Category: Section 475 MTM

Consider 475 Election By Tax Deadline To Save Thousands

February 27, 2018 | By: Robert A. Green, CPA | Read it on

Traders, eligible for trader tax status, should consider attaching a 2018 Section 475 election statement to their 2017 tax return or extension due by April 17, 2018, for individuals, or by March 15 for partnerships and S-Corps. Section 475 turns capital gains and losses into ordinary gains and losses thereby avoiding the capital loss limitation and wash sale loss adjustments (tax loss insurance). There are benefits to 475 income, too.

The Tax Cuts and Jobs Act ushered in a new 20% pass-through deduction on qualified business income, which likely includes Section 475 ordinary income, but excludes capital gains. Trading is a specified service activity, requiring the owner have taxable income under a threshold of $315,000 married or $157,500 for other taxpayers. There is a phase-out range above the limit of $100,000 married and $50,000 other taxpayers. (See How Traders Can Get The 20% QBI Deduction Under New Law.)

Ordinary losses are better than capital losses
The most significant problem for investors and traders occurs when they’re unable to deduct trading losses on tax returns, significantly increasing tax bills or missing opportunities for tax refunds. Investors are stuck with this problem, but business traders with trader tax status (TTS) can avoid it by filing timely elections for business ordinary tax-loss treatment: Section 475 mark-to-market (MTM) for securities and/or commodities.

By default, securities and Section 1256 investors are stuck with capital-loss treatment, meaning they’re limited to a $3,000 net capital loss against ordinary income. The problem is that their trading losses may be much higher and not used as a tax deduction in the current tax year. Capital losses first offset capital gains in full without restriction. After the $3,000 loss limitation against other income is applied, the rest is carried over to the following tax years. Many traders wind up with little money to trade and unused capital losses. It can take a lifetime to use up their capital loss carryovers. What an unfortunate waste! Why not get a tax refund from using Section 475 MTM right away?

Business traders qualifying for TTS have the option to elect Section 475 MTM accounting with ordinary gain or loss treatment in a timely fashion. When traders have negative taxable income generated from business losses, Section 475 accounting classifies them as net operating losses (NOLs). Caution: Individual business traders who miss the Section 475 MTM election date (April 15 for the current tax year) can’t claim business ordinary-loss treatment for the current tax year and will be stuck with capital-loss carryovers.

A new entity set up after April 15 can deliver Section 475 MTM for the rest of the current tax year on trading losses generated in the entity account if it files an internal Section 475 MTM election within 75 days of inception. This election does not change the character of capital loss treatment on the individual accounts before or after its creation. The entity is meant to be a fix for going forward; it’s not a means to clean up the past problems of capital loss treatment.

Ordinary trading losses can offset all types of income (wages, portfolio income, and capital gains) on a joint filing, whereas capital losses only offset capital gains. Plus, business expenses and business ordinary trading losses comprise an NOL, which can be carried back two tax years and/or forward 20 tax years (for 2017). It doesn’t matter if you are a trader or not in a carryback or carryforward year. Business ordinary trading loss treatment is the most significant contributor to federal and state tax refunds for traders.

Starting in 2018, the Tax Cuts and Jobs Act repealed the two-year NOL carryback, except for certain farming losses and casualty and disaster insurance companies. NOLs are carried forward indefinitely, and 2018 and subsequent-year NOLs are limited to 80% of taxable income.

There are many nuances and misconceptions about Section 475 MTM, and it’s essential to learn the rules. For example, you’re entitled to contemporaneously segregate investment positions that aren’t subject to Section 475 MTM treatment, meaning at year-end, you can defer unrealized gains on adequately segregated investments. You can have the best of both worlds — ordinary tax losses on business trading and deferral with lower long-term capital gains tax rates on segregated investment positions. I recommend electing Section 475 on securities only, to retain lower 60/40 capital gains rates on Section 1256 contracts. Far too many accountants and traders confuse TTS and Section 475; they are two different things, yet very connected.

Mark-to-market accounting
Section 475 MTM reports year-end unrealized gains and losses. Marked-to-market means you must impute sales for all open trading business positions at year-end using year-end prices. Many traders have no open business positions at year-end, anyway. You’re reporting realized and unrealized gains and losses, similar to Section 1256 which has MTM built in by default – but don’t confuse Section 1256 with Section 475.

It’s entirely different with Section 1256 contracts where the tax-loss insurance premium is expensive. Electing Section 475 on Section 1256 means you give up the lower Section 1256 60/40 tax rates in exchange for ordinary income rates. There are more nuances to consider as well.

Suitable for securities traders
I coined the term “tax-loss insurance” for Section 475 because if your trading house burns down, you can deduct Section 475 trading losses right away and get a huge tax break (refund or lower tax bill). It’s a free insurance premium on securities because short-term capital gains use ordinary tax rates in the same manner as Section 475 MTM. But, Section 475 losses might generate immediate tax benefits (insurance recovery) whereas capital losses do not.

Securities traders should usually elect Section 475 MTM unless they already have significant capital-loss carryovers. You can’t offset MTM ordinary trading gains with capital-loss carryovers. On the other hand, if a trader generates sizeable new trading losses before April 17, 2018, he or she might prefer to elect Section 475 MTM for 2018 by that sole proprietor election date to have business ordinary-loss treatment retroactive to Jan. 1, 2018. The trader can form a new entity afterward for a “do over” to use capital gains treatment and get back on track with using up capital loss carryovers. Alternatively, the trader can revoke the Section 475 election in the subsequent tax year.

And often not advised for 1256 contracts
Section 1256 contract traders should usually not elect Section 475 to retain the lower 60/40 tax rates. Section 475 would override Section 1256 and subject trading gains to the short-term ordinary tax rate. With Section 1256, 60% of trading gains are considered long-term capital gains — even on day trades — taxed at lower tax rates (up to 20% in 2018), and 40% are short-term capital gains taxed at ordinary tax rates (up to 37% in 2018). The maximum 60/40 blended rate for 2018 is 26.8%, a meaningful 11.2% difference with ordinary rates. There are significant savings throughout the tax brackets.

Investors and business traders may elect to carry back Form 6781 trading losses three tax years, but it’s only applied against Section 1256 contract trading gains on Form 6781, not other types of income.

If you trade Section 1256 contracts and lose a bundle before the election deadline, you may want to elect Section 475, especially if you don’t have the opportunity to carry back Section 1256 contract trading losses against gains in the prior three tax years. Why not take the chance to lock in a sizeable ordinary business loss? You can revoke Section 475 on Section 1256 contracts in the following year by the tax return due date to get back into lower 60/40 tax treatment on Section 1256 contracts.

Exchange-traded notes (ETNs) cannot use Section 475
ETNs are not securities or commodities and are therefore not covered under a Section 475 election. When the VelocityShares Daily Inverse VIX ST ETN (Nasdaq: XIV) significantly dropped in value in early February 2018, during a market correction, many traders incurred substantial trading losses in this and other volatility ETNs. They are dismayed to learn a Section 475 election doesn’t apply to ETNs, and they must use capital loss treatment. ETNs are also not subject to wash sale loss rules for securities.

Cryptocurrencies might be able to use Section 475
Currently, the IRS labels cryptocurrencies (coin) intangible property — not securities or commodities — so that means it likely doesn’t qualify for Section 475 treatment. Many cryptocurrency traders had massive capital gains in 2017, and some of them suffered substantial trading losses in Q1 2018. They would like to use Section 475 ordinary loss treatment for 2018.

Due to recent SEC and CFTC statements calling coin a security and commodity, respectively, I hope the IRS changes its tune. The IRS issued its initial guidance in March 2014, well before regulators made new statements. (Stay tuned for my upcoming blog post “Cryptocurrency traders are eligible for trader tax status benefits.”)

Don’t assume you can deduct trading losses. Unless you are eligible for trader tax status, make a timely Section 475 election, and can use it on the financial products you trade, you might get no immediate tax benefits on capital losses. In 2018, there’s an excellent reason for profitable traders to elect Section 475; the 20% pass-through deduction on qualified business income, which likely includes 475 ordinary income.

This blog post is a modified excerpt from Green’s 2018 Trader Tax Guide. The guide contains information on the Section 475 election procedures, Form 3115, Section 481(a) adjustments, revocation elections, examples for decision-making, and more. There is no room for making errors with a Section 475 election.


Section 481(a) Positive Adjustment Spread Period Changes

May 26, 2016 | By: Robert A. Green, CPA

According to tax research service Thomson Reuters CheckPoint, “Under the new procedures for filing a Form 3115 for tax year 2015 and forward, the four-year spread period generally applicable to a positive Section 481(a) adjustment has been modified as De minimis § 481(a) adjustment amount increased. Under a de minimis provision, positive adjustment may be spread over one year (versus four years) at the taxpayer’s election. The new procedures increases the de minimis threshold to $50,000 from $25,000. The election is made on the new Form 3115 (Rev 12-2015), Part IV, Line 27.”

