August 2017

Tax Reform Is Uncertain So Reconsider Your Investment Strategy

August 31, 2017 | By: Robert A. Green, CPA

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Read Robert’s blog post on Forbes.

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Many American taxpayers are tracking developments in tax reform plans, yet it’s uncertain if it will happen. Consider the adage: “Don’t let the tail wag the dog.” The tail is tax reform, and the dog is your investment strategy.

Some invested in the “Trump trade” — a surge in market prices based on perceived corporate tax cuts and deregulation — and they are waiting to sell winning positions after they expect Congress to lower tax rates. Companies are deferring revenues and accelerating expenses to postpone income to 2018 when lower tax rates may apply.

So, what’s an investor to do during this time of uncertainty? If you feel market conditions are right for selling individual securities or other financial instruments, then you should sell. Don’t wait for lower tax rates, which may not be as good as expected, or not come at all.

Long-term vs. short-term capital gains
The 2017 tax rates on long-term capital gains, held 12 months, are reasonable by historical standards. In the 10% and 15% ordinary tax brackets, long-term capital gains rates are 0%. In the 25% through 35% brackets, the long-term rate is 15%, and in the 39.6% bracket, it’s 20%. In Trump’s tax plan, the top long-term capital gains rate is 20%, and in the House plan, it’s 16.5%. If an investor holding a long-term capital gain believes the price may decline soon, they should consider selling that position in 2017 because a 2018 capital gains rate may not generate tax savings. It would create tax deferral for one year.

Conversely, investors holding short-term winning positions under 12 months may prefer to wait and see if tax reform delivers lower capital gains rates on short-term capital gains. The House Republican Blueprint stated: “Deduction for 50% of net capital gains, dividends, and interest income, leading to rates of 6%, 12.5%, and 16.5%.” Current law subjects short-term capital gains, interest income, and non-qualified dividends to ordinary rates. I expect Congress to clarify this issue along with other details in September and October. (See Comparison Chart of Trump Tax Plan and House Republican Blueprint.)

Investors should try to avoid wash sale loss adjustments on securities at year-end. Wash sales can increase capital gains subject to 2017 tax rates and postpone losses to 2018 when lower rates may apply. (A wash sale loss occurs when an investor realizes a capital loss and buys back a substantially identical position 30 days before or after. The loss is added to the replacement position’s cost basis.)

Deferral of capital gains is not possible for investors using Section 1256 MTM on futures, broad-based indexes, and non-equity options. It’s also not possible for traders in securities using Section 475 MTM. (Mark-to-market accounting reports realized and unrealized gains and losses.)

Obamacare net investment tax
It’s uncertain if Congress will repeal the Obamacare 3.8% net investment tax (NIT) for funding Obamacare expenditures. The Obamacare repeal and replace bill included a repeal of NIT, but that bill failed in the Senate. Although tax reform plans include repeal of NIT, it might survive final negotiations in pursuit of making tax reform revenue neutral. Only the wealthy (the upper 2% of Americans) pay NIT. It’s not a business tax cut that Republicans can argue spurs job creation. President Trump doesn’t want Congress to give up on a new Obamacare repeal and replace bill.

Decision-making example
If you sell a security for a $100,000 capital gain in 2017 and owe the top long-term capital gains rate of 20% and the 3.8% NIT, your federal tax liability is $23,800. That leaves you with $76,200 (assuming there is no state tax). If tax reform fails entirely or comes up short of expectation, the Trump trade could reverse course. Investors might then sell positions at lower prices, yet similar tax rates may apply.

Tax reform may be a massive tax cut on short-term capital gains, so investors may want to wait for details including legislative language to clarify this question. Traders in securities include day traders and swing traders, and they are not going to modify their holding periods for tax reasons.

Selling tax reform to the American people
It’s going to be a challenge for the White House and Congress to sell the American public on the need for tax reform including massive tax cuts at a time when many U.S. public companies have high net profits after tax and record-high stock prices. The proposals provide similar tax cuts to wealthy business owners operating through pass-through entities including LLCs, partnerships, and S-Corps.

Supporters say the tax cuts will bring economic growth because companies will invest their tax savings in U.S. job creation and wage hikes. But, opponents say this is wishful thinking: The current productivity trend is for U.S. companies to invest in robots and other automation, replacing human workers. Plus, the offshoring trend continues to make sense, given record low U.S. unemployment rates and considering that the House dropped its controversial border adjustment tax. Both sides will present studies buttressing their position.

President Trump held a pep rally for tax reform in Missouri on Aug. 30. The president argued that tax reform helps businesses, which will surely use the savings to hire workers, raise wages, and increase paychecks. The White House said it wants employees to see bigger paychecks starting in January 2018, which will help when they turn out for the mid-term elections in November 2018.

But, the most significant tax most middle-income employees have on paychecks is payroll taxes, not income taxes. The payroll tax has two components: 12.4% social security up to the SSA base amount, and 2.9% Medicare without any limit. Congress raises the SSA base most years: For 2017, the SSA base is $127,200, up 7% from $118,500 in 2016. That translates to a tax hike of $1,079 for 2017. In 2007, the SSA base was $97,500. If Republicans want to help workers as they say, why don’t they reduce payroll taxes?

President Trump and Treasury Secretary Steven Mnuchin say tax reform with tax cuts will spur growth rates to more than 3% for many years. Many economists disagree, although the government just revised up the Q2 2017 growth rate to 3%, and that’s an outlier over the past decade. When Congress’s independent body, the CBO, scores the tax cut bill, it probably won’t use dynamic scoring with 3% growth rates over a prolonged period. Tax cuts are likely to be scored as revenue negative, which means they incur deficit spending.

If you take away the tax cuts for business and just simplify the tax code by closing many loopholes and deductions, there may not be as much support for the bill.  There are lots of winners and losers in tax reform, including voters in high-tax states losing state and local tax deductions.

Democrats claim Republican tax reform proposals focus on tax cuts for the wealthy. Senate Minority Leader Chuck Schumer (D-NY) indicated Congressional Democrats and Independents might oppose an increase in the debt ceiling if it’s used to finance tax cuts for the wealthy.

The details are missing, and it’s getting late
Treasury Secretary Mnuchin and National Economic Council Director Gary Cohn promised more information on tax reform in September with passage promised before the end of 2017. Let’s see what legislative language they and the other Big Six tax writers offer in September and October with a crowded legislative calendar including the 2018 budget, increase in the debt ceiling, and several emergency measures including Hurricane Harvey and North Korea.

The expected pathway for tax cuts is Senate budget reconciliation, where Senate rules allow a 51-majority vote, rather than 60 votes needed for cloture (moving forward). Without any Democrats expected to support the Republican bill, the Senate can’t get to 60 votes required for the regular procedure. Using budget reconciliation requires the provision to balance. Otherwise, it’s temporary (sunsets) in 10 years. President Trump has berated Senate Majority Leader Mitch McConnell to change Senate rules, but McConnell won’t budge, so far. Ten-year tax cuts are good for some, but some corporations may not want to build new factories considering that a new Congress and President could repeal and replace these tax cuts.

As we learned with the failure of the majority vote for the Obamacare repeal and replace bill, it only takes three of the 52 Republican senators to vote a bill down if there is no support from Democrats or Independents. Uncertainties and speculation surround the upcoming vote on tax reform, but one thing is sure: We all must be ready for a September and October showdown. Don’t count your tax cut chickens until they hatch and keep an eye out for the Trump trade.

 


Cryptocurrency Traders Risk IRS Trouble With Like-Kind Exchanges

August 13, 2017 | By: Robert A. Green, CPA

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Clash of Bitcoin and Ethereum coins.

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Many cryptocurrency investors are inappropriately deferring capital gains taxes when they exchange one cryptocurrency for another. An example of this practice: exchanging Bitcoin for Ethereum through a cryptocurrency exchange and using IRC Section 1031 “like-kind” exchanges. But if you were to sell Bitcoin for U.S. dollars and buy Ethereum with U.S. dollars, you would have to report a capital gain or loss. Something is amiss!

Several websites encourage traders to consider Section 1031 on exchanges of cryptocurrencies, but none of them adequately state the potential risks.

