Thinking About Private Foundations

 

I’ll admit it: last month (October) left room for improvement. An unresponsive IRS and a dearth of hirable accounting talent is taking its toll here at Command Center. I am hoping that recent hiring at the IRS will take the edge off the former; I see little respite from the latter, however.

This month many of our nonprofit returns are due. That is OK, as those do not approach the volume of individual returns we prepare.

I find myself thinking about private foundations.

I would set-up a family foundation if I came into megabucks. It would, among other things, allow the CTG family to aggregate, review, discuss and decide our charitable giving as a family unit.  

But I have also been in practice long enough to see family foundations misused. A common-enough practice is to hire an … unmotivated … family member as a foundation employee.  

Let’s talk about the self-dealing rules and foundations.

First, let’s clarify what we mean when we use the term private (or family) foundation.

It is a charity – like the March of Dimes or United Way – but not as much. Think of foundations as the milk chocolate to the public charity dark chocolate. The dark chocolate is – let’s be frank – the better chocolate. Contributions to both are tax deductible, but there are restrictions on the private foundation that do not exist for a public charity. Why? Because a public charity tends to have a diverse and diffuse donor base. A private foundation can be one family – or one person. A private foundation can therefore be more disposed to get its nose in traps than a public charity.

Let’s introduce two terms: disqualified persons and self-dealing.

There are two main categories of disqualified persons. I will use the CTG Foundation (and its one donor – me) as an example.

·      Category One

o  A substantial contributor (that would be me)

o  Members of my family

o  A corporation, partnership or trust wherein I am at least a 35% owner

·      Category Two

o  Foundation directors and officers

o  Their families

A family foundation might keep everything in the family, in which case categories one and two are the same people. It does not have to be, though.

We have the players. Now we need an event, such as:

·      Buying or selling property from or to a disqualified (person)

·      Renting from or to a disqualified (unless from and for free)

·      Lending money to or borrowing from a disqualified (unless from and interest free)

·      Allowing disqualifieds to use the foundation’s assets or facilities, except on terms available to all members of the public

·      Paying or reimbursing unreasonable or unrelated expenses of a disqualified

·      Paying excessive compensation to a disqualified

In theory, that last one would discourage hiring the … unmotivated … family member. In reality … there is very little discouragement. The deterring effect of punishment is impacted by its likelihood: no likelihood = no deterrence.

A key thing about self-dealing transactions is that, as a generalization, the tax Code does not care whether the foundation is getting a “deal.”  Say that I own rental real estate in Pigeon Forge. I sell it to the CTG Foundation for pennies on the dollar. Financially, the foundation has received a significant benefit. Tax-wise, there is self-dealing. The Code says “NO” buying or selling to or from a disqualified. There is no modifying language for “a deal.”

So, what happens if there is self-dealing?

There are two tiers of penalties.

·      Tier One

o  A 10% annual penalty on the self-dealer. In our Pigeon Forge example, that would be me. If the violation is not cleaned-up quickly, the 10% applies every year until it is.

o  There may be a 5% penalty on a foundation manager who participated in the act of self-dealing, knowing it to be such. Again, the penalty applies annually.

·      Tier Two

o  The Code wants the foundation and disqualified to reverse and clean-up whatever they did. In that spirit, the penalty becomes severe if they blow it off:

§  The penalty on the self-dealer goes to 200%

§  The penalty on the foundation manager goes to 50%

You clearly want to avoid tier two.

What would impel the foundation to even report self-dealing and pay those penalties?

I like to think that the annual 990-PF preparation by a reputable accounting or law firm would provide motivation. I would immediately fire a private foundation client which entered into and refused to unwind a self-deal. I am more concerned about my reputation and licensure. I can always get another client.

Then there is the possibility of an IRS audit.

It happens. I was reading one where the private foundation made a loan to a disqualified. The disqualified never made payments or even paid interest, and this went on for so long that the statute of limitations expired. According to the IRS, it might not be able to get to those closed years for penalties, but it could force the foundation to increase the loan balance by the missed interest payments (even for closed tax years) when calculating penalties for the open years.

