September 2017

How Tax Reform Framework Impacts Traders And Investors

September 29, 2017 | By: Robert A. Green, CPA



On Sept. 27, the Big Six tax writers released an updated Unified Framework for tax reform making concrete steps forward on corporate and individual tax rates. As expected, they left many details and decisions to Congress on which deductions, credits, and industry-specific tax incentives to repeal to offset the massive reduction in tax rates granted to corporations and pass-throughs (PTE). Over the coming months, tax lobbyists will inevitably hover over tax writers like bees. Until we see the final bill, it’s hard to assess its impact on traders and investors.

Capital gains and investment income tax cuts retracted
I searched the nine-page framework document and was surprised not to find any mention of capital gains. I find that odd considering earlier blueprints promised investors lower capital gains rates on “all” capital gains, dividends, and interest income. “All” includes short-term capital gains and non-qualifying dividends. At first, I wondered if it was an oversight, or because they felt it was unworthy of inclusion in the overview. I became concerned they may have scrapped these tax cuts for traders and investors since they have to scale back some tax cuts for budget reconciliation. I confirmed my suspicions when I saw the following tweet after writing this article: Wall Street Journal tax journalist, “Richard Rubin (@RichardRubinDC) 9/28/17, 11:54 AM @SpeakerRyan on lack of capital gains tax cut: You just can’t do everything you want to do.”

Comparing the framework to earlier versions
BNA’s Comparison Chart of Trump Tax Plan and House Republican Blueprint is an excellent resource. According to “Savings and Investment Income” on p. 3:

Current law: “Long-term capital gain and qualified dividends taxed at rates of 0%, 15%, and 20%. (Top rate plus NIIT equals 23.8%.) Short-term capital gain, interest income and non-qualified dividends taxed at ordinary rates.”

Trump campaign tax plan: “Maximum rate of 20%.” (Current law.)

Trump administration tax reform outline: “Not specifically addressed.” (This omission was the first indication they were backtracking.)

House Republican Blueprint: “Deduction for 50% of net capital gains, dividends, and interest income, leading to rates of 6%, 12.5%, and 16.5%.” The House Blueprint A Better Way “provides for reduced tax on investment income. Families and individuals will be able to deduct 50% of their net capital gains, dividends, and interest income, leading to basic rates of 6%, 12.5%, and 16.5% on such investment income depending on the individual’s tax bracket.”

The new framework doesn’t mention any of these provisions. It only states: “The committees also may consider methods to reduce the double taxation of corporate earnings.”

The new framework omits mention of “carried interest” tax breaks for hedge funds and private equity firms. Does omission indicate they are backtracking on a repeal of this tax break? Perhaps not, as it may not have been worthy of mention since the broad statements about closing industry-specific tax breaks may include carried interest. Hedge funds and private equity have significant lobbying efforts in D.C. Carried-interest for hedge fund managers is like sweat-equity for founders of start-ups.

Pass-through vs. corporations
The new framework’s top tax rate for corporations is 20%, PTE 25%, and individuals 35%. Taxpayers and their advisers will want to consider reorganization to maximize tax benefits. It would be nice to know all this before year-end to reorganize by the start of 2018.

The framework narrowed the definition of which businesses may qualify for the PTE rate: “The business income of small and family-owned businesses conducted as sole proprietorships, partnerships and S corporations.” Traders, eligible for trader tax status (TTS), are small, family-owned businesses.

The framework also calls for measures to prevent abuse of the PTE rate: “the committees [i.e., Ways and Means, and the Senate Finance Committee] will adopt measures to prevent the recharacterization of personal income into business income to prevent wealthy individuals from avoiding the top personal tax rate.” We have to wait for the committees to define “wealthy” in this context. I hope the tax writers don’t consider TTS trading gains as personal income rather than business income.

When the prior framework was released, journalists jumped on the fact that individuals would recast themselves as PTE or corporations to avoid the higher individual rate. Independent contractors are already a significant trend for employers to avoid payroll taxes, unemployment insurance, and employee benefit plans. Employees like the business status to deduct business expenses, reducing income taxes and self-employment taxes.

