April 2017

How To Make The Cut For Trump’s Business Tax Cuts

April 26, 2017 | By: Robert A. Green, CPA

Forbes

How To Make The Cut For Trump’s Business Tax Cuts

Imagine the gold rush that will happen if Trump’s tax plan to lower business tax rates to 15% comes to fruition. Employees will seek to recast themselves as a business, and active traders will try to get the business rate on trading gains. Don’t buy your gold picks and shovels until Congress and the President enact a bill; the devil will be in the details.

Under current law, the corporate tax rate starts at 15% on the first $50,000 of net income and the rate quickly rises to 35%. Imagine all corporate net income taxed at 15%, based on a territorial tax system.

Trump includes owners of pass-through entities (PTE) in his business tax cut plan, which most small businesses use, including LLCs taxed as partnerships or S-Corps. PTEs avoid double taxation by passing through income and loss to the owner’s tax return, where Trump’s individual tax rates will range from 10% to 35%. Trump narrows seven brackets to three: 10%, 25%, and 35%. Individual business owners may potentially save up to 20% on business income.

That’s a huge draw, and the media expects millions of taxpayers to consider reorganization of their businesses, jobs and other activities to cash-in on the Trump tax cuts for business. Treasury Secretary Steven Mnuchin said there would be limits to prevent freelance workers and wealthy taxpayers from misusing entities to benefit from the 15% business tax rate.

The IRS has rules for independent contractors vs. employees
For many decades, the IRS through the tax code, regulations, and audit manuals restrict employers and employees from restructuring as independent contractors (IC), operating as sole proprietors, LLCs or corporations. Employees have sought to reduce their 50% share of payroll taxes, unlock business expenses, home office deductions and high-deductible retirement plans. Employees currently have limited miscellaneous itemized deductions, which Trump’s plan fully repeals. Employers reduce their 50% share of payroll taxes, state unemployment insurance, workmen’s compensation and avoid providing expensive employee benefit plans including health insurance, retirement plan contributions and more. In an audit, the IRS or state tax authorities seek to reclassify ICs as employees. (Read Independent Contractor (Self-Employed) or Employee? and IRS 20 Factor Test – Independent Contractor or Employee?)

The IRS challenges hybrid relationships
Some highly-compensated employees will consider a hybrid structure: Remaining an employee for base salary and employee benefits and setting up a business for receiving performance pay like a bonus, which the employer recharacterizes as something else. For example, maybe house intellectual property (IP) in a PTE and lease it to the employer company in a separate business relationship. That sounds aggressive, and the IRS challenged these hybrid structures in the past.

Highly-paid employees will pay 35% tax rates on marginal income, while small businesses pay 15%. The 20% difference will encourage employees to pursue business dreams. Go for it, that’s the point!

S-Corps are useful for saving payroll taxes
Many technology workers qualify as ICs. They form an LLC to render services to several different clients and work with flexibility and control on a short-term project-by-project basis. That passes muster with the IRS for IC classification.

Most of these ICs select an S-Corp structure to take advantage of the S-Corp payroll tax reduction strategy. S-Corps don’t pass through self-employment income (SEI) to trigger self-employment tax (SE tax), the equivalent of the payroll tax, which includes Social Security and Medicare taxes. SE or payroll tax is 15.3% of wages up to the SSA base amount of $127,200 (2017 limit) and the 2.9% Medicare portion is unlimited. Partnerships pass through SEI.

The IRS knows about the S-Corp SE tax reduction loophole, and Democrats tried to repeal it during the Obama term. Maybe the Trump tax cuts will close this loophole since they are looking to close tax expenditures to help finance the lower business tax rate. To keep this tax break within reason, the IRS requires “reasonable compensation” for officer/owners with the related payroll taxes. Industry guidance suggests 25% of S-Corp net income paid as owner compensation.

Partnerships may become preferable
With Trump’s 15% business tax rate, business taxpayers may prefer a multi-member LLC filing a partnership return instead of an S-Corp. The IRS does not currently require partnerships to pay reasonable compensation because a service company filing a partnership return has SEI for working partners. (It’s conceivable that Trump tax cuts may require PTE to have a reasonable compensation for working owners, so some income is subject to the higher individual rate.)

When choosing between a partnership or S-Corp, compare payroll taxes, business taxes, and individual taxes and see which delivers the lowest total tax.

Traders may qualify for Trump’s business rate
If an active trader qualifies for trader tax status (TTS), they have business expense treatment as a sole proprietor filing a Schedule C. Traders report trading gains and losses on different tax forms: Schedule D for securities with the realization method and Section 1256 Contracts, and Form 4797 for Section 475 elections.

The IRS does not deem trading gains as “business income,” rather it’s income from a capital asset activity. It’s too early to tell if the Trump tax plan will allow trading income to qualify as business income in a PTE.

Trump’s tax plan continues the current long-term capital gains rate regime with a top rate of 20%. The plan also repeals the 3.8% Obamacare Net Investment Tax. The IRS should still tax short-term capital gains with ordinary tax rates.

TTS traders currently form an S-Corp to unlock employee benefit plan deductions including health insurance and retirement plan contributions.

Many PTE elect Section 475 MTM ordinary gain or loss treatment to be exempt from capital loss limitations and wash sale loss adjustments. Even if the Trump business tax cut definition of business income doesn’t include short-term capital gains from active trading, I hope a PTE with TTS can treat Section 475 MTM ordinary income as business income, which makes more sense.