This means that a trader with a Section 481(a) income adjustment up to $50,000 can elect to report the entire amount of income in the current tax year rather than spread the income over four years. The IRS is probably hoping fewer taxpayers defer income and some may forget to report that income in subsequent tax years. 

According to Green’s 2016 Trader Tax Guide, “Form 3115 (Change in Accounting Method) includes a section for reporting a Section 481(a) adjustment, which is required when a change of accounting is made. The rest of the multi-page Form 3115 relates to tax law and code sections, etc. In the case of changing to Section 475 MTM, a trader’s section 481(a) adjustment is his unrealized business trading gain or loss as of Dec. 31 of the prior tax year. A section 481(a) loss is deductible in full; whereas a gain of more than $25,000 must be prorated over four tax years.” Effective for 2015 tax filings, the $25,000 is changed to $50,000. 

For example: If a trader’s 2015 Section 481(a) adjustment is $40,000, on their 2015 Form 3115 they may elect to report the full income. Conversely, if the income adjustment is $60,000 they would have to spread it over four years reporting $15,000 each year.

Section 475 and Section 481(a) adjustments
When a trader with trader tax status (TTS) elects Section 475 mark-to-market (MTM) ordinary gain or loss treatment, the IRS requires a Section 481(a) adjustment on income tax Form 3115 (Application for Change in Accounting Method) and Form 4797 (Sales of Business Property).

The trader is changing accounting method from the cash method on Dec. 31 to the Section 475 MTM method on Jan. 1. If the trader has open TTS securities positions on Dec. 31 the Section 481(a) adjustment is the unrealized gain or loss on TTS positions on Dec. 31. Gain is a positive adjustment and loss is a negative adjustment. Segregated investment positions in securities are not included in the Section 481(a) adjustment. Section 1256 contracts like futures are already subject to MTM so they also are not included in the 481(a) adjustment.

 


IRS Considering “Freeze And Mark” For Section 475 Election

May 10, 2016 | By: Robert A. Green, CPA

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

According to Tax Notes article “IRS Considering ‘Freeze and Mark’ for Trader Election” dated Jan. 20, 2016, Robert Williams, branch 3 senior counsel, IRS Office of Associate Chief Counsel (Financial Institutions and Products), said he was optimistic, though cautious, that updated Section 475 regulations will come out by June 30, 2016.

The Tax Notes article mentioned a few significant potential changes that would affect traders in making a new Section 475 election. If codified by the IRS, I expect these changes won’t apply retroactively, so traders who made a 2016 Section 475 election by April 18 should not be affected.

Clarification of the character of income or loss of a Section 481(a) adjustment: The IRS may clarify that it’s a capital gain or loss, rather than an ordinary income or loss, which is the current interpretation. Many traders have benefited from ordinary loss treatment, especially when a Section 481(a) adjustment included wash sale loss deferrals on open trading business positions.

No election deadline: The changes may allow existing taxpayers to make a new Section 475 election throughout the tax year. Currently,  the election deadline is April 15 for existing partnerships and individuals and March 15 for S-Corps. Many existing taxpayers will appreciate doing away with the deadline.

No retroactive application: Williams discussed applying ordinary income or loss treatment on the election date and going forward, and doing away with retroactive application of ordinary income or loss to Jan. 1.

Under current law, when a trader elected Section 475 by April 18, 2016 for 2016 (normally April 15), the election was retroactive to Jan. 1, 2016, so all 2016 trading gains and losses are ordinary income and loss. If a trader qualified for trader tax status (TTS) at year-end 2015, he also makes a Section 481(a) adjustment on Jan. 1, 2016 for unrealized gains or losses on open trading positions on Dec. 31, 2015.

Traders have been able to use hindsight between Jan. 1 and April 15 to make a last-minute decision about electing Section 475. For example, if they have a large trading loss in Q1, they may elect Section 475 to lock in ordinary loss treatment for that loss, and plan to revoke Section 475 in the subsequent year to get back to capital gains treatment to use up capital loss carryovers. That type of hindsight may be lost with these potential updates in the law.

 

 


Safeguard Use Of Section 475 By Trading In An Entity

| By: Robert A. Green, CPA

Section 475 “tax loss insurance” is a fantastic tax benefit for active securities traders qualifying for trader tax status (TTS). Many individual taxpayers have been using it successfully for years. I’ve exhorted the benefits since 1997, when Congress enacted Section 475 tax law for traders.

Some Section 475 provisions are vague
Increasingly, my firm’s tax compliance CPAs have noticed problems with the nuances of Section 475, including some of the rule sections, which are too vague. The IRS acknowledged this with its “Section 475 Clean Up Project” and read our comment letter to the IRS. The IRS said the project is being completed and to expect updated Section 475 regulations in the summer of 2016. (I cover the changes being discussed at tax attorney conferences in my next blog post IRS Considering “Freeze and Mark” for Section 475 Election.)

One of the problems with Section 475 regulations has to do with segregation of investments. Segregation should be done in form and substance and that can be confusing. A prior IRS proposed regulation called for designation of investment accounts, but that was not sufficient as traders could use substance to trump form.

This problem arises when a trader uses Section 475 and also holds investment positions in substantially identical positions. Traders can’t elect Section 475 by account. The law makes the election by taxpayer identification number, which means the election applies to all active trading accounts and investment accounts containing active trading.

Traders can solve this problem by housing the trading business using Section 475 in a separate legal entity and holding investments in individual accounts. This is the only way to fully segregate investments from trading. (Read my recent blog post Active Traders Should Consider An Entity For Tax Savings for other reasons to form an entity.)

Misidentified investment positions
Many individuals trade substantially identical positions between Section 475 active trading accounts and taxable investment accounts, including joint and spousal accounts. For example, they trade Apple options in a Section 475 account and also hold Apple equity in segregated investment accounts.

The IRS can view this trading as gaming the system, with the trader deducting ordinary losses on Apple options but deferring taxes on unrealized long-term capital gains in Apple equity held as an investment. Because Apple options and Apple equity are substantially identical positions, the IRS has the power in Section 475 regulations to treat either the Apple options or the Apple equity as “misidentified investment positions,” which means it can apply Section 475(d)(2). (Learn more about that Section 475 penalty in my blog post IRS Plays Havoc with Traders Misidentifying Investments.)

Experienced trader tax preparers and IRS agents may seek other ways to address this problem, including reclassifying Section 475 ordinary losses on Apple options as investment capital losses, which then triggers capital loss limitations and wash sale loss adjustments on substantially identical positions across all accounts. Or if it’s better for the IRS position, reclassifying Apple equity investments as Section 475 trades, triggering Section 475 MTM ordinary income treatment, thereby losing tax deferral and missing out on lower long-term capital gains rates on realization.

An entity solves the problem
Traders can avoid this problem by ring-fencing Section 475 trades in separate entity accounts and holding investments in individual accounts. A separate legal entity has a different taxpayer identification number vs. an individual taxpayer social security number.

Don’t transfer investment positions into the entity, as that brings the same problem to the entity-level: having trading and investment accounts and or positions on the same taxpayer identification number.

I suggest that traders using portfolio margining on investment positions make the following decision. Either bring investments into the trading entity for portfolio margining and don’t elect Section 475 in the entity or leave the investments out of the entity and elect Section 475.

A newly formed entity may elect Section 475 by placing a resolution in its own books and records within 75 days of inception. Existing taxpayers must elect Section 475 by making an election statement with the IRS by the due date of the prior year tax return, and later file a timely Form 3115 for the year of the election. (Read my blog post Traders: Consider Ordinary Loss Election By Tax Deadline for more details on making the election.)

IRS scrutinizes individuals with large Section 475-related NOL tax refunds
It’s been over a decade since Chen vs. Commission (2004), but an IRS official recently reiterated the importance of that landmark tax court case, deeming similar cases “Chen cases.”

The IRS official was referring to sole proprietor (individual) traders reporting large Schedule C and Form 4797 (Section 475) ordinary losses on individual tax returns and filing for large NOL carryback refunds claims with the IRS. All the cases in my Green’s 2016 Trader Tax Guide, including Assaderaghi, Nelson, Endicott and Holsinger are similar: individuals with Schedule C and Form 4797 losses.

It’s much better to file as an entity trader with Section 475 ordinary loss treatment. The tax refund is the same, but you substantially reduce your chances of IRS exam and denial of TTS, which is required for use of Section 475.

