Proposed Regs Allow RICs to Pass REIT Income to Shareholders and Take Advantage of 20% Deduction– January 30, 2019 by Robert Velotta

On January 18, 2019, the Treasury Department issued proposed regulation Section 1.199A-3 related to qualified business income, qualified Real Estate Investment Trust (REIT) dividends and qualified Publicly Traded Partnership (PTP) income. These regulations specifically address the flow through of qualified business income to shareholders of Regulated Investment Companies (RICs). The timing of this proposed regulation is critical, as it may impact the 2018 1099-DIV filings many RICs have already begun preparing. 

What the TCJA Says — and the Intent Behind It

Section 199A, enacted as part of the Tax Cuts and Jobs Act (TCJA) of 2017, allows a deduction of up to 20% on qualified business income from flow-through entities. The TCJA provides that dividends from REITs and income from PTPs also qualify for this deduction.
However, throughout 2018, there has been an overriding concern in the investment industry that, because of specific language used in the TCJA, the deduction may get trapped inside of a RIC — meaning a shareholder of a RIC that invests in REITs or PTPs would not receive the 20% benefit provided by Section 199A, whereas a shareholder directly investing in a REIT or PTP would. Given that one of the purposes of the RIC structure is to permit investors to pool assets to obtain professional investment management and a diversified investment in securities without an additional layer of tax, this result would not be appropriate.
In December 2018, the Joint Committee on Taxation released its explanatory document on the TCJA (a.k.a. the Blue Book), which stated Congressional intent for various provisions of the TCJA. The Blue Book describes that it was the intent of Congress to treat an individual shareholder of a RIC that owns stock in a REIT or interests in a PTP as if the shareholder held the interests directly, to the extent any dividends received by the individual of the RIC are attributable to qualified REIT dividends or qualified PTP income received by the RIC. 

How Proposed Regs Will Impact Qualifying Income Earned by RICs

Section 199A(f)(4) grants the Secretary the right to “prescribe such regulations as are necessary to carry out the provisions of this section” and specifically “for the application of this section in the case of tiered entities.” Accordingly, the proposed regulations were issued under this authority.
The proposed regulations in their current form do not provide for a mechanism for conduit treatment of qualified PTP income to shareholders of a RIC. The Treasury Department and the IRS will continue to consider the appropriateness of conduit treatment of qualified PTP income and is seeking commentary on the issue.

For more discussion on PTPs, read "The Future of the Qualified Business Income Deduction for RICs with Income from Publicly Traded Partnerships."
However, the proposed regulations do allow a RIC to compute and report Section 199A dividends from qualifying income received from REITs. The preamble to the regulations describes the areas of existing tax law a shareholder in the RIC may use as a “template” to treat income or gain as if the shareholder had realized it directly, e.g., capital gain dividends and exempt interest dividends. Similar to these provisions, the proposed regulations provide conduit treatment for non-corporate shareholders of RICs receiving Section 199A dividends. Shareholders would treat them as qualified REIT dividends under Section 199A(e)(3) if the shareholder meets the holding period requirements for its shares in the RIC.
The proposed regulations describe the manner in which Section 199A dividends will be calculated for the RIC. Qualified REIT dividend income means the amount of qualified REIT dividends includible in a RIC’s taxable year over the amount of the RIC’s deductions allocable to the income. The requirement to allocate deductions to qualified REIT dividends was unexpected. The preamble explains that the Treasury Department modeled this allocation of deductions after similar requirements for capital gain dividends under Section 852(b)(3) and exempt interest dividends under Section 852(b)(5).
For non-calendar-year RICs, the proposed regulations require them to compute the post-December amount of qualifying income from REITs. If this amount exceeds the “excess reported amount” for the RIC’s taxable year (defined as qualifying income from REITs for the entire taxable year less allocable expenses), the RIC is then required to reduce any post-December distribution by the excess reported amount. In this circumstance, no portion of the excess reported amount is allocated to distributions made in the pre-January period. 

Exclusivity of Qualified Business Income and Qualified Dividend Treatment Still Uncertain

The instructions for Box 5 (Section 199A dividends) of the Form 1099-DIV reference the amount of box 1a (total ordinary dividends) that may be eligible for the qualified business income deduction. There is no specific reference to Box 1b (qualified dividends).
However, many professionals in the investment industry have taken an “either/or” view of dividends being treated as qualified dividends or Section 199A dividends, but not both. This is seemingly based upon Section 199A(e)(3), which defines a qualified REIT dividend as a dividend from a REIT that is neither a capital gain dividend nor qualified dividend income.
There is guidance in other areas of tax law for RICs that would support a concept that the sum of various conduit treatment items being in excess of 100% of the dividends paid by a RIC. For example, amounts classified as interest-related dividends plus qualified dividends can exceed the total dividend amounts paid by the RIC. However, this guidance may be more appropriately limited to different treatment of certain items by U.S. and non-U.S. shareholders of a RIC. The example provided in the proposed regs does not address a situation where a potential amount of a qualified dividend and qualified business income would exceed the total ordinary dividends paid by the RIC. While the “either/or” concept of qualified dividend treatment and qualified business income from a RIC seems opposed to the intent of the regulation preamble to allow for conduit treatment of qualified business income, it is a conservative approach that RICs may need to use to prepare 2018 Form 1099-DIV for RIC shareholders, given the uncertainty of the issue and the need to generate these forms in a timely basis. 

What Should RICs Do Now Regarding their Form 1099-DIV for Investors?

Many RICs are already far along in the process of preparing Form 1099-DIV for investors. These proposed regulations, while generally welcomed by the investment industry and RIC shareholders, create an additional administrative burden to RICs and could potentially delay filings of these forms used to report Section 199A dividends to shareholders. The proposed regulations also leave some questions unanswered. However, the potential tax benefits to shareholders of RICs with significant REIT exposure will be important for RIC managers to consider as they complete year-end reporting to shareholders for 2018.
Please contact a member of your service team, or contact Rob Velotta at, Jay Laurila at or Ravi Singh at for further discussion. 

Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.