ETF risk, Tax burden

ETFs are taxed on earnings from the underlying assets of the investment portfolio. But it’s the shareholders, not the ETF, that pay all U.S. Federal and State taxes on the portfolio income.  The shareholder’s tax burden is the total cost of a tax accountant’s fees combined with tax payments.  The warning signs of increased tax preparer’s fees are Schedule K-1s and trust letters.  The cost of tax preparation may increase by an obligation to prepare tax reports for state governments where a grantor trust or partnership earns income.  I exclude regulated investment companies (RICs) from incurring extra costs of tax preparation (most index ETFs are registered by the U.S. Securities and Exchange Commission as RICs).   The tax rates are higher for precious metals than for long term capital gains.  Portfolio turnover rates above 100% tend to increase the tax burden by generating higher capital gains and ordinary income1,2,3,4,5,6.

U.S. Tax forms4,7,8  The federal tax structures of Grantor Trusts and Partnerships are complex and may require many reporting forms.

  • RICs. Most open-end investment companies and unit investment trusts qualify as RICs.  Brokers provide tax form 1099 to RICs shareholders.
  • Grantor trusts.  Shareholders must report distributions in a trust letter.
  • Limited partnerships.  Returns must be reported on Schedule K-1, which is more complex than tax form 1099.  Shareholders must report their share of the partnership’s income, gains, losses, and deductions on federal income tax returns even if cash distributions are not made.
  • Limited partnerships OR tax-deferred accounts (e.g., IRAs). Shareholders must pay tax at the corporate rate if they incur an “unrelated business taxable income (UBTI)” above $1,000, in which case they must file form 990-T 9.

Tax rates.  Tax rates for income and capital gains are published annually by the Internal Revenue Service.

  • RICs.  The “portfolio turnover rate” reveals a hidden expense of investment operations10,11Turnover rate is the annual replacement rate of portfolio assets.  A 100% turnover rate means that all assets were replaced during the year with two consequences: 1) trading fees decreased the portfolio’s net assets, and 2) the portfolio’s capital gains are taxed at a higher rate when holding periods are below one year.  RICs with higher turnover rates typically invest in high-yield bonds, taxable bonds, REITs, and short-term stocks as sources of frequent taxable distributions in contrast to RICs with lower turnover rates that hold stocks for the long-term and distribute fewer taxable capital gains to shareholders.  Unit investment trusts offer a shelter from the federal unrealized capital gains tax by operating at a low turnover rate.12
  • Grantor trusts.  Long-term capital gains from precious metals are taxed as short-term capital gains (currently 28%) because precious metals are considered ‘collectibles’.
  • Limited partnerships.  Capital gains from futures are subject to taxation by the 60/40 allocation rule (60% at long-term tax rate of 15% and 40% at the short-term tax rate of 28%).

Tax preparation time7

  • Routine.  The tax preparation of RIC-returns involves collection of form 1099, confirmation of the broker-supplied cost basis, computation of income & capital gains taxes, and filing the tax return.
  • Additional.   Additional time is needed for collection of trust letters or K-1 schedules, unusual tax calculations, and complex tax laws.  Brokers are not required to provide the cost basis of investments in open-end investment companies until 2012; nor are they required to provide the cost basis of UITs, grantor trusts, and partnerships until 2013.  Limited-partnership shareholders are liable to file income tax returns in other states when sufficient income is generated from those states.  Out-of-state taxes raise the total income tax and extend the routine tax-preparation time.

Tax efficiency10,11,12.  Passively managed funds are more tax efficient than actively managed funds due to the lower portfolio turnover of passive management.

A tax advantage of ETFsover mutual funds is the ‘erasure’ of unrealized capital gains during share redemption.

  • Mutual funds distribute unrealized capital gains to the retail investor, who is left paying a tax on imaginary gains.
  • ETFs distribute unrealized gains to the authorized participant, not the retail investor.

The ‘erasure’ of unrealized gains by authorized participants is augmented by preferential redemption of security lots with lowest cost basis.  The latter strategy works better for ETFs with lower turnover rates (e.g., passively managed versus actively managed ETFs).

copyright © 2011 Douglas R. Knight, updated June, 2012

References

1.  Partnerships. http://www.irs.gov/businesses/small/article/0,,id=98214,00.html

2.  Abusive Trust Tax Evasion Schemes – Facts (Section II). http://www.irs.gov/businesses/small/article/0,,id=106538,00.html .

3.  Sales and Trades of Investment Property. http://www.irs.gov/publications/p550/ch04.html

4.  U.S. Income Tax Return for Regulated Investment Companies. http://www.irs.gov/pub/irs-pdf/i1120ric.pdf

5.  Internal Revenue Bulletin No. 2003-32, August 11, 2003. Section 851. Definition of Regulated Investment Company.

6.  Little, Pat.  Is that an ETF? Research Note, Hammond Associates, September, 2010.

7.  Laura Saunders, Jason Zweig. Extreme Tax Frustration. Wall Street Journal, June 25-26, 2011.

8.  ETF Education Center, The history of exchange-traded funds.  ©2011 ETFguide.com.

9.  Publication 598 (03/2010), Tax on Unrelated Business Income of Exempt Organizations, revised: March 2010.

10.  Ferri, Richard A., CFA.  All About Index Funds, second edition.  McGraw Hill, 2007.

11.  The “tax efficiency of fund is tied to turnover ratio”, Motley Fool, The Columbus Dispatch, page D4, 3/20/2011.

12.  Investment Company Factbook, 50th Edition, A Review of Trends and Activity in the Investment Company Industry. Investment Company Institute, 2010.

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