Amateur investors often participate in groups called investment clubs. Investment clubs allow the group to pool funds to make larger investments than each member could individually, and earnings are then passed along to each member. Most investment clubs operate as partnerships to avoid paying taxes at a corporate level. Each member receives a Form K-1 every year indicating her share of the earnings or losses, which she must report on her annual tax return. The amount reported on that Form K-1 plays a large role in that member’s tax basis.
Year End Results
Because the club is a partnership, the financial results of the investment club’s positions pass through directly to its members. If the member is still invested in the club, he must report any dividends, interest and gain on his taxes. If the club suffers a loss for the year, he takes the loss onto his taxes as a capital loss, which can only reduce ordinary income by up to $3,000 per year after canceling capital gains. To prevent the member from paying tax twice on club earnings, the member must adjust his basis to include any gain or loss reported on the annual Form K-1. For example, if a member had a cost basis of $1,000 in an investment club that had a proportional share of income of $375, the member would report the $375 on his taxes and increase his basis in the investment club to $1,375.
Because members pay tax on their share of the investment club’s profits each year, withdrawals are tax free as a return of principal. Partial withdrawals reduce the member’s tax basis by the amount of the withdrawal. For example, if a member whose basis in the club was $1,375 withdrew $200 to cover personal expenses, it would decrease her tax basis to $1,175. Withdrawals don’t appear on the annual Form K-1, but the member would receive an additional withdrawal report that contains the relevant tax information.
When investors sell a capital asset, the amount of taxable gain they report is calculated by subtracting the sales revenue from the purchase price. Transaction costs, such as commissions and fees, are included to adjust those values by decreasing sales revenue or increasing purchase price. Purchase price is more accurately described as cost basis, the portion of an asset’s value on which the owner has already paid taxes. When an asset is sold, the owner is allowed to recover the amount he's already been taxed on without paying taxes again.
Most investment clubs allow members to join with unequal investments and to make partial withdrawals down the road. These rules provide flexibility for members but create additional administrative work. After all, when members have different amounts of skin in the game, they shouldn’t share equally in the gains and losses. Units help investment clubs account for variances in member participation, awarding each member a proportional number of units for her investment. The cost to purchase those units forms the initial basis for that investor.
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