How REITs Can Hedge an Employee Benefit

Informally funding a DCP without Triggering Distribution Requirements

In order for Real Estate Investment Trusts (“REITS”) to maintain their designated tax treatment status, they must meet the annual REIT testing requirements. REITS are required to distribute at least 90% of taxable income in the form of dividend payments to their shareholders. Income realized through the growth of mutual funds – even to pay an employee benefit – must be included in the taxable income calculation, causing significant shortfalls when plan balances rise.

Deferred Compensation Plan Funding

Deferred compensation plans (“DCPs”) are common throughout the REIT landscape as they are a tool used to attract and retain top industry talent. Although non-qualified deferred compensation plans cannot be formally funded, many REITS elect to set assets aside in a rabbi trust to informally fund the promised future benefits to its employees. When selecting the funding vehicle to hedge the deferred compensation plan balances, REITS typically choose between mutual funds or corporate owned life insurance. However, an important consideration that is commonly overlooked, is that any realized gains from a sale or rebalancing of mutual funds used for funding the DCP will trigger income included in the dividend distribution requirements.

For example, if a plan participant elects to defer $10,000 of their income into their DCP account and that value increases by 50% before the distribution date, then the REIT will owe that plan participant $15,000. However, if the REIT is using mutual funds to hedge the participants DCP account, then at least 90% of that 50% gain must be included in the dividend distribution payment, leaving the REIT only $10,500 left over to hedge the $15,000 distribution payment. REITS are essentially in a 90% “tax rate” for any realized gains on mutual funds.

Corporate Owned Life Insurance

• Gains inside of a COLI policy may not be subject to REIT dividend distribution requirements
• COLI provides a significantly better hedge for funding DCP liabilities when compared to taxable securities
• Death benefit proceeds generated by COLI policies are also excluded from dividend distribution requirements

If you would like to discuss the deferred compensation plan funding options for REITS, please call your Mullin Barens Sanford Consultant.