Category: Section 475 MTM

Wash Sale Losses for Traders: How to Avoid Phantom Income and Costly Tax Traps

September 10, 2026 | By: Robert A. Green, CPA

A practical 2026 guide to the 61-day window, cross-account reporting, IRA traps, year-end planning, and Section 475 MTM

This article is for active securities traders with frequent turnover, multiple brokerage accounts, options activity, or overlap between taxable and retirement accounts.

Executive Summary

Hyperactive trading in the same securities and related options can generate wash-sale loss adjustments totaling tens or hundreds of thousands of dollars—and sometimes more. Those adjustments can create phantom taxable income when losses remain deferred at year-end. In taxable accounts, the losses are usually deferred rather than lost; however, a replacement purchase in an IRA or Roth IRA can cause the tax benefit to be lost permanently.

Form 1099-B reports broker-level wash-sale adjustments generated throughout the year. Still, it does not determine the taxpayer’s complete wash-sale position or distinguish losses already absorbed in closed positions from losses still deferred in open replacement positions at year-end. Broker reporting follows limited rules, principally for covered securities with the same CUSIP in the same account. Taxpayer-level compliance may require a broader review of multiple taxable accounts, IRAs and Roth IRAs, options, short sales, and other substantially identical positions. Spouse or controlled-entity activity may also require analysis under related-party or anti-abuse principles, but it is not automatically attributed to the taxpayer under the text of Section 1091.

Active traders need multi-account, taxpayer-level trade accounting and year-end planning. GreenTraderTax and Green’s annual Trader Tax Guide use consistent practical positions to address areas where the law does not provide a complete mechanical test. Those positions are explained below.

The wash-sale adjustment reported in box 1g of Form 1099-B can be alarming. But the headline number is not the whole story.

Wash sale rules defer a tax loss rather than erase it. The deferred loss is added to the replacement position’s cost basis. It is usually deductible when the replacement position is sold in a transaction that does not trigger another wash sale. The most serious problems arise when losses remain deferred through year-end—or become permanently nondeductible because the replacement purchase is made in an IRA.

What Is a Wash Sale?

A wash sale occurs when a taxpayer sells stock or securities at a loss and, during the 61 days beginning 30 calendar days before the sale date and ending 30 calendar days after the sale date, acquires substantially identical stock or securities or enters into a contract or option to acquire them. IRC §1091(a). The rule is intended to prevent taxpayers from realizing a tax loss while quickly restoring substantially the same investment position.

The rule also applies when the taxpayer acquires substantially identical securities in a taxable exchange. Purchases of replacement shares in an IRA or a Roth IRA can also trigger the rule.

When the rule applies in a taxable account:

  • The current loss is disallowed.
  • The disallowed loss is added to the tax basis of the replacement position.
  • The holding period of the replacement position includes that of the position sold.
  • If only part of the position is replaced, the wash sale adjustment applies on a share-by-share basis to the matched quantity.

In a taxable-account wash sale, the loss is deferred rather than erased: the disallowed amount is added to the replacement position’s cost basis under IRC §1091(d), and the holding period of the position sold generally tacks onto the replacement position under IRC §1223(3). In practice, tax software applies the rules lot by lot.

A Simple Wash-Sale Example

A trader buys 100 shares for $10,000 and later sells them for $8,000, producing a $2,000 loss. Ten days later, the trader buys 100 substantially identical shares for $8,500.

The $2,000 loss is deferred and added to the replacement shares’ $8,500 purchase price, producing an adjusted tax basis of $10,500. If the trader later sells the replacement shares for $9,500 without another replacement purchase within the wash sale window, the deferred loss is released through the higher basis, resulting in a $1,000 tax loss. The replacement trade produced a $1,000 economic gain, but the higher wash-sale-adjusted basis caused the trader to recognize the correct $1,000 net tax loss across both trades.

Wash sale losses in taxable accounts are therefore usually a timing problem rather than a permanent elimination of the deduction. Repeated trading can keep moving the loss from one replacement position to the next, creating a chain that crosses December 31 and shifts the deduction into the following year. A replacement purchase in an IRA or Roth IRA can produce a different—and potentially permanent—result.

Why Form 1099-B May Not Tell the Full Story

Broker reporting is narrower than the taxpayer’s legal obligation. The IRS Form 1099-B instructions require a broker to report a wash sale when both the loss sale and replacement purchase occur in the same account for covered securities with the same CUSIP. A broker may report more, but it is generally not required to identify a replacement purchase in another account—even in another account at the same brokerage firm.

That difference creates two common problems:

  • Form 1099-B may omit taxpayer-level wash sales involving another brokerage account, an IRA or Roth IRA, stock and related options, different option contracts, or other substantially identical positions.
  • A broker’s aggregate wash-sale adjustments for the year may be large even though most of those losses were absorbed into replacement positions that were sold before year-end.

For example, a broker’s Form 1099-B might report aggregate box 1g wash-sale adjustments of $500,000 for the year. That does not automatically mean $500,000 is deferred into next year. If the trader closed the replacement positions and avoided another acquisition during the applicable wash-sale window, little or none of that amount may remain deferred at year-end. Conversely, a smaller cross-account wash sale omitted from Form 1099-B may still require a taxpayer-level adjustment.

Even if a trader sells securities in December, a January purchase can still trigger a wash sale. Avoid acquiring substantially identical property within 30 days after the loss sale; the trader may reenter on day 31.

Consider using TradeLog for taxpayer-level wash-sale calculations. It imports transactions from multiple brokerage accounts, recalculates wash sales across those accounts, and helps reconcile the results with Forms 1099-B. Importing Forms 1099-B into tax software without this broader reconciliation is a much narrower approach and can leave material wash-sale adjustments unreported.

The IRA Wash-Sale Trap Can Make the Loss Permanent

The harshest wash-sale result occurs when an individual sells stock or securities at a loss in a taxable account and, during the 61-day window, an IRA or Roth IRA acquires substantially identical stock or securities. Under Revenue Ruling 2008-5, the taxable-account loss is disallowed, and the individual’s basis in the IRA or Roth IRA is not increased under Section 1091(d). Unlike an ordinary taxable-account wash sale, the tax benefit can therefore be lost permanently.

An IRA does not report wash sales on trades occurring solely inside the retirement account because its gains and losses are not currently taxable. The danger is the interaction between the taxable loss sale and the IRA or Roth IRA replacement purchase. Revenue Ruling 2008-5 addresses IRAs and Roth IRAs; it does not decide the treatment of employer-sponsored plans such as 401(k) or Solo 401(k) plans. The ruling also does not mention other types of IRAs such as rollover IRAs and SEP IRAs.

A practical safeguard is to maintain a do-not-trade list separating securities traded in taxable accounts from positions held in IRAs and Roth IRAs. A trader might trade individual technology stocks in taxable accounts and hold diversified funds in an IRA, provided the positions are not substantially identical.

Section 475 can provide another solution for a trader who qualifies for trader tax status (TTS). For securities properly included in a valid Section 475(f) trading business, Section 1091 does not apply to losses recognized under the mark-to-market rules. The election does not cover properly identified investment securities, and traders should not assume it resolves every transaction involving an IRA or another related account. A separate trading entity with a timely Section 475 election can also help segregate business trading from investment and retirement holdings.

Stocks, Options, ETFs, and Substantially Identical Positions

Section 1091 applies when a taxpayer acquires substantially identical stock or securities, or enters into a contract or option to acquire them, during the wash-sale window. The Code does not provide a complete mechanical test for deciding when different funds or option contracts are substantially identical.

The technical standard. Different ETFs or mutual funds are not automatically outside Section 1091 merely because they have different tickers, CUSIPs, or sponsors. Two unleveraged ETFs tracking the same S&P 500 index can present a substantially identical risk. The legal conclusion depends on the relevant facts and circumstances, including portfolio composition, index methodology, leverage or inverse exposure, investment objective, issuer rights, and other material economic characteristics.

Consider a conservative approach by treating ETFs tracking the same stock index — such as State Street SPDR S&P 500 ETF Trust (SPY) and Vanguard S&P 500 ETF (VOO) — as substantially identical for purposes of wash-sale loss treatment. On the other hand, SPY and VOO have different legal structures, which can support a formal position that they are not substantially identical.

Options on the same underlying security raise a similar interpretive issue when their strikes, expirations, exercise terms, or contract types differ. An exact replacement of the same option contract is the clearest case. Stock-to-option, option-to-stock, and different-option replacements may require analysis of the rights, risks, and economic exposure created by the positions. Cash settlement alone does not remove a contract or option from Section 1091. Section 1091(a), (f). The conservative posture is to treat all option contracts on the same underlying stock as subject to wash sale rules.

