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How to Split the Gains When a Club Comes Undone
Keep an Eye on Taxes During a Final Distribution
We don’t like to see clubs disband, but this tax season I received several calls concerning tax issues related to a club’s dissolution. In this article I’ll use an example based on one of these clubs to illustrate the importance of tax planning when dissolving a club.
When this club disbanded, the final sell transactions generated about $45,000 in capital gains. Two members had withdrawn slightly earlier than other members, before the final sell transactions were executed. Issue one was the large capital gains realized from these final sales. All members had their shares of this income reported on their final Schedule K-1.
Members believed this was their gain from the investment in the club. It is not. It’s the prorated share of club income and is different from the gain or loss from their investment in the club. It was also a bit of a shock as the individual share of this gain ranged from zero to about $10,000.
The members who withdrew early were no longer members when the sell transactions were executed. Having no ownership interest in the club when the gains were realized, these members had none of these gains allocated to them on their final K-1s. If we assume each of these members had a 10 percent interest in the club at withdrawal, they avoided $4,500 each in additional income from the club.
This total of $9,000 was then allocated to the members withdrawn after the sell transactions were executed. This appeared to be unfair to the members withdrawn later. (The early withdrawers don’t actually avoid reporting $9,000 in income; they just report it differently.)
So how could this club have avoided the unexpected capital gains and the discord from an apparent unfair allocation of club income at dissolution? The easiest way was to avoid selling its appreciated shares and instead transfer those shares to the members.
For investment partnerships, securities transferred to members as part of a withdrawal are treated as property, not cash. When property is distributed to members, all or part of the partner’s cost basis in the partnership is transferred to the property received. The results are good for the club and the members. The club doesn’t need to sell shares, thus realizing the gains. This removes current-year capital gains to be allocated to the members on the final K-1.
This will, however, increase each member’s gain from his or her investment in the club. Fortunately, this gain isn’t realized until the partner sells the shares received as part of their dissolution distribution. Members then gain control over the amount of the gains realized and when they’ll be realized. This can be a big advantage.
How would transferring shares have helped this particular club? To make things simple, let’s assume all stocks they owned at dissolution had unrealized gains. To make sure the amounts come out correctly, they want some cash available, so they sell some stock with the least gains. Let’s say they have $2,000 in gains.
Now instead of the members sharing $45,000 in gains, they’re only sharing $2,000 in gains. Being forewarned, they don’t withdraw any members before the final sales, so there’s no apparent unfair allocation of the gains.
The shares are distributed. So what’s the gain the members report on their personal tax returns for their club investment?
If the cash received in the dissolution is less than their cost basis in the club (likely in this scenario), members report no gain at all from their club investment if they don’t sell any of the shares received in the year the club disbanded. All members should receive a withdrawal report that includes their cost basis in the shares received and the beginning of their holding period.
When they sell the shares, they’d use that information to calculate their reportable gain and whether it’s a long-term or short-term gain.
Several members of the club used as an example here expressed a desire to warn other clubs of the problems of not being informed of the advantages of stock transfers and its effects on planning a club dissolution. So if this article is helpful, give them credit for inspiring the topic this time.
Russell Malley is the Club Accounting Adviser for ICLUBcentral.