January 2014

New IRS guidance on SE tax deductions affects partnership AGI-deduction strategies

January 14, 2014 | By: Robert A. Green, CPA

Update on March 4: Potential solution for 50/50 HW partnership returns. In general, we recommend 50/50 as that is how married couples generally share property. Pay administration fees during the year and if you need more cash flow, the husband and wife can reinvest capital to finance ongoing fee payments. Consult with us about your administration fee agreements and payment schedules.

Update on Feb. 21: With a two-spouse partnership return, you can maximize AGI deductions (health insurance and retirement plans) with the active-trader spouse owning just 1% (or a minority) of capital, rather than 99% (or a majority) of capital. However, that may not be feasible or wise considering joint property issues. In these cases, it’s better to consider an S-Corp election, or add a C-Corp, so the partnership can remain 50/50. Active traders owning 99% (or a majority) should consider changes soon. 2014 S-Corp elections are due by March 15, 2014. Consult with us about these changes.

In Green’s 2014 Trader Tax Guide, see Chapter 7 Entities & Chapter 8 Retirement Plans for our updated strategies on entities and retirement plans.

Business traders reporting an administration fee on an individual tax return Schedule C paid from their trading business partnership in order to unlock AGI deductions for health insurance and retirement plan contributions need to consider some changes as a result of new IRS guidance. The IRS released draft instructions to Form 8960 (Net Investment Income Tax) in January 2014. The instructions state that trading business expenses should be deducted against self-employment income (SEI), and any excess amount generating negative SEI may be deducted against Net Investment Income (NII). These draft instructions are based on the IRS’s final NII regulations released in December 2013.

Business traders using an S-Corp or C-Corp with payroll rather than a partnership administration fee are mostly unaffected by this new IRS guidance. But partnerships need to consider these suggested solutions. We’re adopting this new guidance for 2013 tax returns and subsequent years.

The partnership fee/AGI-deduction strategy can still work on some partnership tax returns.
Prior to 2013, the simplest entity for a husband and wife was a general partnership filing a partnership tax return. To unlock AGI deductions for health insurance and retirement plans, the partnership paid an administration fee to the trading owner’s individual Schedule C, creating the earned income needed for the AGI deductions. But the trading business expenses passed through from the partnership — including the fee payment — were not included in SEI. With new IRS guidance requiring an SEI deduction for partnership expenses, it’s harder to achieve the SEI that is necessary for purposes of maximizing these AGI deductions.

Consider this example of a husband and wife 50/50 general partnership or LLC filing a partnership tax return for 2013. The partnership has trading business expenses of $20,000 before paying an administration fee to the husband, who is the active trader (assume the wife is non-active). Before the new IRS guidance, the partnership could pay an administration fee of $30,000 to the husband to cover AGI deductions for health insurance (close to $12,000) and Individual 401(k) elective deferral ($17,500). Now, the partnership needs to gross up the fee to cover the husband’s 50% share of partnership Schedule E SEI deductions. Therefore, the partnership needs to pay a fee of $80,000 to have a net SEI of $30,000. Fifty percent of the trading partnership’s loss (equal to $50,000 in this example) from trading business expenses ($100,000) is allocated to the husband. (The $100,000 is comprised of the $20,000 expenses and $80,000 fee.) The wife’s 50% allocation with negative SEI has no effect, as SEI and SE tax is calculated separately.

This change is not as simple as it may sound. The partnership needs to generate more income to justify a higher fee — an increase of $50,000 — and it needs the cash flow to execute it. If the husband owned a lower percentage of the partnership, the fee increase can be lower. But, in many HWGP entities, the non-active owner holds 1% of profit and loss, and that is a problem for this potential solution. They should consider changing to 50/50 or even 20/80.

If you want net SEI of $30,000, calculate the fee payment as follows. Trading expenses x allocation percentage = a negative SEI. You want to add an amount to get to $30,000 positive SEI and divide it by the other spouse’s allocation percentage to get the administration fee amount. For example, with 20/80, the negative SEI is: $20,000 x 20% = ($4,000). To get to the target $30,000 SEI, pay $34,000. Next, gross up $34,000 by dividing it by 80% which equals the administration fee of $42,500 (and is only $12,500 more than the $30,000 target). Total expenses are $62,500 ($20,000 expenses + $42,500 fee). Total expenses x the 20% allocation = a negative SEI of ($12,500) + the administration fee of $42,500 = target SEI of $30,000.

If the partnership approach doesn’t work for you, arrange salary not administration fees
The key issue for claiming health insurance and retirement plan deductions is to arrange these employee benefits in connection with a salary. The IRS does not allow partnership tax returns to pay a salary (payroll) to owners; it requires guaranteed payments or administration fees. The solution is to convert an LLC or a general partnership to an S-Corp, or add a C-Corp as a 1% partner, because an S-Corp or C-Corp pay salary to owner/employees.

An existing general partnership or multi-member LLC filing a partnership return can elect to be taxed as an S-Corp for 2014, by filing a federal Form 2553 S-Corp election by March 15, 2014. Some states rely on the federal form and other states have their own election form. Very few states don’t conform to federal “check the box regulations” allowing general partnerships or LLCs to elect S-Corp tax treatment. Consult with us about whether an S-Corp election is beneficial for you, and allowed in your state.

These solutions are less disruptive and lower in cost than opening, and closing entities. You can keep your existing trading business, including its trading accounts and bank accounts, in place.

S-Corp tax treatment is inappropriate for a hedge fund or trading company with special allocations like “carried-interest” to owners as that is considered a second class of equity and is not allowed. These types of partnerships should consider adding a C-Corp as a 1% owner.

A general partnership or multi-member LLC filing a partnership tax return can add a new C-Corp as a 1% owner of the partnership. There are few changes for the partnership: It keeps filing a partnership tax return and pays the C-Corp an administration fee and 1% or more allocation of profits. The C-Corp then has sufficient income to pay the owner a salary to unlock C-Corp-level employee benefits for health insurance and retirement plan contributions.

C-Corp owners have added benefits that are not available with partnership and S-Corp returns. The owner can have a medical reimbursement plan, which increasingly is an attractive idea considering higher deductibles and out-of-network health costs under ObamaCare plans. You can also shift individual income to lower C-Corp tax rates or operate the C-Corp close to break even if state corporate taxation is a concern.

Retirement plan changes
The other change you need to make is converting an individual-level retirement plan to the entity level. Salary-based retirement plans require entity-level retirement plans. This is fairly easy to accomplish, however some brokers may be confused about a general partnership electing S-Corp treatment, so consult with us.

For 2013, if you used a partnership and you reclassified distributions to administration fees, you may want to reclassify them back to distributions so you don’t need to file a 2013 Form 1099-Misc. by the end of February. But if you do file the 1099-Misc., it may not unlock many AGI deductions per the new guidance: The fee payments included in the partnership loss offset the fee income for both gross income and self-employment income purposes. It depends on the fee recipients share of the partnership loss.

If there is insufficient 2013 net self-employment income, you can’t fund retirement plans, so make sure there is no excess retirement plan funding for 2013 subject to IRS penalties. If you already excess funded a plan for 2013, withdraw those excessive funds as soon as possible to avoid penalties.

There’s time to fix 2014, but no time to fully fix 2013
Traders using partnerships can rearrange their tax affairs to get all the tax breaks for 2014 and subsequent years, but 2013 is a transition year so they get left holding the bag on fewer tax breaks such as no or limited AGI deductions based on their trading businesses. They do keep their business expense treatment, Section 475 and other trader tax benefits.

Unfortunately, you can’t reclassify administration fees to payroll, as payroll is a formal contemporaneous filing. It’s not a big deal to handle payroll with an outside firm like paychex.com.

Good news/bad news
This seems like positive news for business traders and other taxpayers, since SEI deductions are more valuable than NII deductions. SE taxes include FICA and Medicare tax, whereas Net Investment Tax (NIT) only includes the 3.8% Medicare tax. Deducting trading business expenses against self-employment income first is generally a good thing and we are not against this new guidance.

Sole proprietor traders with other earned income activities will generally be happy with this new IRS guidance. They can now deduct their trading business expenses from SEI and pay less SE tax. But they also have less earned income for retirement plan calculations.

The bad news is the new guidance causes issues for business traders using AGI-deduction strategies for health insurance and retirement plan contributions arranged through trading business partnership tax returns. Those strategies were constructed based on trading business expenses not being deductible against SEI. With the new IRS guidance, the partnership loss on Schedule E — increased by the administration fee payment — is also deductible against SEI, so the administration fee on Schedule C cannot generate positive SEI needed for the AGI deduction for a 99/1 HWGP.

Our prior position excluding trading business expenses from SEI
To date, we’ve taken the position that trading business expenses — like related trading business gains and losses — should be excluded from SEI.

While Section 1402 (SE tax rules) first state that Section 162 “trade or business” expenses for individuals and partnerships are deductible against SEI, they go on to exclude trading capital gains. IRS publications, trader tax court cases and Website statements all clearly state that business trading gains and losses are excluded from SEI. Unfortunately, we don’t see trading business expenses discussed specifically anywhere. Leading tax publishers have also said this matter was unclear in the law.

We’ve taken a conservative position: Since trading gains and losses are excluded from SEI, so should their related trading business expenses. When tax law is unclear, it’s often appropriate to turn to general tax concepts and theory, which includes a matching concept. If the income is non-taxable, generally the expenses to generate that income are also non-deductible. That’s how it works with tax-exempt income — the investment fees and margin interest to generate that income are non-deductible.

To clarify this matter, we asked an IRS official involved with the new NII regulations about these questions. The IRS person unofficially said the IRS thinks trading business expenses offset SEI first, and then NII. He pointed to example 4 in “Reg §1.1411-9. Exception for self-employment income,” which was released in December. We conclude it’s prudent to adopt this new guidance on 2013 tax filings. We believe our tax filings for 2012 and prior years are correct based on existing tax law at that time.


A major tax reform bill in 2014 is unlikely, and “tax extenders” may be history, too

January 9, 2014 | By: Robert A. Green, CPA

Postscript: Jan. 13, 2014 TaxAnalysts “Piecemeal Reform of Financial Products Tax Unlikely, JCT Economist Says.” “Congress is unlikely to pass a stand-alone financial products tax reform bill without enacting broader tax reform legislation, Joint Committee on Taxation economist Karl Russo said January 9 at the Practising Law Institute’s taxation of financial products and transactions seminar in New York.”

Tax-writing Congressional leaders — Rep. Dave Camp (R-MI), chairman of Ways and Means and Sen. Max Baucus (D-MT), chairman of the Senate Committee on Finance — worked on a tax reform bill last year that included closing many tax loopholes and tax expenditures. Due to gridlock over ObamaCare and the government shutdown, they weren’t able to present the bill, so they punted tax reform to 2014.

Budget-writing Congressional leaders – Rep. Paul Ryan (R-WI), chairman of the House Budget Committee and Sen. Patty Murray (D-WA), chair of Senate Budget Committee — forged a last-minute budget deal enacted into law. While it was a small deal — leaving out the extension of expiring unemployment benefits and “tax extenders” — it did break the paralyzing gridlock.

On Jan. 8, TaxAnalysts published “Camp Remains Focused on Comprehensive Tax Reform, Not Extenders.” Camp is pushing forward in 2014 on completing his tax reform bill, and he doesn’t want to undermine it and get side tracked with budget-busting tax extenders in a separate clean bill. If you want tax policy like tax extenders, then include it, and pass the entire tax reform bill. Kudos to Camp. It will be hard to attach tax extenders to a deficit-ceiling vote coming up soon, since tax extenders cost $50 billion per year. Same reason Ryan left it out of his budget vote.

There is another path to retroactive renewal of “tax extenders”
After Ryan and Murray omitted tax extenders from their year-end budget bill — probably because they would have broken their bank — Senate Majority Leader Harry Reid (D-NV) sponsored a “clean bill” to continue all tax extenders for another year. Perhaps Reid will push it soon on the Senate floor.

While it’s hard to imagine Republican leaders balking at a clean bill for tax breaks, in my view, it would interrupt all tax and budget leaders work toward budget and tax reform. Republicans voted against extending expiring payroll tax cuts a few years back to make a bigger political point. In my opinion, extending tax loopholes and corporate welfare like R&D tax credits undermines concrete efforts underway toward meaningful tax reform. Are separate “clean bills” for extending unemployment insurance benefits and tax extenders meant to embarrass the other party or are they for realistic enactment?

One tax extender that may affect traders and investment managers the most is a significant reduction in Section 179 expensing. For 2014 the maximum Section 179 expense deduction for equipment purchases decreases to $25,000 of the first $200,000 of business property placed in service during 2014. The bonus depreciation of 50 percent is gone, as is the accelerated deduction, where businesses can expense the entire cost of qualified real property in the year of purchase.

Tax reform is unlikely in 2014
Tax reform as contemplated by Camp and Baucus will continue to be highly contested by many lobbyists in Washington campaigning to retain valuable tax breaks for their clients and industries. That’s just the half of it. Even more controversial is the partisan divide over the underlying goals of tax reform. Democrats want to raise revenue and Republicans want it to be revenue neutral.

Will Congress pass tax reform in pieces in 2014? President Obama has continued to campaign on closing the carried interest tax break for investment managers of hedge funds. It’s hard to envision hedge fund managers being sacrificed alone, with Wall Street’s Sen. Charles Schumer (D-NY) representing their interests and Chicago exchange’s Sen. Dick Durbin (D-IL) also in leadership — second and third behind Reid.

While Baucus is expected to leave his chair soon – President Obama nominated him for the next U.S. ambassador to China – Camp has expressed interest to finish his year as chairmain, and run for another one year term. Camp remains dedicated to completing his hard work on tax reform pushing for passage in 2014, no matter the political headwinds.

Camp’s proposals on investments
It is interesting to consider some of the tax reform changes promoted by Camp in connection with investments. He proposed using mark-to-market accounting more than it’s used now — in Section 1256 contracts and with business traders who elect 475 MTM and dealers. This would do away with complex provisions and opportunities for income deferral and tax rate arbitrage.

Camp also proposed connecting entities with their owners for wash-sale loss calculations, and he confirmed that is not the case under existing tax law. IRS Pub. 550 mentions individuals and their controlled entities are connected for wash-sale purposes. We agree with Camp that separate tax filing entities are not connected with individuals under current tax law for purposes of wash sale calculations. It’s important to note that IRS publications are not authoritative tax law.

Bowles-Simpson goes further than Camp
The Bowles-Simpson 2010 Plan (National Commission on Fiscal Responsibility and Reform) suggested one tax rate to do away with a material difference between ordinary income and long-term capital gains tax rates. While that change would surely simplify the tax code in a huge way, Republicans won’t agree to it unless Democrats agree to lower that individual tax rate to around 23% to 25%, which is highly unlikely.

Business traders seem on safe ground
There are no current indications that business traders should fear losing their current trader tax breaks. Of course, business traders are regular individual taxpayers, too, and Congress may further limit their itemized deductions. Trader tax status is more valuable than ever, turning investment expenses into business expenses, which are unlimited.

We have not heard of proposals to repeal Section 475 MTM ordinary gain or loss treatment for business traders, and again we feel it’s positive that Camp favors MTM.

Some progressive Democrats want to repeal lower 60/40 tax rates on futures and other Section 1256 contracts. In a July 11, 2011 New York Times article (An Addition to the List of Tax Loopholes), I defended 60/40 while Warren Buffett argued for its repeal. Will Durbin stand by to watch 60/40 be repealed by Congress? Infamous Rep. Dan Rostenkowski (D-IL) won 60/40 treatment for Chicago futures exchanges. President Obama was a Senator from Illinois, too.

Tax reform goals will certainly be political campaign fodder and platforms for the 2014 midterm election in November and perhaps for the 2016 Presidential election. With continued political infighting over ObamaCare, it’s hard for me to envision Congress enacting a meaningful tax reform in 2014. The November election doesn’t have consequence until the new Congress takes office in January 2015.

ObamaCare tax on investment income
Not all tax change has been favorable to traders and investment managers. The Affordable Care Act’s 3.8% Medicare tax on unearned income — otherwise called the net investment tax (NIT) on net investment income (NII) — takes its first bite out of your apple on 2013 tax returns. New IRS Form 8960 for the NIT will be a nasty surprise for taxpayers with AGIs over $250,000 joint and $200,000 single, providing they have NII. The IRS published instructions for Form 8960 in early January. We are satisfied that the IRS repaired some glaring problems in their proposed NII regulations, making it much more favorable for business traders and investment managers that it otherwise would have been in the proposed regulations. See our Dec. 4, 2013 blog “IRS final regulations for Net Investment Tax help traders.”

Bottom line
Tax breaks for business traders and investment managers are still alive and well.


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