Are reinvested mutual-fund dividends and capital-gain distributions taxable when the investor later sells the fund shares at a loss?

Plain-English summary

Manuel Vigil owed New Mexico personal income tax on mutual-fund dividend and capital-gain distributions that were credited to his account and automatically reinvested. His later $23,000 loss on the fund shares did not cancel the tax on the earlier distributions.

Vigil was a New Mexico resident in 2002. Charles Schwab issued him a Form 1099 reporting distributions from two mutual funds. Under his agreement with Schwab, the distributions were used to buy more shares rather than paid to him in cash.

Vigil omitted the distributions from his federal and New Mexico returns. After the IRS assessed additional federal tax, the Department assessed additional New Mexico personal income tax, penalty, and interest.

Mutual funds pass income through to shareholders

The decision explained that a mutual fund, or regulated investment company, generally operates as a pass-through entity. When it meets the distribution requirement described in Sections 851 and 852 of the Internal Revenue Code, the fund does not pay tax on the distributed dividend and capital-gain income. Its shareholders report their proportional shares instead.

Vigil's Form 1099 identified the income attributable to investments held by the two Schwab funds. As a shareholder, he had to report that income.

A later loss did not erase earlier distributions

The fall in the funds' overall value was a separate event from the distributions. The hearing officer compared it to receiving a dividend on stock and later selling the stock at a loss: the sale loss does not eliminate the tax on the earlier dividend.

Vigil's $23,000 loss on his eventual sale of the mutual-fund shares therefore did not relieve him of tax on the distributions received during 2002.

Reinvestment was constructive receipt

Federal Regulation 1.451-2(a) treats income as constructively received when it is credited to a taxpayer's account or otherwise made available, unless the taxpayer's control is substantially limited.

The Form 1099 established that Vigil's share of income was credited to his Schwab account. At his direction, the money bought additional fund shares and increased his holdings. His voluntary reinvestment choice was not a restriction on access to the money and did not prevent the distributions from being taxable income.

Result: protest DENIED. The 2002 distributions were subject to New Mexico personal income tax.

What this means for you

Mutual-fund investors

Reinvesting a distribution does not usually make it disappear for income-tax purposes. A distribution can be taxable even when no cash reaches your bank account.

Investors with an overall loss

Keep the distribution and later sale as separate tax events. A loss when shares are sold does not automatically offset or reverse tax on dividends and capital-gain distributions from an earlier year.

Taxpayers reviewing Forms 1099

Amounts credited to an investment account may be taxable under constructive-receipt principles even when an automatic election immediately reinvests them.

Common questions

Q: Why were the mutual-fund distributions taxable to Vigil?
A: They represented his proportional share of income earned by the funds and were reported to him on Form 1099.

Q: Did it matter that he never took the distributions in cash?
A: No. They were credited to his account and then reinvested at his direction, which the hearing officer treated as constructive receipt.

Q: What did reinvestment do?
A: It used the credited money to purchase additional shares and increase Vigil's holdings in the funds.

Q: Why did the $23,000 investment loss not eliminate the tax?
A: The later sale loss was distinct from the dividend and capital-gain distributions received in 2002.

Q: Who had the burden to challenge the assessment?
A: Under Section 7-1-17(C), the assessment was presumed correct, so Vigil had to present evidence and legal argument showing that it should be abated.

Citations and references

Statutes and regulation:

• NMSA 1978, § 7-1-17(C) — presumption that an assessment is correct
• NMSA 1978, §§ 7-2-1 et seq. — New Mexico personal income tax
• 26 U.S.C. § 61(a) — gross income includes dividends and gains from property
• 26 U.S.C. §§ 851-852 — regulated investment companies
• 26 C.F.R. § 1.451-2(a) — constructive receipt of income

Other authorities cited:

• Rev. Rul. 89-81, 1989-1 C.B. 226
• MPC Ltd. v. New Mexico Taxation & Revenue Department, 2003-NMCA-021, 133 N.M. 217, 62 P.3d 308
• Holt v. New Mexico Department of Taxation and Revenue, 2002-NMSC-034, 133 N.M. 11, 59 P.3d 491
• Furstenberg v. Commissioner, 83 T.C. 755 (1984)
• Loose v. United States, 74 F.2d 147 (8th Cir. 1934)

Source

• Listing: New Mexico Decisions & Orders
• Decision post: Manuel Vigil
• Decision PDF: D&O 06-21

Original ruling text

BEFORE THE HEARING OFFICER
OF THE TAXATION AND REVENUE DEPARTMENT
OF THE STATE OF NEW MEXICO

IN THE MATTER OF THE PROTEST OF
MANUEL VIGIL TO ASSESSMENT OF 2002 No. 06-21
PERSONAL INCOME TAX ISSUED UNDER
LETTER ID l0813917440

DECISION AND ORDER

An administrative hearing on the above-referenced protest was held on December 13,

2006, before Margaret B. Alcock, Hearing Officer. The Taxation and Revenue Department

(“Department”) was represented by Peter Breen, Special Assistant Attorney General. Manuel

Vigil (“Taxpayer”) represented himself. Based on the evidence and arguments presented, IT

IS DECIDED AND ORDERED AS FOLLOWS:

FINDINGS OF FACT

1. The Taxpayer was a resident of New Mexico during 2002.

2. For tax year 2002, the Taxpayer received a Form 1099 listing the dividend and

capital gain distributions made to the Taxpayer from two Charles Schwab mutual funds.

3. Pursuant to the Taxpayer’s agreement with Charles Schwab, these distributions

were not paid to the Taxpayer in cash, but were reinvested in the two funds.

4. The Taxpayer later sold his shares in the Schwab mutual funds for a $23,000

loss.

5. When the Taxpayer completed his 2002 federal and state income tax returns,

he did not include the mutual fund distributions reported to him on Form 1099.

6. The Internal Revenue Service subsequently assessed the Taxpayer for

additional federal income tax on the 2002 distributions he received from the Schwab mutual

funds.

7. On July 24, 2006, the Department assessed the Taxpayer for additional New

Mexico income tax, plus penalty and interest, on the 2002 distributions he received from the

Schwab mutual funds.

8. On September 28, 2006, pursuant to a retroactive extension of time granted by

the Department, the Taxpayer protested the Department’s assessment.

DISCUSSION

The issue to be determined is whether the Taxpayer is liable for the Department’s

assessment of New Mexico personal income tax on the 2002 distributions from the

Taxpayer’s Charles Schwab mutual funds. There is a statutory presumption that any

assessment of tax made by the Department is correct. NMSA 1978, § 7-1-17(C). See also,

MPC Ltd. v. New Mexico Taxation & Revenue Department, 2003 NMCA 21, ¶ 13, 133 N.M.

217, 62 P.3d 308. Accordingly, it is the Taxpayer’s burden to present evidence and legal

argument to show that he is entitled to an abatement, in full or in part, of the assessment

issued against him.

Payment of New Mexico personal income tax is governed by NMSA 1978, §§ 7-2-1,

et seq. New Mexico is among the majority of states that use the federal income tax system as

the basis for calculating state income taxes, beginning with a taxpayer’s federal adjusted gross

income. See, Holt v. New Mexico Department of Taxation and Revenue, 2002-NMSC-034 ¶¶ 8,

9, 133 N.M. 11, 59 P.3d 491. Although 26 U.S.C. § 61(a) of the Internal Revenue Code defines

2
gross income to include both dividends and gains from dealings in property, the Taxpayer

maintains that he does not owe federal or state income tax on the dividend and capital gain

distributions reported to him by Charles Schwab. The Taxpayer argues (1) that he lost money

on the two mutual funds and should not have to pay tax on a loss; and (2) that he never

received the distributions because they were reinvested in the funds. These arguments are

based on a misunderstanding of the way in which mutual funds operate and the nature of the

distributions reported to the Taxpayer.

