Taxation of Regulated Investment Companies (Portfolio 740)

Be a trusted advisor to your clients with Bloomberg BNA Tax Portfolios. In this portfolio, Premier tax experts discusses in detail the provisions of §§851 through 855, 860 and 4982 of the Internal Revenue Code, which govern the taxation of regulated investment companies (RICs). The Portfolio also discusses the applicability of other Code provisions to RICs.


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The Taxation of Regulated Investment Companies Portfolio discusses in detail the provisions of §§851 through 855, 860 and 4982 of the Internal Revenue Code, which govern the taxation of regulated investment companies (RICs). The Portfolio also discusses the applicability of other Code provisions to RICs.
The RIC provisions provide special favorable rules relating to the taxation of RICs. A domestic corporation (or entity that would otherwise be taxed as a corporation) registered with the Securities and Exchange Commission as an investment company under the provisions of the Investment Company Act of 1940 may elect to be a RIC for any taxable year in which it satisfies certain requirements relating to the source of its income and the diversification of its assets. A RIC that satisfies certain additional distribution requirements will generally be taxed as a pass-through entity that acts as a partial “conduit” of income to its shareholders. Such conduit treatment is achieved by allowing a qualifying RIC to deduct the amount of dividends paid to its shareholders in computing the RIC's taxable income and gains, with the result that the RIC's distributed net income and gains can be passed through to its shareholders free of tax at the RIC level.
A RIC can also pass through the character of its long-term capital gain income to the shareholders by paying “capital gain dividends” and, in certain circumstances, the character of tax-exempt interest income can also be passed through to the shareholders on the payment of “exempt-interest dividends.” Under certain conditions, a RIC may also pass through to its shareholder the ability to take the foreign tax credit (or deduction) with respect to foreign taxes paid by the RIC and the RIC's credits from tax credit bonds and, in certain years, may pass through to some foreign persons exclusions from taxation of interest income and short-term capital gain. The corporate shareholders may also be able to obtain the benefit of the corporate dividends received deduction to the extent of the RIC's income from qualifying dividends. Further, in some circumstances, dividends that shareholders receive from a RIC may be “qualified dividend income,” which may be eligible for taxation to individual shareholders at long-term capital gain rates.

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Richard M. Hervey obtained his B.A. from Herbert Lehman College, his M.A. from the University of California, Berkeley, and his J.D. from the Harvard Law School. He was admitted to the New York Bar and is a member of the American Bar Association (Section of Taxation), Committee on Regulated Investment Companies, and New York State Bar Association (Section on Taxation).

Credentials / B.A., Herbert Lehman College (1972); M.A., University of California, Berkeley (1975); J.D., Harvard Law School (1978); admitted, New York Bar; member, American Bar Association (Section of Taxation); Committee on Regulated Investment Companies, New York State Bar Association (Section on Taxation).


Detailed Analysis

I. Introduction

II. Historical Background

III. Types of Entities that Can Qualify for RIC Status

A. In General

B. Domestic Corporations

C. Registration Under the 1940 Act

D. Business Development Companies

E. Common Trust Funds

F. Capital Structure of RICs

IV. Election of RIC Status


V. Source of Income Requirement

A. In General

B. Historical Background and Purpose of the Qualifying Income Test

C. Gross Income

1. Treatment of Losses

2. Interest on Tax-Exempt Obligations

3. Waivers and Reimbursements of RIC's Expenses

4. Reimbursement of Payments by RICs of Expenses of Another Entity

5. Contributions to Capital

6. Income from Partnerships

7. Balance Credits to RICs from Custodian Banks

8. Custody Fees Received by Unit Investment Trusts

D. Dividends

1. In General

2. Distributions of Property

3. Stock Dividends

4. Redemptions

5. Subpart F Income from Controlled Foreign Corporations

6. Income from Passive Foreign Investment Companies

7. Distributions from REITs

E. Interest

1. Tax-Exempt Interest

2. Original Issue Discount

3. Discount on Treasury Bills

4. Market Discount

5. Bankers' Acceptances

6. Treatment of Fees for Services Performed in Connection with Loans

7. Repurchase Agreements

8. Insurance Proceeds Relating to Defaulted Bonds

F. Payments with Respect to Securities Loans

G. Gain from the Sale or Other Disposition of Stock or Securities or Foreign Currencies, or Other Income (Including but Not Limited to Gains from Options, Futures or Forward Contracts) Derived with Respect to [the RIC's] Business of Investing in Stock, Securities and Currencies

