FIFO vs. Specific Identification Accounting Methods

December 1, 2021 | By: Robert A. Green, CPA | Read it on

BY DEFAULT, the IRS, brokerage firms, and most trade accounting programs use the First-In-First-Out (FIFO) accounting method. If you sell security A, its cost-basis is the first lot purchased — the first one “out” or sold.

But there is another option called the Specific Identification (SI) accounting method. Assume you bought several lots of security A over the year while the stock increased in price. You might prefer to use SI accounting instead of FIFO to specify a higher cost-basis lot to reduce your short-term capital gains for 2021. This enables you to hold the older purchased stock for 12 months at a lower cost-basis for a long-term capital gain taxed at a lower rate (up to 20% for 2021 and 2022).

The IRS requires contemporaneous action for using SI. You must specify the lot to sell before executing the sale, and the broker must confirm those instructions in writing at that same time. You cannot decide to use SI after the sale’s settlement date, like when preparing your tax returns. The IRS provides a little leeway to correct communication errors with the broker by allowing a settlement date rather than a trade date.

FIFO is also the default accounting method for cryptocurrencies. While SI is allowed, it’s challenging to use. See Frequently Asked Questions on Virtual Currency Transactions | Internal Revenue Service (irs.gov)


Don’t Miss The Election For The SALT Cap Workaround

October 5, 2021 | By: Robert A. Green, CPA | Read it on

Many states recently enacted “SALT cap workaround” legislation enabling pass-through entities (PTE) to deduct entity-level SALT payments as a business expense in place of non-deductible itemized deductions over the “SALT cap” of $10,000 per individual tax return. Currently, 20 states have enacted this legislation, and others are considering it.

The SALT cap workaround is not automatic in most states; the owner must file an election for PTE treatment by the deadline, which varies by state. The PTE election deadline for New York State is October 15, 2021. Connecticut’s pass-through entity (PTE) tax for the SALT cap workaround is mandatory, which is unique. In most states, the owner can make the election with a timely filed tax return, which is more convenient.

It’s also essential in most states to pay PTE estimated taxes. For a 2021 business expense deduction on the federal return, make the estimated tax payments before December 31, 2021.

See my updated blog posts on the SALT cap workaround below. As an excerpt, here are some of the updates for NYS and CA.

You can also search “SALT cap workaround” for your state. Several states published FAQs, and many local CPA firms have blog updates about it. 

This alert applies to pass-through entities (PTE), including LLCs, taxed as partnerships or S-Corps. It’s doesn’t apply to sole proprietors. For traders, the PTE must be eligible for trader tax status (TTS).

New York State

NYS Tax Department: New guidance and election application for optional pass-through entity tax (NYS Tax Dept, August 25, 2021) The New York State Tax Department has issued a technical memorandum and webpage to provide information on the new optional PTET.

New York State’s New Pass-Through Entity Tax – The CPA Journal (CPA Journal Aug. 2021)
“Election. To file and pay PTE tax, an eligible partnership or S corporation must make an irrevocable election by the first estimated payment due date, which is March 15 of the calendar year prior to the year in which the PTE tax return is required. The election is made annually and will be effective for the current taxable year. For the 2021 tax year only, an election must be made by October 15, 2021.”

NYS Tax Department: Deadline approaching to opt into pass-through entity tax (PTET) (NYS October 6, 2021)
“To opt-in: Log in to your S corporation’s or partnership’s Business Online Services account. (If the business doesn’t have an account, we recommend creating one by October 8 to avoid missing the election deadline.).”

California

SALT workaround elective pass-through entity tax (Spidell’s California Minute July 18, 2021)

Pass-through entity tax FAQs released by FTB (Spidell September 30, 2021)
“The FTB anticipates releasing the new pass-through entity tax voucher before December 2021. That voucher will provide instructions on how to make the elective tax payment going forward. Note that for federal purposes, the entities will only benefit from the reduction of net income on the 2021 K-1s if the payment is made before the end of the entity’s 2021 taxable year.”

Help with pass-through entity elective tax FAQs (FTB)
“A qualified entity must make the election on its original, timely filed return.” That means the 2021 PTE return due to be filed in 2022.

Other blog posts:

How to Deduct State and Local Taxes Above SALT Cap

Unlock State & Local Tax Deductions With A SALT Cap Workaround. See updates by state.


How to Deduct State and Local Taxes Above SALT Cap

August 3, 2021 | By: Robert A. Green, CPA | Read it on

Updates: As states progress on SALT cap workaround legislation, I update that news at the bottom of my prior post: Unlock State & Local Tax Deductions With A SALT Cap Workaround.

Are you disenfranchised from state and local tax deductions because you exceed the SALT cap of $10,000 per year? 

Organizing an LLC for your business can convert non-deductible SALT into a business expense. Seventeen states have enacted SALT cap workaround laws, and several others are working towards enactment. IRS Notice 2020-75, issued on Nov. 9, 2020, gave the green light to these state laws. Most states drafted their rules to comply with this notice. 

These state laws seem to include a trading business eligible for trader tax status (TTS) but not investment companies. (The reason: TTS entities have business expense treatment, whereas investment companies have suspended investment expenses.)

The states that have enacted SALT cap workaround laws with the effective date:

There is pending legislation in Illinois, Massachusetts, Michigan, North Carolina, Oregon, and Pennsylvania. (Most have passed, see updates).

These SALT cap workaround laws don’t significantly impact state revenues and incentivize entrepreneurs to remain in their state. Even if Congress repeals or revises the SALT limitation, the SALT cap workaround is the better option since you can deduct business expenses from gross income versus itemized deductions subject to an AMT limitation.

California’s new law automatically repeals its SALT cap workaround if Congress repeals the SALT cap limitation. For details on California and several other state laws, see ongoing updates to my June 22, 2021 blog post, Unlock State & Local Tax Deductions With A SALT Cap Workaround. Also, the podcast SALT workaround elective pass-through entity tax (Spidell’s California Minute, July 18, 2021) is an excellent listen for California residents.

TTS traders have other compelling reasons to consider an LLC partnership or S-Corp. 

  • A new LLC taxed as a partnership or S-Corp (pass-through entity PTE) can elect Section 475 MTM within 75 days of inception. That comes in handy since the individual sole proprietor deadline for a 475 election has passed. Section 475 provides tax-loss insurance through its exemption from wash sales and the capital loss limitation. Also, it offers a chance to get a 20% qualified business income (QBI) deduction on TTS/475 net income. 
  • An LLC taxed as an S-Corp unlocks health insurance and retirement plan deductions for TTS traders.

Now more than ever before may be the time to form your TTS entity, but you need to act quickly. Trading in an entity brokerage account for at least all Q4 2021 will help you qualify for TTS. The entity can only pay SALT business expenses on the entity income.

Many states require an election, some by partner, and SALT PTE tax payments have due dates. Dig into the details of your state, and we can help. Don’t miss the boat!

Darren Neuschwander, CPA, contributed to this blog post.


How Some Traders Double-Up On Retirement Plan Contributions

June 23, 2021 | By: Robert A. Green, CPA | Read it on

Profitable traders are keen on maximizing retirement plan contributions in trading activities and also in their full-time jobs. Traders are pros at investing, and they understand the power of tax-free compounding while saving for retirement. However, wages are required to make contributions to a retirement plan.  Active traders eligible for trader tax status (TTS) can use an S-Corp structure to pay themselves the necessary wages.

Those who have a job in addition to trading can double their retirement savings by maximizing their employer 401(k) and contributing another $58,000 to an unaffiliated TTS S-Corp Solo 401(k) or profit-sharing plan.

The TTS S-Corp pays officer compensation, which engineers the earned income required for employee benefit tax deductions, including health insurance premiums and retirement plan contributions. Conversely, trading gains from capital gains or Section 475 ordinary income are considered unearned income, for which the IRS does not permit retirement plan contributions.

An individual TTS trader deducts business expenses on Schedule C. However, a sole proprietor TTS trader cannot arrange AGI deductions for health insurance premiums and retirement plan contributions because underlying trading gains are not self-employment income (SEI) or earned income. A sole proprietor of any kind cannot pay himself payroll (salaries). It’s also tricky for a TTS partnership to create SEI since partnership compensation and other expenses reduce it. Whereas S-Corp payments do not reduce SEI, making the S-Corp the structure of choice for TTS traders for arranging employee benefits.

In the examples below, full-time Trader A contributes the $64,500 cap to a Solo 401(k) retirement plan for 2021. Part-time Trader B doubles up on retirement benefits, maximizing an unaffiliated employer 401(k) plan for $19,500 and contributing up to the $58,000 cap in her TTS S-Corp profit-sharing plan. Unfortunately, part-time Trader C is out of luck; his consulting company is affiliated with his TTS S-Corp, so he must include consulting company employees in his retirement plan.

Fulltime Trader A
This person owns a single-member LLC (SMLLC) taxed as an S-Corp, eligible for TTS business expense deductions.

In December 2021, based on sufficient annual profits, a TTS S-Corp can pay maximum-required officer compensation of $154,000 to make the Solo 401(k) retirement plan contribution cap of $58,000 ($64,500 for age 50 or older; 2021 limits). Trader A’s Solo 401(k) plan comprises a $19,500 elective deferral, $6,500 catch-up elective deferral for age 50 or older, and a $38,500 profit-sharing contribution for an overall plan limit of $64,500.

