ETF Tax And Regulatory Issues

By Robert A. Green, CPA and founder and CEO of Green & Company Inc. (GreenTraderTax.com and GreenTraderFunds.com) Exchange-traded funds (ETFs) are all the rage in financial markets. Large financial institutions pack them for profit, portfolio managers use them for “risk on” and “risk off” trades, and retail traders and investors are attracted to their low cost and ease of use. If you want exposure to a market or industry sector and don't want to bother studying individual stocks or futures, consider an ETF. If you manage a portfolio of securities, and don't want to jump in and out of each underlying stock, triggering capital gains taxes, consider ETFs for hedging. ETFs are good for those who want a simple macro trade and don't have a futures account. There are many more perks to ETFs. Many online brokers offer commission-free ETF trading. Trading professionals avoid wash-sale loss deferrals, straddles, and hedging rules by using ETFs. Rather than purchase a “substantially identical” security, triggering these problems, traders often find an ETF to mimic the replacement. It's not a pure economic offset, but close enough to navigate around tax-loss deferral. ETFs are designed to mimic most exchange-traded products and off-exchange derivatives, so the downside is tax treatment can be very confusing. The IRS is far behind the marketplace in providing guidance on the tax aspects of these relatively new vehicles. The ETF ice cream parlor An ETF is a liquid investment fund that is not burdened with more expensive mutual-fund regulations and restrictions. ETFs are marketed as simple and flexible ways to trade an investment fund comprised of securities, commodities, futures, and other instruments, but be aware they can be hybrids containing lots of derivatives too. ETFs' price action often de-couples from their underlying market components; they have their own supply and demand and market dynamics. Wall Street banks and other large financial institutions are hungry for new business and try to stay one step ahead of regulators. I liken them to ice cream parlors creating and serving up new flavors of ETFs each month. For example, the ETF can have some vanilla (securities), chocolate (futures), and strawberry (currencies). Presto, you have the ETF milkshake de jour, but how will it be structured and taxed? Investment pool rules When it comes to investment pools, it would be inappropriate to use a C-Corp tax structure with taxes owed on the entity level and on the owner level. Personal investment company tax problems would creep up as well. Therefore, investment companies are structured as pass-through entities, where they avoid entity-level taxation. Income and related tax liability are passed to the owners. Hedge funds are considered private investment pools organized as limited partnerships or LLCs; investors receive a Schedule K-1 for their pass-through income and loss. There are some restrictions — hedge-fund advertising is not allowed, and hedge funds can't be publicly traded. Mutual funds are publicly registered investment pools organized as Regulated Investment Companies (RICs). Mutual fund registration is more expensive but benefits include permission to advertise the investment company's performance and publicly trade the units on an exchange. Mutual fund RICs pass capital gains distributions and dividends from their underlying portfolio. Securities ETFs fall in the RIC category, but their registration is more relaxed. For example, they are allowed to institute lower fees due to more passive management and they have the ability to mimic stock indices. Whether you invest in ETFs based on securities, futures, commodities, and more, here are the main points you should know: It's not always easy to tell how your ETF is structured. Start with the prospectus. For example, the ETF may have “Trust” in the name, but it may not have the special trust tax treatment explained later. Some prospectuses may refer to investors as “Shareholders” when the ETF is not a RIC, but rather a grantor trust. Commodity, futures, and precious metal ETFs are not RIC. The SEC doesn't allow RICs to own and trade commodities and futures, so investment bankers sought an exception and adopted publicly traded partnership (PTP) structures for commodities and futures ETFs, and publicly traded trust (PTT) structures for precious metal (bullion) ETFs. Pass-through tax treatment for income inside the ETF. Income generated inside the ETF is passed through to the owners retaining their underlying tax characteristics, including ordinary dividends, qualifying dividends, long-term capital gains, Section 1256 lower 60/40 tax rates, the precious metals long-term collectibles rate, Section 988 forex ordinary gain or loss, and more. Securities ETFs are included on brokerage firm Form 1099s reporting ordinary and qualifying dividends. Commodities/futures ETFs issue annual Schedule K-1s, listing Section 1256 income or loss, among other items too. When you sell a securities ETF or commodities/futures PTP, pass-through treatment of portfolio income ends. Other than ETF trusts, ETFs are