IRS Facilitates REITs' Ability to Utilize Stock Dividends to Preserve Cash

21 January 2009 Publication
Author(s): John B. Palmer Van A. Tengberg

Legal News Alert: Taxation

In response to the current economic crisis, the Internal Revenue Service (IRS) last month issued Revenue Procedure 2008-681 (Rev. Proc.), which provides temporary relief, applicable during 2009 only, to certain cash-strapped real estate investment trusts (REITs), while also highlighting a useful technique for all REITs to preserve cash — the use of stock dividends.

Today’s economic environment has been referred to by many as “the worst economic crisis since the Great Depression.”2 Even the most experienced investors and economic analysts agree that the current state of the capital markets is the worst that they have ever experienced. Despite passage by the U.S. Congress in October 2008 of the $700-billion Emergency Economic Stabilization Act of 2008, and notwithstanding the possible enactment of yet another massive stimulus package on the order of $825 billion,3 most observers expect credit markets to remain sparse through 2009 and perhaps beyond.4

All of this, in turn, has placed renewed emphasis on the ability of companies to obtain and preserve cash. For companies that currently pay dividends to stockholders, one obvious method available to preserve cash is to cut their dividend, either in whole or in part. However, as compared to most other types of companies, entities that are structured as REITs5 are at a distinct disadvantage when it comes to employing this type of cash-saving strategy. This is because the tax code effectively requires the REIT to pay dividends each year equal to 100 percent of its taxable income for such year.6

Stock Dividends
Faced with these regulatory constraints, many REITs are examining one cash-saving technique: declaring a dividend partly in cash and partly in newly issued stock of the REIT. This strategy, however, must comply with another set of tax rules that provide that only certain types of stock dividends will qualify as “dividends” for tax purposes. For example, simply declaring and paying a dividend solely through the pro-rata issuance of new shares of common stock often times will not be treated as a dividend for tax purposes and, thus, while certainly allowing the REIT to preserve cash, will not likely comply with the tax law requirements that REITs distribute dividends equal to 100 percent of their taxable income each year.7

However, certain types of stock dividends do count as dividends for tax purposes and can be employed by cash-strapped REITs. For example, the Code and regulations generally provide that if any shareholder has the “right to an election” with respect to whether a distribution shall be made in either cash or stock (or rights to acquire stock), then with respect to all shareholders, the distribution of stock can qualify as a dividend for tax purposes.8

In several fairly recent private letter rulings,9 the IRS has permitted REITs to utilize this type of distribution, that is, providing shareholders with the election to receive a distribution either in cash or stock of equivalent value, and even to set a limit on the aggregate amount of cash that shareholders would receive in the distribution (irrespective of elections), provided that the aggregate amount of the cash limit was at least equal to 20 percent of the total dividend.10 This effectively permits a REIT to save cash by paying up to 80 percent of its dividend in the form of newly issued stock.

Given the severity and prospective length of the current economic downturn, more and more REITs will undoubtedly continue to consider stock dividends as a viable (and perhaps necessary) cash-saving strategy.11 However, because private letter rulings can only be relied upon by the taxpayer requesting such rulings, this has led the National Association of Real Estate Investment Trusts (NAREIT) and other REIT interest groups to begin lobbying the IRS for more formal guidance. Last month, the IRS responded with Revenue Procedure 2008-68, which provides temporary and limited guidance applicable to all publicly traded REITs.

The Rev. Proc. generally provides that a distribution of stock by a REIT can be treated as a dividend for tax purposes if the following safe harbor requirements are met:

  • The REIT’s stock must be publicly traded on an established securities market in the United States
  • Each shareholder must be permitted to elect to receive the entire dividend in either (i) cash or (ii) stock of the REIT of equivalent value, provided that the REIT does not limit the total amount of cash available to less than 10 percent of the aggregate distribution
  • If too many shareholders elect to receive cash, each shareholder electing to receive cash must receive a pro-rata amount of cash (corresponding to their respective distributions), and in no event shall any shareholder electing to receive cash receive less than 10 percent of their aggregate dividend in cash12

The Rev. Proc. also states that the calculation of the number of shares to be received by any shareholder must be determined, as close as practicable to the payment date, based upon a formula utilizing market prices that is designed to equate in value the number of shares to be received with the amount of money that could be received instead.13

In short, where applicable, the Rev. Proc. is useful in facilitating stock dividend strategies for cash-strapped REITs in that it eliminates the need for the REIT to obtain its own private letter ruling and also expands upon the prior private letter rulings by permitting the cash portion of the dividend to be capped at 10 percent (rather than 20 percent). However, the Rev. Proc. is only temporary guidance in that by its terms it only applies to distributions declared on or after January 1, 2008 and with respect to taxable years ending on or before December 31, 2008. Also, since (as indicated above) it only applies to REITs whose stock is publicly traded on an established securities market in the United States, it does not apply to “private” REITs, nor to so-called non-traded REITs.14 Private and/or non-traded REITs undertaking stock dividend strategies will either need to obtain their own private letter rulings or proceed carefully under the 20 percent limitation with advice from competent tax and securities counsel.

