January 2017

Seven Powerful Ways Traders Save Money On 2016 Tax Returns

January 25, 2017 | By: Robert A. Green, CPA

Forbes

Seven Powerful Ways Traders Save Money On 2016 Tax Returns

Tax software and preparers come up short on traders; they mishandle trader tax status, forms, elections, the treatment of different financial products, entities, employee benefit deductions and investment expenses. Here are seven powerful ways traders save money this tax-filing season.

1. Use correct tax forms
The IRS hasn’t created specific tax forms for individual trading businesses. Traders enter gains and losses, portfolio income, business expenses and investment expenses on various forms. It’s often confusing. Which form should you use if you’re a forex trader? Which form is best for securities traders using the Section 475 MTM method? The different reporting strategies for the various types of traders make tax time not so cut-and-dried.

- Sole proprietor trading business: Other sole-proprietorship businesses report revenue, the cost of goods sold and expenses on Schedule C. But business traders qualifying for trader tax status (TTS) report only expenses on Schedule C. Trading gains and losses are reported on various forms, depending on the situation. In an entity, all trading gains, losses, and expenses are consolidated on the entity tax return — a partnership Form 1065 or S-Corp Form 1120-S. That’s one reason why we recommend entities for TTS traders.

- Sales of securities must be first reported on Form 8949, which then feeds into Schedule D (cash method) with capital losses limited to $3,000 per year against ordinary income (the rest is a capital loss carryover). Capital losses are unlimited against capital gains.

- Business traders who elect and use Section 475 MTM on securities report their business trades (line by line) on Form 4797 Part II. MTM means open business trades are marked-to-market at year-end based on year-end prices. Business traders still report sales of segregated investments in securities (without MTM) on Form 8949. Form 4797 Part II (ordinary gain or loss) has unlimited business ordinary loss treatment and avoids capital loss limitations and wash sale loss treatment. Form 4797 losses are counted in net operating loss (NOL) calculations.

- Section 1256 contract traders (i.e., futures) should use Form 6781 (unless they elected Section 475 for commodities/futures; in that case, Form 4797 is used). Section 1256 traders don’t use Form 8949 — they rely on a one-page Form 1099-B showing their net trading gain or loss (“aggregate profit or loss on contracts”). Just enter that amount in summary form on Form 6781 Part I. If you have a large Section 1256 loss, consider a Section 1256 loss carryback election to carryback those losses three tax years, but only applied against Section 1256 gains in those years. If you want this election, check box D labeled “Net section 1256 contracts loss election ” on the top of Form 6781.

- Forex traders with Section 988 ordinary gains or losses who don’t qualify for TTS should use line 21 (other gross income or loss) on Form 1040. Traders who qualify for TTS should use Form 4797, Part II ordinary gain or loss. What’s the difference? Form 4797 Part II losses contribute to NOL carrybacks and carryforwards against any type of income, whereas Form 1040’s “other losses” do not. The latter can be wasted if the taxpayer has negative income. In that case, a contemporaneous capital gains election is better on the Section 988 trades. If you filed the contemporaneous Section 988 opt-out (capital gains) election, use Form 8949 for minor currencies and Form 6781 for major currencies. Forex uses summary reporting.

2. Maximize business expenses and fix Schedule C problems
Sole-proprietor business traders report business expenses on Schedule C and trading income/loss and portfolio-related income on other tax forms, which may confuse the IRS. It may automatically view a trading business’s Schedule C as unprofitable even if it has substantial net trading gains on other forms. This is one reason why I recommend an entity.

To mitigate this red flag, I advocate a special strategy to transfer a portion of business trading gains to Schedule C to “zero it out” if possible. Don’t report a net income on Schedule C as that would invite IRS computers to look for self-employment (SE) tax, which traders do not owe on trading income. (The exception is a full-fledged dealer/member of an options or futures exchange trading Section 1256 contracts on that exchange; they have self-employment income per Section 1402i.)

