Wednesday, February 6, 2013

Free tax filing isn’t always free: Extra costs add up for many tax self-filers

Isaac M. O'Bannon for CPA Practice Advisor writes: Many do-it-yourself filers could pay about the same to have a credentialed tax expert do them, and still get their refund in about the same time, and with the peace of mind of real professional guidance.  

When is "free" tax filing not really free? People wanting “free tax preparation” often find that state taxes, program upgrades, add-on charges, bank products and other fees can add up quickly.  In fact, many do-it-yourself filers could pay about the same to have a credentialed tax expert do them, and still get their refund in about the same time, and with the peace of mind of real professional guidance.

From January to April 15 of each year, Americans are bombarded with advertising for tax preparation software, online programs and stores.  The most common word in those commercials: Free. Of course, there are a few disclaimers on these commercials, far too many to list at the end, which even used car dealers seem to be able to do. Check out the websites of these “free file” tax advertisers, however, and that’s another story.

So, what does “Free” really mean to a taxpayer at using one of the most popular “do-it-yourself” tax programs? Well, that depends on what a taxpayer hopes or expects it to mean.
However, unless a person lives in one of the seven states with no income tax, rarely does “free” mean that a person can complete and e-file both their federal and state tax returns for free.
Those states are Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming. Tennessee and New Hampshire limit individual taxation to dividend and interest income. The other 41 states, DC and territories do have reporting requirements.

How it Started
Ten years ago, the IRS started the Free File system, which is a partnership between the agency and 15 private companies that make tax preparation software to offer free federal tax preparation and e-filing for many Americans with basic tax needs.

Since it is a voluntary partnership, the companies are not required to participate, and have quite a bit of leeway in designing their own pricing structures, as long as they meet a minimum threshold of preparing and e-filing free federal returns for most people in that income range, but with exceptions for some types of forms.
One of the goals behind the the IRS's Free File system was to spur electronic filing, which has certainly done. More than 75% of individuals now do so for their 1040 returns, either through a software program or a professional.

What “Free” Includes
As a result, qualifying for the free federal versions of these systems varies somewhat, but most of them are designed for preparing and filing very basic returns for Americans without a need for itemizing deductions or with business income and expenses. So, most of the systems do not include a Schedule C unless you upgrade, and many won’t provide even the Earned Income Tax Credit or Child Tax Credit, either.

Some other taxation issues that are almost never included in the free versions include multi-state incomes, capital gains taxes, extensive home-business office expenses, business asset depreciation, moderate investment income or those with household employees.

In no cases that I could find, do the free software programs include preparation of partnership, corporation, non-profit, trust or estate taxes. These definitely require an upgrade, but really, you should be using a true tax professional.

What “Free” Doesn’t Include
After use of the word free in their advertisements, probably the most emphasized feature has been customer support, access to tax professionals, guidance and other expert advice.
While one of the companies has been vocal in noting that their experts are made up of Certified Public Accountants (CPAs), Enrolled Agents (EAs) and Tax Attorneys, the fine print for those services (and similarly for the other programs) state that only live chat or email-based support is available with the free version. Want to talk on the phone? Upgrade.  Want to be able to automatically transfer last year’s data into the program? Upgrade. (Import last year’s tax form from PDF is sometimes available free.)

When Free-Filing Starts to Cost Money 
Let’s start with two specific words left out of the partnership between the IRS and those companies: “state taxes.” The IRS program is designed for preparation and filing of federal individual income taxes, not for state income taxes.

That’s where most of the do-it-yourself tax preparation systems start to ask for money. A taxpayer can still use the federal part for free, then prepare their state return on paper, but most seem to opt for the additional cost of continuing within the program to complete this filing electronically.  In the past month, several advertisements for the big tax preparation companies have promoted the “free” federal filing aspects of their services.

Here’s what TurboTax, H&R Block, TaxAct and TaxSlayer charge for state returns prepared and e-filed in conjunction with the “free” federal version, if the taxpayer qualifies for the free version.  Once again, each of these programs varies in exactly how much you can do with the free version. But for those who qualify, these are the extra costs that most will be encouraged to add on. )The information below is based on their websites' product information and disclaimer pages on Feb. 5, 2013.)

  • TurboTax Online Free Edition
    State preparation fee: $27.99 per state, includes e-filing.
    Tech support and tax support from CPAs, EAs, tax lawyers via email and chat only.
  • H&R Block at Home Free Online Version
    State preparation fee: $27.95 per state, includes e-filing.
    Email tech support; one-time email or chat tax support session.
  • TaxAct Online Free Edition
    State preparation fee: $14.95 for any number of states, w/e-filing.
    Tax and tech support by email only.
  • TaxSlayer Free Tax Edition
    State preparation fee: $17.95 per state, $9.95 for additional states.
    Tech email support only, no tax support.
Note that not all filers qualify for the free version of all of these products.

For filers who manage to stay in the qualification zone for free filing, this can seem still a pretty inexpensive solution. They need to remember, however, that doing your own taxes is like representing yourself in court. It may be okay for small claims, but when the issues start to get even slightly more complex, it’s better to rely on an experienced tax professional.

The Other Costs Add Up
Many taxpayers end up upgrading to a higher (non-free) version of the software, which can cost from $40 to $90 more in addition to often higher ($10 or so) state filing costs. This puts them in the range of $80 to $130.

Then, the tax programs often recommend users have their preparation fees deducted from their tax software. This costs about $30 for many of the programs. Taxpayers can also use a credit card to pay immediately at no extra cost, but there seems to be an encouragement.

Then Come the Bank Products, aka Refund Loans or Advances
Promoted as a faster way for a taxpayer to receive their refunds, these are actually loans offered though the tax software that are issued against the anticipated refund amount.
As loans, they have a cost, because the bank backing the “anticipated” refund has a risk: What if the taxpayer has debts that intercept their refunds or if the taxpayer files false information. As of 2011, the IRS stopped warning preparers and financial institutions if there was such a debt, so the risk increased. With an assortment of various fees and high short-term interest rates, bank loan products can easily add another $60 to $170 to the total cost of a taxpayer’s return.
Without one of the refund advance loans, a taxpayer who e-files their return to the IRS and asks for direct deposit, can get their refund in as little as 10 days, and often faster from their state. That shouldn’t be worth the cost to most taxpayers.

The Cost Now:
Free + State + Upgrade + Deduct Fees + Loan = $$$ ?
So the previously somewhat simple return that was upgraded from a free version of a software program could now be costing the taxpayer $140 to $300.

Real Tax Professionals Are Cost Competitive
Many taxpayers feel that a CPA or EA would be cost prohibitive, but depending on the region of the country, many professionals would be happy to assist with returns in the $150 to $300 range, and most won’t steer their clients toward high-cost loans that don’t really provide more than a couple of days of earlier refund.
In exchange, taxpayers also get much greater assurance that their taxes have been properly prepared and submitted to the IRS and states. If the cost is the same, it’s more than a value. And the odds are, the professional will be able to see and know things that the designers of the software forgot.
“At the end of the day, you’ll get a higher quality product with much better detail and depth,” said Steven Phelan, a CPA in Oklahoma City. “I wouldn’t recommend a person do their own taxes just as I wouldn’t recommend someone do their own dental work. When you are not a professional, and you’re relying on your own expertise to keep you out of trouble, you’re inviting it in.”
For those with very simple tax situations who do still qualify for the free version of do-it-yourself tax software and don’t mind paying for the additional cost of the state preparation, the programs do offer a good value. As long as the taxpayers can avoid the add-on surcharges and fees.

Last Words of Advice
Whether a person does their own taxes online or using software, or has a professional help them, don’t fall for guarantees that promise a refund. (A promise of the “best/max refund possible” doesn’t cross that line, because if you’re not due a refund, you won’t get one.)
Lastly, if anyone promises a specific amount of refund before they’ve even talked about your tax information, or tells you they will charge based on a percentage of your refund … run, don’t walk, away from them. There's a good chance they're going to break the law, and they're going to pull you down with them.



Posted on 9:09 AM | Categories:

Good news! Not everything is taxed (Taxable and Non-Taxable Income)



Kay Bell for BankRate.com writes: There's not much the Internal Revenue Service doesn't consider taxable income. Of course, there are the standbys: salaries, wages, tips, commissions, interest and dividends, rent on property you lease, and all the money you make from that photography business on the side.  Bartering your services won't help, either. The value of noncash items must be determined and then counted as income.


