May 2016

Top 10 Tax Deductions For Active Traders

May 31, 2016 | By: Robert A. Green, CPA

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

Active traders qualifying for trader tax status (TTS) maximize these deductions in the following ways:

1. Home-office (HO) deductions 
Use the square footage or rooms method to allocate every expense of your home including mortgage interest, real estate taxes, rent, utilities, repairs and maintenance, insurance and depreciation. The IRS limits use of HO expenses by requiring business income to offset the deduction, except for the mortgage interest and real estate tax portion. Link the HO Form 8829 to TTS trading gains or transfer some to Schedule C to unlock the HO deduction. If you have trading losses, carry over unallowed HO deductions to subsequent tax year(s). Converting personal home expenses to business use is great.

2. Additions and improvements to office
Consider an addition or improvements to your home office like building more space, replacing windows, walls, and flooring. Depreciate residential real property over 39 years on a straight-line basis. If you rent or own an outside office, depreciation rules are more attractive. The Protecting Americans From Tax Hikes (PATH) Act of 2015 created “qualified improvement property.” It’s a new class of nonresidential real property, excluding additions like increasing square footage. Use 50% bonus depreciation on qualified improvement property placed in service in 2016. PATH extended bonus depreciation through 2019.

3. Tangible property expensing
Expense new tangible property items up to $2,500 per item. Before 2015, the IRS threshold for capitalization with depreciation vs. full expensing was $500. When you purchase a new trading computer system its best to arrange separate invoices for each item not exceeding $2,500.

4. Section 179 (100%) depreciation
For equipment, furniture and fixtures above the tangible property threshold ($2,500), use Section 179 depreciation allowing 100% depreciation expense in the first year. PATH made permanent generous Section 179 limits. The 2016 limit is $500,000 on new and used equipment including off-the-shelf computer software. The IRS limits the use of Section 179 depreciation by requiring income to offset the deduction. Look to business trading gains, other business income or wages, from either spouse, if filing joint.

5. Automated trading systems
Increasingly, traders are writing computer code for developing automated trading systems. The IRS allows a few different choices for expensing “internal-use software.” If you qualify for TTS before incurring software development costs, deduct them like other research expenses in Section 174(a) in the year paid. If you don’t qualify for TTS before incurring software development costs, capitalize them under Section 174(b). Two choices: When you complete the software and qualify for TTS, amortize (expense) the intangible asset over 60 months. Or, wait until you place the software in service with qualification for TTS to amortize (expense) the intangible asset over 36 months. Traders may qualify for TTS using automated trading systems providing they write the code or have other significant involvement with creation and modification of the automated trading systems. Conversely, if a trader purchases an off-the-shelf automated trading system providing entry and exit signals and trade execution, the trader probably doesn’t get credit for the volume and frequency of trades made by the automated trading system.

6. Education, mentoring and seminars
All three are considered education expenses and tax deductibility hinges on qualification for TTS. Education business expenses paid after the start of your business are allowed for maintaining and improving your business. Learning a new business before starting that business is not allowed as a business expense. If you are learning about investing while carrying on an investment activity, that education expense is not allowed as a Section 212 investment expense by Section 274(h)(7). Tip: If you pay for trading education services before qualifying for TTS, consider using Section 195 start-up expenditures treatment below.

7. Section 195 start-up expenditures
Go back a reasonable period (six months) before qualifying for TTS to capitalize a reasonable amount ($15,000) of start-up costs. Start-up expenses include costs to investigate and inquire about a new business. Costs capitalized in Section 195 would have to qualify as a business expense if paid after business commencement. Section 195 allows an expense allowance in the first year up to $5,000. Start a calendar year business late in the year and still get the full $5,000 expense allowance. Amortize the remainder of the costs over 180 months on a straight-line basis. If you exit the trading business, you may write off the unamortized balance.

8. Organization costs
Under Section 248 for corporations and Section 709 for partnerships, treat expenses to organize or form an entity in a similar manner as Section 195 start-up expenditures. There is a separate first-year expense allowance up to $5,000, and the balance is amortizable over 180 months on a straight-line basis.

9. Health insurance premiums
Deduct health insurance premiums from individual AGI if you have an S-Corp trading company paying you W-2 wages which include your premiums. The plan must be in association with your small business and not a third-party employer plan for you or your spouse. Deduct health insurance premiums during the entity period, not before. This S-Corp wage component for health insurance premiums is not subject to social security and Medicare taxes, so enjoy the income tax savings with no offsetting payroll tax costs. A C-Corp management company deducts health insurance premiums on the corporate tax return.

