How BDC Taxes Work

Business development companies receive very preferential tax treatment from the IRS. Managed efficiently, a BDC should pay absolutely nothing in corporate income taxes, instead passing the burden to investors who have to pay taxes on their earnings at their personal tax rate.

But with all things taxes, it's much more complicated than that. There are two criteria BDCs must meet to keep their beneficial tax status and pay zero taxes. Here they are.

1. Pay out 90% of income in distributions
In order to qualify as a registered investment company, a BDC must pay out 90% of its earnings each fiscal year to shareholders. Qualifying as a RIC allows a business development company to avoid any normal federal income taxation.

Across the board, BDCs regularly meet, and often exceed, this minimum distribution amount. Failure to do so would result in losing their RIC status and paying up to 35% of their income to the IRS. Since no BDC wants to be the loser that pays Uncle Sam, they're very good about meeting this requirement.

Only one BDC (that didn't go bankrupt, or get bought out) has opted to forgo its RIC status. American Capital Ltd. (NASDAQ: ACAS  ) chose to move from a RIC setup to a C-corporation to make use of net operating losses. Doing so allowed it to use its earnings to repurchase shares at less than their net asset value, delivering more after-tax value to shareholders than they would have by paying out a dividend. This is a unique situation, however -- one you wouldn't want to see happen to a BDC you own.

2. Pay out 98.2% of ordinary income and 98% of capital gains
Many investors falsely believe that the 90% payout threshold is a surefire way to avoid taxes on a BDC's income statement, but BDCs are also subject to an excise tax.

In each fiscal year, BDCs must pay out 98.2% of ordinary income (fees and interest income plus realized short-term capital gains minus long-term capital losses) and 98% of capital gains (from realized long-term capital gains minus realized short-term losses) to investors.

Failing to meet these requirements results in a 4% excise tax on the retained earnings. Thus, if a BDC pays out 90% of its income, it can maintain its RIC status. However, if it fails to meet requirements for ordinary income and capital gains, the remaining 10% of earnings are taxed at 4%.

BDCs love paying excise taxes
Many BDCs do not meet the standards necessary to avoid excise taxes. Main Street Capital (NYSE: MAIN  ) is the BDC king of retained earnings. The company had $1.33 in spillover income per share as of the last quarter, all of which is or has been subject to a 4% excise tax, if not paid out in its fiscal year-end.

Why would Main Street Capital choose to pay a tax? It's not as ridiculous as it might seem. By holding back spillover income, Main Street Capital has more cash to make future investments without issuing new shares. Selling stock is costly for a company as small as Main Street Capital, as it recently paid nearly 7% in fees to underwriters for a secondary public offering. Paying Uncle Sam 4% beats paying an investment bank 7%.

Larger BDCs Prospect Capital (NASDAQ: PSEC  ) and Ares Capital Corporation (NASDAQ: ARCC  ) also have spillover income on their balance sheets. In their case, having spillover income allows them some insulation against a dividend cut, since if they fail to earn their dividend in any given year or quarter, they can simply paper over the earnings miss with earnings retained from prior years.

When a significant part of your shareholder base cares about dividend stability, spillover income is cost-effective "insurance" against a mass exodus in the event you cannot sustain your dividend temporarily. BDC earnings ebb and flow just like any company's earnings, but no other industry has such rigid requirements for how much cash has to go back to shareholders each quarter. Spillover income is valuable dividend protection.

Get rich with dividends
Dividend stocks can make you rich. It's as simple as that. While they don't garner the notoriety of high-flying growth stocks, they're also less likely to crash and burn. And over the long term, the compounding effect of the quarterly payouts, as well as their growth, adds up faster than most investors imagine. With this in mind, our analysts sat down to identify the absolute best of the best when it comes to rock-solid dividend stocks, drawing up a list in this free report of nine that fit the bill. To discover the identities of these companies before the rest of the market catches on, you can download this valuable free report by simply clicking here now.

 


Read/Post Comments (1) | Recommend This Article (4)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 14, 2013, at 4:22 PM, awallejr wrote:

    Something else to point out is that as a result of an IRS ruling in 2009, BDCs can issue stock instead of cash for its dividend. In fact that is what ACAS did in 2009 (small amount of cash if chosen for and mostly stock).

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2676697, ~/Articles/ArticleHandler.aspx, 10/31/2014 12:38:11 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement