November 2015

IRS Plays Havoc With Traders Misidentifying Investments

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

Click to read Green's blog post

Click to read Green’s blog post

The IRS and some states have been playing havoc with traders in exams, claiming traders did not properly comply with Section 475 rules for segregation of investment positions from trading positions. Noncompliance gives the agent license to drag misidentified investment positions into Section 475 mark-to-market (MTM), or to boot misidentified trading losses out of Section 475 into capital loss treatment subject to the $3,000 capital loss limitation. Both of these types of exam changes cause huge tax bills, penalties and interest.

Traders don’t want to lose capital gains deferral and lower long-term capital gains rates on investment positions in securities. With misidentified investments the IRS has the power to drag those positions into Section 475 subjecting them to MTM and ordinary income tax rates.

Section 475 improper identification
Section 475 contains a clause to limit unrealized losses on investment positions dragged into Section 475. Under Section 475(d)(2) (which is applicable to traders pursuant to Section 475(f)(1)(D)), if a security was misidentified as an investment, then there is Section 475 MTM unrealized loss recognition only against other Section 475 gains, and any excess unrealized losses are deferred until the security is actually sold. Limiting MTM treatment on unrealized losses on investment positions is not much different from unrealized capital losses on those same positions.

Carefully identify investments
If you claim trader tax status and use Section 475 MTM, you can prevent this problem by carefully identifying each investment position on a contemporaneous basis. When you receive confirmation of the purchase of an investment position, email yourself to identify it as investment position as that constitutes a timestamp in your books and records. Don’t hold onto winning Section 475 trading positions and morph them into investment positions, as that does not comply with the rules. If identifying each separate investment is inconvenient, then ring-fence investments into identified investment accounts vs. active trading accounts. Use “Do Not Trade” lists for investing vs. trading accounts so you don’t trade the same symbol in both accounts.

But this compliance is not enough. If you hyperactively trade around your investments, the IRS can say you failed to segregate the investment in substance.

Section 475 clean up project
In 2015, the IRS acknowledged lingering problems with Section 475 and announced a Clean Up Project welcoming comments from tax professionals. I started a successful petition on Rally Congress to fix Section 475 and TTS rules and also sent a cover letter and comments to the IRS. The American Bar Association ABA Comments on Mark-to-Market Rules Under Section 475 are good. See my blog post in Aug. 2014 IRS warns Section 475 traders, which focuses on the segregation of investment issue.

Individuals have a problem
Section 475 misidentification of investments is a huge problem for individual sole proprietor traders who have both trading and investment positions. Section 475 is very valuable since it exempts trades from wash sale loss rules and the $3,000 capital loss limitation allowing full net operating loss (NOL) treatment for losses which generates huge tax refunds. A capital loss limitation is the biggest pitfall for traders.

Individuals often have a few trading accounts and also several investment accounts. Married couples may each have individual accounts, some joint accounts and IRA accounts. They may buy and hold popular equities in investment accounts and then hyperactively trade those same symbols in their designated trading accounts.

Entities navigate around the problem
The simple fix is to form an entity like a single-member or spousal-member LLC with an S-Corp election. Conduct all business trading with Section 475 on securities in those entity accounts. (The entity may elect Section 475 MTM internally within 75 days of inception of the entity.) Trader tax status, business expenses and Section 475 trading gains and losses are reported on the S-Corp tax return.

It’s wise to avoid investment positions in the entity accounts. But some traders want to use portfolio margining, and brokers don’t allow that between individual and entity accounts, so they want to transfer some large investment positions into the entity accounts. That can become a problem for Section 475 segregation of investment rules, especially if you trade the same symbols. Consult a trader tax expert.

Keep investments in your individual investment accounts. The individual and entity accounts are not connected for purposes of Section 475 rules since they’re separate taxpayer identification numbers.

The entity also looks much better in the eyes of the IRS claiming trader tax status and using Section 475 ordinary loss treatment. Plus, an S-Corp trading company can have employee-benefit plan deductions — health insurance and high-deductible Solo 401(k) retirement plan) — whereas a sole proprietor trader may not.

