OCTOBER 2002

A Trove For Club Treasurers

The Best of Jerry Dressel

Editor's Note: Jerry Dressel was an NAIC CompuServe Forum Sysop where he hosted the Treasurer's Chat message section. He is a founding member and the treasurer of the Horizon 21 Investment Club. Jerry is a frequent contributor to I-Club-List discussions. He is recognized as an expert on investment club accounting issues and the NAIC Club Accounting software. This collection of I-Club-List questions and answers was edited for presentation here.

Disclaimer: Except for direct quotes from IRS Publications, statements made in replies to questions are the opinions Jerry expressed on the I-Club-List and are not official statements from either NAIC or the IRS. These statements are not intended to replace your own professional tax or accounting advisors. When in doubt, follow the advice of your local tax advisor or accountant who is familiar with your particular circumstances.

1. What is the easiest way to structure a new club? I don't want to form a partnership if it means filing the 1065 form and all kinds of other paperwork. Is there a solution?
2. We are a new club and each member has invested about $500. Is it better to have new members buy in at our $500 level or to allow them to pay only our monthly dues amount?
3. Is it customary for new members to pay an additional fee to cover the club's previous start up expenses, and if so, how is it recorded?
4. Should club members have equal ownership?
5. How are Valuation Units calculated for Club Members?
6. The club receives a quarterly Dividend Reinvestment Plan statement that shows the current dividend paid and also "Tax Reportable Company Paid Fees and/or Commissions." How are these fees recorded?
7. Are the annual fees for NAIC membership tax deductible as investment expenses? Aren't they tax deductible expenses the club incurs to generate capital gains? Do investment magazines, investment software (Quicken, STB Stock Analyst Plus!, NAIC Investor's Toolkit, etc.) fall into the same category?
8. Is the fee for our Treasurer to attend a Treasurer's Workshop a tax deductible expense?
9. What accounting paperwork needs to be prepared when a member withdraws from the club?
10. Some members are withdrawing from our club. Please explain how to determine the valuation units for each member. What factors are used?
11. May a new member buy out a withdrawing member? May current members subdivide the withdrawing member's share among themselves? Are there fees involved in this type of transaction?
12. The club has members making total withdrawals. What are the options for the member payout?
13. The club has a member who wants to make a partial withdrawal. What are the options for the club and the member?
14. Is there a tax consequence difference to either the club or the departing member if the member is paid off in stock plus a small amount of cash, or all in cash, or all in stock?
15. Is it ethical to pay a withdrawing member with appreciated stock? The method reduces the taxes owed by the rest of the club, but it shifts the entire tax burden to the departing member.
16. Our club has decided to pay a withdrawing member with stock. How do we complete the transfer?
17. What is the deadline for distributing K-1 forms to club members? Our club members insist they must receive their forms by January 31, the deadline for filing 1099 forms.

What is the easiest way to structure a new club? I don't want to form a partnership if it means filing the 1065 form and all kinds of other paperwork. Is there a solution?

A partnership is the most common structure used by investment clubs. NAIC recommends that a club organize as a partnership and file Federal form 1065 and the appropriate schedules, including schedule K-1. It may also be necessary to file state forms.

The NAIC Club Accounting Software makes the job of maintaining an investment club's books relatively easy. The annual "add on" 1065/K-1 software makes tax time easy, too.

Reference materials related to this issue are in The NAIC Official Guide: Starting and Running a Successful Investment Club, the NAIC Accounting Manual, and IRS Publication 541: "Partnerships."

We are a new club and each member has invested about $500. Is it better to have new members buy in at our $500 level or to allow them to pay only our monthly dues amount?

There are no standard guidelines and each club sets its own requirements in its Partnership Agreement. Some clubs require that new members make an initial payment that is higher than the minimum monthly payment. The most important thing is to establish a well-defined policy that is clear to all existing and prospective members.

Is it customary for new members to pay an additional fee to cover the club's previous start up expenses, and if so, how is it recorded?

Many clubs charge new members an initiation fee. A fee is different than a payment. Recording the fee is dependent on the intended use of the funds. The fee can be paid into either the club's bank/broker account or the petty cash fund. Generally, funds placed in the club's bank/broker account are used for investments and tax deductible expenses, while the petty cash fund is normally used for non-deductible expenses. Refer to the NAIC Club Accounting Software Manual and the NAIC Accounting Manual for additional details regarding these differences.

Should club members have equal ownership?

Don't worry about keeping everyone equal. Clubs find that it is virtually impossible. Ownership percentages change as members come and go, make late payments, or need to make a partial withdrawal. Most clubs set a minimum monthly investment and a maximum ownership percentage for members. Within those limitations, members may make monthly contributions that they are comfortable with.

The NAIC accounting methodology and the NAIC Club Accounting Software are designed to provide this flexibility.

How are Valuation Units calculated for Club Members?

Each month, when members make their payments, they purchase units at the current unit value. The unit value is determined for every meeting on a standard, designated valuation date. First, calculate the total value of the club as of the valuation date. Second, divide the total amount by the total number of units outstanding. The unit value fluctuates as members make their monthly payments. Dedicated use of the NAIC Club Accounting Software or the accounting procedures described in the NAIC Accounting Manual will create an ongoing record of each member's valuation units.

The club receives a quarterly Dividend Reinvestment Plan statement that shows the current dividend paid and also "Tax Reportable Company Paid Fees and/or Commissions." How are these fees recorded?

Company-paid fees and commissions are treated as additional dividends. They are reported as taxable dividend income on the 1099-DIV form that your club receives at the end of the year. Company-paid fees are added to the cost basis of the purchased stock.

Refer to the NAIC Club Accounting Manual or software "Help" files for directions on entering "Charges Paid by Company."

Are the annual fees for NAIC membership tax deductible as investment expenses? Aren't they tax deductible expenses the club incurs to generate capital gains? Do investment magazines, investment software (Quicken, STB Stock Analyst Plus!, NAIC Investor's Toolkit, etc.) fall into the same category?

Read IRS Publication 550: "Investment Income and Expenses" for answers to these questions. Pay particular attention to pages 32 and 33.

Is the fee for our Treasurer to attend a Treasurer's Workshop a tax deductible expense?

IRS Publication 550 for 1997 lists Investment-related seminars. It states: "You cannot deduct expenses for attending a convention, seminar, or similar meeting for investment purposes." The club must decide: Is a Treasurer's Workshop related to an investment partnership (club) the same as a "seminar for investment purposes?"

What accounting paperwork needs to be prepared when a member withdraws from the club?

The NAIC Club Accounting Software program calculates the payout amount when a member makes a partial or full withdrawal. The club may make the payout in cash and/or stock. The member who withdraws funds is given a Withdrawal Distribution Report. The report indicates the member's share of distributed income, expenses, etc. up to the date of the withdrawal. The report states the realized gains/losses that result from the withdrawal and indicates the cost basis of any stock that is distributed in the withdrawal.

The club must also issue a schedule K-1 form prior to April 15th of the year following the withdrawal. The K-1 form must be prepared every year and given to all members, including members who withdrew during the previous year.

Some members are withdrawing from our club. Please explain how to determine the valuation units for each member. What factors are used?

Before every monthly meeting, valuations are determined for the club's securities, the unit amount, and each member's capital account. In addition, determine the same factors for each withdrawing member in exactly the same manner.

Enter a member withdrawal in the NAIC Club Accounting Software after a current valuation of the club's securities and an audit are both completed. The withdrawal screen will show the current value of each member's capital account and the number of units owned by the member.

May a new member buy out a withdrawing member? May current members subdivide the withdrawing member's share among themselves? Are there fees involved in this type of transaction?

The NAIC Club Accounting Software manual does describe a "buyout" procedure. In reality, the procedure merely credits the members who make extra contributions with a portion of the withdrawal fee paid by withdrawing members. When members withdraw, it is best to think of those units as liquidated --disappeared -- gone forever. There are complex accounting and tax consequences if units are transferred directly between members. See IRS Publication 541 for details. On the other hand, if remaining members or new members want to invest additional money at the exact same time as other members withdraw, they buy new units. It is just coincidence that the new units happen to be at the same price as the units liquidated by the withdrawing members.