I strongly recommend that business traders always include well-written tax-return footnotes, explaining trader tax law and benefits, why and how you qualify for TTS (business treatment), whether you elected Section 475 MTM or opted out of Section 988, and other tax treatment, such as the income-transfer strategy. If you’re a part-time trader, use the footnotes to explain how you allocate your time between other activities and trading. Including footnotes with your return takes a step to address any questions the IRS may have about your qualification for TTS and the various aspects of its reporting on your return before it has a chance to ask you.

3. Use correct tax treatment of different financial products
Which financial products you trade and where you trade them can make a huge difference in tax savings. Capital gains vs. ordinary income: Most financial instruments — including securities, Section 1256 contracts, options, ETFs, indexes, precious metals and bitcoin held as a capital asset — are subject to capital gains treatment. By default, forex contracts and swap contracts are subject to ordinary gain or loss treatment. The distinction between ordinary and capital gains treatment makes a big difference.

The capital-loss limitation is a problem for traders and investors who may have trouble using up large capital-loss carryovers in subsequent tax years. Traders with TTS and a Section 475 MTM election have business ordinary-loss treatment, which is more likely to generate tax savings or refunds faster. Section 1256 contract traders enjoy lower 60/40 tax rates, summary reporting and no need for accounting.

4. Maximize benefits on an entity tax return
Partnership and S-Corp trading business tax returns show trading gains, losses and business expenses on one set of forms, plus the IRS won’t see the taxpayer’s other activities. That looks much better than a Schedule C.

Form 1065 is filed for a general partnership or multi-member LLC choosing to be taxed as a partnership. Form 1120S is filed for an S-corporation and an LLC electing to be taxed as an S-Corp. Forms 1065 and 1120S issue Schedule K-1s to the owners, so taxes are paid at the owner level rather than at entity level, thereby avoiding double taxation. Ordinary income or loss (mostly business expenses) is summarized on Form 1040 Schedule E rather than in detail on Schedule C (hence less IRS attention). Section 179 is broken out separately on Schedule E, along with unreimbursed partnership expenses (UPE) including home-office expenses.

Under the “trading rule” exception in Section 469 passive-activity loss rules, trading business entities are considered “active” rather than “passive-loss” activities, so losses are allowed in full. Portfolio income (interest and dividends) is passed through to Schedule B. Capital gains and losses are passed through to Schedule D in summary form. Pass-through entities draw less IRS attention than a detailed Schedule C filing. Net taxes don’t change; they’re still paid on the individual level. Pass-through entities file Form 8949 and/or Form 4797 at the entity level.

5. Maximize employee benefit plan deductions
S-Corps provide additional tax breaks including opportunities for employee-benefit plans including retirement plans and health-insurance premium tax deductions; two breaks sole-proprietor and partnership traders can’t use unless they have a source of earned income. Health insurance is a great deduction through a trader S-Corp because there is no payroll tax due on that portion of W-2 wages.

6. File and report tax elections on time
Tax treatment elections can be confusing because the Section 475 MTM and Section 988 elections don’t have tax forms. New taxpayers — such as a new entity — file Section 475 MTM elections internally within 75 days of inception, but existing taxpayers file a statement by the due date of the prior year tax return or extension with the IRS and perfect it later with a Form 3115 filing by the deadline. It’s too late to elect Section 475 for 2016 taxes; the next opportunity is for 2017, by Mar. 15, 2017 for existing partnerships and S-Corps, and Apr. 18, 2017 for individuals.

The forex Section 988 capital gains election is only filed internally on a contemporaneous basis, at any time during the year, from that date going forward.

7. Maximize investment expenses
If you’re filing as an investor, report trading gains and losses as explained earlier. You can’t elect and use Section 475 MTM with Form 4797 ordinary gain or loss treatment, as that election requires TTS.
Report investment interest expense (margin interest) on Form 4952. It’s limited to investment income and investment expenses, and the balance is an investment interest expense carryover to the subsequent tax year(s). The deduction is taken on Schedule A where it may be subject to the Pease limitation, but it’s deductible for alternative minimum tax.

