June 2016

Tax Treatment For Volatility Products Including ETNs

June 27, 2016 | By: Robert A. Green, CPA

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

After the Brexit referendum vote on June 24, 2016, volatility-based financial products skyrocketed in price, and by Monday, June 27, prices had subsided. That’s volatility!

There are many different types of volatility-based financial products to trade, and tax treatment varies. For example, CBOE Volatility Index (VIX) futures are taxed as Section 1256 contracts with lower 60/40 MTM tax rates. The NYSE-traded SVXY is an exchange-traded fund (ETF) taxed as a security. The iPath S&P 500 VIX Short-Term Futures (VXX) is an exchange-traded note (ETN), and while tax treatment is similar to an ETF, there is uncertain tax treatment on ETNs. I focus this blog post on tax treatment for ETNs.

How ETN’s work
Per TAX STRATEGIES FOR LONG-SHORT EQUITY, Practical Tax Strategies, Sep 2014: “An exchange traded note (ETN) can be linked directly to an active index. An ETN is similar to a bond except the interest rate is replaced with the return of an index.” “ETNs include significant creditor risks because they are not backed by underlying assets, but only by the issuer’s ability to pay at maturity (which may be 30 years in the future).” This creditor risk probably increased after the Brexit vote, as many of these banks operate in the U.K. and European Union. Day traders are not as concerned with creditor risks.

VXX prospectus discusses tax treatment
In the prospectus for iPath® S&P 500 VIX Short-Term Futures ETN, tax attorneys write “by purchasing the ETNs you agree to treat the ETNs for all U.S. federal income tax purposes as a pre-paid executory contract with respect to the applicable Index. If the ETNs are so treated, you should generally recognize capital gain or loss upon the sale, early redemption or maturity of your ETNs in an amount equal to the difference between the amount you receive at such time and your tax basis in the ETNs. The U.S. federal income tax consequences of your investment in the ETNs are uncertain.”

Tax publishers use a similar term: “prepaid forward contracts” and tax treatment calls for deferral of taxes until sale and long-term capital gains rates if held 12 months. Constructive receipt of income rules prevents tax avoidance with offsetting positions.

Traditionally, ETN’s are tax advantaged because they allow deferral until realization (sale) and lower long-term capital gains rates if held 12-months. That’s good for investors. But, day and swing traders don’t benefit from deferral and long-term rates; they incur short-term capital gains taxes throughout the year taxed at ordinary rates.

Traders would rather have the option of using Section 1256 tax treatment on volatility ETNs including lower 60/40 capital gains rates. That’s how the IndexCBOE: VIX is taxed. (60% is lower long-term capital gains rates up to 20%, even on day trades, and the other 40% are short-term capital gains at ordinary rates.) Section 1256 also requires mark-to-market (MTM) accounting, imputing sales on open positions at year-end and that’s not a problem for day traders.

IRS ruling
The IRS caused questions when it issued Rev. Rul 2008-1 about foreign currency linked ETN’s. The IRS also issued Rev. Ruling 2008-2 asking for comments on prepaid forward contracts and similar arrangements. The IRS has not yet issued final guidance on ETN’s.

In Rev. Ruling 2008-1, the IRS “looked through” the currency ETN to the underlying market bet on the Euro and market interest rates. The IRS objected to the ETN benefiting from tax deferral and long-term capital gains rates when the underlying foreign currency transactions (Section 988) would require ordinary gain or loss treatment. Plus, debt instruments require accrual of annual interest income. The IRS knows that traditional ETN tax treatment prejudices Treasury, and it would prefer to accrue income and use ordinary rather than capital gains tax rates.

ETFs based on volatility
The IRS can’t apply this same look through logic to ETF’s because as a “registered investment company” (RIC), security ETF’s are taxed as securities.  A commodity ETF can’t use the RIC structure; it’s a publically traded partnership also taxed as securities. A commodity ETF issues a Schedule K-1 passing through Section 1256 contract income or loss.