Trader A’s W-2 wage statement deducts the Solo 401(k) elective deferral amount of $26,000 from taxable income (box 1), and the S-Corp deducts the profit-sharing contribution of $38,500 on Form 1120-S. The profit-sharing contribution is 100% deductible, but it represents 25% of wages, translating to $38,500 of officer wages (25% of $154,000). The elective deferral of $26,000 is 100%  deductible, and it looks to gross income. If the 401(k) plan only provided for an elective deferral (no profit-sharing contribution), then Trader A would only need wages (net of required deductions) of $26,000 before contribution on a pre-tax basis to the 401(k) (a higher amount may be necessary for a Roth IRA).

Alternatively, if Trader A did not make an elective deferral, the TTS S-Corp could contribute $58,000 to the Solo 401(k) plan on officer wages of $232,000 ($58,000 is 25% of $232,000).

Higher wages trigger an additional Medicare tax of 2.90% (plus a 0.9% Obamacare Medicare surtax over the ACA income threshold). The Medicare tax of 3.8% on earned income (wages) often replaces the 3.8% Obamacare net investment tax for upper-income traders.

If Trader A is married and the spouse provides employment services to the S-Corp, the spouse can also participate in the S-Corp retirement plan. The same goes for working-age children rendering services negotiated at arm’s length.

There’s also an option for a Roth 401(k) (after-tax) plan for the elective deferral portion only. Suppose you are willing to forgo the upfront tax deduction. In that case, you’ll enjoy permanent tax-free status on contributions and growth within the plan — subject to satisfying certain IRS conditions —  and minimum distributions at age 72 are not required.

Of course, W-2 wages are subject to payroll taxes. For 2021, on the Social Security wage base amount of $142,800, 6.2% of Social Security taxes are paid and deducted by the employer, and 6.2% are withheld from the employee’s paycheck. Thus, in most cases, the taxpayer saves more in income taxes than they owe in payroll taxes while at the same time accumulating Social Security benefits for retirement.

Part-time Trader B working for Big Tech
This trader has a full-time job with a Big Tech company earning a W-2 salary of $300,000 per year. Trader B seeks to maximize participation in her employer’s 401(k) retirement plan, with an elective deferral of $19,500 (under age 50), plus an employer matching contribution of 6%, which does not count towards the elective deferral limit.

Trader B also operates a TTS S-Corp and makes $400,000 in capital gains for 2021. In addition to her employer’s 401(k), Trader B wants to utilize a Solo 401(k) retirement plan to maximize her savings.

The critical issue is whether Trader B’s TTS S-Corp is affiliated with her employer. Assuming it is unaffiliated, Trader B can maximize multiple employer retirement plans, with an essential restriction: An individual can only defer the limit ($19,500 plus $6,500 catch-up, if over 50) regardless of the number of plans. So, Trader B skips the elective deferral in her Solo 401(k) and makes a $58,000 (2021 limit) profit-sharing contribution to her Solo 401(k) plan or contributes to a SEP IRA. Trader B would need $232,000 in wages to maximize the profit-sharing contribution of $58,000 ($232,000 divided by a 25% rate for an S-Corp). Trader B’s TTS S-Corp shows a net profit after deducting officer compensation and the retirement plan contribution. (See Retirement Topics – 401(k) and Profit-Sharing Plan Contribution Limits.)

When a taxpayer receives wages from more than one employer, there might be duplicate Social Security taxes for the employer share if over the Social Security wage base amount. The individual tax return identifies excess employee Social Security taxes and reclassifies them as a federal tax credit, avoiding redundancy on the employee share.

Part-time Trader C with an Affiliated Company
This trader owns 100% of a consulting business S-Corp with 10 full-time employees. The consulting S-Corp does not offer a retirement plan to its employees. Trader C wonders if the TTS S-Corp can establish a Solo 401(k) plan and deny participation by consulting business employees. The answer is no because these two employers are affiliated.

The controlled group non-discrimination rules prevent an owner from discriminating against his employees by excluding them from retirement benefits. It is wise to consult an employee benefits attorney about vesting and other means to work within the constraints of the non-discrimination, controlled group, and affiliated service group rules. 

Q&A with Employee-benefits Attorneys    

I asked the following questions to employee-benefits attorneys Rick Matta, David Levine, and Joanne Jacobson of Groom Law Group.

  1. Do you agree with the retirement plan strategy for full-time Trader A?

    Yes, with the caveat that a TTS trader must have earned income (W-2 wages) for this retirement plan strategy. 

  2. Can Trader B maximize her Big Tech employer’s 401(k) plan while contributing the maximum allowed $58,000 to a TTS S-Corp profit-sharing plan for 2021?

    Yes, as long as the two employers are unaffiliated. Multiple employers can have various retirement plans, but a taxpayer is limited to one 401(k) elective deferral limit.

  3. If Trader B only contributes $10,000 to his Big Tech employer’s 401(k), can he contribute the remaining $9,500 to a TTS S-Corp Solo 401(k)? If yes, is there a formal integration required?

    Yes, the $19,500 / $26,000 limit is based on the individual across all plans in which he or she participates. Therefore, coordination of these limits across plans is required.

  4. Do you agree that Trader C’s consulting S-Corp is affiliated with his TTS S-Corp? How does affiliation restrict Trader C?

    From the facts presented, it appears that they are affiliated, and the IRS non-discrimination rules could limit the amounts Trade C could save for retirement.  However, it is essential to keep in mind that there are many ways that “affiliation” can occur. For example, it can be due to common ownership (commonly called “controlled group”), sharing of services (commonly called “affiliated service group”), or even common governance or control (especially for non-profits). Therefore, a careful review of each structure is vital to avoid potentially costly failures.

  5. Do you recommend that Traders A, B, and C also consider a nondeductible IRA if they are not eligible for deductible IRA contributions?

    Nondeductible IRAs are always on our list to consider when speaking with TTS traders with earned income. 

  6. Do you support converting IRAs and 401(k) rollovers to Roth IRAs?

    These types of IRAs – called “back door Roth IRAs” by some in the industry – are popular planning tools.  While each individual’s tax planning varies, they are often seen as advantageous.  We also note that there are in-plan Roth conversion opportunities in 401(k) plans that can have other benefits that can be worth considering.

  7. Are defined benefit plans appropriate for upper-income TTS traders? Defined benefit plans – when carefully designed – can provide significant tax-advantaged savings vehicles and are almost always worth consideration.

Many of our TTS trader clients operate in an S-Corp, and they select a Solo 401(k) retirement plan and execute the strategy through year-end payroll. Adding a traditional IRA, Roth IRA, or nondeductible IRA contribution by April 15 tax time is generally a good idea, too.

Consider consulting with an employee benefits attorney to discuss multiple employer retirement plans, affiliate service group rules, defined benefit plans, and back door Roth strategies.

Contributions by Adam Manning, CPA, and Groom Law attorneys Rick Matta, David Levine, and Joanne Jacobson.


Unlock State & Local Tax Deductions With A SALT Cap Workaround

June 22, 2021 | By: Robert A. Green, CPA | Read it on

Updates: As states progress on SALT cap workaround legislation, I will update that news at the bottom of this post. Also, see my August 3, 2021 blog post, How to Deduct State and Local Taxes Above SALT Cap.

Since 2018, taxpayers living in high-tax states have been unable to take an itemized deduction of state and local taxes over a limitation (known as the “SALT” cap) of $10,000 per year. This limitation came from the 2017 Tax Cuts and Jobs Act (TCJA) and is effective for tax years 2018 through 2025. But the good news is that some states have a workaround, which I cover in this post.

On Nov. 9, 2020, Treasury and the IRS issued Notice 2020-75, which says they “intend to issue proposed regulations to clarify that State and local income taxes imposed on and paid by a partnership or an S corporation on its income are allowed as a deduction by the partnership or S corporation in computing its non-separately stated taxable income or loss for the taxable year of payment.”

The Workaround
To date, state laws for SALT cap workarounds vary, but the general idea is that a pass-through entity (PTE) assesses a tax at the state’s rate on individuals. The state then grants the respective owners of the PTE a tax credit on their state personal income tax return. The SALT cap only applies to individual taxes, not PTE entity-level taxes. Other states subject the PTE to an entity-level tax and then exclude that respective PTE income from the owner’s state tax return.

Check the latest news in your state to see if your state has enacted a SALT cap workaround when the tax law is effective (i.e., 2021 or 2022) and how it works. For example, Connecticut made the PTE tax mandatory for the SALT cap workaround strategy. Most of the other states make it elective, giving the taxpayer more choices; however, don’t miss the election deadline. Consult your tax advisor to see how this strategy might save you money and whether you should consider forming a pass-through entity soon in 2021.

Traders seem to qualify for the SALT cap workaround
Many traders eligible for trader tax status (TTS) already use a PTE like a spousal-member LLC/partnership or single-member LLC/S-Corp. TTS traders need an S-Corp to pay officer compensation to unlock health insurance and retirement plan deductions, which otherwise are not allowed on trading gains that are unearned income.

A TTS trader in securities, commodities, and other financial products, has business expense treatment. A TTS trader actively buys and sells capital assets with capital gains and losses, or Section 475 ordinary gains and losses, if elected on a timely basis.

Here’s an example: In 2021, Joe Trader pays $35,000 of state income taxes on the S-Corp level using a SALT cap workaround. His S-Corp net income is $500,000, subject to a state tax rate of 7%. Joe reaches his SALT cap of $10,000 with real estate taxes of $11,000, so he loses a $1,000 deduction. Joe deducts $35,000 of the S-Corp state taxes from his gross income saving $12,950 in federal taxes ($35,000 state tax deduction x 37% top marginal federal tax rate). Without a SALT cap workaround, Joe would have $36,000 of non-deductible SALT.

