Mutual funds enjoy a significant tax advantage—if they follow the rules. Subchapter M of the IRS Code allows funds to avoid corporate-level taxation on income they distribute to shareholders. But with this privilege comes responsibility. The securities industry has clear rules about what constitutes ethical fund sales, and violations carry serious consequences.
Fund Distributions Under Subchapter M
Here's a tax advantage that makes mutual funds viable: Subchapter M of the IRS Code.
The 90% Rule
If a fund distributes at least 90% of its net investment income to shareholders, the fund itself doesn't pay tax on that income. This avoids the "double taxation" problem where a corporation pays tax on income, then shareholders pay again on dividends.
| Distribution Level | Tax Treatment |
|---|---|
| Distributes 90%+ | Fund pays no tax on distributed income |
| Distributes less than 90% | Fund pays corporate tax on retained income |
You pay taxes on the distributions, whether you take them in cash or reinvest them. Reinvested dividends are still taxable in the year received. Many investors are surprised to receive a tax bill for dividends they never saw—because they were automatically reinvested.
Ex-Dividend Dates
| Fund Type | Ex-Dividend Date Set By |
|---|---|
| Closed-End Fund | Exchange/FINRA |
| Open-End Fund | Fund's Board of Directors (usually day AFTER payment) |
Capital Gains and Cost Basis
Funds distribute capital gains annually. Net losses are NOT distributed—they're carried forward by the fund.
Your cost basis for tax purposes is:
- Original purchase price
- PLUS all reinvested distributions
This matters when you eventually sell. If you've been reinvesting dividends for 20 years, your cost basis is much higher than your original investment—which reduces your taxable gain.
Prohibited Sales Practices
The securities industry has rules, and breaking them has consequences. These four practices will get you in serious trouble.
1. Breakpoint Sales
Breakpoint sales are PROHIBITED.
What it is: Selling shares just below a breakpoint to avoid giving the customer a discount.
Example: A customer wants to invest $10,000. The breakpoint for reduced sales charges is $10,001. Recommending they invest $9,999 to avoid the breakpoint? That's a violation.
Also prohibited: Spreading purchases across different fund families to prevent reaching breakpoints within any single family.
Registered representatives must inform customers about breakpoints for large purchases. Failure to disclose is a violation.
2. Churning
Churning is PROHIBITED.
What it is: Recommending unnecessary trades to generate sales charges.
Example: Recommending a client sell Fund A to buy Fund B when both funds are essentially identical in objective and holdings—just to generate a new sales charge.
Mutual funds aren't meant to be traded frequently. The sales charge structure discourages this, but unethical representatives sometimes ignore that.
3. Inappropriate Class B Share Recommendations
Recommending Class B shares when Class A would be more appropriate is PROHIBITED.
Why it happens: Class B shares have no up-front charge, which sounds appealing to customers. But:
- Higher ongoing 12b-1 fees cost more over time
- Large investments miss out on Class A breakpoints
- The CDSC traps investors if circumstances change
Large buyers should generally be placed in Class A since the sales charge may be reduced by breakpoints. Recommending Class B for large, long-term investments is a suitability violation.
4. Selling Dividends
Selling dividends is PROHIBITED.
What it is: Encouraging a customer to buy shares right before a dividend distribution.
Why it's harmful: The day after a dividend, the NAV drops by exactly the dividend amount. The customer hasn't gained anything—they just converted NAV into a taxable dividend.
Example:
- Fund NAV: $20.00
- Tomorrow's dividend: $1.00
- NAV after dividend: $19.00
The customer has $19.00 in shares plus $1.00 in taxable income. They're not richer—but they do owe taxes.
Test Tip: "Selling dividends" is a popular exam topic. Remember: buying before a dividend creates a tax liability without creating any actual gain.
The Four Prohibited Practices Summary
| Practice | What It Is | Why It's Harmful |
|---|---|---|
| Breakpoint Sales | Selling below breakpoint threshold | Customer pays higher sales charge |
| Churning | Excessive trading | Unnecessary sales charges |
| Inappropriate Class B | Wrong share class for situation | Higher costs than necessary |
| Selling Dividends | Buying before dividend | Creates tax liability without gain |
Test Tip: Know all four prohibited practices and be able to identify them in scenarios. The exam frequently presents situations where you must recognize the violation.
Key Points to Remember
- Subchapter M: 90% distribution requirement to avoid fund-level taxation
- Breakpoint sales: Never sell just below a breakpoint
- Churning: Never recommend unnecessary trades for commissions
- Class B inappropriateness: Large, long-term investors should be in Class A
- Selling dividends: Never encourage buying right before ex-dividend date