Yep, that is what got me thinking about private foundations.

For the home gamers, this time we discussed CCA 202243008.

Abusing A Tax-Exempt

I am looking at a tax-exempt case that went off the rails.

There are rules in the tax-exempt area to encourage one to keep their nose clean. The rules can be different depending on whether the entity is a private foundation or not. The reason is that a foundation is generally considered more susceptible to influence than a “classic” tax-exempt, such as a 501(c)(3), as a foundation generally has a smaller pool of donors.

A doctor (Dr O) organized a 501(c)(3) called American Medical Missionary Care, Inc (AMMC) in 1998. In 2000 it applied for and received tax-exempt status from the IRS. Its exempt purpose was to operate a clinic in Michigan providing medical examination and treatment for individuals unable to afford such services.

Sounds like a great cause to me.

Dr O served as president. His spouse (Mrs O) served on the board of directors as well as secretary and treasurer over the years.

In 2013 AMMC filed its Form 990 reporting compensation of $26,000 paid Dr O and $21,000 paid Mrs O.

AMMC however issued W-2s of $26,000 apiece.

There is a mistake here, but it is not necessarily a big deal. They should tighten down the numbers going forward, though.

On its 2014 Form 990 AMMC reported no compensation to Dr or Mrs O.

Seems odd. Compensation does not tend to turn off and on like a spigot.

Meanwhile, Dr O had gotten in trouble with the Michigan Board of Medicine in 2014. He was required to pay a significant amount of money and also relinquished his medical license. Dr O eventually returned to Nigeria in 2017, leaving his wife in the United States.

The IRS selected the nonprofit for examination.

The revenue agent dug around the AMMC’s various bank accounts for 2014 and found biweekly checks to Mrs O of $1,000 each. There were also certified checks ranging from $6,000 to $10,000. In all, Dr and Mrs O had received cash, checks and money orders from AMMC totaling approximately $130 thousand.

The 990 showed the $130 grand as a loan receivable from Dr O.

Oh please.

Dr O got into trouble and needed cash. He turned to AMMC because that is where the money was. A loan implies an ability to repay and intent to collect, all within the normal course and conduct of business. I seriously doubt that is what we had here.

Dr O and Mrs O had outsized influence over the (c)(3). Who was going to tell them no, much less point out that making loans to officers and board members is minefield territory in the tax Code?

The IRS revenue agent felt the same way and assessed a tier-one penalty.

Penalties in the nonprofit area can be a bit different. There can be penalties on an individual or on the entity itself, for example. The more severe penalties revolve around “excess benefit” transactions and “disqualified persons,” which are – as you might suspect – people with substantial authority or influence over the tax-exempt. Dr O organized AMMC years before and served as its president. He was a poster child for a disqualified person.

The IRS assessed a tier-one penalty of $32,500. It also revoked the exempt status of AMMC.

Let’s walk through the tiered penalty.

The IRS assessed a tier-one penalty of $32,500 on the O's. This is 25% of the $130,000 that Dr and Mrs O drew in 2014. The reason I call it a “tier-one” is that there is a possible “tier two.” To avoid a tier-two, one has to return the money to the tax-exempt.

What happens if one fails to return the money?

The penalty goes to 200%.

This is one of the severest penalties in the tax Code, and Congress intended it that way. Years ago, the only recourse the IRS had was to revoke the entity’s exempt status. Congress felt that this response was a sledgehammer, and it instead created a set of “intermediate” penalties, shifting the burden to the person benefiting from the transaction. With that as background, Congress did not consider 200 percent as excessive.

So the O’s now had another penalty of $230,000.

COMMENT: 200 percent of $130,000 is $260,000, not $230,000. The Court made some tweaks which need not concern us here.

You may be wondering why Dr O would care, if he was safely ensconced in Nigeria.

For one, his wife was still in the United States.