Report investment expenses as miscellaneous itemized deductions on Schedule A. Miscellaneous itemized deductions are only allowed in excess of 2% of adjusted gross income (AGI). The allowed amount is subject to the Pease limitation, and it’s not deductible for AMT. Many states limit or do not allow itemized deductions. Business expense treatment with TTS is much better.

Investment expenses are allowed for the production of investment income. Investment expenses exclude home office, education, seminars, travel to seminars and startup expenses. Computers and monitors are allowed if they are predominantly used for managing investments.

Don’t sell yourself short on tax breaks available for traders this tax season.

This blog post is a modified excerpt from Green’s 2017 Trader Tax Guide.

Attend our related Webinar or watch the recording afterward: 7 Ways To Save On 2016 Tax Returns For Traders (Lightspeed Trading)ttg_cover-200x258_2017-1-200x258


CFDs: Tax & Regulatory Treatment

January 18, 2017 | By: Robert A. Green, CPA

On rare occasion, traders ask me how to report “Contracts For Difference” (CFD) trades on their U.S. resident income tax returns. CFD trading is widespread in the UK, with the primary purpose to avoid UK stamp duty tax on shares. More countries are flirting with financial transaction taxes (FTT), so CFD trading platforms may grow around the world.

Definition of a CFD
A CFD is a derivative; a contract between a buyer and seller based on the price of an underlying financial instrument, like a particular equity or futures contract. It’s a bet that the price of an asset will increase or decrease over a set period. Whichever party is underwater on the contract at closing date must pay the other party to settle the CFD contract. It’s not a security, commodity, or futures contract; it’s an off-exchange contract similar to forex.

Is CFD trading legal for American retail customers?
Some American retail customers trade CFDs with counterparties that are not registered with the Commodity Futures Trading Commission (CFTC) or another U.S. regulator to allow CFD trading by American retail customers. I asked the CFTC and National Futures Association (NFA) if that is legal, and both said CFTC regulations for American retail customers apply to counterparties, not American retail customers. Does that imply that CFD trading may be legal for American retail customers, and illegal for counterparties? Perhaps, yes, but I am not sure. It’s risky for American retail customers to trade CFDs because the CFTC may take enforcement action against their counterparties.

U.S. tax treatment of CFD trading
For U.S. tax treatment, CFDs are deemed to be swap contracts, with ordinary gain or loss treatment using the realization method. It’s not a capital gain or loss. Like with Section 988 forex, use summary reporting of trades listing the net trading “Other Income or Loss” on Form 1040 line 21. Report interest expense on long positions as margin interest expense: Business interest with trader tax status, and investment interest expense with investor tax status.

Foreign brokers do not issue a 1099-B tax report to customers or the IRS, and U.S. taxpayers are responsible for reporting all trading gains and losses in worldwide accounts, whether they take distributions from a foreign account or not.

If a trader bases the foreign account in foreign currency, then currency conversion issues apply. Section 988 forex rules apply to physically-held foreign currency, and the trader may not file a capital gains election on physical currency. Therefore, it’s ordinary gain or loss with the realization method, which means when the foreign currency is converted back into U.S. dollars.

Report foreign bank or financial accounts to U.S. Treasury
Foreign CFD trading accounts are subject to foreign bank and financial account reporting (FBAR) on FinCEN Form 114, e-filed annually with U.S. Treasury.

Swaps use ordinary gain or loss treatment
The Dodd-Frank financial regulations promised to clear private swap transactions on exchanges to protect the markets from another swap-induced financial meltdown — remember those credit default swaps with insufficient margin in 2008? When Dodd-Frank was enacted, traders’ hoped that clearing on futures exchanges would allow Section 1256 lower 60/40 capital gains tax treatment. They were wrong: Congress and the IRS immediately communicated that tax-advantaged Section 1256 would not apply to all types of swap transactions, and they confirmed ordinary gain or loss treatment. One exception: Futures swaps on U.S. commodities exchanges probably have Section 1256 treatment. Read Tax Treatment for Swaps, Options On Swaps, Futures Swaps, And Options On ETFs Partially Consisting Of Swaps.

