Why your IRA might get a 990-T and tax bill without a withdrawal

A client opens mail from the plan custodian and finds Form 990-T, Exempt Organization Business Income Tax Return, showing a big balance due from the IRA. They never requested a distribution, never saw any cash from the investment, and their online IRA balance looks unchanged. So why did the client get a tax bill? 

In brief, the IRA owned a limited partnership (LP) or a similar investment that generated unrelated business taxable income (UBTI). Once the UBTI passes the filing threshold, the IRA itself is subject to unrelated business income tax (UBIT), which is reported on Form 990-T. The custodian prepares the return and pays the tax from IRA funds.

Why Form 990-T shows up for some IRAs

An individual retirement account (IRA) is tax-exempt, but it is still subject to income tax on UBTI, including unrelated debt-financed income. UBTI is generally business-type income earned inside the IRA that goes beyond simply receiving interest, dividends or capital gains. If an IRA, SEP or SIMPLE has at least $1,000 of gross UBTI, it must file Form 990-T and pay tax using trust tax rates.

This typically appears in self-directed IRAs that invest in partnerships, limited liability companies or real estate. Business or operating income that is not traditional investment income can create UBTI, while ordinary interest, qualified dividends and most capital gains remain tax-favored. In effect, the IRA keeps its usual tax advantages on investment income, and only the UBTI slice is carved out and taxed.

In many custodial arrangements, the custodian is the legal owner of the partnership interest, which is held for the benefit of the IRA. The investment activity belongs to the IRA, not the individual, so the custodian is responsible for reporting that activity to the IRS.

How can there be tax when the client never got cash?

Think of the LP as a business pearl sitting inside the IRA shell. The general partner or manager controls when assets are bought and sold. When that business sells something or is itself sold, the resulting income flows through on a Schedule K-1 (Form 1065), Partner’s Share of Income, Deductions, Credits, etc., issued to the IRA.

If that K-1 includes UBTI and the gross amount hits the $1,000 threshold, the IRA has a filing obligation. The K-1 is typically issued to the custodian as "FBO [Client] IRA," so nothing from that partnership appears on the client's individual return. Under §408, the IRA is a tax-exempt trust. It does not pass partnership items through to the owner, but the IRA itself can still owe UBIT on those items, which is calculated and reported on Form 990-T.

That is why everything seems to happen in the background. The client did not "initiate" the sale, yet the sale inside the LP still triggered taxable UBTI for the IRA.

Why is the money still in the IRA, and who actually pays the tax?

In a typical custodian scenario, the custodian notifies the taxpayer that it will remit a specific tax amount with Form 990-T. Custodians often calculate the tax first, then debit the IRA and send the payment. Until the debit posts, the client's online balance may appear unchanged, even though a tax payment is pending.

The tax is owed by the IRA, not by the individual who owns it. The custodian should pay the tax from IRA assets, either from existing cash or by selling holdings inside the IRA. Because the tax is paid within the account, there is usually no Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., and no taxable distribution to the client. The practical effect is that the IRA's value will drop by the amount of the tax and any related fees once the payment is processed.

Pro tip: If you see the custodian billing the client personally, or a 1099-R tied only to the tax payment, that is a red flag to investigate.

What should a tax professional review?

When a client shows up with an unexpected Form 990-T tied to an IRA, you can:

1. Confirm the owner and filer. The filer should read along the lines of "XYZ Trust Company FBO [Client] IRA," not the individual.
2. Tie it to the underlying investment. Look for K-1s issued to the IRA or to the custodian listed as “Custodian for the IRA,” especially from publicly traded partnerships, energy funds or real estate ventures. Box 20, code V is a common UBTI flag.
3. Ask about prior years. If the IRA has held the LP or similar investment for several years, review past K-1s to see whether UBTI exceeded the threshold in earlier years without a 990-T filing.

You can also flag whether this type of investment is likely to generate recurring UBTI or other ongoing costs, so the client can discuss next steps with their custodian or investment adviser.

How to talk about it with clients

For many clients, the real shock is emotional. They believed "IRAs are tax-free," so a five-figure tax from an investment they do not fully understand feels like a breach of that promise. A practical way to frame it:

• Most of your IRA income is still tax deferred or tax-free.
• This particular investment behaves differently because it can generate business income or debt-financed income, which Congress treats as taxable even inside retirement accounts.
• The custodian is filing Form 990-T and paying the tax from IRA funds so the account stays in compliance and you avoid additional penalties.

That conversation helps clients feel informed rather than blindsided, and it often opens the door to a broader review of their self-directed holdings.

Keep backup close when IRAs surprise you

Complex IRA issues do not wait for a slow season. If you want backup the next time a surprise 990-T shows up in a file, explore how NATP membership can support your practice.