Are Lower 60/40 Tax Rates On Futures In Jeopardy?

July 12, 2011 | By: Robert A. Green, CPA


Hey Mr. President, Traders Need Tax Breaks Too

Andrew Ross Sorkin of the New York Times interviewed me about the history and future status of lower 60/40 tax rates. Read his article “An Addition to the List of Tax Loopholes” published July 11. 

Mr. Sorkin quoted me and used some content from a draft version of this blog, which I sent to him while he worked on his article. While our articles are similar in content, we reach an opposite conclusion. Mr. Sorkin suggested adding 60/40 futures tax rates to the list of tax loopholes being bandied about by the President and Democrats in connection with the contentious debt-ceiling debate. Conversely, I’m in the Republican camp on taxes — I don’t want tax hikes now, but I support meaningful tax reform efforts. 

Mr. Sorkin told me that some in Congress are looking at the Section 1256 60/40 tax rates, which implies to me they are thinking about getting rid of them. He mentioned they saw a recent CFTC report, which showed that 80 percent of trading volumes on commodities exchanges are short-term trading. Which begs question: Why do futures traders receive the 60 percent long-term capital gains benefit? The remaining 40 percent is subject to short-term capital gains rates — the higher ordinary income tax rates. Why should futures traders and commodities exchanges enjoy this tax break, when securities traders and exchanges don’t? 

The President has his sights on tax expenditures and special tax breaks for “those that can afford it” including hedge fund managers, oil companies and private-jet manufacturers. Is the President going to include commodities exchanges and futures traders on that list too?

The President’s Deficit Commission recommends tax reform, simplifying the tax code and repealing many special tax breaks. It suggests one reduced tax rate applied to all types of income, not distinguishing between ordinary and long-term capital gains. This would mean a repeal of 60/40 tax breaks. But, the Deficit Commission’s recommendations overall are good for traders because the Commission suggests a top marginal tax rate of 23 percent, which is the current 60/40 top blended tax rate now. In effect, securities traders could get a tax cut, using the same tax rate that futures traders use now. Yes, investors would lose many itemized deductions in order to flatten the tax code so rates can be reduced, but business traders would still be able to keep their business tax deductions. Although the Deficit Commission didn’t gain much traction to start, it seems to be getting its rightful consideration now as part of the intense debt ceiling and deficit stand-off. 

Republicans say they won’t budge on tax hikes unless it’s part of Deficit Commission tax reform, with corresponding rate reduction. Will 60/40 tax breaks face the chopping block in that debate? President Obama included repeal of lower 60/40 tax rates for dealers only in his last two budgets. To date, Congress did not include those provisions in any tax bill and it has not been enacted. I covered this on my blog in 2009 .

Back to Mr. Sorkin’s NYT article
After our call, I sent him Green’s 2011 Trader Tax Guide and included this note. 

• I don’t see how President Obama can justify keeping lower 60/40 tax rates to benefit futures traders and commodities exchanges in his home state while pushing hard to raise taxes on securities hedge-fund managers often in Connecticut and New York City. Many securities hedge-fund managers don’t receive carried interest tax breaks with lower 15 percent long-term capital gains tax rates because they mostly generate short-term capital gains taxed at higher ordinary tax rates. Repealing carried interest also subjects the income to self-employment taxes. 

• I think your story could cause a firestorm. We could be witnessing the first preparations for a broadside against lower 60/40 tax rates for futures traders. It will be very interesting to see the politics on this one as they are counter-intuitive with this tax break being a little to close to Chicago’s Democratic stronghold. 

Mr. Sorkin concluded that futures traders are getting a special hard-to-defend tax break.

I told Mr. Sorkin the history of 60/40
President Reagan’s major tax reform in the early 80s to reduce sky-high tax rates was a similar debate. Repeal tax expenditures and tax shelters as a trade-off to lower tax rates. Professional commodities traders were gaming/avoiding the tax system badly. They put on long and short trades at the same time and closed out losing trades before year-end, while deferring profitable trades and related taxes to subsequent years. Many never paid taxes and yet made a fortune. 

