Member Withdrawal - Cash vs Stock
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Member Withdrawal - Cash vs Stock Jerry and I consistently recommend that clubs use
appreciated stock in paying off departing members, even if the club has cash
available. The reason for this is that using cash for partners' withdrawals can
lead to prepayment of taxes if the club owns appreciated stocks. A reader
recently questioned this.......
Re the prepaying of taxes: Are you
saying that members contributing
to buyout the resigning member are in effect purchasing a tax liability because they will be responsible for the appreciation of the securities in "her portfolio" if those securities are sold. Yes, that's what I'm saying. Let's take a simple [I hope]
example. Say we have 3 members in our club - Able, Baker, and Charlie. They have
each put $5,000 in, and we purchased Stocka - 100 shares for $5,000. Assume
those 100 shares become worth $8,000. Now we have $10,000 in cash and $8,000
worth of stock. Charlie's share is 1/3 of that or $6,000. If we simply pay him
$6,000, he will realize a capital gain of $1,000 [$6,000 - $5,000].
Now let's assume that we later sell that stock for the $8,000. The club will realize a gain of $3,000 [$8,000 - $5,000]. That gain will be split among the remaining members - $1,500 each. Consider what has happened at this point. The IRS has collected taxes on $4,000 [$3,000 from the club and $1,000 from Charlie]. But the only economic gain has been the $3,000 on Stocka. That is what I mean by prepaying taxes. Able and Baker will get an offsetting loss when they leave the club, but that may be years down the line. So, the conclusion is that if you own appreciated stocks, you should use them to pay off members, even if you have sufficient cash or if other members are willing to contribute more cash. There is another solution provided by the IRS to avoid
this prepayment of taxes. It is called the 754 election. Under this election,
whenever a member is paid off, any gain recognized by him/her will be added to
the basis of appreciated stocks held by the partnership. At the present time, no
investment club software on the market supports this election. Therefore, the
best way to pay off a departing member, at present, is to use appreciated
stocks.
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