Treasury Secretary Stephen Mnuchin recently suggested service companies, like accounting, law and financial firms, shouldn’t be eligible for the PTE rate. I disagree. Service companies could recast as software-to-service or house intellectual property in a corporation to collect royalties rather than service revenues. Congress should not be picking winners and losers and penalizing service companies who are stellar performers in the American economy with tremendous job creation. Congress should keep the PTE rules straightforward and easy to enforce in the interests of tax simplification.

Some tax writers floated the idea of a 70/30 split of wage income vs. business income as a way to prevent abuse. For example, if an S-Corp has a net income before officer compensation of $1 million, the IRS would require the owner/officer to have “reasonable compensation” of $700,000, subjected to the individual rate up to 35%. The net income of $300,000 would be business income subjected to the PTE rate up to 25%.

With this labor/capital split, the effective PTE rate would be 32%.

This is calculated as follows: (70% wages x 35% individual rate) + (30% business income x 25% PTE rate) = 32% (only 3% less than the top individual rate of 35%). The Obamacare Medicare surcharge of 3.8% applies on the $700,000 of wages, which could negate much of the PTE tax benefit in an S-Corp. With a 70/30 split, many taxpayers may not find much tax savings using a PTE. If the committees use percentage allocation, I hope it’s more like 50/50. Perhaps, a corporation is better.

A trading S-Corp only wants enough officer compensation to unlock a retirement plan deduction, and IRS rules for reasonable compensation don’t apply since the entity does not have earned income. We don’t know yet how tax reform may impact trading companies. If they must use a 70/30 split, traders might have to report more compensation than they want, which triggers more payroll taxes and the individual rate. We don’t even know if the IRS will allow traders to be eligible for the PTE rate on trading income including Section 475 ordinary income. We also need to confirm that retirement plan and health insurance deductions will still be permissible for trading companies in 2018.

There is another glaring omission in the new framework: the health insurance premium deduction in a PTE. The framework repeals medical itemized deductions, but it does not address health insurance premiums deducted from adjusted gross income (AGI). “The framework retains tax benefits that encourage work, higher education and retirement security.” In prior blueprints, they included health insurance premiums next to retirement deductions.

I don’t expect the final bill to address trading businesses, as current law is shy on these issues, too. The IRS has to codify the legislation and write regulations, and that will take a long time. Traders should consult their CPAs and tax attorneys.

With reasonable compensation rules for a PTE, and perhaps none for a corporation, it could make the corporate structure more attractive. The devil will be in the details of final legislation, and tax writers better carefully think out incentives and “Freakonomics,” how incentives sometimes have the reverse effect. To date, corporations have been a bad choice of entity for a trading business due to double taxation, no pass-through of trading losses and expenses, no lower 60/40 rates in Section 1256, and more. Corporations have been good as management companies.

Budget reconciliation
Congressional tax writers are under enormous pressure to whittle down earlier vows to squeeze trillions of dollars in tax cuts into a 1.5 trillion-deficit placeholder negotiated for the 2018 budget. They scheduled the budget vote for Oct. 5, 2017. The Big Six plan to use “budget reconciliation,” affording them a majority vote procedure for Senate Republicans to pass tax reform and cuts without any support from Democrats.

Senator John McCain (R-AZ), who voted “no” on both health care repeal and replace bills, said the main reason was he wants “regular order” which requires a bi-partisan 60-vote cloture vote, and he recently said the same goes for tax reform. Senator Bob Corker (R-TN) told reporters, “What I can tell you is that I’m not about to vote for any bill that increases our deficit, period.”

In a letter to Republican leaders, 45 of the 48 Democratic senators requested bi-partisan negotiations, stating Republicans should not use budget reconciliation to pass tax reform. Democrats wrote they wouldn’t support tax cuts for the top 1% and they don’t agree on deficit-financing to pay for tax cuts.  Despite President Trump’s rhetoric about tax cuts not helping him and his family, and other billionaires in the top 1%, it’s not the case.

The effective tax rate for billionaires is close to the long-term capital gains rate of 20%, 15% before 2013. Long-term capital gains are their primary source of income, as many don’t take much compensation. These billionaires pay AMT because the AMT rate of 28% is higher than the long-term capital gains rate. To limit AMT and avoid estate taxes, many billionaires contribute significant amounts of their net worth to charity. The framework repeals AMT and estate tax, which is a massive tax cut for billionaires, including President Trump and his family. The framework doesn’t mention “step-up in basis” rules where heirs can avoid capital gains taxes. Billionaires and the wealthy own valuable corporations and pass-through entities so they will get lower tax rates on that front, too.

