Chapter 22
Reporting Taxable Income
Chapter twenty-two of the Starting and Running a Profitable Investment Club discusses club members tax requirements and liabilities.
An investment club is not a taxable entity, but the member’s who make up the partnership are liable for taxes on dividends, interest and capital gains. If a club has taxable income at the end of the year it is divided among the members based on a member’s share of ownership in the club. The club reports to the IRS the total taxable income and each member’s portion but the club member is personally liable for payment of their share.
Many people have problems understanding the difference between profit and withdrawal. The example given in this chapter is as follows. If your share of the club’s earnings was $400 then you must pay taxes on the $400. If you also withdrawal $5000 then the taxing of that amount must be calculated based on your tax basis in the club. Your tax basis consists of the sum of deposits you have made in the club plus earnings for which you have paid taxes. Any withdrawal less then your tax basis is tax free. Any amount over your tax basis is taxed as a long-term capital gain as long as the club is more than one year old. States that have an income tax often duplicate the federal rules but individuals should check with their state taxing agency (of course, in Texas we do not have a state income tax). One item to note is that your taxation is for individual accounts only. If your club is part of an IRA or other tax-deferred retirement account then additional taxes and penalties could apply.
Let’s go back to the example above. If you contributed $50 each month last year for a total of $600 and you have no other earnings that you paid taxes on, then your tax basis is $600. You can withdrawal up to $600 tax free. If you withdrawal $5000 then you would have to pay long-term capital gains on $4400 ($5000 - $600).
Partnerships must file tax forms 1065 and K-1 for each member. The club’s income is calculated and divided among the members, based on their ownership in the club. Then each member’s share is further divided into the different income classes (dividends from securities, capital gains from the sale of securities, and interest income). The dividend income is taxed as ordinary income. If the short-term gains are greater then the short-term loses during the year then the difference is taxed as ordinary income. Long-term capital gains are taxable as ordinary income at a maximum tax rate of 28 percent or 20 percent, depending on how long the securities were held before their sale. Note, the tax rates and rules given in this chapter might have changes since the book was written, so individuals should check with a tax advisor before filling your taxes.
To assist with the calculation of taxes an Earnings Distribution Statement should be created. This will ensure that the members are only taxed for their share of the clubs income. This is especially important when members have made a withdrawal during the year. To prepare the Distribution Statement list all the partners in column 1 (See Figure 1). In column 2 list each partner’s valuation united from the Individual Valuation Units Ledger (the total should be the same as the total valuation units show in your Valuation Units Control Ledger. The Income and Expense Statement (Figure 2) provides figures for row 9 in the Earnings Distribution Statement.
Fred Hill made a partial withdrawal on November 26 as shown in row 10 of the Earnings Distribution Statement (Figure 1). The figures in row 10 where calculated at the time Fred Hill made his withdrawal. To calculate the figures in row 10 take the sum of each item at the time of the withdrawal and divide it by the total number of valuation units giving the amount per unit. Then multiply these by the number of units Fred withdrew to determine the total of each. If other members made a withdrawal then another row 10 for that member should be created. To calculate the value for row 11, subtract row 10 from row 9 giving the remaining taxable income to be distributed. You can now calculate the total profit per valuation unit (column 7 row 12) by dividing the adjusted net profit for the year $348.92 by the total number of valuation units 768.835 giving $0.4538. We now need to break down the items into dividends, short-term capital gains, long-term capital gains, and expenses.
You calculate each column 3 through 6 by multiplying the member’s valuation units by the per unit value. Repeat until all members’ taxable income and expenses are calculated. Total the columns and compare them to the taxable income in row 9, they should be equal. Since fractions are being used it might be necessary to adjust some members totals by a couple of pennies to arrive at exact totals.
Figure 1
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(1) |
(2) |
(3) |
(4) |
(5) |
(6) |
(7) |
(8) |
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Valuation Units |
Dividends |
Short-term Capital Gains |
Long-term Capital Gains |
Total Club Expenses |
Year’s Net Profit |
Val. Units Purchased If Profit is Held |
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(9)Taxable income for the year |
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(10) Partial withdrawal by Fred Hill on Nov. 26 |
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(11) Taxable income remaining to be distributed |
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Bob Smith |
63.510 |
22.33 |
3.56 |
15.94 |
(13.01) |
28.82 |
2.0811 |
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Arthur Black |
63.510 |
22.33 |
3.56 |
15.94 |
(13.01) |
28.82 |
2.0811 |
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Mary Brown |
63.510 |
22.33 |
3.56 |
15.94 |
(13.01) |
28.82 |
2.0811 |
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Paul Hill |
63.510 |
22.33 |
3.56 |
15.94 |
(13.01) |
28.82 |
2.0811 |
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Fred Hill * |
52.111 |
27.15 |
5.11 |
23.02 |
(14.39) |
40.89 |
2.9523 |
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Rosilyn Rhodes |
63.510 |
22.33 |
3.56 |
15.94 |
(13.01) |
28.82 |
2.0811 |
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Joe Rodgers |
63.510 |
22.33 |
3.56 |
15.94 |
(13.01) |
28.82 |
2.0811 |
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Faye Dearson |
63.510 |
22.33 |
3.56 |
15.94 |
(13.01) |
28.82 |
2.0811 |
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Donald Luis |
63.510 |
22.33 |
3.56 |
15.94 |
(13.01) |
28.82 |
2.0811 |
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Nellie Neil |
63.510 |
22.33 |
3.56 |
15.94 |
(13.01) |
28.82 |
2.0811 |
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Ed Echels |
63.510 |
22.33 |
3.56 |
15.94 |
(13.01) |
28.82 |
2.0811 |
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Frank
Vestor |
81.624 |
28.70 |
4.57 |
20.49 |
(16.72) |
37.04 |
2.6746 |
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TOTAL |
768.835 |
279.15 |
45.25 |
202.93 |
($161.17) |
366.16 |
26.438 |
Value of unit before distribution $13.85 Value of unit after distribution $13.39
Income and Expense Statement
January 1, 199X through December 31, 199X
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INCOME: |
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Dividends |
$279.15 |
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Sale of securities: |
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Net short-term |
45.25 |
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Net long-term |
202.93 |
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Total income |
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$527.33 |
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EXPENSE: |
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Expense of checking account |
$65.72 |
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Due to National Association of Investment Clubs |
19.50 |
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Postage, paper, and supplies |
25.31 |
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Subscription to business publications |
35.00 |
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Miscellaneous |
15.64 |
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Total expense |
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161.17 |
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Net profit |
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$366.16 |
The earnings members usually leave to be reinvested become additional valuation units. In the example above the club’s total value is $10,648.37 with 768.835 valuation units in the club giving a $13.85 value for each unit. To populate column 8 in the Earnings Distribution Statement (Figure 1) we divide each figure in column 7 by $13.85 giving us a new valuation unit total of 795.273 and a new value for each unit of $13.39 ($10,648.37 divided by 795.273).
