Tax season can be complicated if you own BDCs because their dividends can be taxed at different rates. If you own a BDC in a taxable account, you should expect to receive a Form 1099 that explains the tax treatment of your dividends over the year.
In addition to a 1099, BDCs usually summarize tax information in letters to shareholders or on their investor relations website. Main Street Capital (MAIN) recently sent out a letter to shareholders that explains the tax treatment.
Of the $2.73 in dividends it paid out in 2016:
- 27.9% of these dividends are long-term capital gains
- 2.1% are qualified dividends
- 70.0% are taxed as ordinary income
Long-term capital gains and qualified dividends are ideal because they are always taxed at a lower rate (no more than 20%, or 23.8% including Medicare surtax) than ordinary dividends (which can be taxed at a rate of up to 39.6% at the federal level, just like ordinary income).
What you should know about BDC dividends
Most BDCs invest primarily in debt rather than equity. Therefore, they tend to generate more ordinary interest income, and very little long-term capital gains or qualified dividends. Main Street Capital is an exception to the rule in the BDC industry because it holds more equity investments in its portfolio. It sold some equity investments at a gain, generating long-term capital gains for shareholders.
Depending on your financial situation, it may be smart to invest in BDCs through a tax advantaged account like an Individual Retirement Account because distributions from an IRA are already taxed as ordinary income (Traditional IRAs) or untaxed (Roth IRAs).