As described on Why Do I have to File in an IRA, Unrelated Business Income Tax/Taxable Income (UBIT/UBTI) is a provision added to the Internal Revenue Code by Congress in the Revenue Act of 1950 to eliminate an unfair competitive advantage enjoyed by exempt organizations and entities (later amended to include IRAs) over their taxpaying counterparts in the non-exempt world.
The catalyst for UBIT was Mueller Macaroni which, at the time, had been donated to New York University (NYU) Law School, a tax-exempt organization. Prior to the Revenue Act, the income derived from the sale of those noodles went tax-free to NYU. (Interestingly enough, prior to the Revenue Act of 1950, non-profit/charitable organizations in the United States generally did not pay income tax on income from any of their activities.)
The result of the Revenue Act of 1950 was that certain investments owned within a non-profit/tax-exempt entity (later amended to include retirement accounts such as Roth IRAs, Traditional IRAs, SIMPLE IRAs, SEP IRAs, etc.) must consider UBIT depending on the investment choices. As it pertains to retirement accounts, UBIT investments fall into investments in “flow-through entities” such as Limited Partnerships and Limited Liability Companies.
Taxation for Flow-through Entities
A flow-through entity does not pay tax at the corporate level (like a C-corporation) but rather passes those profits and the tax owed to its owners. Since the income and tax flows through the entity it is not permitted to enter a tax-exempt IRA without incurring UBIT. If UBIT was not applied, the business income would be derived tax-free on both the entity and the IRA level.
While this does create a tax within a typically tax-exempt account, the tax is established through the income from a business that is unrelated to the tax-exempt account’s sole purpose.
Since the IRA’s flow-through entity competes with other taxed organizations, the IRS code has established UBIT as necessary in order to level the playing field, even within an otherwise tax-free or tax-deferred account. For more information on when UBIT is required on entity investments within retirement accounts, please visit When Does my IRA Have to Pay UBIT.