Tax court cases are for individual traders
A senior IRS official stated at an industry conference that the IRS is going after (auditing) “Chen cases,” referring to the landmark Chen tax court case. Chen was a part-time individual trader for just three months and he deducted TTS expenses and a huge Section 475 ordinary loss requesting a huge tax refund. The court denied TTS and use of Section 475.

Other recent trader tax court cases are individual traders claiming large TTS expenses and Section 475 losses. I covered these cases on my blog: see posts for Poppe, Assaderaghi, Nelson, Endicott, Holsinger and Chen (covered in my guides). Some of these traders may have been okay if they used an entity, however many did not qualify for trader tax status, and several botched or lied about electing Section 475.

In my blog post on the Poppe case, I point out that individuals face pitfalls in electing Section 475. The IRS granted Poppe TTS but denied Section 475 ordinary loss treatment because he botched or lied about the Section 475 election and he never filed a Form 3115. A new entity wouldn’t have that problem.

Wash sale losses are similar
Section 1091 wash sale rules are similar, yet different in one important aspect from Section 475 rules. While the entity is a different taxpayer from the individual for wash sale loss purposes, the IRS can apply Section 267 related party transaction rules to connect the entity and individual accounts if the trader purposely tries to avoid wash sale losses between the entity and individual accounts. I have not seen Section 267 mentioned in connection with Section 475 segregation rules.

Bottom line
Section 475 tax loss insurance is a huge tax break for traders who qualify for trader tax status but be careful with properly identifying investments. Be safe on using TTS and Section 475 by trading in an entity. Now is a good time to form one for 2016.


Defined Benefit Plans Offer Huge Tax Breaks

| By: Robert A. Green, CPA

Click to read Green's blog post

Click to read Green’s blog post

Consistently high-income business owners, including trading businesses with owner/employees close to age 50, should consider a defined-benefit retirement savings plan (DBP) for significantly higher income tax and payroll tax savings vs. a defined-contribution retirement savings plan (DCP) like a Solo 401(k).

DBP calculations are complex
DBP calculations are more complex than a DCP profit-sharing plan. With a DBP, an actuary is required to consider various factors in calculating retirement benefits and annual contributions to the DBP.

The first factor is three-year average annual compensation and the IRS limit is $265,000 (2015/2016 limits). W-2 compensation may be higher, but the actuary may only input the IRS limit. Compensation determines the accumulated retirement benefit and retirement plan distributions/income during retirement years. The IRS limits retirement benefits per year to $210,000 (2015/2016 limits). Based on the maximum factors possible, the accumulated retirement benefit would be approximately $2.6* million.

If the participant plans 10 years of service retiring at age 62, with a 5% growth rate the retirement plan contribution would be $207,000* for the initial years. If that same person has 15 years of participation the annual retirement contribution would be $120,500*. (*Calculations provided by PACE TPA.)

Meet with a DBP administrator/actuary
When you meet with a DBP administrator/actuary, look at some “what if” scenarios with different levels of compensation and years to retirement.

There’s plenty of room for different scenarios between a Solo 401(k) limit of $59,000 for age 50 or older vs. a DBP contribution, which can range between $60,000 and $300,000 per year in the initial years. Traders operating in an S-Corp have the option to use a lower officer compensation amount.

What’s the catch?
A DBP requires annual funding contributions, whereas a DCP does not. With a DBP, the owner/employer commits to saving the actuary-determined accumulated retirement savings amount.

Closing a DBP without a valid reason could lead the IRS to disqualify the plan, making the accumulated benefit taxable income in the year of disqualification. Closing a trading company due to significant trading losses should be a valid reason. On DBP termination, most plan documents allow a tax-free rollover to an IRA or other qualified plan or a lump-sum taxable distribution. The 10% early withdrawal tax rules apply on qualified plan distributions before age 55 (see below).

You should consult your DBP administrator on a timely basis — before June 30 or 1,000 hours of service — to modify the DBP when necessary. For example, if you’re making significantly less income in the first three years, the administrator may be able to lower required contributions. Some DBP administrators recommend maximum allowed funding in early years, which serves to reduce minimum funding requirements in later years. This makes sense as you may make less money as you approach retirement.

