A few days ago a friend of mine asked me a question about the income tax treatment of investment club participants. I didn’t have enough information about the club to be able to answer her. There are so many variables involved that the question is even beyond the scope of this article.

            But her query reminded me that investment club participants often don’t give enough thought about structure and operation before getting underway. Before actually collecting cash and buying stocks, participants need to carefully consider what the ground rules are going to be.

             The amount and timing of cash contributions must be clearly set out. A decision needs to be made as to whether dividends, interest and capital gains are going to be distributed or re-invested. A voting procedure must be clearly set out as to how decisions to buy or sell will be made and who will be making those decisions. Clear rules also have to be established for the execution of stock trades and the reporting thereof to the participants. Perhaps the most important ground rule of all is to clearly set out the rules for the admission of new members and what happens when a participant wants to withdraw.

             Then there’s the question of the club’s investment philosophy. This may be the most difficult area upon which to reach agreement because each participant will have his or her own opinion. But it’s absolutely essential that all participants agree on the investment goals and risk tolerance. If these issues are not considered and resolved before cash is actually invested you can be sure they’ll come up in the near future, and when their own money is at stake your erstwhile friends may not be so easy to get along with. From time to time there will be minority views on particular investments, but there is no room for a minority view on philosophy. Anyone who doesn’t agree with the majority view on philosophy shouldn’t participate in the club.

             Financial statements should be prepared regularly; never less frequently than quarterly. It’s been my experience that monthly works best.

             Another important philosophical decision that has to be made beforehand is what kind of a club it’s going to be. If the club is going to be primarily a social club, where people are involved because they have a general interest in investments but also want to meet with their friends on a regular basis, investment decisions may not be as carefully thought out as they should be. On the other hand, if the club is to be operated primarily as a business, the investment decisions may be better but there may not be sufficient social interaction to satisfy some participants. Either is fine, just be clear on which it’s going to be; and don’t try to change it in mid-stream.

             The size of the club should be established at the beginning. Considerations include the amount of bookkeeping and reporting needed, where the meetings will be held, how often they’ll be held, where members will be drawn from and, as mentioned earlier, the balance between business and social activity.

             All the rules and decisions referred to above should be incorporated in a constitution which each participant reads and signs.

             This article was inspired by an income tax question, which brings me to my final point. The income tax implications are not profound; but depending on the particular attributes and structure of the club, they can be complex. No investment club should be instituted without consulting a tax accountant about the income tax implications and reporting requirements.