AMT and state and local taxes
If Congress repeals AMT, the second tax regime intended to ensure that wealthy taxpayers pay their fair share, it makes sense to repeal state and local taxes, which are one of the largest AMT preference items. To repeal the deduction alone would unlock much greater deductibility since AMT would no longer put a cap on it. That would wind up being a tax cut, rather than a tax increase, as intended. There’s already been significant blowback from members of Congress in high-tax states. Leadership is bending to that pressure. Will a tax increase turn into a tax cut on this measure? Or, will tax writers retain state and local tax deductions and AMT, too. Closing this deal will be tough.

There are a few other things I don’t like about the new framework. As with previous blueprints, it’s heavy on marketing content to convince working people that tax reform is for them rather than wealthy individuals and companies. I don’t like the double-talk. For example, the framework makes a big deal about lowering the top individual tax rate to 35%, but then it empowers tax writers to add a new higher rate without giving any details. It states it’s converting to a “territorial tax system” from a “worldwide tax system,” no longer taxing American companies abroad, but then it introduces a minimum tax on global income.

Timing and tax planning
The framework’s only retroactive provision is “full expensing,” active on the framework-date of Sept. 27, 2017. Other provisions won’t take effect until 2018. The Big Six is encouraging businesses to purchase equipment and other deductible assets before year-end to spur growth in the economy. It will help them argue growth pays for the tax cuts rather than deficit spending. The budget gives Republicans in both the House and the Senate a deadline of Nov. 13 to release legislative text on tax reform.

I am anxious to read final tax reform legislation so we can start crunching numbers to determine the winners and losers and help clients with tax planning for 2018. There will be surprises in the outcomes, “believe me.”

Taxpayers should commence 2017 year-end tax planning with the assumption that Obamacare taxes remain in place, only tax reform’s “full expensing” may start Sept. 27, 2017, and otherwise, tax reform, if passed, won’t be active until 2018.

How To Protect Puerto Rico Tax Incentives In The Wake Of Hurricanes Irma And Maria

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


Postscript Oct. 4, 2017: There is good news in IRS Notice 2017-56 helping hurricane victims retain bonafide residency status in Puerto Rico and the U.S. Virgin Islands for 2017. If they fail the presence test, they jeopardize territory tax incentives like Act 22 for traders in Puerto Rico. Many island residents had to flee, and they cannot return for an extended period. “An individual is considered to be present in a U.S. territory on any day that the individual is outside the relevant territory because the individual leaves or is unable to return to the relevant territory during any 14-day period within which a major disaster occurs in the relevant U.S. territory.” Notice 2017-56 relief: “The 14-day period is extended to 117 days, effective beginning September 6, 2017, and ending December 31, 2017.” (IR 2017-168)

Puerto Rico’s low-tax environment was tailor-made for American investors, traders and investment managers willing to move to the island. When Hurricanes Irma and Maria severely damaged the island this September, though, many had to evacuate, leaving traders to wonder how they will satisfy residency requirements.

There is some relief.

Acts 22 and 20
Enacted in 2012, PR Act 22 allows investors and traders with bona fide residence in PR to exclude 100% of all short-term and long-term capital gains from the sale of personal property accrued after moving to PR. Act 22 does not require investment in Puerto Rican stocks and bonds; trades can be made with a U.S. broker or on any exchange around the world.

For example, a trader living in California can go from paying federal and state taxes of more than 50% in the top tax brackets to zero taxes on capital gains, just by becoming a tax resident of PR. The U.S. and PR assess capital gains taxes based on where the seller’s “tax home” is located.

PR Act 20 has a 4% tax rate for companies, including investment managers, who export their services from PR.

These PR Acts have residency requirements, including a day count. (Learn more about Acts 22 and 20 and requirements on my blog post: Puerto Rico’s Tax Haven Status Is Made For Traders.)

Client questions and answers
I asked tax attorney Mark Leeds of Mayer Brown, LLP to help answer clients’ questions.

