By Frank Laub, Contributing Editor, Business Owner's Toolkit

Do you even know someone who doesn't own a mutual fund? Their popularity has made them commonplace parts of our fiscal lives. Other than an unlikely, steep stock market decline, the worst misadventures you're likely to experience with mutual funds are the numerous tax pitfalls and compliance headaches that await the unwary investor. But these oft-overlooked problems merit further scrutiny at tax time.

For example, have you sold mutual funds without retaining records of reinvested dividends and capital gain distributions? Or worse--written checks on funds offering check-writing privileges or made telephone switches within a family of funds not knowing that they have generated a taxable sale? And selling less than an entire position in a fund may require time-consuming cost allocation computations. These and other implications of mutual fund investing go far beyond simply reporting the amounts appearing on the Forms 1099 sent by the funds.

Beware the double taxation pitfall: Since a taxpayer pays tax on dividends and capital gain dividends, even if automatically reinvested, when any portion of the investment is sold, a proportionate part of the previously taxed distribution must be added to the taxpayer's basis to avoid double taxation.

Suppose, for example, a taxpayer sold an investment in a mutual fund for $3,000 in 1996 that had cost him $1,000 in 1990. During this period the fund paid cash dividends and capital gain dividends of $400 that were automatically reinvested in additional fund shares. The correct gain to be reported is $1,600, i.e., $3,000 less basis of $1,400 ($1,000 plus previously taxed $400 of dividends and capital gain distributions). If the gain were reported as $2,000, the taxpayer would be paying tax twice on the $400 distribution. And don't forget that basis includes commissions, redemption fees and loads too.

A capital gain dividend distributed to an investor is treated as a long-term capital gain, regardless of how long the stock has been held. If a shareholder sells shares within six months of acquiring the shares, any capital loss is treated as long-term capital loss to the extent of capital gain dividends received.

Fund switching results in gain or loss recognition: Switching from one fund to another in a family of funds is treated as a sale and reinvestment; such transfers are not treated as tax-free swaps. (An exception applies to portfolio shifts within a qualified retirement plan account, e.g. IRA, 401(k), Keogh, which are not taxable.)

Checks drawn on funds result in gain or loss: It's probably safe to say that mutual funds that offer investors check-writing privileges on their mutual fund account (usually a money-market or bond fund), never advertise the fact that every check written results in a redemption of shares that must be reported on Schedule D, Capital Gains and Losses.

Even if there is no gain or loss (e.g., money-market fund maintaining a stable $1 per share price), the transaction must be reported since any omission would throw off the reconciliation of total sales price per the return and sales proceeds reported on Forms 1099-B, Proceeds From Broker and Barter Exchange Transactions, furnished to the IRS.

Identification of shares: Four different methods for calculating cost basis are available. Under the general rule applicable to investors in stocks and bonds, mutual fund investors that purchase identical shares of stock at different prices or on different dates and then sell only part of the stock, are presumed to have sold the stock acquired earliest (FIFO rule), unless the specific shares sold are adequately identified.

In addition to using the specific share identification rule or the FIFO rule, mutual fund investors can also choose one of two averaging methods to identify the shares they are selling. With the single-category method, all shares are in one pot and each share has an averaged basis. With the double category method, all shares are divided into two categories: those held for one year or less; and those held for more than one year. Shares in each category get an averaged basis.

The method elected must be used for all accounts in the same regulated investment company until it is revoked with the consent of the IRS. Different methods may be used for accounts in different regulated investment companies. Use of the single category method is not allowed if it appears that a purpose is to convert short-term capital gains or losses to long-term capital gains or losses or vice versa.

Happily, some of the large mutual funds will calculate cost basis for investors for shares purchased within the last ten or twelve years. Many funds will provide old statements for a fee where cost information is not otherwise available.

Hopefully these timely reminders may help to save you a few bucks on your 1040 this filing season!