Why Do We Have to Distribute Earnings?

Each year, the question comes back to haunt us again and again. Why bother?

The short answer is that the IRS says we have to report losses and gains for a particular fiscal year. The long answer is that each year, we have some amount of gain or loss that we actually experienced as Loot Lizards. Stocks go up and stocks go down, but until we sell them, the gains and losses we see are paper gains and paper losses. What goes up could go down before we sell it. What is already down could go up before we sell it. So doing a valuation lets us absorb those gains or losses back into the club's assets and start over again for the coming year. (But the real reason is that the IRS says we have to.)

So we have to do something to make our losses or gains explicit to make the IRS happy. And what we do is this:

Calculate the amount of the gain or loss. We add up our gains/losses from selling stock. We add our gains from interest or dividends. We subtract the miscellaneous fees our broker manages to sock us with in spite of our best efforts to avoid them that aren't direct commissions.
Then we do a special year end valuation for 12/31. This makes sure that for the fiscal year, all relevant dividends, interest and sales are present and accounted for. We use 12/31 because banks, brokers, DRP managers and such all generate year end data for us. That way we have a clear point in time when all of our fiscal stars are in alignment and makes life easier for the auditors, too. (It's an extremely rare event for more than one of our broker or bank statements to cover the same time period.)
Then we distribute our earnings or losses to the masses, and that's when the Loot Lizards go, "huh?"

When we distribute earnings, what happens is that each member pretends to buy or sell a number of shares to compensate for the actual gain or loss. So what we report to the IRS is the value of the shares you "bought" or "sold."

Before going into further detail about what happens, we need to clarify three things:

If you owned 5% of the club before a distribution, you'll own 5% afterwards. The percentage ownership of the club doesn't change during a distribution of earnings.
If your shares were worth $1000.00 before a distribution, they'll be worth $1000.00 afterwards. The value of what you own doesn't change during a distribution of earnings.
This is true for all club members, not just you.

Example 1:

The Loot Lizards are reporting a net loss. We have 1000 shares active in the club worth $20.00 on our year end valuation, and the loss being reported is $400.00.
You own 50 shares of the Loot Lizards, or 5% of the Loot Lizards, so you get 5% of the loss, for a whopping $20.00. Coincidentally, this is exactly the price of a single share of the Loot Lizards. So in order to make this loss painfully obvious to all concerned, the Treasurer takes a share away from you. You're now officially out $20.00 and you have 49 shares left and are probably feeling pretty abused.
You're not alone. By the time the Treasurer gets done, we've taken shares away from all of our members, enough to cover the $400.00 loss, which works out to 20 shares at $20.00 a apiece. Now the Loot Lizards have 980 shares left.
But although we have fewer shares, we still are holding onto the same assets. So something peculiar happens: the share price goes up.
We had 1000 shares, worth $20.00 apiece, which means that the club was worth $20,000. Well, the club's still worth $20,000, but now we've got 980 shares. If we recalculate the valuation, it's now 20,000.00 / 980 shares = $20.40816.
Before the distribution, you owned 50 shares worth $20.00 apiece, for a grand total of $1000.00.
After the distribution, you own 49 shares worth $20.40816 apiece, for a grand total of $1000.00.
Coincidence? Freud wouldn't think so.

Example 2:

The Loot Lizards are reporting a net gain. We have 1000 shares active in the club worth $20.00 on our year end valuation, and the gain being reported is $400.00.
You own 50 shares of the Loot Lizards, or 5% of the Loot Lizards, so you get 5% of the gain, for a whopping $20.00. By now, you are beginning to suspect that this is no coincidence that this is exactly the price of a single share of the Loot Lizards. So in order to make this gain pleasantly obvious to all concerned, the Treasurer gives you an extra share of the club. You're now the proud owner of 51 shares of the Loot Lizards.
Unfortunately, you're not alone. By the time the Treasurer gets done, we've given shares to all of our members, enough to cover the $400.00 gain in proportion to each member's club ownership, which works out to 20 more shares at $20.00 a apiece. Now the Loot Lizards have 1020 shares and everybody's feeling pretty darn good.
But that feeling doesn't last long, because although everyone has more shares, we still are holding onto the same assets. So something peculiar happens: the share price goes down.
We had 1000 shares, worth $20.00 apiece, which means that the club was worth $20,000. Well, the club's still worth $20,000, but now we've got 1020 shares. If we recalculate the valuation, it will be 20,000.00 / 1020 shares = $19.60784.
Before the distribution, you owned 50 shares worth $20.00 apiece, for a grand total of $1000.00.
After the distribution, you own 51 shares worth $19.60784 apiece, for a grand total of $1000.00.