The IRS has issued final regulations (TD 9774, the Final Regulations) providing a simplified method of accounting (the net asset value (NAV) method) for gains and losses on shares in money market funds (MMFs) and additional guidance on information reporting. Concurrently, the IRS also issued Revenue Procedure 2016-39, which includes procedures for taxpayers to obtain automatic consent to change to or from the NAV method of accounting provided in the Final Regulations for gain or loss on shares in an MMF.

Background

MMFs generally seek to maintain a stable NAV, typically $1 per share. Historically, an MMF that maintained a portfolio of assets meeting certain maturity, credit-quality, liquidity and diversification requirements could issue and redeem shares at a price of $1 per share, provided that the amortized per-share cost (i.e., the purchase price, adjusted for amortization of premium and accretion of discount) or the actual per-share value of its assets was between $0.9950 and $1.0050 (rounded to the nearest penny, $1). If a fund always maintained a stable NAV of $1 per share, investors would never recognize gain or loss on redeeming shares in the fund.

As a result of the financial crisis that began in 2007, the tight liquidity in the credit markets and significant redemption requests by investors, some MMFs needed investment advisor contributions to capital to stay at a $1 NAV. The SEC issued regulations in 2014 requiring institutional MMFs or "floating-NAV MMFs" (defined generally as any MMF that does not invest almost exclusively in US government securities or limit its beneficial interest holders to natural persons) to issue and redeem shares at market-based values (rounded to the nearest 1/100th of a cent for a $1 NAV fund) by October 14, 2016. As a result, floating-NAV MMFs will no longer be able to use amortized cost and penny rounding. These changes will increase the likelihood of changing NAVs, which would result in shareholders having gain or loss on redemptions. This in turn would affect tax reporting by fund shareholders and Form 1099 providers and potentially implicate the wash sale rules. Similarly, redemptions of MMF shares subject to liquidity fees could result in losses. Thus, the tax compliance burden would increase because shareholders of floating-NAV MMFs would likely recognize gain or loss on redemptions.

On the same day in 2014 that the SEC released its rules, the IRS issued proposed regulations (REG-107012-14, the 2014 Proposed Regulations" intended to mitigate tax compliance burdens that would otherwise result from the SEC's amended MMF rules; the IRS rules provided a simplified accounting method and additional information reporting guidance. Concurrently, in Revenue Procedure 2014-45, the IRS also provided simplified wash sale provisions to accommodate the new rules for floating-NAV MMFs. See Tax Alert 2014-1400 for a discussion of the 2014 Proposed Regulations and Revenue Procedure 2014-45.

In May 2016, the IRS issued two additional pieces of guidance affecting MMFs. Revenue Procedure 2016-31 includes transitional relief for MMFs that receive contributions from their advisors to bring NAV up to $1.0000 as part of the MMF's conversion to a floating-NAV MMF before the October 14, 2016 deadline. In Notice 2016-32, the IRS announced an alternative diversification test under Section 817(h) for segregated asset accounts that invest in government MMFs. See Tax Alert 2016-853.

Final regulations

The Final Regulations adopt the new method of accounting introduced in the 2014 Proposed Regulations that allows shareholders of floating-NAV MMFs to account for gains and losses on their fund shares on an aggregate mark-to-market basis (the NAV method). As described later, the Final Regulations make a number of changes to these rules in response to comments received. In addition, the Final Regulations adopt, without substantive change, the portion of the 2014 Proposed Regulations dealing with information reporting requirements for shares in MMFs. The Final Regulations with respect to the NAV method apply to tax years ending on or after July 8, 2016; for tax years ending on or after July 28, 2014, and beginning before July 8, 2016, taxpayers may rely on the NAV method in either the 2014 Proposed Regulations or the Final Regulations. The Final Regulations concerning information reporting apply to sales of shares in calendar years beginning on or after July 8, 2016; taxpayers and brokers may, however, rely on these rules for sales of shares in calendar years beginning before July 8, 2016.

Under the NAV method, as included in both the 2014 Proposed Regulations and Final Regulations, a shareholder does not determine gain or loss for any individual redemption (or other disposition) of shares. Instead, the shareholder determines gain or loss for a computation period (Computation Period), which may be the shareholder's tax year or certain shorter periods, by determining the difference between: (1) the value of the shareholder's shares at the end of the Computation Period, plus the amount received in redemptions (or other dispositions) of any shares during the Computation Period; and (2) the value of the shareholder's shares at the start of the Computation Period, plus the cost of any shares the shareholder purchased during the Computation Period (including purchases through dividend reinvestments). A positive difference is treated as a gain, while a negative difference is treated as a loss. In either case, the character of any gain or loss is short-term capital, unless no shares are held as a capital asset, in which event the entire gain or loss is ordinary. The NAV method does not affect the manner in which MMF dividends are taxed.

