Regulated investment companies (RIC) must meet the criteria of Section 3(a) of the Investment Company Act of 1940 and register with the U.S. Securities and Exchange Commission (SEC). RICs may transfer the income taxes resulting from earnings such as dividends, interest and capital gains to its investors. The purpose of the transfer is to avoid double taxation.
The eligibility requirements for RICs are extensive. In broad terms, RICs must earn 90 percent of gross income from dividends, interest payments or capital gains made from the purchase and sale of securities and/or currency. Half of the total asset value of the RICs must be invested in cash, cash equivalents, government securities or other RICs. In addition, not more than 25 percent of the RIC's total asset value may be invested in only one security other than those offered by the federal government.
If the RIC distributes at least 90 percent of its net income to its shareholders, the RIC does not have to pay corporate income taxes on net income paid out in distributions. Dividends distributed from the RIC to its shareholders are taxable at the shareholder’s personal income tax rate. The RIC does not have to pay corporate income taxes on long-term capital gains or tax-exempt interest payments earned if it distributes a long-term capital gain dividend and a tax-exempt interest dividend, respectively, to its shareholders.
If an RIC does not distribute 90 percent of its net income to its shareholders by the end of the tax year or within 60 days of the beginning of the new tax year, then the income is subject to taxes at the RIC's marginal corporate tax rate. When shareholders receive their distribution payments the following year, the payments are considered a part of the shareholder’s income. They are then taxed on the distributions -- that were already taxed at that corporate level -- at their personal income tax rate.
RICs cannot take the tax deduction on dividend distributions if the dividends are not distributed proportionally to all shareholders. If the RIC has preferred shares, which is relatively rare, the RIC cannot pay preferred shareholders a higher proportion of the dividends than it pays to regular shareholders. If the RIC does have preferred shareholders and pays dividends only to those shareholders, referred to as preferential dividends, it cannot take the tax deduction on dividend distributions.