Mutual Funds

<div class="Section1">Mutual funds with more than 50 percent of the value of their total assets invested in stock or securities of foreign corporations may elect to give the benefit of the foreign tax credit to their shareholders.<a href="#_ftn1" name="_ftnref1">¹</a></div><br /> <div class="Section1"><br /> <br /> When a mutual fund makes this election, each shareholder, in addition to reporting any ordinary income and capital gains dividends, includes in income his or her proportionate share of foreign taxes paid by the fund. Each shareholder then treats the proportionate share of foreign taxes paid by the mutual fund as if paid by the shareholder for which he or she may take a tax credit or an itemized deduction. (In calculating the credit or deduction, each shareholder treats his or her share of the foreign taxes and the amount of any dividends paid with respect to the foreign income of the fund as foreign income.)<a href="#_ftn2" name="_ftnref2">²</a> The shareholder may take the deduction or the credit, but not both.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> A mutual fund that makes this election must notify each shareholder of his or her share of the foreign taxes paid by the fund and the portion of the dividend that represents foreign income.<a href="#_ftn4" name="_ftnref4">⁴</a> The Service released regulations in 2007 that generally eliminate country-by-country reporting by a mutual fund to its shareholders of foreign source income that the mutual fund takes into account and foreign taxes that it pays. Accordingly, the regulations require that a mutual fund provide aggregate per-country information on a statement filed with its tax return, and require that only summary foreign income and foreign tax amounts be reported to the fund’s shareholders.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 853.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.  IRC § 853(b); Treas. Reg. § 1.853-2(b).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.  IRC § 275.<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.  IRC § 853(c); Treas. Reg. § 1.853-3(a).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.  Treas. Reg. §§ 1.853-3, 1.853-4; TD 9357, 72 Fed. Reg. 48551 (Aug. 24, 2007).<br /> <br /> </div>

<div class="Section1">A money market fund is a mutual fund generally seeking maximum current income and liquidity through investment in short-term money market instruments, such as Treasury bills, certificates of deposit, or commercial paper. Dividends are customarily declared daily, and automatically reinvested in additional shares, unless a distribution option is elected. Shares may be redeemed at any time.</div>

<div class="Section1">A closed-end fund holds a portfolio of investment assets, but does not ordinarily redeem shares at net asset value or sell new shares. Shares of the fund itself are actively traded on the secondary market.<div class="Section1"><br /> <br /> Although a closed-end fund is not actually a mutual fund, if the fund qualifies and makes the necessary election to be taxed as a regulated investment company (RIC), its shareholders will be taxed like shareholders of a mutual fund. <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7938">7938</a> through Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7951">7951</a> for details. If, on the other hand, the closed-end fund is established as a regular corporation, its shareholders will be taxed accordingly (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7501">7501</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7540">7540</a>).<br /> <br /> Because closed-end fund shares are traded in the open market or on an exchange and are not redeemed by the company, capital gain or loss on sale is based on the sale price and not on redemption price.<br /> <br /> <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7922">7922</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7935">7935</a> for a discussion of RICs and their tax treatment.<br /> <br /> </div></div><br />