One customer writes: “I’m wondering if/how Hurricane Maria’s impact on Puerto Rico affects the annual requirements for Act 22, mainly the presence test. I have currently spent 171 days in Puerto Rico out of the required 183 minimums, and I am not sure I’ll be able to complete that requirement by the end of the year. I’m also concerned with the 90-day limit in the U.S.”

Mark Leeds: “First, the ‘less than 90-day presence in the U.S. test’ and the ‘183-day presence in Puerto Rico test’ are separate tests. Satisfaction of either of these tests will enable you to satisfy the presence test for 2017.

“The silver lining to the current disaster is that a day spent in the U.S. because you are unable to return to Puerto Rico during any 14-day* period within which a major disaster occurs in Puerto Rico for which a FEMA Notice of a Presidential declaration of a major disaster is issued in the Federal Register is treated as a day spent in Puerto Rico. Such an order was issued by FEMA Sept. 21. Thus, if you already spent 171 days in Puerto Rico, you should be able to add 14 days to this count, bringing you to 185.  As a result, you should have at least 183 in Puerto Rico for 2017 to satisfy the residency test. (*IRS Notice 2017-56 extended the 14-days to 117 days, effective beginning September 6, 2017, and ending December 31, 2017.)

“Please note that this is the second FEMA Notice of a Presidential declaration of a major disaster issued this month.  The President previously issued a declaration in connection with Hurricane Irma. I believe that these declarations should be considered separately, with the result that if you left Puerto Rico or were unable to return due to that hurricane as well, you’d have up to 28 days in the U.S. that would count as days in Puerto Rico.

“If there is a mandatory evacuation order in effect for where your condo is located, you can treat each day that the order is in effect as a day in Puerto Rico even if you are not in Puerto Rico.”

What a problem situation could look like
Suppose a trader spent late May through mid-September in the U.S. states and planned to spend the remainder of 2017 in PR. He planned to meet the 183-day presence test, and assume he cannot meet any of the other presence tests.

Before Irma struck on Sept. 7, he already had 140 days in PR from Jan. 1 through late May. He does not plan to return to PR for the remainder of 2017. With IRS relief, including 14 days for Hurricane Irma and 14 days for Hurricane Maria, his new day count is 168 days, falling short of the 183 days needed.

If this trader lives in a home that is subject to a mandatory evacuation order, he can count those days spent outside of Puerto Rico toward the 183-day requirement. Conversely, if there were no evacuation order, he would need to go back to PR for 15 more days before year-end or try to satisfy an alternative presence test.

If the trader does not meet the PR residency requirements, the consequence is being assessed U.S. taxes for the entire year 2017. That trader stands to lose zero taxation on capital gains and instead pay IRS taxes on capital gains and all other Puerto Rico-source income (other income remains subject to U.S. tax in any event). Some states might argue that leaving a state for one year or less did not change his state domicile, which brings state taxation into the fold, too.

These tax matters are very complicated, so it’s wise to consult U.S. and PR tax experts on these issues, to protect you from losing the tax advantages as a result of these hurricanes.

As PR-based tax experts resume operations, I expect to hear more news from them on these fiscal matters. Stay tuned!

The devastations Hurricanes Irma and Maria brought to Puerto Rico, and its people are terrible; I encourage traders and others to give plenty of charity and support. Traders and investment managers can bring vital resources and talent to help rebuild PR.

IRS Offers Help to Hurricane Victims: A Recap of Key Tax Relief Provisions Available Following Harvey, Irma and Maria

Mark Leeds contributed to this blog post. 

How To Apply Lower Tax Rates To Volatility Options

September 9, 2017 | By: Robert A. Green, CPA | Read it on

Update May 8, 2018: Some ETNs, like VELOCITYSHARES 3X LNG NTRL GS ETN (UGAZ), are debt obligations taxed as securities. (Check the tax section of the ETN prospectus.)

These days, volatility can be considered its own asset class, and many types of products have been created to fill this niche. If you trade volatility products, you may have many questions regarding how to treat these items on your tax return. But, guess what? Treatment for these items varies, and some of it is uncertain. Don’t sweat it, though — we are here to provide clarity.

