BITS > JUNE 2006

It's Your Money: Pay Attention!

Club Doctor

Herb Barnett compiled a set of comprehensive guidelines that explain the issues that investment clubs encounter. The success of a club is in the hands of all of its members, and depends on whether club members and prospective club members understand all of the issues that affect a club's performance.

When you put money into an investment club, you're buying shares (units) in a partnership, and will be participating in the activities of that partnership. The success of that club is partly in your hands, and in whether or not you and your fellow club members understand all of the issues that affect your club's performance.

Why Worry?

You've invested money (and hopefully some time) in your investment club. The money you put in belongs to you, not to the club. Whether your club realizes a gain depends on how well you and your fellow members make your investment decisions. The accuracy of the club's books dictates whether you and the other members receive your full share of the club's equity when you withdraw, and not less.

Equal Partners

Many new clubs begin with the idea that every member should be treated equally, so everyone must contribute the same amount each month. For several reasons, that can be counterproductive. Perhaps the two most important concepts are equal value and contributions.

• Equal Value

When you require new partners to buy in at an amount equal to current members, you build an ever-higher barrier for recruiting prospective members.

• Contributions

Some members may be able to contribute more than others. Do you limit your members to the amount the least well-off member can contribute?

For more information, see the article, Equal Shares vs. Valuation Units, or go to the BetterInvesting website and search for "equal partners."

Valuation Units

The BetterInvesting club accounting system properly accounts for unequal payments. Members buy valuation units (similar to shares in a mutual fund). The club portfolio is valued before each meeting. The value of one unit is calculated by dividing the total value of the portfolio by the total number of valuation units.

The valuation determines how many units your contribution will buy this month. The value of the portfolio changes with each meeting, so the number of units you buy will also vary.

Fees

Some clubs assess fees, in addition to payments. In general, fees should be used primarily for penalty assessments on individual members (missing a meeting, not being prepared with an assigned stock study, etc). Each club should make its own collective decision about whether it is even appropriate to assess penalties. Any amount that is collected from every member, even "to cover club expenses," can generally be entered as a payment, which buys valuation units, not as a fee.

Transaction Costs

Does your club try to stay fully invested at all times? While it is important to put your funds to work as soon as it is practical, you need to consider the effect of transaction costs on your decisions. BetterInvesting often talks about looking for stocks that have the potential to double in value in five years.

But do you know what it means to double? Maybe not. The cost of buying and selling your shares must be considered.

If you invest $1000 in a stock, and pay your broker $15 to buy the shares, and another $15 when you sell them, those shares need to go up to $1030 before you break even. That's a 3% increase before you start to see any gain on your original investment.

What if you had invested $200? Transaction costs would still be $30, so the stock would have to go to $230 for you to break even. Now your investment has to increase 15% just to break even. You have almost wiped out what we aim for as the first year's gain before you even get started.

Rather than staying "fully invested" at every meeting, consider holding cash until you can invest enough to give you a fighting chance to profit from your investment. Why dig yourselves into a hole before you get started?

If you find that it takes too many months to accumulate funds for a significant purchase, consider increasing the monthly contributions from members, or use Dividend Reinvestment Plans (DRIPs), many of which allow small purchases.

DRIPs

Dividend Reinvestment Plans have two advantages, especially for newer clubs with smaller portfolios.

Dividends are put to work immediately to buy additional whole or fractional shares.

Small amounts of money can usually be invested to purchase additional shares.

• Company-sponsored Plans

Most company-sponsored plans let you invest small amounts of new money with little or no transaction cost, so you minimize the problem discussed in the previous section about transaction costs. Before you sign up for any DRIP, you should investigate the costs and minimum investment requirements to be sure they are reasonable.

• Brokers' DRIP Plans

However, not all Dividend Reinvestment Plans are created equal. Before you're tempted to sign up for dividend reinvestment through your broker account, ask whether or not they charge the normal broker's fees on new money invested in the DRIP stock. Chances are that they do, which wipes out that second advantage.

Petty Cash

Does your club collect extra money for "Petty Cash" to cover your incidental expenses? You really don't need to do that. All of the club's assets can be used to make investments, or to cover expenses such as postage or copying costs.