Nor can you put money in a foreign bank to earn interest out of Uncle Sam's reach. If it's in your name and you can get to it, it's considered income, and the Internal Revenue Service has become really strict about these offshore tax havens in recent years. And don't think for a minute you can get away with some underhanded ways to make a few extra bucks. The IRS specifically says kickbacks and embezzlement proceeds are taxable, too.
The tax folks don't care if you steal it, as long as they get their piece of the action. Remember, it was the IRS that tripped up Al Capone.

This stuff's going to cost you

Even trying to get a better grip on your finances could cost you at tax time.
Did you negotiate with a lender or other account holder to eliminate some of your debt? While you may no longer have a recurring payment, you'll probably now have to make one to the IRS. In most cases, debt you owe that is canceled or forgiven generally is considered income -- taxable income.

An exception is made for some canceled home mortgage debt under a law that was passed in late 2007. But this provision applies to specific residential loans and only those forgiven during tax years 2007 through 2013.

Then there are those minimal amounts you get when trying to do the right thing. Fulfill your civic duty as a juror and get a few bucks, and you owe taxes on that pay. Serve as the administrator or executor of an estate, and any stipend you get is taxable.

Efforts you made to reduce one year's tax bill also could come back to bite you if you get what the IRS terms "recoveries." For example, your itemized deductions last year included medical expenses, mortgage interest and real estate taxes. This year, however, your insurance company had a change of heart (or at least policy), and paid you back for some of those expensive tests. In an election-year frenzy, your county government rebated some of your past property tax payments. And your lender discovered it had misapplied some of your payments as mortgage interest when the money really went toward your home's principal. The IRS requires you to include these amounts as income in the year you receive them up to the amount you previously claimed them as a deduction or credit.

Rewards for a job well done could cost you, too. If you get a bonus, it's income. Many fringe benefits, such as a company car or use of a health club, are also included in your income as compensation unless you pay fair market value for them or the law specifically excludes them. Your employer generally must withhold income tax on these benefits from your regular pay.



You can't get around taxes by claiming the company reward was a gift. The IRS will let it slide if your boss hands out a turkey, ham or nominally priced item at holiday time. But if you're given cash, a gift certificate or an item you can easily exchange for cash, you must include the gift's value as extra salary or wages regardless of the amount involved.
Heck, even if you're out of a job, you're out of tax luck. Unemployment benefits are taxable.
Some instances where the taxman wants his cut include the following.
  • Alimony received.
  • Awards, prizes, contest winnings and gambling proceeds.
  • Back pay awards.
  • Notary public fees.
  • Patent, royalties, license receipts and any infringement compensation.
  • Profit on sales between family members.
  • Punitive damages.
  • Residence sale profit above the exclusion limits.
  • Severance pay.

In the tax clear

There are few sources of income that are not taxable. Unfortunately, many represent money you wish you didn't need to get in the first place.
Types of income the IRS can't touch
  • Black lung disease benefits.
  • Dependent care assistance paid by the military to military personnel.
  • Disaster relief grants.
  • Casualty insurance and other reimbursements.
  • Child support payments.
  • Compensatory damages awarded for physical injury or physical sickness.
  • Damages for emotional distress due to a physical injury or physical sickness.
  • Disability payments if you paid the premiums on the policy with already-taxed dollars.
  • Foster care payments when the care is for youngsters.
  • Interest on certain state or local government obligations.
  • Supplemental Security Income, or SSI.
  • Veterans' benefits.
  • Welfare benefits.
  • Workers' compensation.
And while an inheritance of property is not a taxable event, you'll owe Uncle Sam on any income the bequest produces.




Navigating murky tax waters

As with almost every tax situation, it's not always clear-cut when it comes to taxable versus nontaxable income.

For example, the tax laws treat various scenarios regarding life insurance payments differently. If you surrender a life insurance policy for cash, you must include as taxable income any proceeds that are more than the cost of the policy. But life insurance proceeds paid to you as the beneficiary of the insured person are not taxable unless the policy was turned over to you for a price.

Another instance where income may or may not be taxable is scholarship or fellowship grant money. If you are a candidate for a degree, you can exclude from income amounts you receive as a qualified scholarship or fellowship and used to pay tuition, fees or buy books or other required educational equipment. Grant money used for room and board, however, is taxable.
And there are special taxable income rules for certain professions, such as the clergy or folks who work for foreign employers, as well as for volunteers who might receive nominal amounts for their services.