Next steps
Many accountants had taken a wait-and-see approach on SALT cap workaround strategies since IRS approval was uncertain before the November 2020 IRS notice mentioned above. In addition, the IRS and Treasury previously rejected recharacterizing SALT payments as charitable contributions, which a few states attempted.

This PTE tax approach is not foreign; some southeastern states use PTE composite returns to assess tax on non-resident owners. 

Some tax pundits expected the Biden administration to repeal the SALT cap. However, President Biden’s FY 2022 budget and recent infrastructure bills do not include the reversal of the SALT cap. Congressional Republicans are resistant to undermine TCJA. Some Congressional Democrats stated they might not support Biden’s infrastructure bills unless they fix the SALT cap. Stay tuned!

The PTE tax might be a better solution than pre-TCJA law when SALT was an itemized deduction and a preference for alternative minimum tax (AMT).

Updated news by state below

IRS Signals Approval of Entity-Level SALT Cap Workaround, But States Should Still Think Twice (Tax Foundation Nov. 11, 2020)
“Treasury and IRS signaled their intention to bless one type of state workaround for the $10,000 State and Local Tax (SALT) deduction cap: entity-level taxes that allow owners of pass-through businesses to pay an additional state tax at the business level, with an offsetting credit against their individual income tax liability. Since the SALT deduction cap does not apply to business taxes, this functionally allows these owners to avoid the cap, since the entity-level tax substitutes for their income tax payment, which would have been subject to a capped deduction.”

“Connecticut, Louisiana, Maryland, New Jersey, Oklahoma, Rhode Island, and Wisconsin have all adopted entity-level taxes which offer credits against the owners’ personal tax liability. In Connecticut, the entity-level tax is mandatory. In the other six states, it is elective; business owners can choose to pay it and claim the credit, or may decline if it is not in their best interest to go that route.”

New Jersey enacts SALT deduction cap workaround (Grant Thorton Feb. 14, 2020)

California Lawmakers, Governor Float SALT Cap Workaround Plans (Bloomberg Tax Jan. 14, 2021)
“A new California Senate bill (SB 104) would give pass-throughs—partnerships, limited liability companies, and S corporations—the option to pay an entity-level income tax that would be fully deductible. The bill doesn’t specify a tax rate yet. Individuals who are members of those businesses would exclude the amount the entity pays from their gross income.” (Governor) Newsom’s proposal is narrower, applying only to S corporations. It would give those businesses the option to pay a 13.3% income tax rather than the 1.5% that California currently imposes on S corporations. Shareholders would get a tax credit equal to 13.3% of their passed-through income. Under current California law, an S corporation’s income is also taxable at the shareholder level.”
Calif. Gov. Updates Budget With Tax Rebates, SALT Workaround (Law360 May 14, 2021)
California budget deal reached: More stimulus payments and tax relief (Spidell News June 28, 2021)
“The Governor and legislative leaders announced that they have reached a budget deal. Major tax-related items contained in the deal include an elective passthrough entity tax, which provides a work-around to the $10,000 SALT deduction limitation for owners of passthrough entities…These provisions are contained in draft legislation that has not yet been enacted, although it is anticipated that these bills will be passed within the next week or two.” https://leginfo.legislature.ca.gov/
SALT Cap Workaround, Tax Credit Boosts Go To California Governor (Bloomberg Tax July 1, 2021)
“A California workaround to the $10,000 federal cap on state and local tax deductions, expanded tax credits, and new grants for businesses are included in bills lawmakers sent Thursday to Gov. Gavin Newsom (D). Tax policy changes in a bill lawmakers passed Thursday (A.B. 150) include a workaround for the $10,000 cap on state and local tax deductions for S corporations and their shareholders. The corporations could pay 9.3% income tax rather than the 1.5% rate California currently imposes. Shareholders would get a tax credit equal to 9.3% of their passed-through income. The workaround would be in effect for taxable years 2021 through 2025 and taxpayers would have to use the option on original, timely filed tax returns.
Calif. Joins States With SALT Cap Workaround (Law360 July 16, 2021)
“Gov. Gavin Newsom, a Democrat, signed A.B. 150… he reiterated his position that the cap on the SALT deduction should be lifted but said California would provide “a partial fix” for S corporations and other pass-throughs. California’s SALT workaround for pass-through entities will be an elective tax that the entity pays on behalf of partners. The partners can then receive a credit. The tax rate will be 9.3% and will fall on the distributive shares of income of the partners. Individual partners can choose not to consent, but the entity can still elect to pay the tax. Those partners who do consent will get a nonrefundable credit that equals the amount of tax paid by the entity on the partners’ behalf. The pass-through workaround will begin for tax year 2021 and sunset after tax year 2025, according to the analysis.”
SALT workaround elective passthrough entity tax (Spidell’s California Minute July 18, 2021)
Passthrough entity tax FAQs released by FTB (Spidell Sept. 30, 2021)
“The FTB anticipates releasing the new passthrough entity tax voucher before December 2021. That voucher will provide instructions on how to make the elective tax payment going forward. Note that for federal purposes, the entities will only benefit from the reduction of net income on the 2021 K-1s if the payment is made before the end of the entity’s 2021 taxable year.”
Help with pass-through entity elective tax FAQs (FTB)
“A qualified entity must make the election on its original, timely filed return.”

New York Includes SALT Cap Workaround in Budget Deal (Bloomberg April 6, 2021)
“The deal between New York Gov. Andrew Cuomo (D) and Democratic legislative leaders, announced Tuesday, would allow pass-through businesses to pay taxes at the entity level. The entity-level tax would be offset by a corresponding individual income tax credit.”
New York Governor Signs Bill That Could Provide Pass-Through Entities a SALT Deduction Cap Workaround (NYSSCPA April 10, 2021)
New York State Budget Provides A Work Around To The Federal SALT Cap For Certain Business Entities (Forbes May 27, 2021)
SALT Cap Workaround Rules Due Soon From New York Tax Department (Bloomberg Tax Aug. 19, 2021)
“New York business owners hankering to seize on a fresh tax break may get guidance from the state’s tax department as early as next week, according to a source familiar with the matter.”
NYS Tax Department: New guidance and election application for optional pass-through entity tax (NYS Tax Dept, Aug. 25, 2021) The New York State Tax Department has issued a technical memorandum and webpage to provide information on the new optional PTET.
New York State’s New Pass-Through Entity Tax – The CPA Journal (CPA Journal Aug. 2021)
“Election. To file and pay PTE tax, an eligible partnership or S corporation must make an irrevocable election by the first estimated payment due date, which is March 15 of the calendar year prior to the year in which the PTE tax return is required. The election is made annually and will be effective for the current taxable year. For the 2021 tax year only, an election must be made by October 15, 2021.
New York Pass Through Entity Tax Update & How to Actually Make the Election (linkedin.com) (Sept. 21, 2021)
New York’s Passthrough Entity Tax (CliftonLarsonAllen LLP Sept. 30, 2021). 
“Only an authorized person, as defined, may make this election on behalf of an eligible S corporation or partnership. The PTET election application can be filed electronically by creating a business online services account with the New York State Department of Taxation and Finance.

Alabama Lawmakers Advance Changes to SALT Cap Workaround (Tax Notes April 15, 2021)
Ala. Floats Rule For SALT Cap Workaround (Law360 Sept. 1, 2021)
“The rule, published in Tuesday’s state register, would provide that required annual payments are the lesser of 100% of the tax shown for the taxable year or 100% of the tax shown for the preceding year. The proposed rule also provides that while an entity is transitioning to being taxed at the entity level, required estimated quarterly payments will be 25% of the required annual payment.”

La. Senate Approves SALT Cap Workaround For Pass-Throughs (Law360 May 23, 2021)

SALT Workarounds Spread to More States as Democrats Seek Repeal (Bloomberg Tax April 27, 2021)
“Seven states, including California and Illinois, are poised to join nearly a dozen others like New York and New Jersey that have skirted around the federal cap on state and local tax deductions as the prospect of a federal fix remains elusive. New York and Idaho both recently passed legislation to work around the controversial 2017 tax law feature known as the SALT cap. Georgia and Arizona are awaiting their governors’ approvals of similar SALT cap workarounds, and lawmakers in California, Massachusetts, Illinois, North Carolina, and South Carolina are debating bills of the same nature.” (See the state map of states included in the workaround.)

Massachusetts Lawmakers Push SALT Cap Workaround in Budget (Bloomberg Tax May 11, 2021)
Mass. Senate OKs Budget With Child Credit, SALT Workaround (Law360 June 2, 2021)
“The pass-through provision is similar to other entity-level taxes that states have either enacted or are considering as a workaround to the $10,000 state and local tax deduction cap. The pass-through entity-level tax provisions would take effect for taxable years beginning on and after Jan. 1, 2021.”
Mass. Legislators Pass Budget With SALT Workaround, Credits (Law360 July 9, 2021)
“The Massachusetts Legislature unanimously passed a fiscal year 2022 budget Friday that would establish an entity-level tax for pass-through businesses…would allow an entity-level tax on pass-throughs and provide a credit against a member’s share of that tax.”
Mass. Gov.’s Budget Creates Tax Credits, Vetoes Deduction Delay (Law360 July 19, 2021)
“Republican Gov. Charlie Baker on Friday signed the budget bill while returning to the Legislature a provision that would allow an entity-level tax on pass-throughs and provide a credit against a member’s share of that tax, asking it to increase the credit portion. Baker returned the pass-through provision to the state Legislature with proposed amendments that would increase a member’s credit from 90% of their share in the entity’s tax to 100% of their tax share, saying that taxpayers should collect the full benefit as struggling businesses emerge from the pandemic. The pass-through entity-level tax provisions will take effect for taxable years beginning on and after Jan. 1, 2021.”
Massachusetts Lawmakers Override Governor on SALT Cap Fix (1) (Bloomberg Tax July 29, 2021)
“Both the governor and lawmakers agreed to a SALT cap fix that would allow individuals to get around the $10,000 deduction limit by having pass-through entities they are members of, like S corporations, pay the 5% state excise tax, instead of having income flow to individual members for taxation. The lawmakers’ measure, however, would allow the individual members a credit equal to the share of state taxes owed, multiplied by 0.9. This would bring in $90 million annually to the state, they estimate. Baker had wanted a 100% credit for individual members.” 
Capital gains and Section 475 ordinary income is taxed at the 12% rate. 

