June 2019

How To Structure A Trading Business For Significant Tax Savings

June 26, 2019 | By: Robert A. Green, CPA | Read it on

If you actively trade securities, futures, forex or crypto, consider setting up a trading business to maximize tax benefits. With a sole proprietorship, a trader eligible for trader tax status (TTS) can deduct business and home-office expenses and make a timely Section 475 election on securities for tax loss insurance and a potential qualified business income (QBI) deduction. By forming an LLC taxed as an S-Corp, a TTS trader can also deduct health insurance premiums and a retirement plan contribution. An investor without TTS cannot get any of these tax benefits.

The new tax law (TCJA) severely limits itemized deductions for investors, while expanding the standard deduction and improving business expensing. TCJA also introduced a 20% deduction on QBI, which includes a TTS trading business with Section 475 income but excludes capital gains and portfolio income. With TCJA, TTS and Section 475 are more valuable than ever before.

Table for choosing a TTS trading business structure

Sole proprietorship
An individual TTS trader deducts business expenses and home office deductions on a Schedule C (Profit or Loss From Business – Sole Proprietorship), which is part of a Form 1040 filing. Schedule C losses are an above-the-line deduction from gross income.

It’s easy to set up a sole proprietorship. First, open an individual brokerage account(s) in the trader’s name and social security number. You don’t need a separate employer identification number (EIN) unless you plan to have employees on the payroll. You can also use a joint individual account but list the trader’s name and social security number first. There is no state filing required for a sole proprietorship as there is for organizing an LLC or incorporating a corporation. You also don’t need a “doing business as” (DBA) name, although you can obtain one if you prefer. There isn’t a federal or state tax election for claiming TTS — it’s determined based on facts and circumstances assessed at year-end.

Don’t confuse TTS with a Section 475 election. Only TTS traders can use Section 475 ordinary gain or loss treatment; however, many TTS traders don’t make a 475 election. TTS is like undergraduate school, and Section 475 is like graduate school: The former is needed to get into the latter, but undergraduates don’t necessarily elect to go on to graduate school. For example, a TTS futures trader might skip a 475 election to retain lower 60/40 capital gains rates on 1256 contracts. You can elect Section 475 on securities only, commodities only, or both.

Here’s an example: An active trader realized in mid-2019 that he qualified for TTS for all of 2018. He can add a Schedule C to his 2018 Form 1040 tax return due on an extension by Oct. 15, 2019. (Traders can use TTS on amended tax returns, too.) A Schedule C provides tax benefits for 2018 and year-to-date in 2019. This trader wants to form an S-Corp later in 2019 to unlock a health insurance deduction for the remainder of 2019 and a high-deductible retirement plan deduction. He realized he qualified for TTS after April 15, so was too late to elect 475 on the individual level for 2019. But a new S-Corp can select Section 475 within 75 days of inception so that the trader will be exempt from wash-sale loss adjustments at year-end 2019.

Section 475 tax benefits
TTS traders are entitled to make a Section 475 election, but investors are excluded from it. I call it “tax loss insurance” because the election exempts securities trades from onerous wash-sale loss adjustments, which can defer tax losses to the subsequent year, and the $3,000 capital loss limitation. Ordinary loss treatment is far better; it can generate tax refunds faster than capital loss carryovers.

A partnership or S-Corp formed during the tax year is considered a “new taxpayer,” which can elect Section 475 internally within 75 days of inception. An individual TTS trader had to choose Section 475 with the IRS by April 15, 2019, so a new partnership or S-Corp comes in handy after the April 15 deadline. An existing taxpayer must also file a Form 3115 (Application for Change in Accounting Method), whereas a new taxpayer adopts 475 from inception, so this filing isn’t necessary.

Prior capital-loss carryovers on the individual level still carry over on Schedule Ds. The new entity can pass through capital gains if the taxpayer skips the Section 475 MTM election to use up those capital loss carryovers. Then, the entity can elect Section 475 MTM in a subsequent tax year. It’s easy to revoke a 475 election in a manner that mirrors making a 475 election.

The qualified business income deduction
TCJA introduced a tax benefit for pass-through businesses, which includes a TTS trader with Section 475 income; whether doing business as a sole proprietor, partnership, or S-Corp. Section 199A provides a 20% QBI deduction on a “specified service trade or business” (SSTB), and TTS trading is an SSTB. However, SSTBs are subject to a taxable income threshold, phase-out range, and income cap. The phase-out range has wage and property limitations, too. Also, the 20% deduction is on whichever is lower: QBI or taxable income minus “net capital gains” defined as net long-term capital gains over net short-term capital losses, and qualified dividends. It’s a complicated deduction, and most traders won’t get a QBI deduction. QBI includes Section 475 ordinary income and trading business expenses and excludes capital gains and losses, dividends, interest income, forex and swap ordinary income, and investment expenses.

For 2019, the taxable income (TI) cap is $421,400/$210,700 (married/other taxpayers). The phase-out range below the cap is $100,000/$50,000 (married/other taxpayers). The TI threshold is $321,400/$160,700 (married/other taxpayers).

Pass-through entities
A pass-through entity means the company is a tax filer, but it’s not a taxpayer. The owners are the taxpayers, most often on their tax returns. Taxpayers should consider marriage, state residence, and state tax rules, including annual reports, minimum taxes, franchise taxes, excise taxes, and more when setting up an entity. In most states, these taxes are nominal costs. (In Green’s 2019 Trader Tax Guide, I address state taxes for S-Corps in California, Illinois, other states, and New York City.)

Partnerships
A trader can organize a spousal LLC and file as a partnership. Alternatively, the trader can form a marital general partnership without liability protection afforded by an LLC. Partnerships file a Form 1065 partnership tax return. Establishing a separate legal entity does not alone generate tax benefits; it’s critical for the organization to qualify for TTS. Otherwise, the company is considered an investment company with suspended investment fees and expenses. An investment partnership cannot have business expenses, officer compensation, and employee benefits, including health insurance and retirement plans.

A TTS trading partnership may deduct business expenses, which the partnership Schedule K-1 reports in line one (“ordinary business income/loss”). The individual owner deducts business expenses. If the partnership agreement provides for it, the partner can also deduct “unreimbursed partnership expenses” (UPE) including home office expenses, on Schedule E page 2 (Supplemental Income and Loss). The amounts are entered on the “non-passive income” column since a TTS loss is exempt from Section 469 passive activity loss rules under the “trading rule” exception.

A partnership tax return looks better to the IRS vs. a Schedule C with different tax forms for trading gains and losses. The partnership return consolidates Section 475 ordinary income/loss with business expenses in line one of Schedule K-1. Partnership capital gains are easy to see on the partnership Schedule K and K-1. On the contrary, there is a red flag with a Schedule C displaying business expenses. Individual-level trading gains and losses are on other tax forms: Form 8949 for capital gains and losses, Form 6781 for Section 1256 capital gains and losses using 60/40 treatment and Form 4797 Part II ordinary gain or loss for Section 475 trades. It’s hard for the IRS to decipher TTS items from investments on an individual tax return. Sole proprietors should use a well-crafted tax return footnote to explain the correlation of a TTS Schedule C with the other tax forms for trading gains and losses.

A partnership (or S-Corp) helps segregate investment positions from TTS/Section 475 trading positions. If you trade substantially-identical positions that you also invest in, it could invite the IRS to play havoc with the reclassification of TTS vs. investment positions. Using a TTS company prevents the IRS from reclassifying TTS positions out of Section 475 ordinary loss treatment into a capital loss limitation on investment positions. And, it prevents the IRS from reclassifying unrealized long-term capital gains on investment positions into TTS/475 MTM ordinary income on TTS positions. Traders cannot use portfolio margining between an entity and an individual account, so they carefully weigh the use of portfolio margining vs. Section 475.

