Partial Member Withdrawals - options available to your club
Jerry A. Dressel on
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. The initial reaction of most clubs is to sell
stock, increase member payments, or simply use cash on hand to come up with
enough cash to pay off a withdrawing member. This may or may not, however,
be the most advantageous method from a tax perspective.
IRS Publication #541 -
Partnerships defines the rules pertaining to distributions to
withdrawing members. In accordance with that publication, let's look
at the options available to your club and the withdrawing member.
But first, it must be noted that this document is
assuming a partial withdrawal of the withdrawing
member. Total withdrawals have different IRS rules.
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 bivio 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.
Let's 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. See Tax Allocation
Methods for more information.
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. See Tax Allocation
Methods for more information.
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.