Category: Tax Changes & Planning

How Traders Can Get The 20% QBI Deduction Under New Law

January 12, 2018 | By: Robert A. Green, CPA | Read it on

Like many small business owners, traders eligible for trader tax status (TTS) are considering to restructure their business for 2018 to take maximum advantage of the “Tax Cuts and Jobs Act” (Act). Two tax benefits catch their eye: The 20% deduction on pass-through qualified business income (QBI), and the C-Corp 21% flat tax rate.

The 20% QBI deduction
There are two components for obtaining a 20% deduction on QBI in a pass-through business.

1. QBI: I’ve made some excellent arguments over the past few months in my blog posts for including Section 475 ordinary income for TTS traders in QBI, but the Act did not expressly confirm that position. I am confident that Section 475 is part of QBI, so consider that election for 2018. The law only counts QBI from domestic sources, which may mean trading activity in U.S. markets, but not foreign markets and exchanges.

I’ve also suggested that TTS “business-related” capital gains should be includible in QBI since the Act excludes “investment-related” short-term and long-term capital gains. For now, I assume the IRS may reject all capital gains.

2. SSA vs. non-SSA: Assuming a TTS trader has QBI on Section 475 MTM ordinary income, the calculation depends on whether the business is a specified service activity (SSA) or not. I’ve made some arguments on why a trading business could be a non-SSA but based on the new tax law, TTS traders should assume their business is an SSA.

For example, if a TTS trader has 2018 taxable income under the SSA threshold of $157,500 single and $315,000 married, and assuming the trader has Section 475 ordinary income, then the trader would get a 20% deduction on either QBI or taxable income less net capital gains (whichever is lower). The 20% deduction is phased out above the SSA threshold by $50,000 single and $100,000 married. If taxable income is $416,000, above the phase-out range, the married couple gets no QBI deduction at all.

A QBI deduction is on page two of the Form 1040; it’s not an adjusted gross income (AGI) deduction or a business expense from gross income.

An owner of a non-SSA business, like a manufacturer, is entitled to the 20% deduction without a taxable income limitation, although there is a 50% wage limitation, or alternative 25% wage limitation with 2.5% qualified property factor, above the SSA income threshold. (See Traders Should Be Entitled To The Pass-Through Tax Deduction.)

TTS trading with Section 475 ordinary income
TTS is a hybrid concept: It gives “ordinary and necessary” business expenses (Section 162). A trader in securities and or commodities (Section 1256 contracts) eligible for TTS may elect Section 475(f) mark-to-market (MTM)) accounting, which converts capital gains and losses into ordinary gains and losses.

Steven Rosenthal, Senior Fellow, Urban-Brookings Tax Policy Center, weighed in for my prior blog post and again recently: “Section 475 treats the gain as ordinary income,” he says. “Section 64 provides that gain that is ordinary income shall not be treated as gain from the sale of a capital asset.” Mr. Rosenthal thinks Section 475 ordinary income is QBI under the new tax law for this reason and “because it’s not on the QBI exclusion list.” Rosenthal pointed out there is no statutory definition of “business income.”

In the new law, QBI excludes a list of investment items including short- and long-term capital gains and losses. I don’t see how an IRS agent could construe Section 475 ordinary income as capital gains.

I look forward to the Congressional analysis in the”Blue Book” for the General Explanation of the Act — hopefully, this will shed further light on my questions. Some traders may prefer to wait for IRS regulations on these Act provisions and other types of IRS guidance. Hopefully, big law firms will form a consensus opinion on this issue for their hedge fund clients, soon.

Congress may not have envisioned the pass-through deduction for hedge funds and TTS trading companies, and they may fix things through interpretation or technical correction to prevent that outcome.

Trading in a C-Corp could be costly
Don’t only focus on the federal 21% flat tax rate on the C-Corp level; there are plenty of other taxes, including capital gains taxes on qualified dividends, potential accumulated earnings tax, a possible personal holding company tax penalty, and state corporate taxes in 44 states.

If you pay qualified dividends, there will be double taxation with capital gains taxes on the individual level — capital gains rates are 0%, 15% or 20%. If you avoid paying dividends, the IRS might assess a 20% accumulated earnings tax (AET). If you have trading losses, significant passive income, interest, and dividends, it could trigger personal holding company status with a 20% tax penalty. (See my blog post How To Decide If A C-Corp Is Right For Your Trading Business.)

