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K-1 vs. ‘No K-1’ ETFs: What's the Difference?


Tax planning is a core part of the investing process. While most investors are familiar with 1099s, Schedule K-1 may come as a surprise to investors dabbling in the commodities market. As more investors seek out commodities amid today’s inflationary environment, it’s essential to be mindful of the tax implications of commodity ETFs to avoid any surprises.

Let’s take a closer look at Schedule K-1, what it means for commodity ETFs, and how No K-1 ETFs may help lower your tax burden.

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What Are K-1 ETFs?


Most people assume that all ETFs are the same but, in reality, there may be different structures, including open-end funds, unit investment trusts, exchange-traded notes (ETNs), and limited partnerships. Most commodity ETFs operate as limited partnerships that pass any profits or losses through to investors rather than paying taxes at the fund level.

These commodity ETFs operating as limited partnerships are often referred to as K-1 ETFs since they send Schedule K-1 to their shareholders each year.


Pros


K-1 ETFs fall under the jurisdiction of the CFTC rather than the SEC, meaning they aren’t subject to the diversification requirements or derivatives-specific regulations of open-ended ETFs. As a result, they can invest directly in futures contracts for highly targeted exposure rather than investing in physical commodities or commodity-adjacent equities.

In addition to greater flexibility, K-1 ETFs have potential tax advantages for short-term traders. K-1 ETFs are subject to the 60/40 rule, meaning they’re taxed at 60% long-term gains and 40% short-term gains regardless of the holding period. As a result, short-term traders that would normally pay 100% short-term gains could benefit the lower long-term tax rate.


Cons


Every year, commodity ETFs operating as limited partnerships issue Schedule K-1 to their shareholders, reporting their profits and losses. Since fund managers need ownership data before completing Schedule K-1—and most brokers don’t provide that information until January—the tax form doesn’t typically reach investors until March.

In addition to these delays, K-1 ETFs must mark to market their gains, losses, and income made throughout the year, and then pass the tax liability on to shareholders. As a result, investors may owe taxes even if they did not sell the ETF shares and realize any gains. And these taxes can erode long-term returns for buy-and-hold investors.


How ‘No K-1’ ETFs Work


‘No K-1’ ETFs leverage unique tax strategies to avoid issuing K-1s to their shareholders. For example, many funds invest 25% of their portfolio in a subsidiary that invests in futures contracts while keeping the remaining 75% in high-quality government bonds. These bonds effectively collateralize the futures-focused subsidiary.

Due to their unique structure, these funds can invest in targeted opportunities using futures contracts and provide the same tax structure as any other open-ended ETF. As a result, long-term investors don’t have to worry about paying taxes on unrealized gains each year and can realize the lower long-term capital gains tax rate when they sell.

Many ‘No K-1’ ETFs are actively managed since they require a high level of oversight to maintain. For example, the actively-managed ‘Teucrium Agricultural Strategy No K-1 ETF’ (TILL) offers diversified exposure to corn, wheat, soybeans, and sugar futures, issuing a Form 1099 rather than a Schedule K-1, enabling a broader investor audience to purchase it.

Some of the most popular ‘No K-1’ ETFs are mentioned below. Some of these are actively managed.


 
As of June 14, 2022


The Bottom Line


Commodities are a popular asset class during inflationary periods, but it’s essential to keep the tax implications of various funds in mind. While K-1 ETFs may benefit short-term traders, longer-term investors that hold commodities as part of a diversified portfolio may want to consider ‘No K-1’ ETFs as a more tax-efficient alternative.

Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.