Common IRA K-1 mistakes. UBTI? Will the IRS notice?

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It’s that time of year again – TAX SEASON – which, without fail, leads to many “interesting” situations/challenges for clients and their advisors.  For me, because my legal practice involves clients with “non-traditional” assets within their retirement accounts (e.g., self-directed IRAs, Solo 401Ks), my perspective on this time of year is mostly based on issues I see with tax forms that are issued (or not issued) to my clients’ IRAs.  One of the most common problems I see relates to Schedule K-1 – which is a tax form that is required to be issued to any partner/Member in a partnership or multi-member LLC.  For example, many self-directed IRAs invest into “project” entities, where numerous investors (whether IRAs, individuals, other entities, etc.) acquire a fractional interest in a LLC or Limited Partnership (LP).  These Project entities then often acquire financing/debt (a process that the SDIRA’s owner is entirely uninvolved, and thus, often doesn’t pay much attention to) and invests into a real estate project, for example, an apartment building, commercial property, development, closely-held business, etc.

Typically, the initial investment into the Project entity is somewhat “rushed” and the paperwork is signed by the self-directed IRA’s owner (whether the SDIRA is structured through it’s own IRA-owned LLC or not) without much thought.  The potential problems come up when the Project entity issues it’s first Schedule K-1, which is generally within the first few months of the year following the year when the SDIRA makes its investment – i.e., just enough time for the SDIRA’s owner to somewhat lose track of the situation.

With my above commentary as background, the following is a list of some (but not even close to all) of the problems that I see when K-1s are issued to SDIRAs or SDIRA-owned LLCs:

  1. Incorrect Partner Tax ID Number.  Part II, box E of the K-1 is supposed to list the tax ID number (whether social security number or EIN) of the partner/Member of the Project entity.  In the case of an SDIRA investing into a partnership/LLC, if the SDIRA owner’s social security number is listed on the K-1 (a very common problem!), the IRS will falsely believe that the SDIRA owner individually owes tax on the income listed in Part III of the K-1.  If the SDIRA’s owner ignores the K-1 (which is somewhat logical because he/she knows that the investment is not owned by him/her individually, but rather by his/her IRA), the SDIRA’s owner will likely receive a letter from the IRS (i.e., “we believe that you underreported your income.”) and cause a whole lot of headaches going forward – particularly if the K-1 lists a significant amount of profit (as compared to loss) – whether rental income, interest income, capital gain, etc.  As you might guess, the IRS mostly cares about situations where it looks like people are not reporting income (they could care less if you forgot to take losses/deductions that you were entitled to!).  With the above being said, the correct tax ID number to be listed is either the custodian’s EIN or a standalone IRA EIN (which is best is too complicated of a question for this blog post – sorry!).
  2. 100% IRA-owned LLC’s EIN is listed.  Related to item #1 above, if an SDIRA owns 100% of an LLC (a structure that is tragically referred to as a “checkbook IRA”), then the LLC’s name should be listed on the Project entity’s investment paperwork as the investor.  However, for federal tax purposes, the IRA-owned LLC is completely ignored (i.e., it is a “disregarded entity”), so it’s EIN should not be listed on the K-1.  However, often times, the LLC’s name and EIN will be listed as the “partner” on the K-1 and then the accountants issuing the K-1 (i.e., the accountants for the Project entity) will say that the partner’s (IRA-owned LLC’s) tax classification is “partnership” (see Part III, line I1 of the K-1 form).  The problem with this is the IRS can falsely believe that the IRA-owned LLC should be filing a standalone tax return (Form 1065), when it should not (again, because it’s a 100%-owned disregarded entity).  In other words, despite the IRA-owned LLC’s name being the “investor”, the K-1 should “look through” to the IRA itself.
  3. Unrelated business taxable income (UBTI) or unrelated debt-financed income (UDFI) is applicable, but not enough information is provided.  As I have written in many other posts and articles (for example, see my article in the Journal of Accountancy enticed “Self-directed IRAs – A Tax Compliance Black Hole“), counter to popular belief, a self-directed IRA can definitely owe current tax – if the income earned within the investment is either “UBTI” or “UDFI” [note: this tax is due from the IRA or IRA/LLC directly, not from the SDIRA’s owner individually, another common misunderstanding].  In the case of an SDIRA or SDIRA-owned LLC investing into a Project entity, whether UBTI or UDFI is applicable depends on the income that is “flowing through” on the K-1.  For example, if income appears on Part III, line 1 of the K-1 (“ordinary business income”), then UBTI is almost guaranteed.  Also, if income appears in other boxes in Part III (e.g., capital gain, rental income, interest, etc.), some of that income could be considered UDFI if the Project entity is using financing/debt (hint: look at Part II, part K of the K-1 to see whether the Project entity has “liabilities” – i.e., debt).  However, even if it appears that UBTI or UDFI is applicable, unless the accountants that are preparing the K-1 attach a “20V Schedule” to the K-1 (which will specifically say how much UBTI/UDFI is applicable), then the SDIRA’s owner (and his/her accountant) is somewhat in the dark.  In other words, in order for the SDIRA’s owner (via his/her accountant) to prepare a standalone IRA tax return (Form 990-T, which is the IRS form that reports UBTI/UDFI) and pay tax, they need to have enough information from the Project entity’s accountants.  Round and round we go!!
  4. K-1 mailed to IRA custodian is ignored.  One practical problem that comes up regularly is that the Project entity’s accountants mail the tax forms (e.g., K-1, Form 1099, etc.) directly to the IRA’s custodian, but the custodian does not pass a copy along to the IRA’s owner (perhaps assuming that a copy went to him/her as well).  This can be a major problem if one of the other problems identified above are present – because the SDIRA’s owner (and his/her tax advisors) will be completely unaware of the problem(s), and thus, have no ability to correct it.