February 2019

Traders Elect Section 475 For Massive Tax Savings

February 21, 2019 | By: Robert A. Green, CPA | Read it on

If you are a securities trader eligible for trader tax status (TTS), consider making a timely Section 475 election for 2019. Section 475 means you’ll avoid wash sales and the capital loss limitation. You might also become eligible for the 20% qualified business income deduction, although QBI treatment is currently uncertain for TTS traders.

Historically, the chief tax benefit of Section 475 was deducting trading losses without limits. Section 475 trades are exempt from onerous wash sale loss adjustments on securities, which can trigger a tax bill on phantom income at year-end. Section 475 ordinary losses are not capital losses, which means the puny $3,000 capital loss limitation doesn’t apply.

Example 1: A sole proprietor TTS trader incurred a trading loss of $30,000 in 2018. He elected Section 475 for 2018 by April 17, 2018, and reported it as an ordinary loss on Form 4797 Part II. He also deducted $10,000 of trading business expenses on a Schedule C. He offsets the entire trading business loss of $40,000 against wage income of $100,000 for a gross income of $60,000. That generates a significant tax refund. Without a 475 election, this trader would have a $3,000 capital loss limitation on Schedule D, a $10,000 ordinary loss on Schedule C, and a gross income of $87,000. He would also have a capital loss carryover of $27,000.

Example 2: The markets dropped in December 2018, and many traders incurred significant capital losses. Markets rallied back in January 2019, and many of traders repurchased positions they sold for losses in December. They didn’t wait 31 days, so they triggered wash sale loss adjustments at year-end 2018. It caused many to owe significant capital gains taxes on phantom income. The deferred WS cost basis might cause some traders to have substantial capital losses in 2019, well above the capital loss limitation. A double whammy. A 475 election for 2019 can convert 2019 capital losses into ordinary losses. It doesn’t fix 2018 but helps a lot in 2019.

With the advent of the new tax law TCJA and 199A regs, TTS traders might derive an essential tax benefit from Section 475 ordinary income. TCJA introduced a 20% qualified business income (QBI) deduction, and QBI includes Section 475 ordinary income or loss but excludes capital gains and losses, forex Section 988 and swap contract ordinary income, dividends and interest income. Trading is a “specified service trade or business” (SSTB), which means the QBI deduction is disallowed if the individual’s taxable income exceeds the 2019 income cap of $421,400/$210,700 (married/other taxpayers). However, QBI tax treatment is uncertain because of 199A references to Section 864(c), which seem to deny the QBI treatment for TTS traders. There are conflicts and unresolved questions for traders in 199A, so stay tuned. (See Uncertainty About Using QBI Tax Treatment For Traders.)

Excerpt from Green’s 2019 Trader Tax Guide
By default, securities and Section 1256 investors are stuck with capital-loss treatment, meaning they’re limited to a $3,000 net capital loss against ordinary income. The problem is that their trading losses may be much higher and not useful as a tax deduction in the current tax year. Capital losses first offset capital gains in full without restriction. After the $3,000 loss limitation against other income is applied, the rest is carried over to the following tax years. Many traders wind up with little money to trade and unused capital losses. It can take many years to use up their capital loss carryovers. What an unfortunate waste! Why not get tax savings from using Section 475 MTM right away?

Business traders qualifying for TTS have the option to elect Section 475 MTM accounting with ordinary gain or loss treatment in a timely fashion. When traders have negative taxable income generated from business losses, Section 475 accounting classifies them as net operating losses (NOLs). Caution: Individual business traders who miss the Section 475 MTM election date (April 15, 2019, for 2019) can’t claim business ordinary-loss treatment for 2019 and will be stuck with capital-loss carryovers.

A new entity set up after April 15 can deliver Section 475 MTM for the rest of 2019 on trading losses generated in the entity account if it files an internal Section 475 MTM election within 75 days of inception. This election does not change the character of capital loss treatment on the individual accounts before or after its creation. The entity is meant to be a fix for going forward; it’s not a means to clean up the past problems of capital loss treatment.

Ordinary trading losses can offset all types of income (wages, portfolio income, and capital gains) on a joint or single filing, whereas capital losses only offset capital gains. Plus, business expenses and business ordinary trading losses comprise an NOL, which is carried forward. It doesn’t matter if you are a trader or not in a carryforward year. Business ordinary trading loss treatment is the most significant contributor to federal and state tax refunds for traders.