S-Corps
Taxpayers cannot directly create an S-Corp; instead, it’s a tax election. Organize an LLC or incorporate a corporation, and the entity has the option to file an IRS Form 2553 (Election by a Small Business Corporation) within 75 days of inception. Alternatively, in a subsequent year, the S-Corp election is due by March 15. All the owners must be U.S. residents. Most states accept the federal S-Corp election, although some states including but not limited to New York and New Jersey require a separate state election. There is IRS relief for late S-Corp elections; however, you had to have the intention of making the S-Corp election on a timely basis.

New S-Corps (and partnerships) can elect Section 475 within 75 days of inception.

Unlike a partnership, an S-Corp doesn’t require two or more owners. An unmarried trader can form a single-member LLC to elect S-Corp status. Otherwise, a single-member LLC is a “disregarded entity” (a “tax nothing” in the eyes of the IRS), which takes you back to using sole proprietor status on a Schedule C.

The essential tax benefit of an S-Corp is to arrange tax deductions for health insurance premiums and a high-deductible retirement plan contribution through officer compensation.

Sole proprietors and partnerships cannot achieve these employee-benefit deductions in connection with trading income. A Schedule C cannot pay the owner wages, and partnerships should use “guaranteed payments” instead of salaries. Partnership expenses flow through, including a guaranteed payment, creating negative self-employment income (SEI). That makes a health insurance and retirement plan deduction challenging to achieve for a TTS partnership. Conversely, S-Corps don’t pass through negative SEI, and the employee benefit deductions work tax efficiently.

S-Corp health insurance premiums
TTS traders with significant self-employed health insurance (HI) premiums should consider an S-Corp to arrange a tax deduction through officer compensation; otherwise, they cannot deduct HI.

Not everyone needs a health insurance deduction, but if you do, crunch the numbers. An S-Corp is worthwhile if the HI tax deduction is meaningful, and the tax savings exceed the entity costs of formation and maintenance. A retirement plan deduction adds icing on the cake.

Examples: An unmarried futures trader living in a tax-free state might be in the lowest two tax brackets of 10% and 12%, after taking the standard deduction. With 60/40 treatment on Section 1256 contracts, her blended tax rate is 4% and 4.8%. If her HI deduction is $3,600, then the tax savings is $173. That’s far less than the cost of maintaining an S-Corp. A payroll service provider might cost $600 per year.

On the other hand, a married securities trader in a high-tax state might have a $24,000 HI deduction for family coverage, and with a 40% combined federal and state tax bracket, the tax savings for the HI deduction is $9,600. An S-Corp is a good idea for this trader.

The health insurance deduction is complicated for officer/owners: Add health insurance premiums paid by the entity or individually during the entity period to wages in box one on the officer/owner’s W-2. The health insurance amount in salary is not subject to payroll taxes, so omit this amount from Social Security wages in box 3, and Medicare wages in box five. The officer deducts health insurance premiums as an adjusted gross income (AGI) deduction on his Form 1040 personal tax return. The taxpayer deducts non-owner employees’ health insurance on the S-Corp tax return directly as “insurance expense.”

S-Corp retirement plan contributions
Taxpayers need self-employment income (SEI) to make and deduct retirement plan contributions; however, trading income is not SEI. (The exception is a full-fledged dealer/member of an options or futures exchange, trading Section 1256 contracts on that exchange.) There are tax costs and benefits to SEI: It triggers SE tax but also unlocks a HI and retirement plan deduction. SE tax is the same as payroll tax (FICA and Medicare), which I explain below.

A TTS trader uses an S-Corp to pay officer compensation for these employee benefit deductions. The trader is in control of how much to run through payroll, picking an amount to maximize employee benefit deductions but not to pay too much in the payroll tax.

You should fund retirement plan contributions from net income, not losses. It’s best to wait on the execution of an annual paycheck until early December when there is transparency for the year. A trader should not have a base salary throughout the year. Some traders make money during the year, only to lose it before year-end.