How to proceed
For 2018, TTS traders should consider a partnership or S-Corp for business expenses, and a Section 475 election on securities for exemption from wash sale losses and ordinary loss treatment (tax loss insurance). Consider a TTS S-Corp for employee benefit plan deductions including health insurance and a high-deductible retirement plan, since a TTS spousal partnership or TTS sole proprietor cannot achieve these deductions. Consider this the cake.It puts you in position to potentially qualify for a 20% QBI deduction on Section 475 or Section 988 ordinary income in a TTS trading pass-through entity – icing on the cake. If a TTS trader’s taxable income is under the specified service activity (SSA) threshold of $315,000 (married), and $157,500 (other taxpayers), he or she should get the 20% QBI deduction in partnerships or S-Corps. Within the phase-out range above the threshold, $100,000 (married) and $50,000 (other taxpayers), a partial deduction. QBI likely includes Section 475 and Section 988 ordinary income and excludes capital gains (Section 1256 contracts and cryptocurrencies). It might be a challenge for a TTS sole proprietor to claim the pass-through deduction because Schedule C has trading expenses only; trading gains are on other tax forms.

I suggest you consult with me about these issues soon.

Darren Neuschwander, CPA, and Roger Lorence, Esq., contributed to this post. 


How To Decide If A C-Corp Is Right For Your Trading Business

January 9, 2018 | By: Robert A. Green, CPA | Read it on

When taking into account the Tax Cuts and Jobs Act for 2018, don’t focus solely on the federal 21% flat tax rate on the C-Corp level. There are plenty of other taxes, including capital gains taxes on qualified dividends, state corporate taxes in 44 states, and accumulated earnings tax assessed on excess retained earnings.

When a C-Corp pays qualified dividends to the owner, double taxation occurs with capital gains taxes on the individual level (capital gains rates are 0%, 15% or 20%). If an owner avoids paying sufficient qualified dividends, the IRS is entitled to assess a 20% accumulated earnings tax (AET). It’s a fallacy that owners can retain all earnings inside the C-Corp.

C-Corp vs. individual tax rates
Starting in 2018 under the new tax law, C-Corps may benefit from a 21% flat tax rate vs. individual graduated rates of 10% to 37%. Don’t confuse your tax bracket with your tax rate, which is less. For example, the average individual tax rate is 27% for a married couple entering the top 37% tax bracket of $600,000 and 30% for a single filer approaching the top bracket of $500,000; so the actual rate difference is 6% and 9% in these two examples.

Upper-income traders may also have individual 3.8% net investment tax (NIT) on net investment income (NII). NIT applies on NII over the modified AGI threshold of $250,000 (married) and $200,000 (single). Adding this in, the difference between the flat rate could be 9.8% and 12.8% in our example.

Traders don’t owe self-employment (SE) tax, so I don’t factor that into the equation. Other small business owners have SE or payroll tax in pass-throughs but can avoid it with a C-Corp. Let say the C-Corp has a 10% rate advantage for high-income traders and a lower or no benefit for middle- to lower-income traders.

Now come all the haircuts that can lead to adverse taxes and make the C-Corp a costlier choice for a trader. Double taxation on the federal level can wipe out that savings with a 15% or 20% capital gains tax on “qualified dividends.” Double taxation on the state level can lead to a C-Corp owner paying higher taxes than with a pass-through entity. There are potential 20% accumulated earnings taxes and personal holding company tax penalties. Look before you leap into a C-Corp and consult a trader tax expert.

C-Corp double taxation with qualified dividends
A C-Corp pays taxes first on the entity level, and the owners owe taxes a second time on the individual level on dividends and capital gains.

When C-Corps make a cash or property distribution to owners, it’s a taxable dividend if there are “earnings and profits” (E&P). If the individual holds the C-Corp stock for 60 days, it’s a “qualified dividend,” subject to lower long-term capital gains rates of 0%, 15%, and 20%. The 0% capital gains bracket applies to taxable income up to $77,200 (married) and $38,600 (single). A 15% dividends tax offsets the difference in individual vs. corporate tax rates.

State double taxation can ruin the C-Corp strategy
According to Tax Foundation, “Forty-four states levy a corporate income tax. Rates range from 3 percent in North Carolina to 12 percent in Iowa.” (See your state on the Tax Foundation map, State Corporate Income Tax Rates and Brackets for 2017.) States don’t use lower capital gains rates for taxing individuals; they treat qualified dividends as ordinary income.

A C-Corp is a wrong choice for a trader entity in California with an 8.84% corporate tax rate, but it could be the right choice for a high-income trader in Texas without corporate taxes if he or she retains earnings and can successfully avoid IRS 20% accumulated earnings tax (more on this to come). The Texas 0.75% franchise tax applies to all types of companies with limited liability, including LLCs, and C-Corps, and the “No Tax Due Threshold” is $1.11 million. Most traders won’t trigger the Texas franchise tax.

Don’t try to avoid filing a C-Corp tax return in your resident state. You are entitled to form your entity in a tax-free state, like Delaware, but your home state probably requires registration of a “foreign entity,” if it operates in your state. Setting up a mail forwarding service in a tax-free state does not achieve nexus, whereas, conducting a trading business from your resident state does.

