REVENUE RULE 94-40

Rev. Rul. 94-40 [Fn1]

Internal Revenue Service
Revenue Ruling

REIT OR RIC PARTNER

Published June 10, 1994

Section 4982.--Excise Tax on Undistributed Income of Regulated Investment Companies, 26 C.F.R. 55.4982-1: Imposition of excise tax on undistributed income of regulated investment companies.

(See Also §§ 702, 706, 852, 855, 857, 858, 4981; 1.702-1, 1.706-1, 1.852-11, 55.4981-2.)

REIT or RIC partner. The application of sections 4981 and 1982 of the Code to a real estate investment trust or regulated investment company that is a partner in a partnership is clarified.

ISSUE

If a real estate investment trust (REIT) or regulated investment company (RIC) is a partner in a partnership, how does the REIT or RIC account for partnership items in determining its required distribution under s 4981(a)(1) or s 4982(a)(1) of the Internal Revenue Code?

FACTS

Situation 1. REIT X holds a partnership interest in partnership P1. P1's taxable year is not the calendar year. X's share of partnership items of income, gain, loss, and deduction that X would have taken into account during calendar year 1995 if X had held directly the assets of P1 underlying that share consists of $20,000,000 of rents from real property and $1,000,000 of capital gain from the sale of securities.

Situation 2. RIC Y holds a partnership interest in partnership P2. For purposes of s 4982, Y uses the one-year period ending on October 31 of the calendar year to determine its capital gain net income and foreign currency gains and losses attributable to s 988 transactions. P2's taxable year is neither the calendar year nor the year ending October 31. Y's share of partnership items of gain and loss that Y would have taken into account during November and December 1994 if Y had held directly the assets of P2

underlying that share consists of $800,000 of net capital gain from the sale of securities. Y's share of partnership items of income, gain, loss, and deduction that Y would have taken into account during calendar year 1995 if Y had held directly the assets of P2 underlying that share consists of $30,000,000 of dividends and interest income and $5,000,000 of net capital gain from the sale of securities. Of that $5,000,000 of net capital gain, $700,000 would have been taken into account by Y during November and December 1995 if Y had held directly the assets of P2 underlying that share.

LAW AND ANALYSIS

Section 4981 imposes a nondeductible excise tax on a REIT equal to 4% of the excess, if any, of the REIT's required distribution over the distributed amount for the calendar year. The required distribution is based in part on the REIT's calendar year ordinary income and capital gain net income regardless of the REIT's taxable year for federal income tax purposes.

Section 4982 imposes a nondeductible excise tax on a RIC equal to 4% of the excess, if any, of the RIC's required distribution over the distributed amount for the calendar year. Regardless of the RIC's taxable year for federal income tax purposes, the required distribution is based in part on the RIC's calendar year ordinary income (exclusive of foreign currency gains or losses attributable to s 988 transactions) and, generally, its capital gain net income and s 988 gains and losses for the one-year period ending on October 31 of the calendar year.

Section 857(a) provides generally that the dividends (other than capital gain dividends) that are distributed by a REIT during the taxable year (or that are distributed after the close of the taxable year but relate back to the taxable year under s 858) must be at least 95% of the REIT's taxable income for the taxable year. Under s 858, if a REIT declares a dividend by the due date for filing a return for a taxable year, pays the dividend within 12 months after the close of that taxable year, and meets certain other requirements, the REIT may elect to treat the dividend as paid during that taxable year.

Section 852(a) provides generally that the dividends (other than capital gain dividends) that are distributed by a RIC during the taxable year (or that are distributed after the close of the taxable year but relate back to the taxable year under s 855) must be at least 90% of the RIC's investment company taxable income for the taxable year. Under s 855, if a RIC declares a dividend by the due date for filing a return for a taxable year, pays the dividend within 12 months after the close of that taxable year, and meets certain other requirements, the RIC may elect to treat the dividend as paid during that taxable year.

Section 706(a) and s 1.706-1(a)(1) of the Income Tax Regulations provide that the taxable income of a partner is based on the partner's distributive share of partnership items for any partnership taxable year ending within or with the partner's taxable year.

Section 702(b) provides that the character of items stated in s 702(a) that are included in a partner's distributive share is determined as if those items were realized directly from the source from which they were realized by the partnership or incurred in

the same manner as incurred by the partnership. Section 1.702-l(a)(8)(ii) provides that each partner must also take into account separately the partner's distributive share of any partnership item that if separately taken into account by any partner would result in an income tax liability for that partner different from that which would result if that partner did not take the item into account separately.

Congress enacted §§ 4981 and 4982 to limit the ability of REITs and RICs to achieve deferral of income for their shareholders.

See H.R. Conf. Rep. No. 658, 94th Cong., lst Sess. 360-62 (1975), 1976-3 (Vol. 2) C.B. 1052-54 (s 4981); S. Rep. No. 313, 99th Cong., 2d Sess. 261 (1966), 1986-3 (Vol. 3) C.B. 261 (s 4982). Prior to the enactment of §§ 4981 and 4982, there was no federal tax detriment to a REIT or RIC that delayed payment of dividends under s 858 or s 855, respectively. For example, if a REIT filed federal tax returns on a calendar year basis, dividends reflecting the REIT's 1973 income could be paid in 1974, included in the shareholders' 1974 gross income, but deducted by the REIT in 1973 under s 857. Moreover, additional deferral could be achieved if the REIT had a taxable year different from its shareholders' taxable years.

