Oil prices have plunged, and bullish energy investors find themselves wanting to bet on an oil price recovery in the near future. Many of them have turned to United States Oil Fund (USO 1.52%), an exchange-traded investment that tries to track changes in the spot price of West Texas Intermediate crude oil.
U.S. Oil Fund has gotten a lot of attention recently because of the wild swings in its shares and the huge shifts in its strategy that it's had to make in order to deal with the unprecedented conditions in the oil markets. Yet as speculators pile into the shares, there's one thing that many of them aren't paying attention to -- and it could make their lives a lot more complicated than they realize.
How USO is different from most funds
Most people think of USO as an exchange-traded fund because its shares trade on the stock market during regular business hours. Yet technically, U.S. Oil Fund is set up as a limited partnership, and what investors are buying are actually limited partnership interests rather than shares of a corporation.
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Being a partnership rather than a corporation has a number of ramifications, most of which don't have a huge impact on investors. Yet the big difference for investors in U.S. Oil Fund is that shareholders have to deal with the tax complications of receiving a Schedule K-1 information return every year they're invested in the fund.
That might not seem like such a big deal, since USO doesn't typically pay out distributions. With the fund's sole goal of tracking the price of oil, it doesn't invest in income-producing securities, so there's no income for the fund to pay investors.
However, even though it doesn't actually pay out money to its investors, United States Oil Fund does have to report various tax items to its limited partners. The K-1 can therefore include allocations of income and expenses to each investor, representing the proportional share of the limited partnership's entire operations. Investors have to report that income on their tax returns, even though they didn't receive any actual cash.
What happens when you sell your USO?
Things get even more complicated when you decide to sell out your position in U.S. Oil Fund. As the fund's own information states, your tax reporting responsibility for selling shares requires you to report gains or losses on the sale.
In determining whether you have a gain or a loss, you have to adjust your tax basis to reflect some of the information that shows up on K-1 statements. As the fund literature further explains, you'll generally increase your tax basis by income and gain reported to you on a K-1, while reducing your basis for expenses.
Good news for retirement investors
Many investors in limited partnerships find out the hard way that using tax-favored retirement accounts to invest in them isn't the perfect solution it seems to be. Ordinarily, investors don't have to worry about tax consequences of their investments inside an IRA or other retirement account, because taxes only get charged when you make withdrawals from the account. However, in many cases, partnerships produce something called unrelated business taxable income (UBTI), and too much UBTI can have severe consequences for retirement accounts that can lead to having to pay taxes or even jeopardize the tax-exempt status of the retirement account.
That's an especially important issue for energy investors, because many companies in the sector are set up as master limited partnerships that have to observe those rules. For USO investors, though, UBTI isn't a problem right now. In its 2019 materials, the fund states that none of its allocated income is treated as UBTI. Therefore, owning USO in a retirement account could be a way to avoid some of this mess -- assuming current tax laws don't change in the future.
Know what you're getting into
The worst time to find out about all these tax complications is after you've already invested money in USO. Fortunately, the complications aren't all that dire and are mostly just a nuisance. Your accountant won't be happy with you, but it's not something you can't solve and fix.
Going forward, though, the lesson to learn is that it's important to do research on investments before you buy them. Knowing what to expect can help you steer clear of investments that will end up being more trouble than they're worth.
