Category: Section 475 MTM

Five Ways To Deduct Losses In Financial Markets

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

forbes_logo_main

Green’s blog post    Accountants World

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

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

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

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

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

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

Five ways to maximize losses on tax returns

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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

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

forbes_logo_main

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


New IRS Rules Allow Free And Easy Section 475 Revocation

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

forbes_logo_main

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


April 15 Tax Extensions And Section 475 Election

March 15, 2015 | By: Robert A. Green, CPA

Forbes

Minding Deadlines For Tax Extensions And Elections

Securities brokers issue corrected 1099Bs close to and sometimes even after the April 15 tax deadline due to complications over cost basis reporting. Schedule K-1s often come late, too.

When tax information is incomplete near the deadline, it’s wise to file an automatic six-month extension. Caution: It’s not a payment extension; so try to pay at least 90% of your tax liability to avoid late-payment penalties. If you don’t pay 90%, hopefully the IRS will accept your “reasonable cause” spelled out in a letter seeking penalty abatement. Retaining tax funds as working capital for trading is not reasonable cause in my view. By filing a timely extension, even without payment of taxes owed, you’ll avoid late-filing penalties if you file by the extended due date of Oct. 15, 2016. The late-filing penalty is far higher than the late-payment penalty.

April 15 is also the important deadline for individual and partnership traders qualifying for trader tax status to file a Section 475 MTM election statement with the IRS for 2015 and subsequent years. The election statement is attached to the federal extension.

There are many advantages to filing extensions. One negative is waiting longer for a tax refund, but traders often apply overpayment credits to estimated taxes due on trading income instead of claiming a refund.

Extensions for individuals
If you don’t owe taxes, the extensions are easy. Enter taxes paid (including credits) with the same amount for tax liability reflecting a zero balance due. Perhaps your spouse has a W-2 with ample tax withholding and you have trading business losses, itemized deductions and nominal other income. You don’t need to prepare detailed draft tax returns before April 15.

If you think you may owe taxes, then continue working on your tax filings. Prepare draft tax returns based on tax information in hand, accounting and estimates of missing information to generate the extensions from tax software. If you have year-to-date trading gains in 2015, it’s wise to be conservative with extension payments figuring you can apply overpayment credits toward 2015 estimated income taxes.

Extensions for entities
Tax extensions for pass-through entities are March 16, 2015 for S-Corps (since 15th is a Sunday) and April 15, 2015 for partnerships with an extension due date of Sept. 15. Pass-through entities are tax filers, not taxpayers, so the federal extension is simple to prepare without any tax liability. Be sure to file it on time because the late-filing penalty for missing the election is $195 per month per partner or shareholder up to a maximum of twelve months.

Some states have nominal franchise taxes or minimum taxes so check with your state or tax advisor. The state taxes are generally due with the extension filing. March 16 is also the deadline for an existing entity – LLC, C-Corp or general partnership (in most states) to elect S-Corp tax status (see our recent blog on S-Corps).

Section 475 MTM election
Active securities traders qualifying for trader tax status should consider a Section 475 MTM election for ordinary business loss treatment (tax loss insurance). Generally, you should elect Section 475 on securities only, not Section 1256 contracts so you retain lower 60/40 tax rates on those. Section 475 converts capital losses — otherwise subject to a $3,000 capital loss limitation and wash sales — into unlimited business ordinary losses. If you have large trading losses in 2015, you should consider a Section 475 election to lock in those losses as business ordinary losses. Ordinary losses are far better than capital losses.

If you have material capital loss carryovers, you can form a new trading entity to pass-through capital gains to your individual tax return, thereby using up capital loss carryovers. In the last-minute rush of tax season, many taxpayers and tax preparers make the wrong decision on Section 475 and it costs them thousands of dollars in tax savings.

Existing partnerships and individuals elect Section 475 for 2015 by attaching an election statement to their 2014 federal extension filed by April 15, 2015. For existing S-Corps, the election date is March 16, 2015. The second step is to file a Form 3115 (Change of Accounting Method) with your 2015 tax return filed in 2016. Learn more about Section 475 and see the election statement in Green’s 2015 Trader Tax Guide. Consult a trader tax expert before the election deadline.