If you have sufficient trading profits by Q4, consider establishing a Solo 401(k) retirement plan before year-end. It’s a defined contribution plan; start with the 100% deductible elective deferral (ED; $19,000 for 2019) and pay it through payroll since it’s reported on the annual W-2. Add the ED to Social Security wages and Medicare wages on the W-2 but not taxable wages in box 1, as that is where the tax benefit (deduction) is. The gross wage ED component is subject to payroll taxes, and the S-Corp tax return has a deduction for gross wages. Taxpayers 50 years and older have a “catch up provision” of $6,000, raising the ED limit to $25,000 per year.

If you have large trading gains, consider increasing payroll in December for a performance-based bonus to unlock a 25% deductible Solo 401(k) profit-sharing plan (PSP) contribution that you don’t have to pay into the retirement plan until the due date of the S-Corp tax return (including extensions by Sept. 15). The maximum PSP amount is $37,000. The total limit for a Solo 401(k) is $62,000 ($19,000 ED, $6,000 catch-up ED, and $37,000 PSP). The S-Corp tax return deducts the PSP.

A “traditional” retirement plan is tax deductible, and the related wages are subject to a payroll tax, which includes 12.4% FICA up to the SSA base of $132,900 for 2019, plus 2.9% Medicare tax without a base limit. If the trader is in a high tax bracket, then the income tax savings can well exceed the payroll tax cost, which is also 50% deductible. Crunch the numbers in December for year-end tax planning and consider whether you can afford to save this cash flow until retirement, starting at age 59½ for required minimum distributions.

As an example: Assume an unmarried trader, age 51, has S-Corp net trading income of approximately $225,000 and individual taxable income of $200,000. That puts her in a 32% marginal federal tax bracket, and she lives in a tax-free state. On officer compensation of $25,000, she contributes the maximum Solo 401(k) ED of $25,000, saving $8,000 in federal income taxes. Her payroll tax on $25,000 wages is $3,825, which is 50% tax deductible, so it generates additional income tax savings of $612. She has federal unemployment insurance (FUI) of $50 and is exempt from state workmen’s compensation insurance. Her net overall tax savings is $4,737. She will enjoy tax-free compounding of growth in the retirement plan until she must begin taking required minimum distributions by age 70½, which is taxable income at ordinary rates.

Consider a Roth Solo 401(k) contribution in the years when you can skip an income tax deduction. Roth plans are permanently tax-free for growth and contributions. Early withdrawals can trigger a 10% excise tax penalty. If you have another job with annual wages over the SSA base, then TTS S-Corp wages will convert new FICA to a federal tax credit, since the IRS does not double-charge FICA on a Form 1040. This credit gives a nice incentive to consider a Roth plan.

S-Corp payroll
To arrange employee benefits including health insurance and retirement plan deductions through an S-Corp, you’ll need to pay officer compensation through a formal payroll before year-end. You’ll likely need to engage a payroll service provider for payroll tax compliance. (Our firm works with a dedicated team at Paychex for a price of approximately $600 per year.) If you don’t need employee benefits in a given tax year, you can skip paying officer compensation for that year. IRS “reasonable compensation” rules for S-Corps probably don’t apply to traders since the S-Corp has unearned income. However, the IRS could take the position that reasonable compensation is required in all cases. Once you begin a payroll, you must continue to file payroll tax returns quarterly and annually, even if they are zero returns due to no salary in any given period.

A payroll service includes quarterly payroll tax returns (Form 941), the annual payroll tax return (Form 940), state payroll tax returns and federal unemployment insurance with FUI tax of under $50 for the owner/trader. In most states, the trader/owner is exempt from state unemployment insurance and state workmen’s compensation. The payroll service provider also prepares the W-3s and W-2s

One benefit is you can withhold taxes from payroll in December and have them attributed to being made throughout the year. Take advantage of this tax loophole to reduce quarterly estimated tax payments during the year. Benefit from hindsight and use of the cash flow.

Avoid wash sales with an entity
Permanent wash-sale losses between individual taxable accounts and IRAs and deferred wash-sale losses inside and between taxable accounts significantly impact active investors.

