Exchange-traded products (ETPs) are a relatively new vehicle that allow you to invest in commodity futures without opening a futures trading account. They trade like a stock throughout the day on stock exchanges.
The first ETP was Teucrium Corn Fund (NYSE:CORN) which launched on June 9, 2010. Note the clever ticker symbol! It quickly gained assets as the corn markets soared in 2010 and investors became interested in an asset class with low correlation to the stock market.
The income and expenses are reported to the investor at the end of each year on a Form K-1. Shareholders are actually partners in the fund and must report each category of income and expense on their individual income tax return, even if no cash distributions are made by the ETP. The net taxable income reported each year becomes an addition to your cost basis in the ETP and distributions are reductions in your cost basis (but not below zero.)
Certain methods and conventions are used by some ETPs to simplify the accounting:
1. Monthly Allocation Convention. Transactions in the middle of the month are treated as made as of the 1st of the following month. Income and expense per share are allocated for the whole month to the partner that owned the share on the first day of the month.
2. Mark to Market. Unrealized gain/loss is recorded for any month in which new shares are created or redeemed by the ETP and the capital accounts are adjusted.
3. Section 754 Election. Each partner's basis in ETP assets is adjusted to fair market value whenever any ETP shares are sold on the stock exchange. This is done in order to eliminate differences between a partner's own basis and their proportionate share of tax basis in ETP assets allocable to that partner. The Section 754 election was made at the partnership level; there is nothing that you need to do.
Special Tax Features of ETPs:
1. Internal Revenue Code Section 1256 rules apply to ETPs because they invest in futures contracts eligible for special tax treatment. Sixty percent (60%) of any gain or loss from a Section 1256 contract is treated as a long-term capital gain and forty percent (40%) as a short-term capital gain/loss. The eligible Section 1256 amounts will be reported to you by the ETP. The $3,000 per year limit on capital loss deductions in excess of capital gains continues to apply. However, an individual taxpayer may elect to carry back net Section 1256 losses to the three preceding tax years.
2. Investment-related expenses incurred by the ETP partnership are allocated to you on the Form K-1 but are only deductible to the extent that your total miscellaneous itemized deductions exceed two percent (2%) of your adjusted gross income.
3. Investment interest is also allocated to you on the Form K-1 but it is only deductible to the extent of your own net investment income. Your net investment income generally includes interest income, dividend income, long-term capital gains (if so elected), and gross income from property held for investment, less non-interest expenses directly related to the production of investment income.
Computing your basis:
1. Your initial cost basis is the amount you actually paid to invest in the ETP plus your share of any liabilities of the ETP at the time of your purchase. 2. You then increase your basis each year by the amount of any taxable income and gain that is allocated to you. You also increase your basis for an additional deemed contribution for your share of any increase in the ETP's liabilities. 3. Next, decrease your cost basis each year by your share of the ETP's tax deductions and by the amount of any distributions you received from the ETP. You also decrease your basis for a deemed withdrawal for your share of any decrease in the ETP's liabilities. However, these decreases may not reduce your cost basis below zero. 4. The amount resulting from the three previous steps is your cost basis. If your cost basis reaches zero, all further distributions are capital gains.
Computing your gain on sale.
1. The specific identification method is not allowed, even if you have multiple tax lots of the ETP purchased at different times. You must treat all shares purchased as a unified whole and use an "equitable apportionment" method to allocate a portion to the shares that you sold.
2. Your taxable gain or loss when you dispose of your ETP shares is the net sales proceeds received plus your share of the ETP's outstanding debt less the adjusted cost basis apportioned to those shares.
3. Long-term capital gain treatment is available if you held the ETP shares more than one year. If you hold multiple tax lots and sell only part of them, you need to make an election to identify and use the actual holding period for the shares you sold. Otherwise, you will have a "split" holding period assigned whereby any gain is allocated to short-term versus long-term treatment in proportion to all the shares you owned, not just the ones you sold.
4. Your gain or loss on sale is computed separately from the Sec 1256 contract gains and losses which are reported as taxable gains or losses on your Form K-1 each year. The Section 1256 rules do not apply to your sale of ETP shares.
Other Special Rules:
1. If you lend any of your ETP shares (for instance, to cover short sales), it is a taxable disposition. You must recognize taxable gain or loss as if you had sold those shares for cash. The income, gains, losses, and deductions allocable to those ETP shares are not reported for tax purposes, and any distributions are fully taxable to the Shareholder, usually as ordinary income. To avoid these consequences, notify your brokerage firm that you wish to prohibit the lending of any of your ETP shares and make sure the shares are placed in your cash (not margin) account.
2. Unrelated business taxable income (UBTI) may be generated if the ETP borrows money to acquire investments or if you have any acquisition indebtedness to purchase the ETP. It is best to avoid purchasing ETPs in your IRA in case this happens. You don't want to have to pay UBTI tax from your IRA.