And she was on the Board. She had served as secretary and treasurer. She was a disqualified person in her own right. She was also considered to be a disqualified person by being married to a disqualified person. She was not getting out of this snare.

Mrs O was going to get hammered.

She fielded a last stand:

(1) She argued that much of the money was distributed to needy people to help with rent and utilities, after-school programs for the kids and so forth.

Problem was: she had no records to substantiate any of this. She had not drawn checks in a manner commensurate with this storyline, although she testified that she would hold and re-deposit the certified checks back into the (c)(3) if and as needed. The Court was – by this point – quite skeptical of anything she had to say.

(2)  She argued that much of the money represented compensation to either her or both Dr O and her.

This was her best argument, but unfortunately this route was closed to her.

You see, AMMC should have issued W-2s if it intended for the monies to represent compensation. The tax-exempt did not issue W-2s for 2014. It did not even authorize compensation in its minutes. Some things have to be done currently, and this is one of those things.

A W-2 (or 1099) would have saved a penalty equal to twice its face amount. That is, a $26,000 W-2 to Dr O would have saved a penalty of $52,000 ($26,000 times 200%).

It was a worst-case scenario for the O’s.

Then again, they abused AMCC. That money did not belong to the O’s. It belonged to the (c)(3). The exempt purpose of AMMC was to assist the poor with access to medical care, not to enrich its founding family after the loss of a medical license.

Our case this time was Ononuju v Commissioner, T.C. Memo 2021-94.

 

Honest Attorneys Go Farr

I had forgotten about the conversation.

About a couple of years ago I received a call from a nonclient concerning tax issues for his charity. I normally try to help, at least with general tax issues. I rarely, if ever, help with specific tax advice. That advice is tailored to a given person or situation and should occur in a professional – and compensated – relationship.

Some accountants will not even take the call. I get their point. Tax season, for example, is notorious for nonclient phone calls saying “I just have a quick question.” Sure. Get a Masters degree, practice for 30 years and you will have your answer, Grasshopper.

This phone-call fellow was thinking about drawing payroll from a charity he had founded. It had to do with housing, and he was thinking of contributing additional rental properties he owned personally. However, those rentals provided him some sweet cash flow, and he was looking at ways to retain some of that flow once the properties were in the charity.

Got it. A little benevolence. A little self-interest. Happens all the time.

What about drawing management fees for … you know, managing the properties for the charity.

Someone has to. A charity cannot do so itself because, well, it doesn’t have a body.

Now the hard facts: the charity did not have an independent Board or compensation committee. He was reluctant to form one, as he might not be able to control the outcome. There was no pretense of a comparative compensation or fee study. He arrived at his number because he needed X-amount of money to live on.

Cue the sounds of warning sirens going off.

This is not a likely client for me. I have no problem being aggressive – in fact, I may be more aggressive than the client - but we must agree to play within the lines. Play fudge and smudge and you can find another advisor. We are not making a mutual suicide pact here.

Let’s talk about “excess benefits” and nonprofits.

The concept is simple: the assets of a nonprofit must be used to advance the charitable mission and not for the benefit of organization insiders. If the IRS catches you doing this, there is a 25% penalty. Technically the IRS calls it an “excise tax,” but we know a penalty when we see one. Fail to correct the problem in a timely fashion and the penalty goes to 200%.

That is one of the harshest penalties in the Code.

Generally speaking, an excess benefit requires two things:

(1) Someone in a position to exercise substantial influence over the charity. The term is “disqualified,” and quickly expands to others related to, or companies owned by, such people.

(2) The charity transfers property (probably cash, of course) to a disqualified person without fair value in exchange.

The second one clearly reaches someone who is paid $250,000 for doing nothing but opening the mail, but it would also reach a below-market-interest-rate loan to a disqualified person.

And the second one can become ninja-level sneaky:

When the organization makes a payment to a disqualified for services, it must contemporaneously document its intent to treat such payment as consideration for services. The easiest way to do that is by an employment contract with the issuance of a Form W-2, but there can be other ways.

