STRATEGY LOWERS CAPITAL GAINS: FUNDS EYE PLOY TO CUT TAX BILL ON PAYOUTS

An obscure tax strategy that is sure to appeal to tax-sensitive investors is capturing more attention from mutual fund firms that want to suppress capital gains in their portfolios.

In what is dubbed “equalization accounting,” fund managers subtract a portion of the redemptions they incur each year from the capital gains they must pay out to their shareholders at the end of the year. Industry lawyers and accountants say the method is a perfectly legal way to help investors reduce their taxes.

But the strategy is employed sparingly, industry insiders say, because there are almost no guidelines from the Internal Revenue Service about how to calculate the capital gains.

“(Equalization) is a good thing,” says David Mangefrida, tax partner in the Washington office of Ernst & Young LLP. “My own personal point of view is more funds ought to do it, but they’re scared of the complexity and the uncertainty surrounding it.”

Just a month ago, Donald A. Yacktman’s namesake fund – racked by redemptions and poor performance – was preparing to distribute a gigantic 25% of its net asset value as capital gains to its shareholders. But when Mr. Yacktman regained control in a bruising proxy battle with the fund’s independent directors, he had his accountant use this equalization method to knock the distribution down to the 15%-to-19% level – still hefty, but not outrageous.

Sound like magic?

While “equalization accounting” is simple to understand, the calculations are not easy to do. Many accountants recommend that funds compile records of their daily inflows and outflows to ensure accuracy. And at times, the exercise – which can be costly, given accountants’ fees and the time needed to input data – yields little or no benefit to shareholders.

“To me, it’s sort of the silver bullet for tax efficiency,” says Duncan Richardson, manager of the $3.5 billion Eaton Vance Tax-Managed Growth Fund, an actively managed portfolio that tries to hold down taxes. “You have to envision a nightmarish scenario like Mr. Yacktman’s” before you use it.

Meanwhile, there’s an industry perception of IRS unease with the maneuver, and several fund executives declined to speak on the record about the issue for fear of inciting the agency to clamp down.

An IRS official declined comment on the service’s position.

“I think the reason (funds) don’t use it routinely is there are no clear IRS rules as to when you can do it and how the calculations are figured,” says David Sturms, a lawyer who specializes in mutual funds with Vedder Price Kaufman & Kammholz in Chicago.

Method flawed, IRS admits

A 12-year-old IRS memorandum is the only meaningful guidance on the issue, and even the agency acknowledges the document’s recommended method for calculating the redemption deductions is flawed. In the early 1990s, the IRS informally floated the idea of limiting the practice to “shrinking funds” – those funds whose shareholder base was contracting – but the concept died.

The issue now seems dormant, and industry lawyers and accountants largely want to keep it that way. Nevertheless, funds are reluctant to act out of fear the IRS could threaten their tax-exempt status if it determines they’ve taken too large of a deduction. (While their shareholders pay taxes, mutual funds don’t.)

“There’s too much risk in using active equalization, given the IRS stance,” says an executive at one of the nation’s largest mutual fund complexes who requested anonymity.

For now, distressed funds like Mr. Yacktman’s seem to be the main ones using the method. But Ernst & Young’s Mr. Mangefrida argues that it also could help shareholders in volatile funds that generate a lot of gains and shareholder turnover, but whose assets are growing.

redeeming feature

The case is perhaps even more compelling in a shrinking fund situation, where a smaller shareholder base would otherwise be saddled with all the gains generated from the fund’s trading activities, when at least part of those gains were attributable to investors who bolted.

Like all accounting devices, equalization can be employed aggressively or conservatively.

A conservative use would take into account only net redemptions – that is, withdrawals that exceed new money coming into the fund. An aggressive strategy, which few accountants would recommend, might deduct gross redemptions from a fund’s gains, which arguably could be allowed under the tax code, given the lack of IRS guidance, some accountants say.

Still, despite the IRS’s campaign to appear kinder and gentler, most funds would rather play it safe.

“Nobody likes the idea that the IRS can come back (to a fund) and say, `You’re underdistributed by $48 million over the last three years,’ ” Mr. Mangefrida says.