If you have a good thing going, then twice as much of a good thing can only be that much better, right? As with most of life, it’s more complex than that.
You already know our stand on investment clubs – there are pros, pros, and more pros to starting a club and/or being a club member (and yes, we admit, we’re just a tad biased). That said, if an investment club is a good thing, does that mean that the merging of two investment clubs is even better? Can two clubs merge and if so, how?
That’s the question that was recently posed on the Join the Club! Forum by StockCentral member Lynn Brown. “Has anyone experienced two clubs merging and how did they do it?” she writes. “We have two clubs that are each down to between three and five members. No one wants to sell out their stocks and just join the other club, so we thought about merging.”
I was immediately intrigued, as in my 18 years of writing about investing and investment clubs, no one has ever asked me that question. Even as a former member of an investment club, a club merger had never crossed my mind. So, as you know if you are a regular reader of this column, I once again turned to the experts to find the answer to Lynn’s question.
To Merge or Not to Merge…
As you may remember from the recent series on club treasurers, ICLUBcentral consultant Rip West is a retired CPA who specialized in the accounting and taxation problems partnerships face – and there are plenty of both involved in a club merger. His advice is simple – and to the point – Don’t do it.
That’s the short answer – but, of course, the short answer usually begs an even bigger question: Why not? Rip points out that there are a number of pitfalls, from coping with accounting complications to dealing with arcane IRS rules governing transfers of assets. Perhaps the best way to illustrate why not is to show what would happen…
If Two Clubs Decided to Become One
The first step two clubs involved in a merger would need to take, of course, is for one club to contribute all of its stocks and cash to the other club. The members of the contributing club would then receive units, based on fair market value of the stocks and cash contributions. However, the club’s accounting program must enter each contributing member’s tax basis based on that member’s basis in the original club. This latter requirement can be overcome, but it does entail a “work-around” that is not currently a feature of any club accounting software program.
That's where the problems begin. Though the IRS has no objection to the actual transfer of the assets, there are future tax consequences when the transferred stock is sold. First, the gain must be allocated to the transferor parties, in the amount of the built-in gain at the time of transfer. Then any remaining gain/loss must be allocated to all the members.
For instance, if the original transfer was a stock with a basis of $1,000 and a fair market value of $1,500, and if that stock was subsequently sold for $1,800, the results would be as follows: First, a gain of $500 would be allocated to the transferor partners. Then, the remaining gain of $300 would be allocated to all members of the club. It is this two-step allocation that is beyond the capabilities of current club accounting programs. “This would be the case whether it was one individual contributing stock to a club, or of two clubs merging,” Rip explains.
This is a reality check for most clubs that contemplate a merger. “Usually, when a club approaches ICLUBcentral with this idea, no one wants to pay the taxes involved and that’s where it ends,” Rip says.
Yet, some clubs, undeterred, continue with the merger. If they decide to move forward – eyes wide open – the next hurdle to contend with is the club’s accounting. “There’s no direct way to carry information from a merger into the books,” Rip explains. “The club might have the correct figures, but there is currently no club accounting software program that is designed to handle this situation. The club’s tax return and allocations will be incorrect, due to the built-in (two-tiered) capital gains problem.”
Story of a Merger
About two years ago, two investment clubs tossed around the idea of merging. Despite advice to the contrary from both Rip and ICLUBcentral, the clubs went ahead with the merger. Last year, the club resurfaced when members realized they’d gotten in way over their heads – and needed help to bail themselves out.
In order to correct the problem, the club first had to file an amended tax return with the IRS. “There is no club accounting software currently available that is set up to handle a club merger,” Rip explains. “It could be created if someone had the inclination to do it, but there just isn’t enough of a demand for it.”
So, the only way to handle such an accounting issue is via the method Rip refers to as a “work-around.” Since the software isn’t designed to kick out a correct return in a merger situation, the club members were left to make by hand the calculations on any stocks sold. Then, they filed amended tax returns – for not only the club, but for every club member – with the IRS “as if they had done it wrong the first time,” Rip says. The club will have to continue to manually prepare tax returns by hand and compute the tax consequences for any sale of stock that came over to the club as a contribution from the disbanded club until all of the contributed stock has been sold. “It’s like a time bomb waiting to go off,” Rip says.
An Exception to the Rule
As with most things in life, where there’s a will, there is a way. After all, the IRS does not prohibit club mergers. “There is nothing in the IRS regulations that says you can’t,” Rip says.
In the case of club mergers, there are certain – albeit rare – times when a merger just might prove to be a saving grace. “If there are two clubs that are both experiencing declining membership, and if neither club’s performance is stellar, that could be a case where a merger would make sense,” Rip says. “If one club sells at a loss, they won’t have to face the tax consequences, which then eliminates the tax and accounting problems associated with a club merger. One club can sell its losers, then take that cash, join as members of another club and contribute that cash to the new club’s portfolio.”
This scenario could be accomplished in two steps:
- The club that will experience the least amount of tax consequence fully dissolves.
- The members from the dissolved club buy into the existing club.
It seems a much more reasonable approach than carrying stock contributions over from one club to another. One final thought – keep in mind that merging must make more than just good financial sense. To have the best shot at long-term success, members of both clubs should also make sure that they share compatible investing styles and by-laws.
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