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Are These Investments Worth the Tax Hassle?

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If you've left your taxes until the last minute, the last thing you need is a major tax headache. Unfortunately, with certain types of exchange-traded funds (ETFs), your poor head will probably start hurting once you dig through pages of documents -- many of which you may never have seen before.

Taxes and investments
For the most part, accounting for taxes on most investments is relatively simple. If you own a bond or other fixed-income security, or you have an account like a bank CD that pays regular interest, you'll get a form indicating how much interest you received during the year. Unless you own that investment in a tax-deferred vehicle like an IRA, you report that interest on your tax return and include it in your taxable income. With most stocks, mutual funds, and ETFs, the dividends you receive are reported in much the same way on another tax form.

Depending on which type of tax return you file, you'll typically either add up your total interest income and your total dividend income, or you'll list it line by line on a schedule to your Form 1040.

Given the complexity that you'll find in preparing your tax return, how you deal with interest and dividends is pretty simple. But with a certain type of ETF, you'll find it much more difficult to deal with, and far more complicated than simply entering a number or two on your tax return.

The joy of partnership
In general, most investments are legally structured as corporations. That simplifies tax reporting: If you own a corporate bond, you receive income that's treated as interest; while if you own a stock, the payouts you receive are almost always dividends. Most mutual funds have an extra wrinkle: They pass through their income to their shareholders. But because the investments that most mutual funds own are themselves corporations, the dividends you receive are typically equally simple to account for.

For some reason, certain ETFs have chosen to structure themselves as partnerships for tax purposes. You'll especially run into this with ETFs that invest in commodities. Here are a few examples of ETFs-as-partnerships:

  • The United States Commodity Funds series of commodity ETFs, including United States Oil Fund (NYSE: USO  ) , United States Natural Gas Fund (NYSE: UNG  ) , and United States Gasoline Fund (NYSE: UGA  ) .
  • Various PowerShares DB funds, including PowerShares DB Agriculture (NYSE: DBA  ) and PowerShares DB Commodity Index (NYSE: DBC  ) .
  • Certain ProShares funds, including ProShares Ultra Euro (NYSE: ULE  ) and Ultra Gold ProShares (NYSE: UGL  ) .

What's so bad about being a partnership? For one thing, rather than getting a simple tax form, you get what's known as a Schedule K-1, which has dozens of different numbers on it, many of which you need to include on forms you might otherwise never deal with.

Perhaps the worst aspect of partnership taxation is that you can end up having to pay tax on profits, even if you never receive any cash from a fund. Because partnerships are pass-through entities for tax purposes, the activities of the fund get passed on to you as shareholders. Yet the fund has no requirement to actually pay you cash corresponding to your taxable income. That means that you can end up with tax liability that you have to pay from other sources.

Know the situation
By itself, the fact that a particular fund is subject to partnership taxation doesn't make it a bad investment. If you make the right bet on the direction of commodities prices, then you may well make big profits by investing in ETFs that are structured as partnerships.

From a tax perspective, though, such investments can create big headaches at tax time. That's not what you want to hear as the clock counts down to April 15.

For last-minute help with your taxes, look no further. We've got the info you need at The Motley Fool's Tax Center.

If taxes on your investments are getting you down, you might benefit from consulting an independent financial planner. The Garrett Planning Network is offering a limited-time 10% discount for new Motley Fool clients. Just click this link, search your state, and look for the Motley Fool icon to identify participating advisors.

Fool contributor Dan Caplinger thinks partnership tax returns are one way accountants ensure job security. He doesn't own shares of the companies mentioned in this article. The Fool has a diagonal call position and has written puts on United States Natural Gas Fund. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy will be up until midnight April 15 to soothe your tax-filing woes.


Read/Post Comments (5) | Recommend This Article (5)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 12, 2010, at 10:52 AM, nofool3485 wrote:

    The problem is not K1, turbotax can easily figure that out.

    The problem is that you get taxed twice on the same gain. My stupid broker entered the UNG and USO sale in my 1099. Any suggestions what to do (besides changing tthe UNG cost basis on my scheduleD to exactly the same as the sales price).

  • Report this Comment On April 12, 2010, at 11:23 AM, 1scotty3 wrote:

    Yup, I was taxed @ around 30% of realized profit for UGA. Apparently tax free status on gains in a Roth are null & void with these. K-1 form showed up about

    3 weeks ago. Surprise !

  • Report this Comment On April 12, 2010, at 11:30 AM, peaknic wrote:

    Another issue is that they don't send out the K-1s in a timely manner. I got 2 in the first week of April, but had completed my taxes the 3rd week of March! It stinks to have to pay back part of the return I already received.

  • Report this Comment On April 12, 2010, at 7:54 PM, BigHackAttack wrote:

    I'm no CPA, but have been able to prepare my tax return myself for the last 30 years (thanks to TurboTax and TaxCut).

    As a home-owner, recipient of incentive stock options and someone using part of his home for business purposes, my tax returns have typically been "moderately complex".

    Last year was the first year I owned any Publicly-Traded Partnerships. Ratchet that "moderately complex" up a few notches to "horribly nightmarish". TaxCut didn't help at all, without an accompanying CPA. (Not sure how helpful TurboTax would have been.)

    I sold all my PTPs the day after completing last year's tax return -- problem solved.

  • Report this Comment On April 16, 2010, at 11:42 AM, aapure wrote:

    I've owned a energy MLP for several years and find it an advantage at tax time. Some of the taxes are deferred until I sell. While the K-1 accounting is complicated the MLP provides a booklet with detailed instructions for tax filing.

    I'm considering buying DBC but after reading this article feel I should check out the tax consequences before I buy.

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Dan Caplinger
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Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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