The Self-Directed IRA/Solo 401(k) Tax Trap
By Christopher Granucci, CPA, Senior Manager, Tax & Business Services
Individual Retirement Accounts (IRAs) are a viable investment vehicle for many. Not only do they provide alternate investment options to help individuals diversify their retirement portfolios, but they can also be more flexible than an employer-sponsored retirement plan.
Most people are familiar with the two most common IRA choices: the traditional IRA, to which contributions are made with pre-tax funds, and the Roth IRA, to which contributions are made with post-tax funds. Both are typically easy to execute and an attractive part of a retirement planning strategy.
A third option, one that is perhaps not as well known, is the self-directed IRA, also known as the solo 401(k) plan—a retirement account designed for businesses that solely employ the owner, their spouse, and their business partners. Though it may take a bit more effort by the account holder, it generally allows investors to be more hands-on with their investment options, typically costs investors less in fees, and provides more control over what is invested in.
What most investors do not realize, however, is that there is a potential tax compliance pitfall associated with self-directed IRAs – the requirement to file a Form 990-T.
Form 990-T is the Exempt Organization Business Income Tax Return. Typically, this form is used by a tax-exempt organization to report Unrelated Business Income, which is income earned from sources unrelated to the organization’s charitable purpose. So why is an IRA account holder (an individual) required to file this same form?
While a self-directed IRA may not be a charitable organization, it is subject to IRC Sec. 408(a), which defines the term Individual Retirement Account. This is one of many code sections that has interplay with Form 990-T.
If a self-directed IRA invests in a pass-through entity (a partnership or S-corporation), it will receive a Schedule K-1 showing its share of distributable income from that investment. If gross income on Schedule K-1 equals $1,000 or more, the IRA is deemed to be receiving trade or business income.
An IRA is meant to generate investment income, not trade or business income. Therefore, to prevent taxpayers from using an IRA as a tax-shelter, the IRS imposes tax on any IRA income unrelated to the purpose of an IRA. This is where Form 990-T comes in.
Many investors do not realize that if they invest in a pass-through entity through their self-directed IRA, they are likely creating this tax filing requirement for themselves. Moreover, Form 990-T must be filed by April 15, the same as federal income tax filing Form 1040. Investors may be unaware of this filing requirement until the IRS sends a notice indicating they are delinquent in paying the tax, along with penalties and interest for failure to file and/or pay.
There is a safety net for some investors: In many cases, the custodian of the IRA account, typically a brokerage, will file the form on behalf of the account holder. This creates some additional considerations.
First, ensure that your broker is filing the Form 990-T, if required. If they do not, you, as the accountholder, will be responsible for getting this done.
Second, plan for where the cash to pay the tax is going to come from, and the associated implications. If your IRA only contains the pass-through entity investment and no cash with which to pay the tax, how will the tax be paid?
The options are either for a portion of the investment to be liquidated to create the cash, or for the accountholder to pay in the cash from an outside source. Liquidating a portion of the investment may not be desirable if an accountholder wishes to preserve their investment.
If the investor pays in cash from an outside account, there is a third potential pitfall: the payment would likely be deemed an IRA contribution by the IRS. Beginning in 2023, IRA contributions are limited by the IRS to $6,500 per year; $7,500 per year if the accountholder is 50 years old or older. If an investor exceeds the contribution limit, they may be subject to additional tax on the excess contribution. If an investor has already maxed out their IRA contribution for the year, this is likely to be the case.
If you have a self-directed IRA or solo 401(c) plan and think this circumstance may apply to you, consult your Marcum professional.
For additional information on the IRS 990-T disclosure, please reference our recently published article.