K-1 Taxes Hurdle For Commodity ETFs

More taxes. Higher costs. Bigger headaches. Is there anything to love about the humble commodity pool?

[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.

K-1s: Commodity Pools' Biggest Downside

Each year, commodity-pool ETFs issue Schedule K-1 forms to report each partner/investor's share of the profits and losses that the fund accrued:

Sample K-1 Form for PowerShares DB Silver Fund

Source: PowerShares

To generate these forms, the fund managers must first collate ownership data, which usually isn't provided by brokers until late January. That pushes out mailings of K-1s to investors to March.

If K-1s don't come in time, however, the investor must file and pay for an extension with the IRS. For advisors serving lots of clients, K-1-related delays can result in more paperwork and more headaches.

More Taxes, Every Year

The problem isn't just in the paperwork. Commodity-pool ETFs mark to market their gains, losses and income made throughout the year, then pass on the tax liability to their shareholders. That means if your commodity ETF has a good year, you'll probably have to write a check to the IRS, even if you didn't touch your shares.

For buy-and-hold investors, these annual taxes have the potential to erode long-term returns. Compare the aforementioned DBC to the PowerShares Optimum Yield Diversified Commodity Strategy No K-1 Portfolio (PDBC), which has a nearly identical portfolio to DBC, but is structured as a '40 Act fund. DBC has dropped 3.09% over a three-year period, while PBDC has dropped only 2.91%. (It's unclear how much of this difference could be explained by PBDC's 0.30% lower expense ratio, however.)

Commodity Pools Are More Expensive

One infrequently mentioned downside of commodity pool ETFs is that they just plain cost more than other types of commodity ETFs.

On average, commodity ETFs that issue K-1s are 0.36% more expensive than commodity ETFs that issue only 1099s. That's not for nothing, considering the average expense ratio for a commodity ETF is already a hefty 0.87%.

The reason at least some commodity pools are more expensive is, in part, due to a lack of competitive pressure. The Teucrium Corn Fund (CORN), for example, is the only pure-play corn ETF on the market; as such, it can carry a 2.66% expense ratio with impunity. Same goes for the only soybeans ETF on the market, the Teucrium Soybean Fund (SOYB), and the only wheat fund, the Teucrium Wheat Fund (WEAT), which carry expense ratios of 2.63% and 2.54% each.

In other cases, commodity-pool ETFs were among the first funds in their respective categories; USO is the oldest crude oil fund, for example; and the PowerShares DB Agriculture Fund (DBA) is the oldest agriculture ETF. As such, these ETFs had considerable first-mover advantage over their newer, potentially cheaper peers.

How To Ditch K-1s? Let Me Count The Ways

Source: ETF.com

Commodity investors looking to avoid K-1s and the ETFs that issue them have a wealth of options, including:

ETNs

The vast majority of commodity ETPs—108 of 170—are in fact ETNs. ETNs are unsecured debt instruments designed to track the returns of a given index; as such, they hold no underlying assets.

ETNs don't issue K-1s, but they do carry the credit risk associated with the issuing bank. If an ETN's issuing bank goes belly-up, then investors are out of luck. It doesn't happen often, but as Lehman Brothers investors can tell you, it isn't impossible.

More likely is the risk that ETNs will close to creations, generating significant premiums and discounts to net asset value. Also, many ETNs may be called, or redeemed, at any time, which could mean you lose some or all of your invested money.

Grantor Trusts

Many physically backed metals ETFs opt for the grantor trust structure. Unlike other ETPs, whose portfolios may change day to day, grantor trusts are required to hold a fixed portfolio, making them well-suited for vaulted, nondecaying commodities like gold or silver.

Though grantor trusts avoid the K-1 headache, they do carry higher tax rates in both the short and long term, than commodity pools. Investors are taxed as if they directly owned the underlying metal, which means a 28% long-term capital gains rate instead of 20%, like ETNs or open-ended funds. Short-term capital gains, meanwhile, are taxed as ordinary income.

Equities ETFs

Some investors forgo the commodities themselves and instead invest in their producers, like oil exploratory firms or gold miners. Taxwise, producers ETFs act like any other open-ended fund, issuing 1099s and carrying a 20% long-term, max 39.6% short-term capital gains rate.

The complicating factor with equities ETFs, however, is that commodities producers sometimes—but not always—correlate more closely to the stock market than to the underlying associated commodities. For investors who turn to commodities for their portfolio diversification potential, having two assets that move in tandem may not be what they bargained for.

Open-Ended ‘No K-1’ ETFs

Still, other commodity ETFs, often advertised as "no K-1" funds, invest in futures but use a special workaround to avoid issuing K-1s. Currently, there are 12 "no K-1" ETFs:

Sources: ETF.com, FactSet. Data as of March 17, 2018.

Some portion of the portfolio—typically 25% or less—is held in a subsidiary based in the Cayman Islands. This portion tracks the relevant futures index and provides the fund's notional value. (The 25% cap allows the ETF to still structure itself as a '40 Act fund.) The remaining 75%, meanwhile, is held in high-quality U.S. debt securities, essentially functioning like a collateral portion of a futures investment.

For buy-and-hold investors, these funds blend the best of both worlds: They offer the exposure to futures prices, like commodity pools, but they're taxed like any other open-ended fund, with a 20% long-term cap gains rate and a 39.6% short-term gains rate. The only catch is that you have to be comfortable with the totally-not-a-tax-dodge way in which these funds are structured.