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Topic: Partial Member Withdrawals - options available to your club

The tax implications of a partial withdrawal can be more complex than for a complete withdrawal, depending upon how the member is paid and the source of cash funds that are used.  The initial reaction of most clubs is to sell stock, increase member payments, or simply use cash on hand to come up with enough cash to pay off a withdrawing member.  This may or may not, however, be the most advantageous method from a tax perspective.      IRS Publication #541 - Partnerships defines the rules pertaining to distributions to withdrawing members.   In accordance with that publication, let's look at the options available to your club and the withdrawing member.   But first, it must be noted that this document is assuming a partial withdrawal of the withdrawing member.  Total withdrawals have different IRS rules.

In simple terms, stock transferred in a partial withdrawal has a cost basis equal to the club's cost basis in that stock when it is transferred to the withdrawing member. However, this cost basis may not exceed the withdrawing member's cost basis in the club, reduced by any cash also distributed in the withdrawal. It is important to note that if more than one stock, or even multiple blocks of the same stock, are transferred, the allocation of cost basis between these stocks is quite complex. IRS Publication 541 details this allocation process, and bivio handles the calculations without any problem.

As a comparison, stock transferred in a complete withdrawal has a cost basis equal to the member's cost basis in the club, (not the stock's cost basis) reduced by the amount of any cash distributed in the withdrawal.

Let's compare 5 alternatives for partial withdrawals.

  1. A member makes a partial withdrawal and is paid out with cash on hand.

    Effect on the Withdrawing Member: The withdrawing member's cost basis in the club is reduced by the amount of the withdrawal, down to, but not below, zero. If the withdrawal amount exceeds their cost basis in the club, they must treat the excess as a capital gain in the year in which the withdrawal is made.

    Effect on the other members: none

  2. The club sells stock that it holds at a gain to raise cash for the member making the partial withdrawal.

    All members, including the withdrawing member, realize their pro-rata share of the gain on this sale of stock. See Tax Allocation Methods for more information. 

    Effect on the withdrawing member: The withdrawing member also realizes a gain upon withdrawal if the cash withdrawn exceeds their cost basis in the club.

    Effect on the other members: PROBABLY NOT SO GOOD! Everyone pays capital gains taxes this year.

  3. The club sells stock that it holds at a loss to raise cash for the member making the partial withdrawal.

    All members, including the withdrawing member, realize their pro-rata share of the loss on this sale of stock.  See Tax Allocation Methods for more information. 

    Effect on the withdrawing member: The withdrawing member realizes an additional taxable capital gain upon withdrawal if the cash withdrawn exceeds their cost basis in the club.

    Effect on the other members: PROBABLY GOOD! (From a tax standpoint, anyway.) Everyone writes off a capital loss this year.

    Effect on the club: An under-performing stock is removed from the portfolio. However, just because the stock has under-performed doesn't necessarily mean that it doesn't have potential.

  4. The club issues appreciated stock to the member making the partial withdrawal.

    Effect on the withdrawing member: The withdrawing member's cost basis in the transferred stock is equal to the club's cost basis in that stock when it is transferred to the withdrawing member. However, this cost basis must be adjusted so that it doesn't exceed the withdrawing member's cost basis in the club, reduced by the amount of any cash also distributed in the withdrawal.

    If the club's cost basis in the transferred stock plus cash is less than the withdrawing member's cost basis in the club, the transfer of appreciated stock may cause the withdrawing member to realize a larger gain upon the sale of the stock than if the withdrawing member received cash.

    On the other hand, if the club's cost basis in the transferred stock plus cash is more then the withdrawing member's cost basis in the club, the withdrawing member will realize the same gain as if they had received a cash payout. However, that gain is deferred until the stock is sold.

    The cost basis of the transferred stock, plus any cash that is distributed, reduces the withdrawing member's remaining cost basis in the club, but it is not reduced below zero.

    Effect on the other members: No current gain is realized. The difference between each member's cost basis and their capital account value in the club will be their gain or loss upon withdrawal.

    Q: Will the other members incur a large or disproportionate amount of deferred capital gains taxes?

    A: No. The only gain or loss the other members will have when they withdraw is the difference between their cost basis in the club and the current value of their account when they withdraw.

    Effect on the club: PROBABLY GOOD! The Club transfers a stock that it holds at a gain without the other members realizing a capital gain. This assumes that the club is willing to part with the stock anyway. The club can repurchase the stock at a new cost basis if it still likes the stock.

  5. The club transfers stock it holds at a loss to the member making the partial withdrawal.

    Effect on the withdrawing member: The withdrawing member's cost basis in the transferred stock is equal to the club's cost basis in that stock when it is transferred to the withdrawing member. However, this cost basis must be adjusted so that it doesn't exceed the withdrawing member's cost basis in the club, reduced by the amount of any cash also distributed in the withdrawal.

    If the club's cost basis in the transferred stock plus cash is less than the withdrawing member's cost basis in the club, the transfer of stock held by the club at a loss will cause the withdrawing member to realize a capital loss upon the sale of the stock. On the other hand, if the club's cost basis in the transferred stock plus cash is more than the withdrawing member's cost basis in the club, the transfer of stock held by the club at a loss allows the member making the withdrawal to postpone the gain on the distributed dollar amount that exceeds their cost basis in the club until the stock is sold.

    Effect on the other members: No current loss is realized.

    Effect on the club: PROBABLY NOT GOOD! The Club transfers a stock that it holds at a loss without the other members realizing any current loss. If the club wants to get rid of the stock anyway, it is better to sell it so everyone writes off a current loss. Issue cash to the withdrawing member.

Considerations

Remember.... In the long run, varying payout methods only impacts WHEN gains or losses are realized. Postponing or deferring taxes, to the extent that the IRS allows and to the extent that it is prudent within the management of your club portfolio, can have significant advantages in your long-term investment strategy. The payout method will NOT impact the overall cumulative total of the gains or losses realized by a club member.

The tax treatment of partial withdrawals is complex. Many factors must be considered: the amount of cash distributed, the club's cost basis in the transferred securities, and the cost basis of the member making the partial withdrawal.

Jerry Dressel
St.Louis, Missouri
Trez_Talk@bivio.com