We all know how IRAs work: Generally all of the earnings are tax-deferred until the funds are removed in the form of a distribution. Then, based on the applicable law, those distributions may or may not be taxable. And this is true generally, but not always!

Would you be surprised if I told you that certain investments in your IRA account might produce income that is subject to tax? That's right -- certain investments will cause your IRA account to be assessed a tax on their income. And those taxes will have to be paid by your IRA, not by you.

It's all too true.

Unrelated Business Income Tax
If your IRA invests in things that produce Unrelated Business Income (UBI), and the net income from these investments exceeds $1,000, your IRA could be subject to the Unrelated Business Income Tax (UBIT).

The UBIT was first introduced into law in 1950. Prior to that, tax-exempt organizations had a competitive advantage over for-profit corporations. As long as the level of business activity conducted by a tax-exempt organization was not so extensive that it caused the organization to lose its tax exemption, a tax-exempt organization could undertake business activities and retain the profits without any income tax burden. As a result of highly publicized incidents in which tax-exempt organizations undertook business activities in direct competition with for-profit businesses, Congress enacted a general tax on the "unrelated business income" of tax-exempt organizations.

What do tax-exempt organizations have to do with your IRA account? Nothing, other than the fact that the same rules for UBIT that apply to tax-exempt organizations also applies to your traditional IRA account. They also apply to your Education (Coverdell) IRA and your SEP. The UBIT also appears to apply to your SIMPLE account and your Roth IRA.

Scoffing to yourself, you mumble, "But my IRA doesn't invest in a business. It's in stocks and bonds, money market accounts, mutual funds, and an odd publicly traded limited partnership."

Stop right there!

Unrelated Business Income
The definition of UBI for this purpose is pretty broad. Think about that limited partnership that you are invested in. What is it really? It's a commercial venture. A for-profit activity. The net income that the partnership throws off to your IRA would be subject to the UBIT. It's business income unrelated to the operation of your IRA account.

And, not just partnerships can throw off UBI. UBI can also come from ownership of Limited Liability Company (LLC) interests. It can come from virtually any number of investments, such as rent and royalty income. In short, if you hold anything in your IRA other than "normal" financial instruments such as stocks, bonds, mutual funds, money market accounts, etc., it's very possible that your IRA will generate UBI. And, if that's the case, it's very possible that your IRA will be required to file a tax return and pay UBIT.

As noted, as long as your UBI doesn't exceed $1,000, taxes are not required to be computed or paid. But, as IRAs become a larger part of retirement savings, it's quite possible to realize UBI in excess of $1,000 and be subject to the tax. If that's the case, you (more specifically your IRA custodian) will be required to prepare IRS Form 990-T to report and pay the tax.

This article isn't intended to go through all of the details regarding UBIT. The intention is to let you know that this potential problem might exist in your IRA, depending on your investments and their earnings.

So what?
The taxes that your IRA account is required to pay will reduce the balance in your IRA account, which will reduce your tax-deferred or tax-free income, that's what. And it's a hassle. And, in addition to the tax, the IRA will likely have to pay tax preparation fees, compounding the problem.

So, you really want to look at any business investments with an eagle eye before you actually invest with your IRA funds. You could be buying yourself a big problem, not to mention a big tax bill.

Consider some of the challenges. If your IRA is illiquid (i.e., fully invested) it might not have the cash to pay the tax. If you pay the tax out-of-pocket, it's treated as a contribution to your IRA account, which might lead to excess contributions if you've already made a contribution for the year. Additionally, these types of business investments are generally very illiquid themselves. Once you get your hands on a partnership investment, you've got a firm grip on it for a long, long time. Partnership interests are nearly impossible to sell, so you have to ride out the partnership until it finally pays off or winds down. Many times, selling the business investment early will generate large losses, which is not something that you want in your IRA.

You might think that the IRA can simply sell the business interest to you personally... at an inflated price. Think again. That's a prohibited transaction, regardless of whether the sales price is inflated or not. If you engage in a prohibited transaction in your IRA account, the entire IRA is deemed to have been closed and distributed to you. Can you say, "Big taxes and early distribution penalties?" I knew that you could.

Finally, some of you might be scoffing, "I've had business income in my IRA for years, and I've never filed a tax return or paid any tax on the income." Well, that's very nice for you, at least for the time being. It's clear that the IRS hasn't looked into this issue in the past, so you might have just been lucky, but the law is the law, and the "no cop, no stop" method of tax planning is one that can buy you a ton of trouble.

I personally believe that, as IRA accounts get larger, the IRS might begin some studies on this very issue and will find it an area that could generate substantial tax dollars, which means more audits. I'm sure you would hate to be blindsided by an IRS auditor on this issue, wouldn't you?

Speaking of audits, you might be secretly smiling to yourself and thinking, "Well, since I've never been caught in the past, the statute of limitations has already expired on most of my prior-year indiscretions." Wipe that smile off your face, and think about this: Generally the statute of limitations only begins to run when an appropriate tax return is filed. If no return is filed, the statute of limitations countdown never begins, and if it never begins, it can never end. In effect, there is no statute of limitations protection for a nonfiled return. Yikes!

So, if you have these issues, you really need to deal with them. If you don't have these issues, I hope that I've provided enough information and food for thought to allow you to closely inspect your IRA investments prior to making a purchase, so you never have to deal with IRA Unrelated Business Income Tax issues.

Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.