The new tax law capped state and local income, sales, and property taxes (SALT) itemized deductions at $10,000 per year. It does not suspend SALT deductions paid by C-Corps, but that expense is only the double-taxed portion; the individual SALT on qualified dividends is still limited.

Accumulated earnings tax
If the C-Corp does not pay dividends from E&P, the IRS can assess a 20% “accumulated earnings tax” (AET) if the C-Corp E&P exceeds a threshold and company management cannot justify a business need for retaining E&P. The IRS is trying to incentivize C-Corps to pay dividends to owners. The IRS AET threshold is $250,000, or $150,000 for a personal service corporation. (See Section 533.)

If the IRS treats a trader tax status (TTS) trading company as an “investment company,” then it may assess 20% AET on all E&P and therefore undermine the C-Corp strategy for traders. But I don’t think a TTS trading company with Section 475 ordinary income is an investment company. A TTS trading C-Corp needs to demonstrate a business need for E&P above the $250,000 threshold.

“AET requires the corporation to have adopted a plan for business expansion that will require substantial additional capital,” says Roger Lorence, a tax attorney in the New York City area who specializes in hedge fund tax. “The plan must be in writing and adopted by the Board; it must refer to the analysis of the business, the need for expansion, the need for more capital, and include a timeline for implementation.”

Arguing the C-Corp needs more trading capital for growing profits is likely not an acceptable reason for avoiding dividends. Sufficient reasons might include buying exchange seats, hiring traders and back office staff, and purchasing more equipment and automated trading systems. Over a period, the C-Corp must implement its formal plan. Otherwise, the IRS won’t respect the policy. Many one-person TTS trading companies don’t have these types of expansion plans, and they likely won’t succeed in defending against an AET assessment. Previously, I pointed out a C-Corp might be suitable for a high-income trader, but they would probably exceed the AET threshold in the first year.

Personal holding company tax penalty
“Personal holding company” (PHC) status is triggered when a closely held C-Corp has at least 60% of gross income coming from certain passive income (including interest, dividends, rents, and royalties), and has not made sufficient distributions to shareholders. The IRS is entitled to assess a 20% PHC tax penalty. The new tax law did not revise the PHC rules, and some tax experts think Congress should have tightened them.

Capital gains and Section 475 ordinary income are not passive income, so a successful TTS trader C-Corp will likely not meet the definition. However, if a trader incurs a net trading loss for a given year, then passive income might exceed 60% of gross income and trigger a PHC penalty. If a trader has substantial passive income, don’t hold those positions in a C-Corp.

Officer compensation avoids double taxation
Historically, C-Corps paid higher officer compensation to avoid the 35% C-Corp tax rate. But now, C-Corps may want the 21% C-Corp tax rate over the individual tax rates up to 37% on wage income instead.

C-Corp Cons
1. No lower 60/40 capital gains tax rates on Section 1256 contracts.
2. Ordinary losses do not pass-through to the owner’s tax return, missing an opportunity for immediate tax savings against other income. The new law has an excess business loss limitation of $500,000 (married) and $250,000 (single), and it repealed the NOL carryback, only allowing carryforwards.
3. A C-Corp investment company without TTS may not deduct investment expenses. The Act suspends miscellaneous itemized deductions for individuals, which includes investment expenses. Don’t try to house investments in a C-Corp; it might be deemed a PHC.
4. If you liquidate a C-Corp to realize the capital loss and ordinary loss trapped inside it, you might qualify for Section 1244 ordinary loss treatment up to $100,000 (married) or $50,000 (single), with the remainder of the loss treated as a capital loss. Therefore, you could be stuck with a capital loss carryover. Per Section 1244, “a corporation shall be treated as a small business corporation if the aggregate amount of money and other property received by the corporation for stock, as a contribution to capital, and as paid-in surplus, does not exceed $1,000,000.” Conversely, with a pass-through entity and Section 475 ordinary loss treatment, the trader would have all ordinary loss treatment.

There are a few good things about C-Corps: A more extensive assortment of fringe benefit plans for owners, and charitable contributions, which some individuals may limit due to the higher standard deduction.

Example: Profitable trader in a tax-free state
Nancy Green, a resident of Texas, consistently makes well over $500,000 net income per year trading securities with Section 475 ordinary income. She has officer compensation of $146,000 to maximize her company Solo 401(k) retirement plan contribution of $55,000 (under age 50).

