Most active traders make serious errors on income tax returns, whether they self-prepare or engage a local accountant. Many miss out on trader tax benefits and overpay on their taxes. The cost ranges from $5,000 to hundreds of thousands of dollars.
When you shop for a tax preparer, ask about trader tax status, Section 475 elections, wash sale loss rules, and tax treatment for forex, options, Section 1256 contracts, ETFs, and ETNs. If they look like a deer caught in headlights, you’ll realize that your tax professional is not proficient enough for your needs. CPAs have a code of ethics requiring them to decline an engagement if they are not proficient, but local tax storefronts do not.
Here’s my 2016 list of tax reporting errors made by traders and accountants.
1. Mistakenly believing you can rely on securities Form 1099-B:
Most preparers rely on broker Form 1099-B for tax reporting. There’s a problem with wash sales. A wash sale loss is tax-deferred when you buy back a security position 30 days before or after making a sale at a loss.
Here’s the problem with wash sales reported on the 1099-B: IRS rules for brokers are simple, and most people do not realize that IRS rules for taxpayers are different and more complex. Tax preparers choose to play ignorant and import 1099-B, so it’s easy to reconcile Form 8949 with 1099-B. That means they are using broker rules and willfully disregarding Section 1091 rules for taxpayers. They should use trade accounting software that is compliant with taxpayer rules.
Broker rules base wash sales on identical positions, per account. Taxpayer rules base wash sales on substantially identical positions, across all accounts, including IRAs. A broker does not calculate a wash sale on Apple equity vs. Apple options because they are not identical symbols, but taxpayers must do so because they are substantially identical positions.
With education, traders can avoid wash sale losses. That is better than ignoring taxpayer rules and playing the audit lottery with the IRS.
2. Messing up Form 8949 cost-basis reporting:
The IRS requires reporting each securities trade on Form 8949 with the description, dates acquired and sold, proceeds, cost basis, code, adjustments, and gain or loss.
The primary adjustment is for wash sales. Other cost-basis adjustments include corporate actions (stock splits and reinvested dividends), inherited positions, gifts, and transfers from other accounts. Taxpayers often use incorrect amounts for these items.
There is one scenario where a taxpayer can solely rely on a 1099-B and skip filing Form 8949 by entering 1099-B amounts on Schedule D: when the taxpayer has only one brokerage account and trades equities only with no trading in equity options, which are substantially identical positions. Plus, the taxpayer must not have any wash sale loss or other adjustments.
However, if you trade options and equities, which are substantially identical positions, and/or you have multiple brokerage accounts, including IRAs, then you need trade accounting software that’s compliant with Section 1091 to generate Form 8949. Most software available through brokerage websites are not compliant with taxpayer rules in Section 1091. Download the original trade history from your broker’s website into a compliant program to generate Form 8949 or Form 4797 with Section 475.
3. Overlooking trader tax status or messing it up on Schedule C:
Most tax preparers and tax software do not offer resources about trader tax status (TTS) and related tax benefits. Other CPAs tell me they didn’t even realize their long-term clients had started a trading business. They thought trading was an investing activity using Section 212′s investment expense and the capital gains and loss treatment.
Overlooking qualifications for TTS can cost a trader $5,000 to $15,000 or more in tax benefits due to the preference of Section 162′s business expense treatment on Schedule C vs. Section 212′s restricted expense treatment on Schedule A.
Some accountants err in reporting trading income and losses on Schedule C. They should list trading business expenses only on Schedule C. Traders report trading gains and losses on different tax forms, including Form 8949 for securities, Form 6781 for Section 1256 contracts, and Form 4797 for Section 475 trades.
Traders should include well-written statements with their tax returns explaining TTS, how they qualify, tax treatments, and elections made. They should ask the IRS to view their trading business as a collection of tax forms. Otherwise, the IRS may see Schedule C as a losing business without any revenue. Most preparers do not include footnotes, and if they do, they tell the wrong story.
Don’t fall into the hobby loss or passive activity loss trap: Do not let a preparer or IRS agent subject your trading business to Section 183 hobby loss disallowance rules because it’s not recreational or personal in nature. A trading company is also exempt from Section 469′s passive activity loss rules by the Section 469 “trading rule.”
Recent trader tax court cases served up significant losses to traders. The IRS caught traders trying to deduct capital losses as ordinary losses. Net capital losses are limited to $3,000 per year on Schedule D, and excess capital losses should be carried over to subsequent tax year(s) on Schedule D. Ordinary loss treatment for trading losses is possible if a trader with TTS timely elects Section 475. In that case, report Section 475 trading losses on Form 4797 Part II, not on Schedule C.
A trader can claim TTS business expense treatment after-the-fact, and the IRS does not require an election. Preparers often conflate TTS with Section 475, but that’s a mistake. A trader with TTS has the option to elect Section 475, but many choose not to do so.
4. Overlooking or messing up a Section 475 election:
A trader qualifying for TTS may elect Section 475 MTM with ordinary gain or loss treatment. Report Section 475 trades on Form 4797 Part II, rather than on Form 8949.