These examples are not all-inclusive. So if you have an unusual income situation, check out the IRS rules with your tax adviser. You may -- or may not -- have to pay taxes on the money.
A complete list of what the IRS considers taxable or nontaxable is available in Publication 525, Taxable and Nontaxable Income.

Posted on 8:58 AM | Categories:

Xero : Cloud providers connect accounting, time tracking services

 for Small Business Matters  writes: Xero is partnering with Harvest to bring time tracking and invoicing into its small-business accounting platform. Fast-growing cloud accounting software vendor Xero is teaming up with another cloud service provider, Harvest, to bring time tracking and invoicing capabilities into its platform.  It's just the latest integration for Xero - which has already teamed up with dozens of other cloud providers that are focused on tools for small businesses.

Those connectors span a range of capabilities from customer relationship management to inventory to payroll and other specialized software. "Xero is continuing to partner with industry leaders, like Harvest, who round out our cloud-based offering with tools that make it even easier for small businesses and accounting professionals to manage their finances from anywhere, anytime," said Jamie Sutherland, president of Xero's U.S. operations.
As I write this blog update, here are the eight most popular Xero add-ons aside from Harvest:
WorkflowMax, an online job management solution (owned by Xero)
Receipt Bank, a receipt organization tool
ADP, the payroll and human resources service provider
Unleashed, inventory management
Vend, point of sale software
Capsule CRM, a simple customer relationship management tool
simPRO, an industrial contracting tool for electricians, plumbers and related professions
Shoeboxed, for organizing paper receipts
Fathom, for management reporting and financial analysis
Spotlight Reporting, for small-business accounting professionals
Batchbook Social CRM, for tracking both customer accounts and social conversations
Xero counts more than 111,000 "paying" customers and 200,000 users in 100 countries. The company's service is priced starting at $19 for sole proprietors, although it positions its $29 per month option as the best option for most small businesses.
Posted on 8:37 AM | Categories:

The 2013 Complete Guide To ETF Taxation


Dennis Hudacheck for for Index Universe writes:  2013 Update: Effective Jan. 1, 2013, new capital gains tax rates are applicable to higher-income investors due to the passing of the American Taxpayer Relief Act of 2012. Also effective Jan. 1, 2013 is a new Medicare surcharge tax on investment income applicable to higher-income investors. While these new maximum capital-gains rates are now referenced throughout the paper, for details regarding these changes, see the "2013 Capital Gains Tax Changes" and "New Medicare Surcharge Tax" sections.


Investors spend hours researching funds for expense ratios and spreads, trying to save a few basis points here and there. But often, not enough time is spent researching a fund's structure and the associated tax implications. When shares are eventually sold for a gain, the different tax implications can translate into hundreds or even thousands of basis points.

Investor confusion over tax treatments comes from many sources. Partly, it's because ETF taxation is complicated. Partly, it's because taxes are boring. And partly, it's because ETF issuers provide unclear tax guidance in many prospectuses.

Whatever the reason, we at IndexUniverse think investors deserve better, so we prepared this document to provide complete guidance on how different ETFs are treated by the tax man.

WHAT DRIVES ETF TAXATION
An ETF's taxation is ultimately driven by its underlying holdings. Since funds are structured differently according to how they gain exposure to the underlying asset, an exchange-traded product's tax treatment inherently depends on both the asset class it covers and its particular structure.

A fund's asset class can be classified in one of five categories: equities; fixed income; commodities; currencies; and alternatives.

For tax purposes, exchange-traded products come in one of five structures: open-end funds; unit investment trusts (UITs); grantor trusts; limited partnerships (LPs); and exchange-traded notes (ETNs).

Many commodity and currency funds that hold futures contracts are regulated by the Commodity Futures Trading Commission as commodities pools, but they're classified as limited partnerships for tax purposes by the IRS. Therefore, "limited partnership" will be used to refer to the structure of these funds throughout this paper.

This five-by-five matrix—five asset classes and five fund structures—defines all the potential tax treatments available in the ETF space. In this paper, we'll use asset class as the primary sort, as that is the easiest way to classify and think about funds.

Note: The tax rates we're about to discuss are the maximum long-term and short-term capital gains rates. The rates listed in the tables for each respective asset classes do notinclude the new Medicare surcharge tax of 3.8 percent applicable to certain investors. Long-term capital gains apply to positions held for longer than one year; short-term capital gains apply to positions held for one year or less.
EQUITY AND FIXED-INCOME FUNDS 
Equity and fixed-income ETFs currently operate in three different structures: open-end funds, unit investment trust (UITs) or ETNs.

