As of 2012, roughly 23% of U.S. households’ assets and 50% of retirement assets are invested in mutual funds, thus making mutual funds one of the most important investment vehicles for U.S. households. The federal taxation of mutual funds and mutual fund shareholders has played a vital role in the development of mutual funds and their appeal to U.S. investors.
Despite the significant amount of mutual fund assets held in retirement accounts, there has been very little analysis of the issues that arise when taxable and tax-exempt shareholders invest together in the same mutual fund. A substantial body of research shows that managers are attuned to the tax consequences of their investment activities, but only very recently have researchers begun to explore how the presence of tax-exempt investors affects managers’ investment strategies.
The current tax regime governing mutual funds imposes tax externalities on both taxable and tax-exempt shareholders. When tax-exempt shareholders predominate, fund managers focus less on managing fund tax liability and thereby generate higher taxes and lower after-tax returns for taxable shareholders. When taxable shareholders hold a significant portion of a mutual fund’s assets, the fund manager, focusing on minimizing fund taxable income, may undertake trades that reduce fund income but do not add economic value. These trades impose costs on all shareholders but benefit only taxable shareholders.
This Article considers various options to mitigate these costs, such as requiring funds to disclose the percentage of tax-exempt investors, adopting principles from partnership taxation to better match taxable and economic income, and prohibiting a fund from being offered to both taxable and tax-exempt investors.
This Article concludes that tax externalities resulting from taxable and tax-exempt investment in the same mutual fund are unavoidable absent substantial changes to the basic architecture of mutual fund taxation. Because such changes seem unlikely and would create other issues, this Article suggests revising the tax law to permit the creation of a special class of mutual fund, the “Retirement Mutual Fund,” solely for retirement accounts. A Retirement Mutual Fund would be subject to an alternative tax regime that would mitigate tax externalities for both tax-exempt and taxable shareholders.
Oil and Water: Mixing Taxable and Tax-Exempt Shareholders in Mutual Funds,
Loy. U. Chi. L. J.
Available at: https://lawecommons.luc.edu/luclj/vol45/iss3/11