taxable entities in their own right and treated as a security. Buy and sell these ETFs and you have securities tax treatment, including short-term capital gains (currently up to 35 percent tax rates), and long-term capital gains if held over 12 months (currently up to 15 percent tax rates). Sales of ETFs organized as PTTs (i.e., physically backed precious metals ETFs) are treated as a sale of the underlying trust's asset. These ETF trusts are deemed direct-ownership vehicles, rather than separate entities. In these cases, the owner is not considered to own a security; instead, he has a direct ownership stake in the trust's underlying assets. Commodities/futures ETF special tax rules. The only way to know if an ETF passes through Section 1256 contract treatment is by reading its prospectus. These usually include a tax disclosure section. For example, the U.S. Oil Fund (USO) — a domestic limited partnership — holds almost entirely regulated futures contracts on petroleum products. The tax disclosure in USO's prospectus states these contracts fall under Section 1256. Conversely, if a commodity ETF PTP owns physical oil stored in oil tankers, it passes through ordinary gain or loss treatment on holding physical commodities. Taxpayers invested in commodities/futures ETFs need to make some cost-basis adjustments to capital gains and losses, ensuring they don't double count some of the Schedule K-1 pass-through items. Mutual fund companies provide “average cost basis” capital gain or loss reports. But ETFs don't provide this documentation, so you're on your own. Day traders may trigger a Schedule K-1 if they are listed as an owner at the end of a month, when ETFs perform their investor-level accounting. ETF PTP investor-level accounting is flawed, and therefore Schedule K-1s don't accurately reflect a trader's proper accounting. Precious metal (bullion) ETFs. Physically backed precious metals (bullion) ETFs like the SPDR Gold Trust (GLD) holding gold bullion are grantor trusts (PTTs). PTT portfolio income is passed through on Schedule K-1 and taxed to holders like direct investments in collectibles. The long-term capital gains tax rate (currently up to 28 percent) on collectibles applies on that pass-through income. This happens when the trust sells gold inside the ETF. What about sales of precious metal ETF units? The IRS issued special guidance stating the collectibles tax rate applies on long-term sales of the ETF units themselves. The collectibles tax rate only applies on the long-term portion, not the short-term portion currently taxed up to 35 percent. (This is an area that is often confused.) A memo issued by the IRS Chief Counsel Office in 2008 states bullion ETFs are considered trusts (PTTs). Investors have undivided beneficial interests in the assets held by the trust. If a trustee of a physically backed metal ETF trust sells some of the metal, the investors are treated as having sold the metal. Additionally, if an investor in a physically backed metal ETF trust sells or redeems interest in that ETF, it is treated as a sale of the investor's proportionate share of the metal held by the physically backed metal ETF. The memo concludes if an investor sells his ETF interest or the trust sells a portion of the metal it holds, the investor is treated as having sold all or a portion of his share of the metal. Any gain from the sale is treated as collectible gain subject to the maximum capital gain rate of 28 percent. Other trusts. A fixed-investment trust qualifies as a trust providing it has a fixed portfolio at the launch and is self-liquidating, meaning it's passively managed. This would be viewed as a true trust and is rarely seen because of the fixed-portfolio requirement. Physically backed precious metal ETFs meet the terms of these rules as stated earlier. The more common trust is the business trust. This one is taxable as an entity and has an actively managed portfolio. Actively managed trusts are taxed as partnerships (PTPs). Futures ETFs are often actively managed, so they use the PTP structure too. Retirement accounts. It's unlikely your retirement plan will receive a commodities/futures ETF Schedule K-1 listing investment interest expense, since margin interest is only charged on securities. Be aware that some hybrid ETF PTPs may have margin interest expense on the Schedule K-1. In these cases, you have to pay unrelated business income tax (UBIT) in the retirement plan. Leverage from trading futures, derivatives, or forex doesn't trigger UBIT for a retirement account. Normally, owning precious metals in a retirement plan is a problem. But in two 2007 private rulings, the IRS concluded the acquisition of shares of a precious metal ETF trust by either an IRA or an individually directed account under a qualified retirement plan isn't considered the prohibited acquisition of a collectible. Options on ETFs have unclear tax treatment. The IRS has not clearly stated tax treatment on sales of options based on ETFs. Many tax attorneys make a case that sales of exchange-listed options on broad-based securities ETFs (RIC) as well as on commodities or futures ETFs (PTP) should be treated as Section 1256(g)(3) non-equity options, with lower 60/40 tax rates. Sales of options based on narrow-based securities ETFs are treated like securities. Our suggestion: Draw from the similar tax rules of broad-based indices (futures) vs. narrow-based indices (securities). A broad-based index is comprised of 10 or more underlying securities. Options on all indices are considered Section 1256. Consider the option on the commodity ETF US Oil Fund that primarily holds futures on petroleum products. We believe these options are Section 1256 nonequity options. If the option is listed on a qualified board or exchange (assume that this will always be the case), it's considered a “listed” option. It's a nonequity option because its underlying reference is not stock, rather it's a basket of stocks — the ETF. Similarly, it's not a dealer option or a securities future. Options on ETFs must be listed on a qualified board or exchange. Those options qualify as nonequity options unless something else knocks them out of that category. For example, in some cases it could be argued the ETF is a mere surrogate for the stocks in a narrow-based security index (e.g., the ETF holds under 10 stocks) and the ETF itself is disregarded, so the option is deemed to relate to the nine or fewer underlying stocks. ETFs are often hybrids containing derivatives, so it's hard to argue they're a mere index of a small number of stocks. Can options on ETFs be treated like options on indices? The respected Keyes Treatise states: “Further, under Section 1256(g)(6)(B), an option may be designated as a nonequity option without a CFTC designation, if the Treasury determines that the option otherwise meets the legal requirements for such a designation. In certain cases, the Treasury has done so. For instance, an option on the High Technology Index of the Pacific Stock Exchange was held to be a nonequity option for purposes of Section 1256. In addition, an option on the Institutional Index of the American Stock Exchange was found to constitute a nonequity option for purposes of Section 1256. The Service has also ruled that listed options that are based on a stock index and that are traded on (or subject to the rules of a qualified board or exchange) meet the requirements of law for contract market designation if (1) the options provide for cash settlement, and (2) the SEC has determined that the stock index is a “broad-based” index. (3) The index must be predominantly composed of the securities of unaffiliated issuers and must reflect the market for all publicly traded securities or a substantial segment of the market.” Per Practical Tax Strategies, Oct. 2010, “When an index option settles, the holder receives cash. If the holder received stock, the option could be considered an equity option. As such, the option would be an equity option and not subject to MTM rules. When an option on an ETF settles, the holder receives shares of the investment company. The holder does not receive cash. Whether an option on an ETF is taxed as a 1256 contract is uncertain. There has been no guidance from the IRS or Treasury regarding the tax treatment of an option on ETFs.” Consider getting a tax opinion. In the case of the sale of an ETF RIC or PTP unit, we take the entity approach and treat the investor as not selling the underlying asset but rather selling a security — the ETF unit itself. In the case of an option on such units, if the entity approach were taken, it may not qualify for Section 1256(g)(3) non-equity options treatment. The counterargument is that effectively, the option on the broad-based securities ETF is similar to an option on a stock index Section 1256(g)(6)(B), and therefore it should qualify for Section 1256. Our firm can review your trading and tax situation and advise you on how to report your sales of options on ETFs. Consider a tax opinion from our tax attorneys. Another approach is good tax return disclosure. Which treatment is preferable? With the lack of clear guidance from the IRS specifically addressing options on ETFs, our tax preparers wonder if taxpayers may flip-flop in their interpretation of how options on ETFs are taxed. Sometimes section 1256 treatment is preferred, when the taxpayer has gains taxed at lower 60/40 tax rates. Conversely, if taxpayers have a large trading loss from options on ETFs, and they use Section 475 MTM on securities only, treating the options like securities would be preferred. When it comes to options on ETFs, it best to consult a tax advisor who understands this tax treatment. Bottom line It's easy to day and swing trade ETFs and options on ETFs. But, most traders don't realize they could be opening a can of tax worms. Many traders are surprised to receive complex Schedule K-1s at tax time. Deciphering and reporting them can be problematic. Tax treatment for sales of options based on ETFs is unclear and this leads to additional reporting confusion. Start by reading the prospectus and consult a tax advisor experienced with ETFs. By Robert A. Green, CPA and founder and CEO of Green & Company Inc. (GreenTraderTax.com and GreenTraderFunds.com)