10. Retirement plans
Most traders with TTS should consider a Solo 401(k) retirement plan. Consistently high-income traders with TTS should consider a defined benefit plan if they are close to age 50. Retail traders need an entity like an S-Corp trading company or C-Corp management company to arrange retirement plan deductions since sole proprietor traders don’t have earned income required for employee benefit plan deductions. With one exception: Futures traders using full exchange membership have self-employment income (Section 1402i).

Solo 410(k) plan: S-Corp officer wages of $140,000 unlock the maximum $53,000 contribution/deduction or $59,000 if age 50 or older with the $6,000 catch-up provision. The 100%-deductible elective deferral up to $18,000, or $24,000 with the catch-up provision, provides the greatest income tax savings vs. payroll tax costs. The 25%-deductible profit-sharing plan up to $35,000 is good if you have sufficient cash flow to invest in tax-free compounded growth within the plan.

Defined-benefit plan (DBP): With consistent high trading income, arrange a $100,000 plus contribution/deduction with a defined-benefit plan. Work with an actuary on complex DBP calculations.

Business traders have a wide variety of other expenses including independent contractors and employees for trade assistance and IT, market data providers, charting software, chat rooms and trading groups, subscriptions, books, periodicals, attorneys, accountants, tax advisors and more.

Commissions are not expenses; they are part of the trading capital gain or loss.

Business expenses are deductible “above the line” from gross income, whereas investment expenses face significant limitations “below the line.” Section 212 investment expenses exclude home office, start-up expenditures, employee benefits and education. They are part of miscellaneous itemized deductions, which must first exceed a 2% of AGI threshold. Upper-income taxpayers face additional limitations: a Pease itemized deduction phase-out and AMT taxes since investment expenses are an AMT preference item.

Learn how to qualify for TTS on GreenTraderTax.com.

Related Webinar & Recording: Top 10 Tax Deductions For Active Traders


Section 481(a) Positive Adjustment Spread Period Changes

May 26, 2016 | By: Robert A. Green, CPA

According to tax research service Thomson Reuters CheckPoint, “Under the new procedures for filing a Form 3115 for tax year 2015 and forward, the four-year spread period generally applicable to a positive Section 481(a) adjustment has been modified as De minimis § 481(a) adjustment amount increased. Under a de minimis provision, positive adjustment may be spread over one year (versus four years) at the taxpayer’s election. The new procedures increases the de minimis threshold to $50,000 from $25,000. The election is made on the new Form 3115 (Rev 12-2015), Part IV, Line 27.”

This means that a trader with a Section 481(a) income adjustment up to $50,000 can elect to report the entire amount of income in the current tax year rather than spread the income over four years. The IRS is probably hoping fewer taxpayers defer income and some may forget to report that income in subsequent tax years. 

According to Green’s 2016 Trader Tax Guide, “Form 3115 (Change in Accounting Method) includes a section for reporting a Section 481(a) adjustment, which is required when a change of accounting is made. The rest of the multi-page Form 3115 relates to tax law and code sections, etc. In the case of changing to Section 475 MTM, a trader’s section 481(a) adjustment is his unrealized business trading gain or loss as of Dec. 31 of the prior tax year. A section 481(a) loss is deductible in full; whereas a gain of more than $25,000 must be prorated over four tax years.” Effective for 2015 tax filings, the $25,000 is changed to $50,000. 

For example: If a trader’s 2015 Section 481(a) adjustment is $40,000, on their 2015 Form 3115 they may elect to report the full income. Conversely, if the income adjustment is $60,000 they would have to spread it over four years reporting $15,000 each year.

Section 475 and Section 481(a) adjustments
When a trader with trader tax status (TTS) elects Section 475 mark-to-market (MTM) ordinary gain or loss treatment, the IRS requires a Section 481(a) adjustment on income tax Form 3115 (Application for Change in Accounting Method) and Form 4797 (Sales of Business Property).

The trader is changing accounting method from the cash method on Dec. 31 to the Section 475 MTM method on Jan. 1. If the trader has open TTS securities positions on Dec. 31 the Section 481(a) adjustment is the unrealized gain or loss on TTS positions on Dec. 31. Gain is a positive adjustment and loss is a negative adjustment. Segregated investment positions in securities are not included in the Section 481(a) adjustment. Section 1256 contracts like futures are already subject to MTM so they also are not included in the 481(a) adjustment.