Trading in an entity account might help avoid these problems. The entity is separate from the individual and IRA accounts for purposes of wash sales since it is a different taxpayer. The IRS is entitled to apply related party transaction rules (Section 267) if the entity purposely tries to avoid wash sales with the owner’s accounts. If the company qualifies for TTS, it can consider a Section 475 MTM election exempting it from wash sales (on business positions, not investment positions).

Trade accounting for securities is more comfortable with a new entity since there are no opening-year wash-sale loss adjustments to reverse from the prior year-end, which is sometimes difficult to determine.

Miscellaneous
S-Corps are more formal than partnerships. For example, a TTS trader needs to use an accountable reimbursement plan before year-end for reimbursing the officer’s business expenses. A partnership is less formal; it can use unreimbursed partnership expenses (UPE).

Form the pass-through entity in your state of residence since it passes income to that state, anyway. Don’t be fooled by asset-protection salesman promoting entity formation in tax-free jurisdictions. You live, work, and trade in your home state.

C-Corps are not ideal for traders since the IRS might charge a 20% accumulated earnings tax on top of the 21% flat tax. It’s hard for a trader to have a war chest plan to justify retaining earnings and profits (E&P). There’s double state taxation to consider, too. (See Green’s 2019 Trader Tax Guide.)

Some brokers charge higher professional rates for data feed fees on entity accounts, even though you don’t have investors. A sole proprietor individual account pays non-professional rates, which can save $125 or more per month depending on how many data vendors you have. Inquire about this issue with your brokers.

Qualifying for trader tax status
Many traders and tax advisers don’t fully comprehend TTS, including how to use it properly. Rather than deal with its many nuances, they skip TTS and overlook or miss the 475-election deadline. It’s sad to explain to new clients why they cannot deduct trading expenses and losses.

TTS is the linchpin for the related tax advantages of using an entity. Before forming a company, determine if you qualify for it. An entity does not deliver business expense treatment or automatically provide an opportunity for employee benefits. The organization must be eligible for TTS; otherwise, it’s an investment company like the majority of hedge funds.

To be eligible for claiming TTS, a trader needs approximately four total trades or more per day, trade executions on close to four days per week, with more than 15 total trades per week, 60 trades per month, and 720 trades per year (annualized), per the Poppe court. Average holding periods must be under 31 days per the Endicott court. There are several other factors including having material account size ($25,000 for pattern day trader designation on securities and $15,000 for other instruments), spending over four hours per day, having the intention to run a business to make a living, having trading computers and multiple monitors, and a dedicated home office.

If you have segregated investment positions, it’s better to house your TTS trading in a separate entity. Otherwise, the IRS might drag investment positions into the TTS analysis, which can lengthen holding periods over the 31-day requirement.

Investment vs. TTS business expenses
TCJA suspended all investment fees and costs except for two: investment-interest expense limited to investment income, and stock borrow fees, which are considered “other itemized deductions.” Many traders will use the roughly doubled standard deduction instead of itemized deductions, especially considering the SALT itemized deduction cap of $10,000. The 2019 standard deduction is $12,200 single and $24,400 married.

Trading commissions are not separate expenses; the broker deducts them from sales proceeds and adds them to cost-basis for purchases. Commissions are therefore part of trading gain or loss. With net capital gains, commissions are equivalent to a tax deduction; however, with a capital loss limitation, commissions are part of a capital loss carryover. This can’t be changed even with TTS.

TTS business expenses include expensing of computers, monitors, and mobile devices, home-office expenses if exclusively used for business, post-TTS commencement education costs, Section 195 startup costs including pre-business education going six months back, and Section 248 organization expenses. Additional expenses include data and market information services, subscriptions, charting and other software, platform fees, self-created algorithms and automated trading systems, margin interest, stock borrow fees, coaches, mentors, chatrooms, supplies, seminars, travel, meals, professional expenses including tax advice, and more.

A typical TTS trader has annual business expenses ranging between $5,000 and $25,000 per year. Expect higher costs if there are significant stock borrow fees, margin interest expenses, an outside office, staff, or using a Bloomberg terminal. Forex traders tend to have few costs.

