We have discussed in prior posts about the importance of thinking of tax preparation as more than an annual tax compliance function, but to view it as one step in your tax planning strategies to reduce taxes and to increase your financial wealth. All taxpayers should periodically meet with their tax professional to discuss planned financial transactions and how best to accomplish them.
Let’s consider the following scenario. Your financial advisor recommends that you invest a portion of your IRA in a limited partnership to increase your investment returns and to diversify your portfolio. There is nothing wrong with this picture . . . or is there? When gathering your tax records to send them to your tax professional as part of your annual tax preparation process, you notice that you received a Form 1099-R for IRA distributions of which you were unaware. Since you know for sure that you did not take an IRA distribution, you believe that the 1099-R must have been issued by mistake and you call your investment advisor for an explanation.
Your investment advisor makes some calls and later shares with you that while IRAs are generally exempt from income tax (excluding distributions), there are exceptions and one of those is a tax on unrelated business income. You call your tax professional for guidance. Your tax professional regretfully informs that there are certain situations in which an IRA can generate taxable income in the form of unrelated business taxable income (UBTI) or unrelated debt-financed income (UDFI) which is taxed at a flat rate of 39.6%. You learn that UBTI is “gross income derived by an organization from any unrelated trade or business regularly carried on by the exempt organization . . .” less certain deductions. UBIT (unrelated business income tax) is the tax that is paid on UBTI generated from a trade or business. Whereas most passive income earned such as interest, dividends, royalties, rents and interest from loans is exempt from taxation, there are exceptions when limited liability companies, limited partnerships, leveraged properties and investments in active businesses are involved. UDFI is generally associated with income-leveraged property for which the IRA would earn interest income from lending money related to the acquisition of property.
Partnerships that have UBTI (or UDFI) will send out a Schedule K-1 to its partners showing the amount of UBTI (or UDFI) in Section 20 of the K-1 form. The details regarding the required filing of IRS Form 990-T are beyond the scope of this post and one needs to consult with his tax professional for additional guidance.
When the IRA custodian receives Form 990-T from the IRA investor, the UBIT will be paid from your IRA account (a distribution) which explains why you received the 1099-R. The bad news may get worse. What if the taxpayer was under age 59 ½? The distribution to pay the UBIT tax may be subject to the 10% penalty for early withdrawal. Will the additional taxable income decrease your itemized deductions and personal exemptions resulting in additional income taxes due? Will this additional income subject more of your social security income to taxes? Is it possible that you may now be subject to underpayment penalties for failure to make estimated tax payments during the calendar year relating to this income? To address all of these issues with your tax professional and the filing of additional IRS forms will result in an increased fee to prepare your tax return.
Perhaps your money would have been better spent by meeting with your tax advisor before making this investment? UBTI is not an easy concept to understand. So what is the take-away from this post? When making financial decisions, you should not be hesitant about consulting with your tax advisor. While the investment advisor may have emphasized the expected return on your investment, keep in mind that ROI was a pre-tax estimate. It is important as an investor that you understand your after-tax ROI.
If you want to learn more about your personal tax and financial strategies, we invite you to call 610-594-2601 today to make an appointment at our Exton PA CPA office to discuss your situation. You can also schedule a consultation at Click Here.
