As year-end approaches, many mutual fund investors understand that their investments in mutual funds may generate dividend income, both ordinary and capital gains, in November or December. However, particularly for new investors and fund managers, below is an overview that provides an understanding of why funds pay these year-end distributions.
Among other requirements, a Regulated Investment Company (RIC) is required to pay out 90% of its investment company taxable income so it will not be taxed as a corporation. Practically speaking, most RICs pay out 100% of both their ordinary income and capital gains to avoid any fund-level taxation. Internal Revenue Code (IRC) Section 855 allows a RIC to pay these dividends to investors up to one year after the end of a RIC’s tax year and take a deduction for that tax year. These dividends paid after year-end are commonly referred to as “spillback dividends.” Investors, however, will recognize the dividend income when the amount is paid, which may result in a mismatch in timing between when the RIC earns income and when an investor ultimately pays tax on the income.
Consider the following example:
A March fiscal year-end fund earns $100 from a dividend from an underlying investment on April 15, 2015. The fund has no other income or expenses for its March 31, 2016, year-end. Under the income tax rules, the fund can pay a $100 dividend as late as March 31, 2017, and be able to take a tax deduction for the dividend on its March 31, 2016, tax return. The fund pays a $100 dividend in 2016 to investors who report the income on their 2017 tax returns.
In order to prevent this potential deferral of income, in 1986 Congress added an excise tax on undistributed income under IRC Section 4982. These rules essentially require a RIC to pay dividends to investors on income earned in the same calendar year in which the fund earned the income. Failure to make required distributions under 4982 results in an excise tax to the fund of 4% of the under-distribution amount. The excise tax rules exempt RICs if during all of the calendar year all of its shareholders are tax-exempt or tax-deferred investors, such as pension trusts, segregated assets accounts of life insurance companies held in connection with variable contracts, etc. For these purposes, seed investments of up to $250,000 are disregarded.
To bypass the excise tax under IRC Section 4982, a RIC must distribute the sum of 98% of its ordinary income for the calendar year and 98.2% of its capital gain for the one-year period ending on October 31 of the calendar year. In addition, RICs must make up for any shortfall on distributions from previous calendar years. Some funds with November and December fiscal year-ends may elect to have their capital gain period match their fiscal year-end; however, this election is irrevocable without IRS consent and consideration should be given to this irrevocability before making the election.
The October 31 cut-off date was used for excise tax purposes, as capital gain items are difficult to estimate. Failure to use a non-calendar year cutoff would essentially require a RIC to wait until the last day of the calendar year to make any distributions. Specific transactions with similar uncertainty but that generate ordinary income also can use the October 31 cutoff. These “specified gain or loss” items are from the sale, exchange, or disposition of property and include currency gain and losses, Passive Foreign Investment Company mark-to-market and similar items.
Excise distributions usually occur in November or December as a way to distribute all income from the calendar year. In addition, under IRC Section 852(b)(7), dividends declared by a RIC in October, November, or December and paid in January of the following year are deemed to have been paid on December 31 and are deductions for excise tax purposes.
Funds may look to reduce the taxable dividends to investors using several methods, including the following:
RICs may look at tax loss harvesting or other capital gains planning before October 31 of a year to reduce their required distributions.
Funds also may consider tax-minimization strategies related to redemption activities, such as redeeming shareholders in-kind to avoid recognition of gain on the securities distributed or using equalization. Equalization is a concept that allows a RIC to treat a portion of payments in redemption of shares as a deemed dividend distribution by the RIC.
Any tax planning opportunities should be implemented in consultation with a fund’s tax advisor. As a best practice, RICs should communicate estimates to investors to avoid surprising them with an unanticipated tax liability related to distributions.
Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.