5.5 Fund Taxation & Subchapter M
Internal Revenue Code Subchapter M prevents triple taxation of pooled investments by treating qualifying investment companies as conduit pipelines directly to shareholders.
Key FINRA Exam Takeaways
- Subchapter M (Conduit / Pipeline Theory): If a fund distributes at least 90% of its Net Investment Income (NII), it pays NO corporate tax on the distributed portion.
- Net Investment Income (NII) = (Dividends + Interest) - Operating Expenses. (Capital gains are EXCLUDED from NII).
- Shareholders are taxed on distributions in the year received, even if automatically reinvested in additional shares.
- Wash Sale Rule: Disallowing loss deductions if the same or 'substantially identical' security is purchased within 30 days before or after the sale (61-day window).
The 90% Conduit Rule
If a fund distributes 89% of its NII, it is taxed on 100% of its income as a regular C-corporation! If it distributes 92%, it only pays taxes on the retained 8%.
Wash Sale Rule Mechanics
If an investor sells XYZ at a $4,000 loss and repurchases XYZ 20 days later, the $4,000 loss is disallowed on current taxes and added to the cost basis of the newly acquired shares.
A mutual fund earns $10 million in Net Investment Income during the tax year. To qualify as a regulated investment company under Subchapter M of the Internal Revenue Code, what minimum dollar amount must the fund distribute to shareholders?