With a TTS S-Corp, the health insurance deduction could range from a few thousand to $24,000 or more per year depending on if the trader is single, married, and has children with family coverage. It could be low with an Obamacare subsidy. A Solo 401(k) retirement plan deduction could be up to $62,000 per year per working spouse.

If you want an entity for 2019, you should set it up by the end of Q3. Come November, the window of opportunity closes as two months is too short a period for TTS and to build up employee benefits. In that case, form it in December to be ready for use Jan. 1, 2020.

Consider a 45-minute consultation to review eligibility for TTS, an entity formation plan, Section 475 election, and more. If an entity is a good idea for you, then consider our entity formation service. We also offer our tax compliance service, starting with year-end planning in December.

GNM CPAs Darren Neuschwander, and Adam Manning contributed to this blog post.

For more in-depth information on entities for traders, health insurance, retirement plans, trader tax status, Section 475, QBI and other issues discussed in this blog post, see Green’s 2019 Trader Tax Guide.

Attend our upcoming Webinars on this subject and watch the recording after.


A Rationale For Using QBI Tax Treatment For Traders

June 4, 2019 | By: Robert A. Green, CPA | Read it on

There are two opposing arguments made by tax professionals for applying Section 199A qualified business income (QBI) treatment on 2018 tax returns for traders with trader tax status (TTS).

Those for say Section 199A applies because Section 864(b)(2) is limited to nonresident traders only. U.S. resident TTS traders meet the requirements of Section 864(c)(3) “Other income from sources within United States.” As a result, a U.S. resident TTS trader has effectively connected income (ECI) and therefore, QBI. In this blog post, I refer to this stance as the affirmative or positive rationale.

Those against say Section 199A does not apply to U.S. resident TTS traders because Section 864(b)(2) applies to all traders. This scenario means that “trading for taxpayer’s own account” does not constitute ECI and therefore, QBI does not apply. In this blog post, I refer to this stance as the contrary or negative argument.

Here is what we know. Section 199A labeled TTS trading a “specified service trade or business” (SSTB). The contrary argument would lead to conflict: Why would 199A recognize TTS trading as an SSTB, if 864(b)(2) denied a QBI deduction to U.S. resident TTS traders? With the positive rationale, QBI includes TTS trading business expenses and Section 475 ordinary income/loss. QBI expressly excludes capital gains/losses, interest and dividend income, and forex and swap contract ordinary income/loss. A taxable income threshold, phase-in range, and income cap apply to SSTBs, which leads to some high-income taxpayers not receiving a 20% QBI deduction. (The QBI deduction rules are complex and beyond the scope of this blog post.)

Many traders filed 2018 tax extensions on March 15 (entities) and April 15 (individuals). Their tax preparers are waiting to resolve uncertainty over this issue before the tax return deadlines of Sept. 16, 2019, for partnerships and S-Corps and Oct. 15, 2019, for individual sole proprietorships.

A positive rationale to apply 199A to U.S. resident TTS traders
If you search the 199A final regs, you will find mention of 864(c) beneath the heading “Interaction of Sections 875(1) and 199A.” Section 875(1) states “a nonresident alien individual or foreign corporation shall be considered as being engaged in a trade or business within the United States if the partnership of which such individual or corporation is a member is so engaged.”

199A regs state, “Section 199A(c)(3)(A)(i) provides that for purposes of determining QBI, the term qualified items of income, gain, deduction, and loss means items of income, gain, deduction and loss to the extent such items are effectively connected with the conduct of a trade or business within the United States (within the meaning of section 864(c), determined by substituting ‘qualified trade or business (within the meaning of section 199A’ for ‘nonresident alien individual or a foreign corporation’ or for ‘a foreign corporation’ each place it appears).”

A U.S. resident TTS trader meets the definition of Section 864(c)(3) “Other income from sources within United States.”

“All income, gain, or loss from sources within the United States (other than income, gain, or loss to which paragraph (2) applies) shall be treated as effectively connected with the conduct of a trade or business within the United States.”