Before delving into the various products and their treatment, it’s important to note that Section 1256 rules apply to “non-equity” options and Section 1256 items receive the coveted lower 60/40 tax rates. (At the maximum tax brackets for 2017, the top Section 1256 contract tax rate is 28% — 12% lower than the top ordinary rate of 39.6%. See 60/40 rates table.)

Several brokerage firms, however, classify options on volatility products as “equity options” taxed as securities. Our CPA firm established a substantial authority position to treat most of these volatility options as non-equity options. Don’t expect brokers to correct 1099-Bs if the tax treatment is uncertain. Be prepared to depart from the 1099-B reporting and include an explanation in footnotes and Form 8275. If your tax savings is significant, it’s wise to obtain a substantial authority opinion from a qualified tax attorney to protect against accuracy-related tax penalties.

CBOE-listed futures on VIX Indexes
Let’s start with a simple one. The CFE-traded VIX futures are “regulated futures contracts” (RFCs) on a qualified board or exchange (QBE). Because Section 1256 includes RFCs, I expect brokers to use Section 1256 for these products. There’s no uncertainty here.

CBOE-listed options on VIX Indexes, ETFs, and ETNs
IRS guidance is unclear, but these general rules should apply.

CBOE-listed options on VIX Indexes are not equity options, referencing a single equity price or narrow-based index of equity prices. They are likely non-equity options included in Section 1256, which references a barometer VIX Index, which does not contain equity prices. Most brokers agree.

CBOE-listed options on VIX securities ETFs, structured as registered investment companies (RICs), are likely equity options because a security ETF RIC acts like a single equity. Most brokers agree.

CBOE-listed options on VIX commodity ETFs, structured as publicly traded partnerships (PTPs), are likely non-equity options because a commodity ETF PTP is not a single equity or narrow-based equity index. Most brokers don’t agree; they treat it as an equity option, and I think you can divert from the broker’s 1099-B to use Section 1256 treatment.

CBOE-listed options on VIX ETNs are likely non-equity options because an ETN is not a single equity or narrow-based equity index. An ETN is a prepaid executory contract. Most brokers don’t agree; they treat it as an equity option, and I think you can divert from the broker’s 1099-B to use Section 1256 treatment.

The values of a narrow-based index must reference actual equity prices. The CBOE-listed options on VIX Indexes do not reference equity prices. Even the CBOE VIX Index for an individual equity (VXAPL) does not reference the equity price of APL, but rather the VIX barometer index for APL. Therefore, it’s likely that VXAPL is also a Section 1256 contract. (See CBOE-listed volatility options.)

Volatility ETFs
Issuers organize volatility ETFs as registered investment companies (RIC) or publicly traded partnerships (PTP). Tax treatment varies by the structure.

Securities ETFs: Securities ETFs are RICs. Selling securities ETF is deemed a sale of a security, calling for short- and long-term capital gains tax treatment using the realization method. RIC ETFs often make short- and long-term capital gains distributions to holders. Brokers report securities ETF proceeds and cost basis for each transaction on Form 1099-B.

Volatility ETFs organized as RICs include:
– REX VolMAXX Long VIX Weekly Futures Strategy ETF (VMAX)
– REX VolMAXX Short VIX Weekly Futures Strategy ETF (VMIN)

Commodities/futures ETFs: These ETFs use the PTP structure, also known as master limited partnerships (MLPs). PTPs issue annual Schedule K-1s passing through income or loss, including Section 1256 income or loss from trading within the PTP. Selling a commodity ETF is deemed a sale of a security, calling for short- and long-term capital gains tax treatment using the realization method.

Taxpayers invested in these ETFs should adjust cost-basis on Form 8949 (capital gains and losses and other income or loss), ensuring they don’t double count Schedule K-1 pass through income or loss. Form 1099-B does not make this cost-basis adjustment, so investors need to make a manual adjustment.

Volatility ETFs organized as PTPs include:
– ProShares VIX Short-Term Futures ETF (VIXY) S&P 500® VIX Short-Term Futures Index
– ProShares VIX Mid-Term Futures ETF (VIXM) S&P 500® VIX Mid-Term Futures Index
– ProShares Ultra VIX Short-Term Futures ETF (UVXY) S&P 500® VIX Short-Term Futures Index
-ProShares Short VIX Short-Term Futures ETF (SVXY) S&P 500® VIX Short-Term Futures Index.
– All are listed on the NYSE Arca securities exchange.

