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.