SC Offers SALT Cap Workaround Through Entity-Level Tax (Law360 May 19, 2021)
“Republican Gov. Henry McMaster signed S.B. 627 on Monday, allowing partnerships and S corporations to make an annual election to pay a 3% tax at the entity level while offering a corresponding income exclusion for owners and partners. The bill will take effect starting in tax year 2021.”

Illinois Assembly Approves SALT Workarounds for Partnerships (Bloomberg Tax May 31, 2021)
Illinois Enacts SALT Cap Workaround for Pass-Through Businesses  (Bloomberg Tax Aug. 27, 2021)
Gov. “Pritzker signed S.B. 2531, which allows partnerships and S corporations to pay their income tax at the entity-level rate of 4.95% and then claim a credit on their state return.” The annual election is irrevocable and the tax benefit is available for tax years ending on or after Dec. 31, 2021, and before Jan. 1, 2026.
Ill. Offers Estimated Payment Penalty Relief For Entity-Level Tax (Law30 Sept. 9, 2021)
“Illinois will waive penalties for late estimated payments for the state’s new entity-level tax that acts as a workaround to the federal cap on state and local tax deductions, the state Department of Revenue announced Thursday.”

SALT Workaround for Pass-Throughs Advances to Michigan Governor (Bloomberg Tax June 23, 2021)
“The SALT cap workaround bill (H.B. 4288) could provide roughly $190 million in federal tax relief for Michigan businesses without costing the state a dime, according to a legislative fiscal statement. The measure would let pass-through businesses pay state and local taxes at the entity level starting in tax year 2021, allowing the full deduction of these taxes on federal returns instead of limiting the deduction amount the entity owners can currently claim on their flow-through income.”
Mich. Gov. Vetoes SALT Deduction Cap Workaround Bill (Law360, July 14, 2021).
Michigan’s governor vetoed a bill seeking to create an entity-level tax for pass-through businesses to sidestep the federal cap on state and local tax deductions, saying the bill’s $5 million cost to implement should be part of broader budget negotiations.
Mich. Lawmakers OK Budget Funding SALT Cap Workaround (Law360 Sept. 23, 2021)
“Michigan lawmakers approved a nearly $70 billion budget that includes funding necessary to implement a state and local tax deduction cap workaround for pass-throughs that the governor previously vetoed due to reservations about the program’s cost.”
Michigan Budget Funds SALT Cap Workaround (Law360 Sept. 29, 2021)
“Michigan Gov. Gretchen Whitmer signed the state’s budget Wednesday, including a provision with funding necessary to implement a state and local tax deduction cap workaround for pass-throughs that she previously vetoed due to reservations about the program’s cost.”
Mich. House Fast-Tracks Refiled SALT Cap Workaround Bill (Law360 Oct. 7, 2021)
“Michigan lawmakers moved quickly Thursday to allow a vote on a refiled entity-level tax bill to sidestep the $10,000 federal cap on state and local tax deductions, following the governor’s pledge to support the program after its funding was secured.”
Michigan House Passes Refiled SALT Cap Workaround Bill (Law360 Oct. 14, 2021).
“Michigan’s House of Representatives passed legislation Thursday that would offer an entity-level tax permitting pass-through businesses to sidestep the $10,000 federal cap on state and local tax deductions — a program for which the state’s budget specifically earmarked funding.”

 

Democrats consider ‘SALT’ relief for state and local tax deductions (NBC News June 24, 2021)

Georgia Enacts Salt Cap Workaround For Tax Years Starting In 2022 (Windham Brannon)
House Bill 149, which was signed into law, creates a SALT cap workaround for Georgia partnerships and subchapter S corporations.”

Maryland’s SALT Workaround: Impacts and Planning Opportunities (March 12, 2021)

Rhode Island Budgets For Salt Workaround (Aug. 2019)

Wisconsin enacts SALT deduction workaround with pass-through tax (Dec. 17, 2018)

IRS Provides Clarity Regarding Oklahoma’s Salt Cap Workaround (March 3, 2021)

North Carolina Republicans Introduce SALT Cap Workaround (Tax Notes April 8, 2021)
NC House OKs Budget With Tax Cuts, SALT Cap Workaround (Law 360 Aug. 13, 2021)
“Democratic Gov. Roy Cooper opposes H.B. 334.”

Ore. Senate OKs Trimming Biz Tax Break, SALT Workaround (Law360, June 17, 2021)
“Under S.B. 727, the state would create an elective entity-level tax on qualifying pass-through entities. The tax rate would be 9% for the first $250,000 of income and 9.9% for income above $250,000. If an entity elects to pay the tax, the owners would be allowed an offsetting tax credit to claim on their personal income tax returns.”

Colo. Lawmakers OK Entity-Level Taxation To Skirt SALT Cap (Law360, June 9, 2021)
“Under the bill, the state would allow pass-through entities to elect to pay an entity-level tax for income tax years beginning on or after Jan. 1, 2022. The entity-level tax rate would be 4.55%, the same as the state’s flat income tax rate.”
Colo. Limits Tax Breaks, OKs SALT Workaround In Tax Overhaul (Law360, June 24, 2021)
Gov. signed “H.B. 1327 provides for the entity-level tax to circumvent the $10,000 SALT cap.”

Pa. Bill Seeks Entity-Level Tax To Bypass SALT Deduction Cap (Law360 June 29, 2021)
“H.B. 1709, introduced Monday by Rep. Martina A. White, R-Philadelphia, would allow partnerships and S corporations to elect to be taxed at the entity level while providing an offsetting credit to owners and shareholders.”

Arizona House Panel OKs Entity-Level Tax To Skirt SALT Cap (Law360 Feb. 18, 2021)
Ariz. Adopts High-Earner Tax Bypass, SALT Cap Workaround  (Law360 July 12, 2021)
“Arizona will create an alternative business income tax and an entity-level tax, bypassing both a state income tax surcharge on high earners and the federal cap on state and local tax deductions under two bills signed by the governor. H.B. 2838 will allow partnerships and S corporations to elect to pay a 4.5% tax at the entity level and offer a credit to the entity’s partners, members or shareholders for their pro rata share of the tax, according to a bill analysis. The entity-level tax election will be available only if all of an entity’s members, partners or shareholders are Arizona residents. The bill will take effect on Jan. 1, 2022, and the credit is allowed to be carried forward for up to five consecutive years.”

A Closer Look at Minnesota’s Proposed SALT Cap Workaround (Minnesota Center for Fiscal Excellence)
Minn. To Offer SALT Cap Workaround, PPP Loan Tax Relief (Law360 July 1, 2021)
“Democratic Gov. Tim Walz signed into law H.B. 9. The law creates an entity-level tax for pass-through entities with a refundable credit for entity members, allowing them to bypass the $10,000 state and local tax cap…starting tax year 2021”

Ark. Bill Floats SALT Cap Workaround With Pass-Through Tax (Law360 Jan. 20, 2021)

Some states now offer certain business owners a workaround for cap on state and local tax deduction (CNBC July 22, 2021)

Sens. Endorse Easing SALT Cap, Killing ARPA Tax Cut Limits (Law360 Aug. 11, 2021)
“Under the budget resolution Democrats advanced early Wednesday, a priority for the Senate Finance Committee would be “SALT cap relief.” No definition of relief or other detail is provided… Sen. Chuck Grassley, R-Iowa, offered an amendment to the budget resolution to leave the SALT cap untouched, calling the SALT deduction a provision “that mainly benefits the wealthy.” However, the amendment failed 48-51.”

California Drivers And Ohio Musicians: SALT In Review (Law360 Sept. 3, 2021)
“The good folks at the Institute on Taxation and Economic Policy released a report on potential changes to the SALT deduction limits. ITEP looked at several scenarios:”

NJ Dem Reps Say No SALT Cap Repeal, No Reconciliation (Law360 Sept. 20, 2021)
“A group of New Jersey congressional Democrats said Monday that they will vote against a proposed $3.5 trillion reconciliation bill unless the federal deduction for state and local taxes is fully restored.”

Entity-Level Taxes Grow, But Future Uncertain, Tax Atty Says (Law360 Sept. 23, 2021)
“Although 20 states have adopted pass-through taxes at the entity level as a workaround to the $10,000 cap on the federal deduction for state and local taxes paid, these regimes face a highly uncertain future, a tax professional said Thursday. This month, Democrats on the House Ways and Means Committee released a preliminary $2.9 trillion package of tax increases that left out a repeal of the SALT cap. But House Ways and Means Chairman Richard E. Neal, D-Mass, and Ways and Means members Rep. Bill Pascrell, D-N.J. and Rep. Tom Suozzi, D-N.Y., said afterward that although the measure was left out, they were committed to enacting a law “that will include meaningful SALT relief.”