Club Accounting Software

In addition to tracking your contributions and expenses, your club accounting system must also keep up with changes in tax laws. If your treasurer is still using old club accounting software, or a spreadsheet, your club's tax returns may not have been correct for a number of years. Spreadsheets have another disadvantage, in that it is almost impossible to get help when the treasurer's job has to be turned over to someone else.

It is important that your club keeps its club accounting software current in order to keep up with changes in tax laws. This involves an annual subscription, and periodic updates or upgrades. If your treasurer uses online club accounting software, the updates are automatic.

Taxes

Everyone's favorite subject! As an investment partnership, the club passes along all income and expenses to the individual partners. This means that the club pays no taxes, but is required to file a Partnership Tax Return (Form 1065) and issue a Schedule K-1 to each member, so you can report your share on your personal tax return. As a partnership, the club has until April 15 (not January 31) to file that return and issue K-1s to the members. Except in rare circumstances the treasurer should be able to complete that task much earlier, perhaps by late February or early March. Some states also require clubs to file a partnership return.

As a club member, you should be aware that the IRS imposes penalties for not filing a Form 1065 Partnership Return, or for filing after the April 15 deadline. That penalty amounts to $50 per member per month, up to a maximum of $250 for each person who has been a member at any time during the year. You should try to make sure that your treasurer files the return on time.

REITs & MLPs

Some investments are better suited for personal portfolios than for investment clubs. The problem is their more complex record-keeping requirements, not their investment quality. Examples are REITs (Real Estate Investment Trusts) and MLPs (Master Limited Partnerships. For most companies, dividends are just that, and can be recorded easily by the treasurer. Most companies also issue 1099s by the January 31 deadline.

However, REIT and MLP "dividends" often turn out to be something else. Their 1099s may separate their total distribution for the year into some combination of dividends, interest, capital gains, return of capital, etc. In order to file an accurate tax return, the club's treasurer must then go back and delete each of the quarterly "dividend" entries, calculate the percentage breakdowns and make several new entries for each quarter.

REITs and MLPs also have until April 15 to issue their 1099s. This may require the club to request an extension for filing the Partnership Return, and therefore every member may also need to request an extension.

Because of this extra work and delay, these special types of investments may be better suited for your personal portfolio than for the club's portfolio. The record-keeping complexity is rarely an issue for individuals, because we typically prepare our personal tax return directly from the 1099s, so there are no quarterly bookkeeping entries to correct.

Mutual Funds

We hear so much about using mutual funds to diversify our portfolios that it might be tempting to include one or more in the club portfolio. You may want to consider a couple of reasons why this is not a good idea.

Most of us join a club to learn how to manage our own investments. The club portfolio is your own managed and hopefully diversified portfolio. The professional manager of a mutual fund will not necessarily do better than your club members' collective decisions, so why pay a management fee for something that you are learning to do yourself?

With a common stock portfolio, you decide what to sell, and when to sell. A mutual fund manager takes that decision out of your control, and the fund will probably trade quite a bit more often than your club would. This increased level of trading will mean an increase in your annual tax liabilities.

What to Expect from Your Treasurer

The treasurer's primary responsibility is to maintain accurate and up-to-date records. Without accurate records, you won't know how the club is performing, and probably more important, you're not likely to receive what you should receive when you withdraw.

The treasurer is also responsible for providing regular reports to the members.

Reports at Meetings

Your broker and bank or credit union will keep records of your account, and they will almost certainly be accurate. But their statements tell you nothing about whether the club's own records are accurate. Passing around the broker and bank statements may be interesting, but cannot replace a set of reports generated by the club treasurer.

Club accounting software provides a wide range of reports, many of which are for special situations. Three are important monthly reports on the club's finances.

• Valuation Statement

The Valuation Statement provides details about all of the club's investments and any cash on hand. It also shows the value of an individual unit, as discussed earlier.

• Member Status Report

The Member Status Report lists each member, and details each person's equity in the club. If the "Paid In Since" column is set to the date of the previous month's meeting (the default), it also confirms that your payment from the previous month was recorded properly.

• Transactions Summary

The Transactions Summary details all stock purchases, sales, dividends, splits, mergers and spin-offs, and member payments, interest and expenses. The starting date for this report can be set to any date, but many of us find it useful to include the most recent six or seven weeks. Information about a dividend or interest may not arrive until after the meeting at which it should have been reported, so the extended time period helps to assure that all transactions are reported.