You can do direct-access investing or trading inside the DBP account. Leading brokers may allow trading in stocks, bonds, ETFs and restricted trading in options. Avoid margin interest, which triggers unrelated business income tax (UBIT). Caution: Investment losses in the DBP will require larger contributions to make up those losses. Conversely, stellar trading gains can serve to reduce contributions too.

Compensation defined
In an S-Corp, only wages are considered in compensation; pass-through Schedule K-1 income is not. Conversely, with an operating business partnership tax return, all self-employment income (SEI) including guaranteed payments and pass-through income for active partners is included in compensation. A trading partnership has underlying unearned income, which is not SEI.

Payroll tax savings
Under DBP rules, average compensation is determined over the initial three years of the plan and compensation amounts afterward don’t affect DBP contributions and benefits. After three years, a trader may significantly reduce officer compensation, which has the effect of reducing payroll taxes. Payroll taxes include FICA 12.4% up to the SSA wage base amount of $118,500 (2015 and 2016 limits) and unlimited 2.9% Medicare tax. Plus, upper income taxpayers have a 0.9% Medicare/Obamacare surtax on wages. That leaves traders enjoying the tremendous income tax savings with a much smaller offset of payroll taxes. This option to reduce payroll taxes is not available with a Solo 401(k).

An S-Corp trading company has underlying unearned income, which should be an acceptable reason to the IRS for why the S-Corp may not otherwise comply with IRS guidelines for reasonable officer compensation. Conversely, a regular S-Corp operating business like an investment manager receiving management fees or an IT consultant must adhere to IRS guidelines for reasonable compensation. Currently, the guidelines call for 25% to 50% of net income before wages to be officer compensation.

Establish a DBP and execute payroll before year-end
Speak to a DBP administrator well before year-end to establish the plan by Dec. 31. You can fund the plan up until Sept. 15 of the following year — the extended due date of the S-Corp tax return.

You also need to execute officer compensation payroll before year-end.

Although the DBP is based on a three-year average of compensation, you may open a DBP in the first year of S-Corp trading company. Without a three-year average in that first year, there’s a narrower range of minimum vs. maximum contributions each year. If your income drops considerably in the second year, contact the DBP administrator, who can probably modify the plan to lower compensation amounts. After the three-year average of compensation is set, the administrator can’t modify it lower. You also can’t unwind accumulated retirement benefits earned to date.

Types of DBP plans
For an S-Corp trading company with a single owner/employee or a spousal S-Corp with two employees and no outside employees, we recommend a traditional or personal DBP or a “cash balance” DBP with a separate DBP investment account established for each owner employee.

Two spouses working in an S-Corp trading company can take advantage of the hybrid plan: A DBP integrated with partial Solo 401(k) (elective deferral and 6% profit-sharing rather than the normal 25% profit-sharing). If there’s only one employee, the traditional DBP or cash balance DBP is used.

Anti-discrimination rules
There are many anti-discrimination rules and requirements for high-deductible qualified plans intended to prevent the owner/employee from enjoying huge benefits with “top-heavy plans” while omitting or short-changing non-owner employees. Plan designers offer options like vesting over several years for complying with these rules but still favoring owners where possible.

Affiliated service group (ASG) rules apply in a similar context. If you own a business with many employees, you can’t exclude those employees by owning a separate (affiliated) S-Corp trading company with a high-deductible qualified plan for you alone. Consult an employee-benefit plan attorney.

Consult your tax advisor
After you speak with a DBP administrator, actuary, and perhaps an employee-benefit plan attorney, consult your tax advisor on choosing the compensation amount, which drives the related targeted retirement savings goal under the DBP. For S-Corp operating businesses, officer compensation must adhere to IRS guidelines for reasonable compensation, too.

Make sure you are comfortable committing to the annual minimum funding amounts of the DBP. If you want a lower commitment, choose a lower compensation amount. If the DBP calculation shows an annual contribution under $60,000, you are probably better off choosing a Solo 401(k) as it does not require annual funding and its limit is $53,000 for under age 50 and $59,000 for age 50 and older (2015 and 2016 limits).

