05/04/2009 02:39:25 PM EST
The Saga of the Reserve Primary Fund and Its Tax Consequences
The Reserve Primary Fund had a reputation as a safe, conservative investment vehicle. Thus it sent a shock wave when on September 12, 2008, its value declined from one dollar to 97 cents; no money market fund had done this in the last 14 years. The authors provide background and analyze the tax consequences of these losses, including what they see as the correct tax treatment.
The authors write: The Reserve Primary Fund (hereafter referred to as RPF) had a reputation as a safe, conservative investment vehicle; it was, in fact, the first money market fund.
The Reserve had relationships with many of the nation's leading corporations, endowments, pensions, municipalities and hedge funds, including over 400 financial services firms and over 30% of the Fortune 100 companies. At the close of business on Friday September 12, the holding report of RPF listed assets of $62.5 billion; 5 billion shares alone were owned by the government of . Thus it was a shock when, at 4pm EDT Tuesday, September 17, the RPF per share value broke the buck by declining in value from one dollar to 97 cents; no money market fund had done this in the last 14 years This drop was a result of writing down to zero approximately 785 million dollars in commercial paper and floating rate loans of Lehman Brothers which had declared bankruptcy.
These losses must certainly be tax deductible, but the actual tax saving to investors will depend critically on what method will be permitted in deducting these losses. Moreover, we point out that the loss will not be deductible in any matter until it is realized, which is when RPF is fully liquidated and all the funds have been paid to the investors. We analyze three possible scenarios the last of which we see as the correct approach.
(1) Perhaps the most pragmatic method might be to offset the loss against the income earned with respect to the fund. Using this argument, a deduction in the amount of the loss would arguably be deducted directly from gross income. However, in Rev. Rul. 73-511 the IRS addressed this netting approach in an analogous situation in connection with offsetting interest received on a CD with the penalty paid on early withdrawal of the account balance.
(2) The second approach is to take a deduction under IRC section 165 (26 USCS § 165) which allows losses to be deducted if the loss arises from a transaction entered into for profit which clearly this would be. The important question is whether the loss would be an ordinary or a capital loss. There is an adverse consequence to each of these treatments.
(3) The most technically defensive method is to treat the loss as a non-business bad debt under IRC section 166. In fact this approach, in the opinion of the authors, is the only correct treatment. This obtains from the debtor-creditor relationship between the taxpayer-creditor and the issuer of the shares evidencing the deposit-claim. 7 As indicated in 2 above, IRC section 166 (26 USCS § 166) requires this loss to be treated, by individual taxpayers, as the sale or exchange of a capital asset held for less than one year( i.e. a short term capital loss). As such, the deduction claimed by an individual taxpayer is limited to capital gains plus an extra deduction limited, however to $3,000 per year. The loss to a corporation is limited to capital gain with no extra $3,000. An individual taxpayer is allowed to carry over, to succeeding tax years, any unused loss. Corporations are generally allowed to carry back, to the 3 preceding years, any unused capital loss and then carry any remaining balance over to succeeding years.
Generating capital gains by selling other capital assets, such as stocks or bonds, to be offset against this capital loss is often advanced as a wise tax planning technique. This however is not prudent if the capital gains are long term and therefore subject to the lower capital gains rates.
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