Short-term capital gain distributions from a RIC - accounting income or corpus?

When an estate or trust owns shares of a regulated investment company (RIC), the question often arises as to whether short-term capital gain distributions received from the RIC should be allocated to the estate's or trust's accounting income or corpus; that is, should the distributions be treated as ordinary income or capital gain? An answer to this question can be reached by analyzing Secs. 852 and 643 and the Revised Uniform Principal and Income Act (RUPIA).

Sec. 852(b)(2) generally defines taxable income of a RIC as all taxable income minus net capital gain. The term "net capital gain" is defined under Sec. 1222(11) as net long-term capital gain in excess of net short-term capital loss for the tax year. Thus, a RIC's taxable income equals all income other than long-term capital gain.

As a result, if a RIC has a net short-term capital gain, such gain will be included in computing to RIC's taxable income a taxed at ordinary income rates. Distributions to RIC shareholders out of short-term capital gains are treated as dividend income by the shareholders and not as short-term capital gains. Thus, under Sec. 852, conduit treatment is not available for short-term capital gains distributed from a RIC.

Sec. 643(b) provides that "the term `income', when not preceded by the words `taxable', `distributable net', or `gross', means the amount of income of the estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law." Thus, the definition of accounting income is not contingent on any definition in the Internal Revenue Code of taxable income. Rather, an estate's or trust's accounting income must be determined under the governing instrument and applicable local law.

In the absence of specific provisions in the governing instrument, local law determines how short-term capital gains are treated. RUPIA Section 6 (adopted by many states) addresses the issue of distributions from a RIC as follows:

Distributions made from ordinary income by a regulated investment company or by a trust qualifying and electing to be taxed under federal law as a real estate investment trust are income. All other distributions made by the company or trust, including distributions from capital gains, depreciation, or depletion, whether in the form of cash or an option to take new stock or cash or an option to purchase additional shares, are principal. (Emphasis added.)

Thus, the RUPIA does not distinguish between long-term capital gains and short-term capital gains. instead, the statute clearly indicates that all capital gains are principal for fiduciary accounting purposes.

Based on this analysis, unless the trust's or estate's governing instrument provides otherwise (or applicable local law deviates from the RUPIA with respect to RIC distributions), short-term capital gain distributions from a RIC to a trust or estate should retain their character as capital gain and thus be allocated to corpus.

Observation: An argument can be made that the RUPIA's reference to ordinary income with respect to RIC distributions means taxable income as defined under Sec. 852(b)(2). In such a case, distributions of short-term capital gain from a RIC would constitute ordinary income distributions which the RUPIA provides should be treated as accounting income. However, since RUPIA Section 6 does not make any reference to the Internal Revenue Code, there is no legal support for this position.