Author Archives: Robert Green

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/

Trading Futures & Other Section 1256 Contracts Has Tax Advantages

May 30, 2019 | By: Robert A. Green, CPA | Read it on

There are various types of financial products with different tax treatments, and Section 1256 contracts have the best overall tax advantages.

Tax treatment of financial products affects investors, traders, and hedge funds. But sadly, many tax preparers overlook essential differences in tax treatment for these groups, resulting in overpayments. Education is key.

It’s important to distinguish between securities vs. Section 1256 contracts with lower 60/40 capital gains rates vs. other types of financial products like forex or swaps with ordinary income or loss treatment. Plus, there are various elections available to change tax treatment.

Capital gains vs. ordinary income
Most financial instruments — including securities, Section 1256 contracts, options, ETFs, ETNs, indexes, precious metals, and cryptocurrencies held as a capital asset — are subject to capital gains treatment. However, some of these financial products qualify as Section 1256 contracts with lower 60/40 capital gains rates.

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. There is a Section 1256 loss carryback election.

Traders with trader tax status (TTS) and a Section 475 MTM election have business ordinary-loss treatment, which is more likely to generate tax savings or refunds faster than capital loss carryovers.

60/40 capital gains rates
Section 1256 contracts have lower 60/40 tax rates, meaning 60% (including day trades) are taxed at the lower long-term capital gains rate, and 40% are taxed at the short-term rate, which is the ordinary tax rate.

At the maximum tax brackets for 2018 and 2019, the top Section 1256 contract tax rate is 26.8% —10.2% lower than the highest ordinary rate of 37%. Section 1256 tax rates are 4.2% to 12% lower vs. ordinary rates depending on which tax bracket applies.

For example: Make $100,000 in 1256 contracts in the 35% ordinary bracket, and save $12,000 (12%) with 60/40 rates.

For 2018 and 2019, there is meaningful tax rate reduction throughout the brackets, including zero long-term rates in the 10% and 12% ordinary brackets.

See Section 1256 tax rates vs. ordinary rates (2018 & 2019 rates). State tax rates apply; they do not include a long-term rate.

Trading income is not self-employment income (SEI) for triggering SE tax (FICA and Medicare). Traders who are full members of a futures or options exchange are an exception here; they have self-employment income under Section 1402(i) on their exchange-generated trading gains reported on Form 6781.

List of 1256 contracts

U.S. futures contracts:
- Regulated futures contracts (RFCs) on a qualified board or exchange (QBE).
- U.S. RFCs on commodities (food, energies, and metals), stock indexes, financials (U.S. Treasuries and bonds), currencies, and more.
- Options on U.S. futures (RFCs).
- Foreign futures with CFTC and IRS approval. (Only a handful of exchanges currently have this IRS revenue ruling, including Eurex, LIFFE, ICE Futures Europe, and ICE Futures Canada, see blog post).

Broad-based indexes:
- Broad-based indexes are stock index futures made up of 10 or more underlying securities.
- Options on broad-based indexes are also 1256 contracts.
- Broad-based indexes are taxed differently from exchange-traded funds (ETFs), which are securities.
- The S&P 500 Index (CBOE: SPX) is listed on a commodities exchange, taxed as a Section 1256 contract.
- The SPDR S&P 500 ETF Trust (NYSEARCA: SPY) is listed on a securities exchange, taxed as a security.

Other Section 1256 contracts:
- Options on commodities/futures ETFs taxed as publicly traded partnerships. (Options on securities ETFs are securities.)
- CBOE-listed options on volatility ETNs structured as prepaid forward contracts (the ETN itself is not Section 1256).
- Non-equity options. (Be careful in using this catchall.)
- Forex forward contracts on major currencies, if the taxpayer filed a Section 988 opt-out election to use Section 1256(g) (we make a case for forex spot in major currencies, too).
- Forex OTC options (Wright tax court case).

Mark-to-market accounting
Section 1256 contracts use mark-to-market (MTM) accounting daily. For income tax purposes, MTM means gain/loss calculations report both realized activity from throughout the year, and unrealized gains and losses on open trading positions at year-end. The broker 1099-B also reverses unrealized amounts from the prior year.

With MTM, wash sale (WS) loss adjustments are a moot point; hence, WS apply to securities, only, not 1256 contracts. With MTM, traders don’t have to do “tax loss selling” at year-end, since they will report the unrealized losses, anyway. Many traders have small or no open positions on Section 1256 contracts at year-end.

It might be hard to find an accurate MTM price for valuing long-term options (1256 contracts) at year-end. The broker might use one price on the December monthly statement and a significantly different value on the 1099-B for calculating unrealized gains and losses. Brokers use Options Clearing Corporation (OCC) for FMV, which might be from the last trade in the marketplace. That trade might not indicate the actual FMV. Some taxpayers use Black-Scholes modeling to determine a more accurate FMV.

Tax reporting
With Section 1256 MTM and summary reporting, brokers can issue simple one-page 1099-Bs reporting “aggregate profit or loss on contracts” after taking into account realized and unrealized gains and losses.

That amount is reported on Form 6781 Part I, which breaks it down to the 60/40 split and then moves those amounts to Schedule D capital gains and losses. See a 2019 Form 1099-B lines 8 – 11 for 1256 contract reporting.

One might expect that broker-issued 1099-Bs would handle all tax treatment issues, but for some financial products, they do not. Some brokers categorize CBOE-listed options on volatility ETNs, and ETFs structured as publicly traded partnerships as securities, but there is substantial authority to treat these CBOE-listed options as “non-equity options” included in Section 1256. (Options on securities ETFs are taxed as securities.) The most complicated issue for 1099-Bs is wash sale loss adjustments on securities.

Section 1256 traders should also learn about the “mixed straddle election” and “hedging rules” in Section 1256(d) and (e), and as discussed on Form 6781. Offsetting positions between Section 1256 contracts and securities can generate tax complications under certain circumstances involving the hedging rule. The IRS is concerned about traders reporting Section 1256 MTM unrealized losses and deferring unrealized gains on offsetting securities positions, so there are rules intended to prevent this.

Election to carryback Section 1256 losses
On Form 6781, select the “net section 1256 contracts loss election” in box D. Enter, but don’t deduct the loss on the current tax return. Remove the loss from Form 6781 on line 6. Apply the Section 1256 loss on amended tax return filings against Section 1256 gains only. (Form 1045 is preferable; otherwise, use Form 1040X.) It’s a three-year carryback, and unused amounts are then carried forward. It’s the only time traders can carryback a tax loss. TCJA repealed NOL carrybacks starting in 2018.

Section 475 election
Traders eligible for trader tax status (TTS) are entitled to file a timely election for Section 475 ordinary gain or loss treatment on securities and or commodities (including Section 1256 contracts). Generally, Section 475 is smart for securities traders, but not most 1256 contract traders. Ordinary losses are usually better than capital losses; however, ordinary income rates are worse than 60/40 capital gains rates.

TCJA introduced a new Section 199A “qualified business income” (QBI) deduction. Trading is a “specified service trade or business” (SSTB) subject to an income threshold, phase-in, and cap on the QBI deduction. QBI includes Section 475 ordinary income/loss, and trading business expenses. However, QBI excludes capital gains, 60/40 capital gains, portfolio income, and Section 988 and swap ordinary income. There is uncertainty about this QBI application to traders based on Section 864(b). It is better to use 60/40 capital gains rates.

Watch our Webinar recordingTrading Futures & Other Section 1256 Contracts Has Tax Advantages

Tax Extensions: 12 Tips To Save You Money

March 12, 2019 | By: Robert A. Green, CPA | Read it on

Individual tax returns for 2018 are due April 15, 2019, however, most active traders aren’t ready to file on time. Some brokers issue corrected 1099Bs right up to the deadline, or even beyond. Many partnerships and S-Corps file extensions by March 15, 2019, and don’t issue Schedule K-1s to partners until after April 15. Many securities traders struggle with accounting for wash sale loss adjustments.

