Dear Mr. Berko: Please explain to me what a business development company is and how it works. Also, my brother, who is a certified public accountant, has recommended that I buy 1,000 shares of Main Street Capital. What do you think?
— S.P., Fort Lauderdale, Fla.
Dear S.P.: Business development companies were initiated by Congress in 1980. The goal of BDCs is to encourage the flow of public dollars (your investible funds) to private businesses. Generally, BDCs invest at least 70 percent of their cash in private U.S. companies or in public U.S. companies with market values of less than $250 million. And these BDCs must send quarterly, as well as annual, reports to the Securities and Exchange Commission and to their shareholders. Owning a BDC (only 55 are publicly traded) allows shareholders to have their cake and eat it, too. They enjoy the liquidity of a publicly traded stock while participating in the potential profit of private companies.
A BDC must qualify as a regulated investment company under Subchapter M of the Internal Revenue Code; distribute 98 percent of its ordinary income and 98 percent of net capital gains for one year; derive at least 90 percent of gross income from dividends, interest and capital gains; have no more than 25 percent of their assets invested in the securities of one company or two or more issues that are engaged in the same or similar business activities, limit its debt-to-equity ratio to 1-to-1 or less, and revalue its private investments every quarter.
Like real estate investment trusts, BDCs are not taxed at the corporate level, as long as they pay out the required income to shareholders. This avoids double taxation and allows BDC investments to pay higher dividends than common stock. But there’s a string attached, because a large percentage of a BDC’s cash distribution is considered ordinary income and is taxed at the shareholder’s higher tax rate (33 percent to 39.6 percent) rather than the 15 percent rate for qualified dividends. For this reason, it makes good sense to own BDC investments in an individual retirement account, where distributions are deferred, or in a Roth IRA, where they’re exempt from taxation.
