Taxation of Corporate Trusts, REITs, and Regulated Investment Companies (RICs)

Flow-through treatment rewards real-estate, mutual-fund, and specialized investment vehicles that satisfy distribution, asset, and shareholder requirements, yet penalties await entities that miss annual tests, misclassify income, or overlook excise surtaxes.

REITs escape entity-level tax by distributing nearly all taxable income.

A real estate investment trust that meets the five-income and four-asset tests, is managed by trustees, and has at least 100 shareholders derives protection from corporate tax if it pays dividends equal to at least 90 percent of REIT taxable income before the dividends-paid deduction.

Income tests require 75 percent from rents, mortgage interest, or disposals of real property and 95 percent from those items plus dividends and interest. Asset tests require 75 percent of total asset value in real estate, cash, or government securities and no more than 25 percent in non-qualified assets, with tight limits on taxable REIT subsidiaries. Failure to cure excess securities ownership within 30 days after quarter-end triggers a 100 percent tax on prohibited transactions.

REIT distribution mechanics and dividends-paid deduction.

REITs declare dividends in the last three months of the year and elect to treat January distributions as made in December, preserving cash 31 days longer. Shareholders report ordinary REIT dividends, § 199A qualified business income, and long-term capital-gain components separately. REITs owe a 4 percent excise tax on undistributed ordinary income, capital gains, and net short-term capital gains if they fail to meet the distribution requirement by year-end.

Journal entry — declaring required REIT dividend

Dr Retained Earnings $45 000 000

Cr Dividends Payable $45 000 000

Payment within 90 days of year-end triggers the dividends-paid deduction on the prior-year return.

RICs pass through portfolio-level income while preserving a single tax.

Mutual funds, ETFs, and closed-end funds qualify as regulated investment companies when 90 percent of gross income comes from dividends, interest, and gains; at least 50 percent of assets consist of cash, government securities, or diversified holdings where no single issuer exceeds 5 percent of assets or 10 percent of voting stock; and no single issuer exceeds 25 percent of total assets.

RICs distribute 90 percent of investment company taxable income to avoid entity-level tax and 98 percent of net capital gain to escape excise tax. Conduit rules preserve character: funds pass through qualified dividends, long-term capital gain, and § 1256 60/40 gains, letting shareholders apply preferential rates. Undistributed capital gains tax elections let RICs retain gains, pay tax on behalf of shareholders (often at 21 percent), and increase shareholder basis via a deemed-paid credit.

Excise-tax avoidance drives year-end spillback dividends.

RICs declare “spillback” distributions within the first nine months of the following year and elect to treat them as prior-year dividends. Funds equalize net realized gains and ordinary income against required payout thresholds, smoothing distribution rates for investors.

Journal entry — spillback election

Dr Retained Earnings $12 000 000

Cr Dividends Payable – Spillback $12 000 000

The deduction applies to the prior taxable year, reducing current-year earnings-and-profits.

Corporate trusts follow Subchapter J but rely on yield-deduction elections.

Investment trusts that fail RIC tests or intentionally hold commodities or digital assets may elect to be taxed as grantor or simple trusts; otherwise, they use complex-trust rules. Distributable Net Income (DNI) determines the income passed through; entities deduct distributions up to DNI and pay trust-level tax on any excess income retained.

Grantor-trust status places all income, deductions, and credits on grantor returns, bypassing trust-level tax entirely. Market-linked notes and certain exchange-traded products use grantor-trust engineering to keep ordinary income and capital gains transparent to investors.

Failure to satisfy qualification triggers entity-level tax and built-in-gain traps.

If a REIT or RIC fails an income or asset test and cannot cure within statutory grace periods, it loses flow-through status for the year; corporate tax applies at 21 percent, and a built-in gains tax may apply for five subsequent years on asset dispositions. REITs may pay a penalty tax equal to the shortfall multiplied by the corporate rate plus interest to retain status.

State conformity and withholding taxes complicate distribution planning.

Many states tax REIT and RIC dividends as ordinary income despite federal character pass-through; composite returns and withholding apply to non-resident shareholders. Real-estate owned by REITs in non-conforming states may incur franchise taxes or gross-receipts levies regardless of federal flow-through treatment.

Financial-statement considerations under ASC 946 and ASC 970.

RICs follow specialized investment-company accounting, marking portfolio securities to fair value and expensing distribution-related costs as incurred. REITs capitalize real-estate assets under ASC 970, recognize depreciation, and record deferred taxes only on built-in-gain property held at REIT conversion. Both entities track undistributed income and undistributed net capital gain separately to reconcile book to taxable income.

Planning levers maintain qualification and optimize shareholder yield.

1. Quarter-end asset rebalancing: Adjust leverage and short-term investments to keep 75-percent and 50-percent asset thresholds intact.

2. Taxable REIT subsidiaries: Shift non-qualifying services to TRSs while monitoring 20-percent value cap.

3. In-kind ETF redemptions: Use heartbeat trades to defer portfolio-level gain recognition inside RICs.

4. Capital-gain distribution timing: Pair gains with equal losses or shareholder redemptions to manage excise-tax liability.

5. Built-in-gain monitoring: Plan property dispositions after the five-year recognition period to avoid entity-level tax for REITs post-conversion.

Continuous quarterly testing, tight distribution scheduling, and disciplined asset segregation protect REITs, RICs, and investment trusts from losing flow-through status and incurring avoidable entity-level tax.

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