‘Blocker’ Corporation Considerations for Self-Directed IRA Investors

For a variety of reasons, self-directed individual retirement account (“IRA”) holders transfer assets to a self-directed Roth IRA. Converting a self-directed IRA asset or assets can be extremely beneficial if the IRA holds an asset that is expected to appreciate readily in the future such as pre-IPO stocks. Converting a self-directed IRA asset or assets to a self-directed Roth IRA typically involves opening a new self-directed Roth account, instructing the IRA’s custodian to transfer assets (or doing a 60-day rollover), and paying taxes on the pre-tax amount converted. Investors sometimes use a “blocker corporation” in a self-directed IRA to avoid Unrelated Business Income (“UBTI”) and Unrelated Debt-Financed Income (“UDFI”) taxes. If planned properly, a blocker corporation can either eliminate UBTI and UDFI or significantly reduce the impact of UBTI and UDFI. This article discusses the taxation of self-directed IRAs and why investors place blocker corporations in self-directed IRAs as part of an effective tax planning strategy.

What is a Self Directed IRA

The appeal of investing retirement funds outside of the typical investments has driven a surge in the use of self-directed IRA investment structures. Investments within self-directed IRAs frequently include real estate, closely held business entities, private loans, and can include any other investment that is not specifically prohibited by federal law. Since 1974, the IRS has permitted individuals to totally “self-direct” investments made within their self-directed IRAs that are also authorized by federal law and are held by a trustee or custodian that permits investments in a broader range of assets than is permitted by traditional IRAs. See Levine v. Entrust Grp., Inc., 2012 WL 6087399 (N.D. Dec. 6, 2012). Self-directed IRAs allow individuals and small companies to invest in asset classes that are often deemed illiquid. These include but are not limited to tax lien certificates, real estate, livestock, domestic and foreign private companies. Hence, self-directed IRAs allow individuals who prefer to leverage their personal expertise in their investment to do so.

Although a self-directed IRA allows individuals to invest in numerous illiquid assets, investments in some assets are prohibited. These include, but may not be limited to, collectibles, including artwork, stamps, jewelry, antiques, and rugs. Investments in life insurance are also prohibited. In addition, an individual cannot use an IRA to invest in real estate that he or she will personally use. See IRC Section 408.

Most individuals who fund self-directed IRAs do not realize that funding such a structure may trigger tax obligations and filing requirements. Anyone considering funding a self-directed IRA must understand the term unrelated business taxable income (“UBTI”). If the self-directed IRA earns UBTI, the IRA may need to file a Form 990-T and pay annual taxes. To calculate UBTI, the income from the business activity that is not passive in nature must be identified. Next, any business expenses must be identified. In addition, if the self-directed IRA utilizes non-recourse debt to acquire property, the self-directed IRA may be subject to Unrelated Debt Financing Tax (“UBFI”). Below, please find two illustrations which demonstrate how the aforementioned taxes and filing requirements apply to self-directed IRAs.

The Taxation of UBTI

An IRA is considered a tax-exempt entity, meaning that it generally does not pay taxes on interest, dividends, or capital gains within the account. As a tax-exempt organization, an IRA is subject to the tax-exempt rules stated in the Internal Revenue Code. Since 1950, exempt organizations have been taxed on unrelated business taxable income, which is defined as gross income (less directly connected expenses) derived from an unrelated trade or business. See IRC Section 512(a). If the property producing such income is acquired with borrowed funds, however, the debt-financed property rules of Internal Revenue Code Section 514 treat all or part of the income as unrelated business taxable income with the result that it is subject to tax.

An exempt organization is taxed on unrelated business taxable income which is defined as gross income (less directly connected expenses) derived from an unrelated trade or business. An unrelated trade or business is defined as: (a) any trade or business; (b) that is regularly carried on; and (c) is not substantially related, aside from the need of the organization for funds, to the organization’s exempt purpose.

In most instances, investment activities of exempt organizations would be regularly carried on and not substantially related to the organization’s exempt purpose, thus meeting the second and third prongs of the definition of an unrelated trade or business. It is less clear whether the conduct of investment activities constitutes a trade or business. The regulations of the Internal Revenue Code provide that, in general, the term “trade or business” has the same meaning it has in Section 162 of the Internal Revenue Code and generally includes any activity carried on for the production of income from the sale of goods or the performance of services. The Supreme Court held in Higgins v. Commissioner, 312, 217 (1941) that an individual’s management of his own investments was not a trade or business even though the individual’s activities were extensive enough to require an office and a staff. Congress ultimately overruled Higgins and enacted Section 212 of the Internal Revenue Code. Section 212 of the Internal Revenue Code allows individuals to deduct “ordinary and necessary” expenses for producing income, managing income-producing property, or handling tax-related matters.