The new tax law (TCJA) raises additional complications on 2018 tax returns. There is uncertainty over QBI tax treatment for traders, so we suggest traders eligible for trader tax status (TTS) file extensions. (See Uncertainty About Using QBI Tax Treatment For Traders.)

The good news is traders don’t have to rush completion of their tax returns by April 15. They should take advantage of a simple one-page automatic extension along with payment of taxes owed to the IRS and state. Most active traders file extensions, and it’s helpful to them on many fronts.

Tip 1: Get a six-month extension of time
Request an automatic six-month extension of time to file individual federal and state income tax returns by Oct. 15, 2019. Form 4868 instructions point out how easy it is to get this automatic extension — no reason is required. It’s an extension of time to file a complete tax return, not an extension of time to pay taxes owed. Estimate and report what you think you owe for 2018 based on your tax information received.

Tip 2: Avoid penalties from the IRS and state for being late
Learn how IRS and state late-filing and late-payment penalties apply so you can avoid or reduce them to your satisfaction. 2018 Form 4868 (Application for Automatic Extension of Time To File U.S. Individual Income Tax Return) page two states:

Late Payment Penalty: The late payment penalty is usually ½ of 1% of any tax (other than estimated tax) not paid by the regular due date of your return, which is April 15, 2019, for calendar year filers (April 17, 2019, if you live in Maine or Massachusetts). It’s charged for each month or part of a month the tax is unpaid. The maximum penalty is 25%. The late payment penalty won’t be charged if you can show reasonable cause for not paying on time. Attach a statement to your return fully explaining the reason. Don’t attach the statement to Form 4868. You’re considered to have reasonable cause for the period covered by this automatic extension if both of the following requirements have been met. 1. At least 90% of the total tax on your 2018 return is paid on or before the regular due date of your return through withholding, estimated tax payments, or payments made with Form 4868. 2. The remaining balance is paid with your return.

Late Filing Penalty: A late filing penalty is usually charged if your return is filed after the due date (including extensions). The penalty is usually 5% of the amount due for each month or part of a month your return is late. The maximum penalty is 25%. If your return is more than 60 days late, the minimum penalty is $210 (adjusted for inflation) or the balance of the tax due on your return, whichever is smaller. You might not owe the penalty if you have a reasonable explanation for filing late. Attach a statement to your return fully explaining your reason for filing late. Don’t attach the statement to Form 4868.”

Tip 3: File an automatic extension even if you cannot pay
Even if you can’t pay what you estimate you owe, make sure to file the automatic extension form on time by April 15, 2019. It should help avoid the late-filing penalty, which is ten times more than the late-payment penalty. If you can’t pay in full, you should file your tax return or extension and pay as much as you can.

An example of late-payment and late-filing penalties: Assume your 2018 tax liability estimate is $50,000. Suppose you file an extension by April 15, 2019, but cannot pay any of your tax balance due. You file your actual tax return on the extended due date of Oct. 15, 2019, with full payment. A late-payment penalty applies because you did not pay 90% of your tax liability on April 15, 2019. The late-payment penalty is $1,500 (six months late x 0.5% per month x $50,000). Some traders view a late-payment penalty like a 6% margin loan, and it’s not tax-deductible.

By simply filing the extension on time in the above example, you avoided a late-filing penalty of $11,250 (six months late x 5% per month [25% maximum], less late-payment penalty factor of 2.5% = 22.5%; 22.5% x $50,000 = $11,250). Interest is also charged on taxes paid after April 15, 2019.

If you don’t expect to owe 2018 taxes by April 15, 2019, it’s easy to prepare an extension with no balance due. Make sure to file it on time to avoid a minimum penalty just in case you were wrong and do owe taxes for 2018.

Tip 4: Add a payment cushion for Q1 2019 estimated taxes due
Traders with 2019 year-to-date trading gains and significant tax liability in the past year should consider making quarterly estimated tax payments this year to avoid underestimated tax penalties. The IRS increased AFR interest rates in 2018 and 2019.

I recommend the following strategy for traders and business owners: Overpay your 2018 tax extension on April 15, 2019, and plan to apply an overpayment credit toward Q1 2019 estimated taxes. Most traders don’t make estimated tax payments until Q3 and or Q4 when they have more precise trading results. Why pay estimated taxes for Q1 and Q2 if you incur substantial trading losses later in the year?

It’s a better idea to pay an extra amount for the extension to set yourself up for three good choices: A cushion on 2018 if you underestimated your taxes, an overpayment credit toward 2019 taxes, or a tax refund for 2018 if no 2019 estimated taxes are due.

Tip 5: Consider a 2019 Section 475 MTM election
Traders eligible for trader tax status should consider attaching a 2019 Section 475 election statement to their 2018 tax return or extension. These are due by April 15, 2019, for individuals and corporations and March 15 for partnerships and S-Corps. Section 475 turns capital gains and losses into ordinary gains and losses, thereby avoiding the capital-loss limitation and wash-sale loss adjustments on securities (i.e., tax-loss insurance).

TTS traders might also derive an essential tax benefit from Section 475 ordinary income: TCJA’s 20% qualified business income (QBI) deduction. However, QBI treatment for traders is uncertain at this time. (Read Traders Elect Section 475 For Massive Tax Savings.)

Tip 6: File when it’s more convenient for you
Sophisticated and wealthy taxpayers know the “real” tax deadline is Oct. 15, 2019, for individuals and Sept. 16, 2019, for pass-through entities, including partnership and S-Corp tax returns. Pass-through entities file tax extensions by March 15, 2019. (See March 15 Is Tax Deadline For S-Corp And Partnership Extensions And Elections.)

You don’t have to wait until the last few days of the extension period like most wealthy taxpayers. Try to file your tax return in the summer months.

Tip 7: Be conservative with tax payments
I’ve always advised clients to be aggressive but legal with tax-return filings and look conservative with cash (tax money). Impress the IRS with your patience on overpayment credits and demonstrate you’re not hungry and perhaps overly aggressive to generate tax refunds. It’s a wise strategy for traders to apply overpayment credits toward estimated taxes owed on current-year trading income. You want to look like you’re going to be successful in the current tax year.

The additional time helps build tax positions like qualification for trader tax status in 2018 and 2019. It may open opportunities for new ideas on tax savings. A rushed return does not.

Tip 8: Get more time to fund qualified retirement plans
The extension also pushes back the deadline for paying money into qualified retirement plans including a Solo 401(k), SEP IRA and defined benefit plan. The deadline for 2018 IRA contributions is April 15, 2019.

Tip 9: Respect the policies of your accountants
Your accountant can prepare extension forms quickly for a nominal additional cost related to that job. There are no fees from the IRS or state for filing extensions. Be sure to give your accountant tax information received and estimates for missing data.

Your accountant begins your tax compliance (preparation) engagement, and he or she cuts it off when seeing a solid draft to use for extension filing purposes. Your accountant will wait for final tax information to arrive after April 15, 2019. Think of the extension as a half-time break. It’s not procrastination; accountants want tax returns finished.

Please don’t overwhelm your tax preparer the last few weeks and days before April 15 with minor details in a rush to file a complete tax return. Accounting firms with high standards of quality have internal deadlines for receiving tax information for completing tax returns. It’s unwise to pressure your accountant, which could lead to mistakes or oversights in a rush to file a complete return at the last minute. That doesn’t serve anyone well.

Tip 10: Securities traders should focus on trade accounting
It doesn’t matter if your capital loss is $50,000 or $75,000 at extension time: Either way, you’ll be reporting a capital loss limitation of $3,000 against other income. In this case, don’t get bogged down with trade accounting and reconciliation with Form 1099Bs until after April 15. The capital loss carryover impacts your decision to elect Section 475 MTM for 2019 by April 15, 2019, but an estimate is sufficient.

