August 2015

Eight Ways Profitable Traders Save Taxes

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

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Click for Green’s post on Forbes

Traders thrive on market volatility, profiting from rapid changes in prices up or down as they take long and short positions. It’s different for investors: When market indexes drop into correction or bear market mode, they generally lose money or reduce gains.

There’s been significant market volatility in 2015 and many stocks are in correction or bear market mode. I’ve had tax consultations with many traders that are making a fortune from price volatility, catching the swings in price both up and down.

In my last blog post, I wrote about five ways traders should best deduct trading losses, figuring some traders may not have recognized a stealth correction in many stocks and commodities in enough time to profit from it. In this blog post, I address tax savings for profitable traders because there are many traders who have done very well.

Here are eight ways profitable traders save taxes.

1. Business expenses with qualification for trader tax status
Investment expense treatment is the default method for investors, but if you qualify for trader tax status, you can use the more favorable business expense treatment.

Business expense treatment under Section 162 gives full ordinary deductions, including home-office, education, Section 195 start-up expenses, margin interest, Section 179 (100%) depreciation, amortization on software, seminars, market data and much more. Conversely, investment expenses are only allowed in excess of 2% of adjusted gross income (AGI), and not deductible against the nasty alternative minimum tax (AMT). Investment expenses are further restricted with “Pease” itemized-deduction limitations for taxpayers with AGI over $300,000 (married) and $250,000 (single). Many states limit itemized deductions, too.

Highly profitable traders often have significant expenses including staff, an office outside the home, additional equipment and services and significant employee-benefit plan deductions for retirement and health insurance. Their 2% AGI threshold for deducting investment expenses is very high, so they really appreciate full business expense deductions from gross income.

Learn how to qualify for and claim trader tax status in our Trader Tax Center.

2. Home office expenses

Most traders work in their home with a trading workstation, multiple computers, monitors, mobile devices, TVs, office furniture and fixtures. They exclusively use one or more rooms, storage areas and a bathroom.

A typical allocation percentage might be 10% to 20% of the home. Include every expense of the home including mortgage interest, real estate taxes, utilities, repairs, maintenance, security and more. Also, take depreciation of the home and on improvements. Office equipment and furniture is depreciated directly in the business often with Section 179 (100%) depreciation.

The home office deduction requires income, which can include trading gains. You can have a home office and office outside the home, too. Don’t be shy with this deduction; it helps document your business activity. Investors may not take a home office deduction, trader tax status is required.

3. Business travel, education and seminars
Many traders travel around the country and world to trading conferences, seminars and for education courses. If you qualify for trader tax status, education, seminars, conferences and related travel costs qualify as a business expense. But investors may not deduct education, seminars, conferences and related travel expenses in accordance with Section 274(h)(7).

The IRS is a stickler for separating business versus personal travel, meals and entertainment (see Pub 463). If your spouse accompanies you on a trip and is not active in the trading business, the spouse’s share of expenses are deemed personal. If you spend another week on your trip for vacation reasons, that part of the trip is also personal.

If you entertain other traders and industry players, you may have business meals and entertainment expenses. Be careful with the rules for lavish expenditures.

4. Health insurance premium deductions
Obamacare is forcing many traders into buying health insurance or otherwise owe a shared responsibility payment if they don’t qualify for a hardship exemption. Highly profitable traders don’t qualify for exchange subsidies and they seek AGI deductions for high health insurance premiums. (Out-of-pocket health care expenses including deductibles and co-payments are not allowed as an AGI-deduction and the threshold for itemized deductions for medical expenses is high.)

Self-employed businesses and pass-through entities may take a 100% deduction of health insurance premiums from AGI on individual tax returns. The problem for traders is that trading gains are not self-employment income (SEI) and they can’t have an AGI deduction for health insurance premiums or retirement plans. There is a way to fix that.

Traders need to form a S-Corp trading company (or C-Corp management company) to pay officer’s compensation which allows an AGI deduction for health insurance premiums and retirement plan contributions. Execute payroll before year-end and add the health insurance premium to the officer’s W-2 wages. The officer then takes the AGI deduction on their individual tax return.

