Eight Investments That Could Cause a Tax Headache For Your Registered Fund
Posted by Richard Wagner on Mar 25, 2021 11:26:33 AM
As the saying goes, "You don't know what you don't know." Below we have detailed eight investments that could cause a tax headache if not approached carefully.
- Investments in Commodity Derivatives – Commodities are not included in the definition of a security by the IRS. Therefore, any income that is produced by investing directly in commodities or by investments in derivatives that have underlying commodities in the form of income or realized gains will be considered bad income for the qualifying income test under Subchapter M. This bad income can be avoided by holding the commodities in a wholly owned controlled foreign corporation (“CFC”), which will cleanse the income and turn it into dividend income. While holding the investments in a CFC solves the good income issue, it can create diversification issues as the fund owns more than 10% of the shares of the CFC. Therefore, the CFC is a bad asset even though it is under 5% of the total assets of the fund.
- Investments in Physical Metal ETFs – The structure of physical metal ETFs and ETNs should be verified when adding them to the investment portfolio of a regulated investment company. The ETFs can be structured as grantor trusts for tax purposes. Grantor trusts are flow-through entities for tax purposes. When calculating income and realized gains for purposes of recognition of bad income under Subchapter M, the gross gains from sales could be considered bad income. Another issue that should be considered is that if multiple gold ETFs are held in the same portfolio, for diversification purposes, they should be added together for calculation of the 50% diversification test.
- Investments in Volatility ETFs – ETFs that invest in volatility futures can produce bad income depending on the way they are structured. If they are structured as partnerships, the pass-through nature of the structure would cause the fund to incur bad income on any gross realized gains on distributions or sales of the ETF. If the ETF is structured as a partnership that is traded on an exchange, a Qualified Publicly Traded Partnership (“QPTP”), the structure acts as a blocker and cleanses the bad income. See QPTP below for diversification information.
- Investment in Cryptocurrency Funds– Cryptocurrency funds can be private funds or funds that are traded on a nationally recognized exchange. The most recognizable fund is the Grayscale Bitcoin Trust (GBTC). The tax structure of these entities should be considered because some are structured as grantor trusts. Grantor trusts are flow-through entities for tax purposes. When calculating income and realized gains for purposes of recognition of bad income under Subchapter M, the gross gains from sales could be considered bad income. Bad income can be produced when investing in these entities and selling the securities for a gain, a flow through of gains from the security due to the grantor trust selling cryptocurrencies to pay expenses, or through a fork, (1) which may require the recognition of income by the entity that holds the currency. This income would be recognized by the fund as bad income.
- Investments in Cryptocurrency Derivatives – Cryptocurrencies are not considered securities under IRS guidelines and should have the same considerations as commodity derivatives when held in a regulated investment company that intends to qualify for pass-through status under Subchapter M.
- Investments in Private Companies – Private companies can cause diversification complications if the fund owns more than 10% of the outstanding shares of that entity. Under Subchapter M, if a fund owns more than 10% of the outstanding shares of a company, the value of those shares should be included in the non-diversified assets when calculating diversification for qualification as a regulated investment company under Subchapter M.
- Qualified Publicly Traded Partnerships (QPTP) – QPTPs are publicly traded companies that are structured as partnerships for tax purposes. These entities can have commodity components which when held in a partnership can flow through to the investor. One example of a publicly traded partnership is a Master Limited Partnership (MLP). MLPs are prevalent in the oil and gas industry. QPTPs are subject to an aggregate limitation of 25% of the value of the partnerships in relation to the fund’s gross assets in order to qualify as a regulated investment company for tax purposes under Subchapter M.
- Investments in Real Estate Investment Trusts (REITS) – REITS are income producing entities that invest in real estate. A REIT will typically pay out the income they earn monthly as ordinary income. The REIT will identify the character of the income that is paid out during the year after its fiscal year end. A recharacterization of income can be an issue for a fund that distributes all of its income monthly or even quarterly.
As always, please reach out to us if you have any questions on the investments discussed or any other questions that you may have.(1) Forks are a change in a blockchain’s protocol. Forks can occur when the user base or developers decide that something fundamental about a cryptocurrency needs to change due to software validity or mining discreprencies. The result can be additional coins or currencies being issued to each holder.