1. Gains from the Sale or Other Disposition of Stocks and Securities

a. Definition of Security

b. Investments in REITs

c. Government Securities

d. Certificates of Deposit

e. Notional Principal Contracts

f. Loan Participations

2. Options, Futures, and Forward Contracts on Stock or Securities

a. Options

(1) Options on Stock

(a) Purchased Options

(b) Granted Options

(2) Options on Stock Indexes

(3) Options on Debt Instruments

b. Futures Contracts and Forward Contracts on Stocks or Securities

(1) Futures Contracts on Securities

(2) Futures Contracts on Stock Indexes

(3) Futures Contracts on GNMA Certificates

(4) Futures Contracts on Certificates of Deposit

(5) Futures Contracts on Commercial Paper

(6) Futures Contracts on Municipal Bond Indexes

(7) Futures Contracts on the Consumer Price Index

c. Options on Futures Contracts on Stocks or Securities

(1) Options on Futures Contracts on Securities

(2) Options on Futures Contracts on Stock Indexes

(3) Options on Futures Contracts on Municipal Bond Indexes

3. Treatment of Investments in Foreign Currencies and Derivatives on Foreign Currencies

4. Other Income Derived with Respect to a RIC's Business of Investing in Stocks, Securities, and Currencies

a. Litigation Recoveries

b. Tax Refunds

c. Income from Investments that Hedge or Are Related to Investments in Stock, Securities, or Currencies

