Tax equalization is one of the most tax-efficient strategies available to a regulated investment company (RIC). The strategy can reduce or even potentially eliminate a capital gain distribution requirement for your fund and your shareholders — yet not everyone uses it.
While there are uncertainties associated with calculating tax equalization, it is a valid tax planning tool fund managers should consider as part of their overall tax strategy. Below is a Q&A to help you better understand tax equalization, and if it may be right for your fund.
If an entity qualifies as a RIC for tax purposes, it is allowed a deduction for dividends paid to its shareholders. The tax code says, except in the case of a personal holding company, a dividends paid deduction is allowed with respect to amounts distributed in complete or partial liquidation to the extent a portion of the distribution is out of accumulated and undistributed earnings and profits. The code further says a liquidation includes a redemption of stock, and the amount chargeable to accumulated earnings and profits upon redemption of stock is referred to as tax equalization.
Yes. Tax equalization is a complicated concept, but we can illustrate it with a simple example.
Let's say a shareholder purchased shares in a RIC when they were originally issued at $10 per share. Over the course of the next few months, the fund has earnings of $2 per share, which includes both net investment income and any realized gains during that period. Let’s assume that now the net asset value of the fund shares is $12 per share.
At that point, if a shareholder redeems their shares, they will receive $12 per share, which includes $10 of original paid-in capital and $2 of undistributed accumulated earnings. That $2 paid to the shareholders is considered to have been distributed out of accumulated earnings, which is then referred to as tax equalization. And the fund can then take a dividends paid deduction for those $2.
A redeeming shareholder’s treatment of the redemption is not impacted when the fund takes a deduction for dividends paid based on equalization calculations. Therefore, the redeeming shareholder receives the same information about the redemption proceeds on Form 1099-B.
So, even though the shareholder has some capital gain on which they'll have to pay tax when they redeem from the fund, that fund can use a portion of the distribution as part of their dividends paid deduction and thereby reduce their distribution requirement.
This is certainly not a new concept, and equalization has been around for decades. But the reason more funds are using it now is twofold. One, there's explosive growth in exchange-traded funds (ETFs). ETFs have always focused on tax efficiency, and tax equalization is an important tool for achieving tax efficiency. A RIC that is not an ETF (i.e. a mutual fund) may not want to make capital gain distributions, keeping them more in line with their ETF counterparts from a tax efficiency perspective.
Secondly, we are seeing equalization more because of market conditions. Volatile markets often result in some significant shareholder redemption requests. RICs may need to sell shares of securities they own at significant gains to fund redemption requests, resulting in potential capital gain distributions to remaining shareholders. Equalization allows RICs to reduce the amount of those capital gain distributions.
There are both real and perceived risks, either of which can deter funds from using the approach. While the concept of tax equalization is established in tax law, there is some uncertainty associated with how RICs calculate the accumulated earnings and profits with respect to shares redeemed. Because of this uncertainty, along with lack of guidance from the IRS, the methodology of calculating equalization may vary from one fund complex to another.
Many fund complexes calculate equalization debits based on daily gross redemptions. There are some funds that perform these calculations on a weekly or even monthly basis. Others calculate using daily earnings. Since mutual funds are typically in a position to determine their actual earnings on a daily basis (because of daily net asset value calculations), prorating such earnings over the period is likely not a best practice.
Another big difference is in the area of book tax differences and how they are reflected in the calculation of accumulated earnings and profits. It is virtually impossible to generalize when all the book tax differences should be reflected in the daily calculation of earnings and profits. However, the book-tax differences, when they occur, will dictate as to when they should be included. For example, wash sales should be reflected when they actually occur.
Another area where funds would vary in their practice is how much of a haircut they take after they calculate the available equalization amount. Some funds take a 10% haircut; some funds take as much as 20%; and there are some funds that want to maximize their equalization amount, so, they take no haircut.
First, remember the calculation is based on accumulated earnings and profits. That means any net operating losses and capital loss carry forwards from prior years must be taken into consideration before you can establish an earnings pool for calculating equalization.
Second, funds can use equalization both for regular subchapter M distribution purposes as well as for excise tax distribution purposes.
There are clearly many differences in how tax equalization is calculated. When funds are using equalization, especially when they are setting it up for the first time, there are several conversations that need to happen between fund management, their tax advisers and the administrator so management can determine the appropriate methodology for the fund. Once a fund decides on a methodology, it is important to be consistent year-over-year in that approach, and to document the fund’s methodology.
There are several methodologies available and little guidance from the IRS, but it’s an incredible benefit available to funds and their shareholders. Particularly, in today’s market conditions, funds looking at very large capital gain distributions and significant redemption requests should consider tax equalization.
Contact Jay Laurila, Ravi Singh or a member of your service team to discuss this topic further.
Cohen & Co is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.