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.