Welcome to the Year-End Treasurer's Workshop

(To view Ira's pictures, download the PDF file that is attached to this message.)

Last week, my daughter and I drove from Leonia, New Jersey to Burbank, California. She is finishing her college studies with a semester in Los Angeles and we had to get her and a car safely cross-country. Among the items we brought along was a new Garmin Nüvi350 GPS navigation system. I thought it would be a good thing for her to have in Los Angeles as she's never driven there before. Therein lies a story. 

We were driving through Arkansas and thought it might be fun to make a short detour to Crater of Diamonds State Park in Murfreesboro, AR. Crater of Diamonds is the only diamond field in the world that is open to the public and where you can keep any diamond you find. (A 3+ carat diamond was found the week before we were there.) With the GPS on the dashboard this would be a simple task -- just enter Crater of Diamonds, press "GO", and the GPS would take us there.  

We were nearing the town of Murfreesboro when the the GPS intoned, "Turn left onto County Road 701."  So we left the smooth State Highway 19/26 and turned onto a smooth, but unpaved, road. About 400 yards down the road, we crossed a small bridge, and the road became a little more "rustic" -- some ruts, some larger rocks.  
 

[picture] 
 

Up a hill, down a hill, and up again and after a half mile, the GPS spoke again, "Turn right onto County Road 704."  

[picture] 

There were signs posted on both sides of the road, "Hunting rights reserved for the Wild Bunch Hunting Club." You'll excuse me if I had thoughts of "Deliverance" or "Wrong Turn" echoing in my brain. The road became more "interesting." The ruts were deeper, the rocks bigger. There were mud puddles to ford, weeds growing in the center of the "road" which scraped the car's undercarriage. 

[picture] 

At one point, my daughter had to pull a branch aside so it wouldn't scrape the side of her new car. At another, I lost the road completely and just drove through some low weeds until I could find the trail again. Finally, we reached a fallen tree that crossed the road and couldn't go any further. (That's me in the distance checking out the fallen tree.) 

[picture] 

We had to turn around, slog through the mud puddles, stay out of the ruts, avoid the branches and slowly work our way back to the main highway. Back at the highway, I looked at the GPS settings and discovered that it had been set for shortest distance and had not been set to avoid unpaved roads. 

So, why am I starting with this story? Investment club accounting "today", can be very much like driving by GPS. Little mistakes seem innocuous, but slowly they compound and soon you find yourself lost in the woods of numbers that seem threatening. 

Over the next few days, we'll tackle the seemingly daunting task of closing the club's books at year-end and preparing the club's tax return(s). We'll start with the underlying principles behind the year-end process and then present the specific actions that you'll need to take.  

If my investment club accounting GPS is set correctly, this will be a painless journey. Just keep an ear open for those dueling banjos.

Gene,

As Al said, brokers frequently get it wrong. If there is ever any doubt, just refer them to

http://www.hugotontrust.com/images/pdfs/news/HGT0606_Tax_Basis.pdf

Rip West

Please bear with me. I've encountered some serious computer problems (I should know better than to install new software) and until I can successfully undo that which I've done I can't guarantee that I'll be able to post the remaining parts of the seminar. I hope to have something for you tomorrow (Thursday).

Ira

Why Do We Do What We Do?

One word explains it all... taxes. If it weren't for the requirement to settle up with our Uncle in Washington, DC, life would be simple. We could just keep track of the value of the investment club, determine some way to equitably divide up that value among the members and be done with it.

However, life isn't that simple. We are required to make an annual accounting of our income and pay taxes on that income. Once the income is taxed, we don't have to pay taxes again on the same money. So, we need to keep track of how much of our share of the club's value has already been taxed and how much is yet to be taxed.

Finally, the tax laws of the United States require that we determine the source/type of income and expense and report each of these amounts separately. In part, this is to allow economic analyses of income; in part, because different types of income are subject to different tax rates.

The year-end "closing of the books" process does all this for us. It provides the necessary allocation of income and expense to each member of the investment club, updates the amount of "already taxed" basis for each member, and provides the detailed information necessary to complete the club's and its members' tax returns.

Before we get to the actual process of closing the books, there are two decisions we need to make: how will we allocate income and expense, and will we distribute units as part of the allocation process.