 


IRS Considering “Freeze And Mark” For Section 475 Election

May 10, 2016 | By: Robert A. Green, CPA

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

According to Tax Notes article “IRS Considering ‘Freeze and Mark’ for Trader Election” dated Jan. 20, 2016, Robert Williams, branch 3 senior counsel, IRS Office of Associate Chief Counsel (Financial Institutions and Products), said he was optimistic, though cautious, that updated Section 475 regulations will come out by June 30, 2016.

The Tax Notes article mentioned a few significant potential changes that would affect traders in making a new Section 475 election. If codified by the IRS, I expect these changes won’t apply retroactively, so traders who made a 2016 Section 475 election by April 18 should not be affected.

Clarification of the character of income or loss of a Section 481(a) adjustment: The IRS may clarify that it’s a capital gain or loss, rather than an ordinary income or loss, which is the current interpretation. Many traders have benefited from ordinary loss treatment, especially when a Section 481(a) adjustment included wash sale loss deferrals on open trading business positions.

No election deadline: The changes may allow existing taxpayers to make a new Section 475 election throughout the tax year. Currently,  the election deadline is April 15 for existing partnerships and individuals and March 15 for S-Corps. Many existing taxpayers will appreciate doing away with the deadline.

No retroactive application: Williams discussed applying ordinary income or loss treatment on the election date and going forward, and doing away with retroactive application of ordinary income or loss to Jan. 1.

Under current law, when a trader elected Section 475 by April 18, 2016 for 2016 (normally April 15), the election was retroactive to Jan. 1, 2016, so all 2016 trading gains and losses are ordinary income and loss. If a trader qualified for trader tax status (TTS) at year-end 2015, he also makes a Section 481(a) adjustment on Jan. 1, 2016 for unrealized gains or losses on open trading positions on Dec. 31, 2015.

Traders have been able to use hindsight between Jan. 1 and April 15 to make a last-minute decision about electing Section 475. For example, if they have a large trading loss in Q1, they may elect Section 475 to lock in ordinary loss treatment for that loss, and plan to revoke Section 475 in the subsequent year to get back to capital gains treatment to use up capital loss carryovers. That type of hindsight may be lost with these potential updates in the law.

 

 


Safeguard Use Of Section 475 By Trading In An Entity

| By: Robert A. Green, CPA

Section 475 “tax loss insurance” is a fantastic tax benefit for active securities traders qualifying for trader tax status (TTS). Many individual taxpayers have been using it successfully for years. I’ve exhorted the benefits since 1997, when Congress enacted Section 475 tax law for traders.

Some Section 475 provisions are vague
Increasingly, my firm’s tax compliance CPAs have noticed problems with the nuances of Section 475, including some of the rule sections, which are too vague. The IRS acknowledged this with its “Section 475 Clean Up Project” and read our comment letter to the IRS. The IRS said the project is being completed and to expect updated Section 475 regulations in the summer of 2016. (I cover the changes being discussed at tax attorney conferences in my next blog post IRS Considering “Freeze and Mark” for Section 475 Election.)

One of the problems with Section 475 regulations has to do with segregation of investments. Segregation should be done in form and substance and that can be confusing. A prior IRS proposed regulation called for designation of investment accounts, but that was not sufficient as traders could use substance to trump form.

This problem arises when a trader uses Section 475 and also holds investment positions in substantially identical positions. Traders can’t elect Section 475 by account. The law makes the election by taxpayer identification number, which means the election applies to all active trading accounts and investment accounts containing active trading.

Traders can solve this problem by housing the trading business using Section 475 in a separate legal entity and holding investments in individual accounts. This is the only way to fully segregate investments from trading. (Read my recent blog post Active Traders Should Consider An Entity For Tax Savings for other reasons to form an entity.)

Misidentified investment positions
Many individuals trade substantially identical positions between Section 475 active trading accounts and taxable investment accounts, including joint and spousal accounts. For example, they trade Apple options in a Section 475 account and also hold Apple equity in segregated investment accounts.

The IRS can view this trading as gaming the system, with the trader deducting ordinary losses on Apple options but deferring taxes on unrealized long-term capital gains in Apple equity held as an investment. Because Apple options and Apple equity are substantially identical positions, the IRS has the power in Section 475 regulations to treat either the Apple options or the Apple equity as “misidentified investment positions,” which means it can apply Section 475(d)(2). (Learn more about that Section 475 penalty in my blog post IRS Plays Havoc with Traders Misidentifying Investments.)

