Investment Clubs; Avoiding Probate; and S Corporations with Cancellation of Indebtedness Income

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper,  June 28, 1998

Copyright 1998 Robert L. Sommers, all rights reserved.

Question: We want to start an investment club, but what about the taxes?

Answer: Your club may be organized with separate shares for each member or with a pooling of funds. Separate shares are easier for taxes and accounting. Each member opens a brokerage account and invests according to the club’s recommendations. Since the brokerage account is owned by the member, gains and losses are reported on each member’s return. Also, a member may invest as much or as little as he chooses and can quit the club at any time without disruption to the club’s finances. The separate account method works well for small groups.

The other method involves forming a partnership or limited liability company which elects to be taxed as a partnership. A written agreement controls members’ obligations to make contributions and rights to distributions. A tax return is filed annually and the members receive K-1 forms describing their shares of income, gain and losses from the entity. The accounting may become complicated if investors join at different times or contribute dues sporadically. Special accounting software developed by the National Association of Investors Corporation ("NAIC") is available.

For additional information on starting an investment club, check out Wild Capital Investment Club (http://www.computerland.net/~missouri/starting_club.htm.) and NAIC’s homepage (http://www.better-investing.org/index.html).


Question: Your recent column stated that an IRA was part of the decedent’s estate for tax purposes. I thought estate taxes applied only to the decedent’s probate estate. Should I place my IRA in a revocable trust?

Answer: No. If you transfer your IRA to a trust, the IRA becomes immediately taxable (as a distribution) to you. You may name your trust as beneficiary of an IRA to ensure that it is distributed according to your trust provisions. Note: Because your IRA is not subject to probate in the first place, naming your trust as beneficiary will not help to avoid probate.

The term "estate" has different meanings. An estate for tax purposes includes all property owned or controlled by the decedent, whether or not the property is part of the decedent’s probate estate. Probate is a court proceeding that is used when a decedent leaves property by a will or dies intestate (without a will).

Several asset-ownership methods bypass probate: jointly-held property, contracts naming a beneficiary (insurance policies, annuities, IRAs and retirement plans) pay-on-death bank accounts, life estates and assets owned by trusts. Also, community property assets left to a surviving spouse generally avoid probate. However, these assets (including 50% of a decedent’s community property interest) are counted for estate tax purposes.

Nevertheless, it is important to have a will to distribute those assets otherwise subject to probate. Note: If your estate is worth $100,000 or less, your property may avoid probate under California’s small estates procedure. This procedure is available when a decedent dies with a will or intestate.

Remember: Federal estate taxes apply to your assets, whether they by-pass, or are subject to, probate. Currently, your Unified Estate and Gift Tax Credit is worth $625,000, less any amounts previous applied to gifts. The Unified Credit will gradually increase to $1,000,000 by 2006. California does not impose a separate estate tax.


Question: I’m a 20% owner of an S corporation. If a corporation’s creditor forgives a $100,000 debt, do I have income of $20,000?

Answer: Yes. Unless the corporation was insolvent, you have cancellation of indebtedness ("COD") income since S corporation income flows through to the shareholders. In contrast, a regular corporation ("C" corporation) is a separate tax entity; it pays tax on COD income.

However, if the S corporation was insolvent immediately before the debt was forgiven, then it excludes the COD income at the corporate level; consequently, there is no income to flow to you.

In general, an insolvent S corporation must reduce certain tax attributes (net operating losses, capital loss carryforwards, and the basis in its assets) by the amount of income forgiven. These reductions may cause the corporation to realize gain in the future. For example, if a corporation’s sole asset has a fair market value and adjusted basis of $500 and it excludes $500 of COD income, it must reduce the asset’s basis to zero. A later sale of the asset for $500 will produce a gain of $500 ($500 - $0 = $500). Without the basis reduction, there is no gain on the sale ($500 - $500 = $0).




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**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**