Section 475 tax benefits
Securities traders qualifying for TTS benefit from a Section 475 election. Section 475 securities trades are exempt from wash sale loss adjustments and a capital loss limitation. Section 475 has business ordinary loss treatment, which offsets income of any kind and contributes to net operating losses (NOLs), which may be carried back two years and/or forward 20 years. Short-term capital gains and Section 475 MTM gains are taxed at the ordinary tax rate, so Section 475 is recommended for securities traders.

Conversely, Section 1256 contract traders (futures and more) generally don’t want Section 475 since they would lose lower 60/40 capital gains tax rates in Section 1256 (60% is a long-term capital gain taxed at lower rates and 40% is a short-term capital gain).

Traders can elect Section 475 on securities only, retaining Section 1256 treatment on futures. Section 475 does not apply to segregated investments. Traders value ordinary loss treatment: It’s free tax loss insurance for securities traders.

I’ve been advising traders on tax matters for over 30 years and I’ve seen many ups and downs in the financial markets. I’ve seen professional traders with wide fluctuations of income and loss, too. It’s important to avoid the dreaded $3,000 capital loss limitation against other income and benefit from Section 475 ordinary business loss treatment to generate immediate tax refund relief.

 

 


Traders: Consider Ordinary Loss Election By Tax Deadline

March 22, 2016 | By: Robert A. Green, CPA

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

Traders who qualify for trader tax status (TTS) and have a large trading loss in 2016 should consider filing a 2016 Section 475 MTM (ordinary loss treatment) election statement with their extension or return by the April 18, 2016 due date. Section 475 exempts traders from the capital loss limitation and wash sale loss rules. It’s too late to elect Section 475 for 2015: that election was due last April 15, 2015.

Section 475 allows a choice: an election on securities only, Section 1256 contracts only, or both. Specify such in the election statement. Only traders who qualify for trader tax status may use Section 475 and it applies to active trading in that business activity as a sole proprietor individual or on the entity level. Section 475 doesn’t apply to segregated investment positions, so traders may use long-term capital gains benefits on investments.

The biggest problem for investors and traders occurs when they’re unable to deduct trading losses on tax returns, significantly increasing tax bills or missing opportunities for tax refunds. Investors are stuck with this problem, but business traders with TTS can avoid it by filing timely elections for business ordinary tax-loss treatment: Section 475 mark-to-market (MTM) for securities and/or Section 1256 contracts if elected. (Section 1256 contracts include futures, broad-based indexes, options on futures, options on broad-based indexes and several other instruments.)

By default, securities and Section 1256 investors are stuck with capital-loss treatment, meaning they’re limited to a $3,000 net capital loss against ordinary income. The problem is that their trading losses may be much higher and not useful as a tax deduction in the current tax year. Capital losses first offset capital gains in full without restriction. After the $3,000 loss limitation against other income is applied, the rest is carried over to the following tax years. Many traders wind up with little money to trade and unused capital losses. It can take a lifetime to use up their capital loss carryovers. What an unfortunate waste! Why not get a tax refund from using Section 475 MTM right away?

Business traders qualifying for TTS have the option to elect Section 475 MTM accounting with ordinary gain or loss treatment in a timely fashion. When traders have negative taxable income generated from business losses, Section 475 accounting classifies them as net operating losses (NOLs). Caution: Individual business traders who miss the Section 475 MTM election date (April 18 for 2016) can’t claim business ordinary-loss treatment on trading losses for the current tax year. They will be stuck with capital-loss carryovers.

A new entity set up after April 18, 2016 can deliver Section 475 MTM for the rest of 2016 on trading losses generated in the entity account if the entity files an internal Section 475 MTM election within 75 days of inception. The new entity using Section 475 does not change the character of capital loss treatment on the individual accounts before or after entity inception. The entity is meant to be a fix for going forward; it’s not a means to clean up the past problems of capital loss treatment.

Ordinary trading losses can offset all types of income (wages, portfolio income, and capital gains) for you and your spouse on a joint filing, whereas capital losses only offset capital gains. Plus, business expenses and business ordinary trading losses comprise a NOL, which can be carried back two tax years and/or forward 20 tax years. It doesn’t matter if you are a trader or not in a carryback or carryforward year. Business ordinary trading loss treatment is the biggest contributor to federal and state tax refunds for traders.

There are many nuances and misconceptions about Section 475 MTM, and it’s important to learn the rules. For example, you’re entitled to contemporaneously segregate investment positions that aren’t subject to Section 475 MTM treatment, meaning at year-end you can defer unrealized gains on properly segregated investments. You can have the best of both worlds — ordinary tax losses on business trading and deferral with lower long-term capital gains tax rates on segregated investment positions. We generally recommend electing Section 475 on securities only, so you retain lower 60/40 capital gains rates on Section 1256 contracts. Far too many accountants and traders confuse TTS and Section 475; they are two different things, yet very connected.

Section 475 Election Procedures
Section 475 MTM is optional with TTS. Existing taxpayer individuals and partnerships that qualify for TTS and want Section 475 must file a 2016 Section 475 election statement with their 2015 tax return or extension by April 18, 2016 (April 19, 2016 if you live in Maine or Massachusetts). Existing S-Corps file in the same manner by March 15, 2016.

Election statement. The MTM election statement is one simple paragraph; unfortunately the IRS hasn’t created a tax form for it. It’s a version of the following: “Pursuant to Section 475(f), the Taxpayer hereby elects to adopt the mark-to-market method of accounting for the tax year ended Dec. 31, 2016 and subsequent tax years. The election applies to the following trade or business: Trader in Securities as a sole proprietor (for securities only and not Section 1256 contracts).” If you expect to have a loss in trading Section 1256 contracts, you can modify the parenthetical reference to say “for securities and Section 1256 contracts.” But remember, you’ll give up the lower 60/40 tax rates on Section 1256 contracts. If you trade in an entity, delete “as a sole proprietor” in the statement.

Form 3115 filing. Don’t forget an important second step: Existing taxpayers complete the election process by filing a Form 3115 (change of accounting method) with the election-year tax return. A 2016 MTM election filed by April 18, 2016 is reported and perfected on a 2016 Form 3115 filed with your 2016 tax returns in 2017 – by the due date of the return including extensions. Many accountants and taxpayers confuse this two-step procedure and they file the Form 3115 as step one on the election statement date. The IRS usually sends back the Form 3115, which can jeopardize ordinary-loss treatment.

Key strategy
If you have an individual $50,000 capital-loss carryover going into 2016, and you lose $50,000 in Q1 2016, it’s probably wise to elect Section 475 MTM as a sole proprietor for business ordinary loss treatment — and related tax relief — rather than digging a bigger hole of unutilized capital losses.

You can form a new entity for a “do over” to get back to capital gains treatment, so you can use up your capital loss carryovers. You have 75 days of additional hindsight once the entity commences business to file an internal Section 475 MTM election resolution for the entity trading. You’re hoping to generate capital gains in the entity to use up your remaining capital-loss carryovers and put off the Section 475 MTM election to the following entity year.

For more information on Section 475 and trader tax status, read Green’s 2016 Trader Tax Guide.

 


IRS Plays Havoc With Traders Misidentifying Investments

November 23, 2015 | By: Robert A. Green, CPA

Click to read Green's blog post

Click to read Green’s blog post

The IRS and some states have been playing havoc with traders in exams, claiming traders did not properly comply with Section 475 rules for segregation of investment positions from trading positions. Noncompliance gives the agent license to drag misidentified investment positions into Section 475 mark-to-market (MTM), or to boot misidentified trading losses out of Section 475 into capital loss treatment subject to the $3,000 capital loss limitation. Both of these types of exam changes cause huge tax bills, penalties and interest.

Traders don’t want to lose capital gains deferral and lower long-term capital gains rates on investment positions in securities. With misidentified investments the IRS has the power to drag those positions into Section 475 subjecting them to MTM and ordinary income tax rates.

Section 475 improper identification
Section 475 contains a clause to limit unrealized losses on investment positions dragged into Section 475. Under Section 475(d)(2) (which is applicable to traders pursuant to Section 475(f)(1)(D)), if a security was misidentified as an investment, then there is Section 475 MTM unrealized loss recognition only against other Section 475 gains, and any excess unrealized losses are deferred until the security is actually sold. Limiting MTM treatment on unrealized losses on investment positions is not much different from unrealized capital losses on those same positions.

Carefully identify investments
If you claim trader tax status and use Section 475 MTM, you can prevent this problem by carefully identifying each investment position on a contemporaneous basis. When you receive confirmation of the purchase of an investment position, email yourself to identify it as investment position as that constitutes a timestamp in your books and records. Don’t hold onto winning Section 475 trading positions and morph them into investment positions, as that does not comply with the rules. If identifying each separate investment is inconvenient, then ring-fence investments into identified investment accounts vs. active trading accounts. Use “Do Not Trade” lists for investing vs. trading accounts so you don’t trade the same symbol in both accounts.