MAXIMUM CAP GAINS TAX RATE
STRUCTURELong-TermShort-Term
Open End (40 Act)20%39.6%
UIT (40 Act)20%39.6%
Grantor Trust (33 Act)N/AN/A
Limited Partnership (33 Act)N/AN/A
ETN (33 Act)20%39.6%

Examples of open-end funds include the Vanguard FTSE Emerging Markets Index ETF (NYSEArca: VWO) and the iShares Barclays TIPS Bond Fund (NYSEArca: TIP). An example of a UIT is the SPDR S&P 500 Fund (NYSEArca: SPY), while the iPath MSCI India Index ETN (NYSEArca: INP) is an example of an equity ETN.
Fortunately, all three structures receive the same tax treatment: The long-term capital gains rate is 20 percent if shares are held for more than one year; if shares are held for one year or less, gains are taxed as ordinary income—with a maximum rate of 39.6 percent.

COMMODITY FUNDS
Commodity ETPs come in one of three structures: grantor trusts; limited partnerships; or ETNs. Knowing the structure of commodity funds is crucial, since the tax implications differ dramatically between the various structures.

MAXIMUM CAP GAINS TAX RATE
STRUCTURELong-TermShort-Term
Open End (40 Act)N/AN/A
UIT (40 Act)N/AN/A
Grantor Trust (33 Act)28%39.6%
Limited Partnership (33 Act)*27.84%**27.84%**
ETN (33 Act)20%39.6%
*Distributes K-1
**Max rate of blended 60% LT/40% ST
Commodity Grantor Trusts 
Grantor trust structures are used for "physically held" precious metals ETFs, such as the SPDR Gold Shares (NYSEArca: GLD), the iShares Silver Trust (NYSEArca: SLV) and the ETFS Physical Swiss Gold Shares (NYSEArca: SGOL). These and related funds store the physical commodity in question in vaults, giving investors direct exposure to spot returns.

Under current IRS rules, investments in these precious metals ETFs are considered collectibles. Collectibles never qualify for the 20 percent long-term tax rate applied to traditional equity investments; instead, long-term gains are taxed at a maximum rate of 28 percent. If shares are held for one year or less, gains are taxed as ordinary income, again at a maximum rate of 39.6 percent.

Commodity Limited Partnerships 
Many ETFs hold futures contracts to gain exposure to commodities, and are structured as limited partnerships, or LPs.

Some commodity funds structured as LPs include the PowerShares DB Commodity Index Tracking Fund (NYSEArca: DBC), the United States Natural Gas Fund (NYSEArca: UNG) and the iShares S&P GSCI Commodity-Indexed Trust (NYSEArca: GSG). There are even ETFs that invest in precious metals futures, which stand in contrast to the physically backed funds mentioned earlier.

Futures-based funds have unique tax implications. Currently, 60 percent of any gains are taxed at the long-term capital gains rate of 20 percent, and the remaining 40 percent is taxed at the investor's ordinary income rate, regardless of how long the shares are held. This comes out to a blended maximum capital gains rate of 27.84 percent.

Limited partnership ETFs are considered pass-through investments, so any gains made by the trust are "marked to market" at the end of each year and passed on to its investors, potentially creating a taxable event. This means that your cost basis adjusts at year-end and you can be subject to pay taxes on gains regardless of whether you sold your shares or not.

For tax reporting, limited partnership ETFs also generate a Schedule K-1 form. This can create uncertainty and annoyance for the average investor not familiar with K-1s when they receive these forms in the mail.

Commodity Exchange-Traded Notes
Commodity ETNs do not hold the physical commodity, nor do they hold futures contracts. They are unsubordinated, unsecured debt notes issued by banks that promise to provide the return of a specific index. This means they carry credit risk: If the bank issuing the note goes bankrupt or defaults, investors can lose their entire investment.

Popular commodity ETNs include the iPath Dow Jones-UBS Commodity Index Total Return ETN (NYSEArca: DJP), the Elements Rogers International Commodity Total Return ETN (NYSEArca: RJI) and the iPath S&P GSCI Crude Oil Total Return Index ETN (NYSEArca: OIL).