The practical positions used for trade accounting. Active traders and preparers need consistent, administrable conventions. GreenTraderTax and Green’s annual Trader Tax Guide apply the following practical positions during the year, unless particular facts require separate treatment, paired with a more conservative safeguard specifically at year-end:

• Different index funds: For ongoing trade accounting during the year, different ETFs or mutual funds are not treated as substantially identical merely because they track the same or a similar stock index — two different S&P 500 ETFs are treated as different securities. This is an aggressive position because the IRS has not provided an explicit safe harbor for same-index funds. As a year-end safeguard, revert to the more conservative technical standard described above for any positions still open across December 31: treat same-index ETFs as substantially identical, and avoid opening a replacement position in the other same-index ETF during the wash-sale window. That protects against a later challenge that the two funds were, in fact, substantially identical.

• Stock and options: Stock and all options on the same underlying security are treated as substantially identical without requiring the strike price, expiration date, or other option terms to match. This is a conservative position and may produce more wash-sale adjustments than a contract-by-contract analysis.

These are longstanding practical accounting positions, not a change in trade-accounting methodology. They resolve uncertain areas consistently; they do not mean that Section 1091 expressly mandates either convention in every factual setting. They also go substantially further than accepting an imported Form 1099-B as complete.

Qualifying Section 1256 contracts follow their own mark-to-market and 60-percent-long-term/40-percent-short-term rules and generally are not handled under the ordinary stock-and-securities wash-sale framework. Securities futures and other derivatives require separate analysis. Section 1091(e) also contains rules for certain short-sale and securities-futures losses. Traders should separately consider the straddle, constructive-sale, and other anti-abuse rules when positions offset one another.

Do Wash-Sale Rules Apply to Cryptocurrency?

Under current federal tax law, directly held ordinary spot digital assets, such as bitcoin, are generally treated as property rather than stock or securities, so Section 1091 ordinarily does not apply. The result may differ depending on whether the asset is an ETF, a trust interest, a tokenized security, a partnership interest, a derivative, or another legal wrapper. Traders should verify current legislation before relying on crypto tax-loss harvesting strategies.

Our legal-wrapper series, scheduled for publication beginning in October 2026, will address bitcoin ETFs and other wrapped financial products in detail.

How Traders Can Break the Wash-Sale Chain at Year-End

Waiting for a February Form 1099-B is too late to prevent a wash-sale loss. Traders should review potential wash-sale deferrals before year-end and coordinate activity across all relevant accounts.

A December loss sale can still produce a wash sale if the trader acquires substantially identical positions during the following 30 days in January.

A practical year-end process includes:

  • Use TradeLog, the trade-accounting software we recommend for taxpayer-level wash-sale calculations across multiple brokerage accounts. Run its Potential Wash Sales Report in November and again in December so there is time to plan loss sales and avoid replacement trades in January.
  • Identify securities carrying the largest deferred losses and the replacement tax lots holding those losses.
  • Sell open replacement positions before year-end to potentially release deferred wash-sale losses, and do not reacquire substantially identical property during the applicable restricted period.
  • Review and, where appropriate, pause purchases in relevant taxable accounts, IRAs, and Roth IRAs during the restricted period. Include automatic purchases and option activity. Review spouse, controlled-entity, and employer-plan activity separately when related-party or anti-abuse concerns may be present.
  • Reconcile the year-end carryover by ticker and tax lot so the deferred basis is tracked correctly into the next year.

For example, if a trader sells Apple shares at a loss on December 20, 2026, the trader should avoid Apple shares and substantially identical Apple positions through January 19, 2027, and may reenter on January 20, 2027.

A trader does not need to stop all trading. Under the practical position described above, the trader may switch from one tech stock (Apple) to another tech stock (Google) during the restricted period. 

Section 475 MTM Can Eliminate Wash-Sale Accounting for Qualified Traders

Trader tax status (TTS) by itself does not eliminate wash-sale accounting. Section 1091(a) contains an exception for a dealer in stock or securities when the loss arises in the ordinary course of the dealer’s business, but ordinary trader status is not dealer status.

Section 475 is available to a taxpayer who qualifies for TTS and makes a valid, timely Section 475(f) mark-to-market election for the securities trading business. For covered business securities, Section 475 marks open positions to market at year-end, generally treats the resulting gains and losses as ordinary, and provides that Section 1091 does not apply to losses recognized under the mark-to-market rules. The $3,000 capital-loss limitation also does not apply to those ordinary business losses. Sections 475(d)(1), 475(d)(3), and 475(f).

Section 475 is not automatic and cannot ordinarily be elected retroactively after losses occur. It does not cover properly identified investment securities. The taxpayer must make a timely election and comply with the accounting-method-change requirements, including the filing of Form 3115 when applicable. Sole proprietors generally elect by the unextended due date of the prior-year individual return; partnerships and S corporations use the unextended due date of the prior-year entity return. A new entity has a separate internal election procedure within two months and 15 days of inception.

For most calendar-year individuals, the deadline to make a 2026 Section 475(f) election passed on the unextended due date for the 2025 individual return, April 15, 2026. A trader considering Section 475 after that deadline generally is evaluating an election for the following tax year, subject to the applicable rules.

For an active securities trader who qualifies for TTS, Section 475 can provide valuable tax-loss insurance and cleaner accounting. The decision should be made before the election deadline.

Coming soon in this wash-sale series: “How TTS Traders Report Section 475 MTM Gains and Losses on Form 4797,” covering the election, accounting-method change, segregation rules, and return preparation.

Reporting Wash Sales on Form 8949

For a detailed walkthrough of Form 8949 reconciliation, adjustment codes B and M, substitute statements, and Form 8453 filing requirements, see Part 2 of this series: ‘Wash-Sale Accounting: Why Broker Form 1099-B Reporting Is Not Taxpayer Compliance.

Coming in October: Our Legal Wrapper Series

Beginning in October 2026, we plan to publish our legal wrapper series explaining why the term “security” can have different meanings under different tax provisions. Section 475 MTM uses a broader definition for TTS traders, while Section 1091 wash sales uses a narrower one. As a result, an underlying instrument might fall outside Section 1091, while an ETF, option, or other wrapper referencing that instrument might itself be treated as stock or a security under Section 475.

Bottom Line

Wash-sale losses are manageable when traders monitor them during the year, but they become expensive when ignored until tax season. The biggest risks are not the gross annual adjustment in box 1g. They are losses deferred after December 31, unreported cross-account wash sales, permanent losses caused by IRA or Roth IRA replacement purchases, and incorrect basis carried into future years.

Active securities traders should use multi-account trade accounting, coordinate taxable and retirement-account activity, and plan early enough to break the year-end chain. The longstanding practical positions used by GreenTraderTax and Green’s annual Trader Tax Guide provide a workable and consistent method for uncertain ETF and option relationships. Traders who qualify for TTS should also evaluate a timely Section 475 election for the next tax year. TTS traders under Section 475 avoid the confusion and complexity of wash sale losses in their trading activity.

Sources and Further Reading

IRC Sections 1091 and 475; Treasury Regulation Sections 1.1091-1, 1.1091-2, and 1.6045-1; Revenue Ruling 2008-5; IRS Instructions for Form 1099-B (2026); IRS Instructions for Form 8949 (2026); and IRS Publication 550 (2026).

This article is for educational purposes and does not constitute tax advice. 

RSU Stock and Investment Positions: Avoid Costly Section 475 Tax Traps for Traders

October 13, 2025 | By: Robert A. Green, CPA

Traders who receive RSU stock or hold investment positions in the same account as their trading activity can face hidden tax traps under Section 475(f). Learn how to avoid IRS reclassification, excess-business-loss deferrals, and mismatched tax treatment—while still benefiting from Trader Tax Status and Section 475’s powerful advantages.

A Common Issue for Active Traders

Many active traders who qualify for Trader Tax Status (TTS) and elect Section 475(f) mark-to-market (MTM) treatment also receive restricted stock units (RSUs) from their employers, especially in the technology, finance, and biotech sectors.

When RSUs vest, their fair market value (FMV) is taxed as ordinary income, subject to W-2 withholding. Some traders then transfer those vested shares into their Section 475 trading accounts, assuming the shares automatically qualify as part of the trading business.

Unfortunately, the IRS disagrees. Avoid this problem by selling the RSU-acquired public-company stock and repurchasing it in your TTS trader account. The trader below did not—and ended up with significant phantom income and NOL carryforwards.

(For a basic overview of Trader Tax Status, see IRS Topic No. 429: Traders in Securities.)

IRS Position: RSU Stock Is Not Section 475 Property

RSUs are deferred-compensation property governed by Section 83. No stock is owned until the vesting date, when the employee gains unrestricted rights to the shares. At that time, the FMV becomes ordinary wage income, reported on Form W-2, and it becomes the tax basis.

Acquisition Timing:
The RSU shares are considered acquired on the vesting date, not when deposited into a brokerage or trading account. The subsequent deposit of shares is an administrative action only—it does not change the character of the stock from compensation property to trading property. Even if the shares are immediately transferred into a trader’s Section 475 account, they remain compensation assets governed by Section 83, not trading assets under Section 475(f).

Public vs. Private RSUs:
This rule applies to both public and private company RSUs. Private-company RSUs often include “double-trigger” vesting (time + liquidity). Even after a liquidity event, the shares remain compensation property under Section 83, not trading property under Section 475(f).

Even if the shares are deposited directly into a trader’s MTM account, they were acquired through employment, not through the trading business. Therefore, they fall outside Section 475(f). Section 475 applies only to securities acquired and held in connection with a trading activity, not to compensation or investment assets merely moved into the account.

IRS Chief Counsel Advice 201432016 (Aug. 8, 2014) supports this conclusion (while a CCA is not precedential, it reflects the IRS’s administrative interpretation and is generally followed in practice):

“Section 475(f) applies only to securities held for trading in the ordinary course of a trade or business. Merely transferring such securities into a trading account does not convert them into property held in connection with the trading business.”

Under Proposed Reg. § 1.475(f)-2(a)(2)–(4), RSU-acquired shares are compensation assets, not trading property, and therefore excluded from Section 475(f) mark-to-market accounting—even if later transferred. Although still proposed, these regulations have guided IRS practice since 1998 and remain the accepted authority.

Although the proposed regulation does not explicitly mention employment-related compensation property, its framework distinguishes between trading and non-trading assets. RSU shares fall outside Section 475 because they are governed by Section 83 as compensation property—not acquired in the ordinary course of a trading business. This interpretation is supported by IRS Chief Counsel Advice 201432016 and has been consistently applied by the IRS in its administrative practice.

Once vested, RSU shares have a basis equal to the amount already included in W-2 income, and any subsequent gain or loss is capital, not ordinary. Since the shares were not acquired for trading purposes, Section 475 cannot be applied retroactively.

Brokerage Note: The RSU cost basis is often omitted on Form 1099-B, resulting in an overstated gain. To avoid double taxation, adjust the basis on Form 8949 to include amounts already taxed through W-2 income.

Example: How Mismatched Character and the EBL Limit Create a Tax Trap

A trader receives $1 million of employer stock at RSU vesting (already taxed through payroll) and moves it into the trading account. Later, they trade the position and realize a $750,000 gain, while incurring $900,000 of ordinary trading losses under Section 475(f).

If the RSU stock were ordinary under Section 475, the $750,000 gain would offset most of the $900,000 loss, leaving a net business loss of $150,000 within the Excess Business Loss (EBL) limitation.

However, the IRS treats the RSU shares as capital assets. Even though the trader has an economic loss of $150,000, they owe tax on phantom income of $124,000 because the EBL limit for 2025 is $626,000 (MFJ) / $313,000 (single). The remaining $274,000 EBL becomes an NOL carryforward, usable later but offering no immediate relief.

An NOL carryforward is generally superior to a capital loss carryover, because the NOL can offset income of any kind in future years. In contrast, capital losses may only offset capital gains (plus $3,000 per year against ordinary income). The EBL limitation is indexed annually for inflation, so it primarily affects traders with substantial losses.

The trader could have avoided this problem by selling the RSU-acquired stock when vested and repurchasing it inside their TTS trading account.

A Similar Trap for Traders with Investment Positions

Before discussing portfolio margining and holding period issues, let’s first address the process of transferring assets from a non-MTM investment account into a Section 475(f) trading account.

Moving a security from an investment account into a trading account does not convert it into Section 475 property. To qualify for mark-to-market treatment, a position must be acquired and held in connection with the trading business—not merely transferred after acquisition.

When a trader first elects Section 475(f), a Section 481(a) adjustment converts opening-year TTS trading positions (previously reported under the realization method) into mark-to-market assets by revaluing those securities to fair market value on the first day of the election year. The difference between the prior-year basis and the MTM value becomes the Section 481(a) adjustment, ensuring a clean transition into the new accounting method.

Under Prop. Reg. § 1.475(f)-2(a)(2)–(4) and Section 475(f)(1)(B)(ii), traders must make timely same-day identifications of any investment-held securities to preserve segregation. Once identified, those positions remain permanently outside Section 475 treatment.

Suppose a trader later trades options around those investment positions (for example, selling covered calls). In that case, the stock remains a capital asset, while the option trades can qualify for Section 475 ordinary treatment.

To avoid potential IRS reclassification or mixed-character outcomes, traders should ring-fence their long-term investments in separate individual or joint accounts and/or conduct their TTS/Section 475 activity in an entity account with its own Employer Identification Number (EIN).

Court Cases Reinforce the IRS Position

In Endicott v. Commissioner (T.C. Memo 2013-199), the Tax Court held that holding significant equity positions while trading options around them resembled investment management, rather than an active trading business. The average holding period exceeded 31 days, which the IRS still uses as a bright-line benchmark for TTS analysis.

Similarly, in Holsinger v. Commissioner (T.C. Memo 2008-191), monthly option trading failed the frequency and continuity tests for TTS. Both cases involved portfolio margining that blurred the line between investing and trading, thereby undermining TTS eligibility.

Takeaway: Mixing long-term investments and trading in one account can jeopardize both TTS and Section 475 benefits. Use separate accounts or entities to clearly ring-fence your trading business.

Broader Section 475 Mismatch Risks

While Section 475(f) is typically the most tax-efficient method for active traders, mismatches can occur when some income is classified as capital gain and some as ordinary income. The EBL limits ($313,000 single / $626,000 MFJ for 2025) are relatively high, and most traders don’t lose enough to be affected. Conversely, a trader might have Section 475 income and capital losses, creating the reverse problem.

Example: The Reverse Mismatch

A trader has an $800,000 Section 475(f) MTM gain and sells long-term investment stocks at a $300,000 capital loss. Because the loss is capital, it cannot offset the ordinary 475 income. The trader pays tax on the full $800,000 of ordinary income while carrying forward the $300,000 capital loss, which is usable only against future capital gains ($3,000 per year against ordinary income).

A similar trap arises if RSU stock drops in value after vesting—the subsequent sale produces a capital loss that cannot offset Section 475 ordinary trading income, leaving the trader with higher taxable income despite an overall economic loss.

These mismatches underscore the importance of meticulous planning, account segregation, and accurate year-end tax projections.

Why Section 475(f) Still Matters

Despite these pitfalls, Section 475 remains the best framework for most active traders. Its benefits are substantial:

  • Converts trading results to ordinary income or loss

  • Eliminates wash-sale rules

  • Bypasses the $3,000 capital-loss limit

  • Enables the 20% Qualified Business Income (QBI) deduction for profitable TTS traders operating as pass-through entities or Schedule C sole proprietors

    (SSTB phase-out range for 2025: $394,600–$494,600 MFJ / $197,300–$247,300 single)

Even traders below these thresholds can enjoy the full 20% QBI deduction—another reason Section 475 remains powerful.

California Makes It Even Tougher

California conforms to the federal EBL limit and has suspended NOL deductions for 2024–2026 if AGI exceeds $1 million. This suspension applies even to business losses under Section 475(f).

Any disallowed EBL becomes part of a California NOL carryforward but cannot be used until the suspension lifts. Budget bills SB 167 and SB 175 could be reinstated earlier if state revenues recover.

Audit Checklist: Section 475(f) and TTS Compliance Essentials

  • Adjust the RSU basis on Form 8949 to reflect W-2 income already reported

  • Make timely written identifications of investment positions per Prop. Reg. § 1.475(f)-2(a)(2)–(4)

  • Consider separate entities (with distinct EINs) to ring-fence trading vs. investing

  • Document Section 475 elections and revocations with timely-filed notification statements to the IRS and Form 3115 per Rev. Proc. 2025-23 — see GreenTraderTax: New IRS Rules — Section 475 MTM Revocation Now Locked for Five Years

  • Segregate trading and investment accounts at the broker level

  • Track average holding periods (≤ 31 days) to support TTS qualification

Need Professional Guidance?

Each trader’s facts are unique—especially when RSU stock, segregated investments, and Section 475 intersect.


CPAs at Green, Neuschwander & Manning, LLC (GNM) can help you analyze your facts, minimize mismatches, and plan for 2025 and beyond.

👉 Schedule a consultation at GreenTraderTax.com

Sources & Further Reading

  • IRS Chief Counsel Advice 201432016 (Aug. 8, 2014)

  • Proposed Reg. § 1.475(f)-2(a)(2)–(4)

  • Section 475(f)(1)(B)(ii) identification requirement

  • Endicott v. Commissioner, T.C. Memo 2013-199

  • Holsinger v. Commissioner, T.C. Memo 2008-191

  • Rev. Proc. 2025-23 — Section 475 Revocation Lock-In Rule

  • IRS Topic No. 429 — Traders in Securities

  • California FTB NOL Suspension 2024–2026

  • Articles on Section 475 and TTS at GreenTraderTax.com

New IRS Rules: Section 475 MTM Revocation Now Locked for 5 Years – Planning Options for Traders

September 16, 2025 | By: Robert A. Green, CPA

The IRS recently issued Rev. Proc. 2025-23, which significantly tightens the rules for revoking a Section 475(f) mark-to-market (MTM) election. What was once a “free and easy” revocation process now carries new restrictions and potential costs.

For decades, traders have used an alternative approach to suspend or exit Trader Tax Status (TTS), which also suspends or exits the use of Section 475 MTM and bypasses the need for a formal accounting method change with the IRS.

IRS Five-Year Lock-In Rule Under Rev. Proc. 2025-23

If a taxpayer seeks to revoke Section 475 MTM within this five-year window formally, the following apply:

  • Non-automatic change procedures: You must use the procedures in Section 24.02(9) of Rev. Proc. 2025-23.

  • IRS Commissioner consent: Approval is required before the change takes effect.

  • User fee required: The current IRS fee is $13,225 (per Rev. Proc. 2025-01).

  • Additional compliance burden: The process is lengthier and more complex than an automatic change.

Outside the five-year window, traders may still revoke a Section 475 election under the automatic change procedures without a user fee or advance IRS consent. According to IRS Topic No. 429 – Traders in Securities (which also confirms the five-year non-automatic revocation rule and is consistent with Rev. Proc. 2025-23 §24.02(8)), this involves:

  • Filing a revocation notification statement with the IRS by the original due date (without extensions) of the prior-year tax return, attaching it to the return or extension.

  • Submit Form 3115 (automatic method change) with the current year’s tax return to switch from mark-to-market back to the realization method.

This two-step process is straightforward when outside the five-year window and remains the most cost-effective way to revoke Section 475 MTM.

Example: If you made a Section 475 election for 2022, you cannot use the automatic change procedures to revoke until 2027 (the sixth tax year, counting 2022 as year one). Plan to file your revocation notification with your 2026 tax return (or extension) by April 15, 2027, so that the revocation takes effect for 2027.

Planning Solution: Suspending Section 475 via TTS Disqualification

Suppose a trader wishes to exit Section 475 MTM but avoid the cost and complexity of a non-automatic revocation request. In that case, they can suspend Section 475 MTM by disqualifying from Trader Tax Status (TTS):

  • TTS is a prerequisite for electing and using Section 475 MTM. A trader must assess eligibility for TTS each tax year. If a trader does not qualify for TTS (e.g., by materially reducing trading activity), Section 475 MTM may not be used during the non-qualification period. This effectively suspends both TTS and Section 475 MTM without requiring a formal IRS revocation. Suspension can occur mid-year if qualification is lost (e.g., a TTS trader since 2023 stops trading on July 31, 2025, and has only a few trades for the remainder of 2025). TTS and Section 475 apply until July 31, 2025, only. Be aware that suspending TTS too aggressively to avoid 475 might backfire if traders lose necessary deductions under Section 162.

    If the trader requalifies for TTS in a subsequent year, Section 475 applies again since it was suspended and not formally revoked. Be careful not to incur significant capital losses during the suspended period, as you’ll need capital gains to offset them. Section 475 MTM ordinary income is taxed separately from capital gains and cannot offset capital losses. Capital losses must still be used against capital gains or up to $3,000 of ordinary income per year.

  • Form a new entity without a Section 475 election. Traders who want to continue qualifying for TTS and deducting business expenses can form a new pass-through entity (LLC taxed as a partnership or S-Corp) that does not elect Section 475. This allows them to continue trading actively while switching back to the realization method.

Comparison of Options

Choose the Right Strategy for Your Situation

Option When Available Cost Process Pros Cons
Automatic Revocation After 5 taxable years from election year No IRS fee File notification + Form 3115 under automatic procedures Simple, free, Commissioner consent not required Must wait 5 years before revoking
Non-Automatic Revocation Within first 5 taxable years from election year $13,225 IRS user fee (2025 rate) Request permission under Section 24.02(9) Immediate relief, can exit MTM mid-lock-in Costly, time-consuming, approval required
Suspend MTM via TTS Disqualification / New Entity Anytime No IRS fee Reduce trading to fail TTS or form new entity without 475 election Flexible timing, avoids fees, preserves control over timing May lose business expense deductions if not forming new entity; requires planning

The optimal route depends on timing, activity level, and whether preserving deductions outweighs revoking Section 475 MTM immediately. If you’re considering making or keeping a Section 475 election, here’s what you should know: 

Why Traders Elect Section 475

Section 475 offers substantial tax advantages for active traders eligible for Trader Tax Status (TTS). A Section 475 MTM election converts capital gains and losses on securities into ordinary gains and losses, which means:

  • No wash sale adjustments: Losses are not deferred when buying back substantially identical securities.

  • No $3,000 capital loss limitation: Ordinary losses are fully deductible against any income, potentially creating a net operating loss carryforward.

  • Eligibility for the 20% QBI deduction: Section 475 income qualifies as QBI under Section 199A, whereas capital gains are excluded.

How to Elect Section 475(f)

Traders who qualify for TTS may elect Section 475 on securities (f) and/or commodities (e) by taking two steps:

  1. Section 475 Election Statement: File the election statement by the original due date (without extensions) of the prior-year tax return. For example, to elect Section 475 for tax year 2025, the statement must be filed with the IRS by April 15, 2025, attached to the prior-year return or extension request.

  2. Form 3115: File IRS Form 3115 (Application for Change in Accounting Method) with the 2025 tax return, including extensions. This is the second step to implement the election and change the accounting method to mark-to-market (MTM). There is no IRS fee with this automatic election process.

  3. New Entities: New taxpayers, such as a new pass-through entity, may internally elect Section 475 by resolution within 75 days of entity inception. There is no Form 3115 required for adopting this accounting method from inception.

Re-Electing Section 475 After Revocation: Traders who revoke Section 475—either under the automatic or non-automatic procedures—may re-elect Section 475 in a later year without a waiting period. To re-elect, they must follow the same process above: timely file a new election statement by the prior-year deadline and submit a new Form 3115 with the tax return for the election year.

Bottom Line

Rev. Proc. 2025-23 creates a five-year lock-in that makes revoking Section 475 MTM elections more costly and complicated. Traders should carefully plan when to revoke, consider suspension strategies to avoid fees, and weigh the significant tax benefits of Section 475 before making or revoking the election. Readers can review IRS Topic No. 429 – Traders in Securities for additional IRS guidance on revocation timing and procedures.

Call to Action: Consider scheduling a consultation with Green, Neuschwander & Manning, LLC to discuss your specific situation and plan the best strategy for Section 475 elections or revocations.

Darren Neuschwander, CPA, contributed to this blog post.

Unlock Tax Savings with Section 475: Avoid Wash Sales and Capital Loss Limits

February 3, 2025 | By: Robert A. Green, CPA

Section 475 MTM can convert capital gains and losses into ordinary income and losses, providing significant tax advantages. It allows traders to avoid wash-sale rules and capital-loss limitations, making it a powerful tax strategy for those who qualify. Section 475 ordinary income may also be eligible for the 20% qualified business income deduction.

This summary of Chapter 2 of Green’s 2025 Trader Tax Guide explains the importance of electing Section 475 Mark-to-Market (MTM) accounting for traders with Trader Tax Status (TTS). 

Key Highlights:

  1. Benefits of Section 475 MTM Election:
    • Trader Tax Status:
      Only traders who qualify for trader tax status (TTS) can use Section 475 mark-to-market accounting.
    • Ordinary Income and Loss Treatment:
      Section 475 MTM converts trading gains and losses from capital to ordinary, meaning losses can offset all types of income (ordinary, passive, or investment income). Conversely, capital losses offset capital gains, and there is a net capital loss limitation of $3,000 against ordinary income. For example, if you have wages of $100,000 and a net trading loss of $20,000, with Section 475, your gross income is $80,000; without Section 475, it’s $97,000.
    • Avoidance of Wash-Sale Rules:
      Section 475 exempts traders from wash-sale rules.  Wash-sale rules can create phantom gains by deferring losses to replacement positions bought within 30 days of a sale. This is especially problematic at year-end when December losses are deferred to January of the next tax year. 
    • Potential for Net Operating Loss (NOL) Carryforward:
      Traders with significant ordinary losses in excess of income may generate an NOL, which can be carried forward to reduce taxable income in future years.
    • Potential for 20% QBI deduction:
      Section 475 trading profits are qualified business income (QBI); capital gains are not. If your taxable income is under the QBI cap for a specified service trade or business (SSTB), you are eligible for the 20% QBI deduction. In rough terms, make $100,000 and deduct $20,000. 
  2. Election Procedures:
    • To elect Section 475 MTM for 2025 tax year, traders must file a written election with their 2024 tax return or extension by the following deadlines:
      • March 17, 2025, for existing partnerships and S-Corps.
      • April 15, 2025, for individuals.
    • After filing the election statement, traders must complete the process by submitting Form 3115 (Application for Change in Accounting Method) with their tax return for the year the election takes effect.
  3. Important Nuances:
    • Section 475 applies only to securities and/or commodities. Traders can apply the election to securities only while retaining capital-gains treatment for Section 1256 contracts (regulated futures) to benefit from the lower 60/40 tax rates on commodities.
    • Revocation:
      If traders later wish to revoke the MTM election, they can do so by filing a notification and submitting Form 3115, but they cannot re-elect Section 475 for five years after revocation.
    • Segregation of Investments:
      Traders can maintain separate accounts for long-term investments and trading positions. Only trading positions are subject to Section 475 MTM, while long-term investments retain capital gains treatment.
  4. Section 481(a) Adjustment:
    • When electing Section 475, traders must account for unrealized gains or losses on open TTS positions at the start of the election year through a Section 481(a) adjustment.
      • Losses: Deducted in full in the election year.
      • Gains: Prorated over four years if they exceed $50,000.

Considerations for Different Types of Traders:

  1. Securities Traders:
    Section 475 greatly benefits securities traders by eliminating the $3,000 capital loss limitation and wash-sale issues. It provides immediate tax relief for trading losses, and profitable traders are eligible for the 20% QBI deduction. 
  2. Section 1256 Contract Traders:
    Most traders in Section 1256 contracts (futures and specific options) avoid electing Section 475 because they benefit from the built-in 60/40 tax treatment (60% long-term, 40% short-term capital gains), which offers lower tax rates than ordinary income.
  3. Hedge Funds:
    Hedge funds may face challenges with Section 475 due to rules requiring segregating trading and investment positions. Many hedge funds prefer capital gains treatment, which allows deferral and lower long-term tax rates for their investors.

Practical Tips:

  • Plan Strategically:
    Traders should carefully evaluate whether they have significant capital-loss carryovers before electing Section 475. Capital-loss carryovers cannot be applied against Section 475 ordinary income.
  • Revoking and Re-electing:
    Since revocation locks out the ability to re-elect Section 475 for five years, traders should be cautious and only revoke when necessary.
  • Seek Professional Advice:
    Due to the complexity of the election process and the nuances of filing Form 3115 and Section 481(a) adjustments, professional assistance is recommended to ensure compliance and optimal tax treatment.

Key Takeaway:

Section 475 MTM is a valuable tool for traders with TTS who want to maximize tax efficiency by converting capital losses into ordinary losses, avoiding wash-sale issues, and unlocking the QBI deduction on trading gains. However, proper planning and timely election are crucial to reaping its benefits.

Tax Extensions: 12 Tips To Save You Money

March 14, 2023 | By: Robert A. Green, CPA | Read it on

Individual tax returns for 2022 are due April 18, 2023. However, most active traders aren’t ready to file on time. Some brokers issue corrected 1099Bs right up to the deadline. Many partnerships and S-Corps file extensions by March 15, 2023, and don’t issue Schedule K-1s to partners until after April 18. Many securities traders struggle with accounting for wash sale loss adjustments.

The good news is that traders don’t have to rush the completion of their tax returns by April 18. They should take advantage of a simple one-page automatic extension with payment of taxes owed to the IRS and state. Most active traders file extensions, and it’s helpful to them on many fronts.

You might not have to file an extension if you are eligible for disaster tax relief. However, if you want to elect Section 475 MTM accounting for 2023, then consider filing an extension and attaching the election to that extension. (See Tax Relief In Disaster Situations.)

Tip 1: Get a six-month extension of time
By April 18, 2023, request an automatic six-month extension to file individual federal and state income tax returns due October 16, 2023. Form 4868 instructions indicate how easy it is to get this automatic extension, and the IRS doesn’t require a reason. It’s an extension to file a complete tax return, not an extension to pay taxes owed. Estimate and report what you think you owe for 2022 based on your tax information received.

Tip 2: Avoid penalties from the IRS and state for being late
Learn how IRS late-filing and late-payment penalties apply so you can avoid or reduce them to your satisfaction. 2022 Form 4868 (Application for Automatic Extension of Time To File U.S. Individual Income Tax Return) page two states:

“The late payment penalty is usually 1⁄2 of 1% of any tax (other than estimated tax) not paid by the regular due date of your return, which is April 18, 2023. It’s charged for each month or part of a month the tax is unpaid. The maximum penalty is 25%.

The late payment penalty won’t be charged if you can show reasonable cause for not paying on time. Attach a statement to your return fully explaining the reason. Don’t attach the statement to Form 4868. You’re considered to have reasonable cause for the period covered by this automatic extension if both of the following requirements have been met. At least 90% of the total tax on your 2022 return is paid on or before the regular due date of your return through withholding, estimated tax payments, or payments made with Form 4868. The remaining balance is paid with your return.

A late filing penalty is usually charged if your return is filed after the due date (including extensions). The penalty is usually 5% of the amount due for each month or part of a month your return is late. The maximum penalty is 25%. If your return is more than 60 days late, the minimum penalty is $450 (adjusted for inflation) or the balance of the tax due on your return, whichever is smaller. You might not owe the penalty if you have a reasonable explanation for filing late. Attach a statement to your return fully explaining your reason for filing late. Don’t attach the statement to Form 4868.”

Check these types of penalties with your state, too. 

Tip 3: File an automatic extension even if you cannot pay
Even if you can’t pay what you estimate you owe, file the automatic extension form on time by April 18, 2023. It should help avoid the late-filing penalty, which is ten times more than the late-payment penalty. If you can’t pay in full, you should file your tax return or extension and pay as much as possible.

An example of late payment and late-filing penalties: Assume your 2022 tax liability estimate is $50,000. Suppose you file an extension by April 18, 2023, but cannot pay any of your tax balance due. You file your 2022 tax return on the extended due date of October 16, 2023, with full payment. A late-payment penalty applies because you did not pay 90% of your tax liability on April 18, 2023. The late-payment penalty is $1,500 (six months late x 0.5% per month x $50,000). Some traders view a late-payment penalty as a 6% margin loan, but it’s not tax-deductible.

By simply filing the extension on time in the above example, you avoided a late-filing penalty of $11,250 (six months late x 5% per month [25% maximum], less late-payment penalty factor of 2.5% = 22.5%; 22.5% x $50,000 = $11,250). The IRS also charges Interest on taxes paid after April 18, 2023.

If you don’t expect to owe 2022 taxes by April 18, 2023, it’s easy to prepare an extension with no balance due. Make sure to file it on time to avoid a minimum penalty if you were wrong and owe taxes for 2022.

Tip 4: Add a payment cushion for the first quarter (Q1) 2023 estimated taxes due
Traders with 2023 year-to-date trading gains and significant tax liability in the past year should consider making quarterly estimated tax payments in 2023 to avoid underestimated tax penalties. The IRS increased interest rates in 2022 and 2023, and current rates are 7% for underpayments. (See Interest rates increase for the first quarter of 2023.)

I recommend the following strategy for traders and business owners: Overpay your 2022 tax extension on April 18, 2023, and plan to apply an overpayment credit toward Q1 2023 estimated taxes. Most traders don’t make estimated tax payments until Q3 or Q4, when they have more precise trading results. Why pay estimated taxes for Q1 and Q2 if you incur substantial trading losses later in the year?

It’s better to pay an extra amount for the extension to set yourself up for three good choices: A cushion on 2022 if you underestimated your taxes, an overpayment credit toward 2023 taxes, or a tax refund for 2022 if no 2023 estimated taxes are due.

Tip 5: Consider a 2023 Section 475 MTM election
Traders eligible for trader tax status should consider attaching a 2023 Section 475 election statement to their 2022 federal tax return or extension due by April 18, 2023, for individuals and corporations and March 15, 2023, for partnerships and S-Corps.

Section 475 turns capital gains and losses into ordinary gains and losses, thereby avoiding the capital-loss limitation and wash-sale loss adjustments on securities (i.e., tax-loss insurance). Section 475 gains are eligible for the 20% qualified business income (QBI) deduction. (See How Traders Elect 475 To Maximize Their Tax Savings.)

Tip 6: File tax returns when it’s more convenient for you
Sophisticated and wealthy taxpayers know the “real” tax deadline is October 16, 2023, for individuals and September 15, 2023, for pass-through entities, including partnership and S-Corp tax returns. Pass-through entities file tax extensions by March 15, 2023.

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

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

The additional time helps build tax positions like qualification for trader tax status in 2022 and 2023. It may open opportunities for new ideas on tax savings. A rushed return does not.

Tip 8: Get more time to fund qualified retirement plans
The extension also pushes back the deadline for paying money into qualified retirement plans, including a Solo 401(k), SEP IRA, and defined benefit plan. The deadline for 2023 IRA contributions is April 18, 2023.

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

Your accountant begins your tax compliance (preparation) engagement, and they cut it off when seeing a solid draft to use for extension filing purposes. Your accountant will wait for the final tax information to arrive after April 18, 2023. Think of the extension as a half-time break. It’s not procrastination; accountants want tax returns finished.

Please don’t overwhelm your tax preparer the last few weeks and days before April 18 with minor details in a rush to file a complete tax return. Accounting firms with high-quality standards have internal deadlines for receiving tax information for completing tax returns. It’s unwise to pressure your accountant, which could lead to mistakes or oversights in a rush to file a complete return at the last minute. That doesn’t serve anyone well.

Tip 10: Securities traders should focus on trade accounting
It doesn’t matter if your capital loss is $50,000 or $75,000 at extension time: Either way, you’ll be reporting a capital loss limitation of $3,000 against other income. In this case, don’t get bogged down with trade accounting and reconciliation with Form 1099Bs until after April 18. The capital loss carryover impacts your decision to elect Section 475 MTM for 2023 by April 18, 2023, but an estimate is sufficient.

Consider wash-sale loss rules on securities: If these adjustments don’t change your $3,000 capital loss limitation, you can proceed with your extension filing. But if you suspect wash-sale loss adjustments could lead to reporting capital gains rather than losses, or if you aren’t sure of your capital gains amount, focus your efforts on trade accounting before April 18. (Consider TradeLog or GNM’s trade accounting service.) Try to do accounting work for year-to-date 2023; it also affects your decision-making on the 475 election.

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

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

For partnerships and S-Corps, don’t overlook pass-through entity (PTE) payments with the Form 7004 extension filing to benefit from the state’s SALT cap workaround solution enacted in about 29 states. (See Tax Tips For Traders Preparing 2022 Tax Returns.)

Tip 12: U.S. residents abroad should learn the particular rules
U.S. citizens or aliens residing overseas are allowed an automatic two-month extension until June 15, 2023, to file their tax return and pay any amount due without requesting an extension. (See Form 4868, page 2, “Taxpayers who are out of the country” and the IRS website.)

Darren Neuschwander, CPA, contributed to this blog post. 

 

 

How Traders Elect 475 To Maximize Their Tax Savings

February 3, 2022 | By: Robert A. Green, CPA | Read it on

Avoid wash sale losses and the $3,000 capital loss limitation and qualify for a 20% QBI deduction.

The most significant problem for investors and traders occurs when they cannot 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 Section 475 mark-to-market (MTM) elections for business ordinary tax-loss treatment for securities and/or commodities (Section 1256 contracts).

Profitable traders might also benefit from Section 475. If a TTS trader wants to be eligible for a 20% qualified business income (QBI) deduction, she should consider electing Section 475 ordinary income treatment. The QBI deduction is not allowed if the taxpayer exceeds a taxable income threshold because trading is a specified service business. (See more below).

Capital losses vs. 475 ordinary losses
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 valuable as a tax deduction in the current tax year. Capital losses first offset capital gains in full without restriction. The rest are a capital loss carryover to the following tax year(s). Many traders wind up with little money to trade and unused capital losses. It can take many years to use up their capital loss carryovers. What a tragic waste! Why not get tax savings from using Section 475 MTM right away? 

Traders qualifying for TTS have the option to elect Section 475 MTM accounting with ordinary gain or loss treatment in a timely fashion. You can offset wage and other income with MTM ordinary losses, navigating around the capital loss limitation. When traders have negative taxable income generated from business losses, Section 475 accounting classifies them as net operating loss (NOL) carryovers.

Caution: Individual business traders who missed the 2021 Section 475 MTM election date (May 17, 2021, one-month pandemic postponement deadline, and June 15, 2021, for Texas, Oklahoma, and Louisiana under federal storm disaster relief) can’t claim this treatment for 2021 and will be stuck with capital-loss carryovers to 2022.

Taxpayers without a significant capital-loss carryover may want to consider electing Section 475 for 2022 by the deadlines of April 18, 2022, or March 15, 2022, for existing partnerships and S-Corps. (See 475 election procedures below.)

A “new taxpayer” (new entity) set up after April 18, 2022, can deliver Section 475 MTM for the rest of 2022 on trading losses generated in the entity account if it files an internal Section 475 MTM election within 75 days of entity inception. This election does not change the character of capital loss treatment on the individual accounts before the entity’s start date.

Section 475 trades are exempt from wash sale loss adjustments
The election exempts the Section 475 transactions from wash-sale loss (WS) adjustments on securities, which would otherwise defer tax losses to replacement positions. If WS happens around year-end, it might create a phantom taxable income because it defers tax losses to the subsequent year.

Section 475 MTM allows current-year trading losses to be ordinary business losses rather than a $3,000 capital loss limitation. It generates significant tax breaks immediately, rather than being stuck with large capital-loss carryovers to subsequent tax years. Many traders enjoyed trading gains in 2020 and 2021, and tax-loss insurance was not essential. However, 475 ordinary loss treatments might be crucial in 2022.

Section 475 MTM also reports year-end unrealized gains and losses as marked-to-market, which means one 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. They report the realized and unrealized gains and losses, like Section 1256, which has MTM built-in by default — but don’t confuse Section 1256 with Section 475. MTM treatment is what makes wash sale losses a moot point.

Section 475 is ideal for securities traders.
Securities traders usually elect Section 475 MTM unless they already have significant capital-loss carryovers. Traders can’t offset MTM ordinary trading gains with capital-loss carryovers; only use capital gains (such as gains from segregated investment positions or Section 1256 contracts) in such a manner. However, suppose a trader generates significant new trading losses before April 18, 2022. In that case, she might prefer to elect Section 475 MTM for 2022 by that sole proprietor election date to have business ordinary-loss treatment retroactive to January 1, 2022. 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.

Consider electing Section 475 on securities only to retain lower 60/40 capital gains rates on Section 1256 contracts.

Excess business losses and net operating losses
Starting in 2018, The Tax Cuts and Jobs Act (TCJA) repealed the two-year NOL carryback, except for certain farming losses and casualty and disaster insurance companies. These TCJA changes mean NOLs are carried forward indefinitely (20 years before the TCJA changes), and the deduction of NOLs is limited to 80% of the subsequent year’s taxable income.

TCJA also introduced an “excess business loss” (EBL) limitation of $500,000 married and $250,000 for other taxpayers. The inflation-adjusted 2021 EBL is 524,000 (married)/$262,000 (other taxpayers) and 2022 EBL is $540,00 (married)/$270,00 (other taxpayers). Business ordinary losses over the EBL limits are an NOL carryforward.

The 2020 CARES Act suspended the EBL limitation for 2018, 2019, and 2020 and allowed five-year NOL carrybacks for those years. Taxpayers can recalculate the NOLs without the EBL limitation and file a carryback refund claim if it makes sense. For example, carry back a 2020 NOL to 2015 and any unused NOL to 2016 and subsequent years. TCJA’s NOL and EBL rules applied again in 2021 and 2022.

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

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

Traders eligible for TTS are a “specified service activity,” which means if their taxable income is above an income cap, they won’t receive a QBI deduction. The taxable income (TI) cap is $429,800/$214,900 (married/other taxpayers) for 2021, and $440,100/$220,050 (married/other taxpayers) for 2022. The phase-out range below the cap is $100,000/$50,000 (married/other taxpayers), in which the QBI deduction phases out for specified service activities. The W-2 wage and property basis limitations also apply within the phase-out range. 

TCJA favors non-service businesses, which are not subject to an income cap. The W-2 wage and property basis limitations apply above the TI threshold of $329,800/$164,900 (married/other taxpayers) for 2021 and $340,100/$170,050 (married/other taxpayers) for 2022. The IRS adjusts the annual TI threshold for inflation each year. 

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

475 election procedures
Section 475 MTM is optional with TTS. Existing taxpayer individuals who qualify for TTS and want it must file a 2022 Section 475 election statement with their 2021 tax return or extension by April 18, 2022—existing partnerships and S-Corps file in the same manner by March 15, 2022.

Election statement. The MTM election statement is a short paragraph; unfortunately, the IRS hasn’t created a tax form for it. It’s a version of the following: “According to Section 475(f), the Taxpayer elects to adopt the mark-to-market method of accounting for the tax year ending December 31, 2022, and subsequent tax years. The election applies to the following trade or business: Trader in Securities as a sole proprietor (for securities only and not commodities/Section 1256 contracts).” If a trader expects to have a loss in trading Section 1256 contracts, he can modify the parenthetical reference to say, “for securities and commodities/Section 1256 contracts.” But remember, the lower 60/40 tax rates on Section 1256 contracts will no longer apply. If the taxpayer trades in an entity, he should delete “as a sole proprietor” in the statement.

Form 3115 filing. Don’t forget an essential second step: Existing taxpayers complete the election process by filing Form 3115 (change of accounting method) with the election-year tax return. Complete a 2022 MTM election filed by the April 18, 2022 deadline on Form 3115 filed with your 2022 tax returns — by the due date of the return, including extensions. 

Submit Form 3115 in duplicate — one goes with Form 1040 filing, and a second goes to the IRS national office. There’s no fee for filing Form 3115, and the election is automatic. That means the IRS should not confirm this election statement or the Form 3115 filing.

Forms 4797 and 3115 include a section for reporting a Section 481(a) adjustment, which is required when making a change of accounting. The rest of the multi-page Form 3115 relates to tax law, code sections, etc. This adjustment converts your bookkeeping from cash to MTM on January 1 of the election year.

After filing their Section 475 election statement, some traders changed their minds and wanted to skip the Form 3115 filing. That’s wrong and incumbent on them to finish up the election process. If a trader doesn’t qualify for TTS, they can’t use Section 475, but that must be based on accurate facts and circumstances and not on a whim. It’s essential to be consistent and credible with the IRS.

Internal elections for new entities
The Section 475 election procedure is different for “new taxpayers” like a new entity. Within 75 days of inception, a new taxpayer may file the Section 475 election statement internally in its records. The new entity does not have to submit Form 3115 because it’s adopting Section 475 from the start rather than changing its accounting method. One way to file an internal resolution is for the taxpayer to send himself an email resolution (election), which has a timestamp for proof of timely election.

Individuals are “new taxpayers” only if they have never filed an income tax return before. A new trader is not necessarily a new taxpayer for a 475 election.

Election to revoke section 475
The IRS makes revocation a free and easy process, mirroring the Section 475 election and automatic change of accounting procedure for existing taxpayers. A taxpayer cannot re-elect Section 475 for five years after revocation.  

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

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

475 fixes wash sales with IRAs for TTS trades
If there is an overlap in what you trade in taxable accounts vs. what you invest in IRAs, the trader must avoid triggering permanent wash-sale losses throughout the year. Suppose a trader takes a loss in a taxable account and buys back a substantially identical securities position 30 days before or after in an IRA account. In that case, the wash-sale loss disenfranchisement becomes permanent.

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

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

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

Most traders are unaware of the nuances of triggering permanent wash sales between taxable and IRA accounts. IRS rules for broker-issued 1099-Bs have a narrow view of wash sales; they call for wash-sale loss adjustments on “identical symbols” for the one account. Conversely, IRS wash sale rules for taxpayers have a broader view: Calculate wash sales on “substantially identical positions” (between equities and equity options) on all individual brokerage accounts, including IRAs. Consider using trade accounting software compliant with IRS wash-sale rules for taxpayers.

Section 475 is a consequential election for TTS traders with many advantages but first, consider personal circumstances and nuances.

Learn more about Section 475 in Green’s 2022 Trader Tax Guide.

If you seek advice on making a Section 475 election, consider a 50-minute consultation with us soon.

Traders Should Consider Section 475 Election by the Tax Deadline

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

February 4, 2022: See How Traders Elect 475 To Maximize Their Tax Savings.

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

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

Original post:

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

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

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

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

Existing Individuals and Entities

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

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

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

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

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

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

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

New Entities

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

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

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

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

20% Deduction on Qualified Business Income

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

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

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

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

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

Segregation of Investments 

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

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

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

475 Fixes Wash Sales With IRAs For TTS Trades 

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

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

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

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

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

Examples

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

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

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

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

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

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

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

Original post:

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

Sole Proprietor Trading Business 

Trader tax status (TTS) constitutes business expense treatment and unlocks an assortment of meaningful tax benefits for active traders who qualify. The first step is to determine eligibility. Our golden rules require four trades per day, close to four days per week, and an average holding period under 31 days. See all the requirements at Trader Tax Status: How To Qualify.

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

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

Trading Gains and Losses

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

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

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

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

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

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

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

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

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

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

Business Expenses on Schedule C

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

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

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

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

Make Schedule C Look Better

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

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

Section 475 MTM Accounting

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

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

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

Section 475 Election Procedures

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

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

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

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

Tax Extensions

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

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

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

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

The Form 4868 instructions point out how easy it is to get this automatic extension — no reason is required. It’s an extension of time to file a complete tax return, not an extension of time to pay taxes owed. The taxpayer should estimate and report what he thinks he owes for 2020 based on his received tax information.

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

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

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

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

Partnerships and S-Corps

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

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

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

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

Recent Tax Law Changes

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

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

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

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

Takeaway

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

 

Traders Elect 475 For Enormous Tax Savings (Live Updates)

May 20, 2020 | By: Robert A. Green, CPA | Read it on

Updates

May 20: 2019 calendar-year partnership and S-Corp tax returns, and 2020 Section 475 elections for partnerships and S-Corps, were due March 16, 2020. These pass-through tax returns and entity 475 elections are not eligible for virus tax relief with the July 15, 2020 postponement deadline. Postponement relief is limited to 2019 tax returns due April 1, 2020, or after, and the March 16 deadline was before April 1. However, fiscal-year partnership or S-Corp tax returns due on April 1, 2020, or later are eligible for the July 15 deadline.

Traders have calendar-year partnerships and S-Corps, so these entities are not eligible for the July 15 postponement date. Most traders filed 2019 partnership or S-Corp extensions by March 16, some along with 2020 Section 475 elections for the entity. Some of these traders asked our firm if their entity could take advantage of the postponed deadline for making a Section 475 MTM election. The answer is no. Individual traders (sole proprietors) are eligible for July 15 relief for filing 2019 individual tax returns, extensions, and 2020 individual Section 475 elections.

April 9: IRS Notice 2020-23, dated April 9, states on page 7: “Finally, elections that are made or required to be made on a timely filed Specified Form (or attachment to a Specified Form) shall be timely made if filed on such Specified Form or attachment, as appropriate, on or before July 15, 2020.”

Good news: TTS traders as sole proprietor individuals now have to July 15, 2020, to elect Section 475(f) for 2020, as the 475 MTM election is an attachment to a specified form, either F1040 or F4868. Previously, we recommended TTS traders elect 475 by April 15, 2020, to play it safe.

March 28: On March 27, 2020, President Trump signed into law the Coronavirus Aid, Relief, and Economic Security (CARES) Act. This bill includes significant economic aid and tax relief provisions. Some tax relief applies retroactively to 2018, 2019, and 2020. See how TTS traders carryback NOLs five tax years for 2018, 2019 and 2020 in our blog post CARES Act Allows 5-Year NOL Carrybacks For Immediate Tax Refunds. If you have massive trading losses in 2020, a timely-filed 475 election is essential for TTS traders this year!

March 25: Our Darren Neuschwander, CPA, communicated with the IRS Chief Counsel’s office for Section 475(f) MTM elections. Mr. Neuschwander asked whether the tax deadline for submitting a 2020 Section 475 election is April 15 or July 15, considering that the IRS delayed the tax-filing deadline to July 15. In our email to the IRS, we gave our rationale for why it should be July 15 (see March 24 update below).

The IRS official told us to watch for an IRS FAQ, which they might add to answer our question, although she gave us no assurances or a timeline.

In the meantime, she highly recommends that those who want to elect 475 MTM for 2020 to file the election statement by attachment to a 2019 tax extension (Form 4868) mailed to the IRS by April 15. That’s what Rev Proc 99-17 requires. The IRS tracks 475 elections with extensions or tax return filings, but not if the taxpayer sends a separate letter with the election. It’s okay if the taxpayer files another extension Form 4868 on July 15 to pay 2019 taxes owed. She reminded us that the IRS does not grant tax relief for late-filed 475 elections.

Therefore, we have been advising clients to make 2020 Section 475 MTM elections on securities and/or commodities by April 15. You can prepare the 2019 tax extension with the 2020 election statement attachment, but wait to file it until the April 15 deadline. Meanwhile, monitor the IRS FAQs and our blog to see if the IRS postpones that deadline as well.

What’s the fuss?
A Section 475 election could be a savior this year with extreme volatility and massive trading losses. Instead of having a capital loss limitation of $3,000, you’ll have unlimited ordinary losses and perhaps a net operating loss (NOL) carryback refund.

Pending stimulus legislation suspends the TCJA business loss limitations, including reauthorizing NOL five-year carrybacks for 2018, 2019, and 2020, and repealing the excess business loss (EBL) restriction. TTS traders with 475 elections would get immediate tax relief. That can replenish your trading account and keep you in business!

March 24: The IRS published FAQs to support Notice 2020-18 for the April 15 tax-deadline postponement to July 15: Filing and Payment Deadlines Questions and Answers. CPA industry groups will likely ask for another round of FAQs to address unanswered questions. It’s important to note that FAQs are not yet “substantial authority,” as tax notices are, and the IRS often changes FAQs at a future date like it recently did with cryptocurrency.

  • Elections: The FAQs don’t mention the word “elections,” including the Section 475 election for TTS traders. The Section 475 MTM election wording comes directly from Rev Proc 99-17, which states:

    “The (election) statement must be filed not later than the due date (without regard to extensions) of the original federal income tax return for the taxable year immediately preceding the election year and must be attached either to that  return or, if applicable, to a request for an extension of time to file that return.”

    In the Notice 2020-18, the IRS moved the due date for 2019 individual tax returns to July 15. The above Q12 allows an automatic extension request on July 15 for more time to file. It seems logical to conclude that a 2020 Section 475 election is due July 15. If the IRS does not explicitly address this question, then a TTS trader with a massive 2020 YTD trading loss might want to file a protective extension request with a 475 election statement attachment by April 15 to play it safe.

March 20: It’s not yet certain if the IRS will accept a 2020 Section 475 election submitted by July 15 in conformity with the postponed tax filing deadline. It would afford traders 90 days of additional hindsight. The IRS promised FAQs soon, which might address “elections.” The original CARES Act bill included moving election deadlines, too. (Update March 23: However, the latest version of the CARES Act bill removed that entire section, perhaps because Treasury already moved the tax deadline to July 15.) If you have a significant Q1 2020 trading loss as a trader eligible for trader tax status (TTS), and you are counting on 475 ordinary loss treatment, then it’s currently safer to file an extension by April 15 and attach a 2020 Section 475 election statement. Stay tuned to our blog posts about the election issue. (See April 15 Tax Deadline Moved To July 15.)

Original blog post, dated Feb. 29, 2020:

With heightened market volatility in Q1 2020, many traders incurred massive losses. TTS traders should consider a 2020 Section 475 election to turn capital losses into ordinary losses. Don’t get stuck with a $3,000 capital loss limitation for 2020 and a considerable capital loss carryover to 2021; unlock immediate tax savings with ordinary-loss deductions against wages and other income this year.

Election procedures: Existing TTS partnerships and S-Corps should attach a 475 election statement to their 2019 entity tax return or extension due March 16, 2020. TTS sole proprietors (individuals) should attach a 475 election statement to their 2019 income tax return or extension due April 15, 2020. The second step is to file a 2020 Form 3115 (Application for Change in Accounting Method) with your 2020 tax return. There are other benefits: 475 trades are exempt from dreaded wash sale loss adjustments, and profitable 475/TTS traders are eligible for the 20% QBI deduction if they are under the QBI taxable income thresholds.

Example 1: A TTS securities trader incurred a capital loss of $103,000 in Q1 2020. He elects Section 475 on securities only by April 15, converting the Q1 capital loss into an ordinary loss on Form 4797 Part II. He also plans to deduct $12,000 of trading business expenses on a Schedule C. He intends to offset the entire trading business loss of $115,000 against a wage income of $175,000 for a gross income of $60,000. Without a 475 election, this trader would have a $3,000 capital loss limitation on Schedule D, a $12,000 ordinary loss on Schedule C, and a gross income of $160,000. He would also have a capital loss carryover to 2021 of $100,000. By deducting the entire $100,000 in 2020 with a 475 election, the trader generates a considerable tax refund.

More about 475
Traders eligible for TTS have the option to make a timely election for the Section 475 accounting method on securities and/or commodities. Section 475 is mark-to-market (MTM) accounting with ordinary gain or loss treatment. MTM imputes sales of open positions at the year-end at market prices. Without MTM, securities traders use the realization (cash) method with capital gains and loss treatment, including wash sale loss adjustments and the annual $3,000 capital loss limitation.

Caution: Sole proprietor (individual) TTS traders who missed the Section 475 MTM election date (April 15, 2019, for 2019) can’t use ordinary-loss treatment for 2019 and are stuck with capital gains and losses and perhaps capital-loss carryovers to 2020. Carefully consider a 475 election for 2020, as you need capital gains to use up capital loss carryovers, and 475 is ordinary income.

A new entity set up after April 15 could deliver Section 475 MTM for the rest of 2020 on trading losses generated in the entity account if it filed an internal Section 475 MTM election within 75 days of inception.

Ordinary losses offset all types of income (wages, portfolio income, and capital gains) on a joint or single filing, whereas capital losses only offset capital gains. Plus, business expenses and ordinary trading losses comprise a net operating loss (NOL) carry forward.

By making a 475 election on securities only, TTS traders retain lower 60/40 capital gains rates on Section 1256 contracts (futures), and they can segregate investment positions for long-term capital gains.

TCJA introduced an excess business loss (EBL) limitation starting in 2018. For 2019, the inflation-adjusted EBL limitation is $510,000/married and $255,000/other taxpayers. The EBL applies to Section 475 ordinary losses and trading expenses. Add an EBL to an NOL carryforward. For example, a single taxpayer with a $300,000 ordinary loss from 475 and trading costs, and no other wage or business income, might have an EBL of $45,000.

TCJA offers a 20% qualified business income (QBI) tax deduction for pass-through businesses, including sole proprietors. TTS trading is a specified service activity. QBI includes 475 ordinary income but excludes capital gains/losses, portfolio income, and forex. TTS expenses are negative QBI. A profitable TTS/475 trader is eligible for the QBI deduction providing their taxable income is not over the QBI thresholds.

Don’t miss the 475 election deadline
Applying for 9100 relief within six months of the 475 election due date by private letter ruling is an expensive process, and it’s likely to fail. Only one trader won this type of relief — Mr. Vines displayed no hindsight and good faith, and he had a perfect set of factors. In PLR 202009013 dated Nov. 15, 2019, the IRS ruled, “Taxpayers are not entitled to § 301.9100 relief to make a late § 475(f)(1) election because Taxpayers did not act reasonably and in good faith and granting relief would prejudice the interests of the Government.”

For more information and a sample 475 election statement, see Green’s 2020 Trader Tax Guide, Chapter 2, on Section 475 MTM.

Darren Neuschwander, CPA, contributed to this blog post.

Uncertainty About Using QBI Tax Treatment For Traders

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

See our more recent blog post: A Rationale For Using QBI Tax Treatment For Traders.

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

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

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

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

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

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

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

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

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

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

Section 864(b)(2) — Trading in securities or commodities.

(A): Stocks and securities.

(i)    In general. Trading in stocks or securities through a resident broker, commission agent, custodian, or other independent agent.

(ii)    Trading for taxpayer’s own account. Trading in stocks or securities for the taxpayer’s own account, whether by the taxpayer or his employees or through a resident broker, commission agent, custodian, or other agent, and whether or not any such employee or agent has discretionary authority to make decisions in effecting the transactions. This clause shall not apply in the case of a dealer in stocks or securities.

(C) Limitation. Subparagraphs (A)(i) and (B)(i) (for commodities) shall apply only if, at no time during the taxable year, the taxpayer has an office or other fixed place of business in the United States through which or by the direction of which the transactions in stocks or securities, or in commodities, as the case may be, are effected.”

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

Notice how Section 199A regs reference Section 864:

“Section 199A(c)(3)(A)(i) provides that for purposes of determining QBI, the term qualified items of income, gain, deduction, and loss means items of income, gain, deduction and loss to the extent such items are effectively connected with the conduct of a trade or business within the United States (within the meaning of section 864(c), determined by substituting ‘qualified trade or business (within the meaning of section 199A’ for ‘nonresident alien individual or a foreign corporation’ or for ‘a foreign corporation’ each place it appears).”

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

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

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

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

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

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

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

The 199A regs state:

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

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

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

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

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

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

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

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

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

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

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