Congress said the jig was up and enacted mark-to-market (MTM) accounting, an economic system to report both realized and unrealized gains and losses at year-end. Chairman of Ways & Means Dan Rostenkowski (D-Ill.) saved the day for his local commodities traders and campaign contributors. Rostenkowski may have asked: how can commodities traders receive a long-term capital gains rate — which requires a 12-month holding period — if they have to mark to market before year-end? In that case, every trade is short-term and taxed at higher ordinary income tax rates. The horse trading commenced and no one was better at it than Rostenkowski. Traders probably had 80 percent short-term trading at that time, so it should have been a 20/80 blended rate. Rostenkowski negotiated 60 percent long-term for his loyal constituents.

Futures traders are sometimes worse off 
Having to pay taxes on unrealized gains is a burden when traders wind up with realized losses on those same exact positions. An unrealized gain on Dec. 31 can melt away quickly in January. To counter this, the Section 1256 election allows futures traders to carry back futures tax losses three tax years, but only applied against futures tax gains. Often futures traders overlook this election, or they don’t have sufficient futures gains in earlier years. 

There’s other collateral tax damage too. Those with memberships on futures or options exchanges are subject to self-employment (SE) taxes (social security and Medicare) on their trading gains too (Section 1402i); other types of traders are exempt from SE taxes. SE taxes on the SE base are currently 15.3 percent. Adding that amount to the 23 percent current blended income tax rate equals 38.3 percent.

Traders are the lifeblood of markets
As I pointed out vigorously in our blog “Financial-Transactions Tax Update”, business traders are the infrastructure — the “market-makers” — of the financial markets and without their liquidity, we could all face a “flash crash” at any given moment. Farmers, retail investors, mutual funds, pension funds, and small and large businesses use the futures markets to hedge their positions, and they need a properly functioning futures market at all times. Yes traders are being unfairly attacked on all fronts — FTT, futures tax rates, Dodd-Frank Fin Reg and more. 

The $3,000 capital loss limitation
For individuals — including those using pass-through entities — net capital losses are limited to $3,000 per year, and that puny loss limitation has never been indexed for inflation. Most other clauses in the tax code are indexed, like the AMT patch each year, tax brackets, credits, standard deductions and more. 

Business traders are unfairly lumped with investors and forced to suffer through capital loss limitations and wash sale loss deferrals. Congress designed these “tax sticks” to help offset the “tax carrot” of lower long-term capital gains tax rates. But, business and active traders rarely benefit from lower long-term capital gains rates. 

Give all business traders 60/40 rates
It’s not fair to call the futures 60/40 split a tax loophole. In fact, Congress should allow securities traders the same split rates too. If not, then allow all business traders to use business ordinary loss treatment without limitation by default. Securities traders are caught between a rock and a hard place, with the $3,000 capital loss limitation and the highest ordinary rates.

Will the President add 60/40 to his list of undue tax breaks?
Now that Mr. Sorkin and some in Congress have added futures tax rates to their list of tax loopholes, I wonder if President Obama will take their bait. Doing so will surely awaken the ire of Chicago commodities exchanges and generate heat on Illinois politicians. 

This is not the first broadside against futures tax rates. In 2003, during the eleventh hour of the Bush Tax Cut conferee negotiations between the Senate and House bills, a few Democratic senators tried to repeal 60/40 tax rates. The public never witnessed this broadside, but the Chicago exchanges cried foul and the House didn’t yield, thereby safeguarding 60/40. As we face the end of the Bush-era tax cuts, why revisit this issue again?

If the President doesn’t include futures traders on his list of “undue tax breaks” what does that tell you? That either he doesn’t agree, or he doesn’t want to upset his hometown exchanges and fellow politicians. Would that put Democrats on a potential hypocritical attack on carried interest and the Bush tax cuts for the upper income? One fear is the President might seek to repeal many tax breaks as a trade-off for keeping the Bush-era tax rates for all taxpayers, including the upper-income. That’s not much of a rate reduction and it will represent a huge tax hike for futures traders.

In the end, I like Deficit Commission tax reform ideas with a low 23 percent rate for everyone and business tax deductions safeguarded. As you can see, tax change is a difficult and nuanced undertaking and significant tax reform will take some time.