Understanding Structured Notes for High Net Worth Investors

Structured notes are a sophisticated alternative investment vehicle often misunderstood or overlooked by many advisors. At VIP Wealth Advisors, we embrace the complexity of these instruments because we know they can play a unique and powerful role in the portfolios of high-net-worth (HNW) and ultra-high-net-worth (UHNW) clients. When appropriately structured and integrated thoughtfully into a client’s broader financial plan, they offer tailored exposure, downside protection, and powerful tax characteristics.

This article explores what structured notes are, how they work, and why they may be worth considering, including the all-important tax implications that can significantly affect net outcomes.

A structured note is a hybrid investment product typically issued by a bank or financial institution. It combines two components:

• A traditional bond or debt instrument (providing principal protection or income), and
• A derivative (giving exposure to an underlying asset or index).

Structured notes are designed to offer a customized return profile. Investors can gain access to a wide range of assets, including equities, commodities, interest rates, currencies, or baskets of assets, while incorporating risk management features like downside buffers or capital protection.

• Principal-Protected Notes: Return of principal at maturity, plus participation in underlying asset upside.
• Buffered Notes: Partial downside protection with capped upside potential.
• Reverse Convertible Notes: High-yield notes with risk of converting to equity if the underlying asset falls below a threshold.
• Callable Yield Notes: Enhanced yield, often callable by the issuer before maturity.
• Dual Directional Notes: Potential to profit in both up and down markets within defined boundaries.

• Investment: $1,000,000
• Term: 3 years
• Underlying: S&P 500
• Buffer: 20% (first 20% of losses protected)
• Cap: 25%

• S&P 500 is +15%: Investor receives 15% return ($1,150,000).
• S&P 500 is +30%: Return capped at 25% ($1,250,000).
• S&P 500 is -10%: Investor receives full principal ($1,000,000).
• S&P 500 is -25%: First 20% absorbed by buffer; investor takes 5% loss ($950,000).

1. Customization & Thematic Exposure
   Notes can be tailored to express a specific market view or target exposure to niche themes or baskets.
2. Downside Mitigation
   Buffers and barriers can reduce the impact of volatility or market downturns.
3. Yield Enhancement
   Structured notes can offer high-interest payments, especially in low-rate environments, by taking on targeted risks.
4. Tax Management Opportunities
   Properly structured notes allow for deferral of taxes or strategic realization of gains or losses.

• Issuer Credit Risk: If the issuing bank defaults, the note may become worthless.
• Liquidity: Most notes are not actively traded. Selling before maturity may involve a steep discount.
• Complexity: Many notes involve intricate payoff structures and tax rules.
• Cap on Upside: Investors may forgo significant market gains.

Tax treatment is one of the most critical yet misunderstood aspects of structured note investing. Depending on the specific type and structure, the IRS may treat income and gains in several different ways.

An investor puts $1,000,000 into a 5-year principal-protected structured note with 20% participation in S&P 500 upside.

OID Accruals (Phantom Income):

• The IRS assigns an “imputed interest” to the note. Suppose that’s $5,000 per year.
• Even though the investor receives no cash annually, they must report $5,000 as ordinary income each year on their tax return. Over 5 years, that’s $25,000 of ordinary income taxed as it accrues.

Payoff at Maturity:

• If the S&P 500 rises 40% over the 5 years, the note pays back $1,200,000.
• Of that $200,000 of upside, the vast majority is also reported as ordinary income on Form 1099 (not capital gain).

Tax Reality:

• $25,000 of phantom income taxed along the way (ordinary).
• $200,000 maturity payoff taxed as ordinary income.
• No preferential long-term capital gains treatment, despite the equity link.

These are typically taxed as ordinary income due to the periodic coupon payments.

• No capital gain treatment.
• If converted into stock due to a knock-in event, the cost basis becomes the fair market value at conversion, and future gains are taxed accordingly.

Example:

• Investor receives a 12% annual coupon on a $500,000 note.
• The entire $60,000/year is ordinary income.

• Some structured notes are classified as CPDIs by the IRS. These require a "comparable yield" and a schedule of projected payments.
• Income is taxed annually based on this projected schedule, regardless of actual payouts.
• Deviations between projected and actual results may require adjustments at maturity.

Example:

• Note projects 4% annual yield over 3 years, with final payout linked to the Nasdaq-100.
• IRS requires income of $20,000 taxed each year (on $500K invested).
• If the final payout differs, the final year includes an adjustment.

• Investors may receive Form 1099-OID, 1099-INT, or 1099-B depending on the note structure.
• Often requires supplemental worksheets or corrected reporting to handle correctly.

Structured notes may be appropriate for:

• Accredited and HNW investors seeking tailored exposure.
• Clients looking for defined outcomes (e.g., buffered downside with capped upside).
• Investors with specific views on volatility or market direction.
• Tax-aware investors seeking to defer or manage the timing of income.

They are not suitable for:

• Clients needing high liquidity or full transparency.
• Investors who are highly risk-averse or unfamiliar with derivative mechanics.

We don’t offer structured notes as a "product"; we integrate them as part of a holistic strategy. Whether it's buffering market exposure, enhancing yield in a tax-efficient way, or creating customized payoffs tied to unique client goals, we use structured notes surgically and intentionally.

And we always run the numbers twice: once for return potential, and again for the tax outcome.

Structured notes can be a powerful tool in the right hands. But they demand expertise, due diligence, and clear communication with clients. At VIP Wealth Advisors, we help our clients understand not only the potential return profiles of these strategies but also how taxes, risk, and liquidity affect the real-world results.

If your current advisor is ignoring structured notes because they’re "too complex," they may also be ignoring opportunity.