5. Retirement plan contribution deductions
Generally, the best defined-contribution retirement plan for business traders is a Solo 401(k) plan. It combines a 100% deductible “elective deferral” contribution ($18,000 for 2015) with a 25% deductible profit-sharing plan contribution on an employer-level plan. There is also a “catch up provision” ($6,000 for 2015) for taxpayers age 50 and over. Together, the maximum tax-deductible contribution is $53,000 per year and $59,000 including the catch up provision (based on 2015 IRS limits). A SEP IRA only has a profit sharing plan.

Only traders with trader tax status on an S-Corp trading company (or with dual entity C-Corp management company) can satisfy the requirement for contributions to a retirement plan. That’s because trading gains are not considered SEI, which is required for retirement plan contributions. The trader needs wages from a S-Corp or C-Corp since a sole proprietor trader can’t pay themselves wages.

Retirement plan contributions are only allowed for traders who qualify for trader tax status and who use an S-Corp or C-Corp management company to create compensation as pointed out above.

High-income traders should consider a defined-benefit plan which allows much higher tax-deductible contributions. The maximum limit for 2015 is $210,000 and the actual amount is determined by an actuary.

Retirement plan contributions are made in connection with officer’s compensation, so trader tax status is imperative on these large combined amounts. Investment partnerships are not allowed to pay guaranteed payments to partners; only a trading business partnership may do so. Partnerships pass through losses reducing SEI, whereas S-Corps do not. We prefer the S-Corp for creating the wages needed for maximizing employee-benefit plan deductions.

6. Tax-advantaged growth in retirement plans
In traditional retirement plans, income growth is tax-deferred until taxable distributions are made in retirement subject to ordinary tax rates. Early withdrawals before age 59½ in IRAs and age 55 in qualified plans are also subject to a 10% excise tax penalty. Contributions to traditional retirement plans are tax deductible and hence there is tax-deferral only.

In Roth IRA and Roth 401(k) retirement plans, income growth is permanently tax-free because contributions to a Roth account are not tax deductible. When converting a traditional retirement account to a Roth account, taxes are due on the entire conversion amount. Afterward, the Roth is permanently tax-free. You can reverse the Roth conversion up to Oct. 15 of the following year if you are unhappy with it.

Highly profitable traders generally trade significant retirement assets alongside trading in taxable accounts. Taxable accounts qualify for trader tax status and retirement accounts do not. These traders seek to maximize deductions in connection with taxable accounts and minimize allocations if any to retirement accounts. Consult a CPA trader tax expert on this point.

7. Lower 60/40 capital gains tax rates on 1256 contracts
Profitable traders seek lower tax rates when possible. If you want to trade the Nasdaq 100 index you have two options: an ETF security (NASDAQ: QQQ) taxed at ordinary rates applicable on short-term capital gains, or an emini futures contract (CME: NQ), which is a Section 1256 contract taxed at lower 60/40 capital gains rates.

Section 1256 contracts bring meaningful tax savings throughout all tax brackets. These contracts have lower 60/40 tax rates, meaning 60% (including day trades) are taxed at the lower long-term capital gains rate and 40% are taxed at the short-term rate, which is the ordinary tax rate. At the maximum tax brackets for 2015, the top Section 1256 contract tax rate is 28%, 12% lower than the top ordinary rate of 39.6%. The long-term rate is 0% at the 10% and 15% ordinary tax brackets.

Section 1256 contracts are marked-to-market (MTM) on a daily basis. MTM means you report both realized and unrealized gains and losses at year-end. (Don’t confuse it with Section 475, which is also MTM but has different tax effects.) Many traders have small or no open positions on Section 1256 contracts at year-end. With MTM at year-end, a trader can’t hold a position for a long-term capital gain which requires a 12-month holding period, so Congress negotiated 60/40 capital gains rates. Active traders should take advantage of that tax break.

8. Long-term capital gains taxes
Long-term capital gains on sales of securities are subject to lower capital gains tax rates up to 20% which apply on securities held 12 months or more. Profitable traders often have segregated investment positions in securities — in addition to their trading activity — for which they seek deferral of taxes at year-end and eventually lower long term rates if held 12 months. (Caution: If you use Section 475 MTM, its imperative to properly segregate your investment positions.)

