UBI in IRAs and Qualified Plans from Partnership Investments Can Ba a Nasty Surprise

By Drew Cheney May 20, 2013

During this past tax filing season, we came across several instances where clients experienced unexpected tax return filing requirements and, in some cases, tax liabilities resulting from partnership investments within their individual retirement accounts (IRAs) and qualified retirement plans.  This post will explore some of the issues involved in these unpleasant situations.

In general, tax-exempt organizations are required to pay income tax on net unrelated business income (UBI), which generally means income derived from regular business activities that are unrelated to the organizations’ missions.  In addition, investment income derived from debt-financed investments is generally taxable as UBI.  When people think of “tax-exempt organizations,” they generally think of charities such as hospitals or schools.  However, the term also includes IRAs and qualified retirement plans, which therefore are also potentially subject to tax on UBI.

IRAs sometimes invest directly in active businesses, which can give rise to UBI.  A more common situation, which is the subject of this post, is where the IRA or self-directed account within a 401(k) plan purchases an investment in a flow-through entity such as a publicly traded limited partnership.

On its Form 1065, the partnership is required to report to its tax-exempt partners the amount of these partners’ UBI from their investments.  According to the Instructions to Form 1065, this should be done using Line 20V on each partner’s Schedule K-1.  However, not all partnerships follow this requirement, and in some cases the relevant information regarding UBI is buried deep in the narrative statements attached to the K-1.

To report the tax on the UBI, the IRA or retirement plan needs to file Form 990-T and, in many cases, related state income tax returns.  Whereas most 990-Ts are due on the fifteenth day of the fifth month after year end, the due date for 990-Ts filed by IRAs and qualified plans is the fifteenth can of the fourth month after year end.  Therefore, because the vast majority of IRAs and qualified plans use a calendar year as their fiscal year, the due date is generally April 15.  Because so many other tax returns are due that day, it is easy for IRA owners and retirement plan sponsors to miss this filing deadline.

If an IRA is required to file a Form 990-T to report UBI, it generally must obtain its own unique employer identification number.  In addition, any tax owed is required to be paid directly from the IRA assets, or there is a risk of a prohibited transaction.  And because the K-1s are sometimes available only shortly before the April 15 deadline, the preparation of the 990-T and state returns and the payment of the tax can be a very unwelcome two-minute drill in the days or even hours leading up to the deadline, requiring coordination from the tax return preparer, the IRA owner, and the institutional trustee.

Self-directed accounts within defined contribution plans can give rise to similar UBI surprises.  If the account invests in a flow-through entity that gives rise to UBI, then the plan will have to file a Form 990-T and related state returns.  Any tax should be paid from the self-directed account containing the investment.

In light of the above, IRAs and qualified retirement plans should consider whether the potential investment gain of investing in flow-through entities that give rise to UBI is worth the very considerable administrative headaches that these investments can create.  IRA owners should consider avoiding these investments, and retirement plan sponsors should consider not allowing their self-directed accounts to use these investments.