Volatility exchange traded notes
An exchange-traded note (ETN) calculates its rate of return or interest rate based on the movement of an underlying financial instrument, futures index, or equities index. In IRS jargon, most ETNs are a “prepaid executory contract” or “prepaid forward contract” based on the relevant financial instrument or index. (A few ETNs are debt instruments, see more below.)

Report ETN income when realized (sold) as short- and long-term capital gains and losses. Exception: Report currency ETNs with Section 988 ordinary gain or loss treatment.

ETNs structured as prepaid forward contracts are not a security or a commodity, so they should not qualify for Section 475 ordinary gain or loss treatment used by traders eligible for trader tax status and who elected Section 475 on time.

Section 1091 wash sale loss rules apply to securities. ETNs, structured as prepaid forward contracts, are not securities, so they should be exempt from wash sale loss adjustments. Most 1099-Bs treat ETNs as securities, subjecting them to wash sale losses. Consider departing from the 1099-B, explain why on Form 8275, and in some cases, get a substantial authority opinion letter from a tax attorney.

The ETN holder does not own an underlying instrument or futures index, so he or she should not use Section 1256 treatment. In the VXX ETN prospectus, the tax attorneys suggested reasons why the IRS might apply Section 1256 as “possible alternative” tax treatment. But, they did not imply investors should try to use Section 1256 treatment. Our firm’s tax attorneys researched whether there is “substantial authority” for the position that 1256 applies to VXX and they concluded there is no substantial authority. (Read our rationale in our blog post: Tax Treatment For Exchange Traded Notes (ETNs))

Some ETNs, like VELOCITYSHARES 3X LNG NTRL GS ETN (UGAZ), are actual debt instruments, which are taxed as securities, and not prepaid forward contracts. Our tax attorney Roger Lorence says, “The tax treatment of ETNs is often difficult to determine. You have to review the tax section of each prospectus.  In many cases, the offering is an undivided interest in the underlying positions, such as futures, so that the ETN is not an interest in an entity nor itself a security.  However, other ETNs are structured as a debt instrument, usually with leverage with respect to some index (such as natural gas futures).  In my experience “ETN” is a confusing and largely useless label and you have to go deeper to determine the tax characteristics.”

Volatility ETN products include:
In order of volume
– iPath S&P 500 VIX ST Futures ETN (VXX)
– iPath S&P 500 VIX Mid-Term Futures ETN (VXZ)
– UBS VelocityShares 1X Daily Inverse VSTOXX Futures ETN (EXIV)
– UBS VelocityShares VIX Variable Long/Short ETN (LSVX)
– UBS VelocityShares VIX Tail Risk ETN (BSWN)
– UBS VelocityShares 1X Long VSTOXX Futures ETN (EVIX)
– iPath S&P 500 Dynamic VIX ETN (XVZ)
– Credit Suisse VelocityShares Daily Long VIX Short-Term ETN (VIIX)
Listed on securities exchanges: NYSE, Nasdaq, or Bats.

Options on volatility ETNs
The CBOE lists options on VXX (ETN). An IRS official in the Chief Counsel’s office for financial products explained to our tax attorney Roger D. Lorence that any option listed on CBOE or other qualified board or exchange whose reference is not a single symbol or a narrow-based index is a non-equity option in Section 1256. The equity option definition has two different prongs: single (equity) symbol and narrow-based (equity) index. Using this rationale, the IRS official said the option on VXX (ETN) is a non-equity option in Section 1256.

As mentioned earlier, our CPA firm established a substantial authority (SA) position to use Section 1256 tax treatment for CBOE-listed options on VIX Indexes, volatility ETF PTP, and ETNs (i.e., VXX). SA means it’s 33% likely to be correct, so tax preparers can sign a tax return including that position and avoid accuracy-related tax penalties.

If you are interested, contact our CPA firm at

Roger Lorence JD and Darren Neuschwander CPA contributed to this content.

Attend our Webinar on Sep. 12, 2017, or watch the recording: Tax Treatment For Volatility Products: Options, Futures, ETFs, and ETNs