With an S-Corp, her 2018 gross income is $646,000 ($500,000 K-1 income and $146,000 wages), she takes a $25,000 itemized deduction, which makes her taxable income $621,000. Nancy is over the $207,500 taxable income threshold for a specified service activity, so she does not qualify for the Act’s 20% deduction on qualified business income (QBI) in a pass-through. Her 2018 federal income tax is $195,460. Her marginal tax bracket is the top 37% rate, and her average tax rate is 31% — 10% above the C-Corp flat rate of 21%. She also owes 3.8% NIT on $300,000 ($500,000 K-1 income less the modified AGI threshold of $200,000), which equals $11,400. Nancy’s total federal tax liability using an S-Corp is $206,860.

With a C-Corp, Nancy’s individual tax return gross income is $146,000 from wages, and she takes a $25,000 itemized deduction, which lowers her taxable income to $121,000. Her individual federal income tax is $23,330, which is 19.3% of taxable income. Nancy does not owe NIT in this case. (This assumes she has no qualified dividends from the C-Corp.) The federal corporate tax is $105,000 ($500,000 times 21%). With her individual tax paid using the C-Corp, her total federal tax is $128,330.

The C-Corp structure delivers 2018 federal tax savings of $78,530 vs. the S-Corp. There is no corporate or individual income tax in Texas, and she did not exceed the franchise tax threshold, so the savings with the C-Corp can be significant. It also depends on whether or not she pays qualified dividends or has an IRS 20% AET assessment.

If Nancy needs distributions for living expenses, she has two choices:
1. Pay additional wages, which only are subject to Medicare tax of 2.9%, reducing C-Corp net income at a 21% rate, and subjecting her to more individual tax at 24% and 32% marginal rates. (This might be the more attractive option.)
2. Pay qualified dividends taxed at 15%, plus some 3.8% NIT, which does not reduce C-Corp taxes. Her overall savings will decline, but it’s still substantially positive vs. the S-Corp. For example, a qualified dividend of $300,000 would cause $45,000 of capital gains taxes and $9,348 of NIT. Net federal tax savings from using the C-Corp vs. the S-Corp would be $24,182.

If Nancy moves to California, the C-Corp is not a good idea because California has an 8.84% corporate tax rate and with double taxation, the C-Corp savings disappears. Like many other states, California treats all income as ordinary income; it does not distinguish qualified dividends or long-term capital gains. In Nancy’s case, California’s corporate tax would be $44,200 ($500,000 x 8.84% rate), plus individual taxes on $300,000 qualified dividends would be approximately $28,000. A C-Corp in California would lead to much higher federal and state taxes vs. using a dual entity solution, where a trading partnership and S-Corp management company are used to avoid the state’s 1.5% franchise tax on S-Corps.

The 800-pound gorilla in the room is the 20% accumulated earnings tax (AET), and under what conditions the IRS may assess it on a trading business C-Corp. Nancy can tell the IRS she is a TTS trader entitled to retain earnings up to $250,000. Her C-Corp made $500,000 and paid qualified dividends of $300,000, so she kept $200,000 of profits inside the C-Corp. The IRS allows up to $250,000, so she should be fine for 2018, but what about 2019? Does Nancy have a written plan that is feasible for keeping a war chest of earnings over the $250,000 threshold? Probably not, and that could render the C-Corp tax advantage a mirage for her and others in a similar boat.

I suggest traders consult with me to discuss their 2018 projections and see which shoe fits best: a partnership, S-Corp or C-Corp, or some combination, thereof.

 

 


The Tax Cut Suspended Many Deductions For Individuals

December 29, 2017 | By: Robert A. Green, CPA | Read it on

The Tax Cuts and Jobs Act suspended or trimmed several cherished tax deductions that individuals count on for savings. So, exactly how bad is it and what can you do about it?

The lion’s share of the $1.5-trillion tax cut goes to corporations (C-Corps). The Act lowered the corporate rate from 34% to 21%, a flat rate starting in 2018 and switched from a global income-tax regime to a territorial tax system. The Act made most C-Corp tax cuts permanent, giving multinational corporations confidence in long-term planning.

Democrats lambaste the Act because most of the individual tax cuts expire at the end of 2025. Republicans probably expect Democrats to cooperate in making the individual tax cuts permanent before the 2026 mid-term elections.

Individual changes take effect in 2018
The Act brings forth a mix of negative and positive changes for individuals. The highlights include:

  • Lower tax rates in all seven brackets to 10%, 12%, 22%, 24%, 32%, 35%, and 37%; Four tax brackets for estates and trusts: 10%, 24%, 35%, and 37%;
  • Standard deduction raised to $24,000 married, $18,000 head-of-household, and $12,000 for all other taxpayers, adjusted for inflation;
  • An expanded AMT exemption to $109,400 married and $70,300 single.
  • Many itemized deductions and AGI deductions suspended or trimmed (more on this below);
  • Personal exemptions suspended;
  • Child tax credit increased;
  • New 20% deduction for pass-through income with many limitations;
  • Pease itemized deduction limitation suspended;
  • Obamacare shared responsibility payment lowered to zero for non-compliance with the individual mandate starting in 2019;
  • Children’s income no longer taxed at the parent’s rate; kids must file tax returns to report earned income, and unearned income is subject to tax using the tax brackets for trusts and estates.

