BI > JANUARY 1999

Possible Alternatives in Handling Club Withdrawals

The inevitable has happened. A partner has requested a withdrawal from the club. These things happen. They should be viewed as a natural process in the life of an investment club. Partners will retire from time to time while other partners may request a portion of their investment in the club. The main decision facing the remaining partners is the method of payment. There are several possible alternatives available to the club and a number of variables that will be affecting the decision. The age of the club will naturally affect the decision along with the holdings in the portfolio, the size of the payment or difficulty of the transaction. Even a partner's emotional feelings will enter into the mix. The point of this article is not to suggest that one method of payment is better than another, but some basic thoughts on the subject are in order.

An investment club holds basically two types of assets; cash and securities. So one of the first decisions to be made is whether to pay the partner out in cash, or to transfer securities into the partner's name.

If cash is the desired method, there are several options available to the investment club to accumulate the needed dollar amount. There may be enough funds on hand to pay the partner his/her fair worth in the club. The club may have prospective partners wishing to join the club. Their contributions could supply the club with additional cash to meet the payment. Many times existing partners will wish to purchase additional units in the club. Their increased contributions is again an avenue for raising funds. Remember, however, to treat this option and the withdrawal as two separate transactions.

The existing partner is merely increasing his/her monthly contribution and will be assigned additional units at the current unit value. The withdrawing partner is retiring from the club. In other words, you can't purchase the withdrawing partners units; they are gone forever.

The final option would be for the partners to sell one or two of the holdings in the club's portfolio. The first three options do not result in any tax consequences to the club, but the sale of securities will naturally trigger a recognizable taxable event in the year of sale. Too often partners in an investment club become overly concerned with this option. In reality, this should be viewed as an opportunity to strengthen the club's portfolio. Stocks that are highly appreciated or no longer are a sound investment, that have outperformed their growth potential, or are simply overpriced at the time may be perfect selections for a sale. The capital gains derived from the sale are pro-rated among all the partners, including the withdrawing partner, and distributed at year end with the other taxable items.

In general, newer clubs tend toward the cash method. The dollar amounts of the payments are usually smaller and the partners are still trying to build the club's portfolio. More mature clubs may have to select the selling of securities. As the dollar amount of the partners' capital accounts become larger, the club will need to sell a security to produce the necessary cash. Much more mature clubs may consider paying the partner by transferring securities into his/her name. Since this option tends to be more difficult, we will address the mechanics behind this option in a separate article. For now, we will illustrate the mechanics of a partial or full withdrawal using cash as the payment.

Continuing with the Anytime Investment Club example used in previous columns, Nick Time has requested a full withdrawal from the club. Following the provisions of the sample partnership agreement in the NAIC Official Guide, the process would be:

Sept. 10 -- Nick Time sends a letter in writing requesting a full withdrawal from the club.

Sept. 15 -- The treasurer brings the letter to the meeting. Method of payment is discussed and the remaining partners decide to pay Nick out in cash.

Oct. 13 -- The Valuation Statement prepared for the October meeting determines the exact fair market value of Nick's capital account. Based on this statement, the current unit value is $12.97.

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Since Nick owns 118.6682 units in the club, his capital account is valued at $1,539.13. There was not enough cash on hand to pay Nick, so the remaining partners decided to increase their monthly contributions for October, purchasing additional units. With the additional cash on hand, the treasurer is able to issue Nick a check for the appropriate dollar amount. The transaction would be entered into the Journal Page as illustrated. The cash account is reduced by $1,539.13 while Nick's capital account of $1,300 is removed from the the Paid In by Members account.

As you can see from the illustration, in order to make this journal entry balance a credit entry for $239.13 is required. An account called Surplus Unrealized Gains Disbursed is used for the final entry. The difference represents the fair market value of Nick's capital account less his cost basis in the club. For the club, this amount will sit on the books until the club eventually liquidates.