The IRS made a number of changes to the NAV method in the Final Regulations in response to comments received on the 2014 Proposed Regulations:

— Application of NAV method to stable-NAV MMFs. The Final Regulations permit taxpayers to apply the NAV method to shares in stable-NAV MMFs. The change is intended to reduce the complexity, as well as any tax-based motivation to terminate investment in MMFs, that would result from the imposition of a liquidity fee by a stable-NAV MMF or from a stable-NAV MMF breaking the buck.

— Consistency requirement. The Final Regulations permit MMF shareholders to use different methods of accounting for shares in different MMFs or for shares in a single MMF held in different accounts. Under the 2014 Proposed Regulations, if a taxpayer applied the NAV method to shares in any MMF for a tax year, the taxpayer would have had to apply the NAV method to its shares in all MMFs for which the method was permissible.

— NAV method available to RICs that invest in MMFs. The Final Regulations indicate that a regulated investment company (RIC) that invests in MMFs may use the NAV method, subject to certain special rules involving the interaction of a RIC's fiscal year and excise year.

— NAV method computation periods for RIC excise tax purposes. The Final Regulations clarify that the NAV method applies for purposes of Section 4982 excise tax computations and that the tax year for purposes of those computations should be the relevant period under Section 4982(e). The Final Regulations also require a RIC to be consistent in applying the NAV method to MMF shares for income tax and excise tax purposes. In addition, the Final Regulations: (1) clarify how a RIC may change to or from the NAV method; and (2) eliminate the requirement that computation periods be of approximately equal duration.

— Clarification of certain amounts. The Final Regulations clarify that the fair market value of a share in an MMF at the time of a transaction is presumed to be the published NAV and define which published NAV to use. They also specify how to determine the amount received for purposes of computing a taxpayer's net investment in an MMF for a computation period. In addition, they clarify the effect on net investment of a share acquired from another person with a transferred basis.

Accounting method changes: Revenue Procedure 2016-39

The Final Regulations permit taxpayers to adopt the NAV method for shares in a floating-NAV MMF by using the method in their federal income tax return for the first tax year in which both: (1) the taxpayer holds shares in that MMF; and (2) that MMF is a floating-NAV MMF. Under the Final Regulations, however, taxpayers seeking to change to or from the NAV method must secure consent from the Commissioner. Revenue Procedure 2016-39 provides procedures for taxpayers to obtain automatic consent for such changes.

In general, Revenue Procedure 2016-39 states that taxpayers wanting to change to or from the NAV method of accounting described in Treas. Reg. Section 1.446-7 must use the automatic change procedures in Revenue Procedure 2015-13, or its successor, and Revenue Procedure 2016-29, or its successor (as modified by Revenue Procedure 2016-39). Revenue Procedure 2016-39 modifies Revenue 2016-29 to add a new Section 15.17, "Change to or from the net asset value (NAV) method," which specifies the manner of making such changes and applicable requirements.

A simplified procedure for changing to the NAV method on a federal tax return without filing a Form 3115 is permitted in certain circumstances under Revenue Procedure 2016-39. This simplified procedure is permitted for taxpayers holding shares in a stable-NAV MMF that want to change to the NAV method for a tax year if: (1) the taxpayer has not used the NAV method for shares in the MMF for any tax year prior to the year of change, and (2) prior to the beginning of the year of change, either: (a) the taxpayer's basis in each share of the MMF has been at all times equal to the MMF's target share price, or (b) the taxpayer has not realized any gain or loss on shares in the MMF.

Revenue Procedure 2016-39 also permits a short Form 3115 for obtaining automatic consent for taxpayers changing from the realization method to the NAV method — or changing from the NAV method to a realization method — for shares in an MMF.

Implications

The finalization of these regulations and accompanying guidance in advance of the transition to floating-NAV MMFs is welcome. Although the guidance contains a fair amount of detail covering many unusual situations, the average taxpayer should have a fairly simple time using these rules versus what it would have had to do if floating-NAV MMF shares were subject to the wash sale rules. And although stable-NAV MMF shares remain subject to the wash sale rules, the expansion of the NAV method allows shareholders to avoid that potentially significant administrative burden by using the NAV method as well. RICs holding MMF shares may face a higher level of complexity given the interplay of income and excise tax rules, but the Final Regulations relax the calculations and provide significant detail on how to comply.

The simplified method change regime should be welcome as well, given that certain taxpayers can just start using the NAV method (and can choose to do so on an MMF-by-MMF or an account-level basis). Others can change with an abbreviated Form 3115, which is an automatic method change. All such method changes are on a cut-off basis, rather than with a Section 481(a) adjustment.

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