Starting in 2018, TCJA repealed the two-year NOL carryback, except for certain farming losses and casualty and disaster insurance companies. This means NOLs are carried forward indefinitely, and the deduction of 2018 and subsequent-year NOLs are limited to 80% of taxable income. TCJA also introduced a new excess business loss (EBL) limitation of $500,000 married and $250,000 for other taxpayers. Add EBL to an NOL carryforward.

Section 475 ordinary losses reduce net investment income for calculating the 3.8% Obamacare net investment tax.

There are many nuances and misconceptions about Section 475 MTM, and it’s essential to learn the rules. For example, taxpayers are entitled to contemporaneously segregate investment positions that aren’t subject to Section 475 MTM treatment, meaning at year-end, they can defer unrealized gains on properly segregated investments. Taxpayers can have the best of both worlds — ordinary tax losses on business trading and deferral with lower long-term capital gains tax rates on segregated investment positions. We generally recommend electing Section 475 on securities only to retain lower 60/40 capital gains rates on Section 1256 contracts. Far too many accountants and traders confuse TTS and Section 475; they are two different things, yet very connected.

Section 475 election procedures
Section 475 MTM is optional with TTS. Existing taxpayer individuals that qualify for TTS and want Section 475 must file a 2019 Section 475 election statement with their 2018 tax return or extension by April 15, 2019. Existing partnerships and S-Corps file in the same manner by March 15, 2019.

Election statement. “Under Section 475(f), the Taxpayer elects to adopt the mark-to-market method of accounting for the tax year ending Dec. 31, 2019, and subsequent tax years. The election applies to the following trade or business: Trader in Securities as a sole proprietor (for securities only and not commodities/Section 1256 contracts).”

Form 3115 filing. Don’t forget an essential second step: Existing taxpayers complete the election process by filing a Form 3115 (change of accounting method) with the election-year tax return. (I cover the Section 481(a) adjustment in the guide.)

The Section 475 election procedure is different for new taxpayers like a new entity. Within 75 days of inception, a new taxpayer may file the Section 475 election statement internally in its records. The new entity does not have to submit a Form 3115 because it’s adopting Section 475 from inception, rather than changing its accounting method.

If you have a significant capital loss carryover going into 2019, you might want to wait on making a 475 election since you will need capital gains to use it up. (I cover this decision-making and related 475 strategies in my tax guide.)

For more in-depth information on Section 475, see Green’s 2019 Trader Tax Guide Chapter 2.

I revised this blog post on March 5, 2019, in conjunction with my new blog post Uncertainty About Using QBI Tax Treatment For Traders

 


How To Qualify For Trader Tax Status For Huge Savings

February 9, 2019 | By: Robert A. Green, CPA | Read it on

Trader tax status (TTS) constitutes business expense treatment and unlocks an assortment of meaningful tax benefits for active traders who qualify. The first step is to determine eligibility. If you do qualify for TTS, you can claim some tax breaks such as business expense treatment after the fact and elect and set up other breaks — like Section 475 MTM and employee-benefit plans — on a timely basis.

Section 475 gives a TTS trader “tax loss insurance,” exemption from wash sale loss adjustments on securities and ordinary loss treatment, avoiding the capital loss limitation. With Section 475 income, you might also become eligible for the 20% qualified business income deduction, although QBI treatment is currently uncertain for TTS traders.

There’s no election for TTS
There’s no election for TTS; it’s an optional tax status based on facts and circumstances only. A trader may qualify for TTS one year but not the next.

TTS qualification can be for part of a year, as well. Perhaps a taxpayer qualified for TTS in 2017 and quit or suspended active trading on June 30, 2018. Include the period of qualification on Schedule C or the pass-through entity tax return and deduct business expenses for the partial-year period. If elected, use Section 475 for trades made during the TTS period, too.

Business expense treatment
Qualifying for TTS means a trader can use business treatment for trading expenses. TTS is also a precondition for electing Section 475 MTM ordinary gain and business loss treatment.

Business expense treatment under Section 162 allows for full ordinary deductions, including home-office, education, Section 195 start-up expenses, Section 248 organization expenses, margin interest, tangible property expense, Section 179 (100%) depreciation, amortization on software, seminars, market data, stock borrow fees, and much more. As an example of the potential savings, if TTS business expenses and home office deductions are $20,000, and the taxpayer’s federal and state tax bracket is 35%, then income tax savings is about $7,000.

