K-1 Taxes Hurdle For Commodity ETFs

April 09, 2018

[This article appears in our May 2018 issue of ETF Report.]

Few people enjoy doing their taxes, but commodity investors have extra reason to dread them: the Schedule K-1 form.

Issued by 39 commodity ETFs, including some of the largest funds in the space, Schedule K-1s typically land in mailboxes later than other tax forms, such as the 1099. The delay can potentially push out investors' annual tax filings, or even necessitate extensions.

Schedule K-1s are more than just annoying: Funds that issue them often see higher fees and even more frequent tax events—and who likes paying more than they have to?

Here we look at how and why some funds issue K-1s and what alternatives exist in the commodity space.

What Are Commodity Pools?

Many investors tend to assume "an ETF is an ETF is an ETF." However, exchange-traded products may take any number of structures: open-ended '40 Act funds, unit investment trusts, exchange-traded notes (ETNs)—and limited partnerships.

Limited partnership ETFs treat shareholders not as investors, but as partners. As such, these funds are "pass-through investments," meaning they don't pay federal income taxes at the fund level; instead, they pass along any annual income and gains/losses onto the fund's partners—meaning you, the end investor.

Limited partnership ETFs are referred to and regulated as "commodity pools," which are investment structures that function like mutual funds, with several individuals pooling their money to trade futures contracts as a single unit.

As commodity pools, these ETFs fall under the jurisdiction of the Commodity Futures Trading Commission rather than the Securities and Exchange Commission—a difference that doesn't matter much to investors, but that vastly simplifies things for the fund issuer in terms of oversight and reporting requirements.

Some of the oldest and largest commodity ETFs are commodity pools, including the $2.7 billion PowerShares DB Commodity Index Tracking Fund (DBC) and the $1.8 billion United States Oil Fund LP (USO).

Commodity Pools Benefit Short-Term Traders

As a structure, the commodity pool offers two main benefits, both of which particularly benefit short-term hedgers and traders.

First, commodity pools are more flexible. Typically one of the best ways to access commodities is via futures contracts, and commodity-pool ETFs may hold futures contracts and other derivatives without restriction. Typical open-ended funds, however, must adhere to strict IRS diversification requirements and derivatives-specific regulations; thus, they can only use futures as the seasoning for a portfolio, not as the base.

Second, if you hold your investment for less than 12 months, commodity pools are significantly more tax favorable. Unlike most exchange-traded products, which the IRS taxes differently depending on how long shares were held, commodity pools—like their underlying futures contracts—are taxed in a time-agnostic way.

The products are taxed via the "60/40 rule," meaning 60% of their gains are taxed at the long-term capital gains rate of 20%, no matter how long you held the shares. The remaining 40% are taxed at the short-term capital gains rate (which is just your ordinary income rate, up to a maximum of 39.6%.) Together, this blends to a maximum capital gains rate of 27.84%.

Given that commodity investments are often used to hedge over short time periods, the tax savings offered by commodity pools can be substantial compared to other structures, like open-ended funds, ETNs and grantor trusts.

 

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