When thinking about a member withdrawal, a club will often consider transferring stock, to avoid large capital gains suddenly showing up for remaining club members. This can lead to the question of what happens to the cost of the stock for the member, and how are their capital gains calculated.
In a partial withdrawal, the cost basis of the stock remains unchanged when transferred from the club to a member; whatever the cost basis of the stock when it’s held by the club becomes the cost basis when transferred to the member. Depending on the performance of the stock, this could mean a significant amount of capital gains when the member does eventually sell the stock.
On a full withdrawal though, the cost basis of transferred stocks can be adjusted. Any adjustment is based on the member’s basis at the time of their withdrawal, and the potential gain or loss to the club based on the difference between the Fair Market Value of the stock(s), and the club’s basis. Included below is a spreadsheet that shows two easier examples where:
Depending on the size of your computer screen, you may need to scroll within the spreadsheet to see all of the information. Alternately, you can also view a page with just the spreadsheet in a new window or tab, by clicking here ( https://docs.google.com/spreadsheets/d/1ZO5EE_pIhYGfoKEmif52Y0jm0yfR6hIS9g1xXen2D4E/edit?usp=sharing ).
NOTE: In the spreadsheet, FMV is used as short-hand for Fair Market Value.
What you will notice is that in cases where the member’s basis would be higher than the club’s basis, the member takes the full cost of securities that the club would sell at a loss, and a percentage of the cost if the security would be sold at a gain.
If the member’s basis would be lower than the club’s, the situation is reversed; the member takes the club’s basis where there would be a gain, but only a percentage of the basis if there would be a loss on the sale.
In cases where multiple members are taking stock as part of a withdrawal, and the club has multiple blocks to choose from, you might run into a question of what is a fair / balanced distribution of the blocks of stock, given that each one has its own cost basis. If this comes up, keep in mind that the stock cost basis for each member is adjusted based on their basis in the club. As an example:
Imagine two members who each have a cost basis of $10,000 in the club. Each receives only stock for their withdrawal.
Member A receives blocks of stock whose cost basis to the club is ZERO.
Member B receives blocks of stock whose total cost basis to the club is $8,000.
Despite this difference, each member would end up with a total cost basis of $10,000 for the stocks received, as that was their cost basis in the club. When it comes to the cost basis, the only difference is how much of an adjustment the system makes to ensure that the stock cost basis matches the member's cost basis once the withdrawal is completed.
It's also worth keeping in mind that while the cost basis is adjusted, the term is not. If one of the blocks transferred to a member was originaly bought in 2011, then regardless of when the member sells that block, the type of gain (short or long term) will be determined by the original purchase date, even though the amount of the gain will be calculated from the cost basis printed on the member withdrawal report.
For a more in-depth explanation of how the cost basis is adjusted, please see the Partner's Basis for Distributed Property section of IRS publication 541, at https://www.irs.gov/publications/p541
In publication 541, it is also important to note that securities are described as property. This is because the securities are held by the investment club, and the IRS treats clubs as Investment partnerships, and not business partnerships (where they could be treated as as cash). This is a key piece of why the cost basis can be adjusted. This is also why you might receive different information on how cost basis is handled when contacting the support department at your broker. The broker will often default to assuming that the stock transfer is handled as a transfer from member to member, or from a business partnership. If necessary, you may want to keep a copy of the linked pages of publication 541 for reference.
With this in mind, an important part of the cash and stock withdrawal process is keeping track of this adjusted basis. Depending on which broker you have, they may or may not do this for you. Depending on the broker, this may be the only representation of the change in cost basis when the stock is transferred. Similar to the cost basis section of the club tax printer, members also need to fill in cost basis figures when selling shares of stock. From our company president, Doug Gerlach:
The IRS doesn’t expect that brokers always know the cost basis of shares that are sold. That’s why there’s a form for individuals to file with their taxes that reports any discrepancies between the broker-reported and the individual-reported cost basis. Members would use the cost basis provided with their club withdrawal report, and be sure to enter that at tax time and NOT use the broker-reported number. The IRS will accept the user’s basis.
Again, we cannot stress enough the importance of keeping a printed copy of the withdrawal report generated from the club accounting system, so that individual tax forms can be filled out correctly when the stocks are sold.