Certain types of income, commonly referred to as “passive income,” are excluded from UBTI. See IRC Section 512(b). These include dividends, interest, payments with respect to securities loans, amounts received or accrued as consideration for entering into agreements to make loans, annuities, royalties, rents from real property and personal property leased with the real property if the rent attributable to the personal property is 50 percent or less of the total and the rent does not depend on income or profits derived from the leased property, and capital gains and losses. See IRC Section 512(b)(5). In addition to passive income, royalties are excluded in computing the unrelated business taxable of a tax-exempt entity. A “royalty” has been defined as any payment received in consideration for the use of a valuable intangible property right, whether or not payment is based on the use made of the intangible property. However, payments for services provided in connection with the granting of these types of rights are not royalties and are generally taxable as unrelated business income.

The UBTI for self-directed IRAs are taxed at progressive trust tax rates, which can reach up to 37% for income over $16,000 (as of 2026). If an IRA generates over $1,000 in annual gross income from unrelated business income, it can be subject to UTBI tax at a rate of 37%. As discussed above, deductions are permitted for expenses that are “directly connected” with the carrying on of the unrelated trade or business, and net operating losses are allowed to be carried forward and backward (with certain limitations). Losses from one unrelated business activity are not able to offset gains in another; profit and losses are determined per activity.

Below, please see Illustration 1 which provides an example as to how UBTI can be assessed against a self-directed IRA holder.

Illustration 1.

Jill invested $500,000 from her IRA into an LLC custom jewelry company. The investment gave Jill a 25 percent interest in an LLC. The LLC had three other owners, not related to Jill, and none of the other investors were co-owners with her in any other business entities. Jill was not involved in the LLC’s day-to-day operations and did not otherwise personally benefit from the investment.  The LLC recorded a significant profit on its annual Form 1065, U.S. Partnership Income Tax Return. In turn, each investor, including Jill’s self-directed IRA was issued yearly Schedules K-1, Partner’s Share of Income, Deductions, Credits, etc., which showed ordinary income. The Internal Revenue Code imposes a tax on income earned by a tax-exempt organization in a trade or business that is unrelated to the organization’s exempt purpose. This type of tax liability is known as UBTI and it became a large tax liability for Jill.

It should be understood that most IRA investments do not trigger current tax consequences, not because all income an IRA earns grows tax free, but because the types of income that an IRA typically earns are exempt from UBTI tax rules. For example, IRAs that invest in publicly traded securities (e.g., stocks, bonds, and mutual funds) do not owe current tax because gains from the sale of C corporation stock dividends, and interest income are exempt from UBTI. For this reason, most IRA investors are unaware that an IRA can require a tax return (Form 990-T Exempt Organization Business Income Tax Return) and pay taxes. Income from a business that is regularly carried on (whether directly or indirectly) can result in UBTI and filing requirements.

In this case, since the LLC Jill invested into conducted a regularly conducted business, the self-directed IRA had a tax consequence. To make matters worse, in Jill’s case, the self-directed IRA was taxed at trust rates. This resulted in Jill’s self-directed IRA realizing a far greater tax liability compared to an individual who is taxed at ordinary marginal tax rates. Jill may be shocked to discover that her self-directed IRA is subject to taxes on the LLC’s yearly profits, but also that the tax rate on income over $16,000 is a whopping 37 percent. To add insult to injury, there was an additional net investment income tax of 3.8 percent assessed on the trust income over $16,000.

The Taxation of UDFI

The exclusion for passive income is not available for income derived from debt-financed property. Section 514(a)(1) of the Internal Revenue Code requires an exempt organization to include UDFI a percentage of income derived from “debt-financed property” equal to the “average acquisition indebtedness” for the taxable year over the average amount of the adjusted basis for the taxable year. A like percentage of deduction is allowed in computing UDFI. See IRC Section 514(a)(2). The straight-line method of depreciation must be used. See IRC Section 514(c)(3). Debt-financed property is defined in Section 514(b)(1) as any property held to produce income with respect to which there is an acquisition indebtedness at any time during the taxable year or, if the property is disposed of during the taxable year, at any time during the 12-month period ending on the disposition. The statute contains several exceptions to the definition of debt-financed property, which have the collective effect of limiting its application to investment income. Specifically, the following are excepted from the definition of debt-financed property: (a) any property substantially all of the use of which is substantially related to the organization’s exempt purpose; (b) any property the income from which is included in UDFI without regard to the debt-financed property rules, except that gain from the sale or disposition of such property is not excluded under Section 512(b)(5); (c) any property to the extent income is excluded under Section 512(b)(7) relating to government research, Section 512(h)(9) relating to college, university, and hospital research, and Section 512(b)(9) relating to fundamental research the results of which are made freely available to the public; (d) any property used in any trade or business described in Section 513(a)(1) relating to work performed by volunteers, Section 513(a)(2) relating to convenience of members, etc., and Section 513(a)(3) relating to selling of merchandise received as gifts; and (e) neighborhood land acquired with the intent of using it for exempt purposes within 10 years.

