The most important thing any investor can do is think for the long haul. Think about returns after taxes -- how much of your investing results will flow to your bank account.

Business development companies aren't taxed at the corporate level. All taxes are paid at your personal tax rates. So let's take a deep dive into how BDC returns are taxed, to reveal your expected after-tax return on your investment.

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Four types of BDC dividends
Business development companies are basically just publicly traded funds of private company debt and stock. Being funds, they pay distributions that are taxed in four different ways -- either as income, capital gains, dividends, or returns of capital.

 Here's a quick run through the four types of distribution.

  • Income. This is money earned from fees and interest, generally earned on loans and preferred stock in a BDC's portfolio. You'll pay normal income taxes on these distributions.
  • Non-qualified dividends. Non-qualified dividends are dividend income paid that doesn't qualify for the preferential dividend tax rate. This is taxed at the ordinary income rate -- your personal marginal tax bracket.
  • Qualified dividends. These are funds paid to the BDC from investments in common stock in private companies that qualify for taxation as dividends. Long-term capital gains and dividends were formerly taxed at the same rate and thus combined in some BDCs.
  • Return of capital. This is your money coming back to you. This is not income of any sort, just funds that were returned from the BDC's investment capital. Returns of capital are not taxed, just as you aren't taxed for taking money out of a bank account.

Different BDCs pay out different types of dividends. Most pay out all three kinds of taxable dividends. I went back to three leading BDCs and found the past three years of dividends paid to see how the tax treatment varies.

Here's a table of how BDC dividends were taxed by year. Note that I have combined long-term capital gains and dividends where appropriate because they were both taxed at 15% before 2012.


Ordinary vs. Qualified Dividends, 2010

Ordinary vs. Qualified Dividends, 2011

Ordinary vs. Qualified Dividends, 2012

Main Street Capital (NYSE:MAIN)

81.33% ordinary, 18.67% qualified

73.94% ordinary, 26.06% qualified

53.53% ordinary, 46.47% qualified

Prospect Capital (NASDAQ:PSEC)

62.06% ordinary, 9.32% qualified

(28.62% return of capital)

73.85% ordinary, 13.08% qualified

(13.07% return of capital)

43.39% ordinary, 56.61% qualified

Ares Capital (NASDAQ:ARCC)

98.83% ordinary, 1.17% qualified

77.66% ordinary, 22.34% qualified

91.73% ordinary, 8.27% qualified

Source: Company press releases and websites.

BDC payouts and their tax treatment can vary tremendously from year to year. Main Street Capital, which has more equity investments in its portfolio, pays out the most qualified dividends because more of its earnings are from dividends and capital gains. That bodes well for Main Street Capital shareholders, since many pay a much lower tax rate on dividends than they do ordinary income.

Ares Capital and Prospect Capital pay out significantly more ordinary income to shareholders, so their total after-tax yield is lower than it might otherwise appear. If you owned Ares Capital and earned in the top tax bracket in 2012, you'd pay 35% income taxes on 91.73% of your dividends. Obviously, paying such a high tax rate on the overwhelming majority of Ares Capital's distributions would cost you nearly a third of your total after-tax yield.

In Prospect Capital's case, it returned capital to shareholders following the recession, which gave its shareholders a consistently high dividend, but as much of 28% of it was just investors' money coming back. Prospect Capital has since built up a surplus of undistributed income, and returns of capital this year or next look unlikely.

Forgetting the headache
If you're like most investors and would prefer to forget the tax consequences of BDC dividends, there's an easy solution: Hold them in a 401(k) or IRA. Unlike MLPs, you can hold a BDC safely in a retirement account so that the dividends are taxed like any other gain or dividend. In many cases, especially when you earn in a marginally high tax bracket, putting a BDC in a retirement account will reduce the tax impact and result in higher after-tax returns. 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.