The main tax benefits of Section 475 are an exemption from wash sale loss adjustments and capital loss limitations. Ordinary business losses offset income of any kind, and they are part of net operating loss (NOL) carrybacks and or carryforwards.
One of the biggest pitfalls for traders is messing up the decision-making with a Section 475 election. If you have existing capital losses from a capital loss carryover, year-to-date realized capital losses, and unrealized capital losses, you may want to retain capital gains treatment. That’s because Section 475 is ordinary income, which can’t absorb capital loss carryovers. On the other hand, you don’t want additional capital losses that are unutilized.
Preparers err in making a decision too early, not waiting until the election deadline, which offers some hindsight. They do not understand they can make alternative plans: You can revoke Section 475 in a subsequent tax year or form a new entity for a “do over” on electing Section 475, within 75 days of inception. You can choose Section 475 on securities only and retain lower 60/40 capital gains tax rates on Section 1256 contracts.
Many preparers miss the deadline for filing a Section 475 election statement and Form 3115 (Change in Accounting Method). Any misstep invites the IRS to disallow Section 475. Read recent trader tax court cases on my blog, including on Poppe, Assaderaghi, Nelson, and Endicott.
5. Messing up Form 4797 and overlooking a Section 481(a) adjustment:
Report each Section 475 transaction on Form 4797. Mark-to-market reporting means you must impute sales of open securities positions at year-end based on market prices.
The Section 475 election process includes a Section 481(a) adjustment to convert from the realization (cash) method to the MTM accounting method, as of Jan. 1 of the election year. That adjustment is the unrealized gain or loss on the prior year-end open trading business positions. Negative Section 481(a) adjustments are reportable in full, but positive ones over $50,000 must be pro-rated over four years. Many preparers overlook or err in making this adjustment, and others forget about reporting the deferral income in subsequent years. If you don’t qualify for TTS in the prior year, there is no Section 481(a) adjustment.
6. Commingling Section 475 trades with investment positions:
If you use Section 475 on your trading account and also make investments in a segregated investment account, be sure not to trade the same symbols between the two accounts, as that gives the IRS an opening to reject some Section 475 losses, or to disallow some long-term capital gains. Both will raise your tax bill. Section 475 regulations require careful segregation of investments from Section 475 trades in form and substance. Most preparers are unaware of these nuances in Section 475, and they misadvise clients about how to stay clear of this trouble.
7. Overlooking or messing up capital loss carryovers:
Some self-preparers mistakenly think they should only report a 3k capital loss carryover each year since they figure that is all they can use against other income. That is wrong: Report the entire capital loss carryover on Schedule D, short term vs. long term. It is okay to have a capital loss that carries over again to the next tax year.
Others overlook entering a capital loss carryover. Some figure not reporting them until they have capital gains to use them up. However, it can become too late, since the capital loss carryover year closes after three years. The IRS does not allow a capital loss carryover unless you report it on your prior year’s tax return, so don’t let a capital loss carryover lapse. Capital loss carryovers do not expire.
Capital losses are unlimited against capital gains. Deduct up to $3,000 of net capital losses against other income. It’s automatic, and not optional. For example, carry over $50,000 of capital losses and use it against $30,000 of current year capital gains, leaving a $20,000 net capital loss. Use the $3,000 capital loss limitation against other income and carry over $17,000 of the remaining capital loss to the subsequent tax year.
8. Overlooking the election to carry back a Section 1256 loss:
Many preparers do not know they can elect to carry back a Section 1256 loss. Check that box on top of Form 6781 to report current year net losses on Form 1040X amended tax returns for the prior three tax years, in order of oldest year first. The loss can only offset Form 6781 gains, not other income.
9. Using the wrong tax treatment on various financial instruments:
Many preparers do not realize that some financial instruments require ordinary gain or loss treatment or qualify for lower 60/40 capital gains tax rates in Section 1256. Many preparers incorrectly think that all trading instruments use the realization method with short-term and long-term capital gains rates.
It’s wise to double-check your broker’s 1099-B reporting. For example, a few foreign futures received Section 1256 treatment in IRS revenue rulings. Otherwise, without that ruling, they are treated as securities.
Forex trading is an ordinary gain or loss by default, but traders may elect to opt out of Section 988 into Section 1256(g) on “major currencies” only, which means the U.S. future exchanges list the same pairs. The U.S. brokers do not issue a 1099-B for spot forex transactions. A trader must file a Section 988 opt-out election on a contemporaneous basis in a taxpayer’s books and records. That means internally as opposed to filing it with the IRS. You can file the election for the whole year or part of the year. Many preparers mess up forex tax treatment, and IRS and state agents are confused over the reporting, too.