Experienced trader tax preparers and IRS agents may seek other ways to address this problem, including reclassifying Section 475 ordinary losses on Apple options as investment capital losses, which then triggers capital loss limitations and wash sale loss adjustments on substantially identical positions across all accounts. Or if it’s better for the IRS position, reclassifying Apple equity investments as Section 475 trades, triggering Section 475 MTM ordinary income treatment, thereby losing tax deferral and missing out on lower long-term capital gains rates on realization.

An entity solves the problem
Traders can avoid this problem by ring-fencing Section 475 trades in separate entity accounts and holding investments in individual accounts. A separate legal entity has a different taxpayer identification number vs. an individual taxpayer social security number.

Don’t transfer investment positions into the entity, as that brings the same problem to the entity-level: having trading and investment accounts and or positions on the same taxpayer identification number.

I suggest that traders using portfolio margining on investment positions make the following decision. Either bring investments into the trading entity for portfolio margining and don’t elect Section 475 in the entity or leave the investments out of the entity and elect Section 475.

A newly formed entity may elect Section 475 by placing a resolution in its own books and records within 75 days of inception. Existing taxpayers must elect Section 475 by making an election statement with the IRS by the due date of the prior year tax return, and later file a timely Form 3115 for the year of the election. (Read my blog post Traders: Consider Ordinary Loss Election By Tax Deadline for more details on making the election.)

IRS scrutinizes individuals with large Section 475-related NOL tax refunds
It’s been over a decade since Chen vs. Commission (2004), but an IRS official recently reiterated the importance of that landmark tax court case, deeming similar cases “Chen cases.”

The IRS official was referring to sole proprietor (individual) traders reporting large Schedule C and Form 4797 (Section 475) ordinary losses on individual tax returns and filing for large NOL carryback refunds claims with the IRS. All the cases in my Green’s 2016 Trader Tax Guide, including Assaderaghi, Nelson, Endicott and Holsinger are similar: individuals with Schedule C and Form 4797 losses.

It’s much better to file as an entity trader with Section 475 ordinary loss treatment. The tax refund is the same, but you substantially reduce your chances of IRS exam and denial of TTS, which is required for use of Section 475.

Section 475 tax benefits
Securities traders qualifying for TTS benefit from a Section 475 election. Section 475 securities trades are exempt from wash sale loss adjustments and a capital loss limitation. Section 475 has business ordinary loss treatment, which offsets income of any kind and contributes to net operating losses (NOLs), which may be carried back two years and/or forward 20 years. Short-term capital gains and Section 475 MTM gains are taxed at the ordinary tax rate, so Section 475 is recommended for securities traders.

Conversely, Section 1256 contract traders (futures and more) generally don’t want Section 475 since they would lose lower 60/40 capital gains tax rates in Section 1256 (60% is a long-term capital gain taxed at lower rates and 40% is a short-term capital gain).

Traders can elect Section 475 on securities only, retaining Section 1256 treatment on futures. Section 475 does not apply to segregated investments. Traders value ordinary loss treatment: It’s free tax loss insurance for securities traders.

I’ve been advising traders on tax matters for over 30 years and I’ve seen many ups and downs in the financial markets. I’ve seen professional traders with wide fluctuations of income and loss, too. It’s important to avoid the dreaded $3,000 capital loss limitation against other income and benefit from Section 475 ordinary business loss treatment to generate immediate tax refund relief.

 

 


Active Traders Should Consider An Entity For Tax Savings

May 3, 2016 | By: Robert A. Green, CPA

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

Forming an entity can save active investors and business traders significant taxes. Active investors can limit wash sale losses calculated between their individual taxable investment accounts and IRAs with an entity account. Business traders solidify trader tax status (TTS), unlock employee-benefit deductions, gain flexibility with a Section 475 election and revocation and limit wash-sale losses with individual and IRA accounts. For many active traders, an entity solution generates tax savings in excess of entity formation and compliance costs.

An entity return consolidates your trading activity on a pass-through tax return (partnership Form 1065 or S-Corp 1120-S), making life easier for you, your accountant and the IRS. It’s important to segregate investments from business trading when claiming TTS, and an entity is most useful in that regard. It’s simple and inexpensive to set up and operate.

Additionally, entities help traders elect Section 475 MTM (ordinary-loss treatment) later in the tax year — within 75 days of inception — if they missed the individual MTM election deadline on April 15. And it’s easier for an entity to exit TTS and revoke Section 475 MTM than it is for a sole proprietor. It’s more convenient for a new entity to adopt Section 475 MTM internally from inception, as opposed to an existing taxpayer whom must file a Form 3115 after filing an external election with the IRS.

