While cash hoarding may not be a conventional reaction to the holiday spirit of giving, it is likely a prudent move for some cash-strapped companies. That is especially true of real estate investment trusts, which may be better off paying out dividends in stock, rather than cash.
The National Association of Real Estate Investment Trusts (NAREIT) thought so too, and in response to the current liquidity crisis, was looking for ways to provide incentives to REIT shareholders to nudge them to take stock, rather than cash, out of the trusts. One incentive was to provide shareholders with a tax deduction. However, a tax code threshold — specifically having to do with a cash cap related to a dividend election option — would have to be reduced to sweeten the incentive.
As a result, NAREIT implored the Internal Revenue Service to lower the cash cap associated with the aggregate shareholder distribution to 5 percent. Last week, the IRS budged a little — albeit not as much as the trade association would have liked. In IRS Revenue Procedure 2008-68, the government delivered a cash preservation incentive to REITS that was in line with recent private letter rulings, and dropped the cap needed to qualify for the deduction from 20 percent to 10 percent.
The route to the final pronouncement is involved, but tax managers will likely not mind following the sinuous path to the benefit at the end. To start, consider Section 857(b) of the tax code. It states that a REIT’s annual taxable income is based on a formula that includes the deduction for dividends paid (see Section 11.) However, in this case, dividends to are narrowly defined by two other rules, Section 316 and Section 301.
Specifically, in Section 316, the payout is defined as any distribution of property “to which Section 301 applies.” That means the dividend, which affords the REIT a tax deduction, is a distribution of property that emanates from the corporation’s earnings and profits.1.
Ordinarily, a distribution of stock by a corporation to its shareholders is not a distribution of property to which Section 301 applies, and therefore cannot be a dividend. Indeed, according to the tax code’s Section 305(a), gross income excludes stock distributed by the corporation to its shareholders. However, there are several exceptions to this general rule spelled out in the subsections of the rule.
For example, Section 305(b)(1) overrides Section 305(a), and allows the dividend to be treated as a distribution of property to which Sec. 301 applies, if any shareholder has the option to decide whether the dividend will be paid in stock or property (which includes cash).2.
In fact, Regulation Section 1.305-2 clarifies Section 305(b)(1), noting that if any shareholder “has the right to an election or option” with respect to whether a distribution shall be made either in money or property, or in stock (which includes rights to acquire stock of the distributing corporation), then, the distribution of stock with respect to all shareholders is treated as a distribution of property to which Sec. 301 applies. That is the case regardless of whether the following applies:
• The distribution is made in whole or in part in stock or in stock rights;
• The election or option is exercised or exercisable before or after the declaration of the distribution;
• The declaration of the distribution provides that the distribution will be made in one “medium” unless the shareholder specifically requires payment in the other medium;
• The election governing the nature of the distribution is provided in the declaration of the distribution or in the corporate charter, or arises instead from “the circumstances of the distribution”;
• All or part of the shareholders have the election.
Preserving REIT Cash
In response to entreaties from NAREIT, the IRS on Dec. 10, adapted its rules to the exigencies faced by cash-strapped REITs. With the December Revenue Procedure notice, the IRS announced that it will treat a distribution of stock by a corporation that qualifies as a REIT as a distribution of property to which Section 301 applies (by reason of Sec. 305(b)), and the amount of such distribution of stock will be considered to equal the amount of the money which could have been received instead3 if six conditions are met.
The conditions are as follows:
(1) The distribution is made by the REIT with respect to its stock;
(2) The stock of the REIT is publicly-traded on an established securities market in the United States;
(3) The distribution is declared with respect to a taxable year ending on or before December 31, 2009;
(4) Based on a stated declaration, each shareholder may elect to receive “its entire entitlement” in either money or stock of the distributing corporation. However, the stock or money must be an equivalent value subject to a limitation on the amount of money to be distributed in the aggregate to all shareholders. That means that the “cash limitation” must not be less than 10 percent of the aggregate declared distribution, and if too many shareholders elect to receive money, each shareholder electing to receive money will receive a pro-rata amount of cash corresponding to their respective entitlement under the declaration. However, in no event will any shareholder electing to receive cash receive less than 10 percent of their entire entitlement under the declaration in money;
(5) The calculation of the number of shares to be received by any shareholder will be determined based upon a formula using market prices that is designed to equate in value the number of shares to be received with the amount of money that could be received instead. That determination will be made as close as is practical to the payment date;
(6) With respect to any shareholder participating in a “dividend re-investment plan” (DRIP), the DRIP applies only to the extent that, in the absence of the DRIP, the shareholder would have received the distribution in money.
Historically, the IRS permitted an “optional stock distribution” to be treated as a distribution of property to which Sec. 301 applies only if the cash limitation was not less than 20 percent of the aggregate declared distribution. However, in the wake of the credit crisis, NAREIT importuned the IRS to reduce this figure to five percent.
The IRS chose 10 percent although, technically, a stock distribution should be treated as a distribution of property to which Sec. 301 applies if shareholders have the right to elect whether to receive stock or cash, and the distribution is made, in whole, in stock or in rights to acquire stock. Nevertheless, we would expect cash-strapped REITs to comply with the “10 percent/90 percent” split established by Revenue Procedure 2008-68.
The IRS dispensation for REITs is effective with respect to distributions declared on or after January 1, 2008 and, as indicated, encompasses distributions with respect to a taxable year ending on or before December 31, 2009.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
1In addition, for a REIT to maintain its status as such, the deduction for dividends paid during the taxable year must equal or exceed 90 percent of the trust’s taxable income for the taxable year. See Sec. 857(a)(1).
2Section 305(b)(2) provides an exception for “disproportionate” stock distributions. Thus, Section 305(a) shall not apply to a distribution by a corporation of its stock, and the distribution shall be treated as a distribution of property to which Section 301 applies, if the distribution (or a series of distributions of which such distribution is one) has the result of (1) the receipt of property by some shareholders and (2) an increase in the proportionate interests of other shareholders in the assets or earnings and profits of the corporation.
3 See Regulation Section 1.305-1(b)(2) — in which a corporation which regularly distributes its earnings and profits, such as a mutual fund, declares a dividend pursuant to which the shareholders may elect to receive money or stock of the distributing corporation of equivalent value. In that case, the amount of the distribution of the stock received by any shareholder entitled to receive stock will be considered to equal the amount of the money which could have been received instead.