State and local taxes capped at $10,000 per year
The most contentious deduction modification is to state and local taxes (SALT). After intense deliberations, conferees capped the SALT itemized deduction at $10,000 per year. The Act allows any combination of state and local income, sales or domestic property tax. SALT may not include foreign real property taxes.

The Act prohibited a 2017 itemized deduction for the prepayment of 2018 estimated state and local income taxes. Individuals are entitled to pay and deduct 2017 state and local income taxes by year-end 2017.

The Act permits a 2017 itemized deduction for the advance payment of 2018 real property taxes, providing the city or town assessed the taxes before 2018. For example, a taxpayer could pay real property taxes before Dec. 31, 2017, and deduct it in 2017, on an assessment for the fiscal year July 1, 2017, to June 30, 2018. These IRS rules are similar for all prepaid items for cash basis taxpayers. (See IRS Advisory: Prepaid Real Property Taxes May Be Deductible in 2017 if Assessed and Paid in 2017.)

Consider that SALT is an AMT preference item; it’s not deductible for AMT taxable income.  Many upper-income and middle-income individuals fall into the AMT zone, so they don’t get a full SALT deduction. The Pease itemized deduction limitation also trimmed the SALT deduction for 2017 and prior years.

Many business owners deduct home-office expenses (HO), which include a portion of real property taxes and that allocation is not subject to the $10,000 SALT limit, and the home office deduction is not an AMT preference item. Here’s a tip: Report 100% of real property taxes on home office form 8829, to maximize the HO deduction. Deduct state and local income taxes, and the remainder of real property taxes, to reach the $10,000 SALT limit on Schedule A. When you factor in a more substantial standard deduction for 2018, many individuals may not lose as much of their SALT deduction as they fear. With lower individual tax rates, they might still end up with an overall tax cut.

The Act does not permit a pass-through business owner to allocate SALT to the business tax return. For example, an S-Corp cannot reimburse its owner for his or her individual state and local income taxes paid in connection with that pass-through income.

SALT is still allowed as a deduction from net investment income for calculating the 3.8% Obamacare net investment tax.

High-tax states are fighting back against the SALT cap. State and local jurisdictions are setting up 501(c)(3) charitable organizations to fund state and local social costs, including public schools. Residents would make charitable contributions to the state 501(c)(3) and receive credit for real property and or state income taxes. This type of restructuring would convert non-deductible SALT payments into tax-deductible charitable contributions. It will be difficult to arrange, and the IRS may object, so don’t hold your breath. High-tax states have significant transfer payments to people in need, and it seems appropriate to consider it charity.

Medical expenses modified
The Act retained the medical-expense itemized deduction, which is allowed if it’s more than the AGI threshold. In 2017, the AGI threshold was 10% for taxpayers under age 65, and 7.5% for age 65 or older. The Act uses a 7.5% AGI threshold for all taxpayers in 2018, and a 10% threshold for all taxpayers starting in 2019. Medical expenses are an AMT preference item.

Mortgage debt lowered on new loans
As of Dec. 15, 2017, new acquisition indebtedness is limited to $750,000 ($375,000 in the case of married taxpayers filing separately), down from $1 million, on a primary residence and second home. Mortgage debt incurred before Dec. 15, 2017 is subject to the grandfathered $1 million limit ($500,000 in the case of married taxpayers filing separately). If a taxpayer has a binding written contract to purchase a home before Dec. 15, 2017 and to close by Jan. 1, 2018, he or she is grandfathered under the previous limit. Refinancing debt from before Dec. 15, 2017 keeps the grandfathered limit providing the mortgage is not increased.

The conference report “suspends the deduction for interest on home equity indebtedness” starting in 2018. (IRS news release IR-2018-32, Feb. 21, 2018, Interest on Home Equity Loans Often Still Deductible Under New Law. If you stay within the $750,000 new acquisition indebtedness, and home equity loan funds are used to improve the home it’s borrowed on, then the home equity interest is deductible. Conversely, if you use the HELOC funds for other purposes, it’s not deductible.)

As with SALT, the home office mortgage interest deduction is not subject to Schedule A limits. IRS instructions for home office Form 8829 state, “If the amount of home mortgage interest or qualified mortgage insurance premiums you deduct on Schedule A is limited, enter the part of the excess that qualifies as a direct or indirect expense. Do not include mortgage interest on a loan that did not benefit your home (explained earlier).”

