A deficiency dividend is a unique tax mechanism primarily used by Real Estate Investment Trusts (REITs) and Regulated Investment Companies (RICs), such as mutual funds or ETFs. These entities generally avoid corporate income tax by distributing at least 90% of their taxable income to shareholders annually. However, if they fail to meet this distribution requirement in a prior tax year, the IRS may impose corporate-level taxes on the undistributed income.
To rectify this, the company can issue a deficiency dividend—a special payout to shareholders after the IRS identifies the shortfall. This distribution “makes up” for the missed dividends, allowing the company to claim a deduction retroactively for that prior year’s taxable income. This deduction offsets or eliminates the corporate tax that would otherwise apply, preserving the company’s favorable tax status.
While deficiency dividends help the company avoid double taxation, shareholders must include the dividend as ordinary income in the tax year they receive it, regardless of which year the shortfall occurred. This income is reported on Form 1099-DIV and typically taxed at ordinary income rates, not the lower qualified dividend rates see related article on Ordinary Dividends.
Why Do Deficiency Dividends Occur?
Common triggers include IRS audit adjustments that find a company under-distributed income, accounting errors discovered by the company, or changes in tax law interpretation affecting past income calculations. These scenarios can cause a REIT or RIC to miss distribution thresholds, risking loss of their tax-advantaged status without corrective distributions.
Who is Eligible and Affected?
Only REITs and RICs can declare deficiency dividends due to their special tax treatments. These distributions ensure compliance with IRS rules requiring the distribution of taxable income to avoid corporate taxation. Shareholders of these companies receive deficiency dividends as taxable income in the year of payment.
Tax Implications for Companies and Shareholders
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For Companies: Paying a deficiency dividend avoids corporate income tax on the previously undistributed income, preserving their pass-through status. The amount paid is deductible against the prior year’s income, including any associated IRS interest or penalties.
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For Shareholders: The deficiency dividend is taxable income in the year received and reported as ordinary dividends. It does not affect taxes for past years. Investors should review their Form 1099-DIV carefully to correctly report these payments.
Practical Advice for Investors
Investors in REITs or RICs should monitor company disclosures, especially IRS audit notices or corrections, which might signal potential deficiency dividends. These dividends, while sometimes unexpected, provide a tax catch-up but will increase taxable income for that year.
Common Misconceptions
- Not a sign of financial distress: It often reflects a technical correction rather than financial trouble.
- Not free money: Dividend recipients owe taxes on these payments.
- Not automatic: Companies choose to pay these dividends to maintain tax benefits.
Additional Resources and Related Topics
Learn more about the tax treatment of REITs here and regulated investment companies here. For dividend income taxation, see our article on Ordinary Dividends.
For official guidance, the IRS issued Notice 2004-63, which explains deficiency dividends and their tax implications in detail. The notice is available on IRS.gov here.
By understanding deficiency dividends, investors can better navigate unexpected tax events and maintain informed portfolios.