A U.S. resident TTS trader has Section 162 trade or business expenses. It’s consistent with 199A stating a TTS trading activity is an SSTB.

A U.S. resident TTS trader also meets the definition of 864(c)(2) “Periodical, etc., income from sources within United States—factors.”

“In determining whether income from sources within the United States of the types described in section 871(a)(1), section 871(h) , section 881(a), or section 881(c), or whether gain or loss from sources within the United States from the sale or exchange of capital assets, is effectively connected with the conduct of a trade or business within the United States, the factors taken into account shall include whether—

(A) The income, gain, or loss is derived from assets used in or held for use in the conduct of such trade or business, or

(B) The activities of such trade or business were a material factor in the realization of the income, gain, or loss. In determining whether an asset is used in or held for use in the conduct of such trade or business or whether the activities of such trade or business were a material factor in realizing an item of income, gain, or loss, due regard shall be given to whether or not such asset or such income, gain, or loss was accounted for through such trade or business.”

A U.S. resident TTS trading business uses the capital for the sale of capital assets to derive its income, and money is a material factor.

Section 871(a)(2) provides that a nonresident individual residing in the U.S. for more than 183 days per year is subject to a 30% tax on U.S.-source capital gains. (A tax treaty may provide relief.)

Some accountants think that Section 864(b)(2) prevents all traders, U.S. residents, and nonresidents, from using QBI treatment.

“Section 864(b) – the term a “trade or business within the U.S.” does not include:

Section 864(b)(1) – Performance of personal services for foreign employer.

Section 864(b)(2) – Trading in securities or commodities.

(A): Stocks and securities.
(i)   In general. Trading in stocks or securities through a resident broker, commission agent, custodian, or other independent agent.
(ii)   Trading for taxpayer’s own account. Trading in stocks or securities for the taxpayer’s own account, whether by the taxpayer or his employees or through a resident broker, commission agent, custodian, or other agent, and whether or not any such employee or agent has discretionary authority to make decisions in effecting the transactions. This clause shall not apply in the case of a dealer in stocks or securities.
(C) Limitation. Subparagraphs (A)(i) and (B)(i) (for commodities) shall apply only if, at no time during the taxable year, the taxpayer has an office or other fixed place of business in the United States through which or by the direction of which the transactions in stocks or securities, or in commodities, as the case may be, are effected.”

The (C) Limitation relates to (i) nonresident investors engaging a U.S. broker. This exception applies if the nonresident does not have an office in the U.S. The exemption does not apply to (ii) “trading for taxpayer’s own account.”

In the 1.864-2 reg, there are several examples under “trading for taxpayer’s own account,” and all of the cases are for nonresident individuals and nonresident partnerships. If you read 864(b)(2)(A)(ii) as applying to nonresidents only, then it supports the affirmative rationale for using 199A on U.S. resident TTS traders.

Reg § 1.864-2(a) states:

“(a) In general. As used in part I (section 861 and following) and part II (section 871 and following), subchapter N, chapter 1 of the Code, and chapter 3 (section 1441 and following) of the Code, and the regulations thereunder, the term “engaged in trade or business within the United States” does not include the activities described in paragraphs (c) (trading in stocks or securities) and (d) (trading in commodities) of this section, but includes the performance of personal services within the United States at any time within the taxable year except to the extent otherwise provided in this section.”

The code sections in this heading are all for nonresidents:
861 – Income from sources within the United States
871 – Tax on nonresident alien individuals
Subchapter N – Tax based on income from sources within or without the United States
Chapter 3 – Withholding of tax on nonresident aliens and foreign corporations
1441: Withholding and reporting requirements for payments to a foreign person

Reg § 1.864-2(c) is for “trading in stocks or securities,” and (d) is for “trading in commodities.” Those sections discuss nonresident individuals and nonresident partnerships with U.S. brokerage accounts and explain that no matter how significant the volume of trades, that a nonresident trader does not have ECI in the U.S. This reg displays several examples, and all of them are for nonresidents. Again, this reg and related code Section 864(b)(2) is for nonresident traders only. A U.S. resident TTS trader is covered in Section 864(c), not in Section 864(b)(2).

