Subscribe and download our eBook, "100+ Tax Deductions for Small Business A to Z."
Hidden
Get the:

How Much Should You Pay Yourself?

Retirement Accounts and the Unrelated Business Income Tax

© Vetkit | Dreamstime.com - Financial Concept PhotoIt’s perfectly legal for IRAs or 401(k)s to own your business. (I wrote a lengthy piece about this for the SBA).

Those who put the ownership of their companies within such a plan do so because this may be the only funding option they have to start a business.

But just because your business’ profits are collected by a retirement account which otherwise defers any tax on earnings until distributions are taken doesn’t mean the profits are tax free. There’s something called UBIT.

About UBIT

UBIT stands for unrelated business income tax. It applies when a tax-exempt entity, such as an IRA or a 401(k), owns a trade or business and has unrelated business taxable income (UBTI). (A self-directed IRA as opposed to a regular IRA must be used for this purpose.) The UBIT was enacted in 1950 because many universities (tax-free entities) owned profitable businesses: Columbia University owned Rockefeller Center, Cooper Union owned the Chrysler Building, University of Chicago owned Encyclopedia Britannica, Union College owned Allied Stores (one of the largest department store chains), and NYU owned the C.F. Mueller Co. (a spaghetti and macaroni company). These schools used profits from commercial businesses to fund their activities with no diminution for taxes. But that’s all in the past.

How the UBIT works

If an IRA or 401(k) has an interest in a business, the plan must file Form 990-T, Exempt Organization Business Income Tax Return, and pay the resulting income tax. In other words, the plan’s assets are increased by business profits and reduced by its annual tax bill.

The plan pays federal income tax on trade or business income at the rates applicable to trusts and estates. This means that net income over $12,400 is taxed at 39.6%.  Let’s see how this tax arrangement compares to owning your business outright.

Let’s assume it’s a pass-through entity (an S corporation or limited liability company) so you pay tax on your share of business income on your personal return. If your profit for the year is $100,000 and you’re a joint filer, you’d pay only about $11,000 (assume this is your only income and you take the standard deduction). In contrast, the retirement plan would pay nearly $38,000 in taxes on the same profits.

For 2015 returns due in 2016, Form 990-T is due by May 15. The plan can obtain an automatic three-month filing extension, with an additional three month extension. For returns for 2016 and beyond, the automatic extension becomes six months (with no additional extensions).

Compliance problems

The pass-through entity must send a Schedule K-1 to the plan’s custodian or trustee. It is up to the account owner to see that the plan pays the tax owed. The plan’s custodian or trustee likely won’t provide any guidance in this regard for fear that it is offering tax advice. The failure to file a timely return and timely pay taxes can result in interest and penalties that continue to mount until the matters are resolved.

Bottom line

While it is tempting to use a retirement plan as a source of funding for your business, there are tax traps to avoid. The difficulties of this financing arrangement are amplified when factoring in problems (and penalties) of prohibited transactions as well as accounting and administrative complexities. Don’t involve a retirement plan in business ownership unless you work with a knowledgeable tax and legal advisor.