As you have written about extensively on this blog and within other “self-directed IRA” related articles, one of the key legal matters that SDIRAs face is “unrelated business taxable income” (UBTI) – i.e., current tax from the SDIRA’s investments. Generically speaking, UBTI occurs in two situations: (1) the SDIRA earns income (directly or through a partnership) that is considered “ordinary business income” [example: SDIRA invests into a partnership/LLC that is developing real estate and the resulting gains are treated as coming from an operating business rather than a capital gain]; or (2) the SDIRA earns income that is otherwise not taxable (e.g., rent from real estate, capital gain, interest from a loan), but the SDIRA (or partnership in which the SDIRA is an equity investor) uses “debt-financing”. If the SDIRA has more than $1000 of UBTI in one tax year, the IRA must file a Form 990-T tax return and pay current tax – which is a shock to many SDIRA accountholders!
One thing that happens frequently in UBTI situations is that the SDIRA’s investment initially results in UBTI losses. The best practice in this situation is to file a Form 990-T tax return for the SDIRA and carry-forward the losses – despite the fact that the SDIRA is not technically required to file a tax return if it doesn’t have more than $1000 of UBTI gain. In other words, by carrying-forward the losses, the SDIRA can potentially offset future UBTI gain.
One recent Tax Court case (affirmed by the Ninth Circuit Court of Appeals) demonstrates that the SDIRA’s accountholder absolutely cannot show the SDIRA’s losses on his individual tax return. The summary of this case is below. Brackets “[ ]” are my additional commentary.
Case Citation: Fish, 119 AFTR 2d (10/19/2017)
Facts of case. Mr. Fish, had a traditional (pre-tax) IRA that was a partner in two partnerships. In tax year 2009, both partnerships reported losses [i.e., they issued Schedule K-1s, which should be issued to the SDIRA directly, not under Mr. Fish’s name and SS#]. Mr. Fish reported these losses as ordinary losses on Form 1040 [individual tax return]. IRS disallowed the deduction for the losses.
Tax Court decision. The Tax Court in Fish [TC Memo 2015-176] sided with the IRS and disallowed the deduction.
Mr. Fish argued that an IRA has “all of the attributes of a grantor trust and is therefore a pass through entity which makes all items of income, deduction and credit treated as belonging [to him] and reportable on…[his] individual tax return”. In support of that argument, he contended that restricting an IRA accountholder’s ability to deduct a loss that occurs when an investment held by the IRA is sold thwarts Congressional intent to encourage individuals to save for retirement. He also claimed that requiring retirees to completely liquidate their IRAs in order to recognize a deductible loss is “unreasonable, arbitrary, capricious and completely unworkable for savers dependent upon IRA/SEP income for their retirement”.
The Tax Court said that, while Fish may not agree with the way the law is written and may have reasons that he believes support changing the law, the Court could not do that for him. Tax policy is within Congress’ purview, not within the Court’s. The Court decides cases on the basis of the law enacted by Congress rather than a taxpayer’s policy arguments as to how the law should have been written. Transactions occurring within the IRA do not result in taxable events which are reported on the holder’s individual income tax return. An IRA is a tax-exempt entity, not a passthrough entity. [The Court is essentially saying that if income/gain from an IRA’s investments does not appear on the accountholder’s individual tax return, why should losses?!].
Appeals Court decision. The Appeals Court affirmed the Tax Court [i.e., the SDIRA’s accountholder lost again].
In his appeal, Mr. Fish made an argument involving the UBIT. The Appeals Court said that the Tax Code provides that unrelated business losses may be carried forward or backward to deduct against gains within an IRA. (Code Sec. 512(b)(6); Reg. § 1.512(b)-(1)(e)(1)) (“The net operating loss deduction provided in Code Sec. 172 shall be allowed in computing unrelated business taxable income.”). But, the Code does not provide for the pass-through of UBTI losses to an IRA beneficiary’s individual tax return. (Code Sec. 511–Code Sec. 513)