With Solo 401(k) retirement plans, our CPA firm doesn’t want to see a S-Corp loss after deducting compensation and the retirement plan contribution. We apply this same rationale to the first year of a DBP plan. It’s wise to have sufficient S-Corp year-to-date trading income and expect similar trading gains in subsequent years so there won’t be an S-Corp loss from these large deductions. Once you start the DBP, mandatory contributions may generate a net loss in the S-Corp and that is acceptable. Explain the net loss and DBP funding commitment in a tax return footnote.

Your S-Corp trading company must qualify for trader tax status (business expense treatment), otherwise you can’t have officer compensation and retirement plan contributions in an investment company.

Costs and tax filings
DBP administrators charge $1,200 to $2,000 to design and establish a DBP. DBP administrators also charge around $1,200 to $2,000 per year for plan administration to keep the plan up to date along with modifications based on your evolving needs and changes in the law. Employee-benefit attorneys charge closer to $3,000 to $5,000 or more for DBP design and an attorney is not required. Net tax savings far exceeds these reasonable fees. In many cases, the DB administrator covers the cost of an independent actuary.

Charles Schwab offers a Personal Defined Benefit Plan and they have good resources on their site.

The IRS and The Employee Retirement Income Security Act of 1974 (ERISA) have many stringent rules and requirements for DBPs and it’s imperative to stay in proper compliance. Keep your DBP administrator aware of changes so they can make necessary modifications to the plan on time. There are many pitfalls to avoid with DBP and it’s not as simple as a Solo 401(k) or IRA.

As with all qualified plans, the sponsor of a DBP most likely must file an annual IRS Form 5500 tax return due July 31 of the following year for calendar year entities and plans. A 2½-month extension to Oct. 15 is allowed on Form 5558. Several administrators help with this tax form.

Tax-free growth and retirement distributions
Unless you are making non-tax-deductible contributions to a Roth IRA or Roth Solo 401(k) plan, with traditional retirement plans including qualified plans and IRAs, you get an income tax deduction from gross income for the contribution amount.

With a Roth plan, tax savings are permanent. Conversely, with a traditional qualified plan like a DBP or DCP, there is only tax deferral. Enjoy tax-free growth in the plan until taking taxable retirement plan distributions in retirement years. For traders who do more short-term investing, this annual tax savings is huge. Use a retirement plan calculator and you’ll see the power of tax-free compounded growth. Consider the time-value of money with tax deferral as well.

Under current tax law, retirement-plan distributions are ordinary taxable income. “Early withdrawals”(before retirement years age 59½ in an IRA or age 55 in qualified plans) are also subject to a 10% excise tax penalty on IRS Form 5329. Qualified plans including Solo 401(k) and DBP can offer qualified plan loans, which avoid early withdrawals. Qualified plans are a form of deferred compensation, but there are no payroll taxes on retirement plan distributions or contributions.

In qualified plans, there are required minimum distributions (RMD) by a participant’s required beginning date (RBD). The RBD rule is similar to the RMD rule for IRAs with distributions required no later than by age 70½.

Bottom line
If you are close to age 50, have consistently high annual income, can afford to commit to large tax-deductible contributions and want to smooth your taxable income in retirement taxed at lower tax brackets, then a DBP may be for you. The tax savings is enormous and with tax-free compounded growth it’s an incredible retirement savings tool.

 

 


Traders: Good And Troubling News In Poppe Ruling

November 6, 2015 | By: Robert A. Green, CPA

Click to read Green's blog post

Click to read Green’s post on Forbes

In light of the William F. Poppe vs. Commissioner court case, there’s good news for retail traders on the volume of trades needed to qualify for trader tax status.

There’s also troubling news. The IRS denied Poppe his Section 475 election because he could not prove compliance with the two-step election process. Traders should be more diligent in documenting their election. The consequence was that instead of deducting his $1 million trading loss as an ordinary loss, Poppe was stuck with a $3,000 capital loss limitation and a capital loss carryover.

