|The Accelerated and Uneconomic Bearing of Tax Burdens by Mutual Fund Shareholders|
Shawn P. Travis *
*Currently a tax associate at Ropes and Gray, Shawn P. Travis wrote this article during his third year (2000-2001) at Harvard Law School.
[Editors’ Note: The Tannenwald Writing Competition is sponsored by The Theodore Tannenwald, Jr. Foundation for Excellence in Tax Scholarship and by The American College of Tax Counsel. Mr. Travis’s paper was awarded first prize in the 2001 competition.]
Mutual fund (MF) investors face a variety of issues that differentiate them, in terms of tax burden borne, from investors using self-directed brokerage accounts to trade stocks or bonds similar to those traded by the MF. Congress could revise the tax laws to ameliorate or eliminate these differences, and it arguably should do so—one way or another—in order not to penalize an investor for buying stocks or bonds through the MF instead of buying them directly. Admittedly, the tax treatment of MF shareholders is unlikely to be easily brought entirely in line with that of direct stockholders or bondholders, given that MFs are collective investment vehicles functioning as intermediaries between securities markets and investors. But significant improvements can be made.
A. Illustrative Example
The following example illustrates the type of issues addressed in this Article. The only facts about the current taxation of MFs necessary to develop this example are that a MF is deemed to realize gain when it sells an appreciated portfolio security and that a MF avoids entity level taxation only if it distributes all its realized gains to its shareholders on its annual distribution date.
Three individual investors, A, B, and C, each purchase one share of a MF on January 1 for $100. The MF has no other assets and fully invests the $300 cash in one share each of companies Xco, Yco, and Zco. Over the next four months, each stock appreciates 100%, and the MF’s net asset value (NAV) reaches $200.
C then decides to cash out her share, selling it back to the MF for $200. C will report a short-term capital gain of $100 on her next annual tax return. To pay C for her redeemed share, the MF sells its share of Zco for $200, triggering a MF- level gain of $100. It will distribute this gain to its shareholders at the next distribution date to avoid paying any entity-level tax on the gain.
Seeing better investment opportunities, the MF manager then sells the positions in Xco and Yco for $400 total and invests $100 in one share of Vco and$300 in one share of Wco. The sales trigger the unrealized gain in the MFs Xco and Yco shares, and the MF will avoid paying tax on that gain by distributing it to its shareholders on the next distribution date. At this point, the MF has $300of realized but undistributed gain.
Vco stock neither appreciates nor depreciates over the next eight months, hovering at a value of $100 two weeks before year-end; Wco stock declines over the same time, reaching a value of $100.
Two weeks before year-end, shareholder B decides to cash out when the MF’s NAV is $100. Believing Wco stock has more remaining upside than does Vco stock, the MF manager sells the share of Vco at $100 to redeem shareholder B. The MF realizes no capital gain in the process, so its realized but undistributed gain remains at $300. B faces no current tax liability. One week before the end of the year, shareholder D buys 4 shares of the MF at $100 each. The MF retains $300 of the funds in cash and uses $100 of the funds to double its position in Wco stock, which is still trading at $100 per share. Shareholder A and D remain in the MF through the end of the year, when the MF’s only assets (two shares of Wco stock and $300 cash) have a combined value of $500. The MF therefore has a NAV of $100 prior to its year-end distribution.
Whether they take their distributions in cash or in shares of the MF or in some combination of the two, A and D each owe taxes on their pro rata portions of the $300 distributed by the MF.1 The following table summarizes the tax consequences (as of the distribution date) for A, B, C, and D of their investments in the MF, assuming a marginal income tax rate of 39.6%.
B and C end up in the economic position one would expect. B makes nothing on his investment and therefore pays no taxes. C gains $100 and pays short-term capital gains tax on that amount (while retaining the ability to offset that gain with other short-term losses). Neither B nor C obviously suffers as a result of having purchased MF shares instead of having purchased stocks directly.
But A and D are both economically much worse off as a result of investing in a MF as opposed to buying stocks directly. A’s only investment action all year was to buy and hold a share of the MF. However, because of the investment actions of his fellow shareholders and of the MF’s manager, he owes $23.76 in taxes at the end of the year. Had he invested in the stocks directly and not sold any positions at a gain during the year, he could have deferred that tax indefinitely.
D is similarly worse off than if he had purchased stocks directly. He purchased a share of the MF and one week later received a taxable distribution that was caused by the actions of other shareholders and the MF manager months before. Had he purchased stocks directly, he would not owe taxes on economic gain in which he did not participate.