Acquisition indebtedness is defined as the unpaid amount of (a) indebtedness incurred by the organization in acquiring or improving debt-financed property; (b) indebtedness incurred before the acquisition or improvement of the debt-financed property if such indebtedness would not have been incurred but for such acquisition or improvement; and (c) indebtedness incurred after the acquisition or improvement of the debt-financed property if such indebtedness incurred after the acquisition or improvement of the debt-financed property if such indebtedness would not have been incurred but for such acquisition or improvement and, the incurrence of such indebtedness was reasonably foreseeable at the time of such acquisition or improvement. See IRC Section 514(c).

The statute excludes from the definition of acquisition indebtedness a number of transactions that relate to non-investment transactions common to exempt organizations. These include: (a) a 10-year exception if mortgaged property is acquired by bequest or devise and certain conditions are met; (b) liens for taxes and assessments that attach before the payment date; (c) extension, renewal, or refinancing of an obligation evidencing a pre-existing indebtedness; (d) indebtedness inherent in performing an organization’s exempt purpose such as indebtedness incurred by a credit union accepting deposits from its members; (e) charitable gift annuities; and (f) certain federal financing for low-and-moderate-income persons. The statute also excludes from the definition of acquisition indebtedness securities loans and real property acquired by pensions trusts and schools, colleges, and universities.

If none of the statutory exceptions is applicable, then, to determine whether there is acquisition indebtedness, one must first determine whether there is indebtedness and then determine the indebtedness is traceable to the acquisition or improvement of income-producing property.

Below, please see Illustration 2 which provides an example as to how UDFI can be assessed against a self-directed IRA plan holder.

Illustration 2.

Mark had $1.5 million in his 401(k). Mark decided to invest the $1.5 million in a self-directed IRA. Mark’s goal for his self-directed IRA was to invest in residential real estate through an LLC. Mark found a real estate investment group that frequently organized partnerships and promised “passive” investment (no direct involvement by Mark). The real estate partnership collected capital contributions from 20 investors and used the cash plus debt to purchase an apartment building. The apartment building was held as a rental property, with net income distributed to the investors, including Mark’s self-directed IRA LLC.

As stated above, it is possible for a self-directed IRA to invest in a broad range of investments. Thus, real estate partnerships are acceptable self-directed IRA investments is technically correct. However, this does not answer the question of whether there are more difficult legal or tax issues. For example, “rent from real property” is normally exempt from UBTI, and thus currently not taxable when earned by a self-directed IRA or self-directed IRA LLC. However, income from debt-financed property (whether held directly or indirectly by the self-directed IRA or self-directed IRA LLC) is partially taxable under the  rules because the income generated from the investment is not earned by investment of the self-directed IRA capital, but rather by financing.

In this case, the yearly income that is allocated to Mark’s self-directed LLC is partially subject to tax under the UDFI rules. Income received from debt-financed property may be subject to the  UDFI rules. Because the property placed in the self-directed IRA was financed and subject to the UDFI rules, the self-directed IRA was required to file Form 990-T, annually. This was the case whether or not UDFI taxes were required to be paid. Failure to pay the UDFI taxes and file Form 990-T could subject Mark’s self-directed IRA to significant penalties and interest.

The Benefits of Utilizing a Blocker Corporation

If a self-directed IRA invests in an active business or uses certain types of financing to acquire assets, the self-directed IRA could be subject to UBTI and UDFI. Self-directed IRA investors often place a blocker corporation into their self-directed IRAs to mitigate their exposure to UBTI and UDFI. “Blocker” is a colloquial industry term referring to an investment vehicle that is treated as a corporation for U.S. federal income tax purposes. As a result of its corporate status, all items of income, gain, deduction, or loss of an underlying investment are generally taxed at the corporate level. A blocker corporation is treated as a C corporation or limited liability company that is taxed as a C corporation.

In the case of a self-directed IRA, a blocker corporation isolates the IRA investor from UBTI and UDFI. It achieves this by absorbing this by absorbing the income, treating it as corporate income. At the federal level, C corporations are taxed at a flat rate of 21%. The maximum UBTI and UDFI tax rate is 37%. The blocker itself is subject to corporate income taxes on earnings. Thus, the use of a blocker offers the possibility of significant tax savings.

Anthony Diosdi is a tax attorney at Diosdi & Liu, LLP. He has significant experience defending private clients before the IRS in difficult and complex tax disputes. Anthony counsels clients through examinations and liability disputes and, when necessary, takes disputed issues to court. Anthony has advised a significant number of individuals who hold self-directed IRAs that contain cryptocurrency, pre-IPO shares, unlisted shares, and late-stage private equity, domestic and foreign corporations.

Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.