d. Payments from Investment Advisers

H. Investments in Partnerships and Trusts

1. Income Derived from an Interest in an Entity Other Than a Qualified Publicly Traded Partnership

2. Net Income Derived from an Interest in a Qualified Publicly Traded Partnership

I. Treatment of Investments in Commodities and Derivatives on Commodities

J. Items of Income That May Not Qualify Under the Qualifying Income Test

VI. Diversification Requirements

A. In General

B. Historical Background and Purpose of Diversification Requirements

C. 50% Diversification Requirement: Section 851(b)(3)(A)

D. Assets Qualifying for 50% Diversification Requirement

1. Cash and Cash Items

2. Classification of Various Investments

a. Receivables

b. Demand Deposits and Certificates of Deposit

c. Investments in Money Market Funds

d. Foreign Currency

e. Bankers' Acceptances

f. Repurchase Agreements

g. Overnight Loans of Federal Funds

3. Government Securities

4. Securities of Other Regulated Investment Companies

5. Securities Satisfying the 5 and 10% Test

a. Securities

b. Issuer

(1) Options on Stock

(2) Instruments on Stock Indexes

(3) Futures Contracts on U.S. Government Securities

(4) Options on Debt Instruments

(5) Options on Futures Contracts on U.S. Government Securities

(6) Futures Contracts on Certificates of Deposit

(7) Futures Contracts on Commercial Paper

(8) Tax-Exempt Bonds

(9) Instruments on Foreign Currencies

(10) Futures Contracts on Municipal Bond Indexes

(11) Securities Lending Transactions

(12) Refunded Municipal Bonds

(13) Loan Participations

(14) Repurchase Agreements

c. Voting Securities

6. Examples of Application of the 50% Diversification Requirement

E. 25% Diversification Requirement: § 851(b)(3)(B)

1. Controlled Issuers in the Same or Similar Trade or Businesses or in Related Trade or Businesses

2. Investments in Qualified Publicly Traded Partnerships

3. Investments by Controlled Groups

4. Examples of Application of the 25% Diversification Requirement

F. Investments in Partnerships

G. Investments in Subsidiaries

H. Valuation of Investments for Purposes of Diversification Requirements

1. Total Assets

2. Value

3. Time of Measurement of Value

4. Investments in Stock Options and Options on Stock Indexes

5. Investments in Futures Contracts and Forward Contracts

I. Remedial Provisions Limiting Disqualification for Failure to Satisfy Diversification Requirements

1. Acquisition

2. 30-Day Grace Period

J. Venture Capital Investment Companies

1. Development Corporations

2. Principally Engaged in Furnishing Capital

3. Modified Diversification Rules for Venture Capital Investment Companies

4. Diversification Requirements for RICs Connected with Variable Insurance Contracts

VII. Distribution Requirements for Taxation of RICs as Conduits

A. In General

B. 90% Distribution Requirement: § 852(a)(1)

1. Deduction for Dividends Paid

a. In General

b. Dividend Reinvestment Plans

2. Earnings and Profits

a. Section 852(c)(1)

b. Section 852(c)(2)

3. Preferential Dividends

a. Dividend Reinvestment Plans of Closed-End RICs

b. Reductions of Administrative Expenses for Shareholders Investing at least $10,000,000

