How did South Carolina PLR 93-8 tax a mutual fund's exempt-interest dividends, capital-gain dividends, and insured defaulted-bond interest?

Plain-English summary

South Carolina PLR 93-8 exempted the portion of a mutual fund's exempt-interest dividends attributable to obligations of South Carolina and its political subdivisions, the United States, and qualifying U.S. territories. The same pass-through treatment applied to distributions representing matured or maturing interest on defaulted obligations paid through insurance, but only to the extent the distributions qualified federally as exempt-interest dividends and came from obligations exempt in South Carolina.

Capital-gain dividends were different. The ruling found no South Carolina exemption for them, so individuals domiciled in South Carolina and Subchapter J estates or trusts administered there owed state income tax on those distributions when the shares were held for investment.

Common questions

Q: Did the entire mutual-fund dividend automatically become exempt? No. Exemption followed the portion attributable to qualifying obligations.

Q: Were capital-gain dividends exempt because the fund held municipal bonds? No.

Q: Could insured interest on defaulted bonds retain exemption? Yes, if it qualified federally as exempt-interest dividends and was attributable to obligations exempt from South Carolina tax.

Citations and references

• IRC §§ 852(b)(3) and 852(b)(5) — capital-gain and exempt-interest dividends
• IRC § 103(a) — state and local bond interest
• S.C. Code Ann. § 12-7-430(b) (1992 Supp.) — historical South Carolina gross-income modification
• South Carolina Revenue Ruling 91-15 — exempt-obligation categories discussed in the PLR

Subject

Taxation of Trust Fund

Source

• Landing page: https://dor.sc.gov/advisory-opinion-search
• Original PDF: https://dor.sc.gov/sites/dor/files/policies/PLR93-8.pdf

Original ruling text

SC PRIVATE LETTER RULING #93-8

TO:

XYZ

SUBJECT:

Taxation of Trust Fund
(Income Tax)

DATE:

December 13, 1993

REFERENCES:

Internal Revenue Code §852(b)(5)
Internal Revenue Code §103(a)
SC Code of Laws Ann. §12-7-430(b) (Supp. 1992)

AUTHORITY:

S.C. Code Ann. §12-4-320 (Supp. 1992)

SCOPE:

A Private Letter Ruling is a document issued by the Department of
Revenue to a specific person.

NOTE:

A Private Letter Ruling may only be relied upon by the person to whom it
is issued and only for the transaction or transactions to which it relates. A
Private Letter Ruling has no precedential value.

Questions:

1. Will shareholders who are
   (a) individuals domiciled in South Carolina, or
   (b) estates and trusts taxed under Subchapter J of the Internal Revenue Code and
   administered in South Carolina
   be subject to South Carolina income tax on distributions from the ABC Fund which are exemptinterest dividends as defined in Internal Revenue Code Section 852(b)(5)?
2. Will
   (a) individuals domiciled in South Carolina, or

1

(b) estates and trusts taxed under Subchapter J of the Internal Revenue Code and
administered in South Carolina
holding shares of the ABC Fund for investment purposes be subject to South Carolina income
tax on distributions of capital gain dividends as defined in Section 852(b)(3)(C) of the Internal
Revenue Code?

3. Will distributions with respect to the ABC Fund attributable to proceeds of insurance paid to
   the ABC Fund that represent maturing or matured interest on defaulted obligations held by the
   Portfolio be subject to South Carolina income tax if, and to the extent that, such distributions are
   exempt interest dividends for federal income tax purposes pursuant to Section 852(b)(5) of the
   Internal Revenue Code?
   Conclusions:
   Issue 1: Individuals domiciled in South Carolina and estates and trusts taxed under Subchapter J
   of the Internal Revenue Code and administered in South Carolina who are shareholders will not
   be subject to South Carolina income tax on distributions from the ABC Fund which are exemptinterest dividends as defined in Internal Revenue Code Section 852(b)(5) provided that such
   dividends are attributable to obligations of South Carolina, its political subdivisions, the United
   States or its territories. (See SC Revenue Ruling 91-15 for a more detailed listing of obligations
   which are exempt from South Carolina income taxation.)
   Issue 2: Individuals who are domiciled in South Carolina and estates and trusts taxed under
   Subchapter J of the Internal Revenue Code which are administered in South Carolina who hold
   shares of the ABC Fund for investment purposes will be subject to South Carolina income tax on
   distributions of capital gain dividends.
   Issue 3: Distributions which are attributable to insurance proceeds paid to the Portfolio and
   distributed to the ABC Fund which represent maturing or matured interest on defaulted
   obligations held by the Portfolio are exempt from South Carolina income taxation to the extent
   they are considered exempt-interest dividends for federal income tax purposes and are
   attributable to obligations which are exempt from South Carolina income taxation.
   Facts:
   XYZ (the “ABC Fund”), is a series of the XYZ Trust. This trust is a business trust established
   pursuant to Massachusetts law and operates as a mutual fund (i.e., an open-end management
   investment company). The ABC Fund has one class of shares of beneficial interests (the
   “Shares”), and an unlimited number which may be issued by its trustees. Each Share represents
   an equal proportion of beneficial interest in the South Carolina Fund.
   The ABC Fund will invest primarily in the South Carolina Tax Free Portfolio (the “Portfolio”)
   which is organized as a common law trust and which will be treated and characterized as a
   partnership for federal and South Carolina income tax purposes. The Portfolio will invest in debt
   obligations issued by or on behalf of the State of South Carolina and its political subdivisions

2

and by the governments of Puerto Rico, the U.S. Virgin Islands and Guam. The interest on each
issue of obligations held or to be held by the Portfolio will be excluded from gross income for
federal income tax purposes under Section 103(a) of the Internal Revenue Code of 1986, as
amended. The ABC Fund and the Portfolio will declare distributions of net investment income
daily and pay distributions to holders of its shares on a monthly basis. Distributions by the ABC
Fund will consist of exempt-interest dividends as defined in Internal Revenue Code Section
852(b)(5) or capital gain dividends as defined in Internal Revenue Code Section 852(b)(3)(C), or
represent maturing or matured interest on defaulted obligations held by the Portfolio which are
exempt-interest dividends for federal income tax purposes pursuant to Internal Revenue Code
Section 852(b)(5).
The ABC Fund (a) will be treated as a “regulated investment company” within the meaning of
Section 851 of the Internal Revenue Code and will qualify as such for each taxable year, (b) will
take all other actions required to insure that no federal income taxes will be payable by the ABC
Fund, and (c) will pay to shareholders “exempt-interest dividends” within the meaning of Section
852(b)(5) of the Internal Revenue Code. At all times, at least fifty percent of the value of the
total assets of the Portfolio will consist of the obligations listed above.
Discussion – Issue 1:
South Carolina has adopted sections of the Internal Revenue Code, including IRC Sections 852
and 103. IRC Section 852(b)(5) states that certain dividends paid which are attributable to
exempt interest are not taxable. IRC Section 103(a) provides that gross income does not include
interest on any state or local bond. S.C. Code Section 12-7-430(b) states that South Carolina
gross income is computed as provided in the Internal Revenue Code with certain modifications:
(1) The exclusion from gross income authorized by Internal Revenue Code Section 103
is modified to exempt only interest upon obligations of this State, any of its political
subdivisions, and to exempt interest upon obligations of the United States.
In SC Revenue Ruling 91-15 the Department held that the following are exempt from South
Carolina income tax:
1) Interest from obligations issued by the State of South Carolina or any of its political
subdivisions which are exempt from federal income taxes;
2) Interest from obligations which are issued by federal agencies or instrumentalities and
contain language in their enabling legislation prohibiting the levying of a state or local
tax on the interest from such obligations; and,
3) Interest from obligations of the United States which are characterized by:
a. Written documents,
b. The bearing of interest,

3

c. A binding promise by the United States to pay specified sums at specified dates,
and
d. Specific Congressional authorization, which also pledged the faith and credit of
the United States in support of the promise to pay.
The ruling also listed interest from obligations issued by Guam, Puerto Rico, and the U.S. Virgin
Islands as exempt from South Carolina income tax.
The ruling further stated that a fund need not be invested 50% or greater in exempt obligations in
order for the taxpayer to receive pass-through treatment for the dividends received. If only a
portion of a mutual fund is invested in exempt obligations, the portion of dividends received
which is attributable to such obligations is exempt for South Carolina income tax purposes. (See
SC Revenue Ruling 91-15 for a more detailed discussion of which obligations are considered
exempt from South Carolina income tax.)
Since the Portfolio constitutes and is characterized as a partnership for federal and South
Carolina income tax purposes, the character of Fund income will depend upon the Fund’s
distributive share of the various types of the Portfolio’s income. Therefore, the Fund will be
exempt from South Carolina income taxation to the extent its distributable share of Portfolio
income is attributable to exempt-interest dividends as defined in IRC Section 852(b)(5).
Discussion – Issue 2:
As mentioned above, South Carolina gross income is computed as provided in the Internal
Revenue Code with certain modifications provided in SC Code Section 12-7-430. IRC Section
852(b)(3)(C) defines a capital gain dividend as “any dividend, or part thereof, which is
designated by the company as a capital gain dividend in a written notice mailed to its
shareholders not later than 60 days after the close of its taxable year”. Capital gain dividends are
treated by the shareholders as a gain from the sale or exchange of a capital asset held for more
than 1 year (IRC Section 852(b)(3)(B). There is no provision which exempts capital gain income
from taxation; hence, capital gain dividends on shares held for investment by South Carolina
domiciliaries are subject to South Carolina income taxation.
Discussion – Issue 3:
As discussed above in Discussion 1, exempt-interest dividends, to the extent they represent
interest on South Carolina obligations, its political subdivisions or on obligations of the United
States or its territories, are exempt from South Carolina income taxation. Hence, to the extent
distributions attributable to insurance proceeds paid to the Portfolio which represent matured or
maturing interest on defaulted obligations held by the Portfolio are deeded exempt-interest
dividends for federal income tax purposes, and represent interest on obligations which are
exempt from South Carolina income tax, such distributions will be considered exempt for South
Carolina income tax purposes. (See Revenue Ruling 76-78 (1976-1 CD25).)

4