Commodity ETNs are currently taxed like equity and/or bond funds. Long-term gains are taxed at 20 percent, while short-term gains are taxed as ordinary income (maximum 39.6 percent). Despite the fact that many of these products track futures-based indexes, they do not generate a K-1.
CURRENCY FUNDS
Currency ETPs come in one of four structures: open-end funds; grantor trusts; limited partnerships; or ETNs.

MAXIMUM CAP GAINS TAX RATE
STRUCTURELong-TermShort-Term
Open End (40 Act)20%39.6%
UIT (40 Act)N/AN/A
Grantor Trust (33 Act)39.6%39.6%
Limited Partnership (33 Act)*27.84%**27.84%**
ETN (33 Act)39.6%39.6%
*Distributes K-1
**Max rate of blended 60% LT/40% ST

Currency Open-End Funds
WisdomTree is currently the only issuer to offer currency ETFs structured as open-end funds. Some of its funds include the WisdomTree Dreyfus Chinese Yuan Fund (NYSEArca: CYB), the WisdomTree Dreyfus Emerging Currency Fund (NYSEArca: CEW) and the WisdomTree Dreyfus Brazilian Real Fund (NYSEArca: BZF).

WisdomTree's currency funds do not hold currency notes or futures contracts. Instead, most of their funds hold the bulk of their assets in U.S. Treasury bills and repurchase agreements (repos), while gaining exposure to the reference currencies through forward currency contracts and swaps.

Tax implications for these funds are similar to equity funds. According to WisdomTree's prospectuses, gains are taxed as long-term capital gains (20 percent) if held for more than one year; if held for one year or less, gains are taxed as ordinary income (maximum 39.6 percent).
Currency Grantor Trusts
Rydex's CurrencyShares are structured as grantor trusts. Each CurrencyShares product gives investors exposure to spot exchange rates of the underlying currency by holding the foreign currency in bank accounts. The most popular CurrencyShares are currently the Canadian Dollar Trust (NYSEArca: FXC), the Swiss Franc Trust (NYSEArca: FXF) and the Australian Dollar Trust (NYSEArca: FXA).

The taxation of CurrencyShares products is straightforward. All gains from the sale of shares are taxed as ordinary income (maximum 39.6 percent) regardless of how long they are held by the investor.

Currency Limited Partnerships
Similar to commodity LP funds, currency funds that hold futures contracts are structured as LPs. These funds include the PowerShares DB US Dollar Index Bearish and Bullish Funds (NYSEArca: UDN and NYSEArca: UUP, respectively) as well as leveraged currency funds such as the ProShares UltraShort Euro Fund (NYSEArca: EUO) and the ProShares UltraShort Yen Fund (NYSEArca: YCS).

The tax implications for currency limited partnership ETFs are the same as commodity limited partnership ETFs—gains are subject to the same 60 percent/40 percent blend, regardless of how long the shares are held. They're also marked to market at year-end and are reported on K-1s.

Currency Exchange-Traded Notes
Some uncertainty surrounds the taxation of currency ETNs. Due to an IRS ruling in late 2007—Revenue Ruling 2008-1—gains from currency ETNs are now generally taxed as ordinary income (maximum 39.6 percent), regardless of how long the shares are held by the investor.

However, according to the prospectuses of some currency ETNs, investors might have an option to classify gains as long-term capital gains if a valid election under Section 988 is made before the end of the day that the ETN was purchased.

Also, even though currency ETNs don't pay out any distributions to its shareholders, if a note generates any income throughout the year, investors can be subject to pay taxes on this "phantom income" at year end.

Some currency ETPs structured as exchange-traded notes include the Market Vectors Chinese Renminbi/USD ETN (NYSEArca: CNY), the iPath EUR/USD Exchange Rate ETN (NYSEArca: ERO) and the PowerShares DB 3X Long US Dollar Index ETN (NYSEArca: UUPT).

ALTERNATIVE FUNDS
Alternative funds come in one of three structures: open-end funds; limited partnerships; or ETNs.
Alternative funds seek to provide diversification by combining asset classes or investing in nontraditional assets.
MAXIMUM CAP GAINS TAX RATE
STRUCTURELong-TermShort-Term
Open End (40 Act)20%39.6%
UIT (40 Act)N/AN/A
Grantor Trust (33 Act)N/AN/A
Limited Partnership (33 Act)*27.84%**27.84%**
ETN (33 Act)***20%39.6%
*Distributes K-1
**Max rate of blended 60% LT/40% ST
***Exception is ticker "ICI"; see explanation below

The tax implications of alternative funds fall in line with the tax implications for equities and commodities with their respective structures. For example, alternative funds structured as open-end funds such as the WisdomTree Managed Futures Strategy Fund (NYSEArca: WDTI) and the PowerShares S&P 500 BuyWrite Fund (NYSEArca: PBP) are taxed like equity funds. Long-term gains are taxed at 20 percent and short-term gains are taxed as ordinary income (maximum 39.6 percent).