Investment expenses suspended
The Act has many provisions impacting investors, including suspension of miscellaneous itemized deductions, which include investment expenses, starting in 2018. The Act did not repeal investment interest expense. (See The Tax Cut Impacts Investors In Negative And Positive Ways.)

Investment expenses are still allowed as a deduction from net investment income for calculating the 3.8% Obamacare net investment tax. Retirement plans, including IRAs, are also entitled to deduct investment expenses, although it may be difficult to arrange with the custodian.

Unreimbursed employee business expenses suspended
The Act suspends unreimbursed employee business expenses deducted on Form 2106. Speak with your employer about implementing an accountable reimbursement plan and “use it or lose it” before year-end 2018. See a list of these items below.

Tax preparation and planning fees suspended
Miscellaneous itemized deductions include tax compliance (planning and preparation) fees. If you operate a business, ask your accountant to break down their invoices into individual vs. business costs. The business portion is allowed as a business expense.

Miscellaneous itemized deductions suspended
See the complete list of suspended miscellaneous itemized deductions in the Joint Explanatory Statement p. 95-98. Here are the highlights.

Expenses for the production or collection of income:

  • Clerical help and office rent in caring for investments;
  • Depreciation on home computers used for investments;
  • Fees to collect interest and dividends;
  • Indirect miscellaneous deductions from pass-through entities;
  • Investment fees and expenses;
  • Loss on deposits in an insolvent or bankrupt financial institution;
  • Loss on traditional IRAs or Roth IRAs, when all amounts have been distributed;
  • Trustee’s fees for an IRA, if separately billed and paid.

Unreimbursed expenses attributable to the trade or business of being an employee:

  • Business bad debt of an employee;
  • Business liability insurance premiums;
  • Damages paid to a former employer for breach of an employment contract;
  • Depreciation on a computer a taxpayer’s employer requires him to use in his work;
  • Dues to professional societies;
  • Educator expenses;
  • Home office or part of a taxpayer’s home used regularly and exclusively in the taxpayer’s work;
  • Job search expenses in the taxpayer’s present occupation;
  • Legal fees related to the taxpayer’s job;
  • Licenses and regulatory fees;
  • Malpractice insurance premiums;
  • Medical examinations required by an employer;

Occupational taxes;

  • Research expenses of a college professor;
  • Subscriptions to professional journals and trade magazines related to the taxpayer’s work;
  • Tools and supplies used in the taxpayer’s work;
  • Purchase of travel, transportation, meals, entertainment, gifts, and local lodging related to the taxpayer’s work;
  • Union dues and expenses;
  • Work clothes and uniforms if required and not suitable for everyday use; and
  • Work-related education.

Other miscellaneous itemized deductions subject to the 2% floor include:

  • The share of deductible investment expenses from pass-through entities.

Personal casualty and theft losses suspended
The Act suspends the personal casualty and theft loss itemized deduction, except for losses incurred in a federally declared disaster. If a taxpayer has a personal casualty gains, he or she may apply the loss against the gain.

Gambling loss limitation modified
The Act added professional gambling expenses to gambling losses in applying the limit against gambling winnings. Professional gamblers may no longer deduct expenses more than net winnings.

Charitable contribution deduction limitation increased
The Act raised the 50% limitation for cash contributions to public charities, and certain private foundations to 60%. Excess contributions can be carried forward for five years.

The Act retained charitable contributions as an itemized deduction. But, with the suspension of SALT over the $10,000 cap, and all miscellaneous itemized deductions, many taxpayers are expected not to itemize. Some taxpayers won’t feel the deduction effect from making charitable contributions. Consider a bunching strategy, to double up on charity one year to itemize, and contribute less the next year to use the standard deduction. Another bunching strategy is to set up a charitable trust like at Fidelity.

Alimony deduction suspended
The Act suspends alimony deductions for divorce or separation agreements executed in 2019, and the recipient does not have taxable income.

Moving expenses suspended
The Act suspends the AGI deduction for moving expenses, and employees may no longer exclude moving expense reimbursements, either. “Except for members of the Armed Forces on active duty who move pursuant to a military order and incident to a permanent change of station.”

Expanded use of 529 account funds
The Act significantly expands the permitted use of Section 529 education savings account funds. “Qualified higher education expenses” include tuition at an elementary or secondary public, private, or religious school.

There are many other changes, but they are not in the mainstream.

Consider a consultation with Green Trader Tax to discuss the impact of the “Tax Cut And Jobs Act” on your investment activities.

Learn more about the new law and tax strategies for investors, traders and investment managers in Green’s 2018 Trader Tax Guide.


The Tax Cut Impacts Investors In Negative And Positive Ways

December 27, 2017 | By: Robert A. Green, CPA | Read it on

The Tax Cut and Jobs Act impacts investors in many ways, some negative and others positive. Investors with significant investment expenses will decry the suspension of that miscellaneous itemized deduction. Investors in pass-through entities may be surprised they might be entitled to a 20% deduction on qualified business income. These changes under the new law take effect in 2018.