ProShares has three volatility ETF’s: ULTRA VIX SHORT-TERM FUTURES ETF (NYSEArca: UVXY), SHORT VIX SHORT-TERM FUTURES ETF (NYSEArca: SVXY), and VIX SHORT-TERM FUTURES ETF (NYSEArca: VIXY).  These ProShares ETF’s are taxed as securities: Unlike ETN’s, ETF RIC’s make annual distributions of income and capital gains to shareholders. ETF’s don’t provide as much deferral as ETN’s.

Possible alternative tax treatments for ETN’s
In the VXX prospectus, tax attorneys suggest that Section 1256 is a “possible alternative” tax treatment. “Moreover, it is possible that the IRS could seek to tax your ETNs by reference to your deemed ownership of the Index components. In such a case, it is possible that Section 1256 of the Internal Revenue Code could apply to your ETNs, in which case any gain or loss that you recognize with respect to the ETNs that is attributable to the regulated futures contracts represented in the applicable Index could be treated as 60% long-term capital gain or loss and 40% short-term capital gain or loss, without regard to your holding period in the ETNs… And, currently, accrue ordinary interest income in respect of the notional interest component of the applicable Index.”

Postscript: In my July 11, 2017, blog post How To Avoid Tax Reporting Trouble With Exchange Traded Notes, I explain there is no substantial authority for ETN holders to use Section 1256 tax treatment.

Options on VXX (added Dec. 16, 2016)
After writing this blog post, some clients asked me how options on VXX are treated for tax purposes. I got this reply from our tax attorney Roger Lorence. “I located nothing directly on point. However, the better view in my understanding would be that these options are nonequity options and therefore Section 1256 contracts. The options are listed on CBOE and are therefore listed options on a qualified board or exchange. The underlying is, e.g., VXX ETNs. The tax opinion in the prospectus for the ETNs (Sullivan and Cromwell) is that these are prepaid forward contracts and the holder has an executory contract for the delivery of the underlying futures contracts.  Therefore the CBOE listed options are a derivative contract several levels removed from the ultimate underlying. If a holder were to exercise the CBOE options theoretically, they would not receive equity in a single stock or a narrow-based group of stocks based on a narrow-based index.”

When traders talk about volatility products, they often conflate tax treatments. Until we get further formal guidance from the IRS, the tax treatment on volatility and other ETN’s is uncertain. Consult with a trader tax expert.

Darren Neuschwander, CPA contributed to this blog post.

Some Proprietary Traders Under-Report Income

June 6, 2016 | By: Robert A. Green, CPA

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

Proprietary traders are significantly different from retail traders. Proprietary traders don’t trade their capital. They trade the firm’s capital, usually accessed from a sub-trading account. A prop trader becomes associated with a prop-trading firm either as an independent contractor (1099-Misc), an employee (W-2) or an LLC member (Schedule K-1).

Independent contractors
Profitable independent contractor (IC) proprietary traders receive a 1099-Misc for “non-employee compensation.” Sole proprietors use a Schedule C to report revenue and deduct business expenses. Schedule C net income is subject to federal and state income taxes, and self-employment (SE) taxes.

Reinvesting earnings are taxable income
Prop traders generate trading gains on their sub-trading account. At the end of a defined period, usually monthly, the firm presents them with a choice: Request a fee payment (distribution of earnings) or reinvest income in their sub-trading account. 

Some prop firms only include fee payments on annual tax form 1099-Misc. They don’t include reinvested earnings. That’s a problem: In the above scenario, reinvested earnings constitute “constructive receipt of income,” which should be reportable income. 

This firm’s prop traders are likely under-reporting income since many will inadvertently or purposely overlook reporting reinvested earnings on Schedule C. Taxpayers are responsible for reporting their correct income, even income that should be included on 1099s but is not.

Constructive receipt of income
In the June 2004 issue of Strategic Finance Magazine: “Constructive Receipt and the Substantial Restrictions Limitation,” Charles E. Price, Ph.D., “Treas. Regs. Sec. 1.451-2 explains that a taxpayer need not have physical possession for an amount to be included in gross income. Income that is set aside for the taxpayer, credited to an account, or otherwise made available is constructively received by the taxpayer. If the taxpayer’s control is subject to “substantial limitations or restrictions,” however, the income isn’t considered to be received.”