Traders may benefit from a dual entity solution
If the Trump business tax cuts don’t allow trading gains, then consider a dual entity solution. A partnership trading company that pays administration and license fees for IP to a management company structured as a partnership or S-Corp. The management company should benefit from the business tax rate as it receives fees not trading income. Report trading business expenses on the trading partnership, not the management company to maximize net business income. Fees must be reasonable, which puts a cap on them.

Individual tax return changes
Trump’s tax plan repeals many deductions, including all itemized deductions other than mortgage interest and charitable contributions. Mnuchin mentioned allowing retirement plan deductions but did not mention health insurance deductions, both of which are not itemized deductions.

Commentators complained about the repeal of state and local taxes which could spur upper-income individuals to move to tax-free states which lean Republican. The current AMT tax regime doesn’t allow state and local tax deductions, which has already significantly reduced these deductions for upper-income taxpayers. The Trump plan repeals the AMT tax.

Repeal of investment expenses
The investment management industry will be upset about the apparent repeal of investment interest and investment expense deductions, both itemized deductions. Trump campaigned on repealing “carried interest” tax breaks for hedge fund and private equity fund managers. That may reclassify “profit allocations” of capital gains into investment advisory fees. Investors won’t get a tax deduction for management fees and incentive fees.

Traders don’t have investment expense treatment; they have business expense treatment including margin interest, stock borrow fees, home office deduction, education and much more.

Trader tax status and Section 475 MTM is currently a big tax saver, and it should become even more so in the Trump tax cuts. Stay tuned!

Darren Neuschwander CPA contributed to this blog post. 


If You Can’t Deduct All Your Trading Losses Consider Section 475 Election

April 6, 2017 | By: Robert A. Green, CPA

Forbes

If You Can’t Deduct All Your Trading Losses Consider Section 475 Election

Individuals qualifying for trader tax status (TTS) with a significant trading loss in the first quarter of 2017, should consider a 2017 Section 475 MTM election, due by April 18, 2017. (S-Corps and partnerships had to make this election by March 15, 2017.) Profitable traders should consider the election, too.

Avoid loss limitations including a $3,000 capital loss limitation for 2017, capital loss carryovers to 2018, and wash sale loss adjustments. The Section 475 election converts capital losses into unlimited ordinary business losses, which may generate tax savings immediately. For example, a $50,000 Section 475 ordinary loss offsets wage income without limitation, whereas a capital loss is limited to $3,000 against other income, including wages. I refer to Section 475 as “tax loss insurance,” and it’s one of the most attractive tax benefits for TTS traders. April 18th is the deadline, so make the right decision and act fast.

Here are two scenarios where the election is wise

1. TTS individual trader has trading losses of $50,000 for Q1 2017, comprised of $25,000 losses in securities, and $25,000 losses in futures (Section 1256 contracts). He also has a capital loss carryover of $100,000 from 2016 into 2017.

Starting the year 2017, this trader hoped to generate capital gains to use up his capital loss carryover, figuring the next $100,000 of capital gains is tax-free. But, things went awry, and he generated trading losses in 2017.

Smart move: File a 2017 Section 475 MTM election on securities and Section 1256 contracts by April 18, 2017. It doesn’t make sense adding to a significant capital loss carryover. Next, create an LLC trading company, which files a partnership or S-Corp tax return. That entity may generate capital gains to pass through to the individual level to use up the $100,000 capital loss carryover. If the trading entity incurs trading losses, it can elect Section 475 internally, within 75 days of its inception. Plan to revoke the individual Section 475 election on Section 1256 contracts by April 15, 2018, for 2018.

2. TTS sole proprietor trader has trading gains of $40,000 for YTD 2017 in securities and Section 1256 contracts. She does not have a capital loss carryover or unrealized capital losses, so she has a clean slate for electing Section 475. She also trades IRA accounts, so she faces a potential wash sale loss problem. If she incurs a trading loss in her taxable trading account and buys back a substantially identical position 30-days before or after in her IRA account, she will never get the benefit of that tax loss in either taxable or IRA accounts. That’s far worse than a deferred wash sale loss at year end. (Broker 1099Bs don’t account for wash sales between taxable and IRA accounts, whereas the IRS requires taxpayers to do so.)

Smart move: File a 2017 Section 475 MTM election on securities only, not including Section 1256 contracts, by April 18, 2017. She retains lower 60/40 capital gains tax rates on Section 1256 contracts, with 60% being a long-term capital gain taxed at lower rates. The Section 475 election on securities exempts her from wash sale loss adjustments in her taxable accounts, which also prevents wash sale losses with her IRA trading accounts. If she incurs a significant trading loss later in the year in her taxable accounts, she will be glad to have ordinary loss treatment rather than a capital loss limitation.

Section 475 MTM election statement
Type the below statement on a sheet of paper with your name and social security number (or entity EIN) up top.

“Under IRC 475(f), the Taxpayer at this moment elects to adopt the mark-to-market method of accounting for the tax year ended Dec. 31, 2017, 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 want to include Section 1256 contracts, modify the language accordingly. For external Section 475 MTM elections, this is just the first part of the election process – and the most important part. You also have to file a timely 2017 Form 3115 with your 2017 tax return in 2018 (with a duplicate copy to the IRS National Office).

Learn more about Section 475 MTM in Green’s 2017 Trader Tax Guide. There are many nuances, myths, and scenarios to consider.

Section 475 could be an important election for you, so get it right! Don’t be one of the thousands who complain they missed the boat, which sails on April 18th or messes up the process. If you already filed your 2016 tax return or extension, you should send the IRS a letter by April 18, 2017, explaining you left out the election. Consult a trader tax expert, preferably us.


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