December 2013

IRS final NIT regulations help traders

December 4, 2013 | By: Robert A. Green, CPA

Good news for business traders and investment managers: Our petition and request for fixes to the Net Investment Tax worked! The IRS just issued final regulations (TD 9644) for the Affordable Care Act’s “Net Investment Tax” (NIT), the 3.8% Medicare surtax on unearned income above the AGI thresholds of $250,000 married and $200,000 single.

We are pretty satisfied with the final regulations as they affect business traders and investment managers. What could have been a huge mess complying with the proposed regulations — with unintended consequences like overcharging taxes — worked out to be a simple aggregation with tax fairness on true net trading income in the final regulations.

The NIT regulations affect all types of unearned income activities and they are very complex and beyond the scope of this blog. But in this blog, we’re focused on business traders and investment managers.

The problem in the proposed regulations
There are three separate buckets for different types of unearned income: portfolio income goes in bucket #1, passive activity entities and trading businesses go in bucket #2, and capital gains and losses are housed in bucket #3. The biggest problem with the proposed regulations for the NIT is they counted trading gains in bucket #2, but they (probably unintentionally) counted trading losses in bucket #3. You can’t count an individual bucket with a net loss when aggregating net investment income (NII). Wouldn’t it make more sense to put trading businesses in bucket #3, as they are not passive activities anyway?

Our petition showed how a trading business with a net loss could have NII of several hundred thousand dollars because only gains would be counted and not losses.

Problem solved in the final regulations
Kudos to the IRS, not only did they listen to us — and the AICPA, plenty of other accountants and trading industry groups — but they crafted a clever and simple solution for this fix. In a nutshell, a trading business with an entity structure or without (sole proprietorship), with a Section 475 MTM election or default cash method, are all counted in bucket #3 capital gains and losses. This immediately fixes the glaring problem of a trading entity having gains counted in bucket#2 and losses counted separately in bucket #3.

Using bucket #3 for all trading business gains and losses makes good sense. Doesn’t a trading business have more to do with capital gains and losses in bucket #3 than a passive-activity entity in bucket #2? While many trading businesses are conducted in pass-through entities, it is not considered a passive activity under the “trading rule” in Section 469. Bucket #2 is important for passive activities with unearned income because active businesses generally have earned income subject to Medicare tax on earned income.

There may be even better news, too
The regulations state: “To minimize the inconsistencies between chapter 1 and section 1411 for traders, the final regulations assign all trading gains and trading losses to section 1411(c)(1)(A)(iii). The final regulations also permit a taxpayer to deduct excess losses from the trading business of a section 475 trader from other categories of income. Part 5.C of this preamble describes the treatment of those excess losses.”

Consider the example of a Section 475 MTM trader who arbitrages securities trades against interest income. He has interest income in bucket #1 and securities trading gains and losses in bucket #3. With the final regs, it may be possible for him to offset bucket #1 interest income with net Section 475 MTM ordinary losses in bucket #3. Stay tuned for more news on these regs.

Click here for an excerpt of TD 9644 showing these changes. We added yellow highlights.

According to respected blogger Farm CPA Today, “The final regulations now allow at least three new ways of using losses:

  1. If you have a net capital loss for the year, the regular tax laws limit this loss to $3,000. The final regulations allow this up to $3,000 loss to offset other investment income.
  2. If you have a passive loss such as Section 1231 losses, as long as that loss is allowed for regular income tax purposes, you will be allowed to offset that against other investment income.
  3. Finally, if you have a net operating loss carry forward that contains some amount of net investment losses, you will be allowed to use that portion of the NOL to offset other investment income.”

Bottom line
In our petition, we wanted the IRS to scrap all three buckets entirely, or allow a bucket with a net loss to be counted in NII, as that is how we read the law enacted by Congress. While the IRS hasn’t gone that far, and these regs are still an abomination of complexity and nuance, we are happy the IRS made the law fairer for traders and investors.

Bitcoin is a hot commodity, but how is it taxed?

December 3, 2013 | By: Robert A. Green, CPA

Buttressed by an Internet craze, the price of bitcoin has skyrocketed this past year from $17 to over $1,200. Pundits expect significant price volatility in 2014 as well.

While the Federal Reserve gave tacit approval, stating “virtual currencies like bitcoin have legitimate uses and should not be banned,” the IRS has not yet issued tax guidance. Despite the lack of guidance, income from bitcoin transactions must be reported.

What’s the bitcoin tax treatment for traders?
There are two possibilities how bitcoin should be treated for tax purposes: either it is an (1) intangible asset, or (2) a foreign currency. The problem with saying that it’s a currency is that it is not issued by a government, and traditionally currencies are legal tender issued by governments. In California Bankers Assn v. Shultz, the Supreme Court stated (in a non-tax context): “‘Currency’ is defined in the Secretary’s regulations as the “coin and currency of the United States or of any other country, which circulate in and are customarily used and accepted as money in the country in which issued.” The IRS has not said its opinion, but both Canadian and Swedish tax authorities are treating bitcoins as an asset. Also, the German Finance Ministry says bitcoin is not classified as e-money or a foreign currency, but is rather a financial instrument under German banking rules. It is our sense that unless Congress enacts legislation to treat bitcoins as a foreign currency, the IRS will treat bitcoins as an asset.

