Tax software and preparers come up short on traders; they mishandle trader tax status, forms, elections, the treatment of different financial products, entities, employee benefit deductions and investment expenses. Here are seven powerful ways traders save money this tax-filing season.
1. Use correct tax forms
The IRS hasn’t created specific tax forms for individual trading businesses. Traders enter gains and losses, portfolio income, business expenses and investment expenses on various forms. It’s often confusing. Which form should you use if you’re a forex trader? Which form is best for securities traders using the Section 475 MTM method? The different reporting strategies for the various types of traders make tax time not so cut-and-dried.
- Sole proprietor trading business: Other sole-proprietorship businesses report revenue, the cost of goods sold and expenses on Schedule C. But business traders qualifying for trader tax status (TTS) report only expenses on Schedule C. Trading gains and losses are reported on various forms, depending on the situation. In an entity, all trading gains, losses, and expenses are consolidated on the entity tax return — a partnership Form 1065 or S-Corp Form 1120-S. That’s one reason why we recommend entities for TTS traders.
- Sales of securities must be first reported on Form 8949, which then feeds into Schedule D (cash method) with capital losses limited to $3,000 per year against ordinary income (the rest is a capital loss carryover). Capital losses are unlimited against capital gains.
- Business traders who elect and use Section 475 MTM on securities report their business trades (line by line) on Form 4797 Part II. MTM means open business trades are marked-to-market at year-end based on year-end prices. Business traders still report sales of segregated investments in securities (without MTM) on Form 8949. Form 4797 Part II (ordinary gain or loss) has unlimited business ordinary loss treatment and avoids capital loss limitations and wash sale loss treatment. Form 4797 losses are counted in net operating loss (NOL) calculations.
- Section 1256 contract traders (i.e., futures) should use Form 6781 (unless they elected Section 475 for commodities/futures; in that case, Form 4797 is used). Section 1256 traders don’t use Form 8949 — they rely on a one-page Form 1099-B showing their net trading gain or loss (“aggregate profit or loss on contracts”). Just enter that amount in summary form on Form 6781 Part I. If you have a large Section 1256 loss, consider a Section 1256 loss carryback election to carryback those losses three tax years, but only applied against Section 1256 gains in those years. If you want this election, check box D labeled “Net section 1256 contracts loss election ” on the top of Form 6781.
- Forex traders with Section 988 ordinary gains or losses who don’t qualify for TTS should use line 21 (other gross income or loss) on Form 1040. Traders who qualify for TTS should use Form 4797, Part II ordinary gain or loss. What’s the difference? Form 4797 Part II losses contribute to NOL carrybacks and carryforwards against any type of income, whereas Form 1040’s “other losses” do not. The latter can be wasted if the taxpayer has negative income. In that case, a contemporaneous capital gains election is better on the Section 988 trades. If you filed the contemporaneous Section 988 opt-out (capital gains) election, use Form 8949 for minor currencies and Form 6781 for major currencies. Forex uses summary reporting.
2. Maximize business expenses and fix Schedule C problems
Sole-proprietor business traders report business expenses on Schedule C and trading income/loss and portfolio-related income on other tax forms, which may confuse the IRS. It may automatically view a trading business’s Schedule C as unprofitable even if it has substantial net trading gains on other forms. This is one reason why I recommend an entity.
To mitigate this red flag, I advocate a special strategy to transfer a portion of business trading gains to Schedule C to “zero it out” if possible. Don’t report a net income on Schedule C as that would invite IRS computers to look for self-employment (SE) tax, which traders do not owe on trading income. (The exception is a full-fledged dealer/member of an options or futures exchange trading Section 1256 contracts on that exchange; they have self-employment income per Section 1402i.)
I strongly recommend that business traders always include well-written tax-return footnotes, explaining trader tax law and benefits, why and how you qualify for TTS (business treatment), whether you elected Section 475 MTM or opted out of Section 988, and other tax treatment, such as the income-transfer strategy. If you’re a part-time trader, use the footnotes to explain how you allocate your time between other activities and trading. Including footnotes with your return takes a step to address any questions the IRS may have about your qualification for TTS and the various aspects of its reporting on your return before it has a chance to ask you.
