Payout Requirement

A Payout Requirement is a rule, typically set by tax law, that forces certain types of investment companies to distribute a high percentage of their annual income to their shareholders as dividends. Think of it as a mandatory “share the wealth” plan. The most common examples are REITs and RICs (which include most mutual funds and exchange-traded funds). In exchange for following this rule, these companies get a huge tax break: they can avoid paying corporate income tax on the profits they distribute. This structure, known as a pass-through entity, effectively passes the tax obligation from the company directly to the individual investors, who then pay taxes on the dividends they receive. This setup is designed to prevent double taxation and encourage a steady flow of income to investors.

The mechanism is quite straightforward. At the end of each fiscal year, the company tallies up its taxable income. To maintain its special tax status, it must pay out a legally specified minimum portion of this income to its shareholders. For instance, in the United States, most REITs and RICs are required to distribute at least 90% of their taxable income. If they fail to meet this threshold, they lose their tax-advantaged status and are suddenly on the hook for corporate taxes on all their profits, just like a regular corporation. This is a massive penalty, so you can be sure that management will do everything in its power to meet the payout requirement each year. This creates a highly predictable and often generous stream of dividend income for shareholders.

While the concept applies to various structures globally, a few stand out, particularly in the U.S. market.

REITs are companies that own, operate, or finance income-generating real estate. They allow anyone to invest in a portfolio of properties—from shopping malls and office buildings to apartment complexes and data centers. The 90% payout requirement means that investors in REITs typically receive substantial and regular dividend payments, making them a popular choice for those seeking income.

This is a broad legal category that you're probably already familiar with, as it includes the vast majority of mutual funds and ETFs. To avoid corporate-level taxes on the income and capital gains generated by their investment portfolios, they too must distribute at least 90% of their net investment income to their unitholders. This is why you often receive dividend and capital gain distributions from your funds near the end of the calendar year.

A BDC is a type of publicly traded company that invests in small, developing, or financially troubled businesses. They provide capital to companies that might not have access to public markets or traditional bank loans. Structurally, BDCs often elect to be treated as RICs for tax purposes and are therefore also subject to the 90% payout requirement, often resulting in a high dividend yield.

For a value investor, the payout requirement is a double-edged sword. It offers clear benefits but comes with a significant drawback that strikes at the very heart of long-term value creation.

The most obvious plus is the high, predictable income. For investors in or near retirement, or anyone building an income-focused portfolio, these securities can be fantastic. The pass-through tax structure is also highly efficient, as it avoids the profit-eroding effect of double taxation that plagues ordinary corporate dividends.

Here's the catch. If a company is forced to pay out 90% of its profits, it only has 10% left in retained earnings. This severely limits its ability to reinvest in its own business to fuel organic growth. While a regular company can use its profits to buy back shares, acquire competitors, or fund new projects, a REIT or BDC often has to raise new capital by issuing more debt or, worse, new shares. Issuing new stock can lead to share dilution, which reduces each existing shareholder's ownership stake. This constraint directly opposes one of the most powerful forces in investing: compounding at the corporate level. A master capital allocator like Warren Buffett at Berkshire Hathaway has historically preferred to retain all earnings, reinvesting them at high rates of return and allowing shareholder equity to compound tax-efficiently inside the company for decades. A mandatory payout prevents this powerful strategy.

Ultimately, investing in a company with a high payout requirement is a deliberate trade-off. You are choosing to receive high current income today at the expense of potentially lower internal growth and compounding tomorrow. There is nothing inherently wrong with this choice, but it's one you must make with your eyes open. These entities can be a fine addition to a diversified portfolio, but don't be seduced by the high yield alone. As a value investor, your job is to look past the dividend and analyze the quality of the underlying assets, the competence of the management team, and their ability to create value for shareholders despite the handcuffs of the payout requirement.