More investment options complicate taxes

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As we approach the April 15 tax filing deadline, it has been a frustration of many investors that their tax documents seem to arrive later and later each year. Compounding the impact of the already delayed kickoff to tax season, many investors have had to wait for their last few tax-related documents into the last weeks of March.

A culprit in much of this delay has been the Schedule K-1, issued by business partnerships, trusts, and S Corporations to report each partner, beneficiary and shareholder portion of the tax liability.

If you are a business owner, you may already receive a K-1 from your business activity. If you are not a participant in one of these entities, you may wonder “Why am I receiving this form?”

More and more investors are receiving K-1s from investments such as Exchange Traded Funds and Master Limited Partnerships. ETFs have become a valuable tool for low-cost diversification while MLPs have surged in popularity for their income potential.

The downside to these investments is that MLPs and some ETFs have more complicated tax reporting rules than stocks or bonds. Knowing how they will impact your tax situation can be as important as determining the role they have in your portfolio.

These are some of the K-1 related questions that investors are asking as they weigh the value of these investments:

• What types of investments in my portfolio issue a K-1 instead of a Form 1099?

Most commonly it is investments that are related to natural resources and futures contracts. Master Limited Partnerships are commonly engaged in the production and transportation of oil and natural gas, among other natural resources.

These partnerships have historically paid a high rate of income that is allocated proportionally among the limited partners. MLPs have become very popular in recent years as an alternative to lower yielding equity and fixed income investments.

As ETFs have gained popularity as an investment vehicle in the last decade, they have provided investors with a means of hedging the risk in their stock and bond portfolio. Strategies have included access to sectors such as agricultural commodities, precious metals, and the volatility indices.

An example of these ETFs is the iShares S&P GSCI Commodity-Indexed Trust, which seeks to track an index of energy, industrial and precious metals, agricultural and livestock commodities.

An investor might use this fund, which utilizes futures contracts to track its index, as an alternative to owning the physical commodities. Because of the use of futures contracts, this fund would issue a K-1 instead of a 1099 each year.

• Why am I receiving more of them than before?

The volatility of the equity markets over the last several years combined with the low yield on bonds has contributed to investors seeking returns in nontraditional sectors. Fund companies have been happy to oblige by flooding the market with ETF and mutual fund offerings that provide exposure to increasingly specific markets.

If you trade on your own or work with an adviser, your options may have become more complicated as you weigh whether to use a fund that allows you to short the Australian dollar or invest in natural gas. You may also look to an MLP for a source of income that is well above the yield you can gain on other investments.

Before you make a final decision, you might consult with your tax adviser to determine the tax implications of a nontraditional investment. The answer to your questions may prevent surprises when tax time arrives.

• How do I determine if an MLP investment or commodity ETF is appropriate?

A good first step would be to ask about the structure and suitability of any investment that is concentrated around natural resources or futures contracts. A few important questions:

• Does it require a K-1, report 1099 income, and at what rate will it be taxed?

• Are gains taxed at the end of each year or only when the investment is sold?

• Does it make sense to own the investment in a tax qualified account like an IRA?

• Does the fund own the physical commodity or use derivatives?

• Do the benefits of owning the fund outweigh the risks and potential complications?

The democratization of investing has led to a wealth of options for investors, but it also means layers of complication in tax reporting and risk management.

As you venture away from traditional stocks and bonds in order to hedge risk or increase yield, consult with a tax professional and/or financial adviser to determine the most effective way to accomplish your goal. The answers you gain may help to save you stress as your tax deadlines approach.

Dennis Morton Jr., CFP, is a partner and financial consultant with Concannon Wealth Management in Bethlehem. He oversees the financial affairs of business owners, executives and families in the region. His practice areas include portfolio management, financial planning, estate planning and insurance.

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