3. Use correct tax treatment of different financial products
Which financial products you trade and where you trade them can make a huge difference in tax savings. Capital gains vs. ordinary income: Most financial instruments — including securities, Section 1256 contracts, options, ETFs, indexes, precious metals and bitcoin held as a capital asset — are subject to capital gains treatment. By default, forex contracts and swap contracts are subject to ordinary gain or loss treatment. The distinction between ordinary and capital gains treatment makes a big difference.
The capital-loss limitation is a problem for traders and investors who may have trouble using up large capital-loss carryovers in subsequent tax years. Traders with TTS and a Section 475 MTM election have business ordinary-loss treatment, which is more likely to generate tax savings or refunds faster. Section 1256 contract traders enjoy lower 60/40 tax rates, summary reporting and no need for accounting.
4. Maximize benefits on an entity tax return
Partnership and S-Corp trading business tax returns show trading gains, losses and business expenses on one set of forms, plus the IRS won’t see the taxpayer’s other activities. That looks much better than a Schedule C.
Form 1065 is filed for a general partnership or multi-member LLC choosing to be taxed as a partnership. Form 1120S is filed for an S-corporation and an LLC electing to be taxed as an S-Corp. Forms 1065 and 1120S issue Schedule K-1s to the owners, so taxes are paid at the owner level rather than at entity level, thereby avoiding double taxation. Ordinary income or loss (mostly business expenses) is summarized on Form 1040 Schedule E rather than in detail on Schedule C (hence less IRS attention). Section 179 is broken out separately on Schedule E, along with unreimbursed partnership expenses (UPE) including home-office expenses.
Under the “trading rule” exception in Section 469 passive-activity loss rules, trading business entities are considered “active” rather than “passive-loss” activities, so losses are allowed in full. Portfolio income (interest and dividends) is passed through to Schedule B. Capital gains and losses are passed through to Schedule D in summary form. Pass-through entities draw less IRS attention than a detailed Schedule C filing. Net taxes don’t change; they’re still paid on the individual level. Pass-through entities file Form 8949 and/or Form 4797 at the entity level.
5. Maximize employee benefit plan deductions
S-Corps provide additional tax breaks including opportunities for employee-benefit plans including retirement plans and health-insurance premium tax deductions; two breaks sole-proprietor and partnership traders can’t use unless they have a source of earned income. Health insurance is a great deduction through a trader S-Corp because there is no payroll tax due on that portion of W-2 wages.
6. File and report tax elections on time
Tax treatment elections can be confusing because the Section 475 MTM and Section 988 elections don’t have tax forms. New taxpayers — such as a new entity — file Section 475 MTM elections internally within 75 days of inception, but existing taxpayers file a statement by the due date of the prior year tax return or extension with the IRS and perfect it later with a Form 3115 filing by the deadline. It’s too late to elect Section 475 for 2016 taxes; the next opportunity is for 2017, by Mar. 15, 2017 for existing partnerships and S-Corps, and Apr. 18, 2017 for individuals.
The forex Section 988 capital gains election is only filed internally on a contemporaneous basis, at any time during the year, from that date going forward.
7. Maximize investment expenses
If you’re filing as an investor, report trading gains and losses as explained earlier. You can’t elect and use Section 475 MTM with Form 4797 ordinary gain or loss treatment, as that election requires TTS.
Report investment interest expense (margin interest) on Form 4952. It’s limited to investment income and investment expenses, and the balance is an investment interest expense carryover to the subsequent tax year(s). The deduction is taken on Schedule A where it may be subject to the Pease limitation, but it’s deductible for alternative minimum tax.
Report investment expenses as miscellaneous itemized deductions on Schedule A. Miscellaneous itemized deductions are only allowed in excess of 2% of adjusted gross income (AGI). The allowed amount is subject to the Pease limitation, and it’s not deductible for AMT. Many states limit or do not allow itemized deductions. Business expense treatment with TTS is much better.
Investment expenses are allowed for the production of investment income. Investment expenses exclude home office, education, seminars, travel to seminars and startup expenses. Computers and monitors are allowed if they are predominantly used for managing investments.
Don’t sell yourself short on tax breaks available for traders this tax season.
This blog post is a modified excerpt from Green’s 2017 Trader Tax Guide.
Attend our related Webinar or watch the recording afterward: 7 Ways To Save On 2016 Tax Returns For Traders (Lightspeed Trading)