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IRA UBTI Loss Deduction Disallowed

Ninth Circuit upholds Tax Court ruling regarding UBTI.

The U.S. Court of Appeals for the Ninth Circuit, in an unpublished per curiam opinion affirming the Tax Court, held that an individual can’t deduct from his personal income the unrelated business taxable income, or UBTI, losses sustained by two partnerships held in his individual retirement account.1

IRS Disallows Deduction

In Fish v. Commissioner, the taxpayer maintained an IRA and used it to buy and sell various securities, including shares of two master limited partnerships. For the tax year 2009, the taxpayer received two Schedule K-1s, Partner’s Share of Income, Deductions, Credits, etc., from the partnerships reporting ordinary business losses. A loss may be recognized in a taxpayer’s IRA if all IRA accounts have been distributed and the amounts distributed are less than the individual’s unrecovered basis in the IRAs.2 The taxpayer in Fish deducted the losses reported on the Schedules K-1 by the two partnerships held in his IRA on his 2009 tax return. The IRS subsequently disallowed the deduction, determined a deficiency and imposed an accuracy-related penalty. 

Taxpayer Appeals

The taxpayer argued to the Tax Court that the law and regulations don’t support the IRS’ position that a taxpayer may recognize a loss from IRA investments only when all amounts from all IRA accounts have been distributed.3 He maintained that restricting an IRA holder'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 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, however, stated that although the taxpayer may not agree with the way the law is written, the Court couldn’t change the law for him. The Court therefore sustained the deficiency and the penalty, and the taxpayer appealed. The only issue on appeal was whether the taxpayer could deduct UBTI losses sustained by the partnerships owned by his IRA from his personal taxable income. The taxpayer argued that he should be allowed to deduct UBTI losses within his IRA.  

UBTI Rules for IRAs

Although IRAs are generally tax-exempt, pursuant to Internal Revenue Code Section 408(e)(1), they’re subject to the taxes imposed by IRC Section 511 on UBTI of organizations in which they invest. Under the UBTI rules, tax-exempt entities, such as IRAs, that engage in a trade or business not directly related to that entity’s exempt purposes must pay tax on the UBTI. The UBTI rules were established to redress the balance when tax-exempt organizations engage in a for-profit business that would typically be carried out by non-tax-exempt organizations. The thinking is that a tax-exempt entity is granted its tax exemption to advance its exempt purposes, rather than enabling the entity to compete with businesses that are subject to tax.  Generally, as we see in the Fish case, UBTI comes into play with an IRA when the IRA owns partnerships or other pass-through entities.4 The Tax Code also provides that UBTI losses may be carried forward or backward to deduct against gains within an IRA.5

No Pass-Through of Losses

The Ninth Circuit noted that IRC Sections 511-513, which cover UBTI, don’t provide for the pass-through of UBTI losses to an IRA beneficiary’s personal tax return. Accordingly, they affirmed the judgment of the Tax Court and denied the loss deduction.

 

Endnotes

1.     Fish v. Commissioner, No. 15-73389.

2.     Notice 89-25, 1989-1 CB 662.

3.     Ronald C. Fish v. Comm’r, T.C. Memo. 2015-176.

4.     IRS Publication 598 contains further information regarding unrelated business taxable income.

5.     lRC § 512(b)(6) and Treasury Regulations § 1.512(b)-1(e)(1).

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