Net Income from PTPs Treated as Qualifying RIC Income

A regulated investment company (RIC) generally does not pay Federal income tax at the entity level. Rather, in computing its taxable income, a RIC deducts dividends paid to its shareholders, usually eliminating its taxable income; see Sec. 852(b). RIC taxation is available only if the entity meets several requirements, including one that at least 90% of its gross income consist of interest, dividends and certain other income types. A publicly traded partnership (PTP) is a partnership whose ownership interests are traded on an established securities market or are readily tradable on a secondary market (or the substantial equivalent thereof).

In general, a PTP is treated as a corporation, under Sec. 7704(a); however, under Sec. 7704(c) and (d), it is generally not treated as a corporation if, in each of its tax years, 90% or more of its gross income consists of interest, dividends, real property rents or certain other types of qualifying income. Before the AJCA, RICs were not able to invest in an excepted PTP if the PTP had significant income that was not RIC-qualifying income; see the partnership lookthrough rule in Sec. 851(b).

New Law

AJCA Section 331 modifies the RIC 90% qualifying-income test to include net income derived from an interest in a PTP, but limits the RICs aggregate PTP holdings to no more than 25% of the RICs assets. Further, the provision applies the special rule for PTPs under the passive loss rules (requiring separate treatment) to a RIC holding an interest in a PTP, with regard to items attributable to the interest in the PTP. Thus, PTP flowthrough losses generally cannot offset other RIC income.

Effective Date

This provision is effective for tax years beginning after Oct. 22, 2004.

Implications

This provision allows much more flexibility in investments for RICs, subject to the proposed special Sec. 469 passive activity limit. This is likely to greatly expand the pool of PTP investors and make PTP interests much more marketable.

From Steven Schneider and Robert Crnkovich, Washington, DC