Will UBIT apply here?

Question

Hi,

I have a self directed solo 401K, and am wondering if the following business model will generate UBIT.  I will ask my lawyer/CPA as well, but want to see what BP community thinks.  Here is the model -

• My 401K trust (has an EIN) and an asset manager (individual, not an entity) form an LLC, and the 401K Trust funds the LLC.
• With the manager's help, the LLC buys a property, say for $30K, and retains the title of the property.
• The LLC finds a contractor to fix it up.
• The LLC sells the fixed-up property to a buyer for $50K, netting $20K profit.
• The LLC pays the contractor $10K for its service.
• The LLC and the asset manager each gets $5K as equal partners of the LLC.

Will the $5K profit from the deal generate UBIT for my 401K trust?

I think if the trust directly buys and sells real properties, the trust will not have UBIT.  If the gain/profit is generated from a business that the 401K trust invests in, I think UBIT applies.  However, what I am not clear is that with the above model, the profits is from a pass-thru entity, the LLC, therefore it will not have UBIT for the trust?  Or, if the $5K is distributed to its members (the trust and manager) as dividend, then UBIT won't apply?

Brian Eastman · Answer

@Lue C.

If done regularly, such flipping activity would have UBIT exposure.

The structure of the deal does not determine UBIT exposure, the underlying nature of the income does.  Income that is sourced passively is exempt from UBIT.  This includes interest, dividends, royalties, rent from real property or the sale of an asset that has been held over time to produce passive income.

Flipping houses is considered a trade or business.  When a tax-exempt entity such as a retirement plan engages in a trade or business on a regular or repeated basis, then UBIT applies.  The intent of the tax is to protect taxpaying business from unfair competition when tax-exempt entities are substantively competing with them.

If your Solo 401k were to lend to another investor who is flipping houses for fixed points/interest, that would be passive income not subject to UBIT.

Carl Fischer · Answer

@Lue C.

You have a great answer from @Brian Eastman