What is Unrelated Business Tax?

What is Unrelated Business Income Tax?

The idea of Unrelated Business Income Tax pre dates IRA’s. As a matter of fact, the origin of this concept goes back over 70 years. The definition and treatment of unrelated business income has been amended many times, the most recent major revision was in 1984.

Although this is a tax concept appears to have nothing directly to do with IRA’s; an IRA can easily step over a line and create what is referred to as Unrelated Business Income. This in turn causes Unrelated Business Income Tax. (UBIT). Do not be overly concerned, both the concept and the tax are reasonable. The best tool for avoiding an unintended volition of the IRS rules on this topic is to be armed with some basic knowledge.

You may find that in some cases paying UBIT is a good thing. The fact that there is a clear definition of the concept and the tax allows you additional investment options in your IRA that you may not have had in its absence.

First, a little background: Imagine for a moment that you own a T-Shirt Shop in downtown Chicago about a block from the Art Institute of Chicago (AIC). Your main goal is to sell t-shirts and hats to tourists who are downtown, many of whom are drawn there by the Art Institute.

The directors of the AIC notice that you are doing well selling your shirts and they want to get in on the “action”. So, the AIC opens a T-Shirt shop to compete with your store.

This really bothers you. Not only are they taking away part of your business, they (the Art Institute)  is a recognized “Not for Profit” and thus pays no income tax on their earnings while you must carry the burden of paying income tax.

The IRS recognized this dilemma and responded by defining “Unrelated Business Taxable Income” and creating a tax on such activity. The tax is called “Unrelated Business Income Tax”

In the above example, the IRS would call the income that the CIA earns from T-shirt and hat sales “Unrelated Business Income”.

Even though the Chicago Institute of Art is a recognized “not for profit organization”, their T-shirt shop is a business that is unrelated to the goals of the not for profit and thus its income will be subject to income tax (at the Trust Tax rate).

There are a few exceptions to the rule.

1. If the merchandise sold in the store relates exclusively to the museum. For example: Selling a King Tut T-shirt during a King Tut exhibit is a “related business” and thus not a taxable event.
2. The event is not of an on-going nature. For example: A weekend car wash put on by the museum as a fund raiser.
   

In general, the concept of UBIT is to “level the playing field” for all.

UBIT is charged at the “Trust Income Tax Rate” as of this writing:

$0 to $2,000 Rate 15%
$2,000 to $4,700 Rate 25%
$4,700 to $7,150 Rate 28%
$7,150 to $9,750 Rate 33%
Over $9,750 Rate 35%

The principle time that UBIT can come up is if your IRA uses leverage. The portion of the income that the IRA earned that was due to leverage will be UBIT to the IRA. (The tax is on the IRA, not on the IRA owner)

The computation of UBIT is done by completing IRS Form 990. (Your accountant will be familiar with this form.) Should your accountant want additional information on UBIT we suggest IRS Publication 598.

The following is from the IRS Web site:
For most organizations, an activity is an unrelated business (and subject to unrelated business income tax) if it meets three requirements:
1. It is a trade or business,
2. It is regularly carried on, and
3. It is not substantially related to furthering the exempt purpose of the organization.

There are, however, a number of modifications, exclusions, and exceptions to the general definition of unrelated business income.