If you buy bitcoin for purposes of appreciation and then sell it, then if (1) bitcoin is an asset, you will have capital gain and loss, and (2) if bitcoin is a foreign currency, then under Section 988 you will have ordinary income and loss.

Is bitcoin a commodity?
There is no definition in the Internal Revenue Code of “commodity.” Black’s Law Dictionary 342 (4th ed. 1968) defines commodity: a movable article of value that can be bought or sold. A bitcoin is not movable property, so arguably it’s not a commodity. But at the Senate hearing, academics and financial industry players warned that bitcoin could be regulated as a commodity if market volatility continues. Such financial regulation may or may not impact the tax treatment.

Most bitcoin investors and traders will prefer capital gains tax treatment
After the astronomical rise in bitcoin this past year, most investors and traders may prefer capital gains and loss tax treatment. Consider this example: An American investor bought bitcoin at $17 just over 12 months ago and he sold it recently for $1,200. Is he entitled to significantly lower long-term capital gains tax rates of up to 20% in the top bracket and up to 15% in the second top bracket? That’s 20% lower than the top ordinary rates of 39.6% and 35%.

In this example of incredible appreciation, investors and traders will prefer that the IRS views their bitcoin transactions as trading in a commodity or other capital asset held for price appreciation. As long as the investor did not acquire the bitcoin as part of his business or for personal reasons this tax treatment seems safe to deploy on 2013 tax returns — until the IRS says otherwise.

It’s important to also consider tax treatment for commodities sold in a business vs. trading in commodity futures contracts. A farmer sells his wheat and reports ordinary gain or loss treatment in his trade or business. Conversely, a commodity futures trader holds “capital assets” subject to capital gain or loss treatment. Regulated futures contracts benefit from lower 60/40 capital gains tax rates (60% is a long-term capital gain — even on a day trade — and 40% is ordinary tax rates).

Say a trader’s regulated futures contract expires and he takes delivery of bushels of wheat. If he sells those bushels of wheat in less than 12 months, he receives short-term capital gains treatment, not ordinary gain or loss treatment or lower 60/40 tax rates since the bushel does not qualify as a Section 1256 contract.

Can bitcoin traders use ordinary loss tax treatment in Section 475?
What goes up fast and irrationally may also go down fast and irrationally. New investors may wind up with big trading losses and they may wish for ordinary loss treatment instead of $3,000 capital loss limitations and large capital loss carryovers.

As the bitcoin trading market expands, some bitcoin traders may be able to achieve trader tax status (business treatment) on trading that asset class. It is not clear whether they can make a Section 475 MTM election for trading bitcoin to have business ordinary gain or loss treatment. Section 475 allows “Traders in Securities and or Commodities” to make the election. The term “commodities” above really refers to trading Section 1256 contracts or regulated futures contracts; Section 475 does not seem to include bitcoin. However, if bitcoin becomes regulated as a commodity, it may qualify for Section 475 treatment.

A potential case for using Section 988 ordinary gain or loss treatment
If you don’t qualify for trader tax status in bitcoin, perhaps you can convince the IRS to respect the Fed’s label of “virtual currency,” and argue your bitcoin trades qualify for application of Section 988 (foreign currency transaction) ordinary gain or loss treatment.

Section 988 is the default tax treatment for spot forex trades, which is a huge trading marketplace. Spot forex traders write off trading losses in full as ordinary losses on line 21 of Form 1040 (Other Income). If they have trader tax status, they use Form 4797 Part II business ordinary loss treatment, which feeds into Net Operating Loss (NOL) calculations.

Section 988 allows forex traders and investors, but not manufacturers and other operating businesses, to file a contemporaneous internal opt-out or capital gains election. Many forex traders file a capital gains election and navigate their way into lower Section 1256g lower 60/40 tax rates, too. Section 988 does not allow a capital gains election on holding physical currency and that would apply to holding bitcoin, too if Section 988 were to apply. Section 988 rules for forex traders are complex and beyond the scope of this article.

Bitcoin as a digital currency
In general, American vendors accepting bitcoin as a digital currency in their trade or business should report bitcoin transactions as they would with a foreign currency. Simply translate the foreign or digital currency back into U.S. dollars on the date of receipt. There are no grounds to defer recognition of these transactions simply because it’s in bitcoin.

Holding bitcoin in your business
What happens if a trade or business decides to hold bitcoin for appreciation after acquiring it in a regular business transaction? Is it ordinary gain or loss from holding a commodity in your trade or business, or a capital gain or loss from holding onto a commodity or capital asset for appreciation? Both can be the case and it depends on intention, facts and circumstances.

In the earlier example, the farmer stockpiles wheat in a grain elevator, perhaps waiting for higher prices. The farmer may also hedge wheat prices in the futures market. Under the “hedging rule,” the wheat farmer still has ordinary gain or loss on storing and hedging wheat.

Also, consider the example of a manufacturer who holds foreign currency reserves for later use in foreign markets or for appreciation. The manufacturer also may hedge his foreign currency in the futures market. Like the farmer, the manufacturer has ordinary gain or loss on all these transactions.

An Internet vendor is not a commodity farmer of bitcoin and it’s conceivable that he could segregate bitcoin as a commodity or capital asset held for investment.

Bottom line
Bitcoin is a hot asset for traders and investors and you should learn the tax rules before you plow your money in. If you acquired bitcoin in your business, make sure you reported your sale transactions correctly.