March 2016

Traders: Consider Ordinary Loss Election By Tax Deadline

March 22, 2016 | By: Robert A. Green, CPA

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

Traders who qualify for trader tax status (TTS) and have a large trading loss in 2016 should consider filing a 2016 Section 475 MTM (ordinary loss treatment) election statement with their extension or return by the April 18, 2016 due date. Section 475 exempts traders from the capital loss limitation and wash sale loss rules. It’s too late to elect Section 475 for 2015: that election was due last April 15, 2015.

Section 475 allows a choice: an election on securities only, Section 1256 contracts only, or both. Specify such in the election statement. Only traders who qualify for trader tax status may use Section 475 and it applies to active trading in that business activity as a sole proprietor individual or on the entity level. Section 475 doesn’t apply to segregated investment positions, so traders may use long-term capital gains benefits on investments.

The biggest problem for investors and traders occurs when they’re unable to deduct trading losses on tax returns, significantly increasing tax bills or missing opportunities for tax refunds. Investors are stuck with this problem, but business traders with TTS can avoid it by filing timely elections for business ordinary tax-loss treatment: Section 475 mark-to-market (MTM) for securities and/or Section 1256 contracts if elected. (Section 1256 contracts include futures, broad-based indexes, options on futures, options on broad-based indexes and several other instruments.)

By default, securities and Section 1256 investors are stuck with capital-loss treatment, meaning they’re limited to a $3,000 net capital loss against ordinary income. The problem is that their trading losses may be much higher and not useful as a tax deduction in the current tax year. Capital losses first offset capital gains in full without restriction. After the $3,000 loss limitation against other income is applied, the rest is carried over to the following tax years. Many traders wind up with little money to trade and unused capital losses. It can take a lifetime to use up their capital loss carryovers. What an unfortunate waste! Why not get a tax refund from using Section 475 MTM right away?

Business traders qualifying for TTS have the option to elect Section 475 MTM accounting with ordinary gain or loss treatment in a timely fashion. When traders have negative taxable income generated from business losses, Section 475 accounting classifies them as net operating losses (NOLs). Caution: Individual business traders who miss the Section 475 MTM election date (April 18 for 2016) can’t claim business ordinary-loss treatment on trading losses for the current tax year. They will be stuck with capital-loss carryovers.

A new entity set up after April 18, 2016 can deliver Section 475 MTM for the rest of 2016 on trading losses generated in the entity account if the entity files an internal Section 475 MTM election within 75 days of inception. The new entity using Section 475 does not change the character of capital loss treatment on the individual accounts before or after entity inception. The entity is meant to be a fix for going forward; it’s not a means to clean up the past problems of capital loss treatment.

Ordinary trading losses can offset all types of income (wages, portfolio income, and capital gains) for you and your spouse on a joint filing, whereas capital losses only offset capital gains. Plus, business expenses and business ordinary trading losses comprise a NOL, which can be carried back two tax years and/or forward 20 tax years. It doesn’t matter if you are a trader or not in a carryback or carryforward year. Business ordinary trading loss treatment is the biggest contributor to federal and state tax refunds for traders.

There are many nuances and misconceptions about Section 475 MTM, and it’s important to learn the rules. For example, you’re entitled to contemporaneously segregate investment positions that aren’t subject to Section 475 MTM treatment, meaning at year-end you can defer unrealized gains on properly segregated investments. You can have the best of both worlds — ordinary tax losses on business trading and deferral with lower long-term capital gains tax rates on segregated investment positions. We generally recommend electing Section 475 on securities only, so you retain lower 60/40 capital gains rates on Section 1256 contracts. Far too many accountants and traders confuse TTS and Section 475; they are two different things, yet very connected.

Section 475 Election Procedures
Section 475 MTM is optional with TTS. Existing taxpayer individuals and partnerships that qualify for TTS and want Section 475 must file a 2016 Section 475 election statement with their 2015 tax return or extension by April 18, 2016 (April 19, 2016 if you live in Maine or Massachusetts). Existing S-Corps file in the same manner by March 15, 2016.

Election statement. The MTM election statement is one simple paragraph; unfortunately the IRS hasn’t created a tax form for it. It’s a version of the following: “Pursuant to Section 475(f), the Taxpayer hereby elects to adopt the mark-to-market method of accounting for the tax year ended Dec. 31, 2016 and subsequent tax years. The election applies to the following trade or business: Trader in Securities as a sole proprietor (for securities only and not Section 1256 contracts).” If you expect to have a loss in trading Section 1256 contracts, you can modify the parenthetical reference to say “for securities and Section 1256 contracts.” But remember, you’ll give up the lower 60/40 tax rates on Section 1256 contracts. If you trade in an entity, delete “as a sole proprietor” in the statement.

Form 3115 filing. Don’t forget an important second step: Existing taxpayers complete the election process by filing a Form 3115 (change of accounting method) with the election-year tax return. A 2016 MTM election filed by April 18, 2016 is reported and perfected on a 2016 Form 3115 filed with your 2016 tax returns in 2017 – by the due date of the return including extensions. Many accountants and taxpayers confuse this two-step procedure and they file the Form 3115 as step one on the election statement date. The IRS usually sends back the Form 3115, which can jeopardize ordinary-loss treatment.

