Dealing With The IRS And States
You're entitled to many trader tax benefits and don't let the IRS or your state take them away from you.
The IRS has several initiatives underway that affects traders and investors.
1099-B matching to Form 8949
We expect issues over IRS cost-basis reporting on securities, including cost-basis, wash sales and short or long-term holding periods. With 1099-B computer matching to align broker 1099-Bs with taxpayer Form 8949s, traders should expect to receive tax notices with questions about the differences. The IRS indicated they would hold off on these reconciliations for a few years, and 2016 could be the year the IRS starts sending tax notices.
Attacks on trader tax status (TTS)
Sole proprietor business traders may receive IRS questions on Schedule Cs, as only trading business expenses are reported there which causes it to look like a losing business since trading-related income is reported on other tax forms. Sole proprietor business traders with large ordinary losses from trading expenses and Section 475 MTM losses should expect to hear from the IRS, since such losses will likely generate huge net operating loss (NOL) carryback refunds. Other attention grabbers are perennial money-losing traders and messed up tax return filings on TTS, Section 475, tax treatment and omitted footnotes. Although the IRS is underfunded and the number of agents is down, the slack is being taken up by computer matching and computer-generated tax notices.
Section 475 improper identification
The IRS and some states have been playing havoc with traders in exams, claiming traders did not properly comply with Section 475 rules for segregation of investment positions from trading positions. Noncompliance gives the agent license to drag misidentified investment positions into Section 475 mark-to-market (MTM), or to boot misidentified trading losses out of Section 475 into capital loss treatment subject to the $3,000 capital loss limitation. Both of these types of exam changes cause huge tax bills, penalties and interest. Traders don’t want to lose capital gains deferral and lower long-term capital gains rates on investment positions in securities. With misidentified investments, the IRS has the power to drag positions into Section 475, subjecting them to MTM and ordinary income tax rates.
Tax notices and exams
When a tax notice arrives, don’t panic and gush out everything to an IRS agent. Consult with a trader tax expert. Understand where the IRS is coming from; it may just be a computer-generated notice asking for a few simple open items. If the IRS is getting ready to challenge TTS and Section 475 MTM, it’s important to step back and make sure you have a strong case. Don’t expect the IRS to get it right the first time around. The IRS notice may have a hobby-loss business or passive-loss activity questionnaire and a trading business is exempt from those rules. Agents often calculate volume, frequency and other metrics on your trading activity to determine TTS qualification in ways that are favorable to them and wrong in our view, so do the calculations right. The big issue is TTS, not a few hundred dollars of trading expenses.
Expect the IRS agent to deny TTS unless you have a clear-cut case. Agree to disagree with the agent and go to the appeals level. Show the appeals officer how you are prepared to go to tax court to win based on application of trader tax court cases. It’s best to have a trader tax expert CPA or tax attorney in your corner to present your TTS qualification, explain trader tax law and prepare the appeals letter.
Transfer the exam or appeals
If you work with a CPA firm with expertise and experience on trader tax clients and IRS exams, it’s probably a good idea to transfer the exam to your CPA’s office and local IRS office. If your CPA has worked on many prior exams with local IRS agents, they probably have educated the agents on trader tax status, trader tax treatment and Section 475 elections. This helps avoid problems with less informed agents on trader tax. That’s been our experience at Green, Neuschwander & Manning, LLC.
If appeals deny TTS and Section 475 MTM, and your trader tax expert thinks you have a good case, then file a petition in tax court. We generally suggest a “small case” filing. Engage the trader tax expert to write the tax court petition — preferably a tax attorney well versed in trader tax law.
States also send tax notices and initiate exams
We’ve noticed more states challenging TTS and related tax breaks on their own, without the IRS taking the lead.
For more in-depth information on dealing with the IRS and states, read Green’s 2017 Trader Tax Guide.
Consider our IRS & State Tax Representation Service.