February 2015

C-Corps Have Limited Use For Tax Savings

February 26, 2015 | By: Robert A. Green, CPA

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A C-Corp can help upper-income taxpayers in business save taxes, but it’s not useful to investors.

Increasingly, upper-income folks and their tax professionals are considering a corporate structure in tax planning in order to avoid Obama-era tax hikes. Starting in 2013, Congress raised the top tax bracket for individuals to 39.6% — effectively 41% after factoring in the Pease itemized-deduction limitation. When the 3.8% Net Investment Tax on unearned income is factored in, the combined individual top rate is a hefty 45%. Upper-income taxpayers are rewarded with an 11% or more tax savings when they can shift income from their individual to corporate tax returns. Plus, Congress is discussing corporate tax reform and they may reduce corporate rates widening the gap with individual rates.

Active traders who don’t qualify for trader tax status (business treatment) wonder if a corporate structure allows trading expense deductions considering that Section 212 investment expenses are restricted on individual tax returns. Corporations cannot deduct Section 212 investment expenses; therefore they don’t provide tax relief when a trader does not qualify for trader tax status.

Businesses can efficiently shift income to a corporation
A pass-through-entity trading business – like an LLC or S-Corp – qualifying for trader tax status has business expense treatment. Administration fees paid to a management company organized as a corporation are a business deduction on the pass-through entity. The receiving corporation has business income and expense treatment.

Business treatment on both the pass-through entity and corporation translates to tax efficiency.

Investors cannot efficiently shift income to a corporation
A pass-through-entity investment company has Section 212 investment expense treatment on the individual owner’s level for administration fees paid to a management company organized as a corporation.

That’s not tax efficient since investment expenses face significant limitations on individual tax returns, including the 2% AGI threshold for miscellaneous itemized deductions and the Pease itemized deduction limitation. Miscellaneous itemized deductions are not deductible for AMT tax.

If the investment company allocates a share of trading gains to the management company corporation in lieu of paying fees, the corporation doesn’t have business purpose. Plus, the corporation could be deemed a personal holding company (PHC) subject to a PHC surtax of 20% on undistributed PHC income. A corporation may not deduct non-business expenses including Section 212 investment expenses, which only individuals may deduct.

Corporations deduct business expenses, not investment expenses
Corporations with business activities may deduct Section 162 trade or business expenses. Corporations aren’t permitted to deduct non-business expenses including Section 212 investment expenses for individuals. When a corporation with established trade or business has ancillary investment expenses related to their business activities — like investing working capital — those expenses are deemed Section 162 business expenses and not Section 212 investment expense. Pure investment companies structured as a corporation may not deduct investment expenses. Pass-through entities with investor tax status report investment expenses on Schedule K-1 issued to individual owners.

Tax law is clear
Our CPA firm researched this tax law: It’s clear Section 212 is for individuals only, and corporations need business purpose to deduct Section 162 business expenses. Corporations cannot deduct non-business expenses. I spoke with an IRS official on this matter and his informal advice was to agree with the position stated in this blog.

Here are some excerpts from highly respected tax publication Bittker and Eustice on “Corporate Deductions.”

  • “The Code allows individuals to take a number of deductions that are not allowed to corporations, including the standard deduction, (investment expenses)…. (the code) prevent restrictions aimed primarily at individuals from being sidestepped by a transfer of the restricted activities to a closely held corporation…Section 212 is restricted to individuals, however, presumably on the theory that § 162(a) covers the same ground for corporations that § 162(a) and 212 in combination cover for other taxpayers. Thus, if a corporation engaged in manufacturing holds some securities as an incidental investment, the cost of a safe-deposit box, investment advice, bookkeeping, and so forth incurred with respect to the securities would be deductible under § 162(a) as trade or business expenses, even though an individual proprietor holding such securities would have to resort to § 212 as authority for deducting such expenses.”

Warning to traders not qualifying for trader tax status
Traders not qualifying for trader tax status should not use a corporation since they don’t have business purpose and corporations can’t deduct non-business expenses. While a corporation starts off with presumption of business purpose, that alone doesn’t achieve business purpose. The corporation must qualify for a trade or business. For a trader that means qualification for trader tax status. A corporation is not a remedy for not qualifying for trader tax status.

Corporate tax rates are materially lower than individual rates
The corporate tax rate starts at 15% on the first $50,000 of income, 25% on the next $25,000 and it settles in at 34% thereafter. Personal service companies don’t qualify for the lower rates under 34%. Taxpayers generally try to take advantage of the lower bracket rates so if the corporation pays them qualified dividends years later there’s still meaningful cumulative tax savings.

Unlike pass-through entities including S-corps, LLCs and partnerships, a corporation (C-Corp) pays entity-level taxes. (Note: LLCs can also elect C-Corp tax-filing status.) An individual owner pays taxes on qualified dividends paid by the corporation up to a 20% (long-term capital gains) rate. Plus a 3.8% NIT is applied on unearned income if you’re over the AGI threshold. Paying taxes on the entity and individual levels is commonly referred to as “double taxation.” Corporations avoid double taxation by paying compensation to owner/officers. Most states also tax corporations, so double taxation can defeat the purpose of using a corporation in high tax states. (State taxation for corporations is beyond the scope of this blog post; see more information in Green’s 2015 Trader Tax Guide.)

A corporation needs business purpose
Before you jump into reorganization as a corporation, it’s important to understand the pros, cons and potential pitfalls. My bailiwick is investors, traders and investment managers. In a nutshell, adding a corporation as a second entity makes sense for a business trader or investment manager to reduce Obama-era tax hikes on individuals. But using a C-Corp structure for an investment company does not work. Corporations need a business purpose; therefore, investors won’t find salvation using a corporate structure.

A successful strategy for a trading business
Suppose you have a successful trading company LLC that qualifies for trader tax status and files as either a S-Corp or partnership. Consider adding a corporation as a second entity to provide administration services or to hold intellectual property and charge royalties to the trading company LLC. That has the effect of shifting income from your individual tax return to a corporate tax return. Either the S-Corp trading company or C-Corp management company can unlock employee-benefit plan deductions including health insurance and retirement plans. (Investment companies can’t generate compensation or earned income by arranging employee-benefit plan deductions.)

A failed strategy for an investor
Suppose you have an investment activity that doesn’t qualify for trader tax status (business treatment). (Read How to Qualify.) You also don’t offer investment management services to clients, so you don’t have any business purpose.

A tax salesman approaches you and promises tax deductions using a corporation. These promoters find their prey on the trading education and seminar circuit. The promoter says you can dump your education expenses and other startup expenses into a corporation going 18 months back and generate a net operating loss (NOL) in the corporation to carryover to subsequent tax years. The promoter also suggests a second LLC entity for trading.

If that LLC doesn’t qualify for trader tax status and pays the corporation management or administration fees, it will have investment expense treatment. That defeats the purpose and you’re right back at the beginning of the problem with investment expense limitations on your individual tax return. Seminars and pre-business education are generally not deductible as investment expenses pursuant to Section 274(h)(7).

Conversely, the LLC can wait to achieve trader tax status at a later date and pay the corporation fees then, which will be business deductions for the LLC trading business. The promoters argue the corporation can utilize its NOL to offset the income from the trading business LLC. But, that doesn’t work in my view, as the corporation can’t deduct those expenses in the first place without business purpose from its inception. Dumping expenses that lack deductibility into a corporation for later use does not have legal authority.

At best, the corporation is entitled to capitalize Section 195 startup business expenses for a reasonable amount over a reasonable period if it has business purpose in the works. It’s simple for an IRS agent to determine whether a corporation has trader tax status or business revenue and, therefore, to determine whether any expenses are legitimate Section 162 corporate deductions.

Personal holding company taxes
Corporate structures are intended for trade or business, not investment companies. Personal holding company (PHC) law charges additional taxes on corporations straying into non-business activities. There are exceptions from PHC rules for financial institutions including banks and insurance companies, but that list doesn’t include trading companies.

The PHC tax is 20% of undistributed personal holding company income. PHC income (Section 543) includes dividends, interest, royalties (with exceptions), annuities, rents, personal service contracts (with exceptions) and more. Exceptions from PHC income include active business computer software royalties, active business copyright royalties in many fact patterns and personal service contracts when a specific person (talent) isn’t named in the contract (consult a tax expert). PHC income also does not include capital gains on trading, which is the main source of income in a trading company. PHCs are corporations with five or fewer owners and more than 60% of their income is from PHC income. The definition of PHC Section 542 discusses business deductions and it clearly leaves out Section 212 investment expenses (which are for individuals not corporations).

Bottom line
The tax code is written to prevent individuals from skirting the narrow Section 212 investment expense deduction rules. Schemes to dump these expenses into corporations are poorly conceived and will lead to tax trouble.

Business traders and investment managers paying top Obama-era tax rates should consider adding a corporation to the mix for legitimate tax savings.

Green NFH CPA Darren Neuschwander and tax attorney Roger Lorence contributed to this blog.

 


9 Good Reasons To Engage Us For Tax Preparation

February 23, 2015 | By: Robert A. Green, CPA

Traders have unique tax needs requiring a specialist. Here are nine good reasons to engage our firm for your 2014 federal and state income tax return preparation. Tax compliance including preparation and planning is our core business and we have excellent long-term relationships with our valued clients.

  1. Large trading losses

Filing a tax return with large trading losses reported as ordinary losses causes IRS concern about paying large refunds. The IRS is accustomed to capital loss imitations. Forex traders with the default Section 988 treatment have ordinary losses. Active securities traders qualifying for trader tax status (TTS) and using a timely filed Section 475 election also generate business ordinary losses and net operating loss carryback refund claims. If you’re counting on a large refund or tax benefit from deducting ordinary trading losses, you should have our firm prepare and sign your tax return.

  1. Trader tax status and related tax benefits

The IRS doesn’t fully understand TTS and it’s important to file your tax return without red flags and include good written explanations in tax return footnotes. Many self-preparers and local accountants botch TTS reporting strategies, missing tax benefits and reporting items incorrectly. Taxpayers must properly elect Section 475 on time and perfect the election with a correctly filed Form 3115. The linchpin to trader tax benefits — business expenses, Section 475, and employee-benefit plans with entities — is qualification for TTS and our CPAs are highly trained in analyzing your qualification.

  1. Entities and retirement plans

Traders need to create compensation correctly to unlock and maximize employee-benefit plans including health insurance and retirement plans. Home office and other unreimbursed expenses need to be reported properly on individual returns in relation to entity income passed through on Schedule K-1. Pitfalls need to be avoided with C-Corps.

  1. Wash sales and Form 8949

Active securities traders generate many wash sale loss adjustments and brokers don’t report wash sales according to IRS rules for taxpayers. Taxpayers must make many changes on Form 8949 and they also must reconcile Form 1099Bs and explain differences in footnotes.

  1. Forex traders using lower 60/40 tax rates

We make a case for filing a capital gains election on spot forex to get lower Section 1256(g) 60/40 tax treatment. But those rules are vague and uncertain. If you’re reporting large forex trading gains with lower 60/40 tax rates, it’s wise to have our firm prepare and sign your tax return.

  1. Trading many different financial instruments

Tax treatment varies significantly among different types of financial instruments including securities, options, 1256 contracts, ETFs, indexes, forex, Nadex binary options, swaps, precious metals, bitcoin, and other financial products. It’s not always clear how a financial instrument is taxed and some brokers don’t get it right. Our CPAs look over your financial instruments to identify errors in tax treatment.

  1. Maximize expense deductions

Our CPAs are focused on maximizing deductions for investors, business traders, and investment managers. Where, how, and what expenses to deduct depend on your tax status. We handle thousands of traders and see every type of deduction possible — we won’t miss any for you.

  1. Obamacare net investment tax (NIT)

If you’re over the AGI thresholds for NIT — $250,000 married and $200,000 single — it’s important to reduce 3.8% NIT as much as possible. Many accountants don’t understand the nuances of NIT for traders. For example, unlike other taxpayers, Section 475 traders may offset trading losses against other bucket income getting a better result. Traders can also reduce NII by trading and investment expenses.

  1. Convenience and excellent service

Investor, trader, investment management, and small business tax compliance is complex and nuanced. Self-preparers will spend countless hours trying to get it right and they will probably get it wrong. Local CPAs, accountants and tax storefronts are known to botch tax return planning and preparation for investors, traders, and investment managers. We have endless stories of traders missing vital tax elections like the contemporaneous forex capital gains election or the Section 475 MTM election due by April 15, 2015. Our virtual service is very convenient and we maximize every legal tax benefit while avoiding tax trouble and pitfalls. We utilize best practices and technologies with our highly trained CPAs for excellent communication, work product, and client satisfaction. We have the best client testimonials and media and trading industry endorsements by far. Or tax preparation prices are very competitive and they represent a great value when you factor in tax savings and avoidance of tax trouble. Plus our fees are tax deductible, often as a business expense. We guarantee that you will be pleased with our service!
Tax return or extension due dates are coming up: March 15 for S-Corps and April 15 for individuals and partnerships. Visit our tax compliance section to get started.

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We recommend our trade accounting service for active securities traders with wash sales.

We hope to hear from you soon. Don’t wait until the last minute, as we likely won’t be able to accommodate you then. Thanks for considering our services.

Sincerely,
Robert A. Green, CPA
Darren L. Neuschwander, CPA
Managing Members of Green NFH LLC

 

 


Frequently Asked Questions (FAQs) On Trader Tax

February 19, 2015 | By: Robert A. Green, CPA

How are securities taxed?
Securities traders need to watch out for higher tax rates, wash sales, capital-loss limitations and accounting challenges. Realized transactions in securities are reported trade by trade (or line by line) on Form 8949, which feeds into Schedule D where short- and long-term capital gains rates apply. Click here to see what’s included in securities and to learn more. Visit the Tax Treatment section for tax guidance on all sorts of trading instruments.

How should I handle wash sales on securities?
See our separate FAQs on wash sale losses.

How are Section 1256 contracts taxed?
Section 1256 contract traders enjoy lower 60/40 tax rates, summary reporting, and no need for accounting. (The 60/40 rates mean 60% is taxed at the lower long-term capital gains rate and 40% is taxed at the short-term rate, which is the ordinary tax rate.) Section 1256 contracts are marked-to-market (MTM) on a daily basis and reported on Form 6781. MTM means you report both realized and unrealized gains and losses at year-end. Click here to see what’s included in Section 1256 contracts and to learn more.

What is Section 475 and can that election help me?
Section 475 MTM allows qualifying business traders to deduct trading losses in the current tax year as ordinary business losses, without capital loss limitations or wash sale loss adjustments. Short term capital gains are taxed at the ordinary rate, so taxes are the same on trading gains, but Section 475 is much better on trading losses — we call it “tax loss insurance.” GreenTraderTax recommends Section 475 for securities, but not for Section 1256 contracts where you would otherwise forgo lower 60/40 tax rates. Click here to learn more about Section 475.

Can you request a 1099B based on using Section 475?
Brokers are supposed to prepare Form 1099Bs for the everyman, not based on a taxpayer’s election or other facts and circumstances. How can a broker know for sure that a trader elected Section 475 on time and or is entitled to use Section 475, which is conditional on qualifying for trader tax status?

Can I deduct my trading-related expenses on my tax return?
Deductibility is based on tax status: whether you qualify for trader tax status (business treatment) or must use the default investor tax status (investment treatment).

Individual investors are permitted to deduct Section 212 investment expenses related to the production of investment income. Investment expenses exclude home-office, education, and Section 195 startup costs. There are many limitations for investment expenses, deductible as miscellaneous itemized deductions on Schedule A including the 2% AGI threshold, Pease limitation, listed property rules, and AMT preferences.

Business traders qualifying for trader tax status are able to deduct all trading expenses, including home office, education, and Section 195 startup costs, from gross income. Sole proprietor traders report business expenses (only) on Schedule C, and trading gains and losses are reported on other tax forms. An election is not required for claiming business expense treatment. Click here to learn how to qualify for trader tax status. Click here to learn more about business expense treatment.

Are brokerage commissions tax deductible?
Yes, but they are not separately stated tax deductions. Rather, commissions are part of your trading gain or loss — an adjustment to proceeds and cost-basis.

Do I need to fill out a Form 8949 for my securities trades?
Casual investors might have no wash sale adjustments or other cost-basis adjustments and just one securities brokerage account with a few equity transactions. They may qualify to attach their 1099B and skip inclusion of a Form 8949. Active traders won’t qualify for this short cut.

The cost-basis rules are almost fully phased in. Options and less complex fixed income securities acquired on Jan. 1, 2014 or later are reportable for the first time on Form 1099-Bs for 2014. Click here to learn more about IRS cost-basis reporting and Form 8949.

Where can I learn more about trader tax matters, including entities, retirement plans, Obamacare taxes, compliance tips, and more?
In Green’s 2015 Trader Tax Guide.

I prepared these FAQs for an online broker catering to active securities traders. 

 


Frequently Asked Questions (FAQs) On Wash Sale Losses

| By: Robert A. Green, CPA

Wash sale losses are a major source of confusion for taxpayers and brokers come tax time, so we answered several FAQs to help.

What’s the best solution for reporting wash sale losses correctly?
Trader tax accounting software that downloads all purchase and sale transaction history and calculates wash sale losses according to taxpayer rules recapped below. In most cases, taxpayers can’t solely rely on 1099Bs or broker profit and loss reports for reporting wash sales. GreenTraderTax recommends software to calculate wash sales across all your accounts and for generating a correct Form 8949. You need to reconcile Form 8949 to 1099Bs and explain the differences as best you can. Click here to learn about GreenTraderTax’s accounting service for securities traders.

What are wash sale losses?
Per IRS Pub. 550, “A wash sale occurs when you sell or trade stock or securities at a loss and within 30 days before or after the sale you: buy substantially identical stock or securities; acquire substantially identical stock or securities in a fully taxable trade; acquire a contract or option to buy substantially identical stock or securities, or acquire substantially identical stock for your individual retirement account (IRA) or Roth IRA.”

The IRS wash sale loss rules (Section 1091) are written to protect the U.S. Treasury against taxpayers taking “tax losses” at year-end to lower tax bills while they get right back into the same positions. The IRS views that as a tax loss but not an economic loss and much of the tax code prevents that from happening.

Wash sale loss adjustments defer losses to the subsequent tax year, where a taxpayer hopefully can utilize that loss. However, if you trigger a wash sale loss with an IRA, you permanently lose the wash sale loss.

Do I have to account for wash sale losses?
Yes, if you trade securities including equities, equity options, ETFs, narrow-based indices (made up of nine or fewer securities), and bonds. Click here to learn more about securities.

What’s exempt from wash sale losses?
Wash sales do not apply to Section 1256 contracts including futures, broad-based indices, and options on futures since they are marked-to-market (MTM). That’s economic reporting and there’s no way to defer wash sale losses. Click here to learn more about Section 1256 contracts.

Business traders with a Section 475 MTM election are exempt from wash sale loss reporting on their business trading positions. Consider a timely 2015 Section 475 election to convert 2014 wash sale loss deferrals on business positions into ordinary losses on Jan. 1, 2015. Click here to learn more about Section 475. Existing individuals and partnerships must file a Section 475 election by April 15 and S-Corps by March 15.

Where do I report wash sale loss adjustments?
Report wash sale loss adjustments on Form 8949 (instructions), along with other cost-basis reporting. Learn more about cost-basis reporting in the Green Trader Tax Center.

Do brokers report wash sale loss adjustments on Form 1099B?
Yes, but in compliance with IRS rules for brokers which differ from IRS rules for taxpayers. In most cases, taxpayers need to do additional work on wash sale loss reporting.

How do broker and taxpayer rules differ on wash sales?
Brokers calculate wash sales based on identical positions (an exact symbol only) per brokerage account. Section 1091 requires taxpayers to calculate wash sales based on substantially identical positions (between stocks and options and options at different exercise dates) across all their accounts including IRAs — even Roth IRAs.

What is a substantially identical position?
Apple stock and Apple options are substantially identical, but Apple stock and Google stock are not substantially identical.

Are options subject to cost-basis reporting and wash sale loss adjustments?
Yes, IRS cost-basis reporting rules phased-in options purchased on or after Jan. 1, 2014. Brokers won’t report a wash sale loss between a stock and an option, but taxpayers must do so. Options at different expiration dates have different symbols, so they are considered substantially identical.

Can I rely on my 1099-B for reporting wash sale loss adjustments?
Only if you have one brokerage account trading equities. If you trade stocks and stock options, or just stock options and/or have multiple brokerage accounts, you can’t rely on brokerage firm Form 1099-Bs for reporting wash sale losses correctly because there will be differences in application of taxpayer rules on substantially identical positions.

Are brokerage firm profit and loss reports similar to 1099Bs?
Yes, brokers use the same accounting for the 1099B and their profit and loss reports. When brokers suggest downloading a 1099B into TurboTax, they really mean downloading their profit and loss report. Those P&L reports account for wash sales based on broker rules, not taxpayer rules.

Do I have to worry about my IRA accounts in my wash sale loss calculations?
Yes, as recapped in IRS Pub. 550 above, Section 1091 includes all types of IRAs. It’s a catastrophic mistake to trigger a wash sale loss in your IRA since you will never get that tax loss benefit as it won’t reduce distributions in retirement for a traditional IRA. It’s wise to avoid trading substantially identical positions between an IRA and your taxable accounts.

What accounts are included in the wash sale loss analysis?
It goes by taxpayer identification number. If you are married filing joint, make sure to include each spouse’s separate, joint, and IRA accounts.

Are entity accounts included in the wash sale loss analysis?
Maybe. Although Section 1091 rules do not include your entity accounts, Section 267 related party rules can drag your entities into the wash sale loss analysis. Case law can apply Section 267 related party transaction rules in the event a trader plans to avoid a wash sale loss between his entity and individual accounts. If the related party transaction “is purely coincidental and is not prearranged” Section 267 law does not apply. If Section 267 applies it can lead to wash sale loss deferral or losing the wash sale loss permanently. 

Where can I learn more about wash sales?
Read the GreenTraderTax blog “How will you handle wash sale losses on securities this tax season?” and watch the related Webinar recording.

I prepared these FAQs for an online broker catering to active securities traders. 


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