The court construed Poppe’s proprietary trading firm arrangement to be a disguised retail customer account. This ruling should be a huge concern for the proprietary trading firm industry, especially since regulators warned clearing firms about disguised customer accounts in the past. By agreement, prop traders do not trade their own capital in a retail customer account. They trade a firm sub-account with firm capital and far higher inter-firm leverage than is available with a retail customer account.

Qualification for trader tax status
The Poppe court awarded trader tax status (TTS) with 720 trades (60 trades per month). That’s less than our 2015 golden rule calling for 1,000 trades per annum on an annualized basis. Poppe seems to have satisfied our other golden rules on frequency, holding period, intention to run a business, serious account size, serious equipment, business expenses, and more. Plus, Poppe had a good background as a stockbroker.

In some years, Poppe was a teacher and part-time trader, fitting trading into his schedule. It helped that Poppe made a lot of money trading in a few years in comparison to his teacher’s salary.

Botched Section 475 election
Poppe had large trading losses ($1 million in 2007) for which he claimed Section 475 ordinary business loss treatment rather than a puny $3,000 capital loss imitation against other income. But like other recent tax court cases (Assaderaghi, Nelson, Endicott, Holsinger and Chen), the court busted Poppe for either lying to the IRS about making a timely Section 475 election or making a valid election but not being able to prove it to the IRS. Poppe never filed a required Form 3115 to perfect the Section 475 election, which begs the question: Did he ever file an election statement on time?

The case opinion states that Poppe intended to elect Section 475 for 2003 and he filed his 2003 tax return late in 2005 omitting a required 2003 Form 3115. Poppe’s tax preparer reported 2003 Section 475 trading gains on Schedule C. That’s incorrect: Section 475 trading gains are reported on Form 4797 Part II ordinary gain or loss. This botched reporting indicates to me that Poppe’s tax preparer did not understand Section 475 tax law and it probably buttressed the IRS win.

Many traders are in the same predicament as Poppe and should do their best to document the election filing in case the IRS challenges it later on. We document the process for our clients and ask them to document their filings, too. Send yourself an email with the relevant facts as email has a timestamp. Safeguard a copy of the election and Form 3115 in your permanent files.

One learning moment in the Poppe case is how to properly make a timely Section 475 election and to avoid pitfalls in botching the election process.

Section 475 tax loss insurance
By default, investors and traders in securities and Section 1256 contracts have capital gain and loss treatment, as opposed to ordinary gain or loss treatment. Capital losses offset capital gains without limitation, but a net capital loss is limited to $3,000 per year against other income with the remainder of capital losses carried over to the subsequent tax year(s).

Traders qualifying for TTS may file a timely election for Section 475 ordinary gain or loss treatment (on securities only or Section 1256 contracts, too). Generally, traders prefer to retain Section 1256 treatment with lower 60/40 capital gains rates. Section 475 exempts traders from wash-sale loss treatment on securities and capital loss limitations. It’s known as “tax loss insurance” since it allows full business ordinary loss treatment comprising NOLs generating NOL tax refunds.

A sole proprietor (unincorporated) trader makes an individual-level Section 475 election. A proprietary trading firm or hedge fund makes an entity-level Section 475 election. A partner in a proprietary trading firm or hedge fund cannot override the firm’s Section 475 election or lack of an election made on the entity-level.

Warning: Don’t botch the election
Botching the election empowers the IRS to deny use of Section 475 serving up a simple win for the IRS in tax court. Even when a taxpayer properly makes a Section 475 election, an IRS agent may challenge his or her qualification for TTS, which pulls the rug out from under using Section 475. (Each tax year TTS must be assessed as a prerequisite to using Section 475.)

Section 475 election two-step process
The first step is for the trader to file a timely election statement early in the current tax year to prevent the trader from using hindsight about the election later.

An “existing taxpayer” (who filed a tax return before) must file an election statement with the IRS (that means “external”) by the due date of the prior year tax return not including extensions: April 15 for individuals and partnerships and March 15 for S-Corps. (Note that in 2017, the partnership due date changes to March 15.) Attach the Section 475 election statement to the tax return or extension filing. I suggest documenting this first step in your books and records including emailing a copy to yourself and your accountant. Don’t count on the IRS for keeping a copy of the election statement.

