Legal Structures, Regulations & Taxes
Investors spend hours researching funds for expense ratios and spreads, trying to save a few basis points here and there. But often, not enough time is spent researching a fund’s structure and the associated tax implications, which can translate into hundreds or even thousands of basis points.
An ETF’s taxation is ultimately driven by its underlying holdings. Since funds are structured differently according to how they gain exposure to the underlying asset, an ETF’s tax treatment inherently depends on both the asset class it covers and its particular structure.
A fund’s asset class can be classified in one of five categories: equities; fixed income; commodities; currencies; and alternatives.
For tax purposes, exchange-traded products come in one of five structures: open-end funds; unit investment trusts (UITs); grantor trusts; limited partnerships (LPs); and exchange-traded notes (ETNs).
Many commodity and currency funds that hold futures contracts are regulated by the Commodity Futures Trading Commission as commodity pools, but they’re classified as LPs for tax purposes by the IRS. Therefore, “limited partnership” is used to refer to the structure of these funds with regard to taxation.
This five-by-five matrix—five asset classes and five fund structures—defines the potential tax treatments available in the ETF space.
Equity & Fixed-Income Funds
Equity and fixed-income ETFs currently operate in three different structures: open-end funds, UITs or ETNs.
Commodity ETFs come in one of four structures: open-end funds, grantor trusts, LPs, or ETNs.
Currency ETFs come in one of four structures: open-end funds, grantor trusts, LPs, or ETNs.
Alternative funds come in one of three structures: open-end funds, LPs, or ETNs. (Alternative funds seek to provide diversification by combining asset classes or investing in nontraditional assets.)
Taxation Of Distributions
Besides taxes on capital gains incurred from selling shares of ETFs, investors are also subject to pay taxes on periodic distributions, which can be dividends paid out from the underlying stock holdings, interest from bond holdings, return of capital (ROC) or capital gains—which come in two forms: long-term gains and short-term gains.
Dividend payments from ETFs are usually paid out monthly, quarterly, semiannually or annually. There are two kinds of dividends that investors should be aware of: qualified dividends, and nonqualified dividends.
Qualified dividends are dividends paid out from a U.S. company whose shares have been held for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. Importantly, this refers to the shares held by the ETF itself, and not the holding period of investors in the ETF.
Investors should keep in mind that while monthly distributions from bond ETFs are often called “dividends,” interest from the underlying bond holdings aren’t considered qualified dividends, and are taxed as ordinary income.
Funds can also pay out distributions in excess of the fund’s earnings and profits, called ROC. ROC is generally nontaxable and reduces the investor’s cost basis by the amount of the distribution.
Medicare Surcharge Tax
Effective Jan. 1, 2013, singles with an adjusted gross income (AGI) of more than $200,000, and those married filing jointly with an AGI of more than $250,000, are now subject to an additional 3.8% Medicare surcharge tax on investment income, which includes all capital gains, interest and dividends.
This new tax is levied on the lesser of net investment income or modified AGI in excess of $200,000 single/$250,000 joint. Therefore, for investors in the highest tax brackets, their “true” tax rates on long-term capital gains and qualified dividends can reach 23.8% (20% capital gains plus 3.8% Medicare tax).
Disclaimer: We are not professional tax advisors. This article is for informational purposes only and not intended to be tax advice. Tax rules can change. Individuals should always consult with a professional tax advisor for details about the tax implications of investment products and their personal taxes. Pending legislation could materially affect the information in this article.