c. Distributions by RICs with Multiple Class Distribution Arrangements

d. Inducements to Purchase RIC Shares

e. Other Rulings on Preferential Dividends

4. Equalization Deductions on Redemptions of RIC Shares

5. Consent Dividends

C. Required Distribution of Accumulated Earnings and Profits by Certain RICs

VIII. General Tax Treatment of Qualifying RICs and Shareholders

A. In General

B. Calculation of Investment Company Taxable Income

1. Allowance of Dividends Paid Deduction

2. Treatment of Capital Gains

3. Net Operating Loss Deduction Not Allowed

4. Dividends Received Deduction Not Allowed

5. No Annualization of Income Under § 443(b)

6. Timing of Dividend Income: § 852(b)(9)

7. Treatment of Interest Income from Short-Term Obligations

8. Stock Issuance and Redemption Expenses

a. Stock Issuance Expenses

b. Redemption Expenses

9. Treatment of Rule 12b-1 Fees

10. Expenses of RICs Paying Exempt-Interest Dividends

11. Distributions of Property by RICs in Connection with the Redemption of Shares

12. Foreign Currency Gains and Losses

13. Investments in Passive Foreign Investment Companies

a. Overview of Passive Foreign Investment Companies

b. Mark-to-Market Elections

(1) In General

(2) Application of Mark-to-Market Rules to RICs

14. Investments in REMIC Residual Interests

15. Built-In Gains Subject to § 337(d)

C. Other Special Rules Applicable to RICs

1. Taxation of RICs That Are Also Personal Holding Companies

2. Taxation of RICs That Do Not Maintain Certain Records

3. Other Records Required to Be Kept by RICs

4. Alternative Minimum Tax

5. Environmental Tax

IX. Conduit Treatment of Long-Term Capital Gains

A. In General

B. Taxation of RICs on Capital Gain Income

1. Treatment of Capital Loss Carryovers

2. Bifurcation of Taxable Year

C. Capital Gain Dividends

1. Designation of Capital Gain Dividends

2. Additional Designations with Respect to Capital Gain Dividends

D. Treatment of Post-October Losses

E. Treatment by Shareholders of Capital Gain Dividends

F. Conduit Treatment of Undistributed Capital Gains

1. Undistributed Capital Gains Tax Return

2. Payment of Tax by RIC on Undistributed Capital Gains

3. Notices to Shareholders with Respect to Undistributed Capital Gains

4. Effect on Earnings and Profits if a RIC Makes a Designation of Undistributed Capital Gains

G. Rules for Determining Holding Period

1. In General

a. Options on Stock

b. Options on Narrow-Based Stock Indexes

c. Section 1256 Contracts

2. Termination or Suspension of Holding Period

a. Elimination and/or Reduction of Holding Period Under § 1233

b. Suspension of Holding Period Under § 1092



X. Conduit Treatment of Tax-Exempt Interest Income: § 852(b)(5)

A. In General

B. Obligations Described in § 103(a)

1. Indirect Investments in Tax-Exempt Obligations

2. Transactions Affecting Ownership of Tax-Exempt Obligations

C. 50% Investment Requirement

D. Designation of Exempt-Interest Dividends

E. Issues in Calculating the Amount of Interest Excludible from Gross Income Under § 103(a)

1. Accrued Interest on Purchase

2. Accrued Interest on Sale

3. Original Issue Discount on Tax-Exempt Obligations

4. Tax-Exempt Obligations Acquired at a Market Discount

5. Stripped Tax-Exempt Bonds or Coupons

6. Insurance Proceeds on Defaulted Bonds

7. Gains and Losses on Sale, Retirement, or Other Disposition of Tax-Exempt Obligation

F. Amortization of Premiums on Tax-Exempt Bonds

G. Nondeductible Expenses Under § 265

H. Treatment of Exempt-Interest Dividends by Shareholders

1. Alternative Minimum Tax

2. Social Security

3. Sale or Redemption of Shares

4. Interest Expense Limits for Financial Institutions

XI. Conduit Treatment of Foreign Tax Credit: § 853

A. In General

B. Requirements for Election Under § 853

C. Taxes Covered by § 853 Election

D. Effect of § 853 Election on RIC

E. Effect of § 853 Election on Shareholders

F. Notice of Election to Shareholders

G. Manner of Making the Election Under § 853

H. Treatment of RIC Which Does Not Make § 853 Election

I. Conduit Treatment of Credits on Tax Credit Bonds

XII. Conduit Treatment of Dividends Received Deduction and Qualified Dividend Income: § 854

A. In General

B. Dividends Received Deduction

1. Designation of Dividends as Qualifying for the Deduction

2. Aggregate Dividends Received

3. Other Limitations on Qualifications for the Dividends Received Deduction

4. Effect on Corporate Shareholders of Designations Under § 854(b)(1)(A)

C. Qualified Dividend Income

XIII. Short-Term Capital Gain Dividends

XIV. Interest-Related Dividends

XV. Section 852(b)(7): Dividends Paid in January that are Declared in the Prior Calendar Quarter

XVI. Dividends Paid by a RIC After the Close of Taxable Year: § 855

A. In General

B. Limitation Based on Time of Declaration of Dividend

C. Limitation Based on Time of Distribution of Dividend

D. Limitation Based on Earnings and Profits

E. Method of Making Election Under § 855

F. Irrevocability of Election Under § 855

G. Treatment by RIC of § 855 Dividends

H. Treatment by Shareholders of § 855 Dividends

I. Notices to Shareholders with Respect to § 855 Dividends

XVII. Deficiency Dividends: § 860

A. In General

B. Applicability of Deficiency Dividend Procedure

1. Determination

2. Adjustment

C. Payment of Deficiency Dividends

D. Effect of Deficiency Dividend on RIC

E. Effect of Deficiency Dividend on Shareholders

F. Interest and Penalties

G. Procedure for Claiming Deduction for Deficiency Dividend

H. Suspension of Statute of Limitations and Stay of Collection

I. Claim for Credit or Refund

XVIII. Excise Tax on Failure to Satisfy Calendar Year Distribution Requirements: § 4982

A. In General

B. Amount of Tax

1. In General

2. Tax Return for Excise Tax

C. Required Distribution

D. Ordinary Income

1. In General

2. Treatment of Tax-Exempt Interest

3. Foreign Currency Gains and Losses

4. Investments in Shares of PFICs

5. Adjustments With Respect to Contingent Debt Obligations

6. Investments in Other RICs

7. Investments in REITs

8. Investments in Entities Taxed as Partnerships

E. Capital Gain Net Income

1. Capital Loss Carryovers

2. Reduction of Capital Gain Net Income by Net Ordinary Losses

3. Election to Use Period Ending November 30 or December 31 for Computing Capital Gain Net Income

a. Procedure for Making the Election Under § 4982(e)(4)

b. Revocation of Election Under § 4982(e)(4)