Additionally, the example brings into focus apparent instances of double taxation. A and D pay taxes on gains realized from the sale of stocks that led to the short-term capital gain enjoyed by C, and yet C also recognizes short-term capital gain on this appreciation, though in a different form. A and D share the burden of the tax on this appreciation by paying tax on the distribution realized by the MF when it sold stock owned during C’s participation in the fund. C pays taxes on the increase in the NAV of the MF during his holding period, which was caused by the appreciation in the underlying stock, the sale of which caused A and D to pay taxes at the end of the year. A faces acceleration of part of the capital gains liability he was (hoping to continue) deferring into the future. D, on the other hand, pays tax on gain in which he never participated economically, which tax he would never have had to pay had he purchased stock directly.
As this example illustrates, investors in MFs face several potential tax issues that direct investors in stock or bonds do not face. Among them are the following.
•Redemptions by other shareholders can trigger realization of previously unrealized gains in the MF’s portfolio of securities. Although the direct investor must ultimately pay taxes on his portfolio’s appreciation (unless he holds his securities until death and his heirs receive a stepped-up basis via section 1014), he can control when to recognize such appreciation, thereby lowering the present value of the amount that he will eventually pay in taxes (even if not lowering the undiscounted amount of those taxes).
•Choices by MF’s managers regarding when to sell which portfolio shares cause MF shareholders to recognize gains for reasons not particular to the individual shareholder, whereas the direct investor recognizes gains only when he chooses to sell a position.
•Shareholders in MFs can, depending on when they purchase their shares, incur immediate tax liability for gains realized before they joined the MF. By comparison, a direct buyer of stock does not acquire tax liabilities belonging, in an economic sense, to other owners.
•MF shareholders can end up paying current taxes on economic gains at the MF level that are also currently taxed at the shareholder level to redeemed shareholders. The remaining shareholders pay taxes on the MF’s gains when those are distributed, and the redeemed shareholders pay taxes on those gains insofar as they are accounted for in the difference between the amount realized upon sale of their MF shares and their adjusted bases in those shares.
B. Proposal to Reverse the Bias of the Current Tax Regime
More fundamental reforms to our tax laws, including replacing the income base of our current tax regime with a consumption base or adopting a mark-to-market regime, could entirely eliminate these differences so that the after-tax economics of holding stocks or bonds directly would vary from those of holding them indirectly only insofar as brokerage fees varied from MF management fees. Less fundamental reforms made within the general framework of existing tax law—including exempting MF portfolio trades from capital gains taxation or deferring recognition of reinvested capital gains distributions—could ameliorate these differences but would likely not eliminate them entirely, given the idiosyncrasies of our current income-based tax system and that MFs, unlike regular issuers of stocks or bonds, function as collective intermediaries between securities markets and investors.
Although a complete policy study of the taxation of MF shareholders would analyze possible fundamental reforms—as well as more limited reforms—of our existing tax regime, only a subset of the latter is analyzed here. A primary aim of this Article is to consider those properties of MFs, of MF shareholders, and of the taxation of both that allow the tax burdens borne by MF shareholders to differ from those borne by direct holders of stocks or bonds. A second aim is to examine a few possible legislative and market-based reforms to the current tax system that could reduce this difference. The preferred reform involves moving the tax-relevant realization point from the MF level to the MF shareholder level so that MF shareholders are taxed only when they either sell their MF shares, receive dividend income distributions, or receive non-reinvested capital gains distributions from the MF. Under this proposal, MFs would trigger no tax liabilities when selling portfolio securities, and MF shareholders would not automatically face current tax liability upon receipt of gain distributions. The only realization events for MF investors would be the selling of their shares, the receipt of dividend distributions, and the receipt of capital gains distributions that they elect not to reinvest. As long as they only buy, hold, and reinvest capital gains distributions, MF shareholders would be deemed not to have had any realization events with respect to their MF investments other than the receipt of their pro rata share of the dividends paid to the MF with respect to its portfolio securities.
Before discussing this proposal, this Article considers some details of the MF industry, the basic tax treatment of MFs and MF shareholders, and various externalities (positive and negative) made possible by the current tax treatment. A proposed solution for attenuating those externalities is then compared with other possible solutions, ranging from changes in the tax laws (no current tax due if MF shareholder reinvests capital gains distributions in shares of distributing MF) to market-based solutions (improved disclosure, redemption penalties, in-kind redemption policies, and exchange-traded funds).Although the proposed solution is imperfect (for example, it introduces certain inequities in the process of eliminating others), it largely eliminates the tax externalities involved in owning MF shares and thus better aligns the tax treatment of MF shareholders with that of direct owners of stocks or bonds.