Key strategy
If you have an individual $50,000 capital-loss carryover going into 2016, and you lose $50,000 in Q1 2016, it’s probably wise to elect Section 475 MTM as a sole proprietor for business ordinary loss treatment — and related tax relief — rather than digging a bigger hole of unutilized capital losses.

You can form a new entity for a “do over” to get back to capital gains treatment, so you can use up your capital loss carryovers. You have 75 days of additional hindsight once the entity commences business to file an internal Section 475 MTM election resolution for the entity trading. You’re hoping to generate capital gains in the entity to use up your remaining capital-loss carryovers and put off the Section 475 MTM election to the following entity year.

For more information on Section 475 and trader tax status, read Green’s 2016 Trader Tax Guide.

 


Don’t Sweat The Tax Deadline, Just Get An Extension

| By: Robert A. Green, CPA

Forbes

Don’t Sweat The Tax Deadline, Just Get An Extension

It’s that time of year again: when birds chirp, buds grow on trees and you lose sleep over the April 15th tax deadline. It doesn’t have to be that way: You should have peace of mind to enjoy springtime. This year, the individual 2015 tax return deadline is April 18, 2016 (April 19, 2016 if you live in Maine or Massachusetts), and a six-month extension is available until Oct. 17, 2016.

Six-month extension of time to file
Take charge of your relationship with the IRS: Request an automatic six-month extension of time to file your federal and state income tax returns. Form 4868 instructions point out how easy it is to get this automatic extension — no reason is required.

It’s an extension of time to file a complete tax return, not an extension of time to pay taxes owed. In good faith, estimate and report on the extension form what you think you owe for tax year 2015 based on your tax information received.

Avoid penalties
Try to pay at least 90% of your actual tax return liability with the extension filing to avoid a late-payment penalty of 0.5% per month, up to a maximum of 25%. Filing a timely extension avoids the more onerous late-filing penalty of 5% per month, up to a maximum of 25%. Refer to Form 4868 for further details.

Here’s an example. Assume your 2015 tax liability is $50,000. You file an extension by April 18 but don’t pay any of your tax liability. You file your actual tax return on the extended due date of Oct. 15, 2016 with full payment. A late-payment penalty applies because you did not pay 90% of your tax liability on April 18. The late-payment penalty is $1,500 (6 months late x 0.5% per month x $50,000). Some traders view a late-payment penalty like a 6% margin loan. I’ve seen traders skip an extension payment to trade the tax money longer, only to lose it and cause bigger tax penalties. That’s risky.

By simply filing the extension on time in the above example, you avoided a late-filing penalty of $11,250 (6 months late x 5% per month (25% max), less late-payment penalty factor of 2.5% max, equals a net late-filing penalty of 22.5% x $50,000). Interest is also charged on taxes paid after April 18.

Pay extra with your tax extension
Profitable traders should consider making quarterly estimated tax payments due during the year to avoid underestimated tax penalties. I recommend the following strategy for traders and business owners: Overpay your tax extension on April 15 and apply an overpayment credit toward Q1 current-year estimated taxes. Most traders don’t make estimated tax payments until Q3 and or Q4, when they have more visibility on trading results. Why pay estimated taxes for Q1 and Q2 if you incur large trading losses later in the year?

It’s a better idea to add a cushion to your 2015 tax liability and payment with the extension filing. That gives you three good choices: You’ll have a cushion on 2015 if your estimates of tax liability are low, you can apply an overpayment credit toward 2016 taxes or you may request a tax refund for 2015 if no estimated taxes are due.

Benefits from filing extensions
Sophisticated and wealthy taxpayers know the real tax deadline is Oct. 17, 2016 for individuals and Sept. 15, 2016 for pass-through entities, including partnership and S-Corp tax returns.

You don’t have to wait until the last few days of the extension period like most wealthy taxpayers. Try to file your tax return in the summer months, when IRS and state auditor’s are on vacation. I think audit percentages drop after April 18.

I’ve always advised clients to be aggressive but legal with tax-return filings and look conservative with cash (tax money). Impress the IRS with your patience on overpayment credits and demonstrate you’re not hungry and perhaps overly aggressive to generate tax refunds. It’s a wise strategy for traders to apply overpayment credits toward estimated taxes owed on current-year trading income. You want to look like you’re going to be successful in the current tax year.

The additional time helps build tax positions like qualification for trader tax status in 2015 and 2016. It may open opportunities for new ideas on tax savings. A rushed return does not.  For example, a large trading gain or loss during the summer of 2016 could affect some decision-making about your 2015 tax return. It’s like having the stock market results of April 18 a day early on April 17.

The extension also pushes back the deadline for paying money into qualified retirement plans including a Solo 401(k), SEP IRA and defined benefit plan. If you did a Roth IRA conversion in 2015, you’ll have six months of additional time to recharacterize (unwind) the conversion. That may come in handy, if the stock market drops in Q2 and Q3 2016.