The club has members making total withdrawals. What are the options for the member payout?

The NAIC methodology in the NAIC Accounting Manual and the NAIC Club Accounting Software allow us to compare 5 alternatives for a total withdrawal of members. Partial withdrawals (question 13) have different rules.

The club pays withdrawing members with cash on hand.

The source of this cash can be from existing cash on hand or additional payments by the remaining members. Members who withdraw realize a gain or loss upon withdrawal. The gain or loss is based on the difference between their cost basis in the club and the cash withdrawn.

This method has no effect on remaining members.

The club pays withdrawing members with cash received from the sale of appreciated stock.

All members, including members who are withdrawing, realize their pro-rata share of the gain on the sale of the stock. In addition, the withdrawing members realize a gain or loss that is based on the difference between their cost basis in the club and the cash withdrawn.

The effect on club members: everybody pays capital gains taxes. PROBABLY NOT SO GOOD!

The club pays withdrawing members with cash received from stock that was sold at a loss.

All members, including members who are withdrawing, realize their pro-rata share of the loss on the sale of the stock. In addition, the withdrawing members realize a gain or loss that is based on the difference between their cost basis in the club and the cash withdrawn.

The effect on club members: everyone writes off a capital loss. PROBABLY GOOD...from a tax standpoint anyway.

The club pays withdrawing members by transferring appreciated stock to them. The withdrawing members' cost basis in the transferred stock equals their cost basis in the club. Withdrawing members do not realize a gain until they sell the stock. The remaining members do not realize a current gain. When remaining members withdraw, they will realize a gain or loss based upon the difference between their cost basis and the current value of their account in the club.

The effect on club members: the remaining members do not realize a current gain from the transfer of an appreciated stock. PROBABLY GOOD. If the club wants to continue to own this stock, the club may immediately repurchase the stock at a new cost basis. The wash sale rule does not apply in this situation.

The club pays withdrawing members by transferring stock the club holds at a loss.

The withdrawing members' cost basis in the transferred stock equals their cost basis in the club. Withdrawing members do not realize a gain or loss until they sell the stock. The remaining members do not realize a current loss. When remaining members withdraw, they will realize a gain or loss based upon the difference between their cost basis and the current value of their account in the club.

The effect on club members: the club transfers a stock that it holds at a loss without the remaining members realizing a current loss. PROBABLY NOT GOOD! If the club wants to eliminate the stock, the better option is to sell it. The current members write off a current loss and cash can be issued to the withdrawing member.

The club has a member who wants to make a partial withdrawal. What are the options for the club and the member?

The tax implications of a partial withdrawal can be more complex than for a complete withdrawal, depending upon how the member is paid and the source of cash funds that are used.

In simple terms, stock transferred in a partial withdrawal has a cost basis equal to the club's cost basis in that stock when it is transferred to the withdrawing member. However, this cost basis may not exceed the withdrawing member's cost basis in the club, reduced by any cash also distributed in the withdrawal. It is important to note that if more than one stock, or even multiple blocks of the same stock, are transferred, the allocation of cost basis between these stocks is quite complex. IRS Publication 541 details this allocation process, and the NAIC Club Accounting Software handles the calculations without any problem.

As a comparison, stock transferred in a complete withdrawal has a cost basis equal to the member's cost basis in the club, (not the stock's cost basis) reduced by the amount of any cash distributed in the withdrawal.

The NAIC methodology in the NAIC Accounting Manual and the NAIC Club Accounting Software allows us to compare 5 alternatives for partial withdrawals.

A member makes a partial withdrawal and is paid out with cash on hand. Effect on the Withdrawing Member: The withdrawing member's cost basis in the club is reduced by the amount of the withdrawal, down to, but not below, zero. If the withdrawal amount exceeds their cost basis in the club, they must treat the excess as a capital gain in the year in which the withdrawal is made.

Effect on the other members: none

The club sells stock that it holds at a gain to raise cash for the member making the partial withdrawal.

All members, including the withdrawing member, realize their pro-rata share of the gain on this sale of stock.

Effect on the withdrawing member: The withdrawing member also realizes a gain upon withdrawal if the cash withdrawn exceeds their cost basis in the club.

