IRS 536: Claiming a Deficiency Dividend Deduction

A deficiency dividend provides a remedy for a Regulated Investment Company (RIC) that discovers it has not met the income distribution requirements required by the Internal Revenue Code. RICs must distribute nearly all of their taxable income to shareholders annually to avoid corporate-level taxation. If a RIC fails to meet this threshold, it risks losing its special tax status and facing significant tax liabilities.

The deficiency dividend procedure, outlined in Internal Revenue Code Section 860, allows a RIC to make a corrective distribution to shareholders after a tax year has closed. This subsequent dividend can be used to satisfy the prior year’s distribution requirement, thereby preserving the RIC’s favorable tax treatment. This mechanism acts as a safety valve, preventing errors in income calculation from causing severe tax consequences.

The Determination of a Deficiency

The process for claiming a deficiency dividend deduction cannot begin until a formal “determination” of a tax deficiency has occurred. This is a legally defined event that confirms an adjustment to the RIC’s tax liability for a prior year. A claim cannot be based on an informal discovery or an internal review alone. A determination can be established in one of several ways:

• A final decision by the U.S. Tax Court or another court of competent jurisdiction regarding the RIC’s tax liability.
• A closing agreement made under Internal Revenue Code Section 7121, which is a formal, binding contract between the RIC and the IRS that settles a specific tax issue.
• An agreement signed by both the IRS and the RIC that resolves the company’s tax liability for the period.
• A self-determination filed by the RIC on Form 8927, which allows the company to proactively correct an error it has identified.

Requirements for the Deficiency Dividend Deduction

A deficiency dividend must be paid to shareholders within 90 days after the date of the determination. This 90-day window is inflexible and begins once the determination becomes final. For example, if a court decision is the trigger, the clock starts after that judgment can no longer be appealed.

The dividend itself must meet specific criteria. The distribution must be of a nature that it would have qualified for the dividends-paid deduction under Internal Revenue Code Section 561 if it had been paid during the tax year of the deficiency. This means it must be a pro-rata distribution of property or cash to shareholders who own stock at the time of the deficiency dividend payment, not necessarily those who were shareholders during the original tax year. The amount of the deduction is limited to the adjustment amount identified in the determination.

The character of the dividend, whether it is an ordinary dividend or a capital gain dividend, must also align with the nature of the income adjustment. For instance, if the determination increased the RIC’s ordinary taxable income, the deficiency dividend must be designated as an ordinary dividend. This ensures the corrective distribution properly aligns with the type of income that was originally under-distributed.

Information and Documentation for the Claim

Claiming a deficiency dividend deduction requires the completion of Form 976, Claim for Deficiency Dividend Deduction. This form serves as the official request and must be supported by documentation that substantiates the claim.

When completing Form 976, the RIC must provide its name, address, and taxpayer identification number, along with the tax year for which the deduction is claimed. The form requires a statement of the tax liability from the determination, the amount of the deficiency dividend paid, and the date of payment.

The RIC must indicate how the deficiency was established, whether by a court order, a closing agreement, an agreement with the IRS, or a self-determination. A certified copy of the relevant document, such as the court judgment or signed agreement, must be attached as evidence.

The RIC must also attach a certified copy of the resolution from its board of directors authorizing the payment of the deficiency dividend. Finally, the form requires a detailed computation of the deduction being claimed, ensuring it aligns with the adjustment specified in the determination.

Filing the Claim and Post-Filing Procedures

After completing Form 976 and its attachments, the RIC must file the claim with the IRS within 120 days after the date of the determination. This period provides a 30-day window after the 90-day deadline for paying the dividend to assemble and submit the paperwork.

The filing location for Form 976 depends on how the determination was made. A RIC files the form with the IRS service center where it filed the income tax return for the year of the deficiency. However, if the claim arises from a self-determination on Form 8927, it must be sent to a specific address in Ogden, Utah, as detailed in the form instructions. If the determination was an agreement with an IRS official, the claim may be filed with that official’s office.

The filing of Form 976 suspends the statute of limitations for the IRS to assess taxes related to the deficiency for two years. Additionally, collection activities on the deficiency are stayed during the 120-day period following the determination and, if a claim is filed, until the IRS disallows the claim.

Interest and Penalties

While a successful deficiency dividend deduction can eliminate the underlying corporate tax liability, it does not erase the interest that has accrued on the tax deficiency. Interest is calculated on the amount of the deficiency dividend deduction from the original due date of the tax return for the year of the deficiency, without regard to extensions. The interest period runs until the date the RIC files Form 976. The IRS calculates this amount after the claim is allowed and will notify the RIC of the total due, with rates determined quarterly under Internal Revenue Code Section 6621.

The deficiency dividend procedure provides protection from certain penalties. A RIC that properly uses this procedure is not liable for accuracy-related penalties or penalties for failure to timely pay with respect to the deficiency.

This protection is not absolute. The deduction is not available if the determination finds that any part of the deficiency was due to fraud with intent to evade tax or a willful failure to file an income tax return. In such cases, the RIC cannot use this remedy and will be liable for the full tax deficiency, penalties, and interest.