The tax treatment of income reported by a regulated investment company (RIC) to its shareholders is for the most part, fairly straightforward. From that perspective, a shareholder of a RIC organized under subchapter M of the Internal Revenue Code is, with some exceptions, treated as a shareholder of any other corporation. However, is a tax exempt entity, which is a RIC shareholder, necessarily treated the same as if it were a shareholder of a corporation? In this three-part series of posts, we will examine the general rules that must be considered by a RIC and its shareholders when a RIC’s investments generate “unrelated business taxable income (UBTI).”

An entity that has filed for and received an exemption under Section 501(a) of the Internal Revenue Code is generally exempt from taxation. However, it is taxable on the portion of its income which represents UBTI. For UBTI taxation purposes, taxable entities include tax-deferred retirement plans such as 401(k) plans and Individual Retirement Accounts. UBTI is the net income that a tax-exempt organization earns from activities that do not qualify for purposes of its tax exemption, such as a trade or business which is not related to the organization’s tax-exempt mission. Debt financed activities of a tax-exempt organization also generate UBTI. A tax-exempt shareholder of a corporation is protected from UBTI, and the corporation, in this regard, is treated as a “UBTI blocker.” The character of the UBTI generating activities engaged in by the corporation does not pass-through to the tax-exempt shareholder and therefore UBTI earned by the corporation does not pass through to the tax-exempt shareholder. However, “tax transparent” entities such as partnerships do pass through any UBTI that they earn to their tax-exempt equity holders. For tax purposes, a RIC is a hybrid between a corporation and a pass-through entity in that it maintains certain characteristics of a corporation while at the same time it has some of the conduit features of a pass-through entity.

So does a RIC act as a “UBTI blocker,” and are its tax-exempt shareholders protected from UBTI? The answer is, most of the time, “yes." As with a corporation, the dividends received by a tax-exempt shareholder of a RIC are not subject to tax, even if such dividends are attributable to income that would otherwise be treated as UBTI if the exempt entity were to have earned the income directly. For example, debt financed portfolio income earned by a RIC does not pass through to its tax-exempt shareholders as UBTI but would be UBTI if earned directly by the tax-exempt entity itself. Privately, the IRS has ruled that distributions from a RIC, with investments in UBTI generating partnerships, qualify as corporate distributions and are not subject to UBTI. The IRS has also ruled that the RIC is recognized as a taxpayer separate from its shareholders and that the RIC, not its shareholders, is deemed to own a proportionate share of the underlying assets of its partnership investments (PLR 9726034). In other words, a “look through” rule does not apply – generally speaking.

There are, however, a few exceptions, which will be discussed further, where an investment in a RIC can generate UBTI for a tax-exempt shareholder. In the second post in our series, we will provide a general overview of these exceptions, and in our third installment, we will dive into one of the exceptions in greater detail.