Fail to do that and it is almost certain that you have an excess benefit, even if the disqualified person is truly working there and even if the payment is reasonable. Think of it as “per se”: it just is.

Yet it happens all the time. How do people get around that “automatic” problem?

There is a safe-harbor in the Code.

(1) An independent Board approves the payment in advance.

(2) Prior to approval, the Board does comparative analysis and finds the amount reasonable, based on independent data.

(3) All the while the Board must document its decision-making process. It could hire an English or History graduate to write everything down, I suppose.

Follow the rules and you can hire a disqualified.

Don’t follow the rules and you are poking the bear. 

I thought my caller did not have a prayer.

Would I look into it, he asked.

Cheeky, I thought.

As I said, I forgot about the call, the caller and the “would I look into it.”

What made me think about this was a recent Tax Court decision. It involves someone who had previously organized the Association for Honest Attorneys (AHA). She had gotten it 501(c)(3) status and continued on as chief executive officer.

From its 990 series I can tell AHA is quite small.

Here is a blip from their website:

However, our C.E.O. has 40+ years experience, education and observation of the legal system, holds a B.S. and M.S. Degree in Administration of Justice from Wichita State University, and has helped take ten cases to the United States Supreme Court.

I do not know what a Masters in Administration of Justice is about, but it sounds like she has chops. She should be able to figure out the ins-and-outs of penalties and excess benefits.

She used the charity’s money for the following from 2010 through 2012:

1. Dillards
2. Walmart
3. A&A Auto Salvage
4. Derby Quick Lube
5. Westar Energy
6. Lowes
7. T&S Tree Service
8. Gene’s Stump Grinding Service
9. an animal clinic
10. St John’s Military School (her son’s tuition)
11. The exhumation and DNA testing of her father’s remains

Alrighty then. 

The Tax Court went through the exercise: she used charity money for personal purposes; she never reported the money as income; there was no pretense of the safe harbor.

She was on the hook for both the 25% and 200% excise tax.

How did she expect to get away with this?

I suspect she was playing the audit lottery. If she was not caught then there was no foul, or so she reasoned. That is more latitude than I have. As a tax professional, I am not permitted to consider the audit lottery when deciding whether to take or not take a tax position.

The case is Farr v Commissioner, T.C. Memo 2018-2 for the home gamers.

New Tax On Self-Funded Health Plans Due By July 31

I knew that there was a new tax on self-insured medical plans. I was surprised that it reached health reimbursement arrangements (HRA), though.

I was surprised because it makes little sense, other than as a raw money grab. Next time perhaps the government will just select names at random from a phone book and require them to send money. I suggest they start with the District of Columbia phone book.

Have you heard of a health reimbursement arrangements? We are wading into alphabet soup-land, so let’s take a moment to compare and contrast an HRA with a health savings account (HSA).

 

If your employer is large enough, you may receive an annual letter laying out your health insurance options. Perhaps you can select from standard reimbursement, HMO, preferred provider or high-deductible health plans. That high-deductible plan likely is an HSA.

The concept of an HSA is simple: combine a high-deductible health policy with a medical IRA. If one incurs routine medical costs, one is reimbursed from the IRA. If one does not, then the IRA continues to compound and accumulate. The policy is there for big expenses. For a healthy family the medical IRA can add-up to tens of thousands of dollars.

A health reimbursement arrangement (HRA) is a different animal.   A key difference is that an HRA is all employer money. The HRA can reimburse employees for medical expenses, including vision, dental and chiropractic. It can reimburse on a first-dollar basis, a deductible-first basis, a sandwich basis and any other basis the plan advisor can dream up. It can have an annual cap … or not. Chances it will have an annual cap, as otherwise the employer borders on being financially reckless.

The employee doesn’t own this money, by the way. Should an employee quit, the money reverts to the employer. In truth, many if not most HRAs do not have any money at all. The medical bills are paid directly from company funds when presented for reimbursement. There may be an accounting somewhere that shows every employee and how many dollars are in his/her “account,” but this is for bookkeeping purposes only. The term for this is “notional,” and it means make-believe. Think unicorns, fairies and the New York Jets having a NFL-caliber quarterback.