TCJA suspended “certain (all) miscellaneous itemized deductions subject to the 2% floor,” including investment fees and expenses, commencing in 2018. The only remaining itemized deductions for investors are investment-interest expenses, which are limited to investment income, and stock borrow fees deducted as “other itemized deductions.” TCJA gives more incentive for traders to try to qualify for TTS.

How to qualify
It’s not easy to qualify for TTS. Currently, there’s no statutory law with objective tests for eligibility. Subjective case law applies. Leading tax publishers have interpreted case law to show a two-part test to qualify for TTS:

  1. Taxpayers’ trading activity must be substantial, regular, frequent, and continuous.
  2. The taxpayer must seek to catch swings in 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 words “substantial, regular, frequent, and continuous” are robust terms, yet case law doesn’t give a bright-line test with exact numbers.

The publication mentions holding period, frequency, and dollar amount of trades, as well as time devoted by the taxpayer. It also says the intention to make a livelihood, an essential element in defeating the hobby-loss rules. Trading is not personal or recreational, which are the key terms used in hobby-loss case law.

Golden Rules
We base our golden rules on trader tax court cases and our vast experience with IRS and state controversy for traders. The trader:

Trades full time or part time, for a good portion of the day, almost every day the markets are open. Part-time and money-losing traders face more IRS scrutiny, and individuals face more scrutiny than entity traders.

Hours: Spends more than four hours per day, almost every market day working on his trading business. All-time in the trading activity counts, including execution of trade orders, research, administration, accounting, education, travel, meetings, and more.

Few sporadic lapses: Has infrequent lapses in the trading business during the year. Traders can take vacations, sick time, and personal time off just like everyone else.

Frequency: Executes trades on close to four days per week, every week. Recent tax-court cases show that to help prevent IRS challenge of a TTS claim; it is wise to trade close to four days per week or 75% of available trading days — even if this requires the taxpayer to make smaller trades with reduced risk on otherwise non-trading days.

Volume: Makes 720 total trades per year (Poppe court) on an annualized basis. The buy and sell count as two total trades.  The court mentioned Poppe having 60 trades per month. During the year, it’s crucial to consider the volume of trades daily. We recommend 720 trades per year — about four trades per day, four days per week, 16 trades per week, and 60 trades a month.

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

Holding period: Makes mostly day trades or swing trades. The IRS stated that the holding period is the most critical factor, and in the Endicott court, the IRS said average holding period must be 31 days or less. That’s a bright-line test.

Intention: Has the intention to run a business and make a living. Traders must have the intention to run a separate trading business — trading his or her own money — but it doesn’t have to be one’s exclusive or primary means of making a living. The key word is “a” living, which means it can be a supplemental living.

Operations: Has significant business equipment, education, business services, and a home office. Most business traders have multiple monitors, computers, mobile devices, cloud services, trading services, and subscriptions, education expenses, high-speed broadband, wireless, and a home office.

Account size: Has a material account size. Securities traders need to have $25,000 on deposit with a U.S.-based broker to achieve “pattern day trader” (PDT) status. We like to see more than $15,000 for trading other financial instruments.

What doesn’t qualify?
Don’t count these three types of trading activity for TTS qualification: Automated trading without much involvement by the trader (but a trader creating his or her program qualifies); engaging a professional outside investment manager; and trading in retirement funds. Do not include these trades in the golden rule calculations.

1. Automated trading. An entirely canned automated trading service — sometimes referred to as an “expert adviser” program in the forex area — with little to no involvement by the trader doesn’t help TTS; in fact, it can undermine it. The IRS may view this type of automated trading service the same as a trader who uses a broker to make most buy and sell decisions and executions. On the other hand, if the trader can show he’s very involved with the automated trading program or service — perhaps by writing the code or algorithms, setting the entry and exit signals, and turning over only execution to the program — the IRS may not count the automated trading activity against the trader.

Some traders use a “trade copying” service and copy close to 100% of the trades. Trade copying can be similar to using a canned automated service or outside adviser, where the copycat trader does not qualify for TTS on those trades.

2. Engaging a money manager. Hiring a registered investment adviser (RIA) or commodity trading adviser (CTA) — whether they are duly registered or exempt from registration — to trade one’s account doesn’t count toward TTS qualification.

3. Trading retirement funds. Achieve TTS through trading taxable accounts. Trading activity in non-taxable retirement accounts doesn’t count for purposes of TTS qualification.

For more in-depth information on trader tax status, see Green’s 2019 Trader Tax Guide.


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