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Most Clubs Should Avoid the Urge to Merge
Interested in Joining Forces? Regrouping as a New Entity May Be the Best Way
There is power and wisdom in working as part of a group. That’s the theory behind the investment club movement. And when clubs see their memberships decline, they occasionally view the possibility of a merger as an enticing solution to continuing their operations.
Rick Oprendek of the Analytic Investment Club of Gainesville, Va., recently wrote to ask for advice on the possibility of merging two investment clubs. “Two investment clubs exist within my workplace and neither has had decent membership growth as we compete with each other for new members,” he writes. “Together we can be stronger. How would a merger work for each club and their partners’ assets?”
A merger certainly seems like a good idea for these two investment clubs. Unfortunately, the process is fraught with enough complications as to make a merger ultimately undesirable for most clubs.
Where does the difficulty lie? There’s no legal reason that prevents two general partnerships or limited liability companies from joining together. The Internal Revenue Service doesn’t prohibit the practice, either. But IRS rules regarding the transfer of assets from one entity to another are so cumbersome that a merger becomes quite unpractical for most clubs.
Neither ICLUBcentral’s Club Accounting 3 nor myICLUB.com tools handle the transactions required for a merger of clubs (nor, for that matter, does any other investment club accounting software). In a typical merger, one of the clubs would transfer all of its securities and cash to the other club on behalf of its partners (more of an “acquisition” than a merger).
The IRS does allow transfers of property from an individual or other partnership into a partnership, but the trouble begins in tracking the tax basis for each member based on this person’s basis in the original club. The club treasurer would need to track the basis of each member’s capital account and adjust future withdrawal reporting accordingly.
Matters get more complicated from here. Any stocks transferred into the club are also subject to rules regarding the allocation of their cost bases. When they’re sold, gains up to the amount of gains at the time of transfer are allocated to the members who transferred into the club; the rest is allocated to all current partners.
If this doesn’t sound daunting enough, since all of this has to be managed manually outside of the club accounting software, the club’s federal tax returns will need to be completed by hand.
If a club has a professional accountant in its ranks or is willing to pay several hundred dollars a year for accounting and tax preparation services, this might be a workable — if expensive — approach to its continuing operations as a merged entity. Most investment clubs will not be in a position where this is a realistic proposition, however.
In some scenarios a merger of clubs is workable. This would depend largely on the amounts of unrealized gains, losses and income that would be distributed to members upon the club’s dissolution.
The most expeditious way to accommodate a merger is for one club to dissolve and then for its members to use the proceeds to join the second club. Some club members may object to this process, since they’d be liable for the taxes on gains and income resulting from the dissolution.
But if one club is able to dissolve at a net loss to its members, it may be quite sensible for that club to dissolve and for its members to join the other club. In this case, if the club’s winners outweigh its losers, most of the club’s members would walk away with a net loss to their capital accounts and thus not be penalized for the club’s closure.
If a club has a modest amount of unrealized gains, it might still be well worth it for that club’s members to incur the tax impact of receiving the gains and income in the club’s termination. If the club’s in danger of folding anyway, it probably makes plenty of sense to shut down, have the members take the tax hit and then join the other club.
For a complete analysis of the tax impact of terminating either club, the treasurer should first make two complete backups of the club’s records (using the Backup Manager in myICLUB.com or the Export function in Club Accounting 3). Then complete a full termination of the club. Complete instructions for dissolving a club are on the ICLUB.com website; the process involves selling all securities and then withdrawing all members.
The resulting withdrawal reports would show the amount of gains allocated to each member. Print these so that members can review the impact of dissolving on their individual capital accounts. Once complete, restore the club accounting database from the backup.
If neither club is willing to terminate because of the tax consequences and both clubs want to pursue the merger, a final option is for both to dissolve and then form a new entity. Members would take their payouts from their dissolved clubs and start a completely new investment club.
By pursuing this option, all members would more likely feel as if they were on equal footing in the new club and could look to the future with hope and experience in the market.
Douglas is ICLUBcentral's product manager, helping develop the company's programs including Toolkit 6, myICLUB.com, and the Investor Advisory Service. He is also the author of several investing books, including The Pocket Idiot's Guide to Direct Stock Investing, The Complete Idiot's Guide to Online Investing, The Armchair Millionaire, and Investment Clubs for Dummies.