In addition to these reports, the treasurer should be able to tell you that the club's books are in balance with your bank and broker statements.

Warning Signs

Are your club's books out of date, with member deposits and stock transactions missing?

Do members who have withdrawn still show on your Members Status Report?

Are stocks you no longer own still listed on the Valuation Statement?

Are cash balances and shares of stock not in agreement with the broker's statement?

Answering "yes" to any of these questions means that your books are wrong, and need to be corrected promptly.

Errors

If you find errors in the treasurer's reports, they should be noted in the meeting minutes. The treasurer should then be expected to correct them, and be able to report at the next meeting that the books are in order.

Withdrawals

There are many misunderstandings about handling a withdrawal. To whet your appetite, consider:

• Transfer Shares

In most situations it is to the advantage of the club and the withdrawing member to transfer shares of appreciated stock, instead of selling stock and paying in cash.

• Buy Outs

You can't "buy out" a withdrawing member. When a member withdraws, his or her valuation units are retired. Any new money invested in the club to facilitate the withdrawal buys new units.

• Withdrawal Payouts

Pay off a withdrawing member promptly. Even if your partnership agreement permits it, is it fair to a withdrawing member to make them wait for months to receive their share of the club? Would you want to wait, and let the club continue to use your money?

Withdrawal of a Deceased Partner

Sadly, many clubs eventually need to process a withdrawal for a recently deceased member. Don't make assumptions about who should receive the funds from the withdrawal. It seems natural to assume that the member's spouse is the logical beneficiary. Or the member may even have given the club a "beneficiary statement."

Situations change. If the club writes the withdrawal check in the name of the presumed heir, and it later turns out that someone else should have received the funds, it's possible that the club could be liable for paying the withdrawal amount a second time.

Fortunately, the solution is relatively simple. When processing a withdrawal for a deceased member, always write the check (or transfer stock) to the name of the deceased member, or to "The Estate of . . . " the deceased member. That will protect the club, and assure that the assets go to the legitimate heir.

For a detailed discussion of withdrawals, see Gene Rook's Club Accounting Withdrawals article in the May 2006 BITS.

Verify Your Club Books

We trust our treasurer. If we didn't, someone else would have the job. There's an oft-quoted concept in international relations: "trust, but verify." That is no less true for the club's financial records. Those of us who teach club accounting are frequently asked for help from a new treasurer who has discovered that the former treasurer made a mess of the club's records, and none of the other members were paying attention.

Your treasurer is probably trying to do an accurate and conscientious job, but it is still the responsibility of a committee of the members to review and verify that the books are being kept correctly. This should be done every year.

There are articles and worksheets online to guide the committee in completing this task. Search the BetterInvesting website for "verifying club books" to find a list of several articles and descriptions of the procedure.

Assistant Treasurer

Keeping the club's financial records is a vital task. It's not difficult, but it must be done accurately, and on a timely basis. Too many clubs have disbanded because the treasurer moved away, or wanted to turn the job over to someone else, but no one was willing to take over.

One solution is to have an assistant treasurer -- someone who is learning the job and preparing to take over when the time comes. Some clubs split the treasurer's job into two parts: one person does the record-keeping, preparation of reports, withdrawals, etc. The other collects and deposits member payments, deals with the broker, and writes checks while also learning how to handle the record keeping.

Online Help for Treasurers

Urge your treasurer (and assistant treasurer) to sign up for the BetterInvesting club-treasurers email discussion list. It's not just for new treasurers -- even experienced treasurers can learn something worthwhile from the discussions, and everyone is certainly welcome to answer as well as ask questions.

You can subscribe to the free club-treasurers email discussion list and ask any questions about club accounting issues. Look for the subscription form on the bottom of the page. Everyone is welcome and you don't have to be a treasurer to join.

It Is Your Money

You're investing time and money in your club. The money is entrusted to the club as a whole to invest wisely. But it is still your money.

Unless all of your club's financial decisions are made thoughtfully, and unless the club's records are kept accurately, you may not get your fair share of the club's assets when you withdraw.

Herb Barnett recently retired (again) after serving for 12 years as a director and former chairman of the BetterInvesting Computer Group Advisory Board. In his former life he was a professional photographer, specializing in photography for museums and historic sites nationwide. He co-founded and has been treasurer of two clubs, one nearly 20 years old, and the other 13 years old. Herb has taught club accounting classes for many years.