F. Prior Year Shortfall

G. Distributed Amount

1. Prior Year Overdistributions

2. Amounts on Which Tax Is Imposed at the RIC Level

3. Interaction of Excise Tax Distribution Requirements with Subchapter M Distribution Requirements

4. Treatment of Deficiency Dividends

5. SEC Distribution Rules

H. Certain Funds Exempted from Excise Tax

XIX. Taxation of Shareholders of RICs

A. Taxation of Distributions

1. In General

2. Dividends and Return of Capital Distributions

3. Capital Gain Dividends

4. Exempt-Interest Dividends

5. Redemption of Shares

6. Liquidating Distributions

7. Stock Dividends

8. Dividend Reinvestment Plans

9. Distributions of Property

B. Taxation of Undistributed Capital Gains

C. Basis of Shares

1. Introduction

2. Original Basis

a. Shares Acquired by Purchase

b. Shares Acquired Through Dividend Reinvestment Plans

c. Shares Acquired by Gift

(1) Fair Market Value Less than Donor's Adjusted Basis

(2) Fair Market Value Greater than or Equal to Donor's Adjusted Basis

(3) Determination of Fair Market Value at Time of Gift

(4) Determination of Donor's Adjusted Basis

d. Shares Acquired by Bequest, Inheritance, or Devise

3. Adjustments to Basis

a. Undistributed Capital Gains

b. Return of Capital Distributions

c. Frequent Flier Miles

D. Sale or Exchange of Shares in a RIC

1. Identification of Shares Sold

a. General Rules for Identifying Stock Sold

b. Average Basis Methods

(1) Double Category Method

(2) Single Category Method

(3) Election of Average Basis Method

2. Wash Sale Rules

a. Section 1091 Wash Sale Provision

b. Losses After Receipt of Capital Gain Dividend: § 852(b)(4)(A)

c. Losses after Receipt of Exempt-Interest Dividend: § 852(b)(4)(B)

3. Exchanges of Shares for Shares of Another RIC

a. In General

b. Treatment of Transferable Load Charges

E. Investment Expenses

1. Interest Expense Related to Exempt-Interest Dividends

2. Investment Interest Limitation

3. Custody Fees

4. Creation Fees

F. Alternative Minimum Tax

G. Foreign Tax Credit

XX. Series Funds

A. Background

B. Treatment of Series Funds After the 1986 TRA

XXI. Master-Feeder Structures

XXII. Disallowance of Indirect Deductions by Shareholders for Certain Expenses of Nonpublicly Offered RICs

A. Introduction

B. Publicly Offered RICs

C. Application of § 67(c) to Nonpublicly Offered RICs

1. Affected Investors

2. Affected Expenses

3. Allocation of Affected Expenses

4. Reporting Requirements

XXIII. Special Rules Applicable to Subchapter C Corporations Electing RIC Status and to Reorganizations of Subchapter C Corporations into RICs

A. Introduction

B. § 1374 Treatment

C. Deemed Sale Treatment

D. Exemptions

E. Distribution of Accumulated Earnings and Profits

XXIV. Former Short-Short Test Under Former § 851(b)(3)

A. Description of Former Short-Short Test

B. Repeal of Former Short-Short Test


Working Papers

Table of Worksheets

Worksheet 1 Publication 564, Mutual Fund Distributions

Worksheet 2 List of Key IRS Forms




Treasury Regulations:

Committee Reports:


Committee Print:

Treasury Rulings:



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