2nd Circ. Rejects States’ Challenge To Fed. SALT Cap (Law360 Oct. 5, 2021)
“The federal $10,000 deduction cap on state and local taxes is constitutional, the Second Circuit said Tuesday, finding a challenge to the limitation by Maryland, New York, New Jersey and Connecticut…”

SALT-Cap Relief Faces Rollback as Democrats Eye Less Spending (Bloomberg Tax Oct. 4, 2021)
“Democrats risk settling for a less generous expansion of the state and local tax deduction than previously hoped after President Joe Biden conceded that lawmakers will have to scale back his economic agenda to get it enacted.”

Ohio Bill Seeks Entity-Level Tax To Bypass SALT Cap (Law360 Oct. 6, 2021)
“Under the (proposed) bill, entities that elect to be taxed at the entity level would have to make separate, irrevocable elections each tax year, starting in the entity’s tax year that begins in 2022. The tax rate would be 5% for 2022 and would then be the rate on taxable business income, currently 3%, for later years.”

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

 

 

 

 

 

 

 

 

 

 

 

 

 


The American Rescue Plan Act of 2021 Impacts Traders

June 21, 2021 | By: Robert A. Green, CPA

On March 11, 2021, Congress and President Biden enacted “The American Rescue Plan Act of 2021” (ARP). In this post, I focus on the provisions that could impact traders, including recovery rebates for individuals, EBL extension, child tax credit, loan forgiveness, and more. The quotations included under each topic are from the “American Rescue Plan Act Roadmap” published by Bloomberg Tax & Accounting.

Many of the ARP tax benefits are subject to income thresholds. Traders have widely fluctuating income and losses from year to year, and they might qualify for some of these tax benefits. ARP includes business and health care benefits, but most don’t apply to solo TTS traders.

2021 Recovery Rebates to Individuals

“Provides a $1,400 refundable tax credit to individuals ($2,800 for joint filers) with up to $75,000 in adjusted gross income (or $112,500 for heads of household and $150,000 for married couples filing jointly). Provides $1,400 for dependents (both child and non-child). The credit will be phased out entirely for those with incomes above $80,000 (or $120,000 for heads of household and $160,000 for married couples filing jointly). The credit is reduced between $75,000 and $80,000 (or $112,500 and $120,000 for heads of household and $150,000 and $160,000 for married couples filing jointly).”

Extension of Limitation on Excess Business Losses (EBL)

A trader eligible for trader tax status (TTS) using a Section 475 election for ordinary loss treatment might exceed the EBL threshold. The excess is a net operating loss (NOL) carry forward. The original 2018 EBL threshold was $500,000/$250,000 married/other taxpayers, and it’s adjusted for inflation.

“Extends for an additional year (through 2026) the denial of a current-year deduction for business losses of a noncorporate taxpayer to the extent they exceed business income plus a threshold amount.”

Suspension of Income Tax on Portion of Unemployment Compensation

Many traders collected unemployment compensation in 2020, as they lost their jobs during the Covid pandemic. Some commenced a TTS trading activity after the Covid crash in March 2020; it’s important to note trading gains do not conflict with unemployment insurance benefits. A TTS S-Corp with officer compensation, however, does conflict with unemployment benefits.

“For 2020, excludes from gross income up to $10,200 of unemployment compensation received for individuals with adjusted gross income of less than $150,000.”

Child Tax Credit

“Increases the child tax credit amount for 2021 only, to $3,600 for children under 6, and to $3,000 for children ages 6 to 17; expands definition of ‘qualifying child’ to include 17-year-olds.”

Credits for Paid Sick and Family Leave for Certain Self-Employed Individuals

“Extends the refundable paid sick time and paid family leave credits established by the Families First Coronavirus Response Act through September 30, 2021. For purposes of the family leave credit, between April 1, 2021, and September 30, 2021, eligible wages are increased to $12,000 from $10,000. Extends eligibility to additional self-employed workers.”

Student Loan Forgiveness

“For eligible student loans discharged in 2021-2025, the discharged amounts are excluded from income. The exclusion from income does not apply to the discharge of a loan made by certain lenders if the discharge is on account of services performed for the lender.”

Links

FACT SHEET: The American Rescue Plan Will Deliver Immediate Economic Relief to Families (U.S. Department of the Treasury, March 18, 2021)

The American Rescue Plan (Whitehouse.Gov). Consumer-friendly approach. 

Tax provisions in the American Rescue Plan Act (Journal of Accountancy, Feb. 27, 2021)

 

The IRS postponed the 2020 individual tax deadline to May 17

April 6, 2021 | By: Robert A. Green, CPA

The IRS postponed the 2020 individual tax filing and payment deadline to May 17, 2021, including the 2021 Section 475 election. For Texas, Oklahoma, and Louisiana residents, the deadlines are June 15, 2021. 

April 13, 2021: The IRS continues to assert that 2021 first quarter estimated tax payments are due April 15, even though they postponed the 2020 individual tax filing and payment deadline to May 17, 2021. See IRS notice Electing To Apply a 2020 Return Overpayment From a May 17 Payment with Extension Request to 2021 Estimated Taxes

March 29, 2021: The good news is the individual Section 475 election is due May 17, 2021, with the 2020 tax return or extension. The IRS issued formal guidance Notice 2021-21, “Relief For Form 1040 Filers Affected By Ongoing Coronavirus Disease 2019 Pandemic.” The IRS notice states, “Finally, elections that are made or required to be made on a timely filed Form 1040 series (or attachment to such form) will be timely made if filed on such form or attachment, as appropriate, on or before May 17, 2021.” The IRS notice also postponed the 2020 IRA and HSA contribution tax deadline to May 17, 2021.

March 17, 2021: Tax Day for individuals extended to May 17: Treasury, IRS extend filing and payment deadline. “The Treasury Department and Internal Revenue Service announced today that the federal income tax filing due date for individuals for the 2020 tax year will be automatically extended from April 15, 2021, to May 17, 2021. The IRS will be providing formal guidance in the coming days. Individual taxpayers can also postpone federal income tax payments for the 2020 tax year due on April 15, 2021, to May 17, 2021, without penalties and interest, regardless of the amount owed. This relief does not apply to (2021) estimated tax payments that are due on April 15, 2021. The IRS urges taxpayers to check with their state tax agencies for those details.” (IRS Issue Number: IR-2021-59). Intuit: State Tax Deadline Updates. The postponement does not apply to C-Corps, trusts, and estates.

Feb. 22, 2021: For residents of Texas, Oklahoma, and Louisiana, the IRS postponed the April 15, 2021 tax filing and payment deadline until June 15, 2021, after a federal disaster declaration in February 2021 due to winter storms. It also extended the 2021 Q1 estimated income tax payment deadline from April 15 to June 15, 2021. The delay includes various 2020 business returns due on March 15, including partnerships and S-Corps. The postponement also applies to the 2021 Section 475 election for individuals and pass-through entities in these three states.


Traders Should Consider Section 475 Election by the Tax Deadline

March 9, 2021 | By: Robert A. Green, CPA | Read it on

March 17, 2021: Tax Day for individuals extended to May 17: Treasury, IRS extend filing and payment deadline. “The Treasury Department and Internal Revenue Service announced today that the federal income tax filing due date for individuals for the 2020 tax year will be automatically extended from April 15, 2021, to May 17, 2021. The IRS will be providing formal guidance in the coming days. Individual taxpayers can also postpone federal income tax payments for the 2020 tax year due on April 15, 2021, to May 17, 2021, without penalties and interest, regardless of the amount owed. This relief does not apply to (2021) estimated tax payments that are due on April 15, 2021. The IRS urges taxpayers to check with their state tax agencies for those details.” (IRS Issue Number: IR-2021-59). Intuit: State Tax Deadline Updates. The postponement does not apply to C-Corps, trusts, and estates.

March 29, 2021: The good news is the 475 election is due May 17, 2021, with the 2020 tax return or extension. The IRS issued formal guidance Notice 2021-21, “Relief For Form 1040 Filers Affected By Ongoing Coronavirus Disease 2019 Pandemic.” The IRS notice states, “Finally, elections that are made or required to be made on a timely filed Form 1040 series (or attachment to such form) will be timely made if filed on such form or attachment, as appropriate, on or before May 17, 2021.” The IRS notice also postponed the 2020 IRA and HSA contribution tax deadline to May 17, 2021.

Original post:

Even though it’s too late to elect Section 475 MTM for tax-year 2020, the opportunity for 2021 is available now. In this blog post, I will cover the scenarios that make it prudent to obtain Section 475 for tax-year 2021 and how to make the election. 

Before I dive in, let’s review the deadlines, because they are approaching rapidly. Traders eligible for trader tax status (TTS) can elect 2021 Section 475 MTM on securities and/or commodities by April 15, 2021, for individuals and March 15, 2021, for partnerships and S-Corps. (The IRS postponed the April 15, 2021 tax deadline until June 15, 2021, for residents of Texas, Oklahoma, and Louisiana, after a federal disaster declaration in February 2021 due to winter storms. This postponement also applies to the Section 475 election. The delay includes various 2020 business returns due on March 15 like partnerships and S-Corps.)  

Why is Section 475 so attractive? It exempts securities trades from wash sale loss adjustments and the capital-loss limitation against other income; which is what I call “tax-loss insurance.” Profitable TTS/475 traders are eligible for the 20% qualified business income (QBI) deduction if under the QBI taxable income threshold (see below).