Broker 1099Bs and confusion over wash sales
Many securities brokers are issuing corrected 1099Bs — it’s the new normal. Brokers continue to face many challenges with new IRS cost-basis reporting rules, including wash sale loss adjustments.Options and simple debt instruments purchased on or after Jan. 1, 2014 are considered “covered securities” and are included on 2014 Form 1099Bs for the first time.

Broker and taxpayer rules differ on calculations for wash sales. Brokers calculate wash sales based on the same equity or symbol (identical position) per account. Conversely, taxpayers must calculate wash sales based on substantially identical positions — i.e., between stocks and stock options and options at different expiration dates — across all individual accounts including all IRAs, even Roth IRAs.

Taxpayers can’t rely on 1099Bs and profit and loss reports from brokers if they trade securities and options or have multiple accounts. In these cases, taxpayers should use securities trade accounting software, which calculates wash sales correctly based on substantially identical positions across all accounts. It’s important to reconcile your own software results to 1099Bs, so taxpayers need to account for corrected 1099Bs on tax filings.  Software publishers release program updates late in tax season or after April 15, too.

Traders are not simple like employees
Employees have taxes withheld on each paycheck and many wind up over-withheld generating material tax refunds, which they are anxious to collect. Many employees have simple tax filings and they can file early. Don’t wait for tax refunds every year — update your W-4 for more allowances and less tax withholding. Traders don’t have tax withholding on trading income. They generally owe taxes on trading income on April 15 because many prefer to underpay estimated taxes.

Traders with large Section 475 ordinary losses may be due large tax refunds. These traders have a lot riding on trade accounting and trader tax status; they should not rush their tax filings, especially if corrected 1099Bs are expected. Rushing may lead to errors, delays in tax refunds and potential tax exams, which can hold up refunds.

Futures and forex traders
If you trade Section 1256 contracts (futures), your broker issues a simple one-page 1099-B listing “aggregate profit and loss” based on marked-to-market accounting (realized and unrealized gains and losses). Correct 1099-Bs are rare for Section 1256 contracts. Likewise, forex brokers provide an online tax report that is reliable.

Extensions provide benefits for retirement plans
2014 contributions to Individual 401(k), SEP IRA and employer 401(k) profit-sharing plans must be funded by the due date of your tax return — Oct. 15 if you filed for an extension. That helps your cash flow. But IRAs must be funded by the original due date of April 15.

If your 2014 Roth IRA conversion didn’t work out well — perhaps the securities dropped significantly in value and you paid conversion taxes on the higher value — you’re entitled to “re-characterize” (reverse) the Roth IRA conversion up until the extended due date of Oct. 15. If you already filed your 2014 tax return, you’ll have to amend it to reflect the re-characterization.

Pressuring your tax preparer may lead to errors
If you engage a quality CPA firm for tax compliance, you should not expect them to focus on completing your tax returns during the last few weeks of tax season when filing an extension is a better option. Quality firms have internal deadlines and they avoid error-prone working conditions. I’ve seen countless cases of clients coming to us with botched prior year tax returns where they also missed vital tax elections like Section 475 because they focused on filing a complete return rather than filing an extension and making this election.

Early filers may get audited more
“The early bird gets the worm.” But in this case, the IRS is the bird and your tax return may be the worm selected for audit. I’ve always believed that audit quotas are met based on early filers. The IRS also wants to get started early with exams, and not wait until Oct. 15.

At the start of tax season, the IRS commissioner said there would be delays due to complications over Obamacare taxes, late renewal of “tax extenders” and the IRS being short of resources and staff.

Late-filing and late-payment penalties
Read federal automatic extension Form 4868 with instructions, especially the Page 2 sections on late-filing and late-payment penalties and how to avoid them.

State extensions
Some states don’t require an automatic extension if you’re overpaid and they accept the federal extension. Generally in all states, if you owe taxes, you need to file a state extension with payment. States tend to be less accommodating than the IRS in waiving penalties, so it’s usually wise to cover your state first if you are short on cash. Check the extension rules in your state.

U.S. citizens and resident aliens abroad
Excerpt from the IRS website: “If you are a U.S. citizen or resident alien residing overseas, or are in the military on duty outside the U.S., on the regular due date of your return, you are allowed an automatic 2-month extension to file your return and pay any amount due without requesting an extension. For a calendar year return, the automatic 2-month extension is to June 15. If you qualify for this 2-month extension, penalties for paying any tax late are assessed from the 2-month extended due date of the payment (June 15 for calendar year taxpayers). However, even if you are allowed an extension, you will have to pay interest on any tax not paid by the regular due date of your return (April 15 for calendar year taxpayers).”

 

 


IRS Warns Section 475 Traders

August 13, 2014 | By: Robert A. Green, CPA

The IRS Chief Counsel (ICC) recently gave auditors advice on challenging Section 475 mark-to-market (MTM) traders trying to game the system with segregated investment positions. Section 475 MTM means ordinary gain or business loss treatment, whereas investment positions are capital gain or loss treatment. It’s important not to mix up the two on tax return filings. If you are unclear on your situation, check with one of our CPAs.

In new IRS Chief Counsel Advice 201432016, the IRS focuses on options created on “basket transactions,” which I feel are rarely used tax avoidance schemes. During the past decade, some very large hedge funds parked their trading activity inside of banks and arranged option transactions with the banks to reclaim their trading profits after year-end. These hedge funds avoided application of Section 475 MTM income on their trading gains during the tax year, and replaced it with an option allowing them tax deferral and long-term capital gains tax rates in the following year(s). They converted 40% ordinary tax rates to 20% capital gains rates and received a tax deferral to boot. Their tax savings from these transactions was in the billions of dollars and it attracted the attention of Congress and the IRS. The hedge funds’ arguments about “economic substance” sound pretty hollow to me in relation to tax savings from this tax avoidance scheme. The IRS wants to treat these segregated option transactions as part of the trader’s Section 475 MTM ordinary income trading activities, since they see a connection to those activities (see rules below). To learn more about these schemes, read Hedge Fund Chief Testifies at Senate Tax-Avoidance Hearing (New York Times, July 22, 2014).

There’s a lesson for retail traders using Section 475
We haven’t seen retail traders attempt these complex schemes with bank counterparties. Yet it’s a good time to revisit the segregation rules in Section 475 MTM. It’s a nuanced area of the law and it can have significant consequences on tax returns for business traders who have investments.

All business traders using or considering Section 475 MTM should learn its segregation of investment rules. (One way to prevent this problem is to conduct your business trading activity in an entity separate from individual and IRA investment accounts. The entity has a different taxpayer identification number, so there is no connection in the activity.)

We’ve recommended Section 475 MTM since 1997 when Congress expanded it for traders. The biggest tax benefit is unrestricted business ordinary loss treatment, with taxpayers escaping the onerous rules for wash-sale loss deferrals and the capital loss limitation ($3,000 against ordinary income per year on individual tax returns). Section 475 MTM can be the ticket to receiving huge tax refunds, often on NOL carryback returns.

An example of investments vs. business trades
Many traders want to make long-term investments as well in order to benefit from deferral on taxable income (until sale) and to hold investment securities 12 months for lower long-term capital gains tax rates (currently up to 20% vs. 39.6% the ordinary tax rate on short-term capital gains).

Each year we run into a handful of confusing situations on what’s considered a trading position vs. an investment position. Here’s a common example: A trader may want to house his investment portfolio inside a business trading account for portfolio margining purposes and hyperactively trade stock options around his core investment stock positions.

Suppose a trader holds Apple stock as an investment and trades Apple options for business around it to manage risk. Apple stock and Apple stock options are substantially identical positions for purposes of wash sales and Section 475 MTM. By doing this type of commingling activity, the trader may inadvertently subject his Apple stock investment to Section 475 MTM treatment at year-end, thereby losing deferral on the stock and subjecting his gains to ordinary rates rather than lower long-term capital gains rates.

There are all sorts of scenarios that can come up and in some cases it appears to benefit the taxpayer. It’s important to keep in mind that the IRS is entitled to apply the rules in a way that does not prejudice the government’s position. In the previous example, if the trader had a material loss in the Apple stock held for investment, the IRS is entitled to bar the application of Section 475 on that losing investment position. The IRS can have its cake and can eat it too.

Segregation of investment position rules
Per Thomson Reuters/Tax & Accounting, “Any securities held by the trader are subject to marking unless they fall within the exception to marking under Code Sec. 475(f)(1)(B). In the case of traders, there is only one exception to marking. Under that exception, two requirements must be met. First, it must be established to IRS’s satisfaction that the security has no connection to the activities of such person as a trader. (Code Sec. 475(f)(1)(B)(i)) Second, any such security must be clearly identified in such person’s records as being described in Code Sec. 475(f)(1)(B)(i) before the close of the day on which it was acquired, originated or entered into (or such other time as IRS may by regs prescribe). (Code Sec. 475(f)(1)(B)(ii)) An identification that a security is held for investment for financial reporting purposes is not sufficient for Code Sec. 475 purposes. (Rev Rul 97-39, 1997-2 CB 62).

Generally, gains and losses recognized under Code Sec. 475 are ordinary income or loss to a trader that has made an election under Code Sec. 475(f). (Code Sec. 475(d)(3)(A)(i) and Code Sec. 475(f)(1)(D)) However, Code Sec. 475(d)(3)(B) provides exceptions to the automatically ordinary rule under Code Sec. 475(d)(3)(A). If a taxpayer can establish that it held securities as hedges, or that the securities were not held in connection with its trading business, or that a security is improperly identified (see Code Sec. 475(d)(2) ), then gains and losses are not automatically ordinary. (Code Sec. 475(d)(3)(B)(i), Code Sec. 475(d)(3)(B)(ii) and Code Sec. 475(d)(3)(B)(iii)) Character must then be determined by other relevant Code sections.”

Many hedge funds and some traders skip a Section 475 election because they don’t want to be burdened with identifying investments on the time and date of purchase. They establish a trade and may let their profits run and morph the position into an investment position for long-term capital gain and deferral.

How Section 475 MTM and the segregation rules work
A business trader using Section 475 MTM has ordinary gain or loss treatment, plus open business positions are marked-to-market as imputed sales at year-end. On the first day of the subsequent year, the trader imputes a purchase of that same position at the same year-end price.

Duly segregated investment positions are not subject to Section 475 MTM. For example, a business trader organized as a sole proprietor may have a business trading account at Interactive Brokers and a segregated investment account held jointly with his spouse at Fidelity for making long-term investments. Like all professionals, it’s expected that a business trader would have investments, too.

It’s important for the business trader to contemporaneously segregate investment positions from business positions in “form and substance.” Form means a separate account and substance means don’t trade substantially identical positions with business trading positions. While proposed IRS regulations required a separate account, that rule never became final law, so a trader can have investment positions within a business trading account. Just make sure to email yourself contemporaneously when purchasing an investment position. Don’t trade around investment positions with your business positions, as that runs afoul of the substance rule. The lines of distinction can be blurred in some cases and you should consult a trader tax expert about it.

Read Green’s 2014 Trader Tax Guide Chapter 2 on Section 475 MTM to learn more.

Recent trader tax court cases
In recent trader tax court cases covered on our blog, Assaderaghi, Nelson and Endicott, the IRS won denial of trader tax status partially because these option traders did not segregate active option trading from investing in stocks (similar to the example above). However, even if these traders did follow segregation rules and our above guidance, I still don’t think they traded options enough to qualify for trader tax status. They also sought Section 475 MTM ordinary loss treatment on stock investments, which is not possible.

Bottom line
Section 475 MTM is fantastic for most business traders — we call it “tax loss insurance.” But the fine print requires discipline on dealing with investments. It’s best to trade in a separate entity to skip these handcuffs.

 


Protect yourself from market losses with Section 475 MTM

March 27, 2014 | By: Robert A. Green, CPA

As the dot-com bust and tech wreck unfolded in 2000, we preached the importance of Section 475 MTM elections to business traders for “tax-loss” insurance. We knew when the markets inevitably turned bearish, many traders would incur huge trading losses. This election means losses are considered business ordinary losses; without it, the losses are capital losses limited to $3,000 against ordinary income per year.

Business ordinary losses can be monetized into tax refunds quickly, whereas capital loss carryforwards often take a long time to monetize — sometimes a decade or more. Traders want immediate tax refunds to replenish their trading capital. Otherwise, they may have little capital left to generate capital gains.

Based on 30 years of experience working closely with traders, we know there are huge swings in bull and bear markets. We’ve seen clients make a lot of money in a few years and lose a lot in a subsequent year. Traders need to be able to carry back losses and that can’t be done on securities unless Section 475 is used. Futures traders can carry back Section 1256 contract losses three years but only against Section 1256 contract gains.

A worst-case scenario in the 2000 tech wreck: Several securities traders made $500,000 in 1999 and lost it all in Q1 2000. They lost their 1999 taxes due in Q1 2000 and they missed the Section 475 MTM election by April 15, 2000. They couldn’t pay the IRS for 1999 gains and they got stuck with a capital loss carryover for 2000, which they couldn’t monetize since they had no capital left to trade. With a simple 2000 Section 475 election, they could have filed a net operating loss (NOL) carryback wiping out their 1999 tax debt. They would have been square with the IRS.

Why talk about 1999/2000? Because it feels like similar market conditions are developing now. 2013 was a big income year for traders and Q1 2014 started off rocky. Consider the rush of tech/mobile/gaming IPOs; CNBC’s Jim Cramer says its Deja vu with the dot-com and tech wreck of 1999/2000. There could be a big correction or bear market later this year.

This past week I consulted with a client on a potential worst-case scenario for 2013/2014. He broke even for 2013 but said TradeLog shows over $1 million of wash sales deferred to 2014. That presents a huge 2013 tax liability on phantom income and he already lost all that tax money and more in Q1 2014.

Luckily, he came to us in time — he will file a Section 475 election by April 15, 2014. The required Section 481a adjustment turns deferred wash sales on year-end 2013 business positions into business ordinary losses on Jan. 1, 2014. The important challenge for him is to maintain his trader tax status in 2014 so he can use Section 475. We suggested filing a 2013 Form 9465 Installment Agreement Request including a note that taxpayer expects to file an NOL carryback wiping out his 2013 tax debt.

Section 475 is free to elect, which is why we call it free tax-loss insurance. While it costs money to switch back to the cash method, traders rarely do that — they just exit their trading activity, thereby suspending Section 475. We recommend section 475 on securities only; you want to retain the lower 60/40 tax rates on 1256 contracts.

Be careful to segregate your investments so 475 won’t apply on those investments and you can hold them for lower long-term capital gains rates. Section 475 marks to market open business positions at year-end, but not investment positions.

Only business traders qualifying for trader tax status may use Section 475. The main requirement is 1,000 trade volume per year (annualized) and frequency over 75% of available trading days with trade executions.

Existing taxpayer individuals and partnerships file Section 475 elections by April 15, 2014. Attach the election statement to your 2013 tax return or extension. The second step is to perfect the election with a 2014 Form 3115 (change of accounting method) filed with your 2014 tax return. New taxpayers/new entities may adopt 475 within 75 days of inception by filing an internal resolution.

It’s important to run Tradelog software to determine your trading gains and losses for 2013 and 2014 year to date. Turn on the Section 475 MTM election within Tradelog software for 2014, and the program will calculate the Section 481a adjustment for Jan. 1, 2014.

If you have a large trading loss for Q1 2014, and also a large capital loss carryover, it’s probably wise to make the Section 475 MTM election to lock in the 2014 loss as ordinary. Resume trading in a new entity with capital gains treatment so you can use up the capital loss carryovers.

If the music stops in the markets, don’t be caught without a chair to sit on — Section 475 may be just the chair for you.


Close