Traders thrive on market volatility, profiting from rapid changes in prices up or down as they take long and short positions. It’s different for investors: When market indexes drop into correction or bear market mode, they generally lose money or reduce gains.
There’s been significant market volatility in 2015 and many stocks are in correction or bear market mode. I’ve had tax consultations with many traders that are making a fortune from price volatility, catching the swings in price both up and down.
In my last blog post, I wrote about five ways traders should best deduct trading losses, figuring some traders may not have recognized a stealth correction in many stocks and commodities in enough time to profit from it. In this blog post, I address tax savings for profitable traders because there are many traders who have done very well.
Here are eight ways profitable traders save taxes.
1. Business expenses with qualification for trader tax status
Investment expense treatment is the default method for investors, but if you qualify for trader tax status, you can use the more favorable business expense treatment.
Business expense treatment under Section 162 gives full ordinary deductions, including home-office, education, Section 195 start-up expenses, margin interest, Section 179 (100%) depreciation, amortization on software, seminars, market data and much more. Conversely, investment expenses are only allowed in excess of 2% of adjusted gross income (AGI), and not deductible against the nasty alternative minimum tax (AMT). Investment expenses are further restricted with “Pease” itemized-deduction limitations for taxpayers with AGI over $300,000 (married) and $250,000 (single). Many states limit itemized deductions, too.
Highly profitable traders often have significant expenses including staff, an office outside the home, additional equipment and services and significant employee-benefit plan deductions for retirement and health insurance. Their 2% AGI threshold for deducting investment expenses is very high, so they really appreciate full business expense deductions from gross income.
Learn how to qualify for and claim trader tax status in our Trader Tax Center.
2. Home office expenses
Most traders work in their home with a trading workstation, multiple computers, monitors, mobile devices, TVs, office furniture and fixtures. They exclusively use one or more rooms, storage areas and a bathroom.
A typical allocation percentage might be 10% to 20% of the home. Include every expense of the home including mortgage interest, real estate taxes, utilities, repairs, maintenance, security and more. Also, take depreciation of the home and on improvements. Office equipment and furniture is depreciated directly in the business often with Section 179 (100%) depreciation.
The home office deduction requires income, which can include trading gains. You can have a home office and office outside the home, too. Don’t be shy with this deduction; it helps document your business activity. Investors may not take a home office deduction, trader tax status is required.
3. Business travel, education and seminars
Many traders travel around the country and world to trading conferences, seminars and for education courses. If you qualify for trader tax status, education, seminars, conferences and related travel costs qualify as a business expense. But investors may not deduct education, seminars, conferences and related travel expenses in accordance with Section 274(h)(7).
The IRS is a stickler for separating business versus personal travel, meals and entertainment (see Pub 463). If your spouse accompanies you on a trip and is not active in the trading business, the spouse’s share of expenses are deemed personal. If you spend another week on your trip for vacation reasons, that part of the trip is also personal.
If you entertain other traders and industry players, you may have business meals and entertainment expenses. Be careful with the rules for lavish expenditures.
4. Health insurance premium deductions
Obamacare is forcing many traders into buying health insurance or otherwise owe a shared responsibility payment if they don’t qualify for a hardship exemption. Highly profitable traders don’t qualify for exchange subsidies and they seek AGI deductions for high health insurance premiums. (Out-of-pocket health care expenses including deductibles and co-payments are not allowed as an AGI-deduction and the threshold for itemized deductions for medical expenses is high.)
Self-employed businesses and pass-through entities may take a 100% deduction of health insurance premiums from AGI on individual tax returns. The problem for traders is that trading gains are not self-employment income (SEI) and they can’t have an AGI deduction for health insurance premiums or retirement plans. There is a way to fix that.
Traders need to form a S-Corp trading company (or C-Corp management company) to pay officer’s compensation which allows an AGI deduction for health insurance premiums and retirement plan contributions. Execute payroll before year-end and add the health insurance premium to the officer’s W-2 wages. The officer then takes the AGI deduction on their individual tax return.
5. Retirement plan contribution deductions
Generally, the best defined-contribution retirement plan for business traders is a Solo 401(k) plan. It combines a 100% deductible “elective deferral” contribution ($18,000 for 2015) with a 25% deductible profit-sharing plan contribution on an employer-level plan. There is also a “catch up provision” ($6,000 for 2015) for taxpayers age 50 and over. Together, the maximum tax-deductible contribution is $53,000 per year and $59,000 including the catch up provision (based on 2015 IRS limits). A SEP IRA only has a profit sharing plan.