Allocation Method

In theory, investment clubs can choose almost any method they wish to allocate income and expense to their members, provided that method is clearly stated in the club's Partnership Agreement. The only IRS restriction is that the allocation method must have "substantial economic effect". In the absence of an explicit allocation method in the Partnership Agreement, "the partner's share [of income, gain, loss, deduction, or credit] is determined according to the partner's interest in the partnership." (2006 Instructions for Form 1065 and IRS Reg. 1.704-1) [For the purposes of this workshop, I will ignore the arguments surrounding equal vs. proportional allocation of specific expenses other than to say that your club should adopt language in its Partnership Agreement that documents its choices.]

In practice, most investment clubs allocate income and expense according to the ownership percentage of the assets in the club. This is determined by the number of units each member owns, expressed as a percentage of the total number of units outstanding.

This still leaves us a choice. There are two allocation methods provided within the current investment club accounting software. (When I use "club accounting software" in lower case, I am referring to all of the current software available regardless of supplier, When I use "Club Accounting 3" or "Club Accounting Online", I am referring to specific software products of ICLUBcentral.) The two allocation methods are snapshot (non-time based) and time-based.

Snapshot Allocation

Snapshot (non-time based) Allocation is the older and less-favored allocation method. Its attraction is its simplicity and it was used when club financial records were kept by hand. In the Snapshot method, all income and expense are allocated using the end-of-year ownership percentages. If a member withdraws mid-year, a special allocation is made for that member using the income/expense up to the withdrawal date and her ownership percentage just prior to the withdrawal. One consequence of Snapshot Allocation is that a member who joins the club mid-year will share in income and expenses for the entire year.

Time-based Allocation

Time-based allocation is the favored allocation method. All income and expense are allocated using the ownership percentages on the date the income/expense items are realized. Members only receive allocations for the part of the year that they were members of the club. Computers and club accounting software make the numerous calculations painless.

Distributing Units

The second decision that has to be made before we get down to the nitty-gritty of closing the books is, "Do we want to distribute units as part of the allocation process or not?".

The traditional method as recommended by NAIC was to distribute units at the end of the year. In essence, the investment club was mimicking a mutual fund. The club would determine its net income and "distribute" it to the members in accordance with the allocation method chosen. The club's current value would be decreased by the amount of income distributed, thereby reducing the unit value. The distributed income would then be used to purchase additional units at the new unit value. The purchase of new units was recorded as a contribution of capital to the member's account. The net result was that the number of units and unit value changed for each member, but their percentage ownership and current value did not.

The problem with this method is that it can lead to some weird situations when a club has a net loss for the year. In this case, the loss is distributed to the members. The club's value is INCREASED by the amount of the loss distributed, thereby increasing the unit value. The distributed loss is then used to SELL units at the new unit value. The sale of new units was recorded as a reduction of capital to the member's account. The net result was that members had fewer units, each worth more, while their percentage ownership and current value remained constant. This was and remains extremely confusing to most club members.

In fact, there was never any need to distribute units. Mutual funds are required to distribute their income to shareholders each year in order to qualify for an exemption on paying taxes at the fund level. The choice of whether to reinvest that distribution in the mutual fund or keep the cash is up to the individual investor. Investment clubs are exempt from taxation at the club level by "definition". They are only required to report the taxable items to their members so that the members can pay the appropriate taxes at the individual level.

At the beginning of today's installment, I stated that one of the objectives of the year-end closing process was to update the "already taxed" basis for each member. Once we've determined the net income/loss allocated to each member, all we have to do is add the income or subtract the loss from the cost basis for that member.

Therefore, the current recommendation is that clubs do NOT distribute units when they allocate income and expense.

The current club accounting software from ICLUBcentral (Club Accounting 3 [CA3] and Club Accounting Online [CAO]) allows you to choose whether to distribute units or not. Bivio (from bivio) does not allow you to distribute units.

To wrap up this section, let's make the two preliminary decisions and make sure our software is set correctly.

            CA3:     Club>Settings (in left bar) or Tools>Settings (in top bar). Enter a check in Use time-based earnings allocation if you want time-based allocation. (recommended) Remove the check to use snapshot allocation. If you don't already see an earlier year selected, enter 2006 for the first year to NOT distribute units. (recommended)

            CAO:    Accounting>Utilities>Allocation Settings. Select Time based allocation (recommended) or Non-time based allocation. If you don't already see an earlier year selected, enter 2006 for the first year to NOT distribute units. (recommended)

            bivio:     Administration>Tools>Allocation Method. Select Time Based (recommended) or Snapshot. bivio does not distribute units as part of the allocation process.