Alternative funds that hold futures contracts like some volatility, commodity and currency funds are structured as LPs. Some examples include the PowerShares DB G10 Currency Harvest Fund (NYSEArca: DBV), the iShares Diversified Alternatives Trust (NYSEArca: ALT) and the ProShares VIX Short-Term Futures Fund (NYSEArca: VIXY). All gains are taxed at the blended 60 percent/40 percent rate, regardless of holding period, creating a maximum blended tax rate of 27.84 percent.

Alternative funds structured as ETNs currently have the same tax implications as equity ETNs, with the exception of the iPath Optimized Currency Carry ETN (NYSEArca: ICI). ICI is considered a currency ETN for tax purposes, with gains that generally get taxed as ordinary income regardless of how long shares are held.

TAXATION OF DISTRIBUTIONS
Besides taxes on capital gains incurred from selling shares of ETPs, investors are also subject to pay taxes on periodic distributions paid out to shareholders throughout the year. These distributions can be from dividends paid out from the underlying stock holdings, interest from bond holdings, return of capital (ROC) or capital gains—which come in two forms: long-term gains and short-term gains.

Dividend payments from ETFs are usually paid out monthly, quarterly, semiannually or annually. There are two kinds of dividends that investors should be aware of: qualified dividends and nonqualified dividends.

Qualified dividends are dividends paid out from a U.S. company whose shares have been held for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. Importantly, this refers to the shares held by the ETF itself, and not the holding period of investors in the ETF.

Effective Jan. 1, 2013, qualified dividends are taxed at a maximum rate of 20 percent, compared with nonqualified dividends, which are taxed as ordinary income. Many of the dividends paid out to shareholders in domestic equity ETFs are qualified dividends.
Investors should keep in mind that while monthly distributions from bond ETFs are often called "dividends," interest from the underlying bond holdings aren't considered qualified dividends and are taxed as ordinary income.

Similarly, interest-yielding currency funds such as the CurrencyShares Australian Dollar Trust (NYSEArca: FXA) are also taxed as ordinary income. Some currency funds, such as WisdomTree's funds, can pay out distributions as income from its Treasury holdings and short-term and long-term gains from its holdings in forward currency contracts.

Funds can also pay out distributions in excess of the fund's earnings and profits, called return of capital (ROC). ROC is generally nontaxable and reduces the investor's cost basis by the amount of the distribution. While any fund can potentially pay out ROC distributions, it's more prevalent in REIT and master limited partnership funds, such as the Alerian Master Limited Partnership Fund (NYSEArca: AMLP).

Fortunately for investors, all of this is generally broken down in the 1099-DIV at year-end. The 1099-DIV will first show "Total Ordinary Dividends," which includes both qualified and nonqualified dividends, as well as any short-term capital gains. Qualified dividends that are subject to the beneficial 20 percent tax rate are further separated under the "Qualified Dividends" heading.

Any long-term capital gains that qualify for the 20 percent rate are separated as well, listed under the heading "Total Capital Gains Distributions." ROC distributions should be included in the "Nondividend Distributions" section on the 1099-DIV.

2013 CAPITAL GAINS TAX CHANGES
Effective Jan. 1, 2013, due to the passing of the American Taxpayer Relief Act of 2012, singles with a taxable income over $400,000 and married filing jointly with a taxable income over $450,000 are now subject to higher capital-gains tax rates.

For investors in this higher tax bracket, long-term capital gains rates have increased from 15 to 20 percent, while short-term capital-gains rates increased from 35 to 39.6 percent. Qualified dividends are also now taxed at this new 20 percent rate, while interest income from bond funds will continue to be subject to ordinary income rates, or a maximum of 39.6 percent.

