While traders should consider general year-end planning strategies like deferring income and accelerating expenses, they should also be aware of special strategies.
For each of the past few years, Congress passed “tax extenders” and the AMT patch for another year. While Congress patched AMT in January 2013 with the fiscal cliff deal, they haven’t dealt with “tax extenders” yet. The debt ceiling and CR fiscal mess was punted to year-end, so perhaps there’s a window of opportunity to pin more tax extenders on that donkey. Make sure to get your tax extender break while it’s still hot. Here’s the list of tax extenders expiring in 2013.
Currently, 2014 tax rates match 2013 rates. Generally, that means it’s a good idea to defer income and accelerate business expenses and itemized deductions. There are some situations where it’s better to accelerate income and defer expenses, such as if you happen to be in a very low tax bracket in 2013 due to trading losses and loss of other types of income. Why not take advantage of tax rates up to 28%?
One good way to generate income is with a Roth IRA conversion. You can break up an IRA into pieces in order to convert the amount you like. You can always re-characterize the conversion in 2014 if it doesn’t work well — for example, if you lose the money in the Roth account and prefer a do over.
Smart investors, business traders and investment managers spend December identifying and avoiding potential wash sale losses on “substantially identical positions” (i.e., between Apple stock and Apple options at different strike prices). Don’t wait until you receive broker-issued Form 1099-Bs in February to find out you have a huge tax problem with wash sale loss deferrals which might increase your 2013 tax bill significantly.
Run TradeLog software before year-end to calculate and avoid wash sales, handle cost-basis reporting correctly and generate Form 8949 for tax filings. Keep running it through the end of January for wash sale loss calculations. The latest version of TradeLog has a Potential Wash report, which you should use for year-end planning to avoid wash-sale loss surprises.
Don’t forget to run TradeLog on your individual IRA accounts, too as that is the IRS rule. Avoid permanent wash sale losses between individual taxable accounts and IRAs. Don’t trade substantially identical positions between taxable and IRA accounts. Once you spot a potential wash sale, sell all open positions before year-end and don’t buy it back for 31 days. Or, start trading in a separate entity on Jan. 1 to disconnect your trades under a different taxpayer ID number. A SMLLC disregarded entity doesn’t work here; you need a partnership or S-Corp return.
“Tax loss selling” is a popular phrase in the financial media at year-end. If you have capital gains for the year, why not sell a few more open positions, ones showing unrealized losses in order to reduce your capital gains and related tax bill? But don’t rush to buy back the positions with a January rally as that can cause a wash sale loss deferral at year-end 2013, thereby defeating the purpose of tax loss selling.
Investors, business traders and hedge fund managers seek holding open securities positions with unrealized gains at year-end in order to defer taxes and perhaps achieve lower long-term capital gains rates up to 20%. Hedge fund managers using carried-interest tax breaks to get their allocation of long-term capital gains, too.
Business traders should learn about Section 475 MTM business ordinary gain or loss treatment. If they don’t have Section 475 in 2013, they can elect it for 2014 by April 15, 2014. That 2014 election converts unrealized business trading gains and losses at the end of 2013 into ordinary gains or losses on Jan. 1, 2014 – that’s the required Section 481(a) adjustment. A negative Section 481(a) adjustment on Jan. 1 is far better than a capital loss carried over from 2013 to 2014. In some cases, wash sales are good because they are part of a Section 481(a) adjustment, rather than being a capital loss carryover. Traders generally have a hard time using up large capital loss carryovers.
Hedge fund managers often skip making Section 475 MTM elections because they have a hard time following the rules for “contemporaneous” segregation of investments vs. business trading positions. They also don’t want investors paying taxes on open positions, as investors often request redemptions to pay the tax bill while managers have cash funds tied up in those open positions.
Active retail traders and hedge fund managers should assess qualification for trader tax status before year-end. Sole proprietors and hedge funds can claim TTS after they assess the facts and circumstances of meeting our golden rules. Section 475 MTM is not allowed after the fact; it had to be elected with the IRS by April 15, 2013 for 2013, or within 75 days of a “new taxpayer” new entity filed in the entity books and records (an internal election).
