Ira Smilovitz, treasurer of the Paramus, New Jersey-based Lakshmi Investments, LLC since 1999, tells the story about the members of an investment club who implicitly trusted their treasurer. In fact, they had such faith in their treasurer that they didn’t take a close look at their club’s records for a decade. You read that right – ten years! At which time, Ira received a call from one of the members with a request: the club was having trouble reconciling its records and needed help…fast.

Ira responded to the club’s SOS and was taken aback by what he found as he made his way through a decade of the club’s transactions. The records had been kept as a combination of a notebook filled with handwritten notes and software entries. The treasurer had recorded credit for each member’s monthly dues – whether or not the member had actually made a contribution – and some of the deposits were made in cash, rather than by check.

As if that weren’t enough, after completing the task of reconciling a decade’s worth of records, Ira found that the club’s books showed a $3,000 discrepancy with the bank – the club thought it had three grand more than the bank’s records showed. Further review revealed every club’s worst nightmare. “It turned out that the club’s treasurer had embezzled some of the club’s money,” Ira says. “There were no records for the withdrawals and, when confronted, the club treasurer admitted to ‘borrowing’ the money, but insisted that it had been paid back. Yet, there weren’t any records that the money had ever been returned.”

Following years of poorly-kept records, the club couldn’t prove any wrongdoing by the treasurer and was forced to quietly ask the treasurer to resign and take the loss as a lesson learned. Based on this experience, Ira offers this piece of advice to every investment club:

1.      The club’s books should be verified annually by a committee of club members that doesn’t include the treasurer.
“My club trusts me implicitly – and that’s not such a good idea,” Ira says. “They know I’m a go-to resource for Club Accounting.” But even the best of the best – in 2005, Ira was awarded the Kenfield-Burris Online Service Award by the NAIC Computer Group Advisory Board in recognition of the support he provides to hundreds of clubs throughout the country and the key resource he is for investment clubs with accounting questions – make mistakes.

“Last month, there was a 50-cent discrepancy, and it went back six months,” Ira says. “That just goes to show you that even though I check the statements every month, I make mistakes, too. I bring outside skills to this position, yet I’m not foolproof.”

Certainly, clubs shouldn’t assume the worst-case scenario – that their treasurer isn’t on the up-and-up. That said, club members should be vigilant about overseeing the club’s books, because anyone can make a mistake. “Fresh eyes are wonderful for spotting discrepancies,” Ira says. “During an annual review of the club’s books, the treasurer should be available to answer questions, but the treasurer should not be driving the process. A committee of members should be in charge.”

Speaking of keeping your club’s books in good order, Ira has a few additional tips to offer on the subject, such as…

2.      If you need a separate spreadsheet to keep track of the club’s correct cash balance, you are not properly using the ICLUB Club Accounting software.
“If a club can’t keep a correct balance with the Club Accounting software, it really comes down to a problem with club procedures,” Ira points out. “Any club that thinks it needs to use a separate spreadsheet doesn’t have good procedures in place for what they’re trying to accomplish.”

The problem is likely a matter of a club transaction that shouldn’t be taking place – such as recording club expenses separately from investments (for more on this, see Expert Tips for Club Treasurers, Part II, which was posted on this forum April 24, 2008). “Everything your club needs to do should be able to be handled within the context of the software,” Ira says. Which brings us to Tip #3…

3.      Money transferred between bank and brokerage accounts should be entered as a transfer, not as income or expenses.
This tip is self-explanatory to every club treasurer who conducts these transactions correctly, but not so much to those who don’t. The easiest way to think of it, Ira explains, is to visualize moving money from your left pocket to your right pocket. That’s all that is taking place when a club’s money is transferred from a bank account to a brokerage account, or vice versa.

Recording these transactions as income or expenses is not just the incorrect way of going about it, but could cost your members a substantial amount of money come tax time. “Income is always taxable but expenses aren't always deductible. Even though the income and expense amounts will cancel each other out in the software, recording transfers incorrectly could increase each individual partner’s tax liability,” Ira explains. “So, if the club treasurer is incorrectly recording cash transfers as income and expenses, the result could be a huge – and unnecessary – tax bill for the club’s members.”

4.      Avoid the penalties associated with not filing taxes or filing late.
Speaking of unnecessary tax bills, they can also come in the form of penalties for filing late or not filing at all. “The Federal fine for not filing a tax return or filing late used to be $50 a month times the number of members in the club for up to five months,” Ira says. For a 10-member club, you’re talking about $500 a month. Over a period of five months, that can add up to a hefty chunk of change. This penalty was just increased to $85/month/member for up to 12 months. There is also an additional penalty of $50 for each K-1 that is given to a partner late. The good news is that the club may appeal to the IRS and be successful in getting the fines excused. But, Ira warns, there’s no guarantee the IRS will be forgiving. (Source: www.irs.gov/pub/irs-pdf/i1065.pdf, pg. 4.)

5.      Your investment club software needs to stay current with the ever-changing tax laws.
It would seem to go without saying that in order to file accurate returns, your club needs to stay abreast of the ever-changing IRS tax codes. “Tax laws change and will change again,” Ira says. “By the end of 2009, it's a safe bet that they will be different than they are today, regardless of which party takes control.”

Staying current, as Ira notes, also means keeping your club’s software up-to-date. There are investments clubs that are still using Club Accounting Version 1.04 (the current version is 3.16). “Version 1.04 was last current in 1999 or 2000,” Ira says. “We’re talking nine years ago.”

Without the current version, it’s impossible to use the software to generate a correct tax return. “The older versions, for example, do not correctly calculate allocations for capital gains and cannot handle qualified dividends,” Ira says. “The latest version of the Club Accounting Software is more sophisticated and handles transactions that it could not handle in previous versions.”

6.      Some types of investments are not appropriate for investment clubs, such as REITs, MLPs and unregistered investments.
Investments such as REITS (Real Estate Investment Trusts) and Master Limited Partnerships (MLPs) are separate types of investments but pose the same problem for club treasurers – a big headache. REIT distributions can consist of up to five different classes of income plus return of capital. Unfortunately, the REIT can't tell how much of the distributions are in each category until after the end of its fiscal year. So the poor treasurer has to go back and edit the accounting entries. MLPs pass through operating income via a K-1. “The Club Accounting software cannot handle these transactions and even if it were possible, it would be a hassle,” Ira says. “Clubs and partners may be required to file tax returns in every state where the MLP operates. Clubs need to realize that, after it’s all said and done, the actual income the investment club would receive doesn’t justify the added headache for the treasurer.”

As for unregistered investments, Ira’s advice is to run for the hills. “Life is too short and there are too many quality registered investments out there,” he says. “All I see in this case are red flags.”

I want to thank Ira for sharing his expertise. In the last installment of this series – coming up June 5 – Club Accounting Expert Rip West will delve into the proper procedures for member withdrawals. Don’t forget – there’s still time to post a question for this series!