Consider wash-sale loss rules on securities: If you know these adjustments won’t change your $3,000 capital loss limitation, you can proceed with your extension filing. But if you suspect wash-sale loss adjustments could lead to reporting capital gains rather than losses, or if you aren’t sure of your capital gains amount, focus your efforts on trade accounting before April 15. (Consider our trade accounting service.) Try to do accounting work for year-to-date 2019; it also affects your decision-making on the 475 election.

Section 1256 contract traders can rely on the one-page 1099B showing aggregate profit or loss. Forex traders can depend on the broker’s online tax reports. Wash sales don’t apply to Section 1256 contracts and forex. Cryptocurrency traders should use coin trade accounting programs to generate Form 8949.

Tip 11: Don’t overlook state extensions and payments
Some states don’t require an automatic extension for overpaid returns; they accept the federal extension. If you owe state taxes, you need to file a state extension with payment. States tend to be less accommodating than the IRS in abating penalties, so it’s usually wise to cover your state taxes first if you’re short on cash. Check the extension rules in your state.

Tip 12: U.S. residents abroad should learn the particular rules
U.S. citizens or aliens residing overseas are allowed an automatic two-month extension until June 17, 2019, to file their tax return and pay any amount due without requesting an extension. (See Form 4868 page 2, and the IRS website.)

Darren Neuschwander CPA and Adam Manning CPA contributed to this blog post. 

March 15 Is Tax Deadline For S-Corp And Partnership Extensions And Elections

March 6, 2019 | By: Robert A. Green, CPA | Read it on

March 15, 2019, is the deadline for filing 2018 S-Corp and partnership tax returns, or extensions, 2019 S-Corp elections for existing entities, and 2019 Section 475 elections for a pass-through entity. Don’t miss any of these tax filings or elections; it could cost you.

2018 S-Corp and partnership tax extensions

Extensions are easy to prepare and file for S-Corps and partnerships since they pass through income and loss to the owner, usually an individual. Generally, pass-through entities are tax-filers, but not taxpayers. 2018 individual and calendar-year C-Corp tax returns or extensions, and Section 475 elections are due April 15, 2019. (See IRS Tax Calendars For 2019.)

For S-Corps and partnerships use Form 7004 (Application for Automatic Extension of Time To File Certain Business Income Tax, Information, and Other Returns). 2018 S-Corp and partnership extensions give six additional months to file a federal tax return, by Sep. 16, 2019.

Some states require a state extension filing, whereas others accept the federal extension. Some states have S-Corp franchise taxes, excise taxes, or minimum taxes, and payments are usually due with the extensions by March 15. LLCs filing as a partnership may have minimum taxes or annual reports due with the extension by March 15.

Late Filing Penalties: The IRS late filing penalty regime for S-Corps and partnerships is similar. The IRS assesses $210 for partnerships, $200 for S-Corps, per owner, per month, for a maximum of 12 months. Taxpayers may request penalty abatement based on reasonable cause after the IRS mails a penalty notice. Ignoring the extension deadline is not reasonable cause. There is also a $270 penalty for failure to furnish a Schedule K-1 to an owner on time, and the penalty is higher if intentionally disregarded. States assess penalties and interest, often based on payments due. (See more details about penalties and interest in Form 1065 and 1120S instructions.)

The new tax law TCJA’s Section 199A “qualified business income” (QBI) tax treatment might apply to TTS partnerships and S-Corps, whether they use Section 475 or not. TTS trading expenses are QBI losses. In my recent blog post, Uncertainty About Using QBI Tax Treatment For Traders, I suggest filing extensions to have additional time for a resolution of this matter.

2018 S-Corp elections

Traders qualifying for trader tax status and interested in employee benefit plan deductions, including health insurance and retirement plan deductions, probably need an S-Corp. They should consider a 2019 S-Corp election for an existing trading entity, due by March 15, 2019, or form a new entity and file an S-Corp election within 75 days of inception. Most states accept the federal S-Corp election, but a few states do not; they require a separate S-Corp election filing by March 15. If you overlooked filing a 2018 S-Corp election by March 15, 2018, and intended to elect S-Corp tax treatment as of that date, you may qualify for IRS relief. (See Late Election Relief.) (Sole proprietor traders do not have self-employment income, which means they cannot have self-employed health insurance and retirement plan deductions. TTS partnerships face significant obstacles in achieving self-employment income.)

2019 Section 475 MTM elections for S-Corps and partnerships

Traders, eligible for trader tax status, should consider attaching a 2019 Section 475 election statement to their 2018 tax return or extension due by March 15, 2019, for partnerships and S-Corps, or by April 15, for individuals and C-corps. Section 475 turns capital gains and losses into ordinary gains and losses thereby avoiding the capital loss limitation and wash sale loss adjustments (tax loss insurance). There might also be benefits to 475 income per the new tax law (TCJA) “qualified business income” (QBI) deduction subject to taxable income limitations. However, QBI tax treatment for traders is uncertain at this time. (Read Traders Elect Section 475 For Massive Tax Savings.)

If a trader wants to revoke a prior year Section 475 election, a revocation election statement is due by March 15, 2019. (See New IRS Rules Allow Free And Easy Section 475 Revocation.)

If you need help, consider a consultation or our tax compliance service.

Uncertainty About Using QBI Tax Treatment For Traders

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

Traders in securities and/or commodities, qualifying for trader tax status (TTS) as a sole proprietor, S-Corp, or partnership (including hedge funds), are wondering if they should use “qualified business income” (QBI) tax treatment on their 2018 tax returns. I see a rationale to include such treatment, but there are conflicts and unresolved questions, which renders it uncertain at this time. Section 199A QBI regs include “trading” as a “specified service trade or business” (SSTB), and QBI counts Section 475 ordinary income or loss. However, Section 199A’s interaction with 864(c) may override that and deny QBI tax treatment to U.S. resident traders.

QBI treatment might be an issue for all TTS traders, not just the ones who elected Section 475 ordinary income or loss. For example, a TTS sole proprietor trader filing a Schedule C would report business expenses as a QBI loss, which might reduce aggregate QBI from other activities, thereby reducing an overall QBI deduction. There are QBI loss carryovers, too.

Many TTS traders and hedge funds don’t want QBI tax treatment since they have not elected Section 475, and QBI excludes capital gains, Section 988 forex ordinary income, dividends, and interest income. Hedge fund accountants seem to prefer the Section 864 rationale to not use QBI treatment for TTS funds.

A partnership or S-Corp needs to report QBI items on Schedule K-1 lines for “Other Information,” in box 20 for partnerships and box 17 for S-Corps, including Section 199A income or loss, and related 199A factors like W-2 wages and qualified property.

With uncertainty over QBI tax treatment, traders should file 2018 tax extensions for partnerships and S-Corps by March 15, 2019, and extensions for individuals by April 15, 2019.

A 2019 Section 475 election is due by those extension deadlines. Section 475 gives tax loss insurance: Exemption on wash sale loss adjustments on securities and avoidance of the $3,000 capital loss limitation. There’s a chance traders might be entitled to a QBI deduction on 475 income, so factor that possibility into decision making. (See my recent blog on extensions and 475 elections.)

Section 864 might deny QBI treatment to TTS traders
I took a closer look at the confusing language in Section 199A’s interaction with Section 864(c), which might deny QBI treatment to TTS traders. Section 199A final regs imply that if a trade or business does not constitute “effectively connected income” (ECI) in the hands of a non-resident alien under Section 864(c), then it’s not QBI for a U.S. resident taxpayer operating a domestic trade or business.

Historically, Section 864 applied to nonresident aliens, and foreign entities for determining U.S. source income, including ECI in Section 864(c). Reading Section 864 makes sense with nonresident aliens in mind. However, it gets confusing when 199A overlays language on top of Section 864 for the benefit of determining QBI for U.S. residents.

