How to apply gains from a stocks sold to fund a withdrawal to the departing member

Issue:

How can we make a withdrawing member share in the recognized gains from sales of stocks to fund her withdrawal?

Cause:

A problem arises when a member announces her intention to withdraw from the club. The club enters the withdrawal on the date specified by the partnership agreement, then sells stock to fund the withdrawal. After all the entries have been made, the club is surprised, sometimes outraged, to see that none of the gains on these sales have been allocated to the member whose withdrawal made the sale necessary.

Resolution:

The solution is to fund the withdrawals with transfers of appreciated securities, as described in Use appreciated stock to fund member withdrawals

Unfortunately, by the time the problem is noticed, it may be too late to use this solution. Some treasurers try to ameliorate the effects of this problem by 'adjusting' the books so that a portion of the gains on those sales are allocated to the withdrawing member. This can be done by carefully following certain steps. First, print out the withdrawal statement as originally entered. Then, enter the stock sales. Delete the original withdrawal entry and reenter it, using a date after the date the stocks were sold. Be sure to make the amount paid come out to the original amount by adjusting the withdrawal fees up or down. The withdrawal report will now show that the withdrawing member has now been allocated a portion of the gains on the stock sold to fund her withdrawal. We make no statement as to the legitimacy or advisability of this method. However, this practice has caused a great deal of controversy in clubs, and some outgoing members are incensed because they feel they have been treated unfairly. They have not. THERE IS ABSOLUTELY NO DIFFERENCE IN THE AMOUNT OF THE GAINS THEY WILL BE REPORTING, WHETHER OR NOT THE GAINS FROM SUCH SALES ARE ALLOCATED TO THEM. For this reason, we feel compelled to comment on the consequences of this method, without endorsing or condemning the process.

Let's take an example. Assume that Betty Smith has announced her intent to withdraw. According to the partnership agreement, her account will be valued as of 2/15, and she will be paid shortly after that. In the ordinary course of events, the club will enter a withdrawal as of 2/16, sell stocks as soon as possible after 2/15 and pay Betty off. Let's assume that her withdrawal statement says that she is to be paid $6,500, that her basis for the interest in the club is $5,000, and that she will have to recognize a gain of $1,500 for the disposal of her partnership interest. Ok, on 2/17 the club sells a stock for $4,500 and realizes a capital gain of $2,000 on that sale. Since a withdrawal has been entered for Betty as of 2/16, none of that gain will be allocated to her. The wily treasurer says, 'I can fix that'. She deletes Betty's withdrawal as of 2/16, and enters another as of 2/20. This time the software says that Betty should be paid $6,650 instead of $5,000, so the treasurer enters a withdrawal fee of $150 to force the check amount to come to the same figure as before [$6,500]. Now the withdrawal statement shows that Betty will be allocated $200 of the gain on the sale of stock. But the withdrawal statement also shows that the $200 gain has been added to her basis, so that now she has a gain on withdrawing from the club of $1,300, whereas before, she had a gain of $1,500. So she will report a k-1 gain of $200 and a gain on disposal of her club interest of $1,300. $200 plus $1,300 equals $1,500, which is exactly the gain she would have reported with the previous withdrawal statement. The difference is that now the remaining members have $200 less to report as a consequence of the withdrawal.

That $200 will be reported by those members as they leave the club, but recognition can be delayed until that time. So, what has been the result? The withdrawing partner has no complaint. Her cash proceeds and reportable gain are exactly as they were before. The remaining members are better off, because they have delayed the recognition of taxable income.