Taxes! What BDC Investors Need to Know

Source: 401(K) 2013

Tax time is here again, and Uncle Sam wants his cut. While business development companies, or BDCs, enjoy very preferential tax treatment -- the industry avoids corporate-level taxation -- investors are responsible for paying taxes on the dividends.

Let's look at a handful of BDCs and how their 2013 dividends are taxed in the table below.

BDC name

Ordinary dividends

Qualified dividends

Long term capital gains

Main Street Capital (NYSE: MAIN  )

$1.872

$0.456

$0.346

Prospect Capital (NASDAQ: PSEC  )

$1.263

$0.056

 None

Triangle Capital (NYSE: TCAP  )

$1.571

$0.570

$0.018

Source: Company press releases

How to make sense of taxes due
Because BDCs pass through taxation to shareholders, different types of income have different tax treatment. Ordinary dividends, for instance, are just regular income. If you were a Main Street Capital shareholder for the full year, you'd have $1.872 in regular income per share on which you would pay ordinary income tax rates.

Qualified dividends are much better from a taxation perspective, since they are taxed as dividends, not income, and share the same tax rates as long-term capital gains. Thus, you'll pay anywhere from 0% to 23.8% on dividends in this column. The same is also true for long-term capital gains -- you'll pay 0% to 23.8% on this column, depending on your marginal income tax bracket.

Why the difference?
Tax treatment differs from BDC to BDC and from year to year. Prospect Capital and Triangle Capital are both invested primarily in debt investments, so the majority of dividends paid are regular income. Main Street Capital has a larger equity investment portfolio. In 2013, it realized gains from equity investments, and thus, the gains are passed through to shareholders as capital gains.

Historically, Main Street Capital shareholders have enjoyed much lower taxes than the average BDC investor. In 2012, a full 46% of its dividends were taxed as capital gains or qualified dividends. Of course, a BDC with a larger equity portfolio also experiences larger swings in value, as equity is more volatile than debt investments.

Investors can avoid the tax-time headaches by holding BDC shares in a 401k or IRA, which grow tax-deferred, and are either taxed as income at retirement (traditional plans), or not at all (Roth plans). 

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