The function of Section 864 is to show nonresident aliens how to distinguish between U.S.-source income (effectively connected income) vs. foreign-source income. An essential element of Section 199A is to limit a QBI deduction to “domestic trades or businesses,” not foreign ones. 199A also uses the term “qualified trades or business.” It appears the authors of 199A used a modified Section 864 for determining “domestic QBI.”

Section 864 a “trade or business within the U.S.” does not include:
“Section 864(b) — Trade or business within the United States.

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.”

Example of (ii) above: A nonresident alien “trades his own account” at a U.S. brokerage firm. The nonresident does not have an office in the U.S., but it doesn’t matter since the 864(b)(2)(C) limitation does not apply to (ii), a trader for his account, it only applies to (i). Although this trader might qualify for TTS, he does not have a “trade or business within the U.S.” and therefore does not have QBI as a nonresident alien.

Notice how Section 199A regs reference Section 864:

“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).”

According to tax publisher Checkpoint, “Effectively connected income-qualified business income defined for purposes of the 2018-2025 pass-through deduction.”

“Income derived from excluded services under Code Sec. 864(b)(1) (performance of personal services for foreign employer, or Code Sec. 864(b)(2) (trading in securities or commodities) can never be effectively connected income in the hands of a nonresident alien.

Code Sec. 864(b)(2) generally treats foreign persons, including partnerships, who are trading in stocks, securities, and in commodities for their own account or through a broker or other independent agent as not engaged in a U.S. trade or business. So, if a trade or business isn’t engaged in a U.S. trade or business by reason of Code Sec. 864(b), items of income, gain, deduction, or loss from that trade or business won’t be included in QBI because those items wouldn’t be effectively connected with the conduct of a U.S. trade or business.”

In 199A, the first reference to Section 864 is under the heading “Interaction of Sections 875(1) and 199A.”

“Section 875(1) Partnerships; beneficiaries of estates and trusts: (i) 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, and (ii) a nonresident alien individual or foreign corporation which is a beneficiary of an estate or trust which is engaged in any trade or business within the United States shall be treated as being engaged in such trade or business within the United States.”

An example of Section 875(1): Consider a U.S. partnership in the consulting business. U.S. residents and nonresident alien investors own it. The Schedule K-1 for partners reports ordinary income on line 1, which according to Section 875(1) is ECI for the nonresident partners. The nonresident alien must file a Form 1040NR to report this ECI, and she might be eligible for a QBI deduction since it’s from a “domestic trade or business,” determined on the entity level.

Conflicts and unresolved questions
Tax writers in 199A regs left conflicts and unresolved questions when it comes to traders in securities and or commodities. Are traders in no man’s land? I’ve asked several of the tax attorneys in IRS Office of Chief Counsel listed in the 199A regs to answer the following question: Are U.S. resident traders in securities and or commodities with trader tax status subject to QBI tax treatment? I am awaiting an answer.

The 199A regs state:

“The trade or business of the performance of services that consist of investing and investment management, trading, or dealing in securities (as defined in section 475(c)(2))…

(xii) Meaning of the provision of services in trading. For purposes of section 199A(d)(2) and paragraph (b)(1)(xi) of this section only, the performance of services that consist of trading means a trade or business of trading in securities (as defined in section 475(c)(2)), commodities (as defined in section 475(e)(2)), or partnership interests. Whether a person is a trader in securities, commodities, or partnership interests is determined by taking into account all relevant facts and circumstances, including the source and type of profit that is associated with engaging in the activity regardless of whether that person trades for the person’s own account, for the account of others, or any combination thereof.”

Section 199A regs define “trading” as a “specified service trade or business” (SSTB). The regs focus on “performance of services,” which relates to a proprietary trader performing trading services to a prop trading firm and issued a 1099-Misc as an independent contractor. Some tax advisors had suggested that hedge funds don’t perform trading services; their management companies do. That may be why tax writers added “trading for your own account.”

The million-dollar question is “Why define TTS trading as an SSTB unless the tax writers intended QBI treatment for that SSTB?

Only a Section 475 election can generate QBI income for a trading SSTB (or QBI losses, if incurred). The 199A final regs added Section 475 to QBI. This combination of SSTB and 475 income would make a trader eligible for a QBI deduction. Others could argue 475 was added only for dealers in securities and or commodities.

The 199A regs indicate if a trade or business does not constitute “effectively connected income” (ECI) in the hands of a nonresident alien under Section 864(c), then it’s not QBI for a U.S. resident taxpayer, even if operating a domestic trade or business. Is there a loophole in that “trader in securities or commodities” are covered under Section 864(b)(2), not 864(c)?

My partner Darren Neuschwander CPA, and I communicated with leading CPAs, including two big-four tax partners. Those tax partners acknowledged conflicts and uncertainties in QBI treatment for hedge funds and solo TTS traders. The vast majority of larger hedge funds don’t elect Section 475, so those hedge funds would only experience the downside to QBI treatment — QBI losses for investors.

The tax attorneys who drafted TCJA and199A regs may have intended to exclude TTS trading companies including hedge funds from QBI tax treatment because they figured these companies would most likely have QBI losses caused by TTS business expenses. They knew QBI excluded most portfolio income like capital gains, dividends, and interest income so that traders might consider the law unfair. I advocated for TTS trades to have QBI treatment because many solo TTS traders have elected Section 475 and they would get a QBI deduction.

TTS and 475 elections help traders
No matter which way the pendulum swings on QBI treatment for traders, I still recommend trader tax status for deducting business expenses, and a TTS S-Corp for health insurance and retirement plan deductions. There are always the tax loss insurance benefits in Section 475. (See Traders Elect Section 475 For Massive Tax Savings.)

Darren L. Neuschwander CPA, and Roger Lorence JD contributed to this blog post.

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.

IRS Confirms Section 475 Is Eligible For QBI Tax Deduction

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

Good news for traders: Section 199A final regs confirm QBI includes Section 475 ordinary income and loss.

On Jan. 18, 2019, the IRS issued final 199A regs for the 2017 Tax Cuts and Jobs Act (TCJA) 20% qualified business income (QBI) deduction. The final regs update the August 2018 proposed/reliance 199A regs and confirm that QBI includes Section 475 ordinary income/loss.

Based on our interpretation of TCJA and the proposed/reliance regs, we figured QBI included Section 475 ordinary income/loss, but it was uncertain. Our previous content stated that QBI “likely” included Section 475 ordinary income/loss. The final and proposed/reliance regs each state that QBI expressly excludes capital gains and losses, and also excludes Section 954 items of ordinary income, including forex Section 988 and notional principal contracts.

Making our case to the IRS
After noticing that the proposed/reliance regs were silent about Section 475 income/loss, I contacted one of the lawyers at the Office of Chief Counsel listed on the 199A proposed regs.

The attorney called me back after he saw my interview in Tax Notes, “Groups Urge IRS to Rethink 199A Business Income Rules.” I presented our firm’s rationale for including Section 475 ordinary income/loss in QBI for TTS traders and suggested he read and watch our content. The IRS attorney said my rationale sounded “plausible” in his opinion.

Excerpts from final regs
Final 199A regs, p. 55-56:

“Given the specific reference to section 1231 gain in the proposed regulations, other commenters requested guidance with respect to whether gain or loss under other provisions of the Code would be included in QBI. One commenter asked for clarification about whether real estate gain, which is taxed at a preferential rate, is included in QBI. Additionally, other commenters requested clarification regarding whether items treated as ordinary income, such as gain under sections 475, 1245, and 1250, are included in QBI.

To avoid any unintended inferences, the final regulations remove the specific reference to section 1231 and provide that any item of short-term capital gain, short-term capital loss, long-term capital gain, or long-term capital loss, including any item treated as one of such items under any other provision of the Code, is not taken into account as a qualified item of income, gain, deduction, or loss. To the extent an item is not treated as an item of capital gain or capital loss under any other provision of the Code, it is taken into account as a qualified item of income, gain, deduction, or loss unless otherwise excluded by section 199A or these regulations.