Don’t worry, prior capital loss carryovers on the individual level are not lost; they still carry over on your individual Schedule D. The new entity can pass through capital gains if you skip the Section 475 MTM election to use up those capital loss carryovers. After using up capital loss carryovers, your entity can elect Section 475 MTM in a subsequent tax year.

Business traders often use an S-Corp trading company or an S-Corp or C-Corp management company to pay salary to the owner in connection with a retirement plan contribution, which otherwise isn’t possible in a partnership trading company (unless a trader has other sources of earned income or is a dealer member of a futures or options exchange).

Trading in an entity can help constitute a performance record for traders looking to launch an investment-management business. Finally, many types of entities are useful for asset protection and business continuity. A separate legal entity gives the presumption of business purpose, but a trader entity still must achieve TTS.

Avoid wash sales with an entity
Active investors in securities are significantly impacted by permanent and deferred wash sale losses between IRA and individual taxable accounts.

Trading in an entity helps avoid these problems. The entity is separate from your individual and IRA accounts for purposes of wash sales since the entity is a different taxpayer. An individual calculates wash sales among all their accounts. Ring fencing active trading into an entity account separates those trades from the individual wash sale loss calculations. The IRS is entitled to apply related party transaction rules (Section 267) if the entity purposely tries to avoid wash sales with the owner’s individual accounts. In that case, the entity will not avoid wash sale loss treatment.

If you don’t purposely avoid wash sales, you can break the chain on year-to-date wash sales in taxable individual accounts by switching over to an entity account mid-year or at year-end, and prevent further permanent wash-sale losses with IRAs. If the entity qualifies for TTS, it can consider a Section 475 MTM election exempting it from wash sales (on business positions, not investment positions); that also negates related party rules.

Play it safe on related party transaction rules by avoiding the repurchase of substantially identical positions in the new entity after taking a loss in the individual accounts.

Business traders: consider an entity
Many active traders ramp up into qualification for TTS. They wind up filing an individual Schedule C (Profit or Loss from Business) as a sole proprietor business trader the first year. That’s fine. They deduct trading business expenses on Schedule C and report trading gains and losses on other tax forms. They can even elect Section 475 MTM by April 15 of a given tax year to use ordinary gain or loss treatment (recommended on securities only). But a Schedule C owner may not pay himself compensation and the Schedule C does not generate self-employment income, either of which is required to deduct health insurance premiums and retirement plan contributions from gross income. (The exception is a full-fledged dealer/member of an options or futures exchange trading Section 1256 contracts on that exchange; they have SEI per Section 1402i.) The business trader needs an entity for those employee-benefit plan deductions.

Safeguard use of Section 475

Pass-through entities
We recommend pass-through entities for traders. A pass-through entity means the entity is a tax filer, but it’s not a taxpayer. The owners are the taxpayers, most often on their individual tax returns. Consider marriage, state residence and state tax rules including minimum taxes, franchise taxes and more when setting up your entity. Report all entity trading gains, losses and expenses on the entity tax return and issue a Schedule K-1 to each owner for their respective share — on which income retains its character. For example, the entity can pass through capital gains to utilize individual capital loss carryovers. Or the entity can pass through Section 475 MTM ordinary losses to comprise an individual net operating loss (NOL) carryback for immediate refund.

The best types of entities
We like the S-Corp because it pays compensation (officer’s salary) to the owner, which efficiently unlocks health insurance premium and retirement plan contribution deductions. You can form a single-member LLC or multi-member (spousal) LLC and the LLC can elect S-Corp tax treatment within 75 days of inception or by March 15 of the following tax year. (Another option is to form a corporation and it can elect S-Corp tax treatment, too.) A general partnership can also elect S-Corp status in every state except Connecticut, the District of Columbia, Michigan, New Hampshire, New Jersey and Tennessee.

But the S-Corp is not feasible alone in some states or cities, including California and New York City. In those places, we suggest a trading company partnership return — either a general partnership or LLC — and a management company S-Corp or C-Corp. You can convey interests in the pass-through entity to family revocable trusts or even irrevocable trusts. (See our blog post Business Traders Maximize Tax benefits with an S-Corp.)

Year-end Entity planning
There are important tax matters to execute with entities before year-end. For example, S-corps and C-corps should execute payroll before year-end. A Solo 401(k) defined contribution plan or defined benefit retirement plan must be established before year-end. (Watch our Webinar recording: Year-End Planning For Entities: Payroll, Retirement and Health Insurance.)

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

Webinar 5/17:  Entity & Benefit Plan Tax-Advantaged Solutions 2016. We plan to offer a recording afterwards. 

 

 


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