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Investment companies are vehicles in which investors pool their monies into a common portfolio. The most common type of investment company is the open-end investment company, otherwise known as a mutual fund. Mutual funds operate as pass-through entities. This means that any income they earn is passed through to investors after payment of operating expenses. As pass-through entities, the nature of the income is also passed through to the investors. Hence, dividend income is distributed as dividend income and interest income is distributed as interest income. The investors then declare this income as their taxable to themselves.
Most investment companies will make trades during the year, and as a result generate capital gains and capital losses. Some of these are classified as short-term and the rest are classified as long-term.
At least once each year, mutual funds must compute their net short-term capital gains and their net long-term capital gains, and distribute these gains to the shareholders. These distributions are referred to as capital gains distributions. In some cases, these distributions may be declared at the end of the calendar year, and paid in January. This is one of the few situations in which a person would declare as taxable income in one year money received in the following year. The holding period is based on how long the fund has held a security, not how long the investor has owned shares in a fund. Thus, a person may have just bought a fund and still receive a long-term capital gain distribution, or a person may have held a fund for many years, and still receive a short-term capital gain distribution.