You already know that an Individual Retirement Account (IRA), is a tax-advantaged plan that allows anyone with income to save for retirement. Something that few people know is that to the IRS, the correct phrase for an IRA is “Individual Retirement Arrangements.” That minor difference is not particularly important but when it comes to the IRS, details do count.
Self-directed IRAs are different and the details do count when it comes to reporting to the IRS. Generally, there is no annual IRS filing requirement for IRA accounts. Almost universally true for traditional IRA accounts invested in traditional stocks and bonds on limited opportunity exchanges. Self-directed IRAs do give you much more investment flexibility that can require submitting information forms to the IRS. Providing information does not mean you owe federal.
Keep in mind that IRAs are not subject to federal taxes.
Self-Directed IRA Does Not Trigger IRA Attention
It’s not the IRA itself that can trigger IRS reporting requirements but rather the investing alternatives and flexibility that comes with the self-directed IRA structure that might trigger IRS requirements that are not directly related to the IRA.
These IRS reporting requirements depend on:
- Self-Directed Roth IRA information reporting.
- The IRA owning an LLC (Limited Liability Company).
- The type of LLC – single member or multi-member. Depending on what type of company your IRA owns, the annual filing requirements for your self-directed IRA may differ.
- Unrelated Business Taxable Income (UBTI) and Unrelated Debt-Financed Income (UDFI) taxable transactions.
At first glance, these subjects appear complicated. Rest assured, once explained, they are clear to understand.
Self-Directed Roth IRA Information Reporting
A Roth IRA is very different from a traditional IRA. This is true even if it is not a self-directed IRA. The significant difference is the upfront tax treatment when Roth IRA contributions are made. Contributions are made with after-tax funds. You pay the taxes before the contributions are made but withdrawals are tax-free. The tax-free treatment includes all the earnings that accumulate over the years.
Tax-free is different from tax-deferred, which is what a traditional IRA is. For tax deferred, you pay taxes on withdrawals, but do not pay on contributions. The intent is to withdraw traditional funds after retirement at a lower tax rate. For tax-free, after the Roth IRA account is open for at least five years and you reach age 59 1/2, no taxes are owed on any withdrawals. Although you pay taxes on Roth contributions, you do not pay taxes on Roth withdrawals – this includes not paying taxes on the Roth earnings. Additionally, contributions to a Roth IRA can be withdrawn tax-free at any time because the taxes have already been paid (even before age 59 1/2). However, you cannot withdraw the earnings tax-free until the five years and age 59 1/2 requirements are met.
For these reasons, the IRS requires information reporting on Form 8606, Part III for distributions from a Roth IRA. This is also reported on your 1040 form.
IRA Owning an LLC
An IRA owning an LLC generally does NOT change the tax treatment of income for the IRA that owns the LLC. It also does not change the requirement to avoid prohibitive transactions.
However, UBTI and UDFI generated by an LLC can trigger tax consequences and we’ll get into that in a moment. If there is no UBTI or UDFI, the LLC generally does not have to file a federal income tax return, nor does the self-directed IRA have to file a federal income tax return. Still, the self-directed IRA custodian must file Form 5498 each year, which is information about contributions and the value of the self-directed IRA.
However, there are different reporting requirements if it is a multi-member LLC. Again, the reporting requirements here assume there is no UBTI or UDFI. The IRS treats a multi-member LLC as a partnership. The same as a single-member LLC, multi-member LLCs do not pay taxes on business income. Instead, the LLC owners each pay taxes on their share of the profits on their personal income tax returns. Keep in mind that the IRA owns the LLC, not you as a taxpayer. Your IRA LLC earnings are tax-exempt as your IRA is a tax-exempt entity.
Partnerships (multi-member LLC) must file an informational tax return and prepare income statements for all the owners of the company. The return itself is IRS Form 1065. The income statement to the owners is Schedule K-1 and is prepared by the LLC. The income reported on the IRA owner’s K-1 is not taxable, and does not have to report the income on a personal income tax return.
UBTI or UDFI Tax Filing
UBTI is Unrelated Business Taxable Income and UDFI is Unrelated Debt-Financed Income. These two specific situations do have tax requirements when investing with a self-directed IRA.
If your IRA owns a business, such as a Latte Stand, you will be subject to UBTI; including if the LLC owns the business. UBTI is defined as “gross income derived by any organization from any unrelated trade or business regularly carried on by it.” You may want to read IRS Publication 598. Your IRA is a tax-exempt organization, but engaged in a taxable business. The IRS says it is subject to UBTI if it meets three requirements:
- It is a trade or business,
- Regular act
- It is not substantially related to furthering the exempt purpose of the organization.
For example, flipping houses is considered an active business and will generally owe UBTI (often depending on how many houses are bought and sold each year). There are several modifications, exclusions, and exceptions to the general definition of unrelated business income.
But UBTI does not apply to passive income. So, if your self-directed IRA invests in real estate and other passive sources of income, it should not be subject to UBTI. For instance, rental income from real property is considered passive income and is not subject to UBTI.
IRA Owes UBIT or UDFI
UDFI can trigger owing taxes to the IRS and has filing requirements. UDFI is a type of UBTI when using debt to finance an investment (such as a mortgage to purchase real estate). The taxable amount is in proportion to the amount borrowed to finance the investment. For instance, if your self-directed IRA invests 60% and borrows 40% to purchase a real estate property, the 40% of earnings attributed to the borrowed funds is taxable. The IRS definition of UDFI is in IRC Section 514.
However, with a Solo 401k plan you can use a non-recourse mortgage without being subject to the UDFI rules and UBTI tax. This exemption provides significant tax advantages by using a Solo 401k plan instead of an IRA to purchase real estate.
If an LLC owned by an IRA incurs UBTI or UDFI, Form 990-T must be completed to report the income and pay the tax. It is generally only these two situations that give rise to taxable income for the self-directed IRA. The self-directed IRA owes taxes. Therefore, the self-directed IRA prepares the return using the IRA EIN. IRA funds must pay the taxes.