRA owner must carefully evaluate every transaction that occurs between the IRA owner and any entity owned by her IRA.
Given the existing legal and regulatory guidance from the court and IRS, establishing the investment vehicle for self-directing investments through an IRA is the easy part. After careful tax analysis determines the type of business entity to be owned by the IRA, the real challenges and ERISA pitfalls for the IRA owner come immediately after the business entity is capitalized by their IRA—depending on the type of business entity created and capitalized by the IRA. Consequently, it is critically important for the IRA owner to understand whether or not ERISA governs or restricts any future investment or underlying business activity of the business entity owned by their IRA.
If you have any questions about this article, please contact a Boutwell Fay attorney.
© Boutwell Fay LLP 2019, All Rights Reserved.This handout is for information purposes only, and may constitute attorney advertising. It should not be construed as legal advice and does not create an attorney-client relationship. If you have questions or would like our advice with respect to any of this information, please contact us. The information contained in this article is effective as of April 30, 2019.