Investment expenses suspended
The new law suspends “all miscellaneous itemized deductions that are subject to the two-percent floor under present law.” These include investment expenses, unreimbursed employee business expenses and tax compliance fees for non-business taxpayers. Miscellaneous itemized deductions are an AMT preference for 2017.

Investment expenses include trading expenses when the trader is not eligible for trader tax status (TTS), stock borrow fees and related costs for short sellers without TTS, and investment advisory fees and expenses paid to investment managers. TTS traders have business expense treatment, so qualification for that status is essential in 2018.

Investment expenses are still allowed as a deduction from net investment income for calculating the 3.8% Obamacare net investment tax. Retirement plans, including IRAs, are also entitled to deduct investment expenses, although it may be difficult to arrange with the custodian.

Family offices
A family office (FO) refers to a wealthy family with substantial investments, across multiple asset classes. The FO hires staff, leases office space, and purchases computers and other fixed assets for its investment operations. An FO produces investment income, and the majority of its operating costs are investment expenses. Losing the investment expense deduction comes as a shock to them. Some FOs are evaluating which activities might qualify for business expense treatment to convert non-deductible investment expenses into business deductions from gross income. Some FOs investing in securities and Section 1256 contracts might ring-fence an active trading program into a separate TTS entity for business expenses. Some of them are not natural TTS traders so that it will be a challenge. Other FOs invest in rental real estate and venture capital, which might have business expense treatment. The goal is to allocate general and administrative expenses to business expenses.

Investment interest expenses retained
The present law remains in effect for itemizing investment interest expense. Investment interest expense is deductible up to the extent of investment income. The excess is carried over to the subsequent tax year. (See Form 4952 and instructions.)

Short sellers
If a short seller does not qualify for TTS, the stock borrow fees are considered investment expenses. (Some brokers use the term “interest charges” — in reality,  these expenses are stock borrow fees. See Short Selling: How To Deduct Stock Borrow Fees.)

Interest expense modified
TTS traders have business interest deductions for margin interest on TTS trading positions. According to the new law, “The conference agreement follows the House in exempting from the limitation taxpayers with average annual gross receipts for the three-taxable year period ending with the prior taxable year that do not exceed $25 million.” A TTS trading company will likely not trigger the 30% income limitation on business interest expenses.

Carried interest modified
The new law changed the carried interest tax break for investment managers in investment partnerships, lengthening their holding period on profit allocation of long-term capital gains (LTCG) to three years from one year. If the manager also invests capital in the investment partnership, he or she has LTCG after one year on that interest. The three-year rule only applies to the investment manager’s profit allocation — carried interest. Investors still have LTCG based on one year. Investment partnerships include hedge funds, commodity pools, private equity funds and real estate partnerships. Many hedge funds don’t hold securities more than three years, whereas, private equity, real estate partnerships and venture capital funds do.

Investors also benefit from carried interest in investment partnerships. Had the new tax law repealed carried interest outright, investment partnerships without TTS would be stuck passing investment advisory fees (incentive fees) through on Schedule K-1 as non-deductible investment expenses. Carried interest fixes that: The partnership allocates capital gains to the investment manager instead of paying incentive fees. The investor winds up with a lower capital gain amount vs. a higher capital gain coupled with a non-deductible expense. For example, if the investor’s share of net income is $8,000, he or she is happy to report $8,000 as a net capital gain. Without carried interest, the investor would have a $10,000 capital gain and have a $2,000 (20%) non-deductible investment expense.

FIFO is not required
Senate and House conferees canceled the last minute and controversial proposal to require investors to use First-In-First-Out (FIFO) accounting on the sale of securities. FIFO is the default method, but sellers of securities may also use “specific identification.” Investors are entitled to cherry-pick securities positions they sell for capital gains. For example, if an investor sells a portion of Apple shares, he or she may select lots with higher cost basis to realize a lower capital gain. The specific identification method requires a contemporaneously written instruction to the broker and a written confirmation of that execution by the broker. Many taxpayers don’t comply with these rules. For sales of financial products other than securities (such as cryptocurrency), specific identification may not be possible.

Long-term capital gains rates retained
The new tax law maintains the LTCG rates of 0%, 15%, and 20%, and the capital gains brackets are the same for 2017 and 2018. LTCG rates apply if an investor holds a security for more than12 months before sale or exchange. The new law did not change the small $3,000 capital loss limitation against other income, or capital loss carryovers to subsequent tax years. The new law also retains LTCG rates on qualified dividends.