An existing taxpayer’s second step is to file a Form 3115 (Change Of Accounting Method) with appropriate Section 481(a) adjustment by the due date of the election-year tax return including extensions. The complex Form 3115 must be filed in duplicate: one copy with the timely filed tax return and a second copy to the IRS national office.

Example of existing taxpayer: A sole proprietor trader files a 2015 Section 475 election by April 15, 2015, attaching the election statement to his 2014 federal tax extension filed on time by mail. (You can’t attach an election to an e-filed extension.) Second step: The accountant prepares a 2015 Form 3115 to accompany the 2015 Form 1040 filed by Oct. 15, 2016 with a valid extension filed by April 15, 2016.

Why the two steps? So taxpayers can make a very simple election filing with little hindsight but to allow sufficient time to prepare a complex Form 3115 with the tax return filing after year-end.

Common errors with Section 475 elections
Many local accountants are confused about the two-step process. Some think only one step is required: either filing the Form 3115 in lieu of the election statement, or the election statement as part of a Form 3115 filing with the tax return. They don’t comply with both required steps and that botches the election.

Section 475 “new taxpayer” exception
There is an important exception to the election process for “new taxpayers” such as a new entity. A new taxpayer may file the Section 475 election statement within its own books and records (internally) within 75 days of inception of the new entity.

Existing taxpayers who miss the external 475 election by April 15 should consider forming a new entity to make an internal Section 475 election within 75 days of inception, which is later in the year. A new taxpayer “adopts” Section 475 from inception as opposed to changing its accounting method so they don’t have the second step of filing a Form 3115 with Section 481(a) adjustment (converting realization/cash method to MTM on Jan. 1).

The entity provides better flexibility in making, revoking, and ending Section 475 elections with closure of the entity. With fewer steps to follow, the internal election for new taxpayers is a better choice for prevailing with the IRS.

Poppe’s errors on Section 475
Poppe was not able to verify the external 475 election statement (step one) or a Form 3115 filing (step two). It wasn’t just a question of being late on a Form 3115 filing, Poppe never filed a Form 3115 and he was an existing taxpayer individual.

Traders should file the external Section 475 election statement with certified return receipt. But that may not be enough because it only verifies a mailing, which also contains the tax return or extension. The IRS recognized this problem and suggests that taxpayers include a perjury statement on Form 3115 stating they filed the 475 election statement on time.

Is there any relief from the IRS?
My partner Darren Neuschwander, CPA spoke with an IRS official in the Form 3115 area a few years ago who said the IRS had granted some relief to a few traders providing they were only a little late with their Form 3115 filing and they filed the election statement on time. The IRS official pointed out there is no relief for filing the initial election statement late.

But Poppe was not a little late — he never filed a Form 3115, even with the case being heard years later. It’s wise to file Form 3115 on time per the written rules and not rely on hearsay about possible relief from IRS officials, which may no longer be granted after the Poppe decision. Consult your trader tax advisor.

Poppe’s mental incapacity argument didn’t work
The Poppe case shows that it doesn’t work to claim reasonable cause on noncompliance due to mental incapacity if the taxpayer can’t demonstrate the same mental incapacity in a job, business, or trading. Poppe tried to raise this issue for special relief and the IRS said no because he wasn’t mentally impaired as a teacher and as an active trader.

Per Thomson Reuters, “Poppe argued that his actions met the requirements of the ‘substantial compliance’ doctrine, under which perfect compliance with a tax provision isn’t required. But the Court said that the substantial compliance doctrine does not apply to the Code Sec. 475(f) election and that, even if it did, Poppe failed to meet many of Rev Proc 99-17 ‘s requirements and thus hadn’t substantially complied.”

Proprietary trading account or disguised customer account?
In 2007 (the IRS exam year), Poppe lost $1 million trading with a proprietary trading firm that cleared through Goldman Sachs Execution & Clearing (GSEC). This is the tax loss at the center of this case.