<div class="Section1">Portfolio investment programs provide investors with the opportunity to use a sponsoring broker-dealer&rsquo;s website to &ldquo;create and manage portfolios of securities (&lsquo;baskets&rsquo;) based on each investor&rsquo;s individual needs and objectives.&rdquo; (Portfolio investment programs are frequently referred to as &ldquo;folios,&rdquo; the name of the initial sponsor&rsquo;s product.) However, unlike a mutual fund, &ldquo;the investor does not hold an undivided interest in a pool of securities; rather the investor is the direct beneficial owner of each of the securities included in the portfolio. Each investor has all of the rights of ownership with respect to such securities.&rdquo;<a href="#_ftn1" name="_ftnref1">¹</a>&nbsp;The SEC denied a request from the Investment Company Institute (ICI) to adopt a rule that would deem portfolio investment programs to be regulated as mutual funds.<a href="#_ftn2" name="_ftnref2">²</a><div class="Section1"><br /> <br /> Because investors in investment portfolio programs own the stocks directly, they are taxed on distributions and the sale of their shares in the same manner as stockholders. For the treatment of cash dividends, <em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7502">7502</a>.For the treatment of capital gain on the sale or exchange of stock, <em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7517">7517</a>. For the treatment of capital gains and losses, <em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="702">702</a>.<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; U.S. Securities and Exchange Commission, Letter in Response to Petition for Rulemaking from Investment Company Institute, (August&nbsp;23, 2001); Speech by Paul F. Roye (Director of Investment Management, U.S. Securities and Exchange Commission) to the American Law Institute - American Bar Association Conference on Investment Management Regulation, (October&nbsp;11, 2001).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; Letter in Response to Petition for Rulemaking from Investment Company Institute, above.<br /> <br /> </div></div><br />

<div class="Section1">Mutual funds may pay three kinds of dividends to their shareholders; generally, taxable dividends will be reported to the shareholder on Form&nbsp;1099-DIV.<div class="Section1"><br /> <br /> <em>Exempt interest dividends</em>. Some mutual funds invest in securities that pay interest exempt from federal income tax.&nbsp;This interest may be passed through to the fund&rsquo;s shareholders, retaining its tax-exempt status, provided at least 50 percent of the fund&rsquo;s assets consist of such tax-exempt securities.&nbsp;Thus, a shareholder does not include exempt-interest dividends in income.&nbsp;The mutual fund will send written notice to its shareholders advising them of the amount of any exempt-interest dividends.<a href="#_ftn1" name="_ftnref1">¹</a> Any person required to file a tax return must report the amount of tax-exempt interest received or accrued during the taxable year on that return.<a href="#_ftn2" name="_ftnref2">²</a> Under JGTRRA 2003, exempt-interest dividends do <em>not</em> count as <em>qualified dividend income</em> (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="702">702</a>) for purposes of the 20/15/0 percent tax rates.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&nbsp;852(b)(5).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect;&nbsp;6012(d).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; IRC &sect;&nbsp;1(h)(11)(B).<br /> <br /> </div></div><br />

<div class="Section1">The taxability of a dividend distribution is the same whether the distribution is in cash or portfolio stock or securities; thus, the distribution will be treated as an ordinary income dividend, exempt-interest dividend, or capital gains dividend, as the case may be (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7938">7938</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7940">7940</a>).&nbsp;The amount (if any) that the shareholder reports on the income tax return is the fair market value of the stocks or securities received as of the date of distribution.<a href="#_ftn1" name="_ftnref1">¹</a><div class="Section1"><br /> <br /> For temporary guidance regarding certain distributions declared on or after January&nbsp;1, 2008, and on or before December&nbsp;31, 2012, by publicly traded mutual funds when shareholders have the ability to elect to receive stock instead of cash, <em><em>see</em></em> the discussion of Revenue Procedure 2010-12 in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7977">7977</a>.<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&nbsp;301(b); <em><em>see</em></em> Rev. Rul. 57-421, 1957-2 CB 367.<br /> <br /> </div></div><br />

