June 2017

How To Maximize Tax Savings Using Tax-Favored Health Plans

June 20, 2017 | By: Robert A. Green, CPA


Read it on Forbes

Health insurance premiums, deductibles, and out-of-pocket expenses skyrocketed in recent years with some families paying over $ 30,000 annually. It’s unfortunate that many traders and investors receive few tax breaks on deducting these costs, whereas many business owners and employees deduct or exclude them from gross income.

Deductibles for Obamacare bronze plans are now almost as high as the health insurance premium itself. Don’t just focus on deducting premiums; consider using a tax-favored health plan to maximize tax savings on deductibles and out-of-pocket spending, too.

In this blog post, I show traders eligible for trader tax status (TTS) how to deduct all health care expenses using the right choice of entity and tax-favored health plan.

Investors, who are not eligible for TTS, don’t have earned income so they may not deduct health insurance premiums above the line from gross income. But investors and other taxpayers may contribute to a health savings account (HSA) for a deduction from gross income. The IRS does not require earned income for an HSA deduction.

As a last resort, investors may attempt to deduct health care costs as medical itemized deductions, below the line, limited to a 10% income threshold and AMT preferences, which may lead to no tax deduction at all.

Tax-Favored Health Plans
In IRS Pub. 969, the IRS covers four types of tax-favored health plans: health savings accounts (HSAs), health reimbursement accounts (HRAs), health flexible spending arrangements (FSAs), and medical savings accounts (Archer MSAs and Medicare Advantage MSAs). The IRS phased out medical savings accounts after 2007. Health FSAs are voluntary salary reduction agreements, and the annual limit is just $2,550 (2016 limit). In this article, I focus on HSAs and HRAs.

I recommend an HSA for both TTS traders and investors with high-deductible heath insurance plans and significant out-of-pocket expenses. All taxpayers may deduct HSA contributions from gross income whether they are a TTS trader, another business, or an investor.

For TTS traders with out-of-pocket costs well more than HSA limits, I recommend an HRA in a C-Corp management company, alongside a trading partnership. The dual entity allows a retirement plan deduction, too.

A married TTS trader who doesn’t want a retirement plan can employ his or her spouse with a stand-alone HRA to cover family health insurance and out of pocket spending.

To deduct health insurance premiums, TTS traders filing single need an S-Corp trading company or C-Corp management company. Sole proprietor traders cannot deduct health insurance premiums unless they are married and hire their spouse with an HRA that includes health insurance premiums.

Health Savings Accounts
An HSA is a tax-exempt trust or custodial account set up with a qualified HSA trustee to pay or reimburse qualified medical expenses. It’s a similar concept to an individual retirement account (IRA). There is an annual HSA tax-deductible contribution limit. Funds withdrawn for anything other than covering qualified medical expenses is considered taxable income and may be subject to an additional 20% tax. File Form 8889 to report the HSA activity as part of your tax return.

The 2017 annual tax-deductible contribution limit for HSAs is $3,400 for single and $6,750 for family coverage. Taxpayers must also have a qualified high-deductible health plan (HDHP) with minimum essential coverage.

You are entitled to build up your HSA and cover out-of-pocket health care expenses when needed, which may be years later. Some traders forgo reimbursing medical expenses to grow their HSA account tax-free, especially if their custodian offers direct access trading. The IRS may force these taxpayers to reimburse medical costs, so save receipts since you established the HSA.

I view an HSA as tax-favored self-insurance to cover high deductibles. It provides tax advantages to all taxpayers including investors and TTS traders organized as a sole proprietor, partner, S-Corp or C-Corp management company. The IRS does not require earned income for an HSA deduction as it does for deducting health insurance premiums. The HSA compliments high-deductible Obamacare plans. When you shop for a health insurance plan, see if it’s HSA compatible, which makes it relatively easy to set up and maintain.

Health Reimbursement Accounts
An HRA is designed for employers to reimburse employees for individual health insurance plans and out-of-pocket costs. It’s a tax-free fringe benefit to the employee, entirely funded by the employer.

Self-employed persons aren’t eligible for HRAs. That means an HRA is appropriate for a C-Corp management company that hires the owner as an employee, or a sole proprietorship that employs the owner’s spouse as an employee. A sole proprietorship cannot hire the owner as an employee.

S-Corps and partnerships treat 2% owners and their spouses as self-employed, not employees, which means that 2% owners of pass-through entities won’t be able to deduct HRA payments from income.

On Dec. 13, 2016, President Obama signed the 21st Century Cures Act, which reauthorized qualified small employer health reimbursement arrangements (QSE-HRA) in companies with fewer than 50 employees, starting Jan. 1, 2017.

Before the Cures Act, Obamacare considered small employers not offering group insurance taboo and subjected them to significant Obamacare penalties if the company used an HRA to reimburse employees for individual insurance coverage. Obamacare wanted to incentivize small employers to offer group health insurance coverage. Obamacare compelled large enterprises with 50 or more employees to offer group plans to employees.

This Obamacare incentive didn’t work out as intended so to help get coverage for small business employees; Congress passed the Cures Act with several requirements. The employer must not offer group insurance to any employee. Employees must have individual insurance meeting minimum essential coverage to exclude HRA benefits from income, and employees cannot double dip (i.e., receive both HRA benefits and Obamacare-exchange subsidies or credits).

Another requirement is QSE-HRA plans have limitations on annual spending: $4,950 for employee-only coverage and $10,000 for family coverage. These limits make sense, as Congress wants to keep a lid on the alternative solution.

It’s different for stand-alone HRA plans with one employee. In this case, there is no limit on HRA spending per year. Most TTS traders qualify for a one-employee HRA since they don’t have outside employees. IRS Pub. 969 states there is no limit on HRAs, and I assume they mean the one-employee or stand-alone HRA.

Selecting a Health Plan
Which entity and tax-favored health plan you select depend on how much you expect to spend per year on health care expenses, not paid by your health insurance carrier. In 2017, the maximum allowable out-of-pocket costs for deductibles, co-payments, and co-insurance is $7,150 for single coverage and $14,300 for families.

The preferred entity solution for most TTS traders is an S-Corp. Hopefully, the HSA is adequate for their needs, since the HRA does not work for a 2% S-Corp shareholder. (2% shareholder or partner means if you own 2% or more of the equity, you are a 2% shareholder.)

If a TTS trader wants an HRA and retirement plan, he or she ought to consider a dual entity solution: a trading partnership and C-Corp management company to arrange HRA and retirement tax benefits. If a TTS trader already has an S-Corp, they can switch it to a C-Corp.

2% S-Corp Shareholder Rule
Per Thomson Reuters Checkpoint tax publisher, “Although no direct authority exists, the authors believe that medical benefit payments to 2% shareholders under a self-insured plan (Section 105 HRA) are deductible by the S corporation and includible in the shareholders’ income under Rev. Rul. 91-26. Since the plan is not insured, the benefits cannot be excluded from income under IRC Sec. 104(a)(3) [ Reg. 1.105-5(b) ].

“Regulation 1.105-5(b)(b) Self-employed individuals. Under section 105(g), a self-employed individual is not treated as an employee for purposes of section 105. Therefore, for example, benefits paid under an accident or health plan as referred to in section 105(e) to or on behalf of an individual who is self-employed in the business with respect to which the plan is established will not be treated as received through accident and health insurance for purposes of sections 104(a)(3) and 105.”

The 2% S-Corp shareholder and 2% partner rules in Section 105 are determined by lineal descendant rules, which means they apply to the taxpayer’s spouse, children, and parents. These attribution rules don’t apply to a sole proprietorship or C-Corp, just to pass-through entities like the S-Corp and partnership. A Schedule C or C-Corp can hire a spouse, but a pass-through entity cannot for purposes of establishing an HRA.

Sole Proprietorship
Sole proprietor TTS traders filing a Schedule C are self-employed, and the IRS does not permit the owner to be an employee. Being self-employed, the owner cannot have an HRA. Sole proprietor TTS traders do not have self-employment income from trading, so they cannot deduct health insurance premiums. They wind up with no deduction for these expenses from gross income.

There is a solution for married traders: The sole proprietor employs his or her spouse, who can have a one-employee HRA that covers family health insurance premiums and out-of-pocket spending. The spouse must perform significant and legitimate work for the trading business.

Cash wages to the spouse are subject to payroll taxes, but the HRA benefits are exempt from payroll tax. The Schedule C deducts the HRA payments to the husband or wife, and the spouse excludes those payments from income.

There are some disadvantages. The sole proprietor trader cannot have a retirement plan contribution since he or she does not have self-employment income from trading gains. (One exception: If the trader is a full member of a futures or options exchange trading Section 1256 contracts on that exchange, it is self-employment income under Section 1402i.) The spouse can have a retirement plan contribution on her wage income. The owner is forgoing a retirement plan deduction that can be up to $60,000 per year for a Solo 401(k) plan for a trader age 50 or older. (A retirement plan for the owner is possible with an S-Corp or C-Corp management company.)

There is an IRS red flag from the spouse’s wages and HRA expenses. They could expand the Schedule C loss by $25,000, more or less, which may attract IRS attention, especially if the trader has trading losses reported on other tax forms. In community property states like California, the IRS might view the trading business as jointly owned, which means the spouse cannot have compensation and the HRA.

A non-trader sole proprietor may save self-employment (SE) taxes by including health insurance premiums in the HRA plan. There’s plenty of room with an unlimited one-employee HRA. It makes the health insurance a business deduction rather than an AGI deduction. A business deduction reduces self-employment income (SEI) and SE tax, whereas an AGI deduction does not. SE tax is 15.3% of the base amount of $127,200, and 2.9% unlimited Medicare tax. Sole proprietor traders don’t owe SE tax on trading income, so these SE tax savings do not apply to them.

A 2% partner in a partnership has the same problem as a 2% S-Corp shareholder: HRA benefits are taxable income. TTS traders don’t pay guaranteed payments (compensation) in a partnership because it’s difficult to achieve self-employment income for unlocking a retirement plan contribution as partnerships pass through ordinary losses to the owner’s tax return. TTS traders use an S-Corp to pay officer compensation. (See the chapter on entities in Green’s 2017 Trader Tax Guide.)

A C-Corp may hire the owner or spouse for a one-employee HRA for family coverage.

A C-Corp is a poor choice of entity for a trading company. There is potential double taxation, losses get trapped on the C-Corp level, Section 1256 lower 60/40 tax rates don’t apply on a C-Corp, and there isn’t a $3,000 capital loss allowed against other income. A C-Corp investment company may not deduct Section 212 investment expenses. Some TTS traders use a C-Corp as a management company in conjunction with a trading partnership.

Partnership with C-Corp using an HRA
The ideal solution for a single TTS trader using an HRA, or a married TTS trader using an HRA and retirement plan, is a dual entity structure. A trading partnership and a C-Corp management company with a one-employee HRA plan.

The dual entity solution is right for states and cities that tax S-Corp income like California, Illinois, and New York City.

The partnership pays only a portion of its trading profits to the C-Corp, and the C-Corp pays officer compensation, health insurance premiums, HRA benefits, and retirement plan contributions. With the trading partnership retaining the majority portion of profits, the C-Corp limits double taxation.

It’s a challenge to arrange for the right amount of income in the C-Corp for covering these planned expenses. The C-Corp can be an owner of the partnership and receive a profit allocation plus an administration fee to achieve targeted income. It’s hard to defend higher fees, so the profit allocation is necessary. Keep up formalities between the entities, so the IRS respects the dual entity structure.

If the owner is in a low tax state, consider leaving profits in the C-Corp, which looks better and takes advantage of the 15% federal tax rate on the first $50,000 of C-Corp net income.

The Potential Impact of Tax Reform
Congress may lower C-Corp tax rates for all tax brackets. It also may lower tax rates on business income in pass-through entities, but it’s not clear yet whether trading gains will qualify for business tax rates. I expect that revenue from management fees will be business income, which qualifies for the lower rates.

Tax writers indicated they would safeguard tax benefits for health care expenses and retirement plan contributions. With escalating health care costs, it would be disruptive for Congress to repeal the health care tax exclusions or deductions. Repealing and replacing Obamacare could impact these tax planning strategies.

If you are interested in deducting health insurance premiums and out-of-pocket health care expenditures with an HSA or HRA, contact us for more information.

Postscript June 22, 2017: 
Senate Republicans unveiled their health care bill which improves tax-favored health plans, expanding contribution limits and reducing taxes on excess distributions. Section 121 of the bill raises the annual tax-deductible contribution to health savings accounts (HSAs) to the amount of deductible and out-of-pocket limitation. Current HSA limits are $3,400 for single and $6,750 for family coverage (2017 limits), which left a doughnut hole for many taxpayers since deductibles, and out-of-pocket costs average $7,150 for self-only coverage and $14,300 for families. The Senate bill fixes this problem by covering the costs not paid by a health insurance carrier. All taxpayers may contribute to an HSA, and with expanded limits, there is less need for a health reimbursement account (HRA).

Darren Neuschwander, CPA contributed to this blog post.


How To Avoid An IRS Underpayment Penalty For June 15

June 9, 2017 | By: Robert A. Green, CPA


Read it on Forbes

There are two important tax deadlines for individuals on June 15: quarterly estimated income taxes for 2017, and the 2016 tax deadline for U.S. residents living outside the U.S.

Excerpts from 2017 Federal Tax Calendar IRS Tax Due Dates for the 2017 Calendar Year:

“Individuals: If you are a U.S. citizen or resident alien living and working (or on military duty) outside the U.S. and Puerto Rico, file your 2016 income tax return (Form 1040) and pay any tax due. If you want a 4-month extension of time to file your return, use Form 4868 to extend your filing deadline to October 16. (The IRS grants the above individuals two additional months to file compared to U.S. residents living and working in the U.S. who had to file income tax returns or extensions by April 18, 2017.)”

“Individuals: If you are not paying your 2017 income tax through withholding (or you will not pay enough tax during the year that way), pay the second installment of your 2017 estimated tax. Use Form 1040-ES (Estimated Tax for Individuals). For more information, see IRS Publication 505 (Tax Withholding and Estimated Tax).” (Read a brief IRS explanation What Is Estimated Tax & Who Does It Apply To?.)

The four quarters for estimated taxes are:

• Q1: Jan. 1 — March 31, deadline is April 18, 2017

• Q2: April 1 — May 31, deadline is June 15, 2017

• Q3: June 1 — Aug. 31, deadline is Sept. 15, 2017

• Q4, Sept. 1 — Dec. 31, deadline is Jan. 15, 2018

Exceptions: Generally, you do not have to pay an underpayment penalty if either: Your total tax is less than $1,000, or you had no tax liability last year.

Estimated tax safe harbor rule. If your 2016 adjusted gross income (AGI) was more than $150,000 ($75,000 if you are married filing a separate return), you must pay the smaller of 90% of your expected tax for 2017 or 110%* of the tax shown on your 2016 return to avoid an estimated tax penalty. (*If your AGI is under these high-income thresholds, cover 100% of the prior year.)

Underpayment penalty: Traders with 2017 year-to-date trading gains should consider making quarterly estimated tax payments during the year to avoid an underpayment penalty. For 2016, the underpayment penalty rate was 4%. Some traders think this a reasonable price, sort of like another margin loan from a broker. But, the underpayment penalty is not tax deductible, whereas margin interest is.

Consider using the “Annualized Income Installment Method” if that generates a better result than the “Regular Method.” If you make the bulk of your trading income at the end of the year, the annualized method is better. (See the instructions for Form 2210 Underpayment of Estimated Tax by Individuals, Estates, and Trusts.)

Three common scenarios for traders:

1. You left a high-paying job in late 2016, and your only activity for 2017 is trading, with significant profits year-to-date (YTD). It’s probably wise to make a Q2 estimated tax payment. If you did not pay a Q1 estimate and you don’t have an overpayment credit from 2016, then pay enough for Q2 to catch up for YTD. Under the safe harbor rule, covering your 2016 tax liability will be a substantial amount. Determine whether it’s preferable to pay 90% of 2017 taxes if that is a lower cost. The software used for preparing your 2016 tax return can generate the estimated tax payment vouchers based on the safe harbor exception or 90% of the current year. The state estimated tax rules vary, some require a different percentage for the current year vs. the federal 90%.

2. Your income tax liability for 2016 was small, and you have significant trading gains in 2017. Assume the safe harbor rule is best and cover the prior year tax liability.

3. You have trading losses in 2017. You may not owe estimated taxes for Q2 2017.

Traders face a quandary with estimated taxes:
If you pay what you owe for Q2, you may regret it with trading losses later in the year. You’ll be stuck waiting for a tax refund or applying an overpayment credit towards 2018 taxes. You won’t have that money available for trading capital for the remainder of 2017. Many traders don’t make estimated tax payments until Q3 and or Q4 when they have more visibility on trading results.

Loophole for S-Corp traders:
Traders eligible for trader tax status often use an S-Corp to deduct health insurance premiums and retirement plan contributions. They need to execute officer compensation through payroll in Dec. 2017 to unlock those employee benefits. Traders can withhold a significant portion of their salary as federal and state withholding tax. That alleviates estimated income taxes due. The loophole is that the IRS treats payroll tax withholding reported on a Form W-2 as made throughout the year, even though it’s all withheld in December.

Tax reform:
Congress and President Trump are working on tax reform in 2017, and considering delays; I expect changes won’t be effective until 2018. There’s a small chance Congress could make tax reform retroactive to 2017, which would change 2017 estimated tax payment calculations. I think individuals should make 2017 Q2 estimated tax payments based on current tax law. Let’s see if there is any concrete news on tax reform before the Q3 deadline of Sept. 15, 2017.

Our clients should contact their assigned CPA if they need help with 2017 quarterly estimated tax vouchers.


How To Become Eligible For Trader Tax Status Benefits

June 5, 2017 | By: Robert A. Green, CPA


Click to read on Forbes.

Trader tax status (TTS) drives many key business tax breaks like business expenses, business ordinary trading losses with the Section 475 election and through an S-Corp, employee benefit deductions for retirement plans and health-insurance premiums. These items are deducted from gross income without restriction, whereas investment expenses are subject to itemized deductions, AMT preferences, and Pease limitations, and there are limitations on capital losses and wash sale loss deferral adjustments. Unfortunately, only a small fraction of active traders qualify for TTS, and the rules are vague and confusing to understand. In this blog post, learn how to be eligible for TTS.

TTS is good before and after tax reform:
Congress and President Trump are working on tax reform in 2017, and considering delays; I expect changes won’t be effective until 2018. Don’t wait for concrete plans, get started on 2017 tax planning based on current law, and hopefully, tax reform will favor your planning.

TTS is a case in point: It works perfectly for 2017, and tax reform should be the icing on the cake offering a lower tax rate on business income, hopefully, available to a TTS company. Tax reform may also repeal investment expense deductions, thereby making TTS even more attractive. (Read Consider Smart Tax Moves Now That Work With Possible Reform).

The first step is to determine if you qualify for TTS. If you do, you can claim some tax breaks such as business expense treatment after the fact, and make an election and set up other breaks — like Section 475 MTM and employee-benefit plans — on a timely basis.

There’s no election for TTS:
There’s no election for TTS; it’s an optional tax status based on facts and circumstances. A trader may qualify for TTS one year but not the next. It’s analogous to taking bread out of the oven each year to see if it rose to the level of bread (TTS) or if it’s flat bread (investor tax status). If you elected Section 475 and later don’t qualify for TTS, you must suspend use of Section 475 treatment until you requalify since Section 475 is conditional on qualification for TTS.

You can also qualify for TTS for part of a year. Perhaps you qualified for TTS in 2016 and quit or suspended active trading on June 30, 2017. Or you began active trading on July 1, 2017. Include the period of qualification on Schedule C or the pass-through entity tax return and deduct business expenses during that part-year period. If elected, use Section 475 for the TTS time, too.

TTS uses business expenses:
Qualifying for TTS means you can use business treatment for trading expenses as opposed to the default investment treatment. Business expense treatment under Section 162 gives full ordinary deductions, including home-office, education, Section 195 start-up expenses, Section 248 organization expenses, margin interest, tangible property expensing, Section 179 (100%) depreciation, amortization on software, seminars, market data, stock borrow fees and much more. (Watch my Webinar recording Top 11 Tax Deductions For Active Traders and see how a TTS trader has tax savings of $38,500 vs. an investor with no savings.)

Conversely, investment expenses don’t allow home-office, education, start-up, and organization costs, and they are only allowed as a miscellaneous itemized deduction in excess of 2% of adjusted gross income (AGI), and not deductible against the alternative minimum tax (AMT). The IRS further restricts investment expenses with the “Pease” itemized deduction limitation for taxpayers with AGI’s over $313,800 (married) and $261,500 (single), based on 2017 thresholds. Many states limit itemized deductions too. The bottom line is business expense treatment is much better.

You can claim TTS after year-end; you don’t need to make an election in advance like Section 475 MTM and the forex election to opt out of Section 988. You can claim TTS for the tax year that just ended and even for the prior three tax years with amended returns by including a Schedule C as a sole proprietor on individual accounts or for entities by changing the character of expenses on Schedule K-1s. (Note: Filing amended tax returns may increase your odds of IRS questions or exam so be sure of your status.)

Full-time traders often qualify for TTS, but it’s harder for part-time traders. The bar is raised in the eyes of the IRS — especially if you have significant trading losses with business ordinary loss treatment (Section 475) rather than capital loss limitations.

IRS case law and Publication 550:
It’s not easy to be eligible for TTS. Currently, there’s no statutory law with objective tests. Subjective case law applies. Leading tax publishers have interpreted case law to show a two-part test:

1. Taxpayers’ trading activity must be substantial, regular, frequent and continuous.

2. The taxpayer must seek to catch the swings in the daily market movements and profit from these short-term changes rather than profiting from the long-term holding of investments.

IRS agents often refer to Chapter 4 in IRS Publication 550, “Special Rules for Traders.” Here’s an excerpt: The following facts and circumstances should be considered in determining if your activity is a securities trading business.

– Typical holding periods for securities bought and sold.
– The frequency and dollar amount of your trades during the year.
– The extent to which you pursue the activity to produce income for a livelihood
– The amount of time you devote to the activity.

The IRS does not define the words “substantial, regular, frequent, and continuous” and case law also doesn’t give a bright-line test with exact numbers.

My Golden Rules on how to qualify for TTS:
I base my Golden Rules on trader tax court cases and our CPA firm’s vast experience with IRS and state controversy for traders. The trader:

Trades full time or part time, all day, every day. Part-time and money-losing traders face more IRS scrutiny and individuals face more scrutiny than entities. Full-time options traders actively trading significant portfolios may not qualify because they don’t have enough volume and frequency and their average holding period is over 31 days. On the other hand, a part-time trader with a full-time job may qualify as a day and swing trader in securities meeting all my golden rules.

Hours: Spends more than four hours per day, almost every market day working on his trading business. All time counts, including execution of trade orders, research, administration, accounting, education, travel, meetings, and more. Most active business traders spend more than 40 hours per week in their trading business. Part-time traders usually spend more than four hours per day. In one tax exam our firm handled, the IRS agent brought up “material participation” rules (Section 469), which require 500 hours of work per year (as a general rule). Most business traders easily surpass 500 hours of work. However, Section 469 doesn’t apply to trading activities, under its “trading rule” exemption. Without this exemption, taxpayers could generate passive activity income by investing in hedge funds and the IRS did not want that.

Few to no occasional lapses: The IRS has successfully denied TTS in a few tax court cases by arguing the trader had too many breaks in trading, such as taking several months off during the year. Traders can take vacations, sick time, and personal time off just like everyone else. Some traders take a break from active trading to recover from recent losses and learn new methods and markets. Explain these breaks to the IRS in tax-return footnotes. Retooling and education during an occasional break may be acceptable. Keep good records of your time spent.

Frequency: Executes trades on close to four days per week, every week. It’s wise to prevent an IRS challenge by trading close to four days per week or 75% of available trading days — even if you need to make smaller executions with reduced risk on otherwise non-trading days. It’s not a good idea to have the tax tail wag the dog, and any trading you do for TTS should have an actual economic risk.

Holsinger, Assaderaghi, Endicott and Nelson, options traders with less activity than equity or futures traders, only traded around 40% of available trading days, which is two days per week. Three days per week may be cutting it too close, so try to get closer to four. While we feel the IRS should also count working days when you don’t have an execution, it currently does not as evidenced by the Assaderaghi, Endicott and Nelson cases.

Volume: Makes 720 total trades per year (Poppe court) on an annualized basis. If you start July 1, then you need 360 executions, half of the 720. The court mentioned Poppe having 60 trades per month as being sufficient volume. Count the buy and sell, or open and close, as two total trades.

The markets are open approximately 250 days per year, and with personal days and holidays, you might be able to trade on 240 days. With a 75% frequency, you would trade on 180 days per year, so 720 total trades divided by 180 trading days equals four trades per trading day.

Some traders scale into trades and executions are broken down into smaller lot sizes. Options traders have multi-legged positions on complex trades. We believe you may count each trade confirmation of a complex trade, providing you make the executions separately, although this has not come up in tax court cases. If you initiate a trade and the broker breaks down the lot sizes without your involvement, the IRS may reject counting the extra volume of trades in this case.

Forex and futures trades aren’t listed line by line on tax returns (unlike securities trades), so the IRS doesn’t see those numbers. Report an actual number in your tax return footnotes about TTS.

Proceeds: Have proceeds in the millions of dollars per year on equities. More traders are using options and futures, which have lower proceed values. Explain this well in footnotes since proceeds for futures and forex are not reported on 1099s, and the IRS won’t see the proceeds amount. Proceeds on a Form 1099-B provide the IRS with a quick indication about qualification for TTS.

Holding period: Over the years, the IRS stated that holding period is the most important factor, and in the Endicott court, the IRS said average holding period must be 31 days or less. That’s a bright-line test and the only one.

Active traders usually make day trades or swing trades. Don’t hold many trading positions over a month, unless you segregate them as investments. Exclude investments from average holding period calculations. Investment positions are also not subjected to MTM in Section 475 (if elected), which then allows for deferral at year-end and perhaps lower long-term capital gains tax rates if held 12 months.

Options traders may have average holding periods of over one month if they trade monthly options and keep them open for one or more months. (Note: Holsinger was an options trader and his holding periods averaged between one to two months.)

Many options traders qualify for TTS by trading weekly options, thereby shortening their average holding periods to under 31 days. Their other challenge is frequency, as many still only execute trades on two to three days per week, rather than the requirement closer to four days per week. It’s a challenge for options traders to be that frequent. Some fill in the blanks by trading securities, futures and or forex.

Intention: Has the plan to run a business and make a living. You must have the intention to run a separate trading business — trading your money — but it doesn’t have to be your exclusive or primary means of making a living. The key word is “a” living, which means it can be supplemental income for your livelihood.

Many traders enter an active trading activity while still performing their full-time job. It’s possible to carry on both activities simultaneously using advances in technology and flexible job schedules.

It’s not a good idea to try to achieve TTS within a business entity already principally conducting a different type of business activity. It’s better to form a new trading entity. Trading an existing business’s available working capital seems like a treasury function and sideline, which can undermine trader tax status.

While filing as a sole proprietor on a Schedule C is allowed and used by many, it’s not the best tax filing strategy. Your tax return shows your job and other business activities or retirement, and that may undermine TTS in the eyes of the IRS. The IRS tends to think trading is a secondary activity, and they may seek to deny TTS. It’s best to form a new, separate entity dedicated to trading only.

Operations: Has significant business equipment, education, business services and a home office. Most business traders have multiple monitors, computers, mobile devices, trading services and subscriptions, education expenses, high-speed broadband, wireless and a home office. Some have staff. The IRS needs to see that you have a serious trading business operation. How can you run a business without an office? Casual investors rarely have as elaborate an office set up as business traders do. Why would a long-term investor need multiple monitors? If you use the office exclusively for business rather than personal use, don’t skip reporting a valid home-office deduction.

Account size: Securities traders need to have $25,000 on deposit with a U.S.-based broker to achieve “pattern day trader” (PDT) status. With this status, they can day trade using up to 4:1 margin rather than 2:1. Without PDT status, securities traders, which include equities and equity options, can’t day trade and they will have a hard time qualifying for TTS. The $25,000 amount seems substantial enough to impress the IRS.

Many new traders don’t want to risk $25,000 on day trading securities; they prefer to trade futures or forex, all allowing mini-account sizes of $5,000 or less. A small account size won’t impress the IRS — you probably need more capital to qualify. We like to see over $15,000 for futures or forex accounts.

What doesn’t qualify for TTS:
Three factors don’t qualify for TTS: Automated trading without much involvement by the trader (but creating your program qualifies); engaging a professional outside investment manager; and trading in retirement funds. Don’t include these trades in the golden rule calculations.

This blog post is a partial excerpt from Green’s 2017 Trader Tax Guide. There’s more to learn about TTS in the guide.

Consider a 30-minute paid consultation with Robert A. Green, CPA to discuss: Whether you qualify for trader tax status; if you should elect mark-to-market accounting; if you benefit from an entity and which type of company; and more trader tax benefits.