The foregoing is merely intended as a general summary of Revenue Procedure 2008-68 and necessarily does not address all issues relating to or arising in connection with the use of a stock dividend strategy. Other issues to be considered include, but are not limited to, the following examples:

  • The tax consequences to REIT shareholders of a receipt of stock as part of its dividend (e.g., taxable income without a concomitant receipt of cash)
  • The non-tax ramifications upon the REIT and/or its shareholders of adopting a stock dividend strategy (e.g., analysts’ reactions, generally accepted accounting principles (GAAP) treatment, dilutive effect upon existing shareholders, and so forth)
  • For REITs utilizing the so-called “UP-REIT” structure, the impact of REIT stock dividend upon holders of limited partnership units in the REIT’s operating partnership
  • Fiduciary duties or other non-tax legal constraints upon a board of directors’ ability to implement dilutive stock dividend strategies
  • Consideration of other techniques for preserving cash in connection with the REIT’s required dividends (e.g., conducting rights offerings and/or timing issues in connection with the declaration or payment of dividends)

1 2008-52 IRB 1373 (December 10, 2009), amplified and superseded by Rev. Proc. 2009-15, 2009-4 IRB (January 7, 2009) (extending the principals of Rev. Proc. 2008-68 to regulated investment companies, or RICs).

2 See e.g., Sachs, “The Case for Bigger Government,” Time Mag., Vol. 173, Issue 2 (Jan. 19, 2009).

3 See Bendavid, Williamson and Reddy, “Stimulus Package Unveiled,” Wall St. J’nl., January 16, 2009, page A-1.

4 See e.g., Lyon, “ULI Panel: More Grim News,” (Jan. 19, 2009), available at

5 The term “REIT” refers to entities that are taxable as “real estate investment trusts” within the meaning of Section 856-859 of the Internal Revenue Code of 1986, as amended (IRC or the Code). 

6 Generally speaking, a REIT is required to distribute, as a dividend, at least 90 percent of the REIT’s taxable income (excluding net capital gains) for each year to its shareholders. IRC § 857(a)(1). Failure to do so can cause the REIT to lose its preferential tax status under the Code, thereby subjecting the REIT to corporate-level income taxes imposed at federal rates of 35 percent. In addition, even if a REIT distributes at least 90 percent of its taxable income as a dividend during any particular year, the failure to distribute 100 percent of its taxable income (including net capital gains) as a dividend will subject the REIT to federal corporate income taxes to the extent of the undistributed amounts. IRC § 857(b)(2). Thus, in order to maintain their “tax-exempt” status, REITs are effectively required to pay dividends each year to their shareholders equal to 100 percent of the REIT’s taxable income during such year.

7 See Internal Revenue Code § 305(a).

8 See Internal Revenue Code § 305(b)(1); Treas. Reg. § 1.305-2.

9 Private letter rulings are specific rulings issued to taxpayers on a specific set of facts and are permitted to be relied upon only by the taxpayer receiving such ruling.

10 See e.g., Private Letter Ruling 200817031 (January 28, 2008); PLR 200618009 (May 5, 2006).

11 See e.g., “Vornado Dividend to Include Stock,” Wall. St. J’nl, January 1, 2009, page C-3 (announcing Vornado’s intention to distribute 60 percent of its dividends this year in stock and 40 percent in cash, as “a way to preserve cash during difficult times for markets.”); see also, Pruitt, “UPDATE: REITs Offer Stock/Cash Dividend Combo to Preserve Cash,”, January 15, 2009 (reporting on both Vornado’s and Sunstone Hotel’s intentions to revise their dividend policies to include a large stock component).

12 Rev. Proc. 2008-68, supra, at § 3.

13 Id.

14 The term “non-traded” REITs refers to an entity established as a REIT and whose shares are publicly offered but not publicly listed on any established securities exchange.

Legal News Alert is part of our ongoing commitment to providing up-to-the-minute information about pressing concerns or industry issues affecting our clients and our colleagues.

If you have any questions about this issue or would like to discuss these topics further, please contact your Foley attorney or:

Peter J. Elias
San Diego, California

Van A. Tengberg
San Diego, California

John B. Palmer
Chicago, Illinois

Kenneth R. Appleby
Boston, Massachusetts

Internal Revenue Service regulations generally require that, for purposes of avoiding United States federal tax penalties, a taxpayer may only rely on formal written opinions meeting specific requirements described in those regulations. This newsletter does not meet those requirements. To the extent this newsletter contains written information relating to United States federal tax issues, the written information is not intended or written to be used, and a taxpayer cannot use it, for the purpose of avoiding United States federal tax penalties, and it was not written to support the promotion or marketing of any transaction or matter discussed in the newsletter.

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