It is necessary to distribute the cash value of earnings per year to each member’s account in order to reflect the additional tax-paid investment of club members. Since this income is reported on the member’s personal tax return, it becomes part of their tax-paid investment, their tax basis along with their monthly contributions. At the end of the year the total profit of $366.16 will eventually be transferred to the individual account of each member.
Each member of the club should be given a copy of the Earnings Distribution Statement containing the information they need to file their tax return. Members are also given a K-1 form to be kept with their tax records.
Members should keep these tax regulations in mind:
1. Unrealized gains and losses are not taxable. Taxes become due or losses deducted on in the year the security is sold.
2. Capital gains are treated like ordinary income.
3. Capital losses are offset by short-term and long-term capital gains.
4. There is a limit to the total amount of net capital losses you can deduct each year. Excesses are carried over and applied to future capital gains, up to the annual deduction limits.
5. Capital gains are offset against capital losses to reduce tax liabilities.
6. If you own more than one lot of a security (shares purchased at different times) then you should sell high-cost lots to reduce gain or increase loss. Sell low-cost lots to increase gain or reduce loss. You should specify in writing to your broker which lot you want to sell by identifying lots by their purchase date and cost. Always get a written detailed confirmation from you broker on these transactions.
7. Part of all of the cash dividends paid by certain companies may be classified as return of capital and not taxable. Be sure to determine whether the dividends you club receives are taxable.
8. Generally, stock dividends (dividends paid in the form of additional shares) are not taxable. The tax is postponed until the stock dividend is sold at a gain, when it is subject to capital gains.
9. Cash received in lieu of a fractional share of stock dividend is treated as a sale and a capital gain or loss.
10. In calculating gains on stock sold, the IRS allows you to add commissions you have paid to the purchase price, and to deduct them from the sale price.
11. Costs incurred in connection with investing, such as subscriptions to financial publications, are deductible as itemized miscellaneous deductions for each individual. However, the total of Form 1040, Schedule A, in the category of “Miscellaneous” has to be more than 2 percent of the individual’s adjusted gross income, or there is no deduction.
Dividend income, if under $400 is entered on line 9 otherwise it is entered on Schedule B of Form 1040 with the description of “Share of qualifying corporation dividends received from investment club partnership, $ .”
Return of Capital (dividend income reclassified by the issuing corporation) is deducted from total dividend income at the bottom of Schedule B. (They are also deducted from the cost of the security in the club’s records.)
When issuers have withheld tax from the club’s dividend payment, total dividends are recorded on the Earnings Distribution Statement. The total withheld is recorded in the section on the reverse side of Form 1040 where other withheld amounts are listed.
Capital gains and losses are reported on Schedule D of Form 1040. Short-term capital gains are entered under part I of Schedule D on the line for partnership items. Long and mid-term capital gains are entered in part II. The individual’s share of club expenses show in column 6 of the Earnings Distribution Statement is listed as a separate item in the Miscellaneous Deduction section of Schedule A as “Share of investment club expenses, $ .”
Interest income is show as a separate item on the Income and Expense Statement and on the Earnings Distribution Statement in a special column. Interest is reported on Schedule B, part I of Form 1040 if over $400 and on line 8a of Form 1040 if under $400.
Refer to chapter 17 for more information on member who use the club’s account for their IRAs.
Partnerships file a partnership return (Form 1065) each year. Form 1065 should be files with a copy of the K-1 form for each member. If Form 1065 is filed late or incomplete then the IRS may fine each partner. If the IRS sends a notice of a fine the club should promptly prepare a letter explaining why the Form was late or incorrect and ask that the file be forgiven. If the request is not granted and a second fine note is sent, rewrite your letter and ask that your response be forwarded to the next level of authority. Persist until the fine is forgiven. All contact with the IRS should be done in writing and copies of all items should be kept.
Additional State and Local taxes might need to be addressed. Sometimes the option of paying taxes as a club instead of individually is offered and usually will cost less then if paid by each partner.