Securities ETFs are usually registered investment companies (RICs). Selling a Securities ETF is deemed a sale of security. Many preparers make errors with commodities/futures ETFs, which are publicly-traded partnerships (PTPs). PTPs issue annual Schedule K-1s passing through Section 1256 tax treatment on Section 1256 transactions to investors, as well as other taxable items. Selling a commodities ETF is deemed a sale of security, calling for short-term and long-term capital gains tax treatment. Taxpayers invested in commodities/futures ETFs should make adjustments to cost basis on Form 8949 to capital gains and losses, ensuring they don’t double count Schedule K-1 pass through income or loss. The broker 1099-B will not make this adjustment for you. Options on ETFs are securities whereas options on commodity ETFs can be Section 1256 contracts.
Gold ETFs use the publicly traded trust (PTT) structure, which the IRS considers a disregarded entity. In effect, it’s like directly owning gold bullion. Precious metals are “collectibles” with higher long-term capital gain rates up to 28%. Collectibles held one year, and less are short-term capital gains. Many preparers make errors reporting transactions in precious metals.
Exchange-traded notes (ETNs) are prepaid forward contracts, and tax treatment calls for the deferral of taxes until sale. Alternative tax treatment is unclear on ETNs.
10. Mishandling foreign transactions:
Many Americans trade financial products on global exchanges. Some trade through a U.S. broker who reports all sales globally on Form 1099-B. Most U.S. brokers keep accounts for foreign transactions in U.S. dollars.
It is complicated when traders open an offshore brokerage account held in a foreign currency. Counterparties outside the U.S. do not issue Form 1099-B, and accounting is a challenge. Separate capital gains and losses with embedded currency fluctuation from currency fluctuation on cash balances. Many preparers make mistakes double counting some currency appreciation or depreciation.
Some brokers outside the U.S. encourage Americans to form a foreign entity to set up an offshore brokerage account. Look before you leap: Tax compliance for foreign entities is significant, and there are few to no tax advantages for traders. International tax compliance is very complex and often nuanced, and it’s risky if you mess up tax reporting. Most preparers are not proficient in international tax compliance for U.S. residents.
For U.S. residents, foreign bank, brokerage, investment and other types of accounts — including retirement and insurance in some cases — must be e-filed on FinCEN Form 114, Report of Foreign Bank and Financial Account. If your foreign bank and financial institution accounts combined are under $10,000 for the entire tax year, you fall under the threshold for filing. If you do need to e-file FinCEN Form 114, the deadline is June 30 of the following year. Many preparers overlook FinCEN Form 114, and the penalties can be very high for willful non-compliance.
11. Overlooking or double counting home office deductions:
Most traders with TTS have a room in their home used for business, but they omit home office deductions since they think it’s a red flag with the IRS. The reverse it true: Without a home office or outside office, it does not look like you operate a business.
Some self-preparers double count real estate taxes and mortgage interest deductions on Schedule A. They do not realize Form 8829 allocates the non-business portion of those deductions to Schedule A.
Other preparers wind up with a carryover of home office expenses, with no current year deduction, because they did not point Form 8829 to trading gains or transfer some trading gains to Schedule C as explained in Green’s 2016 Trader Tax Guide. Form 8829 deductions require income; that’s how the IRS keeps a lid on this deduction. Traders without TTS may not deduct home office expenses.
12. Deducting education expenses when not allowed:
New traders often incur significant education costs before they begin trading in live accounts and qualify for TTS. Many preparers incorrectly deduct education as a Section 212 investment expense on Schedule A. However, pre-business education is not deductible in Section 212 by Section 274(h)(7).
Education incurred after business commencement is a business expense. Try to capitalize pre-business education as part of Section 195 startup costs, which can be expensed $5,000 when business commences, with the rest amortized over 15 years. Include a reasonable amount going back six months.
13. Paying self-employment tax when not owed:
Some preparers treat net trading business income as self-employment income (SEI) subject to self-employment (SE) tax. That’s incorrect unless the trader is a full member of an options or futures exchange and trading Section 1256 contracts on that exchange (Section 1402i).
The full SE tax (15.3%) applies to the social security base ($118,500 for 2016). The Medicare portion (2.9%) is unlimited.
14. Deducting employee benefit plans when not allowed:
Preparers compound the above error by having the trader contribute to a retirement plan based on net trading business income. A taxpayer may contribute to a retirement plan if he or she has SEI or wages, but trading gains are not SEI. In this case, the trader is deemed to have an “excessive contribution” subject to tax penalties.
Preparers also mistakenly take an AGI deduction for self-employed health insurance premiums, which requires SEI.
If a trader wants employee benefit plan deductions, including health insurance and a retirement plan, he or she should consider an S-Corp pass-through entity tax return. The S-Corp pays officer compensation to unlock these deductions. Many preparers overlook year-end tax planning, which includes payroll and Solo 401(k) plan execution.
Some preparers err in deducting employer-provided health insurance like COBRA. For health insurance to be AGI-deductible, the medical insurance must be an individual or group plan associated with the business. Many preparers err in not adding the health insurance premiums to the S-Corp officer compensation Form W-2, and it’s not subject to payroll tax.
Watch our video: These Tax Errors Will Cost Professional Traders Dearly.