Only traders with trader tax status on an S-Corp trading company (or with dual entity C-Corp management company) can satisfy the requirement for contributions to a retirement plan. That’s because trading gains are not considered SEI, which is required for retirement plan contributions. The trader needs wages from a S-Corp or C-Corp since a sole proprietor trader can’t pay themselves wages.
Retirement plan contributions are only allowed for traders who qualify for trader tax status and who use an S-Corp or C-Corp management company to create compensation as pointed out above.
High-income traders should consider a defined-benefit plan which allows much higher tax-deductible contributions. The maximum limit for 2015 is $210,000 and the actual amount is determined by an actuary.
Retirement plan contributions are made in connection with officer’s compensation, so trader tax status is imperative on these large combined amounts. Investment partnerships are not allowed to pay guaranteed payments to partners; only a trading business partnership may do so. Partnerships pass through losses reducing SEI, whereas S-Corps do not. We prefer the S-Corp for creating the wages needed for maximizing employee-benefit plan deductions.
6. Tax-advantaged growth in retirement plans
In traditional retirement plans, income growth is tax-deferred until taxable distributions are made in retirement subject to ordinary tax rates. Early withdrawals before age 59½ in IRAs and age 55 in qualified plans are also subject to a 10% excise tax penalty. Contributions to traditional retirement plans are tax deductible and hence there is tax-deferral only.
In Roth IRA and Roth 401(k) retirement plans, income growth is permanently tax-free because contributions to a Roth account are not tax deductible. When converting a traditional retirement account to a Roth account, taxes are due on the entire conversion amount. Afterward, the Roth is permanently tax-free. You can reverse the Roth conversion up to Oct. 15 of the following year if you are unhappy with it.
Highly profitable traders generally trade significant retirement assets alongside trading in taxable accounts. Taxable accounts qualify for trader tax status and retirement accounts do not. These traders seek to maximize deductions in connection with taxable accounts and minimize allocations if any to retirement accounts. Consult a CPA trader tax expert on this point.
7. Lower 60/40 capital gains tax rates on 1256 contracts
Profitable traders seek lower tax rates when possible. If you want to trade the Nasdaq 100 index you have two options: an ETF security (NASDAQ: QQQ) taxed at ordinary rates applicable on short-term capital gains, or an emini futures contract (CME: NQ), which is a Section 1256 contract taxed at lower 60/40 capital gains rates.
Section 1256 contracts bring meaningful tax savings throughout all tax brackets. These contracts have lower 60/40 tax rates, meaning 60% (including day trades) are taxed at the lower long-term capital gains rate and 40% are taxed at the short-term rate, which is the ordinary tax rate. At the maximum tax brackets for 2015, the top Section 1256 contract tax rate is 28%, 12% lower than the top ordinary rate of 39.6%. The long-term rate is 0% at the 10% and 15% ordinary tax brackets.
Section 1256 contracts are marked-to-market (MTM) on a daily basis. MTM means you report both realized and unrealized gains and losses at year-end. (Don’t confuse it with Section 475, which is also MTM but has different tax effects.) Many traders have small or no open positions on Section 1256 contracts at year-end. With MTM at year-end, a trader can’t hold a position for a long-term capital gain which requires a 12-month holding period, so Congress negotiated 60/40 capital gains rates. Active traders should take advantage of that tax break.
8. Long-term capital gains taxes
Long-term capital gains on sales of securities are subject to lower capital gains tax rates up to 20% which apply on securities held 12 months or more. Profitable traders often have segregated investment positions in securities — in addition to their trading activity — for which they seek deferral of taxes at year-end and eventually lower long term rates if held 12 months. (Caution: If you use Section 475 MTM, its imperative to properly segregate your investment positions.)
When market conditions change for their investments, rather than sell before 12 months or by year-end causing taxes on unrealized gains, they manage risk with option trades around the underlying position. For example, if they are long Apple stock and are concerned with its price dropping, they can purchase Apple put options for downside risk protection. They are still long Apple and they can continue to defer their unrealized gains in Apple at year-end.
Profitable traders can do these eight things to lower their tax bill by a significant amount. Why over pay Uncle Sam?