ObamaCare (technically, The Affordable Care Act) is imposing a new fee on self-funded plans, which includes HRAs. It is coming up fast. If you have an HRA whose most current plan year ended after September 30, 2012 and before July 31, 2013 (that is, virtually every HRA), the HRA will have to pay a $1 fee per participant. Next year the fee goes to $2, and thereafter it goes to who-knows-what because some government bureaucrat will decide the amount.

The tax is due by the end of this month – July 31.

This tax will be reportable on Form 720, which may be a new filing for many employers.

It also has to be paid electronically. There is no attaching a check for this one.

I am a big fan of HRAs, as it allows companies to add to their employee benefits package without bankrupting themselves in the process. The HRA can cover deductibles, pay for braces or help with medical expenses that otherwise fall through the cracks left by the main insurance policy. HRAs have gotten more expensive, however, both by the per-participant fee as well as by the tax practitioner’s fee to prepare the return.

New Business Tax Provisions

So what are the key business tax changes from the American Tax Relief Act of 2012? Here are the ones that caught my eye:

(1)  Bonus depreciation extended through 2013.

The bonus allows one to immediately deduct 50% of the cost of qualifying assets.  If you buy a backhoe, for example, you can immediately expense one-half the cost – and you get to depreciate the remaining half.  

(2)  S corporation built-in gain tax recognition period

OK, this one is somewhat obscure. Suffice to say that a C corporation that switches to an S corporation cannot sell its business until after several years have run. It used to be that the period was 10 years, then reduced to 7 and then to 5 years. The Act extends the 5 years for sales through 2013.

What this is about is allowing tax planners to restructure businesses, or parts of businesses, for sale, in the hope of spurring – or at least not deterring – business and job activity.

 

(3)  Expensing for certain film and television activities

If Peter Jackson had filmed The Hobbit in the United States, he would have been able to expense the first $15 million in production costs. Three-fourths of the movie production must take place in the U.S.

The Act extends this break through 2013.

(4)  Increase in Section 179 expensing

Section 179 allows taxpayers to immediately expense equipment used in a business. Normally this type of expenditure would be depreciated over time (barring the bonus depreciation discussed in (1) above). Section 179 however has a limit on the amount that can be expensed and the amount of assets you can purchase and still qualify for the break.

In 2011 the amount that could be expensed was $500,000 as long as assets purchased did not exceed $2 million. That dropped to $125,000 and $500,000 for 2012. The Act retroactively changes 2012 to and sets 2013 at $500,000 and $2 million.

(5)  Faster depreciation of leasehold improvements

The Act extends the 15-year depreciation period for qualifying leasehold, retail and restaurant leasehold improvements.  

For example, the new Mad Mike’s at the Newport Levee would have been depreciated over 39 years. Now it can be depreciated over 15 years.

(6)  Research tax credit 

The Act extends the research credit through 2013.           

This credit is available for improvements in the production process as well as to the product itself. Think Apple and Pfizer.

(7)  Work opportunity tax credit 

This is the tax credit for hiring individuals on welfare, being released from prison, collecting social security disability and so forth.  

The credit is not insignificant: 40% of the first $6,000 in wages. 

Who is this credit important to? Think Cracker Barrel and ....

(8)  Veterans credit 

Technically this is a subset of the work opportunity credit from (7) above. 

Unemployed and disabled veterans are a qualifying category for the tax credit, although the credit amount can vary from $2,400 to $9,600 depending on how long the veteran has been unemployed and whether disabled. 

(9)  The Nascar loophole 

If you were thinking of building a “motorsports entertainment complex,” the Act will allow you to take accelerated depreciation. You have to build it soon, though.

 This one could not be more obvious if Jeff Gordon ran over you.           

(10)   Cover over of the rum excise tax 

There is an excise tax of $13.50 on every gallon of rum sold in the United States. That would normally be a business-breaker, but the government refunds almost all the tax - $13.25 – to Puerto Rico and the Virgin Islands in the form of economic aid. This is called the “cover over.” 

