How would you feel if you were told by your broker that your IRA had to pay $60k in taxes to the IRS? This is not just some grim fairytale, this is actually happening to a new client of mine. I share this horror story so all of you can learn something.

The IRA account was transferred under my management last year. The entire amount was invested in a private partnership, something I have never thought highly of. They are an investment vehicle that is unregulated and not registered with the SEC and thus is not supposed to be sold to the public. They nevertheless find their way into wealthy investors’ portfolios since brokers love to peddle them due to their exorbitant fees. My client invested in 2006, long before he became my client. After 13 years, it has a grand total return of only 40%. A 50/50 portfolio of stock and bond index fund would have more than doubled his money over the same period of time.

It turns out the peril of private partnership investment multiplies if you invest through your IRA account, which again was pushed by brokers for its supposed tax savings. There is a rarely heard tax category called the unrelated business income tax (UBIT) that basically says a tax-exempt organization is not supposed to make investments unrelated to its tax-exempt purpose, otherwise the organization will have to pay the UBIT.

If your IRA account invests in a private partnership, the IRS thinks they are due a UBIT since the IRA is tax-exempt as far as they are concerned and a private partnership is unrelated to the purpose of retirement. Both points are debatable. But since you are debating the IRS, you pay first, argue later.

In the past, few people were aware of this tax so nobody paid. As a result of the Trump Tax Reform, the IRS puts the onus of tax collection on your brokerages. If they find that you have private partnerships in your IRA account, they are required by law to calculate the UBIT due and collect the tax on behalf of the IRS.

By law, passive investments in private partnerships should be exempt, but the brokerages who are tasked with collecting the taxes for the IRS have no reason to care. First of all, they can’t tell if you are active in the business or not. If they assume you are just a passive investor and don’t collect the tax, they might invite the ire of the IRS. It’s much safer for them to just collect the tax.

There are two lessons here: 1) unregistered and unregulated private partnerships are rarely good investments due to asymmetric information and moral hazard. Hedge funds, private equities, venture capitals, oil and gas partnerships, alternative investments, whatever they may be called in their marketing materials, they are usually organized as a private partnership. 2) If you invest in them through your IRA, it can turn a bad investment into a horror story.

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