“I suppose most people who don’t report exchanges between various cryptocurrencies don’t think of it as a like-kind exchange,” says Deborah King, CPA.  “They just do it, and later when they don’t receive a Form 1099, they forget about reporting it.” That’s even worse.

The IRS thinks there is massive under reporting of income
It doesn’t sound like cryptocurrency investors, and traders are duly complying with Section 1031′s elaborate requirements. Few disclose Section 1031 transactions on the required Form 8824. A failed Section 1031 transaction bars tax deferral, and it generates current taxable income.

Recently, the IRS served a “John Doe” summons (the toughest kind) to the largest cryptocurrency exchange, Coinbase, to obtain its customer list for investors and traders with cryptocurrency transactions worth over $20,000. The IRS calculated that less than 900 taxpayers reported capital gain or losses on cryptocurrency transactions in 2015, an alarmingly small number. It’s feasible that many taxpayers inappropriately tried to use Section 1031 like-kind exchanges on cryptocurrency exchanges, and did not disclose it to the IRS on Form 8824, or otherwise.

Cryptocurrency transactions are not “covered instruments” on Form 1099Bs, so cryptocurrency exchanges/dealers did not furnish tax information to the IRS. The IRS also knows that many lawbreakers hide income in cryptocurrency transactions.

How do Section 1031 like-kind exchanges work?
Section 1031 allows a taxpayer to exchange, rather than sell, real property and personal property with another taxpayer in a tax-free exchange. You must hold the property for investment or productive use in a trade or business, and it excludes inventory. For example, enact a like-kind exchange with a commercial building for a shopping mall, or an automobile for another one, but not a truck.

According to Thomson Reuters Checkpoint, “If it’s a straight asset-for-asset exchange, you will not have to recognize any gain from the exchange. You will take the same ‘basis’ (your cost for tax purposes) in your new property that you had in the old property. Even if you do not have to recognize any gain on the exchange, you still have to report the exchange on Form 8824.” If you receive cash or other non-like-kind property (“boot”) in the exchange, you’re required to report boot as taxable income and adjust your cost basis.

Cryptocurrencies may not qualify as like-kind property
If it’s not like-kind property, it’s not a like-kind exchange. Section 1031 specifically excludes stocks, bonds, notes, and indebtedness. It does not mention “cryptocurrency” or “virtual currency” since Section 1031 predated the advent of cryptocurrencies.

“Transactions for two biggest cryptocurrencies, Bitcoin and Ethereum, are priced in different ways, and there are other fundamental differences, too,” says Darren Neuschwander, CPA.

The IRS could rule they are not like-kind property. It’s interesting to see how the IRS ruled on like-kind exchanges between coins and bullion. (Read Bitcoin taxation: Clarity and mystery. See the discussion of Section 1031 and the chart “Sec. 1031 rulings involving coins and bullion.”) In some cases, exchanges of gold for gold coins or silver for silver coins may qualify as like-kind property, but gold for silver coins is not like-kind property. An exchange of U.S. gold coins for South African Krugerrand gold coins was not like-kind property because the coins have a different composition. Krugerrands are bullion-type coins whose value is determined solely by metal content, where the U.S. gold coins are numismatic coins whose value depends on age, condition, number minted, and artistic merit, as well as metal content.

IRS hasn’t addressed Section 1031 on cryptocurrencies
In March 2014, the IRS issued long-awaited guidance (IRS Notice 2014-21) labeling cryptocurrency “intangible property,” but the IRS did not address the use of Section 1031. Investors and traders hold Bitcoin as a capital asset, so it receives capital gain and loss treatment. The AICPA and others requested further guidance from the IRS, including if investors could use Section 1031. The IRS has not yet answered in public.

With a lack of IRS guidance, using Section 1031 on cryptocurrency trades is uncertain, and I suggest wrong in almost all facts and circumstances. There is no “substantial authority” for its use, which would be required to avoid tax penalties.

Two-party vs. multi-party like-kind exchanges
Section 1031 is used most often in real property transactions, such as in commercial real estate. For example, taxpayer A wants to sell real property one (RP1), but defer capital gains taxes by doing a like-kind exchange for real property two (RP2). It’s unlikely that taxpayer B, owner of RP2 wants to do a like-kind exchange with A, which would otherwise be a “direct two-party exchange.”