In the next installment, we'll tackle the actual steps taken to close the books and get ready to complete the club's tax return.

Posted By Margaret Wentworth on 01/18/2007 6:01 PM
My question concerns filling out the IRS forms. There is a place where, if you have less than 10 members during the year, you say so and you get to fill out a different form. We dropped down to 8 members during 2006. We just recruited 3 new ones but they joined in January 2007. Can we just fill out the usual forms using the tax prep software we purchased or must we launch ourselves into unknown territory by saying we had 8 members?

Thanks,
Peg Wentworth, Treasurer, Women's Investment Network, Lancaster, PA

P.S. Hope this forum is still ongoing. It's a great help.

Closing the Books - Part 1

Today we'll begin the actual process to close the club's books for 2006. The procedures presented below are not the only way to close the club's books, but are the way that I have done them for the clubs I handle. If you have other suggestions, please post them as part of the message thread. In particular, I have no experience with bivio's AccountSync so there may be significant procedural differences that apply to clubs using that service.

Preparation

We need to gather the information necessary to close the books. Collect copies of all of the bank, broker and DRP statements for the year. If you've done your treasurer's tasks correctly throughout the year, you'll only need to refer to the December statements, but it's always useful to have everything close at hand. Since you won't have the December statements until sometime in January, you can't really begin your year-end tasks until then. In fact, I find that this week (the third week in January) is ideal for a first pass at the yearend tasks. On the other hand, you might want to wait even longer­ –­ until you receive your tax reporting documents from your bank, broker, DRPs, etc. These should be mailed to you by January 31, and should arrive in early February.

IMPORTANT NOTE: In recent years, many clubs have received corrected tax reporting documents from their brokers. These corrected documents usually don't arrive until late February or early March, so you may want to wait before filing your taxes. (We'll discuss this in the tax session.)

Reconciliation of Cash Balances and Security Holdings

The first thing to do is generate a valuation statement for December 31. You want to compare each of the cash balances on the report to the cash balances reported by your bank/broker. If there are any discrepancies, you need to identify and reconcile them.

Perhaps there's an outstanding check or a deposit in transit, but if there are errors, now is the time to find them and correct them. Generate a report of all of the club's transactions for the year.

            CA3:     Reports>Transaction Summary. Set the dates to 1/1/06 to 12/31/06 and check the box for Subtotal Tax Allocations

            CAO:    Reports>Transaction Summary. Set the dates to 1/1/06 to 12/31/06.

            bivio:     Accounting>Reports>Transaction History. Set the date to 12/31/2006.

I would look for missing dividend or interest entries first. Companies usually pay dividends quarterly, so there should be four entries for each company you've owned for the whole year. Interest is usually paid monthly, so there should be twelve interest entries. If your club uses margin, make sure your margin interest is entered as an expense and not as income. (More on that tomorrow).

After you've finished with the cash entries, compare your December 31 valuation statement against your yearend broker and DRP statements to confirm that your records show the same number of shares of each security as your broker/DRP. Don't worry if the closing price per share is different as that isn't important for our purposes.

If you find a difference, review your transaction report for a missing or doubled entry. If your club reinvests dividends, the most likely source of error is a dividend that was mistakenly recorded as a cash dividend and not a reinvested dividend. You can see this in the transaction summary/history report.

At this point, I also would not worry about reconciling the amount of dividends or interest reported on your year-end statements with your club records as brokers often report these amounts one way on the monthly statements and then reclassify them on the tax reporting documents.

Reconciliation of Income and Expense, Gain and Loss

Within a week or so, your tax documents should arrive from your bank, broker, DRPs, etc. There are six types of tax reporting documents your club may receive:

·         1099-B - Proceeds from Broker and Barter Exchange Transactions

·         1099-DIV - Dividends and Distributions

·         1099-INT - Interest Income

·         1099-MISC - Miscellaneous Income

·         1099-OID - Original Issue Discount

·         Schedule K-1 (Form 1065)  - Partner's Share of Income, Credits, Deductions, etc.

