In this, the third and final post in our series on UBTI issues for RICs and RIC shareholders, we will examine IRS guidance for RICs and REITs on excess inclusion income. As stated in our previous posts on this topic, the most common source of excess inclusion that we believe a RIC may have will typically come from its investment in a mortgage oriented REIT. The rules for passing through excess inclusion income to shareholders for RICs are almost identical for the rules on the same for REITs. RICs with investments in REITs that have mortgage investments could potentially receive excess inclusion allocations from their REIT investments. Therefore, this post will focus on REITs as the source of RIC excess inclusion income. However, a RIC can have excess inclusions from direct investments in taxable mortgage pools or REMIC residual interests, as previously discussed.

In response to inquiries concerning excess inclusion income reporting posed by practitioners in both the RIC and REIT industries, in 2006 the IRS issued Notice 2006-97. While this notice provides guidance to both industries, we will focus in its provisions that are geared towards RIC’s. These provisions include the following:

• Guidance on allocating the excess inclusion income among the RIC’s shareholders.
• Guidance on reporting requirements to shareholders
• Guidance on the tax on excess inclusion income allocable to disqualified shareholders
• Guidance on withholding tax on excess inclusion income allocable to foreign shareholders
• Certain de minimis exceptions to the reporting requirements
• Guidance for non-RIC or REIT pass through entities

We will analyze each of these provisions below:

Allocating Excess Inclusion Income

A RIC’s excess inclusion income is equal to its excess inclusions (we are assuming here that are passed through to it from a REIT) less its taxable income (excluding capital gain net income). Since a RIC’s taxable income is presumably always reduced to zero by the dividends paid deduction, it appears that a RIC’s excess inclusion income will always equal the excess inclusions allocated to it from its REIT investment. Once this excess inclusion income amount is determined, it must be allocated among the RIC’s shareholders in proportion to the dividends paid to such shareholders. Note – the rules on excess inclusion income allow the RIC to reduce the dividends that in pays to “disqualified shareholders” by the amount of tax on excess inclusion income allocated to such shareholders, without such a reduction resulting in a preferential dividend. As will be discussed below, a RIC must pay an entity level tax on excess inclusion income allocated to disqualified shareholders. This tax must be added back to the dividends paid to disqualified shareholders for purposes of making this allocation. What is not made clear in Notice 2006-97 is how such allocations should be made when the RIC pays no dividends for the fiscal year. Presumably, it then escapes further reporting and taxation.

Reporting Requirements to Shareholders

Once the RIC has allocated its excess inclusion income among its shareholders, as described above, it must report such amounts to certain shareholders. First off, a RIC must report the excess inclusion income allocated to any shareholder that is a nominee (broker omnibus type accounts) to that shareholder. The nominee is then subject to reporting obligations of its own to report the excess inclusion income to the beneficial account holders.

Tax on Allocations to Disqualified Shareholders

To the extent that the RIC has allocated excess inclusion income to so-called disqualified shareholders, it does not have to report such excess inclusion income to these shareholders. Instead, it is required to compute and pay a RIC-level tax measured by the amount of excess inclusion income allocated to all such disqualified shareholders times the highest corporate tax rate (35%). Such disqualified organizations include states and other governmental entities, political organizations, home owners associations and charitable remainder trusts among others.

Foreign Shareholders

To the extent that allocations of excess inclusion income are made to foreign shareholders, the RIC must withhold tax without regard to any exemptions from taxation or rate reductions resulting from a tax treaty. This will generally result in a 30% withholding.

Allocations to Non-Nominee Shareholder and De Minimis Rules

For RIC taxable years beginning on or after January 1, 2007, with respect to allocations of excess inclusion income made to non-nominee shareholders of a RIC, the RIC is only required to report such amounts to these non-nominee shareholders if its excess inclusion income from all sources exceeds 1% of its gross income. There is a somewhat confusing exception to this de minimis rule. That is, a RIC that is not subject to the reporting rules for non-nominee shareholders is nevertheless required to report excess inclusion income to its non-nominee shareholders (but only that excess inclusion income that is passed through to it from a REIT), if the following conditions exist:

The REIT has reported to its shareholders for the most recent REIT taxable year ending not later than nine months before the first day of the RIC's taxable year and:

• A portion of the REIT's dividends for the year was excess inclusion income, and
• This excess inclusion income exceeded three percent of the REIT's total dividends for the year.

Notice 2006-97 gives an example of this exception that reads as follows:

A reporting requirement for the RIC “applies to a fiscal year RIC for its taxable year beginning February 1, 2007, with respect to excess inclusion income allocated to the RIC by that REIT for the REIT's taxable year ending December 31, 2007, if the REIT had reported for its taxable year ending December 31, 2005, that its excess inclusion income exceeded three percent of its total dividends for that year.” Presumably, the exception is drafted this way in order to give a RIC owning shares of a REIT that passes through excess inclusion income time to determine if it will have to report pass through excess inclusion income to its shareholders. In the example, the REIT’s fiscal year ending December 31, 2006 is not used to make the determination because it ends later than nine months before the first day of the RIC’s taxable year (February 1, 2007). Accordingly, since the date that is nine months prior to February 1, 2007 is May 1, 2006, any REIT fiscal year end up to April 30, 2006 could have been utilized in making this determination. For a calendar year RIC investing in a calendar year REIT, this means that the REIT fiscal year end that is two years prior would be used to make the determination. For example, for 2012, a calendar year RIC investing in a calendar year REIT would have its fiscal year begin on January 1, 2012. The date nine months prior to such date is April 1, 2011 and the REIT’s fiscal year ending no later than this date is December 31, 2010.

Guidance for Non-RIC or REIT pass through entities

Notice 2006-97 also includes guidance for investment funds that are not registered – i.e. private investment partnerships and hedge funds (basically any entity taxed as a partnership for tax purposes). Unfortunately for such entities, there is no de minimis exception. A partnership is required to allocate excess inclusion income among partners utilizing its normal allocation methodology, report the amounts so allocated to all of its partners who are not disqualified organizations, pay the tax on excess inclusion income allocated to disqualified organizations, and withhold and report on excess inclusion income allocated to foreign partners.

Conclusion

Excess inclusion income is a more complicated area of the tax law. Such income has obvious relevance to tax exempt organizations in that it is considered to be UBTI. Additionally, while such excess inclusion income would seem to have little relevance to taxpayers other that exempt organizations, the rules related to it deny the deduction of net operating losses and certain deductions against it. This is why RICs and REITs also have to report it to their non-tax exempt shareholders. The rules are complicated when multiple pass through entities such as RICs, REITs and partnerships are involved and further complicated by the tax on allocations of excess inclusion income to disqualified entities as well as the withholding on foreign partners or shareholders. Any investment fund, be it a RIC or a partnership, either investing in REMIC residual interests directly or receiving allocations of excess inclusion income from a REIT, should consult a qualified tax advisor.