But this compliance is not enough. If you hyperactively trade around your investments, the IRS can say you failed to segregate the investment in substance.

Section 475 clean up project
In 2015, the IRS acknowledged lingering problems with Section 475 and announced a Clean Up Project welcoming comments from tax professionals. I started a successful petition on Rally Congress to fix Section 475 and TTS rules and also sent a cover letter and comments to the IRS. The American Bar Association ABA Comments on Mark-to-Market Rules Under Section 475 are good. See my blog post in Aug. 2014 IRS warns Section 475 traders, which focuses on the segregation of investment issue.

Individuals have a problem
Section 475 misidentification of investments is a huge problem for individual sole proprietor traders who have both trading and investment positions. Section 475 is very valuable since it exempts trades from wash sale loss rules and the $3,000 capital loss limitation allowing full net operating loss (NOL) treatment for losses which generates huge tax refunds. A capital loss limitation is the biggest pitfall for traders.

Individuals often have a few trading accounts and also several investment accounts. Married couples may each have individual accounts, some joint accounts and IRA accounts. They may buy and hold popular equities in investment accounts and then hyperactively trade those same symbols in their designated trading accounts.

Entities navigate around the problem
The simple fix is to form an entity like a single-member or spousal-member LLC with an S-Corp election. Conduct all business trading with Section 475 on securities in those entity accounts. (The entity may elect Section 475 MTM internally within 75 days of inception of the entity.) Trader tax status, business expenses and Section 475 trading gains and losses are reported on the S-Corp tax return.

It’s wise to avoid investment positions in the entity accounts. But some traders want to use portfolio margining, and brokers don’t allow that between individual and entity accounts, so they want to transfer some large investment positions into the entity accounts. That can become a problem for Section 475 segregation of investment rules, especially if you trade the same symbols. Consult a trader tax expert.

Keep investments in your individual investment accounts. The individual and entity accounts are not connected for purposes of Section 475 rules since they’re separate taxpayer identification numbers.

The entity also looks much better in the eyes of the IRS claiming trader tax status and using Section 475 ordinary loss treatment. Plus, an S-Corp trading company can have employee-benefit plan deductions — health insurance and high-deductible Solo 401(k) retirement plan) — whereas a sole proprietor trader may not.

Tax court cases are for individual traders
A senior IRS official stated at an industry conference that the IRS is going after (auditing) “Chen cases,” referring to the landmark Chen tax court case. Chen was a part-time individual trader for just three months and he deducted TTS expenses and a huge Section 475 ordinary loss requesting a huge tax refund. The court denied TTS and use of Section 475.

Other recent trader tax court cases are individual traders claiming large TTS expenses and Section 475 losses. I covered these cases on my blog: see posts for Poppe, Assaderaghi, Nelson, Endicott, Holsinger and Chen (covered in my guides). Some of these traders may have been okay if they used an entity, however many did not qualify for trader tax status, and several botched or lied about electing Section 475.

In my blog post on the Poppe case, I point out that individuals face pitfalls in electing Section 475. The IRS granted Poppe TTS but denied Section 475 ordinary loss treatment because he botched or lied about the Section 475 election and he never filed a Form 3115. A new entity wouldn’t have that problem.

Wash sale losses are similar
Section 1091 wash sale rules are similar, yet different in one important aspect from Section 475 rules. While the entity is a different taxpayer from the individual for wash sale loss purposes, the IRS can apply Section 267 related party transaction rules to connect the entity and individual accounts if the trader purposely tries to avoid wash sale losses between the entity and individual accounts. I have not seen Section 267 mentioned in connection with Section 475 segregation rules.

Bottom line
Section 475 tax loss insurance is a huge tax break for traders who qualify for trader tax status but be careful with properly identifying investments. Be safe on using TTS and Section 475 by trading in an entity. Now is a good time to form one for 2016.


Traders: Good And Troubling News In Poppe Ruling

November 6, 2015 | By: Robert A. Green, CPA

Click to read Green's blog post

Click to read Green’s post on Forbes

In light of the William F. Poppe vs. Commissioner court case, there’s good news for retail traders on the volume of trades needed to qualify for trader tax status.

There’s also troubling news. The IRS denied Poppe his Section 475 election because he could not prove compliance with the two-step election process. Traders should be more diligent in documenting their election. The consequence was that instead of deducting his $1 million trading loss as an ordinary loss, Poppe was stuck with a $3,000 capital loss limitation and a capital loss carryover.

The court construed Poppe’s proprietary trading firm arrangement to be a disguised retail customer account. This ruling should be a huge concern for the proprietary trading firm industry, especially since regulators warned clearing firms about disguised customer accounts in the past. By agreement, prop traders do not trade their own capital in a retail customer account. They trade a firm sub-account with firm capital and far higher inter-firm leverage than is available with a retail customer account.

Qualification for trader tax status
The Poppe court awarded trader tax status (TTS) with 720 trades (60 trades per month). That’s less than our 2015 golden rule calling for 1,000 trades per annum on an annualized basis. Poppe seems to have satisfied our other golden rules on frequency, holding period, intention to run a business, serious account size, serious equipment, business expenses, and more. Plus, Poppe had a good background as a stockbroker.

In some years, Poppe was a teacher and part-time trader, fitting trading into his schedule. It helped that Poppe made a lot of money trading in a few years in comparison to his teacher’s salary.

Botched Section 475 election
Poppe had large trading losses ($1 million in 2007) for which he claimed Section 475 ordinary business loss treatment rather than a puny $3,000 capital loss imitation against other income. But like other recent tax court cases (Assaderaghi, Nelson, Endicott, Holsinger and Chen), the court busted Poppe for either lying to the IRS about making a timely Section 475 election or making a valid election but not being able to prove it to the IRS. Poppe never filed a required Form 3115 to perfect the Section 475 election, which begs the question: Did he ever file an election statement on time?

The case opinion states that Poppe intended to elect Section 475 for 2003 and he filed his 2003 tax return late in 2005 omitting a required 2003 Form 3115. Poppe’s tax preparer reported 2003 Section 475 trading gains on Schedule C. That’s incorrect: Section 475 trading gains are reported on Form 4797 Part II ordinary gain or loss. This botched reporting indicates to me that Poppe’s tax preparer did not understand Section 475 tax law and it probably buttressed the IRS win.

Many traders are in the same predicament as Poppe and should do their best to document the election filing in case the IRS challenges it later on. We document the process for our clients and ask them to document their filings, too. Send yourself an email with the relevant facts as email has a timestamp. Safeguard a copy of the election and Form 3115 in your permanent files.

One learning moment in the Poppe case is how to properly make a timely Section 475 election and to avoid pitfalls in botching the election process.

Section 475 tax loss insurance
By default, investors and traders in securities and Section 1256 contracts have capital gain and loss treatment, as opposed to ordinary gain or loss treatment. Capital losses offset capital gains without limitation, but a net capital loss is limited to $3,000 per year against other income with the remainder of capital losses carried over to the subsequent tax year(s).

Traders qualifying for TTS may file a timely election for Section 475 ordinary gain or loss treatment (on securities only or Section 1256 contracts, too). Generally, traders prefer to retain Section 1256 treatment with lower 60/40 capital gains rates. Section 475 exempts traders from wash-sale loss treatment on securities and capital loss limitations. It’s known as “tax loss insurance” since it allows full business ordinary loss treatment comprising NOLs generating NOL tax refunds.

A sole proprietor (unincorporated) trader makes an individual-level Section 475 election. A proprietary trading firm or hedge fund makes an entity-level Section 475 election. A partner in a proprietary trading firm or hedge fund cannot override the firm’s Section 475 election or lack of an election made on the entity-level.

Warning: Don’t botch the election
Botching the election empowers the IRS to deny use of Section 475 serving up a simple win for the IRS in tax court. Even when a taxpayer properly makes a Section 475 election, an IRS agent may challenge his or her qualification for TTS, which pulls the rug out from under using Section 475. (Each tax year TTS must be assessed as a prerequisite to using Section 475.)

Section 475 election two-step process
The first step is for the trader to file a timely election statement early in the current tax year to prevent the trader from using hindsight about the election later.

An “existing taxpayer” (who filed a tax return before) must file an election statement with the IRS (that means “external”) by the due date of the prior year tax return not including extensions: April 15 for individuals and partnerships and March 15 for S-Corps. (Note that in 2017, the partnership due date changes to March 15.) Attach the Section 475 election statement to the tax return or extension filing. I suggest documenting this first step in your books and records including emailing a copy to yourself and your accountant. Don’t count on the IRS for keeping a copy of the election statement.

