Fund Gains Aren’t All They Seem
Mutual fund investors are notorious for ignoring the fine print.
And if people don’t read prospectuses before investing--and evidence shows that most don’t--there is no reason to believe they’ll pay attention to mutual fund tax paperwork, either.
This year, according to the Internal Revenue Service, that could be costly.
IRS officials say their computer record-matching program should catch up this time with thousands of fund investors who for years have probably been getting away with making what could be called either a common tax-reporting error or a little bit of chicanery.
It’s a complex story with all kinds of regulatory twists and turns, but the lesson for fund investors should be clear from the start: Don’t assume.
The problem involves short-term capital gains, loosely defined as the profit a mutual fund earns on quick trades.
Typically, capital gains are treated differently from dividend income. Dividends and interest income are taxed at an investor’s regular tax rate--often 31% or more at the margin--whereas capital gains are taxed at a lower rate.
In addition, any losses can be used to reduce gains for tax purposes.
Except when it comes to mutual funds.
For reasons far too intricate and boring to explain here, short-term capital gains earned by your fund are “ordinary dividends” to Uncle Sam. Kiss off the tax savings.
This has confused investors for years. When a fund group sends year-end statements to investors, it lists the fund’s dividends/interest income, short-term gains and long-term gains. The funds do this, they say, to meet regulatory requirements.
When the fund later sends its 1099-DIV forms, it lists just dividends/income--now including the short-term capital gains--and “capital gains,” actually a misnomer, since it excludes the quick-hit profits. Funds do this in accordance with IRS rules, as that agency gets a copy of the paperwork.
Everything gets explained in the fine print--which no one reads.
The double reporting standards have left investors and tax preparers weaving around the rules, often from confusion, but sometimes with a sense that the IRS wouldn’t catch on.
In filing tax forms, some investors have been using the annual statement instead of relying solely on the 1099-DIV. They pull out the short-term gains number, carry it over to where they lump the rest of the capital gains and file for their tax benefits.
What is interesting is that the bean counters at fund companies are quick to acknowledge that the short-term gains number is pretty useless. It has benefit in some extremely rare situations--which could be learned by a phone call to the fund group--and to people who want to try cheating on their taxes. It’s a liability to people who don’t read the paperwork--and are about to get snagged for their carelessness.
“People have a piece of information, and they certainly can choose to use that information incorrectly,” says Michael Klein, tax manager at Fidelity Investments. “We try to educate investors as best we can--I think the whole industry does. We don’t control what they do with that information. It would be easier on everyone if we didn’t have to give out the information the way it is now, but we don’t have that choice now.”
The whole gains-reporting situation is particularly important with regard to 1995 tax forms because many funds racked up fast gains last year, inflating quick-hit profits passed to investors. Hold your breath and let’s look at some numbers:
Let’s say a mutual fund shareholder received, according to the annual statement, dividends of $100, short-term capital gains of $200 and long-term gains of $300.
The fund’s corresponding tax paperwork would show dividends of $300 and capital gains of $300. The shareholder trying incorrectly to realize short-term gains would file a tax return showing $100 in dividends and $500 in gains.
IRS officials say this would be caught in a flash during an audit but that, until now, the computer matching system wasn’t very good at catching that particular trick.
When 1995 returns finally roll into the “automated under-reporting system”--sometime in 1998--”it would appear that this would be pretty routine for us to find,” says one IRS computer guru. “We’re onto it.”
Congress has not shown any inclination to fix the reporting requirements. The next best solution would be for funds to remove short-term gains from annual statements, although currently such an action could violate federal securities law.
However, Janus Funds stopped reporting short-term gains last year, issuing annual statements that match its 1099-DIV. Janus officials think there is a loophole in the rules that allows a fund to simplify its tax reporting this way.
Fund industry researchers can’t find another fund group that has followed suit.
For its trouble, Denver-based Janus has taken grief from shareholders who want short-term gains numbers. The firm also could be in trouble with the Securities and Exchange Commission.
“Whatever heat we catch is worth it if we can spare our shareholders that nasty letter from the IRS,” says Matt Luoma, Janus’ director of taxation. “If the IRS is really about to catch on to this, it’s important we make it easy for investors to file their returns without confusion and mistakes.”
No matter how it works out, we’re the ones who get to pay for it--hopefully without penalties and interest charges.
Says Ray Angelos, a tax auditor in the IRS Examination Division in Boston: “People will keep making this mistake so long as funds report the information this way. What has changed now is that we can almost guarantee that someone who doesn’t do it right this year is going to get a letter in the future.”