Similarly, another commenter requested clarification regarding whether income from foreign currencies and notional principal contracts are excluded from QBI if they are ordinary income. Section 199A(c)(3)(B)(iv) and §1.199A-3(b)(3)(D) provide that any item of gain or loss described in section 954(c)(1)(C) (transactions in commodities) or section 954(c)(1)(D) (excess foreign currency gains) is not included as a qualified item of income, gain, deduction, or loss. Section 199A(c)(3)(B)(v) and §1.199A-3(b)(3)(E) provide any item of income, gain, deduction, or loss described in section 954(c)(1)(F) (income from notional principal contracts) determined without regard to section 954(c)(1)(F)(ii) and other than items attributable to notional principal contracts entered into in transactions qualifying under section 1221(a)(7) is not included as a qualified item of income, gain, deduction, or loss. The statutory language does not provide for the ability to permit an exception to these rules based on the character of the income. Accordingly, income from foreign currencies and notional principal contracts described in the listed sections is excluded from QBI, regardless of whether it is ordinary income.”

Parsing the language in the final 199A regs
In the proposed 199A regs, QBI excluded all capital gains and losses, and ordinary income/loss items expressly listed in Section 954. Section 954 does not include Section 475 ordinary income/loss. In the proposed regs, QBI expressly included Section 1231 losses from the sale of business property, whereas, QBI excluded Section 1231 capital gains. Section 475 ordinary income/loss is similar to Section 1231 ordinary losses, and it’s not in Section 954, so we determined that QBI likely included Section 475 ordinary income/loss.

The final 199A regs acknowledge the uncertainty and tax writers fixed it in the above language. They opened the door for Section 1231 losses to include more items like Section 475 ordinary income/loss, reiterating that it must not be on the Section 954 list, which Section 475 is not.

There’s an important caveat
Section 199A interacts with a modified Section 864(c), and Section 864 might deny QBI treatment to TTS traders and hedge funds. On the one hand, there is a rationale for QBI treatment for TTS traders, as expressed in this blog post, and Section 864 conflicts with that case. There are unresolved questions which I expect to write a blog post about it soon. Considering conflicts with Section 864, I think QBI treatment for traders is uncertain at this time.

How QBI might work for a TTS trading business
The proposed and final 199A regs state that traders eligible for trader tax status are a “specified service trade or business” (SSTB), so the SSTB taxable income (TI) cap applies. Taxpayers who make one dollar over the TI cap will not be allowed a QBI deduction on SSTB QBI. On the other hand, non-SSTB activity is not restricted to the TI cap, although the W-2 wage and property limitations apply over the TI threshold.

For 2018, the SSTB TI cap is $415,000/$207,500 (married/other taxpayers). The phase-out range below the cap is $100,000/$50,000 (married/other taxpayers), in which the QBI deduction phases out for an SSTB. The 50% W-2 wage and property basis limitations also apply within the phase-out range. For 2018, the TI threshold is $315,000/$157,500 (married/other taxpayers): If a taxpayer is below the TI threshold, there are no phase-out, wage or property limitations for SSTB and non-SSTB.

For 2019, the SSTB TI cap increases to $421,400/$210,700 (married/other taxpayers) based on the inflation adjustment. The phase-out range remains the same, so for 2019, the TI threshold is $321,400/$160,700 (married/other taxpayers).

Hedge funds with TTS and Section 475 ordinary income/loss should report QBI, too. Investors in these hedge funds are eligible for a QBI deduction if they are under the TI cap. Even without a 475 election, trading SSTB has QBI losses from trading expenses.

Investment managers are also SSTB, and they have QBI from advisory fees. Carried interest as a profit allocation of Section 475 ordinary income/loss is QBI, too. Carried interest in capital gains is not.

It’s more crucial to qualify for TTS than ever before
TTS allows business expense treatment, whereas, TCJA suspended “certain miscellaneous itemized deductions subject to the 2% floor,” which includes investment fees and investment expenses. TCJA still allows investors itemized deductions for investment-interest expenses limited to investment income, and stock borrow fees as other itemized deductions. TTS business expenses allow a long list of deductions from gross income, including home office, and that’s far better!

TTS traders may elect Section 475 mark-to-market (MTM) accounting on securities and or commodities (Section 1256 contracts). Securities traders appreciate that Section 475 trades are exempt from dreaded wash-sale loss adjustments and the $3,000 capital loss limitation. I call it “tax loss insurance,” because 475 ordinary losses lead to much faster tax refunds. (TCJA did repeal NOL carrybacks, forcing NOL carryforwards, instead.) TTS traders are entitled to segregate investment positions to achieve lower tax rates on long-term capital gains. TTS traders prefer to skip Section 475 on commodities to retain lower 60/40 capital gains rates on Section 1256 contracts.

Now with final 199A regs, there’s still uncertainty for QBI treatment for TTS traders. Profitable TTS traders might want to consider a Section 475 election to be perhaps eligible for a potential QBI deduction. In some years, the trader might be under the TI cap, allowing a QBI deduction, and in other years, he might have a (good) problem of exceeding the cap for no QBI deduction.

Married taxpayers should consider filing separately, as that might unlock a QBI deduction for one spouse since the other spouse might have income exceeding the SSA income cap. TCJA equalized the tax rates for filing jointly vs. separately.

TTS traders with Section 475 ordinary losses might be unhappy. For example, assume a trader has $100,000 of QBI from a consulting business. She also has TTS/Section 475 ordinary losses of $40,000, so her aggregate QBI is $60,000, which reduces the QBI deduction.

Section 199A regs are complicated
There are complex issues over what constitutes an SSTB vs. non-SSTB, how to calculate the W-2 wage and property limitations, definitions of QBI, and more.

Taxpayers have to calculate the QBI deduction on whichever is lower: aggregate QBI or taxable income minus net capital gains/losses.

If you expect to receive a 2018 Schedule K-1 containing QBI tax information, then consider filing an automatic extension by April 15. I assume that many pass-through entities won’t issue final 2018 Schedule K-1s until after that date. It’s great that the IRS issued the final 199A regs now, but there are still conflicts and unresolved questions. Look for QBI items on partnership Schedule K-1 line 20 “Other Information” marked with various codes for 199A items of income, wages, property and more. See the K-1 instructions for line 20.

Elect Section 475 on time
Individual TTS traders need to file a 2019 Section 475 election statement with the IRS by April 15, 2019. Existing partnerships and S-Corps need to file a 2019 Section 475 election statement with the IRS by March 15, 2019. New taxpayers (i.e., new entities) may elect Section 475 within 75 days of inception by internal election. Existing taxpayers have a second step to file a Form 3115 with their 2019 tax return.

Learn more about TTS, Section 475, QBI and entity solutions in Green’s 2019 Trader Tax Guide.

Darren L. Neuschwander, CPA contributed to this blog post.

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

Highlights From Green’s 2019 Trader Tax Guide

January 15, 2019 | By: Robert A. Green, CPA | Read it on

Use Green’s 2019 Trader Tax Guide to receive every trader tax break you’re entitled to on your 2018 tax returns. Our 2019 guide covers the 2017 Tax Cuts and Jobs Act’s impact on investors, traders, and investment managers. Learn various smart moves to make in 2019.

Whether you prepare your 2018 tax returns as a trader or investor, this guide can help. Even though it may be too late for some tax breaks on 2018 tax returns, you can still use this guide to execute these tax strategies and elections for tax-year 2019.

Tax Cuts and Jobs Act

Tax Cuts and Jobs Act (TCJA) was enacted on Dec. 22, 2017, and the law changes take effect in the 2018 tax year.

Like many small business owners, traders eligible for trader tax status (TTS) restructured their business for 2018 and 2019 to take advantage of TCJA. TCJA suspended investment fees and expenses, which makes TTS even more crucial. (TCJA continues to allow itemized deductions for investment-interest expenses and stock borrow fees.)