An existing taxpayer’s second step is to file a Form 3115 (Change Of Accounting Method) with appropriate Section 481(a) adjustment by the due date of the election-year tax return including extensions. The complex Form 3115 must be filed in duplicate: one copy with the timely filed tax return and a second copy to the IRS national office.

Example of existing taxpayer: A sole proprietor trader files a 2015 Section 475 election by April 15, 2015, attaching the election statement to his 2014 federal tax extension filed on time by mail. (You can’t attach an election to an e-filed extension.) Second step: The accountant prepares a 2015 Form 3115 to accompany the 2015 Form 1040 filed by Oct. 15, 2016 with a valid extension filed by April 15, 2016.

Why the two steps? So taxpayers can make a very simple election filing with little hindsight but to allow sufficient time to prepare a complex Form 3115 with the tax return filing after year-end.

Common errors with Section 475 elections
Many local accountants are confused about the two-step process. Some think only one step is required: either filing the Form 3115 in lieu of the election statement, or the election statement as part of a Form 3115 filing with the tax return. They don’t comply with both required steps and that botches the election.

Section 475 “new taxpayer” exception
There is an important exception to the election process for “new taxpayers” such as a new entity. A new taxpayer may file the Section 475 election statement within its own books and records (internally) within 75 days of inception of the new entity.

Existing taxpayers who miss the external 475 election by April 15 should consider forming a new entity to make an internal Section 475 election within 75 days of inception, which is later in the year. A new taxpayer “adopts” Section 475 from inception as opposed to changing its accounting method so they don’t have the second step of filing a Form 3115 with Section 481(a) adjustment (converting realization/cash method to MTM on Jan. 1).

The entity provides better flexibility in making, revoking, and ending Section 475 elections with closure of the entity. With fewer steps to follow, the internal election for new taxpayers is a better choice for prevailing with the IRS.

Poppe’s errors on Section 475
Poppe was not able to verify the external 475 election statement (step one) or a Form 3115 filing (step two). It wasn’t just a question of being late on a Form 3115 filing, Poppe never filed a Form 3115 and he was an existing taxpayer individual.

Traders should file the external Section 475 election statement with certified return receipt. But that may not be enough because it only verifies a mailing, which also contains the tax return or extension. The IRS recognized this problem and suggests that taxpayers include a perjury statement on Form 3115 stating they filed the 475 election statement on time.

Is there any relief from the IRS?
My partner Darren Neuschwander, CPA spoke with an IRS official in the Form 3115 area a few years ago who said the IRS had granted some relief to a few traders providing they were only a little late with their Form 3115 filing and they filed the election statement on time. The IRS official pointed out there is no relief for filing the initial election statement late.

But Poppe was not a little late — he never filed a Form 3115, even with the case being heard years later. It’s wise to file Form 3115 on time per the written rules and not rely on hearsay about possible relief from IRS officials, which may no longer be granted after the Poppe decision. Consult your trader tax advisor.

Poppe’s mental incapacity argument didn’t work
The Poppe case shows that it doesn’t work to claim reasonable cause on noncompliance due to mental incapacity if the taxpayer can’t demonstrate the same mental incapacity in a job, business, or trading. Poppe tried to raise this issue for special relief and the IRS said no because he wasn’t mentally impaired as a teacher and as an active trader.

Per Thomson Reuters, “Poppe argued that his actions met the requirements of the ‘substantial compliance’ doctrine, under which perfect compliance with a tax provision isn’t required. But the Court said that the substantial compliance doctrine does not apply to the Code Sec. 475(f) election and that, even if it did, Poppe failed to meet many of Rev Proc 99-17 ‘s requirements and thus hadn’t substantially complied.”

Proprietary trading account or disguised customer account?
In 2007 (the IRS exam year), Poppe lost $1 million trading with a proprietary trading firm that cleared through Goldman Sachs Execution & Clearing (GSEC). This is the tax loss at the center of this case.

On his original tax return filing, Poppe reported this loss (assumed) on Schedule E page 2, as an ordinary loss flowing through to him as a partner in a partnership. If the proprietary trading firm qualified for TTS and filed a timely Section 475 election on the firm level, then trading losses allocated to partners would have ordinary loss treatment.

Poppe attached a partner Schedule K-1 to his tax return even though it is not required. But during the exam, the IRS was unable to find Poppe’s K-1 in the partnership tax return filings where it is required to be attached. This begs the question: Did Poppe fabricate his own Schedule K-1? That would be illegal. Or did the firm present Poppe with a Schedule K-1 only to retract it in their partnership tax filing later on? (IRS computers match K-1s reported on partner’s individual tax returns with partnership tax filings looking for incorrect reporting.)

Prop trading firm arrangements, agreements, tax treatment and regulatory issues are murky. Perhaps Poppe never formally signed the prop trading firm’s LLC Operating Agreement. The case states Poppe couldn’t satisfy the IRS that he was a partner in the firm. If not an LLC member, perhaps he was an independent contractor, which is the second business model for proprietary trading firms.

Poppe claimed he was a Class B member of the firm. Generally, the main owners (Class A members) are allocated firm-wide trading losses on their K-1s since they own the firm’s capital in their capital accounts, which provide tax basis for deducting trading losses. Generally, Class B members don’t have capital accounts so they aren’t allocated losses since they wouldn’t have tax basis to deduct losses, which would then be suspended to subsequent years when they might have capital.

Instead of paying into firm capital, Class B members pay “deposits” to the firm. This is where the confusion mainly lies. The firm applies these deposits to cover the prop trader’s trading losses incurred in a firm sub-account. Prop traders are entitled to deduct lost deposits as business bad debts, which are ordinary business losses. Perhaps Poppe should have considered lost deposit bad debt tax treatment instead of using an incorrect K-1 and later relying on an alleged Section 475 election as a retail individual trader.

I’ve been covering the proprietary trading industry since the late 1990s. Around 2000, some people questioned whether proprietary trading firm arrangements were really “disguised” retail customer accounts. Reg T margin rules allow 4:1 margin on pattern day trader (PDT) customer accounts requiring a $25,000 minimum account size. Otherwise, retail investors are limited to 2:1 margin on securities. The big attraction of proprietary trading firms is they offer proprietary traders (LLC members or independent contractors) far greater leverage (greater than 10:1 in some cases) on their deposits made with the firm. Some proprietary trading firms have minimum deposit amounts as low as $2,000.

If the firm’s profit sharing arrangement is more than 80% sharing to the prop trader, FINRA’s Regulatory Notice 10-18 issued to clearing firms stated it’s one of several signs it may be a disguised retail customer account. Read my June 2010 blog post FINRA’s notice to prop traders. Poppe had 90% profit sharing and perhaps that led the IRS to conclude it was a disguised retail customer account. GSEC is a popular clearing firm for proprietary trading firms and I don’t believe it services individual retail customers. Goldman Sachs brokerage firm has high standards for opening individual retail customer accounts.

The Poppe opinion states: “The parties stipulated that all transactions and capital in the GSEC account belonged to petitioner (Poppe).” Perhaps the parties preferred this tact so they could ague the case over Poppe’s alleged Section 475 election as a retail trader. In my view, the word “stipulate” means the parties agreed on facts as a pre-condition to negotiating a settlement. But it’s not necessarily the true facts.

Should prop traders file Section 475 elections as a backup position in case the IRS later considers them a disguised retail customer account? I imagine plenty proprietary trading firms and prop traders are in tax controversy (exams, appeals or tax court) now and I suggest they consider contacting our CPA firm for help soon.

Bottom line
I’m happy to see a new trader tax court case moving the goal posts back to 720 trades from 1,000. That opens the door for more traders. I am not surprised that another trader (and his accountant) botched the complex Section 475 election process and later tried to bamboozle the IRS about it in order to get a huge tax benefit. Proprietary trading firm arrangements with prop traders are murky and the IRS may turn up the heat on them both soon.

For more information, check out T.C. Memo. 2015-205.

Darren Neuschwander CPA contributed to this blog post.


Five Ways To Deduct Losses In Financial Markets

August 23, 2015 | By: Robert A. Green, CPA

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Green’s blog post    Accountants World

Investors often asked J.P. Morgan his stock market predictions, and his retort was: “There are only two good predictions — the market will go up or down.” Because it’s impossible to predict the stock market, it’s essential to learn the best way to write off losses.

The deck is stacked against you
The tax code disenfranchises investors and traders from deducting losses. The capital-loss limitation, wash-sale loss deferrals, passive-loss activity limitations and carryovers, investment interest expense carryovers, wasted personal investment losses, at-risk limitations and more are used to pay for or offset lower long-term capital gains rates (up to 20%) on positions held over 12 months and on qualifying dividends. Ordinary tax rates rise to 39.6%, almost twice as high as long-term capital gains rates.