Forex Section 988 opt-out “capital gains” internal elections on major forex going into Section 1256g lower 60/40 tax rates had to be filed “contemporaneously” during the year on a “good to cancel basis.” Otherwise, Section 988 is ordinary gain or loss treatment.
Cash-basis business traders should accelerate business expenses in 2013, and using credit cards on the last days of the year counts. They may not qualify for TTS in 2014, triggering far less beneficial investment expense treatment. Get business deductions while you still can, including our firm’s advance payments for tax compliance services made with credit cards. Investment expenses exclude home office, education and startup costs. (Business expenses allow them.)
A trading entity provides more tax breaks for business traders. Set up a trading entity in early November 2013 to enjoy many trader tax breaks through year-end. Break the chain on wash sales in your individual and IRA accounts, by continuing trading in an entity which has a different taxpayer ID number — thereby disconnecting the trading for wash sales with your individual accounts. In the entity, capitalize a reasonable amount of Section 195 startup costs going six months back before the entity commencement date. Generate trading gains in the entity and pay yourself an administration fee to unlock 100% AGI deductions for health insurance premiums and retirement plans. Don’t wait until December, it’s too narrow a window of opportunity in the eyes of the IRS. If you miss the boat on forming the entity now, try to start your entity on Jan. 1, 2014 for a clean year of trading in 2014, without the added complication of trading individually as well.
Business traders should open an Individual 401(k) plan before year-end — otherwise, you will miss the boat on the best retirement plan choice for most traders. The 401(k) elective deferral of $17,500 is 100% deductible, plus it’s paired with a 20% profit-sharing plan allowing a total contribution up to $51,000. There’s also a catch-up contribution for taxpayers aged 50 and over of $5,500. Make sure to pay administration fees or salaries before year-end — or reclassify other payments to administration fees — to execute these AGI deduction strategies. High income traders still have time to consider a defined benefit plan where you can contribute much higher amounts per year. Consider different options for your retirement plan contributions, and whether you have sufficient cash flow to maximize this tax deduction. Can you afford a Roth contribution too? See retirement plan limits for 2013 on the IRS site here.
Focus on accounting before year-end to get a proper handle on tax planning. New entities need an accounting solution like excel worksheets, or QuickBooks – if set up properly – to set up a proper balance sheet and profit & loss statement, and to track capital, fixed assets, intangible assets like software, startup costs, organization costs and more. Additions and withdrawals to capital (basis) need to be tracked as well. This will make tax compliance (preparation) much easier, more effective and less costly. In many cases, we’ve seen clients use QuickBooks, but botch the accounting.
Execute expense reimbursements before year-end — a requirement in S-Corps and suggested in partnerships.
Learn how to handle the health insurance premium AGI deduction, which is tricky with S-Corps. AGI deductions determine the amount of administration fees or officer’s salaries needed to unlock those deductions. S-Corps should consider using salaries in December and engaging a payroll processing firm — we recommend paychex.com.
Try to manage your income thresholds for the Obama-era tax hikes on modified AGI of $250k married/$200k single, household income for ACA health insurance mandate tax credit subsidies, navigating between the marginal tax brackets, other types of tax credits and more.
Consider the GreenTraderTax strategies to avoid Obama-era tax hikes on the upper income. Use a C-Corp to house intellectual property, charging your trading entity royalties for usage. Or, the C-Corp can charge the trading entity for administration fees. This takes advantage of lower C-Corp tax rates on the first $50,000 of net income. A medical reimbursement plan (MRP) is a good way to pay for high deductible ACA-compliant health insurance plans. You can use a middleman S-Corp for receiving the administration fee first. S-Corps help reduce both self-employment (SE) taxes and ObamaCare Medicare taxes on unearned income. Read about these strategies in Green’s 2013 Trader Tax Guide, which is on promotion now.
Don’t forget to get caught up with your 2013 estimated income taxes. Many traders underpay during the year, considering the underestimated tax penalty like a low-cost margin loan. The Q4 estimate is due Jan. 15, 2014, so you can see where you stand at year-end first. Consider paying the state(s) before year-end for another 2013 tax deduction, unless you trigger AMT and don’t get that benefit.
If you want a tax reduction, then you must attend to year-end planning. There is only so much you can do after the year closes.
Here’s an excellent “Year-end tax planning client letter” from our tax research service RIA.
Watch the related Webinar recording.