By far most of the money goes to Puerto Rico.

However... 

Do you know Diageo? They are based in London and produce  – among others - Captain Morgan rum. A few years ago, they moved their production of Captain Morgan from Puerto Rico to St. Croix, which is in the Virgin Islands. It seems that the USVI was able to provide a (1) 90% tax break, (2) a bigger kickback of the cover over, and (3) an exemption from property taxes.  

     

(11)    The “Subpart F active financing exception”

You ever wonder how a company like General Electric can pay no corporate income tax?           

Well, one way is that they lost a lot of money in previous years. This provision is another way.  

The U.S. (generally) considers interest earned by a U.S. corporation anywhere in the world to be a passive business activity. Makes sense, as accountants could easily move interest from country to country. By calling it passive, the goal is to make the interest taxable to the U.S. There are exceptions, of course, and this is one. 

This provision came into being in 1997 and with a significant amount of lobbying by General Electric. Why? Think G.E. Capital, and you are on the right track. It allows one to establish a captive finance company overseas, generate profits there but not pay taxes on the profits until the money is brought back to the U.S. 

This provision has been extended many times since 1997. It has now been extended again.

IRAs and Nontraditional Investments

We have received several inquiries over the last year or so about using IRAs for nontraditional investments. This frequently means real estate, perhaps commercial real estate to house a closely-held business. It might also mean using the IRA to start the business itself.

These types of transactions are not without risk. One has the risk of business failure or decline in property value, of course, but also the risk of disqualifying the IRA itself. This would be very bad, as this makes the IRA immediately taxable. To protect against this, one should roll-over the required funds from the “main” IRA into a separate IRA. Should the unfortunate occur, only the roll-over IRA will blow-up. One has contained the damage.

A nontraditional investment requires a self-directed IRA. You will need to find a custodian that will permit nontraditional investments. Most will not. Let’s say you found one. Let’s use the acronym SDIRA for a self-directed IRA in our discussion.

A SDIRA can invest in a privately-owned business. We already know that an IRA can invest in a non-private business, as these are the publicly-traded companies whose stocks are in your IRA or are in the mutual funds in your IRA. This is your Google stock or your Fidelity Contrafund.

The type of business entity is important. The SDIRA can invest in a C corporation but not in an S corporation. Why not? Because the IRS does not permit an IRA to be a shareholder in an S corporation.

The level of involvement in the business owned by the SDIRA is also critical. There are two key tax issues here:

·         The SDIRA cannot enter into a “prohibited transaction.” This is a death sentence. The SDIRA will lose its tax-exempt status and become immediately taxable. If you are under age 59 ½, there will also be penalties.

·         The SDIRA might enter into investments which themselves trigger a tax. This is not as bad as a prohibited transaction, as the overall SDIRA does not become taxable. There is tax only on the income. If the deal is good enough, paying tax may be acceptable.

Prohibited Transactions

The IRS defines a disqualified person as

·         The IRA account holder

·         A family member of the account holder.

o   This goes vertical: grandparents, parents, children and spouses

·         An entity owned 50% or more by the account holder

Think about that last one. Here at Kruse & Crawford, I could theoretically use my IRA, buy an office building and rent it to the firm, as I am not a 50%-or-more owner. Rick Kruse however could not.

Let’s go though the prohibited transactions:

(A) Sale, exchange or leasing of any property between an IRA and a disqualified person

Example 1: My SDIRA purchases property from me or my wife.  This is prohibited. It doesn’t matter if it purchases the property in a “commercially reasonable” manner – i.e. obtain an appraisal. It is not allowed. Period.

Example 2: My SDIRA pays my daughter twenty-five dollars to mow the lawn on the property.  My daughter is a family member. It is prohibited. The amount of money is irrelevant. 

(B) Lending of money or other extension of credit between an IRA and a disqualified person

Example 3: I lend you $10,000 from my IRA.