On his original tax return filing, Poppe reported this loss (assumed) on Schedule E page 2, as an ordinary loss flowing through to him as a partner in a partnership. If the proprietary trading firm qualified for TTS and filed a timely Section 475 election on the firm level, then trading losses allocated to partners would have ordinary loss treatment.

Poppe attached a partner Schedule K-1 to his tax return even though it is not required. But during the exam, the IRS was unable to find Poppe’s K-1 in the partnership tax return filings where it is required to be attached. This begs the question: Did Poppe fabricate his own Schedule K-1? That would be illegal. Or did the firm present Poppe with a Schedule K-1 only to retract it in their partnership tax filing later on? (IRS computers match K-1s reported on partner’s individual tax returns with partnership tax filings looking for incorrect reporting.)

Prop trading firm arrangements, agreements, tax treatment and regulatory issues are murky. Perhaps Poppe never formally signed the prop trading firm’s LLC Operating Agreement. The case states Poppe couldn’t satisfy the IRS that he was a partner in the firm. If not an LLC member, perhaps he was an independent contractor, which is the second business model for proprietary trading firms.

Poppe claimed he was a Class B member of the firm. Generally, the main owners (Class A members) are allocated firm-wide trading losses on their K-1s since they own the firm’s capital in their capital accounts, which provide tax basis for deducting trading losses. Generally, Class B members don’t have capital accounts so they aren’t allocated losses since they wouldn’t have tax basis to deduct losses, which would then be suspended to subsequent years when they might have capital.

Instead of paying into firm capital, Class B members pay “deposits” to the firm. This is where the confusion mainly lies. The firm applies these deposits to cover the prop trader’s trading losses incurred in a firm sub-account. Prop traders are entitled to deduct lost deposits as business bad debts, which are ordinary business losses. Perhaps Poppe should have considered lost deposit bad debt tax treatment instead of using an incorrect K-1 and later relying on an alleged Section 475 election as a retail individual trader.

I’ve been covering the proprietary trading industry since the late 1990s. Around 2000, some people questioned whether proprietary trading firm arrangements were really “disguised” retail customer accounts. Reg T margin rules allow 4:1 margin on pattern day trader (PDT) customer accounts requiring a $25,000 minimum account size. Otherwise, retail investors are limited to 2:1 margin on securities. The big attraction of proprietary trading firms is they offer proprietary traders (LLC members or independent contractors) far greater leverage (greater than 10:1 in some cases) on their deposits made with the firm. Some proprietary trading firms have minimum deposit amounts as low as $2,000.

If the firm’s profit sharing arrangement is more than 80% sharing to the prop trader, FINRA’s Regulatory Notice 10-18 issued to clearing firms stated it’s one of several signs it may be a disguised retail customer account. Read my June 2010 blog post FINRA’s notice to prop traders. Poppe had 90% profit sharing and perhaps that led the IRS to conclude it was a disguised retail customer account. GSEC is a popular clearing firm for proprietary trading firms and I don’t believe it services individual retail customers. Goldman Sachs brokerage firm has high standards for opening individual retail customer accounts.

The Poppe opinion states: “The parties stipulated that all transactions and capital in the GSEC account belonged to petitioner (Poppe).” Perhaps the parties preferred this tact so they could ague the case over Poppe’s alleged Section 475 election as a retail trader. In my view, the word “stipulate” means the parties agreed on facts as a pre-condition to negotiating a settlement. But it’s not necessarily the true facts.

Should prop traders file Section 475 elections as a backup position in case the IRS later considers them a disguised retail customer account? I imagine plenty proprietary trading firms and prop traders are in tax controversy (exams, appeals or tax court) now and I suggest they consider contacting our CPA firm for help soon.

Bottom line
I’m happy to see a new trader tax court case moving the goal posts back to 720 trades from 1,000. That opens the door for more traders. I am not surprised that another trader (and his accountant) botched the complex Section 475 election process and later tried to bamboozle the IRS about it in order to get a huge tax benefit. Proprietary trading firm arrangements with prop traders are murky and the IRS may turn up the heat on them both soon.

For more information, check out T.C. Memo. 2015-205.

Darren Neuschwander CPA contributed to this blog post.


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