TCJA didn’t change trader tax matters, including business expense treatment, Section 475 MTM ordinary gain or loss treatment, wash-sale loss adjustments on securities, Solo 401(k) retirement contributions, and health insurance deductions for S-Corp TTS traders. TCJA also retains the lower Section 1256 60/40 capital gains tax rates; the Section 1256 loss carryback election; Section 988 forex ordinary gain or loss; and tax treatment on financial products including options, ETFs, ETNs, swaps, precious metals, and more.

Tax forms changed with TCJA for 2018

TCJA required significant revisions to 2018 income tax forms. The redesigned two-page 2018 Form 1040 resembles a postcard because the IRS moved many sections to six new 2018 Schedules (Form 1040). It’s a block-building approach with the elimination of Form 1040-EZ and 1040-A.

See the new 2018 Schedule 1 (Form 1040) for reporting “Additional Income” including state tax refunds, Schedule C, D, E, Form 4797 (Section 475), and Other Income/Loss (Section 988 forex) on line 21. Schedule 1 (Form 1040) is also for reporting “Adjustments To Income,” previously called items of “adjusted gross income” (AGI).

The IRS significantly changed Schedule A (Itemized Deductions). TCJA suspended “certain miscellaneous itemized deductions subject to the 2% floor.” These deductions were included in “Job Expenses and Certain Miscellaneous Deductions” on the 2017 Schedule A, lines 21 through 24. The revised 2018 Schedule A deletes these deductions, including job expenses, investment fees and expenses, and tax compliance fees and expenses.

The 2017 Schedule A also had “Other Miscellaneous Deductions,” not subject to the 2% floor, on line 28. That’s where investors reported stock-borrow fees, which are not investment fees and expenses. The 2018 Schedule A changed the name to “Other Itemized Deductions” on line 16.

TCJA introduced a new 20% deduction on qualified business income, but the IRS did not draft a tax form for it. A taxpayer must use a worksheet for the calculation and report a “qualified business income deduction” on the 2018 Form 1040, page 2, line 9.

Business traders fare better

By default, the IRS lumps all traders into “investor tax status,” and investors get penalized in the tax code — more so with TCJA. Investors have restricted investment interest expense deductions, and investment fees and expenses are suspended. Investors have capital-loss limitations ($3,000 per year), and wash-sale loss deferrals; they do not have the Section 475 MTM election option or health insurance and retirement plan deduction strategies. Investors benefit from lower long-term capital gains rates (0%, 15%, and 20%) on positions held 12 months or more before sale. If active traders have segregated long-term investment positions, this is available to them as well.

Business traders eligible for TTS are entitled to many tax breaks. A sole proprietor (individual) TTS trader deducts business expenses and is entitled to elect Section 475 MTM ordinary gain or loss treatment. However, to deduct health insurance and retirement plan contributions, a TTS trader needs an S-Corp to create earned income with officer compensation.

Don’t confuse TTS with the related tax-treatment election of Section 475 MTM accounting.  The election converts new capital gains and losses into business ordinary gains and losses, avoiding the $3,000 capital loss limitation. Only qualified business traders may use Section 475 MTM; investors may not. Section 475 trades are also exempt from wash-sale loss adjustments.

A business trader can assess and claim TTS after year-end and even going back three open tax years. But business traders may only use Section 475 MTM if they filed an election on time, either by April 15 of the current year (i.e., April 17, 2018, for 2018) or within 75 days of inception of a new taxpayer (i.e., a new entity).

Can traders deduct trading losses?

Deducting trading losses depends on the instrument traded, the trader’s tax status, and various elections.

Many traders are hoping to find a way to deduct their 2018 trading losses. Maybe they qualify for TTS, but that only gives them the right to deduct trading business expenses.

Securities, Section 1256 contracts, ETN prepaid forward contracts, and cryptocurrency trading receive capital gain/loss treatment by default. If a TTS trader did not file a Section 475 election on securities and/or commodities on time (i.e., by April 17, 2018), or have Section 475 from a prior year, they are stuck with capital loss treatment on securities and Section 1256 contracts. Section 475 does not apply to ETN prepaid forward contracts, which are not securities, or cryptocurrencies, which are intangible property.

Capital losses offset capital gains without limitation, whether short-term or long-term, but a net capital loss on Schedule D is limited to $3,000 per year against other income. Excess capital losses are carried over to the subsequent tax year(s).

Once taxpayers get in the capital loss carryover trap, a problem they often face is how to use up the carryover in the following year(s). If a taxpayer elects Section 475 by April 15, 2019, the 2019 business trading gains will be ordinary rather than capital. Remember, only capital gains can offset capital loss carryovers. Once a trader has a capital loss carryover hole, he or she needs a capital gains ladder to climb out of it and a Section 475 election to prevent digging an even bigger one. The IRS allows revocation of Section 475 elections if a Section 475 trader later decides he or she wants capital gain/loss treatment again. Even so, an entity is still better for electing and revoking Section 475 as needed.

Traders with capital losses from trading Section 1256 contracts (such as futures) might be in luck if they had gains in Section 1256 contracts in the prior three tax years. On the top of Form 6781, traders can file a Section 1256 loss carryback election.  This allows taxpayers to offset their current-year losses against prior-year 1256 gains to receive a refund of taxes paid in prior years.  Business traders may elect Section 475 MTM on Section 1256 contracts, but most elect it on securities only so they can retain the lower 60/40 capital gains tax rates on Section 1256 gains, where 60% is considered a long-term capital gain, even on day trades.

Taxpayers with losses trading forex contracts in the off-exchange Interbank market may be in luck. By default, Section 988 for forex transactions receives ordinary gain or loss treatment, which means the capital loss limitation doesn’t apply. However, without TTS, the forex loss isn’t a business loss and therefore can’t be included in a net operating loss (NOL) calculation — potentially making it a wasted loss since it also can’t be added to the capital loss carryover. If taxpayer has another source of taxable income, the forex ordinary loss offsets it; the concern is when there is negative taxable income. Forex traders can file a contemporaneous “capital gains and losses” election in their books and records to opt out of Section 988, which is wise when capital loss carryovers exist. Contemporaneous means in advance — not after the fact using hindsight. In some cases, this election qualifies for Section 1256(g) lower 60/40 capital gains tax rates on major pairs, not minors.

A TTS trader using Section 475 on securities has ordinary loss treatment, which avoids wash-sale loss adjustments and the $3,000 capital loss limitation. Section 475 ordinary losses offset income of any kind, and a net operating loss carries forward to subsequent tax year(s). TCJA’s “excess business loss” (EBL) limitation of $500,000 married and $250,000 other taxpayers applies to Section 475 ordinary losses and trading expenses. Add an EBL to an NOL carryforward.

Tax treatment on financial products

There are complexities in sorting through different tax-treatment rules and tax rates. It’s often hard to tell what falls into each category.

Securities have realized gain and loss treatment and are subject to wash-sale rules and the $3,000 per year capital loss limitation on individual tax returns.

Section 1256 contracts — including regulated futures contracts on U.S. commodities exchanges — are marked to market by default, so there are no wash-sale adjustments, and they receive lower 60/40 capital gains tax rates.

Options have a wide range of tax treatment. An option is a derivative of an underlying financial instrument, and the tax treatment is generally the same. Equity options are taxed the same as equities, which are securities. Index options are derivatives of indexes, and broad-based indexes are Section 1256 contracts. Simple and complex equity option trades have special tax rules on holding period, adjustments, and more.

Forex receives an ordinary gain or loss treatment on realized trades (including rollovers), unless a contemporaneous capital gains election is filed. In some cases, lower 60/40 capital gains tax rates on majors may apply.

Physical precious metals are collectibles and, if these capital assets are held over one year, sales are subject to the taxpayer’s ordinary rate capped at 28% (the collectibles rate).

Cryptocurrencies are intangible property taxed like securities on Form 8949, but wash-sale loss and Section 475 rules do not apply because they are not securities.