Under subchapter K of the Code, a partnership is considered to be either an aggregate of its members or a separate entity. Under the aggregate approach, each partner is treated as an owner of an undivided interest in partnership assets. Under the entity approach, the partnership is treated as a separate entity in which partners have no direct interest in partnership assets. See H.R. Conf. Rep. No. 2543, 83d Cong., 2d Sess. 59 (1954). In adopting the entity approach to transactions between a partner and a partnership, the conference committee stated, "No inference is intended, however, that a partnership is to be considered as a separate entity for the purpose of applying other provisions of the internal revenue laws if the concept of the partnership as a collection of individuals is more appropriate for such provisions." Id. See Casel v. Commissioner, 79 T.C. 424, 433 (1982)

(aggregate theory applied under former s 267(a)(2)).

Section 706(a) reflects the entity approach to partnership taxation. Thus, for purposes of determining income and earnings and profits under subchapter M, a REIT or RIC that is a partner in a partnership takes its distributive share of partnership items into account in the taxable year that contains the last day of the taxable year of the partnership.

On the other hand, for purposes of determining the required distribution necessary to avoid excise tax liability under s 4981 or s 4982, the aggregate approach to partnership taxation is appropriate because that treatment is necessary to achieve the anti-deferral purpose of those sections. For example, if a RIC is a partner in a partnership some of whose assets are shares of corporate stock, the RIC must compute its required distribution under s 4982(a)(1) by using a method under which dividends received by the partnership are taken into account by the RIC partner when they would have been taken into account if the RIC had held the stock directly. By contrast, applying the entity approach in this situation would permit the very deferral that §§ 4981 and 4982

were intended to prevent. This aggregate approach applies to all partnerships in a tiered partnership structure if a REIT or RIC holds an interest in an upper-tier partnership.

The time at which a REIT or RIC partner accounts for partnership items under s 4981 or s 4982 may also affect the REIT's or RIC's treatment of those items for other purposes of the Code. For example, under s 8S2(c), a RIC must determine its post-October capital loss and post-October currency loss based on when those items are taken into account for purposes of s 4982. See s 1.852- 11(c)(2).

Thus, if a partnership that files returns on a calendar year basis realizes a capital loss on October 31, a RIC partner takes the loss into account on December 31 for purposes of subchapter M generally but does not treat the loss as a post-October capital loss under s 852(c)(2) and s 1.852-11.

HOLDINGS

Situation 1. Regardless of the taxable years of a REIT and any partnership in which the REIT is a partner, for purposes of determining the REIT's required distribution for a calendar year under s 4981(a)(1), the REIT must take into account its share of partnership items of income, gain, loss, and deduction that the REIT would have taken into account during the calendar year if the REIT had held directly the assets of the partnership underlying that share. Thus, for purposes of determining X's calendar year 1995 required distribution under s 4981(a)(1), X must take into account its $20,000,000 share of rents from real property and its $1,000,000 share of capital gain from the sale of securities.

Situation 2. Regardless of the taxable years of a RIC and any partnership in which the RIC is a partner, for purposes of determining the RIC's required distribution for a calendar year under s 4982(a)(1), the RIC must take into account its share of partnership items of income, gain, loss, and deduction that the RIC would have taken into account during the calendar year (or during the one-year period ending on October 31 or November 30 of the calendar year, as the case may be) if the RIC had held directly the assets of the partnership underlying that share. Thus, for purposes of determining Y's calendar year 1995 required distribution under s 4982(a)(1), Y must take into account its $5,100,000 ($800,000 plus [$5,000,000 minus $700,000]) share of net capital gain from the sale of securities for the one-year period ending on October 31, 1995, and its $30,000,000 share of dividends and interest income. (Similarly, if Y filed returns on a calendar year basis and had elected under s 4982(e)(4)(A) to use its taxable year in lieu of the one-year period ending on October 31 to determine its capital gain net income, Y would include $5,000,000 of capital gain in its capital gain net income in determining its calendar year 1995 required distribution.)

PROSPECTIVE APPLICATION

Under s 7805(b), this revenue ruling will not be applied adversely to any REIT or RIC for calendar years prior to 1994. If a REIT or RIC changes the way in which it takes partnership items into account for purposes of s 4981(h)(1) or s 4982(b)(1), it must take into account in the year of change any adjustments that are necessary to prevent the change from causing an omission or duplication of any partnership item.

DRAFTING INFORMATION

The principal author of this revenue ruling is Alan B. Munro of the Office of Assistant Chief Counsel (Financial Institutions and Products). For further information regarding this revenue ruling contact Mr. Munro on (202) 622-3950 (not a toll-free call).

Fn1. As printed here, Rev. Rul. 94-40 incorporates the changes effected by Rev. Rul. 94-40A, page 276, this Bulletin.

Rev. Rul. 94-40, 1994-1 C.B. 274, 1994-26 I.R.B. 7.