Effect on the other members: PROBABLY NOT SO GOOD! Everyone pays capital gains taxes this year.

The club sells stock that it holds at a loss to raise cash for the member making the partial withdrawal.

All members, including the withdrawing member, realize their pro-rata share of the loss on this sale of stock.

Effect on the withdrawing member: The withdrawing member realizes an additional taxable capital gain upon withdrawal if the cash withdrawn exceeds their cost basis in the club.

Effect on the other members: PROBABLY GOOD! (From a tax standpoint, anyway.) Everyone writes off a capital loss this year.

Effect on the club: An under-performing stock is removed from the portfolio. However, just because the stock has under-performed doesn't necessarily mean that it doesn't have potential.

The club issues appreciated stock to the member making the partial withdrawal.

Effect on the withdrawing member: The withdrawing member's cost basis in the transferred stock is equal to the club's cost basis in that stock when it is transferred to the withdrawing member. However, this cost basis must be adjusted so that it doesn't exceed the withdrawing member's cost basis in the club, reduced by the amount of any cash also distributed in the withdrawal.

If the club's cost basis in the transferred stock plus cash is less than the withdrawing member's cost basis in the club, the transfer of appreciated stock may cause the withdrawing member to realize a larger gain upon the sale of the stock than if the withdrawing member received cash.

On the other hand, if the club's cost basis in the transferred stock plus cash is more then the withdrawing member's cost basis in the club, the withdrawing member will realize the same gain as if they had received a cash payout. However, that gain is deferred until the stock is sold.

The cost basis of the transferred stock, plus any cash that is distributed, reduces the withdrawing member's remaining cost basis in the club, but it is not reduced below zero.

Effect on the other members: No current gain is realized. The difference between each member's cost basis and their capital account value in the club will be their gain or loss upon withdrawal.

Q: Will the other members incur a large or disproportionate amount of deferred capital gains taxes?

A: No. The only gain or loss the other members will have when they withdraw is the difference between their cost basis in the club and the current value of their account when they withdraw.

Effect on the club: PROBABLY GOOD! The Club transfers a stock that it holds at a gain without the other members realizing a capital gain. This assumes that the club is willing to part with the stock anyway. The club can repurchase the stock at a new cost basis if it still likes the stock.

The club transfers stock it holds at a loss to the member making the partial withdrawal.

Effect on the withdrawing member: The withdrawing member's cost basis in the transferred stock is equal to the club's cost basis in that stock when it is transferred to the withdrawing member. However, this cost basis must be adjusted so that it doesn't exceed the withdrawing member's cost basis in the club, reduced by the amount of any cash also distributed in the withdrawal.

If the club's cost basis in the transferred stock plus cash is less than the withdrawing member's cost basis in the club, the transfer of stock held by the club at a loss will cause the withdrawing member to realize a capital loss upon the sale of the stock. On the other hand, if the club's cost basis in the transferred stock plus cash is more than the withdrawing member's cost basis in the club, the transfer of stock held by the club at a loss allows the member making the withdrawal to postpone the gain on the distributed dollar amount that exceeds their cost basis in the club until the stock is sold.

Effect on the other members: No current loss is realized.

Effect on the club: PROBABLY NOT GOOD! The Club transfers a stock that it holds at a loss without the other members realizing any current loss. If the club wants to get rid of the stock anyway, it is better to sell it so everyone writes off a current loss. Issue cash to the withdrawing member.

Considerations

Remember.... In the long run, varying payout methods only impacts WHEN gains or losses are realized. Postponing or deferring taxes, to the extent that the IRS allows and to the extent that it is prudent within the management of your club portfolio, can have significant advantages in your long-term investment strategy. The payout method will NOT impact the overall cumulative total of the gains or losses realized by a club member.

The tax treatment of partial withdrawals is complex. Many factors must be considered: the amount of cash distributed, the club's cost basis in the transferred securities, and the cost basis of the member making the partial withdrawal. Don't be afraid to try several different scenarios in the NAIC Club Accounting software...just be certain to back up your data before you play "what if"so that you can restore your data when you're finished.

