May 2014

Can business traders apply Section 475 elections to bitcoin trades?

May 21, 2014 | By: Robert A. Green, CPA

At the May 9 American Bar Association (ABA) meeting, tax attorneys asked the IRS about bitcoin. According to Tax Analysts coverage of the meeting, Jo Lynn Ricks of Deloitte Tax LLP said the IRS guidance didn’t answer the question of whether a virtual currency could be a commodity, adding that if it is a commodity, dealers and traders could elect mark-to-market treatment under section 475(e) and (f).

“If you have something that trades through a futures contract, then it could be a commodity through the [Commodity Exchange Act],” she said. Bitcoin futures are traded on an exchange called ICBIT, creating the potential for virtual currencies to meet that broader definition of commodity, according to Ricks.

In its guidance, the IRS labels bitcoin an “intangible asset,” but it doesn’t go as far as labeling bitcoin a commodity. The sale of an intangible asset, commodity or security brings capital gains or loss treatment. The sale of a commodity futures contract traded on a U.S. commodities or futures exchange means lower 60/40 tax rates under Section 1256.

Business traders electing Section 475 have ordinary gain or business loss treatment on Form 4797 Part II. We generally recommend business traders elect Section 475 on securities only, so they can retain lower 60/40 tax capital gains tax rates on futures (considered “commodities” in Section 475). Our tax attorney Mark Feldman suggests that to deal with bitcoins, the election language be changed so that it applies “for securities and for those commodities which are not eligible for Section 1256 treatment.”

Puerto Rico’s Tax Haven Status Is Made For Traders

May 13, 2014 | By: Robert A. Green, CPA

Postscript Aug. 2017: On July 11, 2017, the Governor of Puerto Rico signed into law House Bill 878 as Act 43 amending Act 20 of 2012, and Senate Bill No. 369 as Act 45 amending Act 22 of 2012. Act 43 eliminates the minimum employment requirement of five employees from Act 20. Act 45 adds a new $5,000 annual PR charity requirement in Act 22.(See BDO PR Newsletter: Act 43 & 45 – Amendments To Incentive Acts 20 & 22.)

Postscript June 12, 2017: On June 11, 2017, Puerto Ricans voted to change their status from U.S. territory to statehood in a non-binding referendum. Statehood would render PR’s territorial tax incentives invalid, including Act 22 and 20 for traders and investment managers. Statehood requires U.S. Congressional approval, which is doubtful in this Republican Congress, considering that PR has mostly Democratic representatives.

Postscript Mar. 22, 2016: On Nov. 30, 2015, PR enacted Act 187-2015 amending Acts 22 and 20 to stiffen the requirements. For Act 22 incentives, PR now requires new applicants after Dec. 1, 2015, to purchase residential property in PR within two years and open a deposit account. For Act 20 incentives, PR requires gradually hiring five full-time employees in PR. Read more about the changes on a PR attorney’s blog, Puerto Rico Expands Tax Haven Deal For Americans To Its Own EmigrantsPuerto Rico Act 22 – The Individual Investors Act and Puerto Rico Act 20 – The Export Services Act.

Postscript Oct. 1, 2014: I recommend this excellent article from The Tax Adviser, Tax Advantages for U.S. Traders of Securities and Commodities Relocating to Puerto Rico.

Watch our related Webinar recording “Puerto Rico’s tax haven status is tailor made for investors, traders and investment managers.”



Puerto Rico Pours On Tax Incentives For Investors

Puerto Rico’s new tax incentive acts are tailor made for traders/investors, investment managers and financial institutions. In the past, Puerto Rico offered tax incentives to manufacturers. Puerto Rican officials now believe investors, investment managers and financial institutions can more easily move virtual businesses there. The officials figure these groups will bring an influx of new money and key investments to the island to help it rise above its current state of financial distress.

“Puerto Rico is one of only a few places in the world where a U.S. citizen or permanent resident can live, without giving up their U.S. citizenship and passport, while legitimately avoiding payment of tax to the IRS on PR source income,” NYC tax attorney William Blum says. “Those who would like to legally reduce their tax burden, and who are ready for an exciting lifestyle change, should seriously consider it.”

Act 22 for traders and investors
Enacted in 2012, PR Act 22 allows investors and traders with bona fide residence in Puerto Rico to exclude 100% of all short-term and long-term capital gains from the sale of personal property accrued after moving to PR. Act 22 does not require investment in Puerto Rican stocks and bonds; trades can be made with a U.S. broker or on any exchange around the world. This applies to day traders. While trader tax status and Section 475 MTM elections are important tax strategies for residents of the U.S., they are irrelevant when applying PR Act 22 exclusions.

U.S. tax law Section 933 “Income from sources within Puerto Rico” is synchronized with PR tax law, including Acts 22 and 20. Americans with residence in PR split their income, reporting “non-PR source” income (income in the U.S. and elsewhere other than in PR) on U.S. Form 1040, and PR-source income on a PR income tax return filed with Hacienda (PR’s tax authority).

IRS Pub 1321 “Special Instructions For Bona Fide Residents Of Puerto Rico Who Must File A U.S. Individual Income Tax Return (Form 1040 or 1040A)” shows how to treat different types of income (see page 2, “Source of Income Rules”). Other than the “sale of personal property” which is sourced in the “seller’s tax home” (presumably in Puerto Rico), other types of income are sourced from: the location of payer for interest and dividend income; where the service is performed for wages and compensation; where services were performed that earned the pension income; where the property is used for royalties paid on patents, copyrights and IP; and the location of property for the sale or real property like residential, rental and commercial real estate.

Can you see the tax loophole? Worldwide capital gains (other than gains on real property) are sourced in PR and they are 100% excluded from both U.S. and PR tax, resulting in a trader’s tax nirvana. There’s one exception: trades made from an office outside of PR do not qualify as PR source capital gains subject to the exclusion.

Pub 1321 includes these instructions: “Caution: There are special rules for gains from dispositions of certain investment property (for example, stocks, bonds, debt instruments, diamonds, and gold) owned by a U.S. citizen or resident alien prior to becoming a bona fide resident of a possession. You are subject to these special rules if you meet both of the following conditions: For the tax year for which the source of gain must be determined, you are a bona fide resident of Puerto Rico; for any of the 10 years preceding that year, you were a citizen or resident alien of the United States (other than a bona fide resident of Puerto Rico); if you meet these conditions, gains from the disposition of this property will not be treated as income from sources within the relevant possession for purposes of the Internal Revenue Code. Accordingly, bona fide residents of American Samoa and Puerto Rico, for example, may not exclude the gain on their U.S. tax return. However, there is a special election that you can make to allocate gain/losses between the U.S. and Puerto Rico from disposition of certain property. For additional details see Publication 570.”

It’s a bit deceptive in marketing materials from PR sites for Act 22. Many promise 100% exclusion on all interest and dividend income, but the U.S. will keep taxing non-PR source interest and dividend income, even if PR does not. Act 22 also provides a 10% PR tax rate on the sale of real property located in PR if held under 10 years since establishing PR residence, and a 5% tax rate if held more than 10 years.

Act 20 for investment managers
Investment managers charge advisory fees, which are service business revenues. They export their services to investors outside of Puerto Rico and hence they can qualify for Act 20 tax incentives for “export service businesses.”

To receive these incentives, they need to move their operations to PR and they should have a minimum of three employees there who are paid reasonable wages. The employees are bona fide residents and they pay PR taxes on their individual tax returns on this compensation. PR is part of FICA and Medicare, so the employer needs to charge payroll taxes in a similar manner to the U.S.

The Act 20 tax incentive is a 4% flat tax rate on net business income. The owner receives Act 22 100% exclusion on dividends received from the PR business entity. PR-sourced dividends are excluded from U.S. taxes under Section 933.

Companies retaining some operations in the U.S. will have “effectively connected” trade or business income subject to U.S. tax.

Many owners and employees of investment management operations have significant capital gains income generated from their own investment portfolios, including investments in their own funds and profit allocations of capital gains in their managed hedge funds. These capital gains can be excluded under Act 22, except for the trades that originate from an office outside of PR. A CEO of an investment management firm can not be the only one that moves to PR, he also needs to bring along much of his investment management operations and employees, too.

Bona fide residence has stringent tests
You must pass all three different tests — the presence test, tax home test and closer connection test – for individual bona fide residence and all three are not easy to pass. Many taxpayers and advisors are aggressive about state residency tests for domicile and they lose when audited by tough tax examiners. PR’s Act 22 and 20 are new and only 2012 and 2013 tax returns have been filed, not giving state and PR auditors much time to check yet.

It’s difficult to move an investment management business to PR. You have to change documents with investors, hedge funds and counterparties to reflect the PR company name and address and carry on your business from Puerto Rico.

Everyone There Will Have Moved Here! An Overview of the US Federal and Puerto Rican Tax Incentives for Bona Fide Residents of Puerto Rico” is an excellent article by NYC tax attorney Mark Leeds and PR tax accountant Gabriel Hernandez. (The article includes in-depth information about the three residency tests and an example of an investment manager.)

When someone calls with questions about Puerto Rican tax benefits, Leeds says offspring are an important factor. “The first thing I ask is do you have kids and what are their ages? The sweet spot of the PR tax strategy is for people in their 20s without kids and older people whose children have moved on,” he says. “If children are embedded in communities, it’s hard to make the change of residence work because it’s hard to meet the bona fide residence tests. If kids and spouses will stay in the U.S., it’s unlikely that the trader will satisfy the closer connection test. The strategy works well for young traders and older guys in private equity and hedge funds.”

The article says “(Act 22) has a 100% tax exemption from Puerto Rico income taxes on all long-term capital gains accrued after the individual becomes a bona fide resident of Puerto Rico.” I asked Mr. Hernandez if this should say all capital gains (including short term). Hernandez confirmed all capital gains now receive the exemption.

“Originally, PR Act 22 had only the long-term capital gains exclusion and after a short while they corrected it to include all capital gains (on the sale of personal property),” he says. Afterwards, I asked Mr. Hernandez for a legal citation on this correction and he emailed me Law 138 in Spanish and wrote “Article 3 of Law 138 amends Article 5 of Act 22 to provide exemption to the “totalidad” (which means 100%) of the capital gains.”

Some tax professionals feel the Hacienda might consider a day trader, scalper or high-frequency trading market-maker to be a business, and disqualify their trading gains from Act 22 exclusions. But Hernandez and Leeds disagree.

“Puerto Rico follows federal precedents on trade or business, and trading is a capital gains activity in the U.S.,” Hernandez says.

Moving to a foreign country instead
If an American citizen or legal resident (greencard holder) becomes a bona fide resident of a foreign country, as opposed to a U.S. territory or possession like Puerto Rico, their taxes are handled as follows: If they retain U.S. citizenship or legal residence status, they may use Section 911’s Foreign Earned Income Exclusion ($99,200 for 2014). If they surrender U.S. citizenship or legal residence status, they are subject to Section 877’s Expatriation Tax rules. (Both are beyond the scope of this article.)

Bottom line
For traders and investment managers who are ready, willing and able to meet the stringent bona fide residency tests, PR Act 22 and Act 20 tax incentives are probably a great deal.

For such a drastic move and change of lifestyle, you will want to be conservative in assessing your passing of the residency tests. It’s wise to discuss the ins and outs of these tax programs with experts in these matters, and run pro-forma U.S. and PR tax returns based on your facts and circumstances over a few years of projected stay. Carefully assess the pros and cons. One con is there’s no Section 475 NOL tax loss insurance for business traders.

If you’re young and single or an empty nester, this type of move may work well for you. Saving up to 50% or more on federal and state income tax rates on your trading gains can beef up your retirement income in a significant way. Plus, in PR you already found your retirement home in the sun!

For more information
Moving to Puerto Rico

Hedge Funds Take Muni Bond Market by Storm

A key update on trading entities and management companies

May 6, 2014 | By: Robert A. Green, CPA

Prior to 2014, we suggested that business traders organize as an unincorporated sole proprietorship, or for additional tax benefits like adjusted gross income (AGI) deductions for health insurance and retirement plan contributions, trade in partnership tax structures.

With 2014 guidance from the IRS on self-employment income (SEI) for traders, we pivoted our entity strategies to recommend S-Corps, or adding a C-Corp to a partnership, for the health insurance premium and retirement plan deductions. We’ve been fine tuning our new entity strategies since January and here’s an important update.

Starting in 2014, we suggest business traders use entities in one of three ways:
1. Partnership tax return: Trade in a general partnership or multi-member LLC filing a partnership return and focus on the health insurance premium deduction and the 100%-deductible “elective deferral” portion of an Individual 401k plan ($17,500 for 2014, plus the $5,500 catchup provision for over age 50). While it’s now harder (Note 1) to achieve targeted SEI for these AGI deductions, it’s still possible in some limited situations. But it’s very unlikely that one can achieve a tax-efficient 20% profit sharing retirement plan deduction, too.

If you don’t need these AGI deductions, the partnership tax structure alone works fine. In most states, a general partnership or LLC can elect S-Corp status at a later day, generally by March 15 of a current tax year.

2. Dual-entity solution: Trade in a general partnership or multi-member LLC filing a partnership return and add a C-Corp or S-Corp to the mix as a second entity (a management company). Providing you have sufficient trading gains, it’s possible to receive a maximum 20% profit-sharing retirement plan deduction in either the C-Corp or S-Corp.

If you are in a top individual tax bracket (39.6%), and want to take advantage of lower C-Corp federal tax rates (15%) on the first $50,000 of C-Corp net income — perhaps you’re in a tax-free state for C-Corps and/or you want a medical reimbursement plan which only C-Corps may have — then consider a C-Corp for your second entity. Form an LLC or corporation and you can choose between C-Corp or S-Corp tax treatment within 75 days of inception (by filing a Form 2553 S-Corp election).

If this isn’t your case and there are limited (or no) “stealth” taxes (such as material minimum taxes or franchise taxes) on the S-Corp in your state, you may prefer an S-Corp for your second entity. (See additional tax rules for S-Corps below).

How do you get income into the management company? The management company should own a small percentage of the trading partnership to bring trader tax status to the partnership level. The management company can charge a reasonable administration fee, perhaps $1,000 or $2,000 per month, but not more as that would be unreasonable. (Formalize administration fee agreements early on).

The C-Corp can also get a profit-allocation (carried interest) in the partnership agreement (perhaps 5% to 30%), which can provide the additional income needed to maximize a retirement plan deduction. The profit allocation clause in the partnership agreement is better than a C-Corp owning a higher percentage of equity, as you don’t want partnership trading losses allocated to a C-Corp where there is no immediate tax relief to the owner. Capital losses are limited in C-Corps to a 3 year carryback and 5 year carryforward. That’s not a problem with an S-Corp as the management company, as the S-Corp passes losses to the owner’s individual tax return.

3. S-Corp: Trade in an S-Corp tax structure. Have a base salary for covering the health insurance premium deduction, even if you have trading losses, although profits look better. If you have sufficient profits, make a tax-deductible retirement plan contribution after year-end. Start with the 100%-deductible Individual 401k elective deferral of $17,500. If you have large trading gains, increase payroll in December for a performance-based bonus and then do a 20% profit-sharing retirement plan contribution, totaling up to $33,500 on top of the elective deferral amount. The total defined-contribution retirement plan deduction limit is $51,000 (or $56,500 with the over age 50 catchup provision).

Consider a defined-benefit plan instead of a defined-contribution plan. The defined-benefit plan tax-deductible contribution limit is $210,000 for 2014 on salary determined by an actuary which could be as low as $100,000. Huge savings!

If you use an S-Corp, read Note 2: S-Corps have tax challenges.

Payroll tax compliance is not a big deal for traders
Payroll is not a big deal for a simple trading or management company with spousal or single ownership. can handle all your payroll tax compliance needs and the total cost is around $650 per year.

The Paychex service includes quarterly payroll tax returns (Form 941), the annual payroll tax return (Form 940), state payroll tax returns, and federal unemployment insurance with FUI tax of under $50 for the owner/trader. In most states, the trader/owner is exempt from state unemployment insurance and state workmen’s compensation.

One benefit is you can withhold taxes from payroll in December and have them attributed to being made throughout the year. Take advantage of this tax loophole to reduce quarterly estimated tax payments during the year. Benefit from hindsight and use of the cash flow.

Hedge funds use partnerships for trading, and S-Corps for their management company
Partnerships are the best tax vehicle for a trading business and that’s why hedge funds use a partnership structure in the U.S. (General partnerships and limited partnerships file partnership tax returns and so do most LLCs.) A hedge fund manager uses a management company to charge management fees and to arrange health insurance and retirement plan deductions for the owner/managers and other employees.

Partnership tax returns are more favorable vs. S-Corps on owner basis and allocation of income and loss rules. Partnerships allow “special allocations” with hedge fund managers often getting profit allocation, otherwise known as “carried interest.” By default, hedge funds use investor-level accounting with net asset value (NAV) and profit and loss allocated to each partner for only when they are owners. That’s not the case with S-Corps, as explained below.

Medical reimbursement plans in C-Corps
A C-Corp may have a medical reimbursement plan (MRP), whereas pass-through entities (partnerships and S-Corps) may not for more than 2% owners — and attribution rules apply to spousal owners.

Medical reimbursement plans generally require a minimum of a two-person group health insurance plan arranged on the C-Corp entity level. Group health insurance plan participants generally have a minimum work requirement of 30 hours per week as formal employees under ACA.

If you already enrolled in an individual health insurance plan compliant with ACA, you may have trouble making changes before the enrollment period for 2015, although a new entity and group plan is like changing a job and that may allow for changes mid-year. Check with a state health insurance broker.

If a MRP doesn’t work out for you, perhaps consider a Health Savings Account (HSA). Some HSAs are compliant with ACA. You can arrange a HSA deduction with a trading partnership, S-Corp or management C-Corp. With an HSA, you can increase your health insurance premium deduction by the HSA contribution ($6,550 for a family, plus $1,000 for over age 55 for 2014).

Bottom line
There is no easy tax-structure solution for business traders. While a sole proprietorship is good for deducting business expenses, it’s a red flag with the IRS and you can’t have health insurance and retirement plan deductions in connection with trading gains (with the exception of members of a futures exchange trading futures on that exchange). Every trader’s facts and circumstances are different based on income levels, marital status, state residency including community-property rules if applicable, capital, health insurance coverage, goals for retirement plan contributions, and more.

It’s best to consult with Robert A. Green, CPA about which business tax and entity plan makes most sense for you. Maybe you don’t qualify for trader tax status (TTS) and should be an individual investor. Or maybe you do qualify for TTS and should start off as a sole proprietor. Keep in mind that after April 15, it’s too late for sole proprietors to elect Section 475 MTM treatment, whereas new entities may elect Section 475 MTM within 75 days of inception. Perhaps an S-Corp trading company works well for you and you don’t expect any basis and distribution tax issues (Note 2). Or perhaps you’re better off with a partnership or dual entity solution including a C-Corp or S-Corp for the management company. Our job is to come up with a plan where the benefits far exceed the cost and complications. Entities are a very important part of a successful business trading plan, so it’s certainly worth the time and effort to get it right!


1. New IRS guidance on self-employment income
It’s harder to arrange AGI deductions for health insurance and retirement plans in connection with “earned income” from administration fees received from the trading business filing a partnership tax return — with the administration fees reported on a an individual tax return Schedule C. With partnerships, the new IRS guidance requires individual owners to reduce SEI — the administration fee income — by their share of trading business expenses passed-through from the same partnership.

With the S-Corp and C-Corp, compensation is not reduced by a share of trading business expenses and that’s why it’s more tax efficient for health insurance and retirement plan deductions. (For more, see “New IRS guidance on SE tax deductions affects partnership AGI-deduction strategies.”)

2. S-Corps have tax challenges
S-Corps do not allow special allocations, so you can’t have profit allocations (carried interest). S-Corps can’t have foreign partners or C-Corp partners.

With S-Corps, the default allocation method is annual net profit and loss calculated on a “pro-rata share” basis. The rule requires per-share, per-day basis, based on ownership percentages. If the annual net income is $100,000 and partner B owned 50% for 100 days only, that’s his allocation — 100/365 x 50%. Never mind that the company may have lost money during his ownership period.

For example, if a new owner is admitted on July 1 and the S-Corp had large net trading gains in the first half of the year and losses in the second half, the new owner is allocated his pro rata share of annual net profit and loss. Conversely, with a partnership the default allocation is based on only the period of ownership so new owners don’t get a share of profits outside of their ownership period. There is an S-Corp election to fix this, but it’s crude.

Closing of the books method election: For the previous example, consider making a “closing of the books” method election on the S-Corp dated June 30. That closes the books on June 30 and reopens them on the date the new owner is admitted on July 1. To qualify for this election, the S-Corp owner must dispose of their entire interest during the year or dispose of more than 20% of their ownership interest. Every owner must consent as well. This issue is not common for retail traders, as they generally don’t admit new partners.

Some traders want a profit allocation so they must trade in a partnership structure and the S-Corp won’t work for them as a trading vehicle. One example is when a parent contributes 100% of capital and the son or daughter trader wants a profit allocation based on new high-net profits.

S-Corp basis ordering rules
Although IRS regulations for S-Corps are intended to prevent double-taxation on income or double tax benefits on losses, the unintended consequence is added tax compliance work and in some cases suspended (deferred) losses if they exceed stock and debt basis and acceleration of taxes on distributions in excess of stock basis. This is not a problem for our firm in tax compliance work as our professional software handles these issues automatically.

The basis ordering rules require a specific order in how you calculate your individual S-Corp basis: increases first followed by decreases.

1. Increase by capital contributions;
2. Increase by non-separately stated income (includes Section 475 MTM net ordinary trading gains);
3. Increase by separately stated income (includes portfolio income and net capital gains);
4. Increase by tax-exempt income (includes muni bond interest);
5. Decrease by distributions of cash and FMV of property;
6. Decrease by non-separately stated losses (includes Section 475 MTM net ordinary trading losses and trading business expenses);
7. Decrease by separately stated items of loss or deduction (includes net capital losses and investment expenses);
8. Decrease by non-deductible expenses (50% of meals deduction).

There is a permanent election to change to move non-deductible expenses up one notch above losses. But while that may help in the short-term, it could hurt over the long-term as you must carry over these losses to future years, which will reduce basis.

Tips for using the S-Corp structure
Keep it simple and avoid financing your S-Corp with debt, which brings up debt basis issues. . When you contribute money to the S-Corp, it’s best to treat it as equity, not debt.

In most cases, even if your S-Corp has debt on its books, it’s not debt basis for you unless you are personally set back by it. A personal guarantee doesn’t count until you make a payment to the lender. Conversely, partnership owners are credited with basis for their share of certain partnership debt.

Margin lending is technically not considered debt. With margin, the broker grants the trader additional buying power on securities. If the trader incurs a decrease in account value in connection with the “borrowed positions,” the broker issues a margin call requiring the account holder to deposit more cash into their account. While the margin call itself could be deemed a debt, the account holder generally pays the additional cash immediately or the broker unwinds part of the margined positions. Generally, either the S-Corp has sufficient cash on hand to meet the margin call, or shareholders contribute more capital to meet the call. A note payable is not recorded on the S-Corp books and it’s not debt financing, which means there’s unlikely to be suspended losses due to margin calls.

Suspended losses can happen if the S-Corp borrows actual funds from a third-party who is not a shareholder, and the S-Corp incurs a loss in excess of shareholder equity. In that case, the shareholder’s loss may exceed their stock and debt basis and they would have a suspended loss. For example, say an S-Corp obtains a credit card, purchases equipment and does not pay off the balance right away. A personal guarantee on that card is not shareholder debt basis. Another example is if the S-Corp borrows money from an outside third-party or family member. To avoid these situations, the shareholder should borrow the money individually and then contribute it to the S-Corp as equity or debt to have stock or debt basis.

If you do have debt on the S-Corp, make sure you have sufficient profits to distribute before making a distribution. You need to have good interim accounting on trading gains, losses and expenses. If you take a distribution in excess of your stock basis — effectively benefiting personally from tapping into debt-financed funds — that may trigger capital gains income and related capital gains taxes on the excess distributions. (Debt basis doesn’t count for distributions.)

Are you worse off with an S-Corp trading business vs. a partnership or sole proprietorship structure? Only if you have suspended losses caused by third-party debt that is not shareholder debt basis. That’s rarely the case for most business traders. Sole proprietors need to be “at risk” for losses deducted on a Schedule C and that generally is the case. Form 4797 ordinary losses using Section 475 have similar at risk rules as the Schedule C and they are almost always met by traders. Partners in partnerships have suspended losses when their Form K-1 losses exceed their capital account and share of certain partnership debt. So the answer is no, the S-Corp works fine for most business traders.

Many self preparers and local accountants don’t properly comply with the S-Corp basis ordering rules which can lead to complications and extra taxes. When our firm helps form your trading business as an S-Corp, we recommend our tax compliance service to handle basis and distribution related issues right.