TAX WATCH: Buying into funds? Check those distributions

Tax law requires capital gains distributions when a fund sells a stock at a gain. If the fund doesn’t have offsetting losses, investors are required to report their share of that gain on their individual tax return.

The problem arises for those who buy into the fund shortly before the distribution. They’ll pay tax on gains where they received no benefit. Their net worth will have decreased by the amount of those taxes. Or, from another perspective, waiting until after the distribution allows an investor to purchase more shares.

Keep in mind that if the shares are held in a tax-deferred account such as an IRA or 401(k), there is no problem. Even non-protected taxpayers investing monthly in a fund should not be overly concerned. Buying even $1,000 of shares in the fund and getting saddled with an extra $250 capital gains distribution will result in additional taxes of only $60.

If, on the other hand, an investor is considering a large investment or moving from one fund to another, research is necessary to find out how much of a distribution is forthcoming and when it will be made.

The risk is that when they do buy a few weeks or months from now, the price of the fund will be higher – so much that the gain forgone comes out much larger than whatever was saved on taxes.

Tax-cut compromise off to good start

Secretary of the Treasury Lawrence Summers and House Majority Leader Dick Armey recently announced that they made a good start in their effort to develop a compromise tax-cut package that would be added to a final budget agreement passed by Congress.

“We came to a better understanding of each other’s views and concerns,” Mr. Summers said after their recent 90-minute discussion – a meeting that stretched longer than aides expected. The meeting between the two top-level officials could pave the way for some type of tax relief to be included in this year’s final budget deal.

Mr. Armey, whom House Republicans have designated their chief tax negotiator, said that the two “have a general understanding of the parameters. It’s a very good beginning.”

He offered a list of several tax reductions that would cut revenue by about $300 billion over 10 years and said he reviewed the administration’s proposals, details of which weren’t released.

The Texas Republican is proposing five major items: boosting the yearly contribution to individual retirement accounts to $5,000, from $2,000, repealing a 3% telephone tax, aiding struggling urban and rural communities with tax breaks, providing tax breaks for U.S. exporters and offering small businesses tax relief in a bill to boost the minimum wage. The package would cost the Treasury about $13.5 billion in 2001, says Armey spokeswoman Michelle Davis.

Mr. Armey said that he won’t pursue estate-tax repeal this year. He said that the House’s failed attempt to override President Clinton’s veto of a $105 billion, 10-year estate tax bill is “as far as you can carry it in the legislative process.”

Treasury and White House officials declined to comment about the Clinton administration’s expectations in the talks or the likelihood of any deal.

The tax bills keep on coming

Senate Finance Committee Chairman William Roth has announced that he will send the Senate an anti-poverty plan that also includes some tax breaks for farmers, oil and gas producers, and energy conservation. But the Delaware Republican, unable to hold the line on a slew of amendments sought by committee members, said that he was bypassing a committee vote on the bill and instead taking it directly to the full Senate.

The proposal, which would provide tax incentives to spur business investment and housing development in poor urban and rural areas, was first put forward by President Clinton and Speaker of the House Dennis Hastert last May.

Study finds hole In Bush tax plan

Nearly 27 million Americans would not get the full benefit of George W. Bush’s tax cuts because they would become subject to another tax originally designed to prevent investors and the wealthy from sheltering too much of their income, a congressional analysis recently found.

The Joint Committee on Taxation, a bipartisan congressional panel, said that some 12.2 million Americans would see smaller-than-anticipated reductions under the GOP presidential nominee’s 10-year, $1.3 trillion tax-cut plan because they would become subject to the alternative minimum tax. That’s in addition to the 14.7 million people who under current law would have to pay the AMT by 2010 and thus would be eligible to have their taxes reduced or eliminated.

The panel, in a report prepared for Rep. Charles Rangel of New York, ranking Democrat on the House Ways and Means Committee, said increased exposure to the minimum tax could reduce the size of Mr. Bush’s tax relief by $192 billion over 10 years.

“Governor Bush has advertised his tax plan as simple: `If you pay income tax, you get a tax cut,”‘ Mr. Rangel said recently. “But the governor’s statements disagree with the facts regarding his tax plan. The fact of the matter is, millions of taxpayers will not receive any tax reduction from the Bush plan.”

Bush spokesman Ari Fleischer said the alternative minimum tax, in its current structure, is a “pernicious little thing” that Republicans sought to substantially repeal when they took control of Congress in 1995. He noted that President Clinton vetoed that legislation. “Unlike Clinton/Gore, who vetoed AMT relief, the Bush government will look forward to working with Congress to protect more Americans from the AMT,” he said.

The alternative minimum tax is essentially a parallel income tax system created in 1969 to ensure that the wealthy and corporations could not entirely escape taxes through write-offs and other legal means. Income is taxed up to 28%.

This umbrella Reit sprang a leak

In a recently released technical advisory, the Internal Revenue Service ruled that the reconfiguration of a partnership into an umbrella partnership real estate investment trust was actually a disguised sale of a portion of the original partners’ interests in the partnership.

The original partnership which, according to the IRS, was in the business of leasing and managing shopping centers, received loans from two trusts. Although it isn’t clear from the facts in this ruling, the trusts were apparently related to, or controlled by, the original partners. The trusts also acquired options to purchase limited interests in the partnership.

The partnership used some of the funds from the loans and the options to make loans to the original partners, who used them to make their contributions to partnership capital.

The original partners and the trusts then decided to reconfigure the partnership into an umbrella partnership with a public offering of a real estate investment trust. The plan resulted in a sale of Reit shares to the public, and the admission of the Reit and the lending trusts into the original partnership.

In carrying out this plan, the parties formed a second partnership that, except for another trust and a corporation wholly owned by one of the original partners – both of which made small contributions – had the same partners as the original partnership did.

The second partnership then became a limited partner in the original partnership by contributing the property that it had received from the original partners and the trusts. The original partnership transferred the loans from the trusts to the second partnership. The Reit made its public offering and, in conjunction with various other transfers, transferred cash and shares to a third partnership formed by the lending trusts. The third partnership then transferred interests in the trusts’ loans and options to the Reit. In short, after the reconfiguration, the original partnership was owned by the Reit, the second and third partnerships, and the original partners.

After figuring that out, the IRS concluded that the substance of the reconfiguration was the sale of a portion of the original partners’ interests in the original partnership to the Reit and to the third partnership accomplished through related contributions to and distributions from the original partnership. The substance, said the IRS, was similar to the substance of the transactions in a couple of court cases cited by Congress when it passed Section 707 (Related Interests Transactions) of the tax law to prohibit disguised sales of partnership interests.

The IRS also concluded that the second partnership’s ownership of the loans should be disregarded. Therefore, even if the reconfiguration is not treated as a disguised sale under Section 707, the loans should still be treated as having been distributed to the original partners.

Cite: TAM 200037005