Example 4: I personally guarantee a bank loan to my IRA.

Example 5: My IRA loans money to me. 

(C) furnishing of goods, services, or facilities between an IRA and a disqualified person

Example 6: I buy a piece of property through my SDIRA and hire my wife to manage the property.

(D) transfer to, use by or for the benefit of a disqualified person of IRA income or assets

Example 7: My SDIRA purchases real estate in Ireland. The SDIRA rents out the property for most of the year. However, my wife and I use the property for one week twice a year.   Even if my wife and I pay fair-market-value rent, this is a prohibited transaction.

(E) Act by a disqualified person who is a fiduciary whereby he deals with IRA income or assets in his own interest or for his own account

Example 8: I charge my SDIRA a fee to manage its stocks, bonds, mutual funds or other investments.

(F) receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the IRA in connection with a transaction involving IRA income or assets.

Example 9:  My SDIRA purchase a vacation house is in Augusta. I am offered the use of a Wyoming condo in exchange for use of the Augusta property during the Master’s tournament.

IRA Taxes

(1) Active Business Income (UBTI)

Earnings within an IRA are generally tax exempt. However, certain investments can create taxable income called “unrelated business taxable income” (UBTI).  Generally, UBTI is trade or business income which is not otherwise related to the tax-exempt purpose of the IRA. The idea here is that Congress does not want a tax-exempt entity competing with the taxable business enterprise next door to it.

So if you buy a Panera’s or a Caribou Coffee, you have UBTI.

There are some exceptions to UBTI, including but not limited to:

·         dividends

·         interest

·         royalties

·         rent from real property (however see debt-financed below)

·         sales of real property, if the property is not held as inventory or held in the ordinary course of business

Dividends and interest make immediate sense, as this means stocks and bonds - the traditional investments in an IRA.

UBTI Examples:

Example 1:  The SDIRA purchases a restaurant.  The income from the restaurant will be treated as UBTI.

Example 2:  The SDIRA purchases 25% of an LLC that flips (buys, fixes and sells) real estate. Since the real estate is considered inventory, the income to the SDIRA will be UBTI. 

(2) Debt-Financed Income ( UDFI)

If there is debt involved there will likely be UDFI.

Fortunately, UDFI refers only to the percentage of income resulting from the debt-financed portion of the property,

UDFI Example:

Example 3: My SDIRA purchases a B&B in Ireland putting down 75% and borrowing 25%. 

Note that if there was no debt, the rent would be tax-free to the SDIRA.

But there is 25% debt. This means that 25% of the rent is taxable to the SDIRA. The SDIRA does get to claim rental expenses, however.

Wealth Planning

You may have read that nontraditional IRAs are being used for wealth planning. For example, Max Levchin, the chairman of the social review site Yelp, sold over 3 million shares of Yelp held in his Roth IRA. There is no tax on Roth withdrawals if one waits until age 59 ½. Levchin is in his mid-30s. He will have to wait a while, but the money will be tax-free when it comes out.

Peter Thiel did a similar transaction. He bought shares of PayPal for approximately 30 cents per share while he was CEO of the company. In 2002 eBay bought PayPal for $19 a share. 

Now how did Levchin and Thiel avoid the prohibited transaction rules? Actually, it is very simple. You have to control the company to get into a prohibited transaction. Control is usually defined as at-least-50%. When you drain your IRA to buy that Five Guys Burgers and Fries location, chances are you will own 100%. Compare that to a publicly-traded company with tens if not hundreds of millions of shares. Neither Levchin nor Thiel came close to owning 50%. 

Is this fair? I would lead off by noting that “fair” is subjective, somewhat like asking what music one likes. Levchin and Thiel played the game between the lines. You or I could do the same. It might take a new skill set and a tractor-trailer load of luck, but you or I could (theoretically) do it.

Congress has noted these transactions. There is debate about whether this type of wealth accumulation should be permitted. Discussion has sometimes involved a “ceiling” on the amount invested/deferred in the Roth, but until now nothing has developed.