“Constructive receipt requires an unqualified vested right to receive income – there can be no condition, limitation, or restriction that prevents the taxpayer from having unrestricted access to his or her money without penalty. The taxpayer, however, can’t waive a present right to receive income— in other words, the taxpayer may not “turn his back” on income that is already earned. But if the taxpayer requests deferral of payment prior to receiving an unqualified vested right to income, constructive receipt doesn’t occur.”

“The key to recognition or deferral is an unrestricted present right of the taxpayer to control the disposition of the income. If substantial limitations or restrictions hinder the taxpayer’s right of access to income, then recognition can be deferred. Taxpayers who seek to defer income recognition must avoid an unqualified right to control that income.”

The trader’s income is set aside and credited to his sub-trading account for his benefit.

 The trader receives an unrestricted, present right to control the disposition of the income, so income deferral is inappropriate.

A prop trader pays $5,000 as a deposit or expense to a prop trading firm, and the firm gives them a limited power of attorney to trade a sub-trading account containing $25,000.

In month 1, the trader earns $1,000. (Generally, a prop trader receives around 70% of trading gains in the form of non-employee compensation.) The sub-trading account balance is now $26,000. 

The firm offers the trader a distribution (fee payment) of $1,000, but the IC may decline (turn his back on income) and reinvest the $1,000 in the sub-trading account.

After a few additional months with trading gains, the sub-trading account balance is $30,000 containing: reinvested earnings of $5,000, $25,000 of firm capital, and no fee payments to the trader. The firm decides to allocate another $25,000, so the trader is now trading a sub-account with $55,000.

 At the end of the calendar year, the account balance is $65,000 containing trader earnings of $15,000, $50,000 of the firm’s capital, and no fee payments to the trader. 

In the above example, the firm we spoke with would not issue a 1099-Misc because they did not pay fees during the year. The trader’s $15,000 of reinvested earnings meets the IRS definition of a constructive receipt of income, so the firm should report it on a 1099-Misc.

The IRS holds the trader responsible for reporting $15,000 of revenue on Schedule C whether or not the prop trading firm issues a correct 1099-Misc. 
The IRS may also assess a tax penalty to the firm for under-reporting on a 1099-Misc.

Losses of reinvested earnings
Assume the same facts as in the above example; only the trader has $6,000 in trading losses in December. That leaves an account balance of $59,000, containing trader earnings of $9,000, $50,000 of the firm’s capital, and no fee payments.

It may be acceptable to net the losses against the income by issuing a 1099-Misc for $9,000. Otherwise without netting, the 1099-Misc should be for $15,000, and the prop trader can report a $6,000 business bad-debt deduction on Schedule C. Firms should provide traders’ with accounting for reinvested earnings.

Initial deposits
Aspiring traders have two choices: Open a retail trading account or join a prop trading firm.

Retail traders place a deposit with a broker-dealer. If they want to day trade securities, four or more times in five business days, they need “pattern day trading” (PDT) privileges allowing a 4:1 margin and the minimum account size is $25,000. Otherwise, a retail trader is limited by Reg T margin rules to a 2:1 margin.

Many securities traders can’t afford $25,000, and they are drawn to prop trading firms offering higher leverage with less money required upfront. Some prop trading firms ask prop traders for a deposit or another type of payment. Some firms use murky accounting and tax classifications to avoid calling it a “deposit” because they are non-customer broker-dealers who may not accept deposits. Only customer broker-dealers accept deposits. Non-customer broker-dealers also have lower capital requirements and less regulatory scrutiny versus customer broker-dealers.

Some prop trading firms classify initial deposits and reinvested earnings as education expenses or other service expenses, reporting revenue for these payments in the firm’s books and records. But, there are conflicts with sales materials and other paperwork referring to the payments as a deposit or a share of capital.

If a prop trader loses an initial deposit, he can report a business bad-debt deduction on Schedule C, provided they have entered into an independent contractor agreement for rendering trading services.

For other tax tips for prop traders, read Green’s 2016 Trader Tax Guide, Chapter 12 Proprietary Trading.

 Darren Neuschwander, CPA, contributed to this article.

Webinar June 21 & Recording: Proprietary Trader Tax Treatment & Recent Developments