The IRS Chief Counsel (ICC) recently gave auditors advice on challenging Section 475 mark-to-market (MTM) traders trying to game the system with segregated investment positions. Section 475 MTM means ordinary gain or business loss treatment, whereas investment positions are capital gain or loss treatment. It’s important not to mix up the two on tax return filings. If you are unclear on your situation, check with one of our CPAs.
In new IRS Chief Counsel Advice 201432016, the IRS focuses on options created on “basket transactions,” which I feel are rarely used tax avoidance schemes. During the past decade, some very large hedge funds parked their trading activity inside of banks and arranged option transactions with the banks to reclaim their trading profits after year-end. These hedge funds avoided application of Section 475 MTM income on their trading gains during the tax year, and replaced it with an option allowing them tax deferral and long-term capital gains tax rates in the following year(s). They converted 40% ordinary tax rates to 20% capital gains rates and received a tax deferral to boot. Their tax savings from these transactions was in the billions of dollars and it attracted the attention of Congress and the IRS. The hedge funds’ arguments about “economic substance” sound pretty hollow to me in relation to tax savings from this tax avoidance scheme. The IRS wants to treat these segregated option transactions as part of the trader’s Section 475 MTM ordinary income trading activities, since they see a connection to those activities (see rules below). To learn more about these schemes, read Hedge Fund Chief Testifies at Senate Tax-Avoidance Hearing (New York Times, July 22, 2014).
There’s a lesson for retail traders using Section 475
We haven’t seen retail traders attempt these complex schemes with bank counterparties. Yet it’s a good time to revisit the segregation rules in Section 475 MTM. It’s a nuanced area of the law and it can have significant consequences on tax returns for business traders who have investments.
All business traders using or considering Section 475 MTM should learn its segregation of investment rules. (One way to prevent this problem is to conduct your business trading activity in an entity separate from individual and IRA investment accounts. The entity has a different taxpayer identification number, so there is no connection in the activity.)
We’ve recommended Section 475 MTM since 1997 when Congress expanded it for traders. The biggest tax benefit is unrestricted business ordinary loss treatment, with taxpayers escaping the onerous rules for wash-sale loss deferrals and the capital loss limitation ($3,000 against ordinary income per year on individual tax returns). Section 475 MTM can be the ticket to receiving huge tax refunds, often on NOL carryback returns.
An example of investments vs. business trades
Many traders want to make long-term investments as well in order to benefit from deferral on taxable income (until sale) and to hold investment securities 12 months for lower long-term capital gains tax rates (currently up to 20% vs. 39.6% the ordinary tax rate on short-term capital gains).
Each year we run into a handful of confusing situations on what’s considered a trading position vs. an investment position. Here’s a common example: A trader may want to house his investment portfolio inside a business trading account for portfolio margining purposes and hyperactively trade stock options around his core investment stock positions.
Suppose a trader holds Apple stock as an investment and trades Apple options for business around it to manage risk. Apple stock and Apple stock options are substantially identical positions for purposes of wash sales and Section 475 MTM. By doing this type of commingling activity, the trader may inadvertently subject his Apple stock investment to Section 475 MTM treatment at year-end, thereby losing deferral on the stock and subjecting his gains to ordinary rates rather than lower long-term capital gains rates.
There are all sorts of scenarios that can come up and in some cases it appears to benefit the taxpayer. It’s important to keep in mind that the IRS is entitled to apply the rules in a way that does not prejudice the government’s position. In the previous example, if the trader had a material loss in the Apple stock held for investment, the IRS is entitled to bar the application of Section 475 on that losing investment position. The IRS can have its cake and can eat it too.
Segregation of investment position rules
Per Thomson Reuters/Tax & Accounting, “Any securities held by the trader are subject to marking unless they fall within the exception to marking under Code Sec. 475(f)(1)(B). In the case of traders, there is only one exception to marking. Under that exception, two requirements must be met. First, it must be established to IRS’s satisfaction that the security has no connection to the activities of such person as a trader. (Code Sec. 475(f)(1)(B)(i)) Second, any such security must be clearly identified in such person’s records as being described in Code Sec. 475(f)(1)(B)(i) before the close of the day on which it was acquired, originated or entered into (or such other time as IRS may by regs prescribe). (Code Sec. 475(f)(1)(B)(ii)) An identification that a security is held for investment for financial reporting purposes is not sufficient for Code Sec. 475 purposes. (Rev Rul 97-39, 1997-2 CB 62).
Generally, gains and losses recognized under Code Sec. 475 are ordinary income or loss to a trader that has made an election under Code Sec. 475(f). (Code Sec. 475(d)(3)(A)(i) and Code Sec. 475(f)(1)(D)) However, Code Sec. 475(d)(3)(B) provides exceptions to the automatically ordinary rule under Code Sec. 475(d)(3)(A). If a taxpayer can establish that it held securities as hedges, or that the securities were not held in connection with its trading business, or that a security is improperly identified (see Code Sec. 475(d)(2) ), then gains and losses are not automatically ordinary. (Code Sec. 475(d)(3)(B)(i), Code Sec. 475(d)(3)(B)(ii) and Code Sec. 475(d)(3)(B)(iii)) Character must then be determined by other relevant Code sections.”
Many hedge funds and some traders skip a Section 475 election because they don’t want to be burdened with identifying investments on the time and date of purchase. They establish a trade and may let their profits run and morph the position into an investment position for long-term capital gain and deferral.
How Section 475 MTM and the segregation rules work
A business trader using Section 475 MTM has ordinary gain or loss treatment, plus open business positions are marked-to-market as imputed sales at year-end. On the first day of the subsequent year, the trader imputes a purchase of that same position at the same year-end price.
Duly segregated investment positions are not subject to Section 475 MTM. For example, a business trader organized as a sole proprietor may have a business trading account at Interactive Brokers and a segregated investment account held jointly with his spouse at Fidelity for making long-term investments. Like all professionals, it’s expected that a business trader would have investments, too.
It’s important for the business trader to contemporaneously segregate investment positions from business positions in “form and substance.” Form means a separate account and substance means don’t trade substantially identical positions with business trading positions. While proposed IRS regulations required a separate account, that rule never became final law, so a trader can have investment positions within a business trading account. Just make sure to email yourself contemporaneously when purchasing an investment position. Don’t trade around investment positions with your business positions, as that runs afoul of the substance rule. The lines of distinction can be blurred in some cases and you should consult a trader tax expert about it.
Read Green’s 2014 Trader Tax Guide Chapter 2 on Section 475 MTM to learn more.
Recent trader tax court cases
In recent trader tax court cases covered on our blog, Assaderaghi, Nelson and Endicott, the IRS won denial of trader tax status partially because these option traders did not segregate active option trading from investing in stocks (similar to the example above). However, even if these traders did follow segregation rules and our above guidance, I still don’t think they traded options enough to qualify for trader tax status. They also sought Section 475 MTM ordinary loss treatment on stock investments, which is not possible.
Section 475 MTM is fantastic for most business traders — we call it “tax loss insurance.” But the fine print requires discipline on dealing with investments. It’s best to trade in a separate entity to skip these handcuffs.