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There is one more job the treasurer must complete before the withdrawal is done. You may have noticed on the Journal Page illustration the memo entry for the pro-rated portion of the club's taxable items up to that point of withdrawal. Once a partner retires from a partnership, they no longer have any rights in, or responsibility to, the investment club. It is very important for tax purposes to determine Nick's portion of the taxable items from the beginning of the year to point of withdrawal from the club. The dollar amounts are arrived at as shown in the formula in the box above.

For Nick, the treasurer must do a partial closing of the books to determine his portion of any taxable items. The club currently has only two items: expenses and dividend income.

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At year end the club's books will be closed. A balance sheet, income statement and distribution statement will be prepared by the treasurer. On the distribution statement, Nick will be assigned $43.78 in expenses and $8.05 in dividend income. These amounts will also need to appear on Nick's K-1 tax form and he must place them on his personal tax returns.

The withdrawal from the club will create one more item for Nick at the personal level. Nick's withdrawal in essence is a sale of an investment. He earned money on his investment while he was in the club and now must report capital gains on his personal tax return. Let's analyze his capital account.

Since the club began in 1998, Nick had no beginning balance in his capital account. While he was in the club he invested $1,300. For 1998, Nick's pro-rated earnings and expenses resulted in a net reduction of his tax liability of $35.73 ($43.78 - $8.06). Since Nick exceeded his cost, or tax basis in the club, he must also report on his personal tax returns a capital gain of $274.86.

I would like to stress the concept of adjusting the partner's capital accounts annually. In Nick's case, the end result for the year was a reduction of tax liability because his expenses were greater than his earnings. This resulted in a downward adjustment. As the club continues, earnings will generally outweigh the expenses of the club resulting in net earnings for the year. This would result in an upward adjustment. If the treasurer does not adjust the capital accounts for the net effect of the yearly taxable items, the partners will end up being double taxed on these items whenever they do retire from the club.

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Say, for example, that partner A had net earnings for 1996, 1997 and 1998 which he paid taxes on of $100, $110, and $75, respectively. During those three years, he contributed $3,000 and his account had a current fair market value of $3,750. At the end of 1998, Partner A requests a full withdrawal from the club. Let's look at a capital account analysis with and without the yearly adjustments for net earnings (see box below). As you can see, if the annual adjustments are not made, partners upon retirement from a club will be taxed on those same items again.

Now returning to our example, instead of a full withdrawal, let us say Nick requests a partial withdrawal of approximately $650. Based on the $12.97 current unit value, the approximate number of units that will be withdrawn is 50 (50 X $12.97 = $648.50). Referring back to the illustrations, you will note that there is no need this time to use the Surplus Unrealized Gain Disbursed account. The dollar amount of the withdrawal did not exceed the cost basis of Nick's capital account. In other words, the partial withdrawal does not trigger any capital gains tax on the personal level. We again must do a partial closing to determine Nick's pro-rated portion of taxable items up to the point of withdrawal, but this time it will only be based on the 50 units being withdrawn from the club. In this instance, Nick is assigned $3.40 of dividend income and $18.45 of expenses. Since he still remains a partner in the club, the treasurer will assign additional amounts at year end based on the number of units owned at that time. These two amounts must be added together for an appropriate dollar amount.

For example, let's say Nick is assigned an additional $8.52 of dividend income and $2.45 of expenses at year end. The dividend income from October 16 of $3.40 is added to the year end amount of $8.52 for total dividend income of $11.92. Expenses will total $20.90. Nick will place these amounts on his personal tax returns. The treasurer will report these amounts to the IRS on Nick's K-1 tax form. Nick's capital account will be adjusted for the net effect of the two item, or $8.98. Here again, Nick's expenses were larger than his dividend income resulting in a downward adjustment to his capital account. An analysis of Nick's capital account is as follows:

The mechanics behind a cash payment is not particularly difficult, but it does require additional calculations for the treasurer. In the next column, we will discuss withdrawals made with a combination of cash and the transferring of securities. Although they tend to be much more complicated to perform, there could be definite tax advantages to both the investment club and the withdrawal partner.

Martha A. Moore is a guest columnist for BetterInvesting Magazine.