myICLUB Blog

Under Internal Revenue Service rules, when a partnership transfers property (which includes securities in an investing partnership) to a fully-withdrawing partner, any capital gains that would have been realized in the transfer are deferred for remaining members until such time as those remaining partners fully withdraw from the partnership themselves.

Our my new myICLUB Deferred Capital Gains Report lists any of these capital gains which have been deferred as the result of securities transferred for full partner withdrawals.

This is a very cool feature of tax law that relates to investing partnerships and can have a huge benefit to remaining members after a partner leaves the club. Here's why.

When shares of a security are sold there are two important tax-related events. First, all partners will be allocated their share of the gain from the sale which will be reported on schedule K-1 for the tax year. Each partner will then be responsible to report and pay tax on this gain.

Second, all partners will also have their cost basis in the partnership increased by their share of the gain when the year-end allocation of income is processed. 

However, when appreciated shares of a security are transferred to a fully-withdrawing partner, the remaining partners benefit by getting to use the increased value of the securities to pay off the withdrawing member. However, the remaining partners do not get the cost basis increase they would get if the club had sold the appreciated shares. As a result, each remaining partner will have a cost basis when they fully withdraw that is lower -- by the amount of their share of club gains on transferred shares in past full withdrawals -- than if the club had sold the shares instead of transferring them. This will result in a higher capital gain on their investment in the club. In effect, remaining members defer gains on appreciated stock transferred that is used to pay a full withdrawal until they fully withdraw from the club.

To be sure, when shares of a security are transferred to a fully-withdrawing partners, capital gains are triggered just as if the club sold the securities. It's just that those gains are not realized at the time of the transfer by the partners still in the club, but are postponed.

Why Not Just Sell the Shares?

In the case of a full member withdrawal, the club could simply sell shares. However, this would cause the capital gains to be immediately realized -- when the club prepares its tax return and Schedule K-1s after year-end, remaining members will then receive their share of any capital gains which in turn would be reported on their personal tax returns.

If shares are transferred instead, the amount of capital gains remains the same as if the shares were sold, but the gains are not passed through to remaining members right away, and are kept on the books in myICLUB and can be viewed on the myICLUB Deferred Capital Gains Report. Later, when each member withdraws, they will be allocated their share of the gains from that withdrawal.

This delay of the realization of capital gains to a later date (which could be years in the future) provides a meaningful tool for portfolio management as well as for reducing the club's exposure to highly-appreciated or over-weighted positions. Often, a club will resist selling overvalued securities because the members don't want to incur the capital gains and resulting taxes. By transferring the shares, the club could trim an overweighted position

Is the Withdrawing Partner Liable for Capital Gains Taxes on the Transferred Shares?

For fully-departing members, the value of their withdrawal is the same and their eventual tax burden is the same whether or not they receive cash or securities -- at least at the time of their withdrawal. However, if they receive shares of securities, the withdrawn member can control when they trigger the realization of gains by holding on to the shares and selling at a later date.
In withdrawals that receive shares of securities, the tax basis of those securities is adjusted according to the member's tax basis in the investment club. In other words, the original tax basis of the shares sticks with the remaining members, and the withdrawing partner has a new basis reflecting how much they paid into the club.

The holding period of the transferred shares remains the same, so the acquisition date of the shares sticks with the shares when they get passed to the partner. Importantly, though, the member now controls when capital gains might get triggered on the transferred shares. If they hold onto those same shares for 20 years, in effect their club investment wouldn't trigger capital gains taxes until 20 years after they leave the club!

Of course, if the market turns south or the stock takes a dive after the member receives the transferred shares, any gains could turn into capital losses. If the member were to sell transferred shares as soon as they were received, the taxable impact is much the same as if they had received cash. The slight inconvenience of coping with transferred security shares is often far outweighed by the practical advantages of accepting shares instead of cash.

A Few Final Notes

IRS rules for partial withdrawals are not the same as for full withdrawals. For partial withdrawals, a partner receiving stock has the same cost basis in the stock as the club. When a partner takes a partial withdrawal, they first receive the monies they invested in the club -- a return of their capital. Only if their partial withdrawals exceed their paid-in-plus-earnings (PIPE) does the withdrawal become a taxable event. As a result, there is usually no tax benefit from transferring shares to a partially withdrawing member.

Check Out the Deferred Gains Report

From your club's myICLUB website, you will find the Deferred Gains Report in the Members section of the Reports tab. If you have never transferred securities to a departing member, then there will be no gains to show on this report. Only those who were members at the time that a full withdrawal with securities was processed will be shown on the report, as members who have since withdrawn have taken their deferred capital gains with them.