Working with accountants
Your accountant can prepare extension forms quickly for a nominal additional cost related to that job. There are no fees from the IRS or state for filing extensions.

Your accountant begins your tax compliance (preparation) engagement and he or she cuts it off when seeing a reliable draft to use for extension filing purposes. Your accountant will wait for final tax information to arrive after April 18 to complete your tax return. Think of the extension as a half-time break. It’s not procrastination; accountants want tax returns finished.

Please don’t overwhelm your accountants the last few weeks and days before April 18 with minor details on your tax return in a rush to file a complete tax return. Accounting firms with high standards of quality have internal deadlines for receiving tax information for completing tax returns. It’s unwise to pressure your accountant, which could lead to mistakes or oversights in a rush to file a complete return the last-minute. That doesn’t serve anyone well.

Broker 1099-Bs often come late
It’s difficult for securities traders to file a complete tax return by April 18 considering that many brokers send original and corrected Form 1099-Bs late. In some cases, this occurs just days before April 18, or even after.

In a blog post earlier this tax season, I pointed out how securities Form 1099-Bs are apples vs. oranges when it comes to applying Section 1091 wash sale loss rules for taxpayers. It’s a challenge to reconcile your own trade accounting with 1099-Bs so why stress over this reconciliation before the tax deadline? (Read my blog post Securities Brokers Don’t Tell The Full Story About Wash Sale Losses.)

It’s unwise to rush to file a complete tax return based on a 1099-B that could be corrected after filing. Corrected 1099-Bs based on complex cost-basis regulations have been par for the course the last few years. Why incur the cost and risk of filing an amended tax return? If you don’t reconcile your Form 8949 with the 1099-B, IRS computers will likely send you a tax notice, spotting differences under their matching program. (Read my blog post Traders: Don’t Talk To An IRS Agent Until You Read This.)

Traders should focus on trade accounting
If you know you’ll have a capital loss limitation of $3,000, it doesn’t matter if your capital loss is $50,000 or $75,000 at extension time. Either way, you’ll be reporting a capital loss limitation of $3,000 against other income. In this case, don’t get bogged down with trade accounting and reconciliation with Form 1099-Bs until after April 18.

Consider wash sale loss rules. If you know wash sale loss adjustments won’t change your $3,000 capital loss limitation, you can proceed with your extension filing. But if you suspect wash sale loss adjustments could lead to reporting capital gains rather than losses, or if you aren’t sure of your capital gains amount, focus your efforts on trade accounting well before April 18.  Trade accounting software downloads original transactions, not 1099-B information, so you won’t be held up waiting for 1099-Bs.

For Section 1256 contracts, you can rely on the one-page 1099-B showing aggregate profit or loss. For forex, you can rely on the broker’s online tax reports. Wash sales don’t apply to Section 1256 contracts and forex.

State extensions
Some states don’t require an automatic extension if you’re overpaid; they accept the federal extension. Generally in all states, if you owe taxes, you need to file a state extension with payment. States tend to be less accommodating than the IRS in waiving penalties, so it’s usually wise to cover your state first if you’re short on cash. Check the extension rules in your state.

U.S. citizens and resident aliens abroad
Excerpt from the IRS website: “If you are a U.S. citizen or resident alien residing overseas, or are in the military on duty outside the U.S., on the regular due date of your return, you are allowed an automatic two-month extension to file your return and pay any amount due without requesting an extension. For a calendar year return, the automatic two-month extension is to June 15. If you qualify for this two-month extension, penalties for paying any tax late are assessed from the two-month extended due date of the payment (June 15 for calendar year taxpayers). However, even if you are allowed an extension, you will have to pay interest on any tax not paid by the regular due date of your return (April 15 for calendar year taxpayers).”

Extensions for entities
Tax extensions for pass-through entities are March 15, 2016 for S-Corps and April 18, 2016 for partnerships with an extension due date of Sept. 15, 2016. (Note that the IRS recently changed the rule for next year: 2016 partnership tax returns will be due March 15, 2017 to synchronize with S-Corps.)

Pass-through entities are tax filers, not taxpayers, so the federal extension is simple to prepare without any tax liability. Be sure to file it on time because the late-filing penalty for missing the election is $195 per month per partner or shareholder up to a maximum of 12 months.

Some states have nominal franchise taxes, minimum taxes or excise taxes so check with your state or tax advisor. The state taxes are generally due with the extension filing. March 15 is also the deadline for an existing entity — LLC, C-Corp or general partnership (in most states) to elect S-Corp tax status. And March 15 is the date for existing S-Corps to elect Section 475 MTM treatment.

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes. It’s a prior and different version.



Tax Treatment Can Be Tricky With Options and ETFs

March 2, 2016 | By: Robert A. Green, CPA

Click to read Green’s blog post in Forbes

Tax treatment affects investors, retail business traders, proprietary traders and hedge funds. Here is valuable information about how the various instruments are treated come tax time. Read blog post

This blog post is an excerpt from Green’s 2016 Trader Tax Guide.


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