Foreign futures are taxed like securities unless the IRS issues a revenue ruling allowing Section 1256 tax benefits.

Several brokerage firms classify options on volatility exchange-traded notes (ETNs) and options on volatility exchange-traded funds (ETFs) structured as publicly traded partnerships as “equity options” taxed as securities. There is substantial authority to treat these CBOE-listed options as “non-equity options” eligible for Section 1256 contract treatment. Volatility ETNs have special tax treatment: ETNs structured as prepaid forward contracts are not securities, whereas, ETNs structured as debt instruments are.

Don’t solely rely on broker 1099-Bs: There are opportunities to switch to lower 60/40 tax capital gains rates in Section 1256, use Section 475 ordinary loss treatment if elected on time, and report wash-sale losses differently. Vital 2019 tax elections need to be made on time.

Entities for traders

Entities can solidify TTS, unlock health insurance and retirement plan deductions, gain flexibility with a Section 475 election or revocation, and prevent wash-sale losses with individual and IRA accounts. An entity return consolidates trading activity on a pass-through tax return, making life easier for traders, accountants, and the IRS. Trading in an entity allows individually held investments to be separate from business trading. It operates as a separate taxpayer yet is inexpensive and straightforward to set up and manage.

An LLC with S-Corp election is generally the best choice for a single or married couple seeking health insurance and retirement plan deductions.

Retirement plans for traders

Annual tax-deductible contributions up to $62,000 for 2019 to a TTS S-Corp Solo 401(k) retirement plan generally saves traders significantly more in income taxes than it costs in payroll taxes (FICA and Medicare). Trading gains aren’t earned income, so traders use an S-Corp to pay officer compensation.

There’s also an option for a Solo 401(k) Roth: If you are willing to forgo the tax deduction, you’ll enjoy permanent tax-free status on contributions and growth within the plan.

20% deduction on qualified business income

In August 2018, the IRS issued proposed reliance regulations (Proposed §1.199A) for TCJA’s 20% deduction on qualified business income (QBI). (Postscript: On Jan. 18, 2019, the IRS issued final 199A regs.) The final regs confirm that TTS traders are a “specified service activity,” which means if their taxable income is above an income cap, they won’t get any QBI deduction. The 2018 taxable income (TI) cap is $415,000/$207,500 (married/other taxpayers). The phase-out range below the cap is $100,000/$50,000 (married/other taxpayers), in which the QBI deduction phases out for specified service activities. The W-2 wage and property basis limitations also apply within the phase-out range. TTS hedge funds and investment managers are specified service activities, too. The final 199A regs preamble confirm that QBI includes Section 475 ordinary income, whereas, TCJA expressly excluded capital gains and losses from it. (See our more recent blog posts, IRS Confirms Section 475 Is Eligible For QBI Tax Deduction and Uncertainty About Using QBI Tax Treatment For Traders.)

Affordable Care Act

TCJA did not change the Affordable Care Act’s (ACA) 3.8% Medicare tax on unearned income. The net investment tax (NIT) applies on net investment income (NII) for individual taxpayers with modified AGI over $250,000 (married) and $200,000 (single). The threshold is not indexed for inflation. Traders can reduce NIT by deducting TTS trading expenses, including salaries paid to them and their spouses. Traders may also reduce NII with investment expenses that are allowed on Schedule A, such as investment-interest expense and stock borrow fees. Investment fees and other investment expenses are not deductible for NII.

ACA’s individual health insurance mandate and shared responsibility fee for non-compliance, exchange subsidies, and premium tax credits continue to apply for 2018 and 2019. However, TCJA reduced the shared responsibility fee to $0 starting in 2019.

Investment management carried interest

TCJA modified the carried interest tax break for investment managers in investment partnerships, lengthening their holding period on profit allocation of long-term capital gains (LTCG) from one year to three years. If the manager also invests capital in the partnership, he or she has LTCG after one year on that interest. The three-year rule only applies to the investment manager’s profit allocation — carried interest. Investors still have LTCG based on one year.

Investment partnerships include hedge funds, commodity pools, private equity funds, and real estate partnerships. Many hedge funds don’t hold securities more than three years, whereas, private equity, real estate partnerships, and venture capital funds do.

Investors also benefit from carried interest in investment partnerships. TCJA suspended “certain miscellaneous itemized deductions subject to the 2% floor,” which includes investment fees and expenses. Separately managed account investors are out of luck, but hedge fund investors can limit the negative impact by using carried-interest tax breaks. Carried interest reduces a hedge fund investor’s capital gains instead of having a suspended investment fee deduction.

Family office

Restructuring investment fees and expenses into a management company might achieve business expense treatment providing it’s a genuine family office with substantial staff rendering financial services to extended family members and outside clients.

The IRS might assert the family office is managing “one’s own investments,” not for outside clients, so the management company is also an investment company with non-deductible investment expenses.

Learn more about and purchase Green’s 2019 Trader Tax Guide and see the Table of Contents.

To Save Taxes, Traders Need To Deal With Unique Issues Before Year-End

October 31, 2018 | By: Robert A. Green, CPA | Read it on

While the 2017 Tax Cuts and Jobs Act did not change trader tax status, Section 475 MTM, wash-sale loss rules on securities, and more, there is still plenty to consider.

To Get The Most Out Of Tax Reform, Traders Need To Act Fast covered critical moves to make before the calendar year expires. But that’s just the tip of the hat. Read on for more action items to initiate sooner, rather than later.

Wash sales: Securities traders must comply with wash-sale loss rules, but the IRS makes it difficult by applying different standards for taxpayers vs. brokers on tax reports and Form 1099-Bs. Taxpayers must report wash sales on substantially identical positions across all accounts, whereas brokers report only identical positions per account. Active securities traders should use a trade accounting program or service to identify potential wash sale loss problems going into year-end. In taxable accounts, break the chain by selling the position before year-end and not repurchasing a substantially identical position 30 days before or after in any of your taxable or IRA accounts. Avoid wash sales between taxable and IRA accounts throughout the year, as that is otherwise a permanent wash sale loss. (Starting a new entity effective Jan. 1, 2019, can break the chain on individual account wash sales at year-end 2018 provided you don’t purposely avoid wash sales with the related party entity.) Read strategies to avoid wash sale losses. Wash sales only apply to securities; not Section 1256 contracts, cryptocurrencies as intangible property, and volatility ETNs structured as prepaid forward contracts.

Wash sale losses might be preferable to capital loss carryovers at year-end 2018 for TTS traders. A Section 475 election in 2019 converts year-end 2018 wash sale losses on TTS positions (not investment positions) into ordinary losses in 2019. That’s better than a capital loss carryover into 2019, which might then give you pause to making a Section 475 election. You want a clean slate with no remaining capital losses before electing Section 475 ordinary income and loss. (Learn more about wash sales and capital loss limitations in a video on our Website and consider our trade accounting service.)

Trader tax status: If you qualify for TTS (business expense treatment — no election needed) in 2018, accelerate trading expenses into that qualification period as a sole proprietor or entity. If you don’t qualify until 2019, try to defer trading expenses until then. You may also capitalize and amortize (expense) Section 195 startup costs and Section 248 organization costs in the new TTS business, going back six months before commencement. TTS is a prerequisite for electing and using Section 475 MTM. (Learn more about trader tax status in a video on our Website.)

Section 475 MTM: TTS traders choose Section 475 on securities for exemption from wash-sale rules and the $3,000 capital loss limitation — and to receive the new 20% QBI deduction. Existing individual taxpayers had to elect Section 475 by April 17, 2018, for 2018 (March 15 for existing S-Corps and partnerships). They need to complete the election process by filing a 2018 Form 3115 with their 2018 tax return. If you missed the 2018 election deadline, then consider the election for 2019. Capital loss carryovers are a concern.