Who should make the Section 475 election? Capital gains are needed to absorb capital losses, so if you have capital loss carryovers or significant unrealized capital losses on segregated investment positions, the MTM election would be a gamble. If a TTS trader has new trading losses in 2021 YTD before the election deadline, then a 2021 Section 475 MTM election is generally preferred since it allows ordinary loss treatment and does not add to capital loss carryovers. 

Existing Individuals and Entities

To make the election, simply write this statement on a sheet of paper with your name and social security number (or entity EIN) up top. 

“Under IRC 475(f), the Taxpayer at this moment elects to adopt the mark-to-market method of accounting for the tax year ended December 31, 2021, and subsequent tax years. The election applies to the following trade or business: Trader in Securities as a sole proprietor (for securities and not Section 1256 contracts).” 

Attach the 475 election statement to your 2020 tax return or extension. (See Tips For Traders: Preparing 2020 Tax Returns, Extensions, and 475 Elections.) If you plan to e-file your 2020 tax return or extension, but cannot include the 475 election statement in the e-filing, then submit the 475 election statement with a cover letter to the IRS before the 2020 tax deadline. 

If you want to apply Section 475 to 1256 contracts, revise the statement to include commodities. (Generally, retaining lower 60/40 capital gains rates on 1256 contracts is the better choice.) 

The election statement is just the first part of the process — and the most crucial part. You also have to file a timely 2021 Form 3115 with your 2021 tax return in 2022 and fax a duplicative copy to the IRS. 

You can revoke a Section 475 election by the due dates in a mirror process. 

Section 475 MTM does not apply to duly segregated investment positions (more on that below).  

New Entities

The 475 election process is different for a new taxpayer, a newly formed entity, or first-time individual tax return filer. You must place the statement below in your books and records within 75 days of your new entity’s inception (new LLC/partnership or S-Corp). It’s safest to use the date you obtained the employer identification number (EIN).  

“Under IRC 475(f), the Taxpayer at this moment elects to adopt the mark-to-market method of accounting for the tax year ended December 31, 2021, and subsequent tax years. The election applies to the following trade or business: Trader in Securities as an entity (for securities only and not Section 1256 contracts).” 

A new taxpayer does not need to file a Form 3115 for an internal Section 475 MTM election. The new entity adopts the 475 MTM accounting method from inception. 

If you want to include Section 1256 contracts in the 475 election, then revise the election statement to include “commodities” (Section 1256 contracts). This action is wise if you have significant losses in the first 75 days in these contracts.

20% Deduction on Qualified Business Income

The Tax Cuts and Jobs Act of 2017 introduced a new tax deduction for pass-through businesses, including sole proprietors, partnerships, and S-Corps. Subject to haircuts and limitations, a pass-through business could be eligible for a 20% deduction on qualified business income (QBI). 

Traders eligible for TTS are considered a “specified service activity,” which means if their taxable income is above an income cap, they won’t receive a QBI deduction. The taxable income (TI) cap is $426,600/$213,300 (married/other taxpayers) for 2020, and $429,800/$214,900 (married/other taxpayers) for 2021. The phase-out range below the cap is $100,000/$50,000 (married/other taxpayers). The W-2 wage and property basis limitations also apply within the phase-out range. Investment managers are specified service activities, too. 

QBI for traders includes Section 475 ordinary income and loss and trading business expenses. QBI excludes capital gains and losses, Section 988 forex ordinary income or loss, dividends, and interest income. 

TCJA favors non-service businesses, which are not subject to an income cap. The W-2 wage and property basis limitations apply above the TI threshold of $326,600/$163,300 (married/other taxpayers) for 2020 and $329,800/$164,900 (married/other taxpayers) for 2021. The IRS adjusts the annual TI threshold for inflation each year. 

Sole proprietor TTS traders cannot pay themselves wages, so they likely cannot use the phase-out range, and the threshold is their cap. 

Segregation of Investments 

Suppose a trader holds investment positions in equities and trades substantially identical securities positions in equities or equity options using TTS and Section 475. The IRS could recharacterize trades as investments, or vice versa, whichever suits them best. For example, the IRS could reclassify an investment position in Apple equity currently deferred for long-term capital gains into Section 475 MTM ordinary income at year-end. Alternatively, the IRS could recharacterize Section 475 MTM ordinary losses on Apple options as capital losses triggering a $3,000 capital-loss limitation. 

Traders with overlap between investing and trading activity should consider ringfencing TTS/475 trading into an entity and conducting their investment activity on the individual level. That solution would fix the potential IRS problem. 

Here’s an example: Joe owns an investment portfolio of equities. He leverages his investments using portfolio margining to trade equity options around those investment positions to manage risk on the portfolio and collect option premium. Joe is not selling naked options because he holds equity investments and trades in the same brokerage account. Joe needs to choose between using Section 475 or portfolio margining. 

475 Fixes Wash Sales With IRAs For TTS Trades 

If there is an overlap in securities traded in taxable accounts vs. what’s invested in IRAs, the trader has to avoid triggering permanent wash-sale losses throughout the year. If a trader takes a loss in a taxable account and buys back a substantially identical securities position 30 days before or after in an IRA account, the loss becomes permanent. 

Traders can fix this problem with a “do not invest” list to avoid such overlap. One strategy is to trade equities and equity options in taxable accounts and invest in ETFs, mutual funds, and REITs in IRAs. 

TTS traders can make a Section 475 election to do away with wash sales between trades and the IRAs, so overlap is not a problem. 

Consider all IRA accounts for married filing joint, including traditional IRAs, Roth IRAs, rollover IRAs, and SEP IRAs. Don’t include qualified plans like 401(k) or solo 401(k) plans.

Most traders are not aware of the nuances of triggering permanent wash sales between taxable and IRA accounts. IRS rules for broker-issued 1099-Bs have a narrow view of wash sales; they call for wash-sale loss adjustments on “identical symbols” for the one account. Conversely, IRS wash sale rules for taxpayers have a broader view: Calculate wash sales on “substantially identical positions” (between equities and equity options) on all individual brokerage accounts, including IRAs. Consider using trade accounting software that’s compliant with IRS wash-sale rules for taxpayers. 

Examples

Joe Trader has a $100,000 Q1 2021 trading loss in securities, and he elects Section 475 by April 15, 2021, to offset the ordinary loss against wage income of $150,000. Without the election, Joe would have a $3,000 capital loss limitation against wages and a $97,000 capital loss carryover to 2022. Instead, he used his full trading loss in 2021. 

Nancy Trader has a $50,000 Q1 2021 trading gain and annual wages of $60,000. She might be eligible to receive a QBI deduction of $10,000 (20% x $50,000 QBI 475 net income). 

Section 475 is a consequential election for TTS traders with many advantages but consider your circumstances and the nuances first. We cover various Section 475 scenarios and more in-depth information on 475 elections in Green’s 2021 Trader Tax Guide (see Chapter 2 on MTM). 


Tips For Traders: Preparing 2020 Tax Returns, Extensions, and 475 Elections

March 1, 2021 | By: Robert A. Green, CPA | Read it on

March 17, 2021: Tax Day for individuals extended to May 17: Treasury, IRS extend filing and payment deadline. “The Treasury Department and Internal Revenue Service announced today that the federal income tax filing due date for individuals for the 2020 tax year will be automatically extended from April 15, 2021, to May 17, 2021. The IRS will be providing formal guidance in the coming days. Individual taxpayers can also postpone federal income tax payments for the 2020 tax year due on April 15, 2021, to May 17, 2021, without penalties and interest, regardless of the amount owed. This relief does not apply to (2021) estimated tax payments that are due on April 15, 2021. The IRS urges taxpayers to check with their state tax agencies for those details.” (IRS Issue Number: IR-2021-59). Intuit: State Tax Deadline Updates. The postponement does not apply to C-Corps, trusts, and estates.

March 29, 2021: The good news is the 475 election is due May 17, 2021, with the 2020 tax return or extension. The IRS issued formal guidance Notice 2021-21, “Relief For Form 1040 Filers Affected By Ongoing Coronavirus Disease 2019 Pandemic.” The IRS notice states, “Finally, elections that are made or required to be made on a timely filed Form 1040 series (or attachment to such form) will be timely made if filed on such form or attachment, as appropriate, on or before May 17, 2021.” The IRS notice also postponed the 2020 IRA and HSA contribution tax deadline to May 17, 2021.

Original post:

Traders use various tax forms as the IRS hasn’t created specialized tax forms for individual trading businesses. Traders enter gains and losses, portfolio income, and business expenses on different forms. It’s often confusing. Which form should forex traders use? Which form is correct for securities traders using the Section 475 MTM method? Can one report trading gains directly on a Schedule C? The different reporting strategies for various types of traders make tax time not so cut-and-dry.

Sole Proprietor Trading Business 

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. Our golden rules require four trades per day, close to four days per week, and an average holding period under 31 days. See all the requirements at Trader Tax Status: How To Qualify.

If a trader qualifies for TTS, he can claim some tax breaks after the fact (such as business expense treatment) and elect and set up other benefits (such as Section 475 MTM and employee-benefit plans) on a timely basis. You can assess and claim TTS business expense deductions for all or part of 2020.

Other sole-proprietorship businesses report revenue, cost of goods sold, and expenses on Schedule C. But TTS business traders report only trading business expenses on Schedule C. Trading gains and losses are reported on various forms, depending on the situation. 