Buy and hold investments
If you buy and hold securities, you may wind up selling and holding capital loss carryovers. If you have unrealized capital gain positions and are close to the 12-month holding period for lower long-term capital gains rates, consider buying protection on the long equity position in the options market (e.g., buying a put option).

Capital-loss carryovers can take decades to use up
Many investors still haven’t used up their capital-loss carryovers realized in the dot.com crash in 2000. While capital losses are deductible in full against capital gains, individuals may only deduct $3,000 of capital losses per tax year against non-capital gains income like wages. Plus, that $3,000 limitation isn’t indexed for inflation. I’ve seen it take decades to use up capital-loss carryovers in the hundreds of thousands of dollars for many clients.

Pundits suggest planning for losses at this time
Since the Great Recession and market meltdown of 2007, the financial markets recovered to new highs riding the coattails of Fed monetary easing and government stimulus which appear to be ending soon. The world’s locomotive economy China is apparently slowing and its financial markets are exhibiting some signs of boom/bust conditions. That seems to be causing contagion in emerging and even developed markets.

While some investors see buying opportunities, others feel it’s different this time around and they don’t want to catch a falling knife. Remember J.P. Morgan’s words about making predictions.

Five ways to maximize losses on tax returns

1. Elect Section 475 for unlimited ordinary losses
If you trade as a business activity and qualify for trader tax status (TTS), you’re entitled to make a timely Section 475 MTM election. Section 475 trades are reported on Form 4797 (Sale or Business Property) Part II ordinary gain or loss tax treatment. Ordinary losses are exempt from capital-loss limitations and wash-sale loss deferral rules.

Unfortunately, too many traders and tax advisors aren’t experienced with Section 475 and TTS and they missed filing a 2015 election by April 15, 2015 for existing individuals and partnerships and March 15 for existing S-Corps.

“New taxpayers” (new entities) can elect Section 475 within 75 days of inception, so consider a new entity later in the year. Caution: pre-entity losses remain capital losses, so wait the 75 days to decide whether to elect 475 internally or not. If the entity has capital gains, it can pass through capital gains to soak up individual-level capital losses, so you can skip the entity 475 election that first year. Conversely, if the entity has significant losses, you should elect Section 475 for ordinary loss treatment. You can revoke Section 475 the following year to get back to generating capital gains to soak up capital-loss carryovers. If you dig a big hole of capital-loss carryovers, it’s important to climb out of that hole with a capital gains ladder and not dig a bigger hole with a Section 475 floor.

2. Net operating losses generate tax refunds
Section 475 ordinary losses reduce gross income without any limitation. If you have negative taxable income, Section 475 losses are includible in a net operating loss (NOL) tax computation. NOLs are carried back two tax years and or forward 20 years. You can file a timely election to forgo the NOL carry back and only carry it forward. NOLs offset all types of income.

3. Wash sale losses require careful management
If you take a loss on a security in a taxable account and buy a substantially identical position back 30 days before or afterward in any of your individual accounts including IRAs, it’s considered a wash-sale loss. On taxable accounts, it’s a deferral with adding the wash-sale loss adjustment to the replacement position’s cost-basis.

Caution: The wash-sale loss is permanently lost on an IRA account. That rule does not apply to qualified retirement plans like a Solo 401(k). Lesson: don’t trade substantially identical positions between taxable and IRA accounts. Also, consider active trading in an entity account — this account is considered a different taxpayer, although related party rules can apply if you purposely try to avoid wash sales with the related accounts.

Monitor wash-sale loss conditions using software like Tradelog and “break the chain” on wash sales at year-end. (Don’t worry too much about wash sale losses on taxable accounts during the year as they may melt away by year-end and that’s when it counts most.) Break the chain means realize the loss and don’t buy back a substantially identical position 30 days before or afterward. “Substantially identical position” means between Apple stock and Apple options and Apple options at different expiration dates. Apple stock and Google stock are not substantially identical positions.

Note that broker-issued 1099Bs calculate wash-sale loss adjustments on a per account basis and based on identical positions. Broker rules differ from taxpayer rules who calculate wash sales based on all their accounts including IRAs based on substantially identical positions. This causes non-compliance and significant confusion.

4. Section 1256 loss carry back election
In general, capital losses may never be carried back like NOLs. There is one exception: Section 1256 contract losses may be carried back three tax years but applied only against Section 1256 gains in those prior years.

Section 1256 contracts include regulated futures contracts (RFCs), broad-based indexes like e-minis, options on futures, options on indexes and non-equity options. A broad-based index has 10 or more underlining securities in the index (e.g. S&P 500). Exchange-traded funds (ETFs) are securities and they aren’t Section 1256 contracts.

Section 1256 contracts have other tax breaks. Section 1256 contracts are marked-to-market (MTM) which means wash-sale loss rules are a moot point and don’t apply. MTM also means a long-term holding period of 12 months is impossible to achieve so Congress negotiated a blended long-term and short-term capital gains rate: 60% and 40%, respectively. In the highest tax bracket, the blended 60/40 rate is 28%, almost 12% less than the highest ordinary rate (39.6%). There are meaningful differences in the rates throughout the tax brackets since the lowest long-term rate is 0% for the 10% and 15% ordinary tax brackets.

Unlike a Section 475 election required during the tax year, a Section 1256 loss carry back election can be made after year-end. Simply check the box on top of Form 6781 for the Section 1256 loss carry back election. Omit the losses from the current year tax return and include them on amended tax returns for one or more of the prior three tax years (in order of oldest year first).

5. Forex losses are ordinary by default
Spot forex trading losses in the Interbank market are Section 988 ordinary gain or loss treatment, meaning they aren’t subject to the capital-loss limitation or wash-sale loss treatment.

Unlike manufacturers, investors and traders holding forex as a capital asset may file a contemporaneous and internal capital gains election to opt out of Section 988 into capital gain or loss treatment. If you have large capital-loss carryovers, that election can help soak up losses with capital gains on forex trading.

Caution: If you have negative taxable income caused by forex trading losses, you need trader tax status to have NOL treatment. Otherwise, you’ll waste part or all of your forex loss since it’s not a capital loss carryover.

If you trade the major currencies, with the capital gains election you can navigate into lower Section 1256(g) 60/40 tax rates and use the Section 1256 loss carry back election. Section 988 losses over $50,000 require a Form 8886 filing.

Losses in retirement plans
In traditional retirements plans, taxes are deferred on trading gains until taxable distributions are withdrawn in retirement. Losses are deferred deductions because they reduce retirement distributions accordingly.

It’s different with Roth IRA and Roth Solo 401(k) plans. There are no taxes owed on normal retirement distributions with permanent deferral. That means losses are not deductible and they are wasted. If you lose a lot in a Roth conversion executed for 2014 or 2015, you may be able to reverse the Roth conversion in order to benefit from the losses.

Bottom line
Losses can paralyze investors. Some exit the markets entirely, figuring they can’t afford more non-deductible capital losses. Traders need refunds from losses to replenish their trading capital. Understand what you are trading and how losses work and maximize your tax affairs accordingly. Consult with a trader tax expert.


Dear IRS & Congress: Please Fix Tax Rules For Active Traders

May 14, 2015 | By: Robert A. Green, CPA

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We mailed the IRS Commissioner this cover letter and comments for the IRS Section 475 “Clean Up Project.” This blog post is comprised of those comments. 

Please take action: sign our Petition to CongressWithout your participation traders are too small a voice. 

The IRS recognizes problems with tax rules for active traders including Section 475 marked-to-market (MTM) reporting, Section 1091 wash sale loss rules and trader tax status (business treatment).

These problems are connected. Only a trader who qualifies for trader tax status may elect and use Section 475(f) MTM ordinary gain or loss treatment. Otherwise with the default “realization method” (cash method), securities trades are subject to Section 1091 wash sale loss rules and capital gain and loss treatment. Wash sale rules are a huge problem for active securities traders; non-compliance is widespread and the IRS is not enforcing the rules. That is unsustainable.

Trader tax status is a requirement for Section 475(f)
Traders, tax professionals, IRS and state tax agents don’t fully understand trader tax status (TTS), and the result is botched tax compliance causing significant losses from higher taxes, penalties, interest and professional fees.

Hundreds of thousands of active traders qualify for TTS, trading their own funds as a business activity. Most of them don’t know they are entitled to file a timely election for Section 475(f) MTM ordinary gain or loss treatment and exemption from Section 1091 wash sale loss treatment. They also don’t realize they can use Section 162 business expense treatment as a sole proprietor or in a pass-through trading company without an election required for Section 162.

Since enactment in 1997, Section 475 and TTS rules remain too confusing to tax professionals and traders. Many local tax preparers conflate the two code sections, not realizing a qualifying trader may use Section 162 but not elect Section 475(f). The IRS needs to do a better job with its guidance.