Swaps use the realization method
Swap contracts are Section 1.446-3 “Notional Principal Contracts” (NPC) with ordinary gain or loss tax treatment using the realization method, not the mark-to-market (MTM) accounting method. The realization method means a trader does not report a taxable gain or loss until the position is closed (realized). Conversely, with MTM, a taxpayer reports realized and unrealized gains and losses at year-end.

Many active traders qualify for trader tax status, and they timely elected Section 475 MTM ordinary gain or loss treatment, but Section 475 MTM does not apply to NPC; Section 475 only applies to securities and commodities (Section 1256 contracts).

Regulations for counterparties working with American retail customers
The CFTC and SEC require counterparties offering leveraged financial products to American retail customers to register with the CFTC, SEC or another regulator. The CFTC considers a CFD contract based on the underlying price of forex, to be a CFD and not a forex contract. I don’t know any counterparties currently registered with a U.S. regulator for conducting business with American retail customers in CFDs.

The Dodd-Frank Act requires clearing of swap contracts for American retail customers on U.S. exchanges. For example, security-based swaps on Apple equity for retail investors clear on a U.S. securities exchange.

North American Derivatives Exchange, Inc. (“Nadex”), a US-based CFTC-regulated exchange offers binary options and spreads on stock indices, forex, commodities, and events. Nadex is a CFTC Designated Contract Market and Derivatives Clearing Organization. U.S. regulators do not allow American retail customers to trade on other domestic or foreign binary option trading platforms because they are off-exchange.

UK-based CFD brokers
I emailed a few UK-based CFD brokers and asked them if they do business with Americans retail customers. One said, “Unfortunately we don’t work with US citizens living in the US.” I asked why and he said, “There is a difference in the regulation in the US and UK. Therefore, we are not allowed to offer our service to US citizens.” Another UK CFD broker said something similar.

Taxes: Even if a CFD counterparty is in breach of U.S. regulations for American retail customers, which they do at their peril, the trader still owes taxes to the IRS on worldwide income, whether they repatriate funds back to the U.S. or not.

Proprietary trading firms
I recently heard about a foreign proprietary trading firm charging Americans for education in CFD trading. After completion of the curriculum, the company offers the student rights to trade CFDs in a sub-trading account. As an independent contractor (IC) prop trader, the firm pays the IC consulting fees based on their performance in the sub-trading account. There is no 1099-Misc from a foreign payor, but the fee income is taxable as ordinary income. I wonder if U.S. regulators would view this as CFD trading, or just consulting services.


Four Key Tax Due Dates And Two Elections For Professional Traders

January 11, 2017 | By: Robert A. Green, CPA

Forbes

Four Key Tax Due Dates And Two Elections For Professional Traders

Don’t wait until the last minute to prepare and file your 2016 tax returns; that’s stressful, and it leads to errors and over-paying. Get organized now and comply with the below list of Tax Due Dates.

Try to file and pay your individual tax returns well before the April 18, 2017 deadline. If you cannot, then file an automatic extension to receive six-months additional time. Caution: It’s only an extension of time to file, 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 the tax year 2016 based on your tax information received. (Learn more in my blog post Don’t Sweat The Tax Deadline, Just Get An Extension.)

Consider our excellent GNM Virtual Tax compliance service for traders and general clients.

Tax Due Dates

*Jan. 17, 2017:
- Q4 2016 estimated taxes are due. Many traders omitted or underpaid Q1, Q2 and or Q3 2016 estimated tax vouchers since they thought they could lose money later in the year. Now is the time to catch up based on actual profit or loss. Don’t overlook the “prior year safe harbor” rule: You only have to cover 100% of 2015 taxes, 110% if AGI was over $150,000, with the balance of 2016 taxes payable April 18, 2017.

