The U.S. Internal Revenue Service (IRS) has temporarily reduced the percentage of a combined distribution of cash and stock by a public real estate investment trust (REIT) or a public regulated investment company (RIC) required to be in cash to make that distribution taxable to the REIT or RIC shareholders and, accordingly, deductible by the distributing REIT or RIC, which is relevant for purposes of computing the REIT or RIC’s taxable income and determining whether such entity satisfies the 90 percent annual minimum distribution requirement applicable to REITs and RICs. Previously, the IRS created a permanent safe harbor for such treatment if shareholders could elect to receive at least 20 percent of such a distribution in cash and certain other requirements were satisfied. Now, the IRS has temporarily reduced that minimum to 10 percent for distributions declared between April 1 and December 31, 2020.
The IRS said this temporary relief is in “recognition of the need for enhanced liquidity during the current period of economic disruption”1 due to COVID-19. Some public mortgage REITs in particular are experiencing significant liquidity problems in connection with short-term warehouse and repurchase financing positions that they have in place. RICs generally do not face the same problem because of the nontax legal and practical commercial limits on leverage imposed on RICs. Both mortgage and equity REITs may also face liquidity issues due to being required to accrue interest or rental income that is not accompanied by a cash payment due to either government-mandated forbearance or the general inability of borrowers or tenants to keep current in their loan or rental payments.
These aforementioned liquidity problems are heightened by the requirement that REITs and RICs generally must distribute 90 percent of their taxable income to their shareholders annually. Revenue Procedure 2020-19 will temporarily permit such REITs and RICs to pay up to 90 percent (rather than 80 percent) of the dividends they use to meet this requirement in the form of stock.
A corporation that meets the requirements for either REIT or RIC status is entitled to a dividends-paid deduction for the taxable dividends it pays to its shareholders and therefore generally is not subject to U.S. federal corporate income tax to the extent that it distributes its taxable income (computed without regard to the dividends-paid deduction) to its shareholders as taxable dividends. Most REITs and RICs make such distributions in order not to be required to pay any United States corporate income tax. In addition, to qualify as a REIT or a RIC, an entity seeking such qualification must generally distribute at least 90 percent of its taxable income (computed without regard to the dividends-paid deduction, capital gains and certain other modifications) annually.
For a REIT or a RIC distribution to be eligible for the dividends-paid deduction, the distribution must generally be taxable to the recipient shareholders. A corporate distribution in the form of stock is taxable only if it comes within one of the categories described in Section 305(b) of the Internal Revenue Code of 1986 (Code). In general, that section of the Code looks to whether there has been a significant enough change in the shareholders’ respective proportionate claims on the corporation’s assets or future earnings such that the distribution should be taxable; for example, a strictly proportionate distribution of shares of common stock as a “dividend” on common stock involves no such change and is generally not taxable. Under Section 305(b)(1) of the Code, if any shareholder has a right to receive a distribution in cash while other shareholders receive only stock, then the aggregate distribution of stock and cash to the shareholders is taxable. When all shareholders have the right to elect to receive a distribution in either cash or stock, the question is how much of the aggregate distribution must be in cash for the potential change in the shareholders’ relative rights, based on their elections, to be regarded as significant enough for the distribution to be taxable even though there may be no change at all in their proportionate stock ownership if they all make the same election.2
Revenue Procedure 2017-45 sets out the requirements to qualify for a safe harbor for distributions to be treated as taxable (and therefore deductible) when shareholders of public REITs and public RICs have the right to elect whether to receive cash or stock. One of the general safe harbor’s requirements is that cash must make up at least 20 percent of the aggregate distribution.
The Safe Harbor, as Modified by Revenue Procedure 2020-19
Under Revenue Procedure 2020-19, a distribution of cash and stock by a public REIT or a public RIC will be treated as a taxable (and deductible) distribution if the following requirements are satisfied:
- The distribution is made by the REIT or the RIC to its shareholders with respect to its stock.
- The REIT is a “publicly offered REIT” within the meaning of Section 562(c)(2) of the Code, or the RIC is a “publicly offered RIC” within the meaning of Section 67(c)(2)(B) of the Code, as applicable.
- Pursuant to the distribution declaration, each shareholder may elect to receive its entire entitlement under the distribution declaration either in cash or in stock of the REIT or the RIC of equivalent value.
- The maximum aggregate amount of cash to be distributed to all shareholders as limited by the distribution declaration (Cash Limitation Amount) over the aggregate declared distribution (Cash Limitation Percentage) is not less than 10 percent.
- Every shareholder electing to receive less than the Cash Limitation Percentage in cash receives cash equal to the shareholder’s elected cash amount.
- If the aggregate of all shareholders’ elected cash amounts does not exceed the Cash Limitation Amount, then every shareholder whose elected cash percentage exceeds the Cash Limitation Percentage receives cash equal to that shareholder’s elected cash amount.
- If the aggregate of all shareholders’ elected cash amounts exceeds the Cash Limitation Amount, then each shareholder whose elected cash percentage exceeds the Cash Limitation Percentage receives a pro rata amount of cash corresponding to the shareholder’s respective entitlement under the distribution declaration.
- The calculation of the number of shares to be received by a shareholder is determined based on a formula that (a) uses the market price of the shares, (b) is designed so that the value of the number of shares to be received in lieu of cash with respect to a share corresponds as closely as practicable to the amount of cash to be received under the distribution declaration and (c) uses data from a period of no more than two weeks ending as close as practicable to the payment date.
In addition to the obvious issue of requiring shareholders to pay taxes on a dividend distribution that is not in the form of cash, investors may view taxable dividends composed largely of stock of the distributing corporation as a dividend reduction, with all the concomitant adverse effects on the market price of the corporation’s stock. Therefore, public REITs and public RICs should carefully weigh the liquidity benefits of the safe harbor under Revenue Procedure 2017-45, as modified by Revenue Procedure 2020-19, against the potentially negative nontax consequences to them and their shareholders.
1 Similar temporary relief was granted with respect to the financial crisis of 2008-12, also by the issuance of revenue procedures.
2 Another technique used by some REITs in the past has been to distribute convertible preferred stock, with terms and conversion rights such that it is likely that a significant portion of shareholders will elect to convert and a significant portion of the shareholders will not. A distribution of convertible preferred stock having such terms and characteristics (particularly if it has the outcome described) may be treated as taxable.
3 Section 199A of the Code may reduce the amount of “phantom income” of noncorporate REIT shareholders by allowing such shareholders to claim a 20 percent “qualified business income” deduction for ordinary REIT dividends for years beginning after December 31, 2017, and before January 1, 2026, provided the shareholder satisfies certain holding period requirements. However, Section 199A of the Code may not offset all such phantom income, and Section 199A of the Code is available only to noncorporate REIT shareholders. Furthermore, there is no corresponding “per se” 20 percent deduction for RIC dividends.
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