Better define trader tax status
There is no “statutory law” defining qualification for TTS. There is only “case law” and “trader tax” cases have a broad range of criteria without giving a bright-line test, except the Endicott court stated average holding period must be 31 days or less. Traders need similar standards for volume and frequency of trades and hours per day.

Case law rewards losing day traders with TTS and 475(f) elections, but denies both to profitable options traders who may make a consistent living but have less volume and frequency of trades. The average trader with TTS has business expenses of approximately $15,000 and that does not stress the Treasury in terms of tax benefits.

The IRS has a history of misquoting TTS case law to traders in tax exams. On several occasions, IRS agents told traders they needed to make their “primary or sole living” from trading, whereas tax law requires “an intention to make a living.” Hobby loss rules do not apply to trading because trading is “not recreational or personal in nature.”

Section 475(f) MTM
Section 475 was drafted for dealers in securities and or commodities. In 1997, Congress expanded Section 475 to include traders who qualify for trader tax status adding Section 475(f). The IRS added the terms “trader in securities” and “trader in commodities.” Traders must qualify for TTS to elect and use Section 475(f).

Securities traders consider a Section 475(f) election for two reasons: exemption from wash sale loss deferral rules and the $3,000 capital loss limitation. Section 475 MTM is ordinary gain or loss treatment. Section 475 trading losses contribute to NOL carry backs and forwards which generate tax refunds faster than carrying forward capital loss carryovers, which otherwise are the biggest pitfall for traders. Section 475 MTM ordinary income is taxed at the same ordinary tax rate as short-term capital gains.

Better define commodities
The IRS needs to better define the term “commodities” in Section 475 (and throughout the tax code). The definition needs to clearly state that traders may elect Section 475(f) on “securities only” and retain lower 60/40 tax rates on Section 1256 contracts (futures and broad based indexes). While dealers sell bushels of wheat (commodities), traders do not.

I appreciate the ABA’s comments to the IRS. Their comments on the definition of commodities are confusing. The ABA addresses dealers and traders, whereas we focus on traders only.

Suspending Section 475 treatment
One of the challenges in administrating Section 475 is in the determination of qualification for TTS. Falling short of TTS means the trader must suspend use of Section 475 and use the realization (cash) method until he or she re-qualifies in a subsequent tax year. Suspension treatment is not included in Section 475 rules, yet it should be. The concept is that without TTS, all open positions automatically become investment positions.

The IRS recently fixed Section 475 revocation rules
There’s good news for traders about Section 475 MTM buried in the IRS annual update on procedures for changes of accounting method. It has always been free and easy to elect Section 475 MTM, yet difficult and costly to revoke that election. With this rule change, the IRS makes revocation a free and easy process. (Read my blog post New IRS rules allow free and easy Section 475 revocation.)

Section 475(f) election and Form 3115
Current rules for making a Section 475(f) election are too narrow and complex. In other words, there is a very small window of opportunity to consider and make a 475(f) election and most traders don’t speak with their tax advisor on time. Far too many qualified traders who would benefit from Section 475(f) miss the boat and that’s unfair.

“Existing taxpayers” must elect Section 475(f) by the original due date of the prior year tax return (not including extensions). That provides about three months of hindsight from Jan. 1 until April 15 for individuals and partnerships and March 15 for S-Corps. It’s an election statement as there isn’t a tax form.

The second step — to perfect the election — is to file a Form 3115 with the current year tax return. Many accountants think it’s a one-step procedure and they botch the election by missing either the election statement or the Form 3115 filing (required in duplicate).

A taxpayer must attach the election statement to their extension or tax return and a certified return receipt only proves a tax filing not the election statement. The IRS admits they don’t have a system to record the 475(f) election, so they ask a taxpayer for a perjury statement on the Form 3115 representing they filed the election statement on time. The IRS provides relief for late Form 3115s but not late election statements.

Provide late relief for Section 475 elections
Tax law (Regulation Section 301.9100-3 relief) allows six months to file a private letter ruling to get late relief on certain elections including Section 475(f). But to date it has been almost impossible to get this type of relief for a late Section 475(f) election. The process requires a private letter ruling and the IRS denied all of them to date with the exception of Larry Vines who had a perfect fact pattern. The IRS refuses late relief for Section 475(f) by claiming prejudice to Treasury and hindsight. It takes almost a perfect set of factors to get by this stringent posture. An open portfolio of unrealized capital losses is currently considered enough of a reason for the IRS to deny late relief for a Section 475(f) election.

Rather than loosen up here, I prefer the IRS just allow a Section 475(f) election with more time. Focusing too much on hindsight disenfranchises traders.

Expand Section 475(f)new taxpayerexception
Under current law, there is an exception for “new taxpayers” like a new entity. A new taxpayer may elect Section 475(f) by internal resolution within 75 days of inception. If you start trading after April 15, you can’t make a 475(f) election as an individual; but you can form a new entity to make the election within 75 days of inception.

The new taxpayer exception isn’t clear or broad enough. The IRS should broaden it to accommodate “new traders” qualifying for TTS, not just a new entity. Individual traders or entities qualifying for TTS after April 15 should be able to elect Section 475(f) within 75 days of qualification.

I think the IRS should go even further by allowing the election on the tax return filing after year-end. Traders using Section 162 business expense treatment simply claim that treatment on their tax return (Schedule C) where they also choose the cash method or accrual method of accounting for expenses. Why not enact the same procedure for a Section 475(f) election? Why make Section 475 confusing and different from Section 162 since they are so tied together already?

Most tax professionals don’t know their client qualified for TTS until tax time and often that’s after the April 15 deadline for filing extensions. Their clients often miss the 475(f) election for the past year, as well as the current year, too.

Taxpayers often don’t discuss election opportunities with their accountants until after year-end, not when they launch a new activity. Traders don’t even realize that trading can be a business; otherwise they might call their accountant early on. It’s unreasonable for the IRS to assume traders can digest the complications of Section 475(f) and TTS on their own.

First year hindsight is reasonable
While extending the 475(f) election until tax filing time gives traders more hindsight during the first calendar year (and into the next tax year) and new IRS rules for revocation allow reversal in a subsequent year, once revoked, Section 475 can’t be re-elected for five years.

Most tax elections are made on a tax return filing, and they are not required earlier in the year – hindsight is allowed. With so many traders missing the boat on Section 475 — and then building up a capital loss carryover hole committing them to the realization method — it’s reasonable for traders to conclude the onerous 475(f) election rules are intended to disenfranchise traders from using ordinary loss treatment.

The original tax law on Section 475(f) mentioned the IRS would issue a tax form for the election. But, to date the IRS has not issued a form. Even with the S-Corp election Form 2553 due within 75 days of inception, the IRS grants relief for late-filed elections. I don’t see precedent for stringent hindsight rules against traders. Missing the Section 475(f) election requirement is the biggest problem in Section 475 and it causes the most inequity for traders contrary to the intention of Congress in expanding Section 475 to traders.

Section 475 segregation of investmentrules are vague
I disagree with IRS proposed regulations for segregation of investments from Section 475 calling for a separate investment account.

Segregation should be done in “form and substance.” It’s not enough to designate an account as an investment account (in form) because traders often actively trade around core investment positions in an active trading account (in substance). Segregation must be assessed in overall actions by traders. (Read my blog post IRS warns traders on Section 475.)

I agree with Chief Counsel Advice (“CCA”) 201432016 stating “the 475 election is made on an entity-by-entity basis, not a separate trade or business basis, and only in the case of separate commodities and securities businesses can a taxpayer make separate elections.” I also agree the proposed regulation stating “a trader may identify an investment with ‘clear and convincing evidence that a security has no connection to its trading activities.’”

As tax preparers for traders, real world fact patterns can be confusing and it would be good if the IRS issued more guidance on segregation of investments. If a client trades the same symbol for which he invests and uses Section 475(f) for active trading but not investing, should all the symbols traded and invested be consolidated into Section 475(f) or into investment treatment, or otherwise? The proposed regulations offer some solutions but they need more work. Tax preparers need support for taking positions that don’t prejudice Treasury. In general, I agree with many of ABA’s comments on May 7, 2015 in this regard.

Wash sale rules are a problem
A Section 475(f) election is an escape hatch for a qualifying trader from wash sale loss treatment (Section 1091). When the IRS considers changes to Section 475, they should also address significant problems with Section 1091 as these code sections are joined at the hip for active traders.

IRS rules for broker 1099Bs differ from rules for taxpayer reporting of wash sale adjustments on Form 8949 (Capital Gains & Losses). The IRS requires brokers to calculate wash sales based on identical positions (same symbol) per account. Conversely, the IRS requires taxpayers to report wash sales based on substantially identical positions (stocks and options) across all accounts including IRAs. With apples and oranges structurally in the rules, there are obviously large, unreconciled differences between broker 1099Bs and taxpayer Form 8949, especially for active traders with multiple accounts and those who trade stocks and options. These 1099B matching problems will overwhelm the IRS in coming years.

The IRS doesn
t enforce wash sales
Too often taxpayers and tax professionals cut corners choosing to solely rely on broker-issued 1099Bs. They don’t comply with different IRS wash sale rules for taxpayers (see above).

Brokers aren’t helping with taxpayer compliance; they are encouraging clients to download 1099-B data into TurboTax and they don’t sufficiently mention Section 1091 compliance issues. The IRS needs to either enforce or change the wash sale rules to better coordinate broker and taxpayer reporting.

Cost-basis reporting also has problems
In 2008, Congress enacted cost-basis reporting to close the “tax gap” on investors. Prior to cost basis rules, Form 1099Bs only reported proceeds on securities, and cost-basis information wasn’t included. Starting in 2011, the IRS phased in the cost-basis reporting rules.

While cost-basis reporting requires wash-sale adjustments, it falls short of the needs of active traders with multiple accounts and those who trade substantially identical positions (stocks and options).

Starting in 2014, 1099Bs reported equity options for the first time. But brokers don’t calculate wash sales between stocks and options and options at different expiration dates whereas taxpayers must do so. This will generate many unreconciled differences or non-compliance with Section 1091 rules.

While cost-basis rules help the IRS with millions of investors, they are not working well enough for active traders who are stuck with huge unreconciled differences. The choice is either reconciliation and non-compliance or huge differences and compliance.

Cost basis problems are another great reason to open the door wider to 475 elections. It’s easier to explain why a Form 4797 (where 475 is reported) is different from a 1099B prepared for the realization method.

Improve sole proprietor tax return reporting
A sole proprietor trader tax return is a red flag in the eyes of IRS agents and IRS computer algorithms because Section 162 trading expenses are reported on Schedule C but trading gains and losses are reported on other tax forms. That looks like a losing business without revenue.

There should be a formal way to transfer some trading gains to Schedule C to show a profitable activity or zero it out. Trading gains are not self-employment income (SEI) and they are exempt from SE tax, with the exception of members of a futures exchange (Section 1402i).

Traders work hard every day and they deserve a tax code that respects their unique tax needs. Since the Great Recession of 2008, the markets have experienced tremendous growth and capital gains taxes have skyrocketed.

Darren Neuschwander CPA and co-managing member of Green NFH contributed to this blog post.


New IRS Rules Allow Free And Easy Section 475 Revocation

May 1, 2015 | By: Robert A. Green, CPA

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There’s good news for traders about Section 475 MTM buried in the IRS annual update on procedures for changes of accounting method. It has always been free and easy to elect Section 475 MTM, yet difficult and costly to revoke that election. With this rule change, the IRS makes revocation a free and easy process, mirroring the Section 475 election and automatic change of accounting procedure for existing taxpayers.

Before this rule change, the Section 475 revocation procedure cost several thousand dollars in filing fees (close to $7,000 for hedge funds) and the outcome was uncertain since it required advanced consent from the IRS, which could be denied. Few traders opted for revocation; most used other options like suspension or exit (see below).

New revocation procedure is similar to the election procedure
To elect Section 475, “existing taxpayers” must file an election statement with the IRS attached to their prior year tax return or extension by April 15 of the current tax year for individuals and partnerships and March 15 for S-Corps. The second step requires filing a Form 3115 with the tax return for year of the election. For example, a 2015 Section 475 election statement must be filed by April 15, 2015 and the 2015 Form 3115 must be filed (in duplicate) with the 2015 tax return in 2016.

There’s an exception for “new taxpayers” (new entities) who file the election statement in their own books and records within 75 days of inception, since there is no prior tax return to attach the election to. New taxpayers don’t file a Form 3115 because they adopt Section 475 from inception rather than change an accounting method.

The new revocation procedure is similar to the election procedure. An existing individual or partnership must file a 2016 notification statement of revocation (see details below) with the IRS by April 15, 2016 (March 15, 2016 for S-Corps). The second step is to file 2016 Form 3115 for revocation of Section 475 with the 2016 tax return in 2017.

Suspension of Section 475
Historically, our trader clients navigated around the costly and uncertain revocation procedure by “suspending” their Section 475 election.

By disqualifying themselves for trader tax status, they became investors who could not use Section 475 as of the disqualification date. In that case, the Section 475 election was suspended until the trader re-qualified (if ever) for trader tax status. While the IRS may have preferred that the trader follow the costly revocation procedure, we suggested suspension as another option free of cost.

Taxpayers will appreciate having this new choice to revoke Section 475 instead of leaving it suspended on their individual returns if they elected it as a sole proprietor trader.

Other options besides revocation
Prior to this rule change, our trader clients avoided the costly and uncertain revocation procedure in two ways: by trading less and falling short of qualification for TTS, thereby “suspending”the Section 475 election; or by closing a trading business entity which used Section 475, thereby terminating Section 475. These traders could form a new “do over”entity to get back to the cash method, otherwise called the “realization” method.

When to revoke Section 475
A trader may want to elect Section 475 MTM on securities and also Section 1256 contracts to benefit from large ordinary business loss treatment year-to-date as of the April 15 election deadline of the current tax year. In the subsequent tax year, the trader may want to return to lower Section 1256 60/40 capital gains tax rates and retain Section 475 on securities only. With this rule change, the trader can revoke Section 475 on commodities (Section 1256 contracts) only and not securities.

Unlike with retail traders, it’s not convenient for an investment manager to close a hedge fund or trade less to revoke Section 475. Hedge funds will really appreciate the new automatic and free revocation procedure. Hedge funds often have trouble following Section 475 segregation of investment rules. They enter a trading position and sometimes “let profits run” by having it morph into an investment position. That doesn’t adhere to stringent Section 475 segregation of investment position rules. Plus, the manager prefers deferral at year-end so investors don’t request redemptions in order to pay taxes on unrealized gains if using Section 475 MTM. Segregation requires contemporaneous (same day) identification of investment positions and segregation must be done in form and substance. (Read IRS warns Section 475 traders.)

Rev. Proc. 2015-14
Click on Rev. Proc. 2015-14 and scroll down to pages 349 through 355. It starts at SECTION 23. MARK-TO-MARKET ACCOUNTING METHOD (§475). This explains the election procedure for Section 475. Scroll further to page 351: 23.02 Taxpayers requesting to change their method of accounting from the mark-to-market method of accounting described in §475 to a realization method.

  • “(2) Exclusive procedure. The procedure set forth in this section 23.02 is the exclusive procedure for changing a taxpayer’s method of accounting from the mark-to-market method described in §475 to a realization method. Thus, filing the Notification Statement described in section 23.02(6) of this revenue procedure is the exclusive manner of revoking a §475(e), (f)(1), or (f)(2) election. Moreover, any taxpayer requesting permission to change to a realization method must follow the procedures described in this section 23.02 and other applicable provisions of Rev. Proc. 2015-13, 2015-5 I.R.B. XX, to request consent to change its method of accounting for securities described in §475(c)(2) (Section 475 Securities), commodities described in §475(e)(2) (Section 475 Commodities), or both.”
  • “(5) Manner of making change. This change is made using a cut-off basis and applies only to Section 475 Securities, Section 475 Commodities, or both, that are accounted for using the mark-to-market method of accounting described in §475 and for which a change in method is requested under this section 23.02. Accordingly, a §481(a) adjustment is neither permitted nor required…Under the cut-off basis, a taxpayer must make a final mark of all Section 475 Securities, Section 475 Commodities, or both, that are being marked to market and that are the subject of the accounting method change being requested, on the last business day of the year preceding the year of change…”

I see some issues here. This assumes the taxpayer qualifies for trader tax status on the last day of the year for the final mark. If the taxpayer disqualifies for trader tax status before year-end, then Section 475 MTM is used only to the date of qualification ending. See suspension treatment above.

One catch
Darren Neuschwander, CPA, my co-managing member and our head of tax compliance, pointed out one catch.

“If a trader uses the automatic election to revoke Section 475(f), then the trader can’t use the automatic election to get 475(f) again for five years without going through the non-automatic procedures with the IRS, which includes a fee,” he said. “Now we have an opportunity for successful traders to remove Section 475 MTM, if needed, to use against capital loss carryovers without having to use a new entity. Also, we can help people remove MTM if they are concerned that they don’t want it in place in the future as an individual, without having to petition the commission of the IRS or pay the user fee. Basically, notification statement and another Form 3115 filing. Much simpler!”

For more information on the benefits of Section 475, click here.


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