The first three are common and most clubs can expect to receive them; the other three are rare. You would receive a 1099-MISC if your club's shares were lent by your broker to another investor to sell short and you received payments from that investor in lieu of the dividends/interest you should have received. You would receive a 1099-OID if you invest in certain types of securitized loans such as REMICs, and CMOs. You would receive a Schedule K-1 if your club invested in another partnership and/or certain natural resource royalty trusts. If your club receives one of these three forms, you will have to take additional steps to close your books and prepare your taxes that are beyond the scope of this workshop.

We'll need to look at a few other reports to reconcile the tax documents against the club's records: a tax allocation report and a capital gains report. Before you generate these reports, you may need to confirm that each of your club's investments is correctly classified within the accounting software.

            CA3:     1) Securities, Double-click on each security and choose among Common Stock, REIT, Other Publicly Traded, Mutual Fund or Fixed Income Investment, or

                        Tools>Year-End Tasks and go through the wizard. You will encounter a screen where you can review and change all of the security settings.

                        2) Tools>Allocate Income and Expenses. Select 2006.

3) Reports>Club Capital Gains. Click the Prev. Full Year button.

4) Reports>Allocation of Income and Expenses. Choose 12/31/2006.

            CAO:    1) Securities>Update Security Settings. Click on the edit link for each security and choose among Stock (common, reit or other), Mutual Fund or Other.

                        2) Accounting>Utilities>Allocate Income and Expenses. Select 2006.

3) Reports>Club Capital Gains. Set the dates from 1/1/06 to 12/31/06.

4) Reports>Allocation of Income and Expenses. Choose 2006.

            bivio:     1) Reports>Member Tax Allocations. Choose 2006.

                        2) Reports>Capital Gains and Losses. Choose 2006.

Interest

Compare the interest reported on your 1099-INT (box 1 and/or box 3) with the totals reported on either the transaction report or the allocation report. If your club received any tax-exempt interest, it will not be reported on the 1099-INT, but it will appear in your club reports. In CA3 and CAO, it will be included in the "Cash Income and Expenses" section of the transaction report in the "Income" column. In bivio, you will have to subtract the tax-exempt interest from the interest total in the transaction report. Tax-exempt interest is reported separately on all allocation reports.

Dividends

Compare the ordinary dividends reported on your 1099-DIV (box 1a) with the total dividends reported on either the transaction report or the allocation report. Sources of differences could be missing entries (though we should have caught them in the earlier reconciliation of cash balances and stock holdings), and/or foreign taxes which weren't entered correctly in the software.

Next compare the qualified dividends reported on your 1099-DIV (box 1b) with the qualified dividends reported on the allocation report. If you find differences, make sure that you entered the ex-dividend dates correctly. In bivio, you get a chance to review the ex-dividend dates when you go through the tax interview. In CA3/CAO, you can review your entries by preparing a Security Dividends report.

            CA3:     Reports>Security Dividends. Set the dates from 1/1/06 to 12/31/06. Check Include inactive securities. Then click on Select all securities.

            CAO:    Reports>Security Dividends. Set the dates from 1/1/06 to 12/31/06. Choose both Active and Inactive securities.

Another source of errors is REIT and mutual fund distributions that were entered incorrectly. REIT and mutual fund distributions are nonqualified dividends by default, but some dsitributions may actually be "qualified". In CA3 and CAO, you will have been asked to enter the qualified amount when you generated the Allocation report. I have to confess that I'm not sure of the best way to do this in bivio. You could split the distributions between qualified and nonqualified when received by using different Distribution Type entries. I don't recall if bivio asks for this information as part of the tax return preparation process. Perhaps someone with relevant experience can post the answer.

Similarly, entries in boxes 2a, 2b, or 3 of your 1099-DIV can point you to other errors associated with REIT/mutual fund distributions. Check your software entries to see that they accurately reflect the nature of the REIT/mutual fund distributions as follows.

Capital gains distributions (Form 1099-DIV, box 2a) should be entered as:

            CA3:     Transactions>Enter New>Select Transaction Type:(Reinvested) Dividend or Distribution>Type:Long term capital gain

            CAO:    Accounting>Securities>Cash Dividend (or Reinvest)>Type:Long term capital gain

            bivio:     Accounting>Investments>Income or Reinvest>Distribution Type:Long-term
Capital Gain. NOTE: If there is an entry in box 2b of Form 1099-DIV, you must subtract this amount before entering the long-term capital gain distribution in bivio.