When market conditions change for their investments, rather than sell before 12 months or by year-end causing taxes on unrealized gains, they manage risk with option trades around the underlying position. For example, if they are long Apple stock and are concerned with its price dropping, they can purchase Apple put options for downside risk protection. They are still long Apple and they can continue to defer their unrealized gains in Apple at year-end.

Profitable traders can do these eight things to lower their tax bill by a significant amount. Why over pay Uncle Sam?

 


Five Ways To Deduct Losses In Financial Markets

| By: Robert A. Green, CPA

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Green’s blog post    Accountants World

Investors often asked J.P. Morgan his stock market predictions, and his retort was: “There are only two good predictions — the market will go up or down.” Because it’s impossible to predict the stock market, it’s essential to learn the best way to write off losses.

The deck is stacked against you
The tax code disenfranchises investors and traders from deducting losses. The capital-loss limitation, wash-sale loss deferrals, passive-loss activity limitations and carryovers, investment interest expense carryovers, wasted personal investment losses, at-risk limitations and more are used to pay for or offset lower long-term capital gains rates (up to 20%) on positions held over 12 months and on qualifying dividends. Ordinary tax rates rise to 39.6%, almost twice as high as long-term capital gains rates.

Buy and hold investments
If you buy and hold securities, you may wind up selling and holding capital loss carryovers. If you have unrealized capital gain positions and are close to the 12-month holding period for lower long-term capital gains rates, consider buying protection on the long equity position in the options market (e.g., buying a put option).

Capital-loss carryovers can take decades to use up
Many investors still haven’t used up their capital-loss carryovers realized in the dot.com crash in 2000. While capital losses are deductible in full against capital gains, individuals may only deduct $3,000 of capital losses per tax year against non-capital gains income like wages. Plus, that $3,000 limitation isn’t indexed for inflation. I’ve seen it take decades to use up capital-loss carryovers in the hundreds of thousands of dollars for many clients.

Pundits suggest planning for losses at this time
Since the Great Recession and market meltdown of 2007, the financial markets recovered to new highs riding the coattails of Fed monetary easing and government stimulus which appear to be ending soon. The world’s locomotive economy China is apparently slowing and its financial markets are exhibiting some signs of boom/bust conditions. That seems to be causing contagion in emerging and even developed markets.

While some investors see buying opportunities, others feel it’s different this time around and they don’t want to catch a falling knife. Remember J.P. Morgan’s words about making predictions.

Five ways to maximize losses on tax returns

1. Elect Section 475 for unlimited ordinary losses
If you trade as a business activity and qualify for trader tax status (TTS), you’re entitled to make a timely Section 475 MTM election. Section 475 trades are reported on Form 4797 (Sale or Business Property) Part II ordinary gain or loss tax treatment. Ordinary losses are exempt from capital-loss limitations and wash-sale loss deferral rules.

Unfortunately, too many traders and tax advisors aren’t experienced with Section 475 and TTS and they missed filing a 2015 election by April 15, 2015 for existing individuals and partnerships and March 15 for existing S-Corps.

“New taxpayers” (new entities) can elect Section 475 within 75 days of inception, so consider a new entity later in the year. Caution: pre-entity losses remain capital losses, so wait the 75 days to decide whether to elect 475 internally or not. If the entity has capital gains, it can pass through capital gains to soak up individual-level capital losses, so you can skip the entity 475 election that first year. Conversely, if the entity has significant losses, you should elect Section 475 for ordinary loss treatment. You can revoke Section 475 the following year to get back to generating capital gains to soak up capital-loss carryovers. If you dig a big hole of capital-loss carryovers, it’s important to climb out of that hole with a capital gains ladder and not dig a bigger hole with a Section 475 floor.

2. Net operating losses generate tax refunds
Section 475 ordinary losses reduce gross income without any limitation. If you have negative taxable income, Section 475 losses are includible in a net operating loss (NOL) tax computation. NOLs are carried back two tax years and or forward 20 years. You can file a timely election to forgo the NOL carry back and only carry it forward. NOLs offset all types of income.

3. Wash sale losses require careful management
If you take a loss on a security in a taxable account and buy a substantially identical position back 30 days before or afterward in any of your individual accounts including IRAs, it’s considered a wash-sale loss. On taxable accounts, it’s a deferral with adding the wash-sale loss adjustment to the replacement position’s cost-basis.

