Mutual funds are regulated investment companies under Internal Revenue Code Subchapter M. Under this subchapter, the mutual fund itself does not pay taxes on investment income, dividends and capital gains. Instead, the mutual fund serves as a conduit - or pass-through - to the mutual fund investors.

In order to qualify, the investment company must register under the Investment Company Act of 1940 and must distribute all, or substantially all (90% or more) of net investment income to the shareholders. Also, 90% of the fund's income must derive from income from dividends, interest and capital gains from the portfolio's securities. Finally, at least 50% of the fund must be invested in diversified securities.

Capital gains distributions may be made only once a year and at least 98% of capital gain net income must be distributed. Failure to do so results in a 4% excise tax on the undistributed income. These distributions are typically long-term capital gains only (from sales of securities held for longer than a year). Short-term capital gains (from sales of securities held less than a year) are distributed along with dividends.

Gross investment income is the total amount of dividend and interest income earned by the securities in the fund. Net investment income is calculated by deducting operating expenses (such as management fees, taxes, legal and fees) from gross investment income.

An important concept to know for the exam is net dividend income, which is calculated by subtracting the mutual fund's expenses from the investment income received. Dividends based on net investment income may be distributed as often as the fund company determines is appropriate. Many fund companies designed to provide income to investors distribute diividends monthly..

Tax Consequences of an Investor's Activities

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