Although this emergency stopgap measure by the Treasury Department helped prevent a catastrophic financial disaster, it was too late for the thousands of shareholders in the Reserve Primary Fund. Their fate was sealed with frozen funds priced at some amount below the buck. Now they await the disposition of their accounts some time in the future.
What else awaits them is a potential income tax liability that may be categorized as "phantom income tax." I have seen what I refer to as phantom income tax in the past, where a mutual fund has declared a capital gain, yet the investor's account has dropped in value during the year.
Unlike a money market fund, clients can recoup some of the taxes paid on the capital gain pass-through when they sell the mutual fund. Their cost basis increases with each capital gain provided they reinvest those dollars back into the same fund.
But a money market fund doesn't work the same way. I believe that because the Reserve Fund was the first money market fund to actually lose principal in modern memory, no real tax rules apply to the treatment of that loss.
As calls come in from clients and referrals who have money frozen in the Reserve Fund, I'm recommending that we interface with their accountants to have in place a strategy for how to account for and reduce this potential tax trap.
Based on conservative estimates and referring to the Reserve Fund's own Web site and press releases, an investor can currently assume a loss of principal of between 1% and 3%. That means when they receive a 1099 INT, they must account for it on their 2008 tax return. The reality is a return of all their principal without any realized interest is a distinct possibility. In essence, shareholders will have a loss--not a taxable gain.
The Treasury, the IRS and congress have a vested interest in not coming out with a detailed tax method to account for this loss: To do so could suggest other money markets might "break the buck," which could then have a cascading effect just when government officials are throwing the kitchen sink at the liquidity problem. Either way, shareholders should not be further penalized by a phantom tax on what by any definition should be considered a loss of principal.
After consulting numerous CPAs and a tax attorney, I believe affected shareholders should report the amount of interest income on schedule B, while simultaneously deducting that amount on schedule D as a short-term loss.
If shareholders of the Reserve Primary Fund receive more than we anticipate, then I would report that income in the year they receive it. To offset the potential confusion, taxpayers could attach IRS form 8082-- "notice of inconsistent treatment--or apply for a private letter ruling directly from the IRS.
Either way, shareholders who have been damaged by the Reserve Primary Money Market Fund should not have to suffer more when it comes to ambiguous tax reporting methods.
Richard P. Cross
American Premier Financial Group