Unrecaptured Section 1250 Gain (Form 1099-DIV, box 2b) is entered in the tax programs in CA3 and CAO (to be discussed in the tax session). In bivio, you will enter it as:

            bivio:     Accounting>Investments>Income or Reinvest>Distribution Type:Unrecaptured Section 1250 Gain

Non-dividend distributions (return of capital, Form 1099-DIV, box 3) should be entered as:

            CA3:     Transactions>Enter New>Select Transaction Type:(Reinvested) Dividend or Distribution>Type:Return of capital

            CAO:    Accounting>Securities>Cash Dividend (or Reinvest)>Type:Return of capital

            bivio:     Accounting>Investments>Income or Reinvest>Distribution Type:Return of
Capital

Capital Gains

Compare the sales proceeds on the capital gains report to the total proceeds reported on Form 1099-B. One possible source of differences is cash-in-lieu received from the sale of fractional shares of stock that were recorded either in your software or by the broker as a dividend. These are correctly reported as sale proceeds. There are also some brokers who don't report cash-in-lieu at all on a 1099 form if the amount is less than $10. While the total sales proceeds in the capital gains report should match the 1099-B, you only need to worry if the total sales proceeds shown on your report are less than that shown on the 1099-B. The IRS won't care if you over-report your sales.

Other Income

Most clubs should not have any other sources of income. If your transaction summary report shows any other form of income, you should review the specific entries and determine if you have made them correctly. You might want to ask here or on the club-treasurers list for assistance in making this determination.

Since this is getting long, we'll save the analysis and closing of the expense side of the books for tomorrow's session.

Thanks for your response. You are being so helpful with these little nagging questions.

Peg

Maybe the last question:

We bought GLD, the Streettracks gold shares. Is that an ETF? How would that be classified? Common stock, other publicly traded,or what?
Also, we own several ADR's, including TEVA. Are they common stocks for our purposes?

Thanks,

Peg Wentworth

>If we earned interest but it is not credited to our account until 1.3.07, I assume we do not report that for 2006?

Correct. Investment clubs are cash-basis entities. They report income and expense when it occurs. (There are some exceptions, but this isn't one of them.)

Ira Smilovitz

GLD is an ETF. I would classify it as "other". Your investment in GLD may create another problem for you. I'm not sure, but I believe that GLD qualifies as an investment in precious metal (and not a stock). Therefore the capital gain on the sale of GLD is not subject to the usual 15% maximum rate, but is subject to a 28% maximum rate. I don't believe that any of the current software is designed to handle this. Perhaps someone with more familiarity with GLD can provide further insight.

ADRs are considered common stock for club accounting purposes.

Ira Smilovitz

>I had a nitpick annoying thing happen when I ran the distribution of income and expenses. Using CAO I ran my valuation for 12/31/2006 and ran all my reports for my club books. Then I ran the distribution of income/expenses and reran the 12/31/2006 valuation statement again to ensure nothing had changed. Unfortunately, there was a very minor change in the number of units and cost/unit. I checked valuations for the entire year and discovered the error in the month following the Cendant Spin-Offs. I don't know if that was the problem, but it's suspicious. Anyway, I reran my valuation, member and transaction reports from then through 12/31/2006. Ain't being the treasurer fun ?

Never a dull moment!

Ira Smilovitz

>I'm confused. I'm using CA3 accounting program and I installed the recent upgrade. I have my settings on time-based earnings and the year 2006 as the first year to not distribute.
However, after I do the allocation, my units differ on the valuation from prior to doing the allocation. They differ in "value of each unit this date" and also in "Number of units each $10 will purchase." The amount is small but I was under the impression the units were not to change. The units also change on the member status report after I do the allocation. Am I missing something?

Not that I know of. I can't say why you're seeing the difference, but one possibility is that you entered/deleted/edited a transaction between the time you did the first valuation and the time you did the allocation. Another possibility is that you had an older transaction that somehow never got included in the unit value calculation and the allocation calculation forced it. I know I'm not explaining this clearly, but there have been some situations where the calcualted unit value didn't change for several months even though there were transactions which were large enough to change it. You might want to contact customer support for further information. I'm sure they can explain this better than I just did.

Ira Smilovitz