TaxProf Blog

Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Thursday, August 28, 2014

Brunson: The Taxation of Mutual Funds

Samuel D. Brunson (Loyola-Chicago), The Taxation of RICs: Replicating Portfolio Investment or Eliminating Double Taxation?:

Mutual FundsMutual funds and other regulated investment companies currently occupy a central space in American households’ financial lives. Is spite of their near-ubiquity, though, regulated investment companies occupy a strange tax limbo as quasi-pass-through entities, neither fully taxable nor fully tax-transparent. To qualify for this quasi-pass-through status, regulated investment companies must, among other things, distribute the bulk of their income to shareholders annually.

The distribution requirement imposes costs on both regulated investment companies and on their shareholders. It is commonly framed as an attempt to make the economics of investing in regulated investment companies similar to the economics of making direct portfolio investments. History shows, though, that the distribution requirement finds its basis in marketing, and not in any tax policy consideration. If the distribution requirement benefited the shareholders, or benefitted the government, it would be worth the costs it imposes. But this article concludes that the complexity and expense are not.

When tax policymakers discard their flawed premise of attempting to replicate the tax treatment of direct portfolio investment, they can stop clumsily and partially attempting to recreate true pass-through taxation for regulated investment companies. Instead, they can reframe regulated investment company taxation in a way that imposes a single level of taxation while, at the same time, protects regulated investment companies from being transformed into a vehicle for tax deferral.

In this Article, I evaluate several ways the tax law could tax regulated investment companies and their shareholders while imposing only a single level of taxation and ensuring that shareholders have the liquidity with which to pay taxes. Ultimately, I find that the best model would defer exempt regulated investment companies from taxation. At the same time, it would defer taxing shareholders until they realized income or gain. It would make up for that deferral by imposing an interest charge on the gain. For shareholders who wanted to avoid this interest regime, it would also allow for a mark-to-market election.

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Interesting this comes out now in lite of the Vanguard situation and the allegation of tax fraud on its mutual fund products.

Posted by: Dennis | Aug 29, 2014 6:29:40 AM