BDCs and Taxes: What You Need to Know
BDCs are essentially investment funds that generate income, qualified dividends, unqualified dividends, and sometimes returns of capital (giving shareholders their money back). Every dividend will have a certain percentage of each kind of income (except for returns of capital which you never want to see).
The company reports the actual breakdown after the end of its fiscal year and sends it to investors in a 1099 form. Here’s a look at how Main Street Capital’s dividend payments were classified in 2015:
Source: Main Street Capital
Prospect Capital provides another example here:
Source: Prospect Capital
While the individual makeup of each BDC will vary and can change substantially from year to year, generally the largest percentage of the dividend is taxed as unqualified ordinary income. This is because Congress created BDCs to help fund small business growth and so structured them as pass through entities, similar to REITs, which also pay unqualified dividends.
The reason that some BDCs, such as Main Street Capital, have relatively high qualified proportions of their dividends is due to their larger equity stakes in the companies they finance, which generate qualified dividends and long-term capital gains.
The importance of qualified versus unqualified dividends is that qualified dividends are taxed at either 0%, 15%, or 20% depending on your tax bracket, while unqualified dividends are taxed at your top marginal income tax rate.
| Tax Bracket | Qualified Dividend Tax Rate |
| 10% | 0% |
| 15% | 0% |
| 25% | 15% |
| 39.6% | 15% |
| Above 39.6% (surcharge) | 20% |
Source: Wells Fargo
Want to avoid the tax headache entirely? Then owning BDCs inside tax sheltered or deferred accounts such as Roth IRAs, IRAs, and 401Ks is a good way to do that. And unlike MLPs, which generate UBTI (unrelated business taxable income) that you have to report and pay taxes on if your annual UBTI is above $1,000, BDCs are safe to own in these kinds of accounts because they create no UBTI.
Conclusion
BDCs are high risk and are not for low risk investors seeking steady and steadily rising dividends. They are complex, volatile, and much like banks, can be hard to decipher “black boxes” of various loans, and financial assets that many investors simply don’t wish to bother with.
BDCs generally fall outside of my circle of competence and don’t seem appropriate for the fairly concentrated dividend portfolios I oversee (including our Conservative Retirees dividend portfolio, which holds 25 stocks). However, as long as you understand what they are, the risks involved, and how to decipher the best of breed BDCs from the toxic trash, select BDCs can make a reasonable, but small, contribution as part of a well-diversified dividend portfolio in search of yield.
Additional Links
(1) http://www.simplysafedividends.com/the-best-stock-sectors-for-dividend-income/
(2) http://www.simplysafedividends.com/real-estate-investment-trusts-reits/
(3) http://www.nytimes.com/2015/12/25/business/dealbook/obscure-corner-of-wall-st-draws-skepticism-from-investors.html