A mutual fund, also known as a regulated investment company, is generally treated as

a pass-through entity for tax purposes. See, 26 U.S.C. §§ 851-852. As long as a mutual fund

distributes at least 90 percent of the dividend and capital gain income generated from the

fund’s investment activity, the fund pays no tax on this income. Instead, the fund’s

shareholders are required to report the distributions on their own tax returns. As explained in

Rev. Rul. 89-81, 1989-1 C.B. 226, this pass-through tax treatment allows small investors to

pool their resources and obtain a professionally managed and diversified investment portfolio

without paying the penalty of a second layer of tax, which would normally apply if the

mutual fund were taxed as a regular corporation. In effect, each shareholder pays tax on his

pro rata share of the mutual fund’s income as if the shareholder, rather than the fund, had

invested in the various stocks and bonds held in the fund.

In this case, the Form 1099 the Taxpayer received from Charles Schwab set out the

2002 dividend and capital gain income attributable to the investments held in two Schwab

mutual funds. As a shareholder in the funds, the Taxpayer was required to report and pay tax

3
on this income. The fact that the overall value of the funds’ assets dropped and the Taxpayer

suffered a loss does not relieve the Taxpayer of this liability. As a simplified analogy,

assume that the Taxpayer owned 100 shares of Stock A, which he purchased for $3,000; that

the Taxpayer received a $45 stock dividend during 2002; and that the Taxpayer subsequently

sold the stock for $2,700, resulting in a loss of $300. The fact that the Taxpayer lost money

on his sale of Stock A would not relieve him of the obligation to pay income tax on the $45

dividend he received during 2002. Similarly, the fact that the Taxpayer lost money on his

overall investment in the Schwab mutual funds does not relieve him of his obligation to pay

income tax on his pro rata share of the funds’ income distributions.

Nor does the fact that the distributions were reinvested in the funds—rather than paid

to the Taxpayer in cash—affect the Taxpayer’s income tax liability. Pursuant to 26 C.F.R. §

1.451-2(a) of the federal income tax regulations:

Income although not actually reduced to a taxpayer's possession is
constructively received by him in the taxable year during which it is credited to
his account, set apart for him, or otherwise made available so that he may draw
upon it at any time, or so that he could have drawn upon it during the taxable
year if notice of intention to withdraw had been given. However, income is
not constructively received if the taxpayer's control of its receipt is subject to
substantial limitations or restrictions....

Here, the 2002 Form 1099 admitted into evidence establishes that the Taxpayer’s distributive

share of mutual fund income was credited to his account with Charles Schwab. At the

Taxpayer’s direction, that money was then reinvested through the purchase of additional shares,

which served to increase the Taxpayer’s holdings in the Schwab funds. As noted in

Furstenberg v. Commissioner, 83 T.C. 755, 791 (1984) (quoting Loose v. United States, 74

4
F.2d 147, 150 (8th Cir.1934)), income is received by cash basis taxpayers “when it is made

subject to the will and control of the taxpayer and can be, except for his own action or

inaction, reduced to actual possession.” In this case, the Taxpayer elected not to take his

distributions in cash, but to have them reinvested. This voluntary action on the part of the

Taxpayer cannot be treated as a restriction or limitation on his use of that money or relieve him

of his obligation to report it as income on his 2002 personal income tax returns.

CONCLUSIONS OF LAW

A. The Taxpayer filed a timely, written protest to the assessment issued under Letter

ID l0813917440, and jurisdiction lies over the parties and the subject matter of this protest.

B. The 2002 mutual fund distributions reported to the Taxpayer on Form 1099 are

subject to New Mexico personal income tax.

C. The Taxpayer’s subsequent loss on his sale of shares in the mutual funds does

not affect his liability for tax on distributions from the funds.

D. The Taxpayer’s decision to reinvest his mutual fund distributions, instead of

taking them in cash, does not affect his liability for tax on the distributions.

For the foregoing reasons, the Taxpayer’s protest IS DENIED.

DATED December 18, 2006.

5