Legal Definitions - deficiency dividend

A deficiency dividend is a special payment made by certain types of companies, such as Real Estate Investment Trusts (REITs) or mutual funds (which are often Regulated Investment Companies or RICs). This dividend is issued when an audit, typically by the Internal Revenue Service (IRS), reveals that the company failed to distribute the legally required amount of its income to its shareholders in a previous tax year. By paying a deficiency dividend, the company can correct this past error, avoid significant tax penalties, and maintain its favorable tax status, which often allows it to avoid corporate-level income tax. For tax purposes, this dividend is treated as if it were paid in the original year of the shortfall.

• Example 1 (Real Estate Investment Trust - REIT): Imagine a company called "Urban Properties REIT" that owns and manages commercial buildings. To qualify as a REIT and avoid paying corporate income tax, it must distribute at least 90% of its taxable income to shareholders each year. In 2022, after an IRS audit of its 2020 tax return, it's discovered that due to an accounting error, Urban Properties REIT only distributed 88% of its 2020 taxable income. To rectify this deficiency and prevent the loss of its REIT status for 2020 (which would result in a large corporate tax bill and penalties), the company declares and pays a deficiency dividend in 2022. This payment is then treated as if it were part of its 2020 distributions for tax purposes.

• Example 2 (Mutual Fund - Regulated Investment Company): Consider "Global Growth Fund," a mutual fund structured as a Regulated Investment Company (RIC). RICs must distribute at least 90% of their investment company taxable income to shareholders annually to avoid corporate tax. In 2023, an IRS examination of Global Growth Fund's 2021 tax filings reveals that a miscalculation of capital gains led to an underestimation of its required distributions for that year. To avoid substantial corporate income tax and penalties for 2021, Global Growth Fund issues a deficiency dividend to its shareholders in 2023. This dividend effectively corrects the 2021 shortfall, allowing the fund to retain its RIC tax benefits for that period.

• Example 3 (Specialized Investment Trust): A specialized investment trust, "Renewable Energy Partners," operates under tax rules requiring it to pass through nearly all its income to investors to avoid entity-level taxation. During a routine review in 2024, the trust's independent auditors identify that certain income streams from 2021 were incorrectly categorized, leading to a lower reported taxable income and, consequently, a smaller distribution than legally mandated. To prevent the IRS from reclassifying the trust as a regular corporation for 2021, which would trigger significant back taxes and interest, Renewable Energy Partners promptly declares and pays a deficiency dividend to its unitholders. This action ensures the trust complies with its distribution requirements for the past year and preserves its tax-advantaged status.