The essential point is that the 199A regs do not state to “substitute qualified trade or business for nonresident or foreign” in Section 864(b) – so that code section remains applicable to nonresident traders only. The 199A regs required this substitution for 864(c) only.

Tax attorney Johnny Lyle J.D. weighs in:

“To read IRC Section 864(b) into the equation, you have to determine that the language ‘In the case of a qualified trade or business (within the meaning of section 199A) engaged in trade or business within the United States during the taxable year…’ requires you to determine ‘qualified trade or business under Section 199A,’ but then turn around and determine ‘trade or business within the United States’ under IRC Section 864(b),” Lyle said.

Further, Treasury Regulation Section 1.864-4, titled “U.S. source income effectively connected with U.S. business” states: “This section applies only to a nonresident alien individual or a foreign corporation that is engaged in a trade or business in the United States at some time during a taxable year beginning after December 31, 1966, and to the income, gain, or loss of such person from sources within the United States.”

Treasury Regulation Section 1.864-2, titled “Trade or business within the United States” uses only nonresident aliens and foreign corporations in its examples.

Lyle said two arguments could be made regarding Congress using the language specifically referencing IRC Section 864(c) in IRC Section 199A. First, if Congress wanted to incorporate Section 864(b) into the equation, it would have said effectively connected with the conduct of a trade or business within the United States (within the meaning of section 864) without reference to 864(c). Second, under the Treasury Regulations, 864(b) only applies to nonresident aliens. Therefore, the restriction in 864(b)(2)(A)(ii) would only apply to nonresident aliens, and a taxpayer who was a day trader, but not a nonresident alien, would not be excluded from ECI.

“If Congress intended to exclude all trader income, it would have done so under IRC Section 199A(c)(3)(B) rather than a more roundabout, back door way, rendering IRC Section 199A(d)(2)(B) meaningless,” Lyle said. “If Congress wanted to specifically incorporate Section 864(b), it would have worded it this way: …effectively connected (within the meaning of section 864(c)) with the conduct of a trade or business within the United States (within the meaning of section 864(b)), determined by substituting ‘qualified trade or business (within the meaning of section 199A)’ for ‘nonresident alien individual or a foreign corporation’ or for ‘a foreign corporation’ each place it appears.”

It gives me some pause that some big-four accountants prepared a few 2018 hedge fund partnership K-1s without applying 199A tax treatment. Their K-1 notes indicated reliance on Sections 864(c) and or 864(b) to skip the application of 199A. When we asked some big-four tax partners for clarification, they said they were not wedded to that position. Did these accountants take an easy way out, by reading Section 864(b)(2) out of context? The hedge fund investors would have been hurt with QBI treatment since they would have QBI losses from TTS trading business expenses. The hedge fund had capital gains, which QBI excludes. The hedge fund did not elect Section 475 ordinary income or loss, which QBI includes.

On the other side of the debate, I’ve seen some K-1s from proprietary trading firms, and all of those K-1s did report 199A information. They reported QBI income since they elected Section 475 on securities. I asked their tax preparers about it, and they said 864(b)(2) applies to foreign partnerships, not these U.S. trading partnerships.

I spoke with a tax attorney in IRS Office of Chief Counsel listed on the Section 199A regs, and he thought the positive rationale makes sense. He even accommodated my request to add Section 475 by name to inclusion in QBI in the final 199A regs. The IRS attorney did not raise Section 864(c) or 864(b)(2) as being a problem for U.S. resident TTS traders.

It’s time to complete 2018 tax returns even with remaining uncertainty. I suggest that U.S. resident TTS traders, living, working, and trading in the U.S. consider applying 199A to their trading business. Consult your tax advisor.

CPAs Darren Neuschwander and Adam Manning, and tax attorney Johnny Lyle contributed to this blog post.

See my prior blog posts on 199A for traders at https://greentradertax.com/uncertainty-about-using-qbi-tax-treatment-for-traders/


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