The boom in alternative investments that began during the 2008 financial crisis as investors scrambled to buy noncorrelated assets echoes even louder in today's quest for higher yields and less risk than bonds can offer, and lower volatility than equities face.
But investors, and even some financial advisers, experience a nasty surprise by the tax treatment of more “exotic” alternatives when returns are prepared.
In describing their portfolio, “new clients will tell me, "I have something that invests in gold or commodities,' and have no idea of the tax consequences,” said Harold C. Anderson, president of Parkshore Wealth Management.
The fact that some advisers also may be left scratching their heads about complex tax issues comes as no surprise to Andrea Kramer, a tax attorney with Will McDermott & Emery, who specializes in taxation of investment vehicles.
Many of the “anti-abuse” Internal Revenue Code provisions offering guidance are “scattered all over the place” — making it difficult to find a coherent and consistent set of rules, she said.
In addition, different rules often apply not only to categories of investment but to assorted types of taxpayers as well, making rules of thumb impossible, Ms. Kramer said.
TRIP-UPS
What are the idiosyncrasies that can trip up advisers?
For starters, many who invest in exchange-traded funds backed by gold don't realize that the metal is deemed a “collectible whether in coins, bricks or any other form, except the stock of gold-mining companies.” Therefore, long-term gains are subject to a 28% federal income tax, possibly in addition to the 3.8% investment income surtax for high earners added to the tax code by the Affordable Care Act.
In addition, such ETFs typically need to liquidate sufficient gold in the portfolio on a regular basis to cover the fund's operating expenses. Although investors receive no dividends, they are taxed on those distributions, assuming that it is structured as a grantor trust.
That legal structure generally applies to all ETFs that own “physical” assets such as gold, commodities and passive foreign currencies, according to Paul S. Lee, national managing director of Bernstein Global Wealth Management.
He noted several other tax implications of this category of ETF:
• Foreign-currency ETFs give rise to Section 988 gains, which are taxed as ordinary income.
• Each sale of underlying property requires calculation of basis and holding period of shares in the ETF.
• Each sale or exchange of these ETF shares is treated as a sale of a portion of the underlying asset.
Other ETFs, including leveraged ETFs, and passive and active “securities” ETFs, may be taxed as regulated investment companies under Internal Revenue Service Regulation M.
They can pass through long-term capital gains, but no capital losses are distributed, Mr. Lee said.
EXCHANGE-TRADED NOTES
The taxation of exchange-traded notes, by contrast, can be far murkier.
The prospectus used by Barclays iPath ETNs warns: “Significant aspects of the tax treatment of the ETN are uncertain. You should consult your own tax adviser about your own tax situation.”
Mr. Lee said ETNs could be taxed in three ways: as an open transaction such as a prepaid variable forward contract with capital gains or losses taken upon maturity or sale; based on the original-issue discount principles such as zero-coupon bonds with ordinary losses realized during the investment; or as if the investor actually owned the underlying assets themselves.
For Ms. Kramer, ETN tax treatment comes down to principal protection.
“If there is no principal protection, the ETN is a derivative,” she said.
“To be treated as a debt instrument, the principal protection needs to be at a sufficient level,” Ms. Kramer said.
Because the IRS has elected, for now, not to offer any clear guidance on the matter of “sufficient level,” the standard may be in the eye of the beholder.
Another investment vehicle with potentially ambiguous tax treatment is the structured note. An example is an arrangement in which the investor is promised a return equal to appreciation on the S&P 500, with a guaranteed return of principal if the index has gone south by the time the note is due.
Underlying these deals are typically zero-coupon bonds and call options on the stock index.
Investors often don't receive payment equal to the dividends that they would have received through direct ownership, nor interest on the note.
This structure gives rise to varying interpretations of the tax treatment and, as with ETNs, the IRS hasn't given clear guidance on the matter.
One facet of Section 1256 contracts — which include regulated futures contracts, foreign-currency contracts, non-equity options based on stock indexes, debt options and additional categories — that must be explained to investors is the annual settlement or mark-to-market. Somewhat arbitrarily, 60% of any capital gains are assumed to be long-term and 40% short-term.
“That's what surprises most people,” Mr. Anderson said.
The good news is that investors get a step-up in their basis annually to blunt the tax burden for the final year of the contract period, he said.
Legislation is pending in Congress that would subject all derivatives to mark-to-market treatment, though its prospects are uncertain.
AVOIDING COMPLEXITY
Some advisers simply prefer to keep complex alternative investments out of clients' portfolios and stick to the basics. And in some situations, they may have no choice in the matter if they don't want to forfeit their errors-and-omissions -coverage.
“Many E&O providers will not cover ETNs under an adviser's insurance protection,” said Jessica Maldonado, vice president of registered investment adviser Searcy Financial Services Inc.
She avoids leveraged ETFs for the same reason.
“If our insurance carrier isn't willing to take that risk, why should we?” Ms. Maldonado asked.
Still, understanding tax attributes of alternative investments isn't always beyond reach. Often they are well-explained in prospectuses.
And when investors are offered multiple ways to treat income, gains and losses, “going with generally accepted methods is the best bet,” said Mark S. Germain, founder and chief executive of Beacon Wealth Management.
“We do not try to create our own personal opinions on issues that have already been tackled by others,” he said.
If a client were adamant about taking an unorthodox approach, Mr. Germain would encourage that client to secure a formal legal opinion.
“But often the cost of an opinion may offset the benefit,” he said.
Still, legal advice, by contrast to a formal, documented opinion, doesn't always have to cost a fortune, according to Ms. Kramer.
“You can get a pretty good reaction to a question in a reasonable amount of time” and therefore expense, she said.
Advisers may have varying appetites for delving into tax issues with clients or their tax professionals.
“Whenever taxes are concerned, we always communicate with the client's accountant,” Ms. Maldonado said. “In fact, our ability to consult with their attorney and accountant is built into our engagement agreement because we want to be sure we're on the same page.”
Ms. Maldonado also takes pains to make sure clients understand what they are getting into.
That may involve a follow-up conversation after the initial discussion, she said.
And if Ms. Maldonado doesn't fully grasp the tax nuances herself, “I will not buy it — period,” she said.
Richard F. Stolz is a freelance financial writer based in Rockville, Md.