It’s common for A to engage a “qualified intermediary” (QI) in a “multi-party like-kind exchange.” For example, A transfers RP1 to QI, who withholds cash payment to A. B transfers or sells RP2 to QI who then transfers RP2 to A, thereby completing A’s like-kind exchange. Section 1031 has many requirements including various procedures, documentation, and reporting. Non-compliance leads to a failed Section 1031 transaction, which negates tax deferral.

Like-kind exchanges are not happening on cryptocurrency exchanges
There aren’t direct two-party like-kind exchanges between trader A and B through the exchange. Trader A doesn’t meet or know trader B, and each executes their trades directly with the exchange.

There also isn’t a multi-party like-kind exchange. Taxpayer A trades on the exchange, and the exchange does not meet the Section 1031 requirement for acting as a QI in a multi-party like-kind exchange. The exchange does not complete any of the required paperwork as a QI, and the trades occur in nanoseconds, not over months.

The IRS would likely consider the exchange a dealer. Section 1031 prohibits dealers from participating in direct two-party like-kind exchanges since dealers hold inventory in a trade or business, not capital assets. The IRS would likely treat the exchange as a disqualified person in a multi-party like-kind exchange.

It might be possible for cryptocurrency holder A to execute a direct two-party exchange with holder B if he knows him and executes the transaction off-exchange. However, the IRS might not consider Bitcoin like-kind property with Ethereum.

Accuracy related penalties and the statute of limitations
The IRS is coming after cryptocurrency investors, traders and users to collect its share of the significant income made in cryptocurrencies since 2009. The IRS will likely assess accuracy related penalties: A negligence penalty of 20% and a substantial understatement penalty of 20% if you understate your income by 10% or more. (Read Avoiding Penalties and the Tax Gap.)

Don’t count on the year closing after three years. If a taxpayer omits more than 25% of taxable income (substantial omission), the statute of limitations expands to six years. If the IRS can establish a false or fraudulent return, or willful attempt to evade tax, or failure to file a return, then the year never closes. The John Doe summons on Coinbase reminds me of the IRS strong-arming foreign banks to bust Americans who hid income and assets in offshore bank accounts.

If you have under-reported income on cryptocurrency sales and exchanges, it’s wise to consult a cryptocurrency tax expert and consider amending prior tax returns before the IRS catches up with you. That may help with a request for penalty abatement or reduction. Hopefully, the IRS will issue more guidance on these questions soon. (Read my recent blog posts: How To Report Bitcoin Cash And Avoid IRS Trouble, and If You Traded Bitcoin, You Should Report Capital Gains To The IRS.)

Darren Neuschwander, CPA and Deborah King, CPA contributed to this blog post. 


Traders Need Fair Tax Reform

August 7, 2017 | By: Robert A. Green, CPA

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Please sign our petition: Traders Need Fair Tax Reform

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A Tax Reform Wish List For Traders

Dear U.S. Senate, House of Representatives, Treasury Secretary Steven Mnuchin and National Economic Council Director Gary Cohn:

As you deliberate on tax reform, I ask that you consider the needs of traders.

There are hundreds of thousands of small-business traders around the country and probably tens of thousands in your state. Traders provide for their families and pay billions in taxes. One of the brightest stars of the economy is America’s financial market, and as market makers providing liquidity, traders earn their share of America’s success.

Here’s a prioritized list of traders’ needs in tax reform:

• Trader tax status: The tax cornerstone is “trader tax status” (TTS), which delivers business expense treatment. To be eligible for TTS, a trader needs about four trades per day, four days per week with holding periods under 31 days. There are other factors explained in IRS Pub. 550. Please safeguard trading business expenses.

• Section 475 MTM: In 1997, Congress expanded Section 475 to traders in securities and commodities. Use of Section 475 requires eligibility for TTS. MTM (mark-to-market accounting) imputes sales of open positions at year-end, so the taxpayer reports realized and unrealized gains and losses. MTM is the epitome of “tax simplification,” doing away with complicated rules for wash sale loss adjustments, straddles losses, and tax deferral. Also, Section 475 trades are exempt from the $3,000 capital loss limitation against other income. Please safeguard the use of Section 475 MTM for TTS traders, make it easier to elect, and apply it to most financial instruments.

• Section 1256 MTM: Futures and other Section 1256 contracts are subject to MTM reporting with lower 60/40 tax rates. Section 1256 does not require TTS or an election; all investors use it by default. I ask that you consider bringing more financial instruments into Section 1256 MTM and safeguard this code section in tax reform.

• Lower tax rate on business income: One of the most significant tax reform proposals is a lower tax rate on “business income,” applied to corporations and pass-through entities (PTE). It’s vital to include PTE as most small businesses operate as a PTE. Please prevent discrimination against a trading business PTE with TTS and Section 475 MTM ordinary income; it deserves the lower tax rate on business income just like other small businesses.

• Lower tax rate on investment income: Tax reform proposals include a lower tax rate on investment income. Alternatively, the House proposed a 50% exclusion of investment income taxed at ordinary rates. These proposals include all capital gains, dividends, and interest income. Current law limits a lower capital gains tax rate to long-term capital gains and qualified dividends. Please support extending the lower rate or 50% exclusion to all capital gains.

• Net operating losses (NOLs): One tax reform proposal repeals the two-year NOL carryback, retaining the 20-year NOL carry forward. Please don’t support this change as it defeats the primary purpose of NOL law. When a small business incurs a substantial loss generating an NOL, the business is likely dependent on a quick NOL carryback tax refund to replenish itself and retain its employees.

• Cost-basis reporting: In 2011, Congress implemented cost-basis reporting rules, beefing up broker 1099Bs to include cost basis and holding period information on securities. But, there’s a problem: IRS wash-sale loss adjustment rules for brokers differ from rules for taxpayers. (Wash sale definition: If a taxpayer buys back a losing position 30 days before or after, the IRS wants the tax loss deferred to the replacement position.) Most taxpayers and their tax preparers are not compliant with taxpayer rules; they cut corners relying on broker 1099Bs. One way to alleviate this problem is for Congress to expand the use of Section 475 MTM and Section 1256 MTM, which exempts those trades from wash sale loss adjustments.

Traders support tax reform legislation, and they respectfully request your consideration of these important issues that will affect their small businesses.

Thank you for your time.


How To Report Bitcoin Cash And Avoid IRS Trouble

August 2, 2017 | By: Robert A. Green, CPA

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Read it on Forbes.

In light of the Aug. 1 split of Bitcoin into two separate cryptocurrencies, Bitcoin and Bitcoin Cash, many questions remain. While the IRS has issued guidance on cryptocurrency — labeling it an “intangible asset” for investors subject to capital gains and loss treatment using the realization method — it has not issued guidance on cryptocurrency split or “fork” transactions. There are thousands of cryptocurrencies, and many formed in this type of division in the blockchain.

Tax reporting for the receipt of Bitcoin Cash
The initial market price of Bitcoin Cash was $266 per unit, which was 9.5% of the comparable Bitcoin unit price at that time of $2,801. Bitcoin holders were distributed one unit of Bitcoin Cash for each unit of Bitcoin, a separate financial instrument with a liquid market value. In the eyes of the IRS, that’s taxable income. (An alternative name for Bitcoin Cash is BCash.)

Bitcoin holders should report the receipt of Bitcoin Cash on their 2017 income tax returns. It does not qualify as dividend income on Schedule B since a cryptocurrency is not a security. It’s also not considered interest income on a debt instrument or bank deposit. I suggest reporting the value received as “Other Income” on line 21 of Form 1040 —a catchall category for income that does not fit into a standard category.

Some taxpayers might choose to use Form 8949 (Sales and Other Dispositions of Capital Assets) instead. The taxpayer reports the $266 value of Bitcoin Cash as proceeds and 9.5% of Bitcoin cost basis as Bitcoin Cash cost basis. The initial value of Bitcoin Cash was 9.5% of the Bitcoin price at that time. This alternative treatment reduces taxable income by the cost basis amount. Another benefit is capital gains use up capital loss carryovers. I question whether this method would pass muster with the IRS — Bitcoin did not decline in value by a material amount after the split, and that undermines the use of this treatment.

Constructive receipt of income
Some Bitcoin holders mishandled or skipped arranging access to Bitcoin Cash, or their exchange does not support Bitcoin Cash, making retrieval difficult or impossible after Aug. 1, 2017. These taxpayers may believe they don’t have to report the Bitcoin Cash as taxable income since they don’t currently have access to it. While that seems reasonable, the IRS could apply the constructive receipt of income doctrine to argue the Bitcoin holder had access to Bitcoin Cash but turned his or her back on receiving it. Kelly Phillips Erb of Forbes goes into more detail in her article, Bitcoin Shift Could Cause Tax Headaches For Some Users).

Tax reporting for the sale of Bitcoin Cash
If you sold your Bitcoin Cash, you need to use capital gains treatment on Form 8949. For proceeds, enter the selling price. For cost basis, enter the $266 Bitcoin Cash value received per unit as you previously reported it as Other Income on line 21 of your 2017 Form 1040. The holding period for these units of Bitcoin Cash started on Aug. 1, 2017.

A cryptocurrency split is not a tax-free exchange
Taxpayers may feel a cryptocurrency split such as Bitcoin Cash qualifies as a tax-free exchange. I don’t think it does because cryptocurrencies are not securities, where tax-free splits are possible.

“Receipt of new Bitcoin Cash assets is a taxable event,” said tax attorney Roger D. Lorence. “Corporate taxation concepts on distributions to shareholders, dividends, spinoffs, split-offs, corporate reorganization nonrecognition events under Section 368 and allied rules, are all not applicable, as cryptocurrency is not a security. The new Bitcoin Cash assets are substantially different economically from the old Bitcoin assets.”

Lorence said the Supreme Court decision in Cottage Savings supports the view that the two classes of Bitcoin assets are not identical and therefore the transfer of the assets is considered a new class for which no nonrecognition provision of the code applies.

The IRS goes after cryptocurrency investors
Many cryptocurrency investors made a fortune the past several years selling high-flying Bitcoin and other cryptocurrencies for cash. Unfortunately, far too many of them did not report this taxable income to the IRS. Some cryptocurrency investors used Section 1031 like-kind exchange tax law to defer taxation, but that may be inappropriate (stay tuned for a blog post on that soon). Some cryptocurrency exchanges issued Form 1099-K, Payment Card and Third Party Network Transactions. The IRS feels they are insufficiently informed, so they are taking action.

Bitcoin rose in price from $13 in 2009 to more than $3,000 on June 11, 2017, and on Aug. 1, 2017, its market cap was $44 billion. Ethereum had a market cap of $21 billion. Bitcoin Cash skyrocketed overnight to a market cap of $12 billion on Aug. 2, 2017. The IRS figures hundreds of thousands of American residents did not report income from sales or exchanges of cryptocurrency and they might be able to collect several billion dollars in back taxes, penalties, and interest.

The IRS recently summoned Coinbase, one of the largest cryptocurrency exchanges, to turn over its customer lists. It later agreed to narrow the scope of the list to people with cryptocurrency transactions worth over $20,000 without a Form 1099-K. (Read IRS Blinks in Bitcoin Probe, Exempts Coinbase Transactions Under $20,000.)

Tax treatment for sales of cryptocurrencies
The IRS was slow to issue guidance for cryptocurrencies. It finally declared cryptocurrencies an “intangible asset,” not a sovereign currency, and sales and exchanges are subject to capital gain or loss treatment for investors and traders, using the realization method. (Read If You Traded Bitcoin, You Should Report Capital Gains To The IRS.)

There is tax controversy brewing with cryptocurrency investors, which means tax exams will escalate. Don’t be greedy: Pay your capital gains taxes on windfall income and amend tax returns to report capital gains before the IRS catches up with you.

Darren Neuschwander CPA, Adam Manning CPA and tax attorneys Roger D. Lorence and Mark M. Feldman contributed to this blog post.


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