Caution: The wash-sale loss is permanently lost on an IRA account. That rule does not apply to qualified retirement plans like a Solo 401(k). Lesson: don’t trade substantially identical positions between taxable and IRA accounts. Also, consider active trading in an entity account — this account is considered a different taxpayer, although related party rules can apply if you purposely try to avoid wash sales with the related accounts.

Monitor wash-sale loss conditions using software like Tradelog and “break the chain” on wash sales at year-end. (Don’t worry too much about wash sale losses on taxable accounts during the year as they may melt away by year-end and that’s when it counts most.) Break the chain means realize the loss and don’t buy back a substantially identical position 30 days before or afterward. “Substantially identical position” means between Apple stock and Apple options and Apple options at different expiration dates. Apple stock and Google stock are not substantially identical positions.

Note that broker-issued 1099Bs calculate wash-sale loss adjustments on a per account basis and based on identical positions. Broker rules differ from taxpayer rules who calculate wash sales based on all their accounts including IRAs based on substantially identical positions. This causes non-compliance and significant confusion.

4. Section 1256 loss carry back election
In general, capital losses may never be carried back like NOLs. There is one exception: Section 1256 contract losses may be carried back three tax years but applied only against Section 1256 gains in those prior years.

Section 1256 contracts include regulated futures contracts (RFCs), broad-based indexes like e-minis, options on futures, options on indexes and non-equity options. A broad-based index has 10 or more underlining securities in the index (e.g. S&P 500). Exchange-traded funds (ETFs) are securities and they aren’t Section 1256 contracts.

Section 1256 contracts have other tax breaks. Section 1256 contracts are marked-to-market (MTM) which means wash-sale loss rules are a moot point and don’t apply. MTM also means a long-term holding period of 12 months is impossible to achieve so Congress negotiated a blended long-term and short-term capital gains rate: 60% and 40%, respectively. In the highest tax bracket, the blended 60/40 rate is 28%, almost 12% less than the highest ordinary rate (39.6%). There are meaningful differences in the rates throughout the tax brackets since the lowest long-term rate is 0% for the 10% and 15% ordinary tax brackets.

Unlike a Section 475 election required during the tax year, a Section 1256 loss carry back election can be made after year-end. Simply check the box on top of Form 6781 for the Section 1256 loss carry back election. Omit the losses from the current year tax return and include them on amended tax returns for one or more of the prior three tax years (in order of oldest year first).

5. Forex losses are ordinary by default
Spot forex trading losses in the Interbank market are Section 988 ordinary gain or loss treatment, meaning they aren’t subject to the capital-loss limitation or wash-sale loss treatment.

Unlike manufacturers, investors and traders holding forex as a capital asset may file a contemporaneous and internal capital gains election to opt out of Section 988 into capital gain or loss treatment. If you have large capital-loss carryovers, that election can help soak up losses with capital gains on forex trading.

Caution: If you have negative taxable income caused by forex trading losses, you need trader tax status to have NOL treatment. Otherwise, you’ll waste part or all of your forex loss since it’s not a capital loss carryover.

If you trade the major currencies, with the capital gains election you can navigate into lower Section 1256(g) 60/40 tax rates and use the Section 1256 loss carry back election. Section 988 losses over $50,000 require a Form 8886 filing.

Losses in retirement plans
In traditional retirements plans, taxes are deferred on trading gains until taxable distributions are withdrawn in retirement. Losses are deferred deductions because they reduce retirement distributions accordingly.

It’s different with Roth IRA and Roth Solo 401(k) plans. There are no taxes owed on normal retirement distributions with permanent deferral. That means losses are not deductible and they are wasted. If you lose a lot in a Roth conversion executed for 2014 or 2015, you may be able to reverse the Roth conversion in order to benefit from the losses.

Bottom line
Losses can paralyze investors. Some exit the markets entirely, figuring they can’t afford more non-deductible capital losses. Traders need refunds from losses to replenish their trading capital. Understand what you are trading and how losses work and maximize your tax affairs accordingly. Consult with a trader tax expert.


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