Trading Gains and Losses

Sales of securities must be first reported (line by line) on Form 8949 based on the realization method with cost basis adjustments, including wash sale (WS) losses. Form 8949 then feeds into Schedule D short-term capital gains using the ordinary tax rate and long-term capital gains for securities held 12 months using the lower capital gains rate. Capital losses offset capital gains in full, and net capital losses are limited to $3,000 per year against ordinary income (the rest is a capital loss carryover to subsequent years). 

Some brokers provide Form 8949 in addition to Form 1099-B. Consider using trade accounting software to calculate WS loss adjustments. See Form 8949 & 1099-B Issues.

TTS traders who use Section 475 MTM accounting on securities report their TTS trades (line by line) on Form 4797 Part II. “MTM” means open positions are marked-to-market at year-end. Form 4797 Part II has business ordinary loss treatment and avoids the capital loss limitation and wash-sale loss adjustments. Form 4797 losses are included in net operating loss (NOL) calculations. Consider using trade accounting software to generate Form 4797 for Section 475 trades. Without wash sale losses, the trader will be departing from the 1099-B and should explain that in a tax return footnote. 

Section 1256 contracts (i.e., regulated futures contracts) use MTM accounting and are reported on Form 6781 (unless the TTS trader elected Section 475 for commodities/futures; in that case Form 4797 is used). Section 1256 traders rely on a one-page Form 1099-B showing their net trading gain or loss (“aggregate profit or loss on contracts”). They may simply enter that amount in summary form on Form 6781 Part I. There are no wash-sale losses on 1256 contracts. 

Section 1256 contracts have lower 60/40 capital gains tax rates: 60% (including day trades) subject to lower long-term capital gains rates, and 40% taxed as short-term capital gains using the ordinary rate. At the maximum tax bracket for 2020, the blended 60/40 rate is 26.8% — 10.2% lower than the highest ordinary rate of 37%. See Section 1256 Contracts.

If the trader had a significant Section 1256 loss in 2020, she should consider carrying back those losses three tax years but only apply against Section 1256 gains in those years. To obtain this election, check box D labeled “Net section 1256 contracts loss election” on the top of Form 6781. You can make this election with a tax return filed on time, including extensions.

Forex traded in the Interbank market uses Section 988 ordinary gain or loss treatment. Forex traders who don’t qualify for TTS should use line 8 (other income or loss) on 2020 Schedule 1 (Form 1040).  TTS forex traders should use Form 4797, Part II ordinary gain or loss. What’s the difference? Form 4797 Part II losses contribute to NOL carryforwards against any type of income, whereas Form 1040’s “other losses” do not. The latter is wasted if the taxpayer has a negative income. 

In that case, a contemporaneous forex capital gains election is better on the Section 988 trades. If the taxpayer filed the Section 988 opt-out (capital gains) election, she should use Form 8949 for minor currencies and Form 6781 for major currencies. Forex uses summary reporting. See Forex.

Selling, exchanging, or using cryptocurrency triggers capital gains and losses. The IRS treats cryptocurrencies as intangible property. The realization method applies to short-term vs. long-term capital gains and losses, and there is no WS or 475 on intangible property. Report a capital gain or loss on each transaction, including cryptocurrency-to-currency sales, crypto-to-crypto trades, and purchases of goods or services using crypto. Answer the IRS question about cryptocurrency on the 2020 Form 1040 page 1 up top. 

For tax treatment on options, ETFs, ETNs, precious metals, foreign futures, and swaps, see Tax Treatment On Financial Products.

Business Expenses on Schedule C

TTS allows a trader to add a Schedule C to deduct business expenses, including these items:

  • “Tangible personal property” up to $2,500 per item for equipment and furniture.
  • Section 179 (100%) depreciation on fixed assets. Otherwise, bonus and regular depreciation.
  • Amortization of start-up costs (Section 195), organization costs (Section 248), and software.
  • Education expenses paid and courses taken after the commencement of TTS. Otherwise, pre-business education may not be deductible. (Alternatively, include pre-business education in Section 195 start-up costs.) 
  • Subscriptions, scanners, publications, market data, professional services, chat rooms, mentors, coaches, supplies, phone, travel, seminars, conferences, assistants, and consultants.
  • Home-office expenses for the business portion of the home.
  • Margin interest expenses.
  • Stock-borrow fees for short-sellers.
  • Internal-use software for self-created automated trading systems.

Home office (HO) expenses are first reported on Form 8829. HO is one of the most significant tax deductions for traders. It requires trading gains to unlock most of the deduction; mortgage interest and real estate tax portions of HO do not require income. 

When commencing TTS, look back six months to capitalize Section 195 start-up costs, including trading education expenses. The trader can expense (amortize) up to $5,000 in the first year and the balance over 15 years. 

Make Schedule C Look Better

The IRS may view a trading business’s Schedule C as unprofitable even if it has significant net trading gains on other forms and is profitable after expenses. 

To mitigate this red flag, transfer a portion of business trading gains to Schedule C “Other Income” (not revenue) to zero the expenses out but not show a net profit. Showing a profit could cause the IRS to inquire about self-employment (SE) tax on self-employment income (SEI). Trading expenses reduce SEI, but trading gains and losses are not SEI. Learn how to do this transfer strategy in Green’s 2021 Trader Tax Guide

Section 475 MTM Accounting

Only TTS traders can elect and use Section 475, not investors. Section 475 trades are exempt from WS loss adjustments on securities. Section 475 ordinary losses are also not subject to the $3,000 capital loss limitation against ordinary income. Section 475 losses and TTS expenses contribute to net operating losses (NOLs). Hence our phrase “tax loss insurance.”

We usually recommend a Section 475 election on securities only to retain lower 60/40 capital gains rates on Section 1256 contracts (commodities). 

Profitable traders might also benefit from Section 475. TCJA introduced a 20% deduction on qualified business income (QBI) in pass-through businesses, and TTS traders with 475 elections are eligible for the deduction. QBI includes Section 475 income less TTS expenses. However, QBI excludes capital gains and other portfolio income. TTS traders are a “specified service activity,” which means if their taxable income is above an income cap, they won’t receive a QBI deduction. The 2020 taxable income (TI) cap is $426,600/$213,300 (married/other taxpayers). The phase-out range below the cap is $100,000/$50,000 (married/other taxpayers). The W-2 wage and property basis limitations also apply within the phase-out range. Use Form 8995 or Form 8995-A for QBI deductions. 

Section 475 Election Procedures

To obtain Section 475 as an individual, you must file a 2021 Section 475 election statement with your 2020 tax return or extension due by April 15, 2021. Existing partnerships and S-Corps must file a Section 475 election statement by March 15, 2021. 

“New taxpayers” like new entities file an internal Section 475 MTM election resolution within 75 days of inception.

Traders who filed a 475 election for 2020 on time (by July 15, 2020, for individuals) must complete the process by sending a Form 3115 with the 2020 tax return and a duplicate to the national office. 

Learn more about Section 475, the pros, cons, and nuances in Green’s 2021 Trader Tax Guide. The guide includes the election statement to use with your filing. 

Tax Extensions

The 2020 income tax returns for individuals are due by April 15, 2021 — however, most active traders aren’t ready to file a complete tax return by then. Some brokers issue corrected 1099-Bs right up to the deadline or even beyond. Many partnerships and S-Corps file extensions by March 15, 2021, and don’t issue final Schedule K-1s to investors until after April 15. 

The excellent news is traders don’t have to rush the completion of their tax returns by April 15. They may want to consider sending a one-page automatic extension along with payment of taxes owed to the IRS and state.

The IRS postponed the April 15, 2021 tax deadline until June 15, 2021, for residents of Texas, Oklahoma, and Louisiana, after a federal disaster declaration in February 2021 due to winter storms. This postponement also applies to the Section 475 election. The delay includes various 2020 business returns due on March 15 like partnerships and S-Corps. 

Traders can request an automatic six-month extension on Form 4868 to file their federal income tax return by Oct. 15, 2021. States also provide tax extensions, with some states accepting the federal election; however, if the taxpayer owes state taxes, a state tax voucher/extension form is required. 

The 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. The taxpayer should estimate and report what he thinks he owes for 2020 based on his received tax information.

See how the IRS assesses late-filing penalties and late-payment penalties on page two of Form 4868. If a taxpayer cannot pay the taxes owed, he should estimate the balance due by April 15 and report it on the extension. 

Even if a taxpayer cannot pay the balance due, he should at least file Form 4868 by April 15, 2021. Merely filing the extension will avoid the late-filing penalties of 5% per month up to 25%, which are 10 times higher than the late-payment penalty of 0.5% per month up to 25%. The IRS charges interest, too. 

Many traders made massive trading gains in 2020 with an explosion of new pandemic-fueled traders and market volatility. Some used the estimated tax payment “safe harbor” exception to cover their 2019 tax liability with a Q4 2020 estimated tax payment made by Jan. 15, 2021. They plan to pay the balance of taxes owed by April 15, 2021. They should consider setting aside and protecting those tax payments. See Traders Should Focus On Q4 Estimated Taxes Due January 15.

Some traders will risk those 2020 tax payments in the markets right up to the deadline, and they should be careful not to lose them because that will cause significant tax trouble with the IRS and state. 

Partnerships and S-Corps

The 2020 partnership and S-Corp tax extensions are due March 15, 2021. They are easy to prepare since they pass income and loss to the owner, usually an individual. Generally, pass-through entities are tax-filers but not taxpayers.

S-Corps and partnerships use Form 7004 (Application for Automatic Extension of Time To File Certain Business Income Tax, Information, and Other Returns). Extensions give six additional months to file a federal tax return — by Sept. 15, 2021.

