In June the Internal Revenue Service issued final rules permitting dividends received from a real estate investment trust by a RIC shareholder to qualify for the 20% pass-through deduction under Section 199A
. The final regulations confirmed REIT dividends received by RIC shareholders qualified for "conduit treatment," meaning they are treated as if received directly by the shareholder for purposes of the pass-through deduction.However, the final rules didn't address what happens when a RIC shareholder earns qualified PTP income, effectively preventing shareholders from claiming the 20% deduction for that income, according to Andrew Howlett, a member and tax attorney at Miller & Chevalier Chtd. Since directly owned PTP income is eligible for the deduction under the statute, the final rules could encourage RIC shareholders to invest directly in a PTP, Howlett said.
"Because there are no regs that allow this conduit treatment, then anyone who owns PTPs through RICs, which could certainly be millions of people, won't be able to get the benefit of the 199A deduction," Howlett said. "So if all you cared about is maximizing your 199A deduction, then an investor would just invest [directly] in the PTP instead of the RIC."
Investing directly in PTPs may be attractive to an investor because PTPs are traded on public exchanges, which means they are liquid and can be easily bought and sold on trading platforms, he said. So it's certainly possible someone may choose to invest directly in a more liquid PTP to take advantage of the 20% pass-through deduction, Howlett said.
However, investors in a RIC should not solely base their decision on the availability of the 199A deduction because RICs offer other advantages such as diversity in portfolios that may be difficult to achieve at an individual ownership level, he said. Some people may want to stay invested in a RIC simply to maintain that diversity of exposure, Howlett said.
Another advantage of RICs is that they shield foreign investors from filing a U.S. federal tax return, Howlett said.
"RICs can be used as a blocker of sorts for foreign investors and for tax-exempt investors for PTPs that would otherwise produce effectively connected income and require the investor to file a return, or create unrelated taxable business income that the tax-exempt would have to pay taxes on," he said. "So they are [still] a popular vehicle for those types of investors to invest in a publicly traded partnership."
Robert A. Velotta, a tax partner at accounting firm Cohen & Company Ltd., told Law360 he was disappointed with the final regulations because they put RIC investors who receive PTP income and direct investors in PTPs in different tax positions.
It does not make sense to exclude RIC shareholders that receive PTP income from conduit treatment when a direct PTP investor may qualify for the deduction, he said.
The IRS may have punted on the issue because calculating a 199A deduction for PTP income received by a RIC shareholder is more complicated than calculating dividends received by a RIC shareholder from a real estate investment trust, Velotta said.
Figuring out the 199A deduction at the RIC level is also administratively difficult because a RIC would have to request Schedule K-1 partnership returns from all of the PTPs from which it receives income to figure out how much of the pass-through deduction should be allocated to each RIC shareholder, he told Law360.
So in deciding whether to exit the RIC and invest directly in a PTP, the investor should be aware that the burden would shift to them to track all of the separate K-1s, which can be a difficult task, Velotta said.
However, just because it may be hard for RICs to administer conduit treatment of PTP income does not mean the IRS should ignore the issue, he said.
The IRS and U.S. Department of the Treasury did not immediately respond to questions from Law360.
Not explicitly allowing conduit treatment of PTP income for RIC shareholders may lead RICs to reevaluate their PTP investments, according to Michael T. Donovan, the chairman of the tax department at Lewis Rice LLC.
The 199A deduction would certainly be a factor in whether a RIC invests in a publicly traded partnership, Donovan told Law360.
In the preamble to the final regulations, the IRS said it plans to continue studying conduit treatment for RIC shareholders who receive PTP income and requested comments on the issue, so it's possible that the agency may allow it depending on practitioner feedback, he said.
The Joint Committee on Taxation's Bluebook report indicates Congress intended to provide conduit treatment to PTP income passing through a RIC, so now it's up to the IRS to figure out how to implement it, even if that results in administrative inconvenience and requires more record keeping, Donovan said.
"No one is saying there aren't complex issues there, but I think the right answer is that there ought to be conduit treatment and the IRS needs to find a way to make it work," he said. "And they haven't told us they are not going to give us conduit treatment."
--Editing by Tim Ruel and Joyce Laskowski.
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