<div class="Section1">A mutual fund may declare but retain a capital gain dividend. If it does so, the mutual fund will notify its shareholders of the amount of the undistributed dividend and, prior to 2018, paid federal income tax on the undistributed amount at the corporate alternative capital gain rate, which was 35 percent. However, the corporate AMT was repealed for tax years beginning after 2017. For tax years beginning after 2017, the now-applicable 21 percent corporate tax rate applies.<a href="#_ftn1" name="_ftnref1">¹</a><div class="Section1"><br /> <br /> A shareholder who is notified of an undistributed capital gain dividend includes the amount of the dividend in income in the same manner as a normal capital gain dividend (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7938">7938</a>). However, the shareholder is also credited with having paid his or her share of the tax paid by the mutual fund on the undistributed amount; thus, on the shareholder&rsquo;s income tax return, the shareholder is treated as though he or she has made an advance payment of tax equal to 21 percent of the amount of the undistributed dividend reported.&nbsp;The shareholder reports the undistributed dividend and is credited with the payment of tax for the calendar year that includes the last day of the mutual fund&rsquo;s taxable year during which the dividend was declared.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> Generally, a shareholder who reports an undistributed capital gain dividend increases the tax basis in his or her shares of the mutual fund by the difference between the amount of the undistributed capital gain dividend and the tax deemed paid by the shareholder in respect of such shares.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="702">702</a> for the treatment of capital gains and losses.<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&sect;&nbsp;1201(a); 852(b)(3)(A).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect;&nbsp;852(b)(3)(D).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; IRC &sect;&nbsp;852(b)(3)(D)(iii);&nbsp;Treas. Reg. &sect;&nbsp;1.852-4(b)(2).<br /> <br /> </div></div><br />

<div class="Section1"><em>Editor&rsquo;s Note:</em>&nbsp;The 2017 tax reform legislation eliminated the corporate AMT for tax years beginning after 2017.<div class="Section1"><br /> <br /> The receipt of an exempt-interest dividend creates a tax preference to the extent that the dividend is derived from interest paid on certain private activity bonds issued after August&nbsp;7, 1986 (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="777">777</a>).<a href="#_ftn1" name="_ftnref1">¹</a> (The receipt of capital gain and ordinary income mutual fund dividends generally does not create tax preferences.) Also, mutual funds do pass through, and each shareholder must report a proportionate share of, the fund&rsquo;s own tax preference items.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> For an explanation of the alternative minimum tax, <em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="777">777</a>.<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&nbsp;57(a)(5)(B).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect;&nbsp;59(d).<br /> <br /> </div></div><br />

<div class="Section1">A distribution from a mutual fund that does not come from its earnings is a return of capital distribution (sometimes incorrectly referred to as a &ldquo;nontaxable dividend&rdquo; or &ldquo;tax-free dividend&rdquo;).&nbsp;These often occur when the fund is liquidating.&nbsp;The shareholder treats the return of capital as nontaxable to the extent of tax basis in the shares. Any excess over the shareholder&rsquo;s basis is treated as a capital gain, which will be long-term or short-term depending on how long the shareholder held the mutual fund shares with respect to which the distribution was made.&nbsp;The shareholder must also reduce tax basis (but not below zero) in those shares by the amount of the return of capital distribution.<a href="#_ftn1" name="_ftnref1">¹</a> <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="702">702</a> for the treatment of capital gain.<div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&nbsp;301(c); <em><em>See</em></em> Rev. Rul. 57-421, 1957-2 CB 367; IRS Pub. 550.<br /> <br /> </div></div><br />

<div class="Section1">A wash sale of mutual fund shares is taxed in the same manner as a wash sale of regular corporation stock or other securities (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7536">7536</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7539">7539</a>).<div class="Section1"><br /> <br /> However, when the double category method is used for determining basis and holding period, a wash sale of mutual fund shares from the &ldquo;one year or less&rdquo; category <em>after</em> acquisition of the replacement shares will result in the aggregate basis of the shares remaining in the &ldquo;one year or less&rdquo; category being increased by the amount of the loss that is disallowed.<a href="#_ftn1" name="_ftnref1">¹</a> When the single category method is used for determining basis, or when an average basis method is not used, the general wash sale tax basis rules apply.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; Treas. Reg. &sect;&nbsp;1.1012-1(e)(3)(iii)(d); IRC &sect;&nbsp;1091(d).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; Treas. Reg. &sect;&nbsp;1.1012-1(e)(4)(iv).<br /> <br /> </div></div><br />