Tax ramifications of departing members
Vincent Esselborn asks....

We are in a newly formed investment club (March 1999) and have  questions  about how to account for members who came and went. We had two original members subsequently leave the club, and we paid them out of cash that had not yet been invested, and calculated their share at the current net asset value of their shares. We now are sitting on unrealized capital gains. Some members are under the impression that once these gains are realized they (the remaining members) will be subject to a greater share of the capital gains than would have been the case had all members remained in the club.

Here are our questions

I understand that the tax return is based on realized gains or losses, but how do we account for the distribution received by the members who cashed out?
The partnership has no tax ramification from the distribution received by the departing members. They will record the difference between what they received and their tax basis for their partnership interests as capital gains on the Schedule D of their individual returns. The gains will be short-term or long-term, depending on how long they were in the partnership.
 Do we adjust the cost basis of the stock when a member cashes out early? On the K-1 forms, how do we allocate dividend income received during the year - it seems unfair that the remaining members should be on the hook for all the taxes?
You raise a sticky question. Let's take the easier one first. The dividend income (and any expenses and realized gains) should be allocated in accordance with ownership in the partnership as of the date the income was realized. This means that, if the departing partners were in the club when the dividends were earned, some of that income would be allocated to them.
The other question is more difficult. The departing members have escaped no tax. As stated before they will be reporting a gain on their schedule D. (Incidentally, this gain will be reduced by any dividend income allocated to them, since such allocations increase the basis of their partnership interest.)
It is true that taxes for the remaining members are accelerated under your example, because they will have to report gains on all the appreciated stocks, even though the departing members were paid off on the basis of those stocks. I say accelerated, because these existing members will add this additional income to their tax basis and get an offsetting loss when they leave the club. Since this event may occur twenty years down the line, I realize that this offsetting loss may be of small consolation.
There are ways to get around this problem. If you had distributed appreciated stock to the departing members, the remaining partners would not incur this acceleration, and the terminated partners would be no worse off. In addition, there is an election, under Section 754 of the Internal Revenue Code, which would allocate the gains of the terminated members to the cost basis of the appreciated stocks remaining in the partnership. Be warned, however, that this election will stay in force for the term of the partnership, or until permission is received by the Internal Revenue Service to revoke the election. The election may also cause you to reduce the basis of your remaining stocks, if the terminated partners have net accumulated losses. Be warned also, that, at present, there is no Investment Club software on the market which will accommodate this election. Our engineers have assured me that the software will have this capability before the end of the year 2000. In view of what they have been able to accomplish to date, I am very confident that they will reach this goal.
I apologize for the length and complexity of this response. However, it is an extremely complex subject. Be sure to come back for further clarification, if necessary.
Rip West
Ridgway, CO