Is there a tax consequence difference to either the club or the departing member if the member is paid off in stock plus a small amount of cash, or all in cash, or all in stock?

Generally, the tax consequences of a mixed cash/stock payout are the same as a complete stock payout. It is always advisable to distribute appreciated stock if the club is going to perform a stock payout. In a total withdrawal where the payout is all stock, the cost basis of the stock distributed will equal the withdrawing member's adjusted cost basis in the club at the time of withdrawal. In a mixed payout, however, the cost basis of the stock paid out to the withdrawing member is reduced by any cash paid out in the withdrawal, but not below zero. If the cash paid out is more than the member's adjusted cost basis in the club, the excess becomes a realized and taxable gain, and the cost basis of the distributed stock is zero.

The NAIC Club Accounting Software makes it easy to play "what if." First, back up your data! You can enter various sample transactions to see their impact. Restore your data after you've played "what if" and before you make the actual withdrawal.

Is it ethical to pay a withdrawing member with appreciated stock? The method reduces the taxes owed by the rest of the club, but it shifts the entire tax burden to the departing member.

There is nothing unethical, inequitable, or improper about distributing appreciated stock to a withdrawing member of a club. No tax burden is shifted. In the case of a complete withdrawal, the withdrawing member's tax basis in the distributed stock is the same as the member's adjusted tax basis in the club at the time of withdrawal (less any cash also distributed). There is no reduction to the tax basis of the remaining club members due to this stock distribution to a withdrawing member.

Why is it a good idea to distribute appreciated stock?

Withdrawing members may choose to postpone the sale of the stock so that any potential gains will be realized at a time of their choice and not necessarily at the time of withdrawal. In addition, the remaining members are not forced to realize current gains from the distribution of the stock. Their gain will be realized when they withdraw from the club.

For more information on the treatment of stock distributions in withdrawals, refer to IRS Publication 541, the NAIC Accounting Manual, and The NAIC Official Guide: Starting and Running a Successful Investment Club.

Our club has decided to pay a withdrawing member with stock. How do we complete the transfer?

Let's assume your club has a fairly typical partnership agreement. This agreement states something to the effect that a withdrawing partner must submit a notice of withdrawal at a meeting and that the withdrawal will be valued and paid at the next meeting. Let's also assume that the club uses one of the many stockbrokers that will transfer securities, at little or no charge, from a club account to a member's account.

Ideally, the withdrawing member already has an account with the same broker. If not, instruct the member to open one in order to simplify the transaction and avoid fees. It is an easy matter to open an individual account.

At the meeting when the notice of withdrawal is recorded, the club decides to distribute stock. It must also decide which stock to transfer and how many shares. It is advisable to allow for stock price fluctuations so that the club doesn't inadvertently distribute stock with a higher value than the value of the withdrawing partner's payout amount.

Prior to the next meeting, the partner who is authorized to transact business with the broker on behalf of the club must notify the broker in writing to transfer "X" number of shares of company "XYZ" to the withdrawing partner's account on the date of the next meeting.

In preparation for the meeting when the payout is made, the financial partner values the holdings by entering the security valuations in the NAIC Club Accounting Software. Next, enter the withdrawal and prepare the normal reports plus the withdrawing partner's Withdrawal Distribution Report. In addition, write a check for the residual cash payout to complete the member withdrawal. The financial partner delivers the check and a copy of the Withdrawal Distribution Report at the meeting.

That's it! Simple and straightforward.

Note: Be sure to check with your broker for their specific requirements involving a stock transfer.

What is the deadline for distributing K-1 forms to club members? Our club members insist they must receive their forms by January 31, the deadline for filing 1099 forms.

The 1997 IRS Publication 541 states: "Schedule K-1 due to partners. The partnership must furnish copies of Schedule K-1 (Form 1065) to the partners by the date Form 1065 is required to be filed, including extensions." Clubs whose tax year ends on December 31 must file a tax return by April 15 of the following year. Club members will thank you if you distribute K-1 forms well before the due date.

Jerry Dressel has been an online volunteer and is a former director for the Computer Group Advisory Board. Jerry is a founding member of the Horizon 21 Investment Club. He is recognized as an expert on club accounting issues and Club Accounting Software.