For all other filers with a taxable income equal to or less than the $400,000/$450,000 threshold, all rates on capital gains and qualified dividends remain the same as in 2012 (excluding the Medicare tax, which is a separate tax with a different income threshold), with maximum long-term capital gains and qualified dividends still taxed at a 15 percent rate, and maximum short-term rates taxed at 35 percent.

NEW MEDICARE SURCHARGE TAX
Effective Jan. 1, 2013, due to the passing of the Patient Protection and Affordable Care Act, singles with an adjusted gross income (AGI) over $200,000 and married filing jointly with an AGI over $250,000 are now subject to an additional 3.8 percent Medicare surcharge tax on investment income, which includes all capital gains, interest and dividends.

This new tax will be levied on the lesser of net investment income or modified adjusted gross income (MAGI) in excess of $200,000 single/$250,000 joint. Therefore, for investors in the highest tax brackets, their "true" tax rates on long-term capital gains and qualified dividends can reach 23.8 percent (20 percent capital gains plus 3.8 percent Medicare tax).

CHOOSING THE RIGHT FUND FOR YOU
There are many reasons besides tax implications for choosing between funds. This paper does not try to address those issues. But knowing the tax implications of different choices can certainly help investors make a decision, especially with commodity and currency funds. We call out a few examples below.

Commodity Funds 
From a tax perspective, the time period that you expect to own that asset can make a difference. For short-term holders in higher tax brackets, for example, LPs offer a strong tax benefit, since 60 percent of any gains are taxed at the low 20 percent tax rate, regardless of holding period. In other structures, short-term gains are taxed as ordinary income, with rates up to 39.6 percent.

On the flip side, long-term investors might gain an advantage with ETNs because they are subject to 20 percent long-term gains, compared with the 60/40 blend of partnerships, which comes out to a blended maximum of 27.84 percent. The Catch-22 is that ETNs come with credit risk of the counterparty.
Then there are tax reporting differences. The tax structure associated with LPs can be challenging for investors who are accustomed to 1099s when they receive K-1s in the mail. For investors looking to simplify their taxes without K-1s, grantor trusts and ETNs might look more appealing.
Currency Funds
While CurrencyShares offers the "purest" way to gain exposure to a currency through an exchange-traded product, any distributed income or gains from selling shares are taxed as ordinary income, so investors don't get any long-term capital gains tax advantages.

WisdomTree's open-end funds might have a tax advantage for long-term investors, but, for better or worse, funds using forward contracts don't always perfectly follow spot exchange rates of the underlying currency.

Similar to commodities, currency limited partnership ETFs can be beneficial for short-term traders because of the blended maximum 27.84 percent rate even if shares are held for less than one year. But investors need to deal with K-1 forms, and shares are marked to market if they're held over into a new calendar year.

As always, the choice comes down to the individual. Nonetheless, it pays to have a full understanding of the potential tax treatments so you can make an informed decision.
Max LT/ST Capital Gains Rates (Taxable Income Equal to or Less than $400K Single/$450K Joint)
Equity & Fixed IncomeCommodityCurrencyAlternative
FUND STRUCTURE
Open End (40's Act)15/35N/A15/3515/35
UIT (40's Act)15/35N/AN/AN/A
Grantor Trust (33 Act)N/A28/3535/35N/A
Limited Partnership (33 Act)N/A23/23*23/23*23/23*
ETN (33 Act)15/3515/3535/3515/35
*Max blended rate of 60% LT/40% ST
NOTE: These rates are NOT inclusive of the 3.8% Medicare surcharge tax or any additional taxes applicable from the phaseout of itemized deductions and personal exemptions.

Max LT/ST Capital Gains Rates (Taxable Income Greater than $400K Single/$450K Joint)
Equity & Fixed IncomeCommodityCurrencyAlternative
FUND STRUCTURE
Open End (40's Act)20/39.6N/A20/39.620/39.6
UIT (40's Act)20/39.6N/AN/AN/A
Grantor Trust (33 Act)N/A28/39.639.6/39.6N/A
Limited Partnership (33 Act)N/A27.84/27.84*27.84/27.84*27.84/27.84*
ETN (33 Act)20/39.620/39.639.6/39.620/39.6
*Max blended rate of 60% LT/40% ST
NOTE: These rates are NOT inclusive of the 3.8% Medicare surcharge tax or any additional taxes applicable from the phaseout of itemized deductions and personal exemptions.
Contact ExactCPA if you have any questions.
Posted on 8:32 AM | Categories: