May 2015

Tax Treatment For Trading Options

May 27, 2015 | By: Robert A. Green, CPA

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Options trading is proliferating with the advent and innovation of retail option trading platforms, brokerage firms and trading schools. A trader can open an options trading account with just a few thousand dollars vs. $25,000 required for “pattern day trading” equities (Reg T margin rules).

Options trading provides the opportunity to make big profits on little capital using “risk it all” strategies. Options are a “tradable” financial instrument and a way to reduce risk with hedging strategies. When it comes to option taxation, complex trades with offsetting positions raise complex tax treatment issues like wash sale and straddle loss deferral rules.

Investors also trade options to manage risk in their investment portfolios. For example, if an investor owns significant equity in Apple and Exxon, he or she may want to trade options to manage risk or enhance income on long equity positions. He or she can collect premium by selling or “writing” an options contract or buy a “married put” for portfolio insurance. Traders also use ETFs and indexes for portfolio-wide insurance. (Investopedia has explanations for different option trading strategies.)

Simple vs. complex option trades
There are simple option trading strategies like buying and selling call and put options known as “outrights.” And there are complex option trades known as “option spreads”which include multi-legged offsetting positions like iron condorsbutterfly spreads; vertical, horizontal and diagonal spreads; and debit and credit spreads.

Tax treatment for outright option trades is fairly straightforward and covered below. Tax treatment for complex trades triggers a bevy of complex IRS rules geared toward preventing taxpayers from tax avoidance schemes: deducting losses and expenses from the losing side of a complex trade in the current tax year while deferring income on the offsetting winning position until a subsequent tax year.

Look to the underlying financial instrument tax treatment
Options are “derivatives” of underlying financial instruments including equities, ETFs, futures, indexes, forex, and more. The first key to determining an option’s tax treatment is to look at the tax treatment for its underlying financial instrument. The option is to buy or sell that financial instrument and it’s tied at the hip.

For example, an equity option looks to the tax treatment of equities, which are considered “securities.” Conversely, options on Section 1256 contracts are deemed “non-equity options.”

ETFs are taxed as securities, so options on securities ETFs are taxed as securities. Options on commodity ETFs (structured as publicly traded partnerships) are non-equity options taxed as Section 1256 contracts. Options on futures are taxed as futures, which are Section 1256 contracts.

Capital gains and losses for securities are reported when realized (sold or closed). Conversely, Section 1256 contracts are marked-to-market (MTM) at year-end and they benefit from lower 60/40 capital gains tax rates: 60% long-term and 40% short-term. MTM imputes sales on open positions at market prices so there is no chance to defer an offsetting position at year-end. Generally, that means wash sale and straddle loss deferral rules don’t apply to Section 1256 options.

There are three things that can happen with outright option trades:

  • Trade option (closing transaction)
    Trading call and put equity options held as a capital asset are taxed the same as trading underlying equities. Report proceeds, cost basis, net capital gain or loss and holding period (short-term vs. long-term held over 12 months) from realized transactions only on Form 8949 (Capital Gains & Losses).
  • Option expires (lapses)
    There’s a minor twist on the above scenario. Rather than realizing a dollar amount on the closing out of the option trade, the closeout price is zero since the option expires worthless.Use zero for the realized proceeds or cost basis, depending on whether you’re the “writer”or “holder” of the option and if it’s a call or put. Use common sense — collecting premium on the option trade is proceeds and therefore the corresponding worthless exercise represents zero cost basis in this realized transaction. For guidance on entering option transactions as “expired”on Form 8949, read IRS Pub. 550 – Capital Gains And Losses: Options.
  • Exercise the option
    This is where tax treatment gets more complicated. Exercising an option is not a realized gain or loss transaction; it’s a stepping-stone to a subsequent realized gain or loss transaction on the underlying financial instrument acquired. The original option transaction amount is absorbed (adjusted) into the subsequent financial instrument cost basis or net proceed amount.Per IRS Pub. 550 Capital Gains & Losses: Options: “If you exercise a call, add its cost to the basis of the stock you bought. If you exercise a put, reduce your amount realized on the sale of the underlying stock by the cost of the put when figuring your gain or loss. Any gain or loss on the sale of the underlying stock is long term or short term depending on your holding period for the underlying stock…If a put you write is exercised and you buy the underlying stock, decrease your basis in the stock by the amount you received for the put…If a call you write is exercised and you sell the underlying stock, increase your amount realized on the sale of the stock by the amount you received for the call when figuring your gain or loss.” Some brokers interpret IRS rules differently, which can lead to confusion in attempting to reconcile broker-issued Form 1099Bs to trade accounting software. A few brokers may reduce proceeds when they should add the amount to cost basis. Equity options are reportable for the first time on 2014 Form 1099Bs.Exercising an option gets to the basics of what an option is all about: it’s the right, but not the obligation, to purchase or sell a financial instrument at a fixed “strike price” by an expiration date. Exercise may happen at any time until the option lapses. An investor can have an in the money option before expiration date and choose not to execute it, but rather hold or sell it before expiration.
  • Holding period for long-term capital gains
    When an equity option is exercised, the option holding period becomes irrelevant and the holding period for the equity begins anew. The holding period of the option doesn’t help achieve a long-term capital gain 12-month holding period on the subsequent sale of the equity. When an option is closed or lapsed, the option holding period does dictate short- or long-term capital gains treatment on the capital gain or loss.With exceptions recapped in IRS Pub. 550: “Put option as short sale.  Buying a put option is generally treated as a short sale, and the exercise, sale, or expiration of the put is a closing of the short sale. If you have held the underlying stock for one year or less at the time you buy the put, any gain on the exercise, sale, or expiration of the put is a short-term capital gain. The same is true if you buy the underlying stock after you buy the put but before its exercise, sale, or expiration.”

Complex trades lead to complex tax treatment issues
In general, if an investor has an offsetting position he or she should look into more complex tax treatment issues.

Offsetting Positions
IRS Pub. 550: Capital Gains & Losses: Straddles defines an “offsetting position” as “a position that substantially reduces any risk of loss you may have from holding another position.”

In the old days, shrewd professional options traders would enter offsetting positions and close out the losing side before year-end for a significant tax loss and let the winning side remain open until the subsequent year. They used this strategy to avoid paying taxes. The IRS goes through (and causes) great pains to prevent this type of tax avoidance. Offsetting position rules included “related persons” including a spouse and your flow-through entities.

“Loss Deferral Rules”in IRS Pub. 550 state “Generally, you can deduct a loss on the disposition of one or more positions only to the extent the loss is more than any unrecognized gain you have on offsetting positions. Unused losses are treated as sustained in the next tax year.”

IRS enforcement of offsetting position rules
Frankly, the offsetting position rules are complex, nuanced and inconsistently applied. There are insufficient tools and programs for complying with straddle loss deferral rules. Brokers don’t comply with taxpayer wash sale rules or straddle loss deferral rules on Form 1099Bs or profit and loss reports. Few local tax preparers and CPAs understand these rules, let alone know how to spot them on client trading records.

The IRS probably enforces wash sale and straddle loss deferral rules during audits of large taxpayers who are obviously avoiding taxes with offsetting positions. They make a lot of money, but it’s always deferred to the next tax year. The IRS doesn’t seem to be questioning wash sales and straddles during exams for the average Joe Trader.

I expect the IRS will launch a tax exam initiative for measuring taxpayer compliance with new cost-basis reporting law and regulations. I see a big problem brewing with unreconciled differences between taxpayer and broker rules on wash sales.

Wash sales
As we stress in our extensive content on wash sale loss deferral rules, Section 1091 rules for taxpayers require wash sale loss treatment on substantially identical positions across all accounts including IRAs. Substantially identical positions include Apple equity, Apply options and Apple options at different expiration dates on both puts and calls.

If a taxpayer re-enters a substantially identical position within 30 days before or after existing a position, the IRS defers the tax loss by adding it to the cost basis of the replacement position. When a taxable account has a wash sale caused by a replacement position purchased in an IRA, the wash sale loss is permanently lost.

Cost-basis regulations phased-in options as “covered securities” starting with 2014 Form 1099Bs. Brokers report wash sales based on identical positions, not substantially identical positions. Investors who trade equities and equity options cannot solely rely on Form 1099Bs and they should use their own trade accounting software to generate Form 8949. Learn more about wash sales in our Trader Tax Center.

Straddle loss deferral rules
Options traders use option spreads containing offsetting positions to limit risk and provide a reasonable opportunity to make a net profit on the trade. That’s very different from an unscrupulous trader entering a complex trade with offsetting positions set up for no overall risk (the rule is substantially reduced risk) or reward. Why would an options trader do that? For tax avoidance reasons only.

The IRS straddle loss deferral rules are set up to catch this trader and prevent this type of tax avoidance. The straddle loss deferral rule defers a loss to the subsequent tax year when the winning side of the position is closed, thereby reversing what the unscrupulous trader was trying to achieve. The IRS also suspends holding period so it’s impossible to qualify for long-term capital gains rates in the following year, too. Transaction-related expenses (carrying costs) and margin interest (certain interest) are also deferred by adding them to the cost-basis of the offsetting winning position.

Learn more about straddle loss deferral rules in connection with options in IRS Pub. 550: Capital Gains & Losses: Straddles. “A straddle is any set of offsetting positions on personal property. For example, a straddle may consist of a purchased option to buy and a purchased option to sell on the same number of shares of the security, with the same exercise price and period. Personal property. This is any actively traded property. It includes stock options and contracts to buy stock but generally does not include stock. Straddle rules for stock. Although stock is generally excluded from the definition of personal property when applying the straddle rules, it is included in the following two situations. 1) The stock is of a type which is actively traded, and at least one of the offsetting positions is a position on that stock or substantially similar or related property. 2) The stock is in a corporation formed or availed of to take positions in personal property that offset positions taken by any shareholder.”

Straddle loss rules are complex and beyond the scope of this blog post. Consult a tax adviser who understands the rules well.

Caution to unsuspecting option traders
Active traders in equities and equity options entering complex trades with multi-legged offsetting positions may unwittingly trigger straddle loss deferral rules if they calculate risk and reward wrong and there is substantially no risk.

Section 475 MTM
Traders who qualify for trader tax status may elect Section 475(f) MTM accounting, provided they do so by the deadline. MTM means the trader reports unrealized gains and losses on trading positions at year-end by imputing sales at year-end prices. Segregated investment positions are excluded from MTM. The character of the income changes from capital gain and loss to ordinary gain or loss. Section 475 trades are exempt from Section 1091 wash sale rules and straddle loss deferral rules since no open positions are deferred at year-end.

Employee stock options
Don’t confuse tradable options with employee stock options. When an employee acquires non-qualified options on his employer’s stock (equity), the later exercise of those options triggers ordinary income reported on the employee W-2 because the appreciated value is considered a form of wage compensation.

Other resources
Ernst & Young prepared a useful guide with a good section on options taxation. It was requested by The Options Industry Council and is available on the CBOE website at https://www.cboe.com/LearnCenter/pdf/TaxesandInvesting.pdf.


Dear IRS & Congress: Please Fix Tax Rules For Active Traders

May 14, 2015 | By: Robert A. Green, CPA

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We mailed the IRS Commissioner this cover letter and comments for the IRS Section 475 “Clean Up Project.” This blog post is comprised of those comments. 

Please take action: sign our Petition to CongressWithout your participation traders are too small a voice. 

The IRS recognizes problems with tax rules for active traders including Section 475 marked-to-market (MTM) reporting, Section 1091 wash sale loss rules and trader tax status (business treatment).

These problems are connected. Only a trader who qualifies for trader tax status may elect and use Section 475(f) MTM ordinary gain or loss treatment. Otherwise with the default “realization method” (cash method), securities trades are subject to Section 1091 wash sale loss rules and capital gain and loss treatment. Wash sale rules are a huge problem for active securities traders; non-compliance is widespread and the IRS is not enforcing the rules. That is unsustainable.

Trader tax status is a requirement for Section 475(f)
Traders, tax professionals, IRS and state tax agents don’t fully understand trader tax status (TTS), and the result is botched tax compliance causing significant losses from higher taxes, penalties, interest and professional fees.

Hundreds of thousands of active traders qualify for TTS, trading their own funds as a business activity. Most of them don’t know they are entitled to file a timely election for Section 475(f) MTM ordinary gain or loss treatment and exemption from Section 1091 wash sale loss treatment. They also don’t realize they can use Section 162 business expense treatment as a sole proprietor or in a pass-through trading company without an election required for Section 162.

Since enactment in 1997, Section 475 and TTS rules remain too confusing to tax professionals and traders. Many local tax preparers conflate the two code sections, not realizing a qualifying trader may use Section 162 but not elect Section 475(f). The IRS needs to do a better job with its guidance.

Better define trader tax status
There is no “statutory law” defining qualification for TTS. There is only “case law” and “trader tax” cases have a broad range of criteria without giving a bright-line test, except the Endicott court stated average holding period must be 31 days or less. Traders need similar standards for volume and frequency of trades and hours per day.

Case law rewards losing day traders with TTS and 475(f) elections, but denies both to profitable options traders who may make a consistent living but have less volume and frequency of trades. The average trader with TTS has business expenses of approximately $15,000 and that does not stress the Treasury in terms of tax benefits.

The IRS has a history of misquoting TTS case law to traders in tax exams. On several occasions, IRS agents told traders they needed to make their “primary or sole living” from trading, whereas tax law requires “an intention to make a living.” Hobby loss rules do not apply to trading because trading is “not recreational or personal in nature.”

Section 475(f) MTM
Section 475 was drafted for dealers in securities and or commodities. In 1997, Congress expanded Section 475 to include traders who qualify for trader tax status adding Section 475(f). The IRS added the terms “trader in securities” and “trader in commodities.” Traders must qualify for TTS to elect and use Section 475(f).

Securities traders consider a Section 475(f) election for two reasons: exemption from wash sale loss deferral rules and the $3,000 capital loss limitation. Section 475 MTM is ordinary gain or loss treatment. Section 475 trading losses contribute to NOL carry backs and forwards which generate tax refunds faster than carrying forward capital loss carryovers, which otherwise are the biggest pitfall for traders. Section 475 MTM ordinary income is taxed at the same ordinary tax rate as short-term capital gains.

Better define commodities
The IRS needs to better define the term “commodities” in Section 475 (and throughout the tax code). The definition needs to clearly state that traders may elect Section 475(f) on “securities only” and retain lower 60/40 tax rates on Section 1256 contracts (futures and broad based indexes). While dealers sell bushels of wheat (commodities), traders do not.

I appreciate the ABA’s comments to the IRS. Their comments on the definition of commodities are confusing. The ABA addresses dealers and traders, whereas we focus on traders only.

Suspending Section 475 treatment
One of the challenges in administrating Section 475 is in the determination of qualification for TTS. Falling short of TTS means the trader must suspend use of Section 475 and use the realization (cash) method until he or she re-qualifies in a subsequent tax year. Suspension treatment is not included in Section 475 rules, yet it should be. The concept is that without TTS, all open positions automatically become investment positions.

The IRS recently fixed Section 475 revocation rules
There’s good news for traders about Section 475 MTM buried in the IRS annual update on procedures for changes of accounting method. It has always been free and easy to elect Section 475 MTM, yet difficult and costly to revoke that election. With this rule change, the IRS makes revocation a free and easy process. (Read my blog post New IRS rules allow free and easy Section 475 revocation.)

Section 475(f) election and Form 3115
Current rules for making a Section 475(f) election are too narrow and complex. In other words, there is a very small window of opportunity to consider and make a 475(f) election and most traders don’t speak with their tax advisor on time. Far too many qualified traders who would benefit from Section 475(f) miss the boat and that’s unfair.

“Existing taxpayers” must elect Section 475(f) by the original due date of the prior year tax return (not including extensions). That provides about three months of hindsight from Jan. 1 until April 15 for individuals and partnerships and March 15 for S-Corps. It’s an election statement as there isn’t a tax form.

The second step — to perfect the election — is to file a Form 3115 with the current year tax return. Many accountants think it’s a one-step procedure and they botch the election by missing either the election statement or the Form 3115 filing (required in duplicate).

A taxpayer must attach the election statement to their extension or tax return and a certified return receipt only proves a tax filing not the election statement. The IRS admits they don’t have a system to record the 475(f) election, so they ask a taxpayer for a perjury statement on the Form 3115 representing they filed the election statement on time. The IRS provides relief for late Form 3115s but not late election statements.

Provide late relief for Section 475 elections
Tax law (Regulation Section 301.9100-3 relief) allows six months to file a private letter ruling to get late relief on certain elections including Section 475(f). But to date it has been almost impossible to get this type of relief for a late Section 475(f) election. The process requires a private letter ruling and the IRS denied all of them to date with the exception of Larry Vines who had a perfect fact pattern. The IRS refuses late relief for Section 475(f) by claiming prejudice to Treasury and hindsight. It takes almost a perfect set of factors to get by this stringent posture. An open portfolio of unrealized capital losses is currently considered enough of a reason for the IRS to deny late relief for a Section 475(f) election.

Rather than loosen up here, I prefer the IRS just allow a Section 475(f) election with more time. Focusing too much on hindsight disenfranchises traders.

Expand Section 475(f)new taxpayerexception
Under current law, there is an exception for “new taxpayers” like a new entity. A new taxpayer may elect Section 475(f) by internal resolution within 75 days of inception. If you start trading after April 15, you can’t make a 475(f) election as an individual; but you can form a new entity to make the election within 75 days of inception.

The new taxpayer exception isn’t clear or broad enough. The IRS should broaden it to accommodate “new traders” qualifying for TTS, not just a new entity. Individual traders or entities qualifying for TTS after April 15 should be able to elect Section 475(f) within 75 days of qualification.

I think the IRS should go even further by allowing the election on the tax return filing after year-end. Traders using Section 162 business expense treatment simply claim that treatment on their tax return (Schedule C) where they also choose the cash method or accrual method of accounting for expenses. Why not enact the same procedure for a Section 475(f) election? Why make Section 475 confusing and different from Section 162 since they are so tied together already?

Most tax professionals don’t know their client qualified for TTS until tax time and often that’s after the April 15 deadline for filing extensions. Their clients often miss the 475(f) election for the past year, as well as the current year, too.

Taxpayers often don’t discuss election opportunities with their accountants until after year-end, not when they launch a new activity. Traders don’t even realize that trading can be a business; otherwise they might call their accountant early on. It’s unreasonable for the IRS to assume traders can digest the complications of Section 475(f) and TTS on their own.

First year hindsight is reasonable
While extending the 475(f) election until tax filing time gives traders more hindsight during the first calendar year (and into the next tax year) and new IRS rules for revocation allow reversal in a subsequent year, once revoked, Section 475 can’t be re-elected for five years.

Most tax elections are made on a tax return filing, and they are not required earlier in the year – hindsight is allowed. With so many traders missing the boat on Section 475 — and then building up a capital loss carryover hole committing them to the realization method — it’s reasonable for traders to conclude the onerous 475(f) election rules are intended to disenfranchise traders from using ordinary loss treatment.

The original tax law on Section 475(f) mentioned the IRS would issue a tax form for the election. But, to date the IRS has not issued a form. Even with the S-Corp election Form 2553 due within 75 days of inception, the IRS grants relief for late-filed elections. I don’t see precedent for stringent hindsight rules against traders. Missing the Section 475(f) election requirement is the biggest problem in Section 475 and it causes the most inequity for traders contrary to the intention of Congress in expanding Section 475 to traders.

Section 475 segregation of investmentrules are vague
I disagree with IRS proposed regulations for segregation of investments from Section 475 calling for a separate investment account.

Segregation should be done in “form and substance.” It’s not enough to designate an account as an investment account (in form) because traders often actively trade around core investment positions in an active trading account (in substance). Segregation must be assessed in overall actions by traders. (Read my blog post IRS warns traders on Section 475.)

I agree with Chief Counsel Advice (“CCA”) 201432016 stating “the 475 election is made on an entity-by-entity basis, not a separate trade or business basis, and only in the case of separate commodities and securities businesses can a taxpayer make separate elections.” I also agree the proposed regulation stating “a trader may identify an investment with ‘clear and convincing evidence that a security has no connection to its trading activities.’”

As tax preparers for traders, real world fact patterns can be confusing and it would be good if the IRS issued more guidance on segregation of investments. If a client trades the same symbol for which he invests and uses Section 475(f) for active trading but not investing, should all the symbols traded and invested be consolidated into Section 475(f) or into investment treatment, or otherwise? The proposed regulations offer some solutions but they need more work. Tax preparers need support for taking positions that don’t prejudice Treasury. In general, I agree with many of ABA’s comments on May 7, 2015 in this regard.

Wash sale rules are a problem
A Section 475(f) election is an escape hatch for a qualifying trader from wash sale loss treatment (Section 1091). When the IRS considers changes to Section 475, they should also address significant problems with Section 1091 as these code sections are joined at the hip for active traders.

IRS rules for broker 1099Bs differ from rules for taxpayer reporting of wash sale adjustments on Form 8949 (Capital Gains & Losses). The IRS requires brokers to calculate wash sales based on identical positions (same symbol) per account. Conversely, the IRS requires taxpayers to report wash sales based on substantially identical positions (stocks and options) across all accounts including IRAs. With apples and oranges structurally in the rules, there are obviously large, unreconciled differences between broker 1099Bs and taxpayer Form 8949, especially for active traders with multiple accounts and those who trade stocks and options. These 1099B matching problems will overwhelm the IRS in coming years.

The IRS doesn
t enforce wash sales
Too often taxpayers and tax professionals cut corners choosing to solely rely on broker-issued 1099Bs. They don’t comply with different IRS wash sale rules for taxpayers (see above).

Brokers aren’t helping with taxpayer compliance; they are encouraging clients to download 1099-B data into TurboTax and they don’t sufficiently mention Section 1091 compliance issues. The IRS needs to either enforce or change the wash sale rules to better coordinate broker and taxpayer reporting.

Cost-basis reporting also has problems
In 2008, Congress enacted cost-basis reporting to close the “tax gap” on investors. Prior to cost basis rules, Form 1099Bs only reported proceeds on securities, and cost-basis information wasn’t included. Starting in 2011, the IRS phased in the cost-basis reporting rules.

While cost-basis reporting requires wash-sale adjustments, it falls short of the needs of active traders with multiple accounts and those who trade substantially identical positions (stocks and options).

Starting in 2014, 1099Bs reported equity options for the first time. But brokers don’t calculate wash sales between stocks and options and options at different expiration dates whereas taxpayers must do so. This will generate many unreconciled differences or non-compliance with Section 1091 rules.

While cost-basis rules help the IRS with millions of investors, they are not working well enough for active traders who are stuck with huge unreconciled differences. The choice is either reconciliation and non-compliance or huge differences and compliance.

Cost basis problems are another great reason to open the door wider to 475 elections. It’s easier to explain why a Form 4797 (where 475 is reported) is different from a 1099B prepared for the realization method.

Improve sole proprietor tax return reporting
A sole proprietor trader tax return is a red flag in the eyes of IRS agents and IRS computer algorithms because Section 162 trading expenses are reported on Schedule C but trading gains and losses are reported on other tax forms. That looks like a losing business without revenue.

There should be a formal way to transfer some trading gains to Schedule C to show a profitable activity or zero it out. Trading gains are not self-employment income (SEI) and they are exempt from SE tax, with the exception of members of a futures exchange (Section 1402i).

Traders work hard every day and they deserve a tax code that respects their unique tax needs. Since the Great Recession of 2008, the markets have experienced tremendous growth and capital gains taxes have skyrocketed.

Darren Neuschwander CPA and co-managing member of Green NFH contributed to this blog post.


New IRS Rules Allow Free And Easy Section 475 Revocation

May 1, 2015 | By: Robert A. Green, CPA

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There’s good news for traders about Section 475 MTM buried in the IRS annual update on procedures for changes of accounting method. It has always been free and easy to elect Section 475 MTM, yet difficult and costly to revoke that election. With this rule change, the IRS makes revocation a free and easy process, mirroring the Section 475 election and automatic change of accounting procedure for existing taxpayers.

Before this rule change, the Section 475 revocation procedure cost several thousand dollars in filing fees (close to $7,000 for hedge funds) and the outcome was uncertain since it required advanced consent from the IRS, which could be denied. Few traders opted for revocation; most used other options like suspension or exit (see below).

New revocation procedure is similar to the election procedure
To elect Section 475, “existing taxpayers” must file an election statement with the IRS attached to their prior year tax return or extension by April 15 of the current tax year for individuals and partnerships and March 15 for S-Corps. The second step requires filing a Form 3115 with the tax return for year of the election. For example, a 2015 Section 475 election statement must be filed by April 15, 2015 and the 2015 Form 3115 must be filed (in duplicate) with the 2015 tax return in 2016.

There’s an exception for “new taxpayers” (new entities) who file the election statement in their own books and records within 75 days of inception, since there is no prior tax return to attach the election to. New taxpayers don’t file a Form 3115 because they adopt Section 475 from inception rather than change an accounting method.

The new revocation procedure is similar to the election procedure. An existing individual or partnership must file a 2016 notification statement of revocation (see details below) with the IRS by April 15, 2016 (March 15, 2016 for S-Corps). The second step is to file 2016 Form 3115 for revocation of Section 475 with the 2016 tax return in 2017.

Suspension of Section 475
Historically, our trader clients navigated around the costly and uncertain revocation procedure by “suspending” their Section 475 election.

By disqualifying themselves for trader tax status, they became investors who could not use Section 475 as of the disqualification date. In that case, the Section 475 election was suspended until the trader re-qualified (if ever) for trader tax status. While the IRS may have preferred that the trader follow the costly revocation procedure, we suggested suspension as another option free of cost.

Taxpayers will appreciate having this new choice to revoke Section 475 instead of leaving it suspended on their individual returns if they elected it as a sole proprietor trader.

Other options besides revocation
Prior to this rule change, our trader clients avoided the costly and uncertain revocation procedure in two ways: by trading less and falling short of qualification for TTS, thereby “suspending”the Section 475 election; or by closing a trading business entity which used Section 475, thereby terminating Section 475. These traders could form a new “do over”entity to get back to the cash method, otherwise called the “realization” method.

When to revoke Section 475
A trader may want to elect Section 475 MTM on securities and also Section 1256 contracts to benefit from large ordinary business loss treatment year-to-date as of the April 15 election deadline of the current tax year. In the subsequent tax year, the trader may want to return to lower Section 1256 60/40 capital gains tax rates and retain Section 475 on securities only. With this rule change, the trader can revoke Section 475 on commodities (Section 1256 contracts) only and not securities.

Unlike with retail traders, it’s not convenient for an investment manager to close a hedge fund or trade less to revoke Section 475. Hedge funds will really appreciate the new automatic and free revocation procedure. Hedge funds often have trouble following Section 475 segregation of investment rules. They enter a trading position and sometimes “let profits run” by having it morph into an investment position. That doesn’t adhere to stringent Section 475 segregation of investment position rules. Plus, the manager prefers deferral at year-end so investors don’t request redemptions in order to pay taxes on unrealized gains if using Section 475 MTM. Segregation requires contemporaneous (same day) identification of investment positions and segregation must be done in form and substance. (Read IRS warns Section 475 traders.)

Rev. Proc. 2015-14
Click on Rev. Proc. 2015-14 and scroll down to pages 349 through 355. It starts at SECTION 23. MARK-TO-MARKET ACCOUNTING METHOD (§475). This explains the election procedure for Section 475. Scroll further to page 351: 23.02 Taxpayers requesting to change their method of accounting from the mark-to-market method of accounting described in §475 to a realization method.

  • “(2) Exclusive procedure. The procedure set forth in this section 23.02 is the exclusive procedure for changing a taxpayer’s method of accounting from the mark-to-market method described in §475 to a realization method. Thus, filing the Notification Statement described in section 23.02(6) of this revenue procedure is the exclusive manner of revoking a §475(e), (f)(1), or (f)(2) election. Moreover, any taxpayer requesting permission to change to a realization method must follow the procedures described in this section 23.02 and other applicable provisions of Rev. Proc. 2015-13, 2015-5 I.R.B. XX, to request consent to change its method of accounting for securities described in §475(c)(2) (Section 475 Securities), commodities described in §475(e)(2) (Section 475 Commodities), or both.”
  • “(5) Manner of making change. This change is made using a cut-off basis and applies only to Section 475 Securities, Section 475 Commodities, or both, that are accounted for using the mark-to-market method of accounting described in §475 and for which a change in method is requested under this section 23.02. Accordingly, a §481(a) adjustment is neither permitted nor required…Under the cut-off basis, a taxpayer must make a final mark of all Section 475 Securities, Section 475 Commodities, or both, that are being marked to market and that are the subject of the accounting method change being requested, on the last business day of the year preceding the year of change…”

I see some issues here. This assumes the taxpayer qualifies for trader tax status on the last day of the year for the final mark. If the taxpayer disqualifies for trader tax status before year-end, then Section 475 MTM is used only to the date of qualification ending. See suspension treatment above.

One catch
Darren Neuschwander, CPA, my co-managing member and our head of tax compliance, pointed out one catch.

“If a trader uses the automatic election to revoke Section 475(f), then the trader can’t use the automatic election to get 475(f) again for five years without going through the non-automatic procedures with the IRS, which includes a fee,” he said. “Now we have an opportunity for successful traders to remove Section 475 MTM, if needed, to use against capital loss carryovers without having to use a new entity. Also, we can help people remove MTM if they are concerned that they don’t want it in place in the future as an individual, without having to petition the commission of the IRS or pay the user fee. Basically, notification statement and another Form 3115 filing. Much simpler!”

For more information on the benefits of Section 475, click here.


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