Investment Company Taxation
Understanding how investment companies are taxed—and how that taxation flows through to shareholders—is essential for the Series 7 exam.
Conduit (Pipeline) Theory
Most mutual funds qualify as Regulated Investment Companies (RICs) under IRC Subchapter M. This provides conduit treatment:
The 90% Distribution Requirement
To avoid taxation at the fund level, a fund must distribute at least 90% of its net investment income to shareholders:
| Scenario | Tax Treatment |
|---|---|
| Distributes 90%+ | Fund pays no federal income tax |
| Distributes less than 90% | Fund taxed on 100% of income |
This prevents triple taxation (corporate level → fund level → shareholder level).
Types of Distributions
Dividend Distributions
- From interest and dividends received by the fund
- Taxed as ordinary income to shareholders
- Qualified dividends may receive preferential rates
Capital Gains Distributions
- From fund's net realized capital gains
- Taxed as long-term capital gains regardless of:
- How long shareholder owned fund shares
- When shareholder purchased shares
Important: Capital gains distributions are taxable even if automatically reinvested!
Return of Capital (Non-Taxable Distribution)
- Not from income or gains
- Reduces shareholder's cost basis
- Not immediately taxable
- Creates deferred tax liability
Tax Treatment Summary
| Distribution Type | Tax Treatment |
|---|---|
| Interest income | Ordinary income |
| Qualified dividends | Preferential rate (0%, 15%, 20%) |
| Non-qualified dividends | Ordinary income |
| Short-term capital gains | Ordinary income |
| Long-term capital gains | Preferential rate (0%, 15%, 20%) |
| Return of capital | Not taxable (reduces cost basis) |
Reinvestment at NAV
When shareholders reinvest distributions:
- Reinvestment occurs at Net Asset Value (no sales charge)
- New shares purchased equal to distribution amount ÷ NAV
- Distribution is still taxable even though reinvested
- Cost basis increases by amount reinvested
Example:
- Distribution: $500
- NAV at reinvestment: $25
- New shares: $500 ÷ $25 = 20 shares
- These 20 shares have cost basis of $25 each
Redemption Taxation
When shareholders sell (redeem) fund shares:
Calculating Gain or Loss
Gain/Loss = Sale Proceeds - Cost Basis
Cost Basis Methods
| Method | Description |
|---|---|
| FIFO (First In, First Out) | Oldest shares sold first (default) |
| Specific Identification | Choose which shares to sell |
| Average Cost | Average of all share costs |
Holding Period
| Holding Period | Tax Rate |
|---|---|
| One year or less | Short-term (ordinary income rates) |
| More than one year | Long-term (preferential rates) |
Tax-Exempt Funds
Municipal Bond Funds invest in tax-exempt securities:
- Interest distributions are federally tax-exempt
- May be state tax-exempt if fund invests in investor's home state
- Capital gains distributions are still taxable
Private Activity Bond (AMT) Funds
Some municipal bond funds invest in private activity bonds:
- Interest may be subject to Alternative Minimum Tax (AMT)
- Must disclose AMT exposure in prospectus
Important: Key Exam Point - Capital Gains Distributions Capital gains distributions are always taxed as LONG-TERM gains to shareholders, regardless of how long they've owned the fund shares. This is because the fund held the underlying securities for more than one year.
A mutual fund has total assets of $200 million, liabilities of $2 million, and 10 million shares outstanding. What is the NAV per share?
An investor places a mutual fund purchase order at 3:30 PM ET on Tuesday. At what price will the order execute?
Which of the following characteristics applies to a Unit Investment Trust (UIT)?
A fund has an NAV of $12.00 and a 4% front-end sales charge. What is the Public Offering Price (POP)?
What is the maximum total 12b-1 fee that can be charged by a mutual fund?
An investor has $48,000 invested in a fund. The $50,000 breakpoint offers 4.25% load. She invests an additional $5,000. Under rights of accumulation, what sales charge applies?
A closed-end fund has an NAV of $25.00 and is trading at $22.50. The fund is trading at:
Which type of fund is MOST likely to have the lowest expense ratio?
To qualify as a Regulated Investment Company and avoid taxation at the fund level, a mutual fund must distribute what percentage of its net investment income?
An investor purchased mutual fund shares 6 months ago. She receives a capital gains distribution from the fund. This distribution is taxed as:
When a mutual fund shareholder reinvests dividends, the reinvestment occurs at:
A customer signs a Letter of Intent (LOI) to reach a breakpoint. What is the maximum time period allowed to complete the investment?
Which share class would be MOST appropriate for an investor planning to hold a fund for 10+ years with a $100,000 investment?
What percentage of a mutual fund's board of directors must be independent (non-interested)?
An investor purchases shares of a municipal bond fund. Which of the following distributions would be TAXABLE?
Which of the following would be considered "breakpoint selling" and a FINRA violation?
6.1 Annuity Basics
Chapter 6: Variable Products & Annuities