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Passing On Taxes


The Los Angeles City Council two weeks ago passed a $6.9 billion budget. The council closed a $336-million revenue shortfall by cutting police overtime pay and some fire engine teams.

Then, the city began considering whether to stop levying a tax on mutual funds.

Taxing their operations brings in $8.4 million a year in revenue. But, if they were to leave, an additional $12.5 million is at risk.

And L.A. is the only city in California that enforces a tax on mutual funds.

State and federal governments exempt mutual funds from taxation, because they "pass through" their earnings to customers. Taxes are levied on investors, rather than the funds.

Which is why the Regulated Investment Company Modernization Act of 2010 warrants close attention, even if it is turning out to be a "no-muss, no-fuss" piece of legislation for mutual funds (see story, page one).

The act, even in it's modernized form, is designed to protect the tax benefits afforded such companies, aka mutual funds.

To be considered a regulated investment company, a fund must pass through essentially all of its income to investors, who in turn pay the government for their earnings on the funds. There is no double taxation on shareholders in mutual funds, unlike for shareholders in corporations. Corporations first pay tax on their earnings, then, with what's left, they pay dividends to their shareholders. And shareholders pay tax, again, on those dividends.

A regulated investment company may find, for instance, that, after filing its federal income tax return, it failed to fully distribute all of its taxable income with respect to a given tax year.

A shortfall may arise for many reasons including the discovery of a tax calculation error or because some change comes up which affects the taxable income of the company. In these situations, a company can still pay a dividend to eliminate the taxable income.

This is as it should be.

Investing in an individual company or a fund that invests in multiple companies should always result in just one taxable bottom line. If it's the company that pays the tax, then the investor shouldn't.

If the investor pays the tax, the company shouldn't.

Unless you don't want investment in the engines of capitalism.