*Jan. 31, 2017:
- Jan. 30 is the end of the 30-day period for calculating wash sale loss deferrals on closed securities trades in 2016. Be diligent in Jan. to avoid wash sales, which can increase your 2016 capital gains income.
- Prepare, issue and e-file W-2s for employees, and Form 1099-Misc for vendors and independent contractors of your business. (Accelerated due date, NEW this year).
- Fund 401(k) retirement plan elective deferrals for Dec. 2016.

*Mar. 15, 2017:
- 2016 S-Corp tax returns or extensions are due.
- 2016 Partnership tax returns or extensions are due (NEW this year, it used to be April 15).
- 2016 S-Corp or partnership Form 7004 extension filings allow for 6-months additional time to file until Sep. 15, 2017.
- 2017 S-Corp Election Form 2553 is due for existing S-Corps. Most states accept the federal election, but a few do not. (Traders need an S-Corp to unlock employee benefit plan deductions, including health insurance and retirement.)
- 2017 Section 475 election is due for existing S-Corp or partnership trading companies with trader tax status. (If you have significant Q1 2017 trading losses, you should seriously consider this election, even if you have a capital loss carryover to use up.)
- 2017 Section 475 revocation election is due for existing S-Corp or partnership trading companies.

*April 18, 2017: (the 15th is on the weekend)
- 2016 Individual tax returns or extensions are due with tax payments.
- 2016 Individual Form 4868 extension filings allow for 6-months additional time to file until Oct. 17, 2017.
- 2017 Section 475 election is due for existing individual taxpayers with trader tax status. (If you have significant Q1 2017 trading losses, you should seriously consider this election, even if you have a capital loss carryover to use up. You can form an entity right afterward to get back to capital gains treatment.)
- 2017 Section 475 revocation election is due for existing individuals.
- 2016 Traditional or Roth IRA and Health Savings Account (HSA) contributions are due.

Get organized

- Download 2016 tax information documents in PDF format and upload them in a secure and encrypted manner to your tax compliance service provider.
- Fill out questionnaires and follow checklists from your CPA firm.
- Accounting: Use an accounting solution or service customized to your needs, and catch up with annual accounting for 2016. Your accounting system should generate revenue, income, capital gains and losses, business expenses, itemized deductions, and home-office expenses. For entities, it should also produce the balance sheet including assets, liabilities and equity. Proper accounting saves tax preparation time, and it ensures maximizing tax deductions.
- Accounting for securities trading: Active traders should consider the GNM trade accounting service, whether you use the realization or Section 475 MTM method. Download transactions from brokers.

Consider the GNM virtual process

You don’t have to be a trader to benefit from our web-based virtual tax service, available to U.S. residents around the U.S. and the world. Since 1997, clients and the media recognize GNM Virtual Tax as the leading CPA firm for traders. We earned their recognition for two reasons: Valuable “trader tax” ideas and clients appreciating our efficient virtual process, delivering excellent customer experience and service. Learn more about GNM Virtual Tax and our virtual process.

Resources for the 2017 tax season

- Green’s 2017 Trader Tax Guide available in paperback and PDF format.
- Webinars: GreenTraderTax Webinars scheduled for Interactive Brokers, Lightspeed Trading, and others during Q1 2017.
- Events: Robert Green CPA is presenting a Workshop “Trader Tax Law” at the Traders Expo New York City on Feb. 28, 2017, at 8:00 am ET. Meet Mr. Green at our kiosk in the Exhibit Hall.
- Website content: Visit our Trader Tax Center, blog archive, Webinar recordings, Tax Tools and other content on our Website.

We wish you a successful tax season.

Darren Neuschwander CPA and Adam Manning CPA contributed to this blog post. 


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