Your must file the partnership or S-Corp extension on time. Otherwise, late-filing penalties apply $210 per month per owner up to 12 months. See the Form 1065 and 1120S instructions for further details about penalties.  

Some states require a state extension, whereas others accept a federal extension. Some states have S-Corp franchise taxes, excise taxes, minimum taxes, and payments usually due to the extensions by March 15. LLCs filing as partnerships may have minimum taxes or annual reports due to the extension by March 15. States assess penalties and interest, often based on payments due.

Recent Tax Law Changes

The 2017 Tax Cuts And Jobs Act (TCJA) introduced an “excess business loss” limitation: $500,000 married and $250,000 other taxpayers for 2018, and it’s indexed for inflation each year. Business losses exceeding the EBL limitation are a NOL carryforward. TCJA also suspended NOL carrybacks, allowing NOL carryforwards with 80% limits against subsequent year’s taxable income. The rest carries forward indefinitely. 

The 2020 CARES Act provided temporary tax relief: It suspended TCJA’s EBL rules for 2018 through 2020 and allowed five-year NOL carrybacks for 2018, 2019, and 2020. TCJA EBL and NOL rules apply again in 2021. 

For other recent tax law changes that impact traders, see TCJA, CARES Act, and Emergency $900 Billion Pandemic Relief.

We expect tax legislation in 2021 that impacts traders, so stay tuned to our blog post for updates. 

Takeaway

Traders should focus on the big picture of filing a 2020 automatic extension by the April 15, 2021 deadline. With or without sufficient payment of taxes, filing the extension avoids the late-filing penalty of 5% per month, assessed on the tax balance due. Try to pay 90% of the tax liability to avoid the late-payment penalty of 0.5% per month. Traders unsure of TTS qualification can leave out Schedule C trading expenses from the tax liability calculations used for the extension filing and settle that issue before filing the complete tax return later. The most important issue might be a 2021 Section 475 election due with the 2020 extension by April 15, 2021, for individuals, and March 15, 2021, for partnerships and S-Corps. Overpaying the extension payment is wise for profitable traders to apply the overpayment credit towards 2021 quarterly estimated taxes. It also leaves a cushion on 2020 taxes.

 


Green’s 2021 Trader Tax Guide Available Now

January 27, 2021 | By: Robert A. Green, CPA

Green’s 2021 Trader Tax Guide is ready! Our 2021 guide covers the 2017 Tax Cuts and Jobs Act (TCJA) and the 2020 Coronavirus Aid, Relief, and Economic Security (CARES) Act’s impact on investors, traders, and investment managers.

Purchase the paperback version on Amazon here. Purchase the online version for immediate access here. Watch our Webinar covering the highlights of Green’s 2021 Trader Tax Guide here.

The highlights of this year’s guide are included below.

TAX CUTS AND JOBS ACT

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

Like many small business owners, traders eligible for trader tax status (TTS) restructured their business to take advantage of TCJA. Two tax changes caught their eye: The 20% deduction on qualified business income (QBI) in pass-through entities, and suspended investment fees and expenses, which makes TTS even more crucial. (TCJA continues to allow itemized deductions for investment-interest expenses.) 

TCJA didn’t change trader tax matters, including business expense treatment, Section 475 MTM ordinary gain or loss treatment, and wash-sale loss adjustments on securities; it didn’t change TTS S-Corps’, Solo 401(k) retirement contributions and health-insurance deductions, either. 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.

CORONAVIRUS AID, RELIEF, AND ECONOMIC SECURITY ACT 

The 2020 Coronavirus Aid, Relief, and Economic Security Act (CARES) overrode TCJA’s limitations on tax losses. CARES suspended TCJA’s “excess business loss” limitation for 2018, 2019, and 2020. CARES also provided for five-year NOL carrybacks, whereas TCJA suspended NOL carrybacks. Traders with trader tax status and Section 475 ordinary loss treatment consider NOL carrybacks for 2018, 2019, and 2020. Learn more about CARES’ impact on traders in Chapter 18.

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 against ordinary income ($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 for 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, startup costs, and home office 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 475 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. The 20% deduction on qualified business income includes Section 475 ordinary income but excludes capital gains, interest, and dividend income. The QBI deduction for TTS/475 traders is subject to a taxable income threshold and cap. 

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 (July 15, 2020, for 2020, with three-month postponement under CARES) or within 75 days of inception of a new taxpayer (i.e., a new entity). For more on TTS, see Chapter 1.

CAN TRADERS DEDUCT TRADING LOSSES?

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

Many traders bought this guide hoping to find a way to deduct their 2020 trading losses. Maybe they qualify for TTS, but that only gives them the right to deduct trading business expenses. 

Securities, Section 1256 contracts, ETNs, 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 July 15, 2020, or April 15, 2021, for 2021), or have Section 475 from a prior year, he is 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, 2021, the 2021 TTS trading gains will be ordinary rather than capital. Remember, only capital gains can offset capital loss carryovers. That creates a predicament addressed in Chapter 2 on Section 475 MTM. Once a trader has a capital loss carryover hole, 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 she wants capital gain/loss treatment again. 

Traders with capital losses from Section 1256 contracts (such as futures) may 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. The other 40% fall under ordinary income rates.

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 the 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 currency pairs.

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. 

The CARES Act allows taxpayers to submit five-year NOL carryback refund claims for the tax years 2018, 2019, and 2020 (i.e., a 2020 NOL carries back to 2015). Or taxpayers may choose to carry the NOL forward. TCJA tax-loss limitation provisions will apply again in 2021, allowing only NOL carryforwards used against 80% of the subsequent year’s taxable income. 

TCJA’s “excess business loss” (EBL) limitation also returns in 2021: $500,000 married and $250,000 other taxpayers (2018 limits). In 2021, taxpayers may add an EBL to a NOL carryforward. CARES suspended EBL rules for 2018, 2019, and 2020. See TCJA changes in Chapter 17 and CARES changes in Chapter 18.

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. To help our readers with this, we cover the many trading instruments and their tax treatment in Chapter 3. Here’s a brief breakdown.

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 (stock index futures) are Section 1256 contracts. Simple and complex equity option trades have special tax rules on holding period, adjustments, and more. 

Forex receives 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 under Section 1256(g). 

Physical precious metals are collectibles; if these capital assets are held for more than one year, sales are subject to the collectibles capital gains rate capped at 28%. 

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 exchange-traded notes (ETNs) and 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 2021 tax elections need to be made on time. See Chapter 3. 

ENTITIES FOR TRADERS

Entities can solidify TTS, unlock health insurance and retirement plan deductions, gain flexibility with a Section 475 election or revocation, prevent wash-sale losses with individual and IRA accounts, and enhance a QBI deduction on Section 475 income less trading expenses. 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. See Chapter 7.

RETIREMENT PLANS FOR TRADERS 

Annual tax-deductible contributions up to $63,500 for 2020 and $64,500 for 2021 to a TTS S-Corp Solo 401(k) retirement plan generally save traders significantly more in income taxes when compared to the costs of 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 for the elective-deferral portion only: If you are willing to forgo the tax deduction, you’ll enjoy permanent tax-free status on contributions and growth within the plan. See Chapter 8. 

20% DEDUCTION ON QUALIFIED BUSINESS INCOME

TCJA introduced a new tax deduction for pass-through businesses, including sole proprietors, partnerships, and S-Corps. Subject to haircuts and limitations, a pass-through business could be eligible for a 20% deduction on qualified business income (QBI). 

Traders eligible for TTS are a “specified service activity,” which means if their taxable income is above an income cap, they won’t receive a QBI deduction. The taxable income (TI) cap is $426,600/$213,300 (married/other taxpayers) for 2020, and $429,800/$214,900 (married/other taxpayers) for 2021. The phase-out range below the cap is $100,000/$50,000 (married/other taxpayers). The W-2 wage and property basis limitations also apply within the phase-out range. Investment managers are specified service activities, too. 

QBI for traders includes Section 475 ordinary income and loss and trading business expenses. QBI excludes capital gains and losses, Section 988 forex ordinary income or loss, dividends, and interest income. 

TCJA favors non-service businesses, which are not subject to an income cap. The W-2 wage and property basis limitations apply above the TI threshold of $326,600/$163,300 (married/other taxpayers) for 2020, and $329,800/$164,900 (married/other taxpayers) for 2020. The IRS adjusts the annual TI threshold for inflation each year. 

Sole proprietor TTS traders cannot pay themselves wages, so they likely cannot use the phase-out range, and the threshold is their cap. For more information, see Chapter 7 and Chapter 17.

AFFORDABLE CARE ACT

TCJA and CARES 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. Investment fees and other investment expenses suspended from Schedule A also 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 2020 and 2021. However, TCJA reduced the shared responsibility fee to $0 starting in 2019. 

For more information, see Chapter 9 and Chapter 15.

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, she has LTCG on that interest after one year. 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 for 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 investment fees and expenses. Separately managed account investors are out of luck as investors pay investment fees, but hedge fund investors can limit the negative impact by using carried-interest tax breaks. The carried interest reduces a hedge fund investor’s capital gains instead of having a suspended incentive fee deduction.

INTERNATIONAL TAX MATTERS 

When it comes to global tax matters, we focus on the following types of traders: U.S. residents living abroad, U.S. residents with international investments, U.S. residents moving to U.S. territories like Puerto Rico (with substantial tax breaks), U.S. residents surrendering citizenship or green cards, and nonresident aliens investing in the U.S. with individual U.S. brokerage accounts or through an entity. See Chapter 14.