Trading entities: A “new taxpayer” entity can elect Section 475 within 75 days of inception. But it’s getting late to form a new trading entity by the middle of November, and still qualify for TTS in that short period before year-end. Elect 475 once, and it applies in subsequent years in which you are eligible for TTS unless you revoke the election. (Learn more about Section 475 in a video on our Website.)

Net operating losses: Section 475 ordinary losses and TTS business expenses contribute to net operating loss (NOL) carryforwards, which are limited to 80% of taxable income in the subsequent year(s). TCJA repealed two-year NOL carrybacks, except for farmers. For some traders, this is the worst change in TCJA as traders have counted on quick NOL carryback refunds to replenish their trading accounts and remain in business. Get immediate use of NOLs with a Roth IRA conversion before year-end and other income acceleration strategies.

Excess business losses: TCJA introduced an “excess business loss” (EBL) limitation of $500,000/$250,000 (married/other taxpayers), per tax year. Aggregate EBL from all pass-through businesses: A profitable company can offset another business with losses to remain under the limit. EBL is an NOL carryforward. For example, if a single TTS/475 trader has an ordinary loss of $300,000, his EBL is $50,000, and it’s an NOL carryforward.

2018 S-Corp: TTS traders use an S-Corp trading company to arrange health insurance and retirement plan deductions. The S-Corp must execute officer compensation, in conjunction with these employee benefit deductions, through formal payroll tax compliance before year-end. Otherwise, you will miss the boat. TTS is an absolute must since an S-Corp investment company cannot have tax-deductible wages, health insurance, and retirement plan deductions. This S-Corp is not required to have “reasonable compensation” as other types of businesses are, so a TTS trader may determine officer compensation based on how much to reimburse for health insurance, and how much they want to contribute to a retirement plan. Some use a dual-entity solution: An LLC/partnership trading company, and a management company, organized as a C-Corp, or S-Corp. In that case, the management company executes year-end payroll and these employee benefits. (C-Corps can have other types of employee benefits, too.)

TTS traders organized as a sole proprietorship (an unincorporated business), cannot have health insurance and retirement plan deductions because they don’t have self-employment income (SEI) from trading income. A TTS Schedule C does not have a net income, and the IRS does not permit a TTS sole proprietor to pay officer compensation (wages) to themselves as owners. A TTS partnership faces obstacles in attempting to arrange health insurance and retirement plan deductions because the partnership passes through expenses for reducing SEI, whereas, an S-Corp does not pass through expenses or losses for SEI — that’s why the S-Corp works for traders.

An S-Corp formed later in the year can unlock a retirement plan deduction for an entire year by paying sufficient officer compensation in December when results for the year are evident. The S-Corp may only deduct health insurance for the months the entity was operational and qualified for TTS.

Another reason to create officer compensation is to increase the 20% QBI deduction if you are in the phase-out range subject to the 50% wage limitation. (See my other blog posts and Webinars on year-end planning for TTS S-Corps to execute health insurance, make retirement plan contributions, and generate a QBI deduction.)

2019 S-Corp: If you missed out on employee benefits in 2018, then consider an LLC/S-Corp for 2019. Starting 2019 with trading in the new S-Corp is beneficial. That breaks the chain on wash sales with your individual account at year-end 2018. If you start later, you will have tax compliance for your individual return and S-Corp return in dealing with broker 1099Bs and more.

If you wait to start your entity formation process on Jan. 1, 2019, you won’t be ready to trade in an entity account on Jan. 2, 2019. Instead, you can form a single-member LLC by mid-December 2018, obtain the employee identification number (EIN) at irs.gov, and open the entity brokerage account before year-end. If desired, add your spouse as a member of the LLC on Jan. 1, 2019, which means the LLC will file a partnership return. If you want health insurance and retirement plan deductions, then your LLC should submit an S-Corp election for 2019 by March 15. The S-Corp should also consider making a Section 475 MTM election on securities only for 2019 by March 15. (Consider our entity formation service.)

Solo 401(k): A Solo 401(k) retirement plan for a TTS S-Corp must be established (opened) with a financial intermediary before year-end. Plan to pay (or fund) the 2018 elective deferral amount up to a maximum $18,500 (or $24,500 if age 50 or older) executed with December payroll by Jan. 31, 2019. Plan to pay (fund) the 25% profit-sharing plan (PSP) portion of the S-Corp Solo 401(k) up to a maximum of $36,500, by the due date of the 2018 S-Corp tax return, including extensions, which means Sept. 15, 2019. The maximum PSP contribution requires wages of $146,000 ($36,500 divided by 25% defined contribution rate.) A SEP IRA is less attractive; it doesn’t have a 100%-deductible elective deferral, which means a similar contribution requires more compensation that is subject to Medicare taxes.

Cryptocurrencies: Report realized capital gains and losses for all sales of cryptocurrencies. The IRS classifies cryptocurrencies as intangible property. Include crypto-to-altcoin sales, crypto-to-currency sales, hard forks if you have control and there is a fair market value and purchases of items using crypto. Many crypto traders inappropriately deferred 2017 income on crypto-to-altcoin sales claiming Section 1031 like-kind deferral treatment. TCJA restricted Section 1031 usage to real property only starting in 2018. Bitcoin, Ethereum and other crypto are not securities so wash sale loss rules, and Section 475 MTM elections do not apply. The SEC recently stated that some ICOs and tokens are securities, but not Bitcoin and Ethereum. The IRS has not changed its designation as intangible property, and I expect updated crypto tax guidance from the IRS soon. (See the cryptocurrencies section of our Website.)

With the 2018 crash in cryptocurrency prices, now before year-end 2018 is an excellent time to sell losing crypto positions to realize capital losses which offset capital gains on securities (“tax loss selling”). The wash sale loss rules on securities don’t apply on crypto because it is intangible property, not a security. You can repurchase the crypto positions within hours after booking the tax loss.

Fill in the gaps in tax brackets

If you own an investment portfolio, you have the opportunity to reduce capital gains taxes via “tax loss selling.” You may wish to sell winning positions to accelerate income, perhaps to use up a capital loss carryover or an NOL. TTS traders want a “clean slate” — meaning no capital loss carryovers — so they can make a Section 475 election in the subsequent tax year.

If you are in the lowest two “ordinary” tax brackets for 2018 (10% or 12%), try to take advantage of the 0% long-term capital gains rate. The 12% ordinary income bracket applies on taxable income up to $37,800/$77,400 (single/married). For example, if your single taxable income is $30,000, you can realize $7,500 of long-term capital gains with zero federal tax.

If you realized significant short-term capital gains year-to-date in 2018 and had open positions with substantial unrealized capital losses, you should consider selling (realizing) some of those losses to reduce 2018 capital gains taxes. Don’t repurchase the losing position 30 days before or after, as that would negate the tax loss with wash-sale-loss rules.

The IRS has rules to prevent deferral of income and acceleration of losses in offsetting positions that lack sufficient economic risk. These rules include straddles, the constructive sale rule, and shorting against the box. Also, be aware of “constructive receipt of income” — you cannot receive payment for services, turn your back on that income, and defer it to the next tax year. (See Some Proprietary Traders Under-Report Income.)

Tax-loss selling is inefficient for short-term positions that reduce long-term capital gains. It’s also a moot point with Section 1256 and Section 475 positions since they are mark-to-market (MTM) positions reporting realized and unrealized gains and losses.

Taxpayers should review tax brackets, Social Security and retirement contribution limits, standard deductions, and more. See Tax Rates, other tax charts, and analysis of TCJA at Tax Foundation. There are differences in filing status.

We recommend discussing year-end planning with your tax adviser by early December. Don’t wait until the last minute! If our firm prepared your 2017 tax return, your Client Copy includes a “Tax Reform Impact Summary,” which shows the impact of TCJA on your 2017 file. Our CPAs and I hope to hear from you soon.

Darren L. Neuschwander CPA contributed to this blog post. 

Webinar: Traders Have Unique Issues For Year-End Planning. Come to the Dec. 5, 2018 event or watch the recording after.