Unrelated Business Income Tax

[bdeancpa]

We have a client who has decided he wants to use his retirment plan to get into real estate development. This year he invested with a contractor and they built one house and sold it. The contractor and the plan split the profit. We told our client the wouldn't be any UBIT on the transaction if this was a one time deal as the plan did not own a trade or business.

Because of the success of the venture, the client wants to continue develping real estate. I have concerns regarding UBIT if he goes this route. If the plan owned a non-management interest in an LLC and the contractor (not a related entity) was the managing LLC member, would the plan still be subject to UBIT on its share of the profits? If so, is there anywhay the plan could do something like this and avoid UBIT?

Thanks for your help.

Dean Huber

[JAY21]

I don't believe it matters whether there is an "LLC" between the plan and the real estate ownership. The same issue exists. The LLC would still report the amount of the UBIT to the plan via a k-1 statement (if it's determined to be UBIT). My personal opinion is that you're in a grey area now as to whether you're running a business within a tax qualified plan. I don't believe there is any specific guidance as to how many much such deals the plan could do before running the risk of being deemed a business. It's probably a facts-and-circumstances issue and subject to the Trustees risk tolerance and potentital IRS auditor's take on it. For what it's worth rental income on real estate is expressly exempt from UBIT, although if there's debt financing involved on the deal it's trickier and then could still trigger UBIT in some situations.

[Lori Friedman]

if there's debt financing involved on the deal it's trickier and then could still trigger UBIT

We don't really have any information about the plan. If Dean's asking about a Sec. 401(a) qualified plan, the debt-financing rules shouldn't be an issue for real estate transactions. With certain limitations, a qualified plan trust is exempt from UBIT on income from debt-financed real estate property. Unlike other exempt organizations, a Sec. 501(a) trust can incur debt for the acquisition and improvement of real estate without being liable for UBIT on any rental income or capital gain from selling the property. I.R.C. Sec. 514©(9)(A) and ©.

[Kirk Maldonado]

Lori:

There is an exception from Unrelated Debt Financed Income for certain leveraged real estate transactions, but that is not a blanket exemption from unrelated business taxable income rules.

[Lori Friedman]

Kirk, I'm not suggesting that qualified trusts have any "blanket" exclusion from UBIT. To the contrary, the trusts are very much subject to UBIT. Sec. 514©(9) provides a general rental income and capital gains from debt-financed real estate property. If the qualified trust uses debt-financing to purchase other types of property -- for example, investment assets -- the related income is subject to UBIT.

[mbozek]

The exemption from UBIT for debt financed RE is subject to several qualfications in subsection (B). A small plan sponsor is unlikely to seek tax advice as to the qualifications for purchasing leveraged RE which is why I would never recommend it as an investment technique. In addition the RE is subject to seizure by the lender if the loan goes into default leaving the plan fid subject to a claim of breach of fiducary duty under ERISA.

[JAY21]

The several qualifications to remain exempt under subsection B was what I meant by "tricky".