Section 1256 60/40 capital gains rates retained
The 60/40 capital gains rates on Section 1256 contracts are intact, and the new law did not mention any changes to the Section 1256 loss carryback election. At the maximum tax bracket for 2018, the blended 60/40 rate is 26.8% — 10.2% lower than the top ordinary rate of 37%. 

Wash sale loss rules and Section 475
The new law did not fix wash sale loss rules for securities in Section 1091. For more on this lingering issue, see Don’t Solely Rely On 1099-Bs For Wash Sale Loss Adjustments.

The new law does not make any changes to Section 475 MTM ordinary income or loss. It does not change tax treatment for various financial products including spot forex in Section 988, ETFs, ETNs, volatility options, precious metals, swap contracts, foreign futures and more.

Section 1031 like-kind exchanges restricted to real property
The new law limits Section 1031 like-kind exchanges to real property, not for sale. Investors may no longer use Section 1031 to defer income recognition on exchanges in artwork, collectibles, and other tangible and intangible property. Cryptocurrency (coin) is intangible property.

Before 2018, some tax experts indicated it might be possible to defer capital gains and losses on coin-to-coin exchanges as Section 1031 like-kind exchanges. The IRS never said Section 1031 could be used on coin-to-coin trades, and I don’t think it applied to coin-to-coin trading on coin exchanges. I don’t think coin exchanges meet the Section 1031 requirement to act as a qualified intermediary in a multi-party exchange. (See Cryptocurrency Traders Owe Massive Taxes For 2017.)

20% QBI deduction on pass-through entities
The new tax law states, “An individual taxpayer generally may deduct 20 percent of qualified business income from a partnership, S-corporation, or sole proprietorship, as well as 20 percent of aggregate qualified REIT dividends, qualified cooperative dividends, and qualified publicly traded partnership income. Special rules apply to specified agricultural or horticultural cooperatives. A limitation based on W-2 wages paid is phased in above a threshold amount of taxable income. A disallowance of the deduction with respect to specified service trades or businesses is also phased-in above the threshold amount of taxable income.”

The threshold is $315,000 (married) and $157,500 (other taxpayers), and the phase-out range is $100,000 (married) and $50,000 (other taxpayers).

As an example, a securities hedge fund eligible for TTS with Section 475 ordinary income may have qualified business income (QBI), and the hedge fund is likely a specified service activity (SSA). If a non-active limited partner has taxable income under $315,000 (married) or $157,500 (other taxpayers), he or she might get a 20% deduction on the partnership share of QBI or taxable income less net capital gains (whichever is lower). In the $100,000/$50,000 phase-out range above the income threshold, the QBI deduction phase-out. Some investors may exceed the phase-out, and not qualify for the deduction, but others may have lower income and be eligible for the deduction.

A passive investor in a non-SSA might be eligible for the 20% deduction above the income threshold, subject to a 50% wage limitation, or alternative 25% wage limitation plus 2.5% of the qualified property. The 20% deduction on pass-through entities applies to active, non-active and passive owners without distinction. (Learn more about the 20% pass-through deduction on my blog post How Traders Can Get The 20% QBI Deduction Under New Law.)

Obamacare net investment tax retained
The new law retained the Obamacare net investment tax (NIT) of 3.8% on net investment income (NII) over modified AGI of $200,000 single and $250,000 married, not indexed for inflation.

The Act suspends investment expenses as a miscellaneous itemized deduction on Schedule A, but it does not interrupt investment expenses for NII. Form 8960 Part II “Investment Expenses Allocable to Investment Income and Modifications” includes miscellaneous investment expenses, investment interest expenses, and state, local and foreign income taxes. The new law capped state and local income taxes on Schedule A at $10,000 per year, but there is no cap for these expenses on Form 8960. Continue to keep track of these costs.

Ordinary tax rates reduced
The new law lowered tax rates on ordinary income for individuals for almost all tax brackets and filing status. It decreased the top rate to 37% in 2018 from 39.6% in 2017. Short-term capital gains are taxed at ordinary rates, so investors receive this benefit.

Repeal of the recharacterization option for Roth IRA conversions
If a 2017 converted Roth account drops significantly in value in 2018, a taxpayer can reverse the Roth conversion with a “recharacterization” by the due date of the tax return including extensions (Oct. 15, 2018). That’s the last year to do a reversal. The new law repeals this recharacterization option starting in 2018.

Temporary tax cuts for individuals
The individual tax cuts are temporary through 2025, which applies to most provisions, including the suspension of investment expenses. Republicans probably expect Democrats to extend, or make permanent, the individual tax cuts before the 2026 midterm election year. President Barrack Obama made the President George W. Bush’s 10-year tax cuts permanent for all individuals, other than the upper 2%, in the fiscal cliff at the end of 2012. In 2010, Obama extended all Bush tax cuts to 2012.

Republicans in Congress forged the new tax law in haste. A technical corrections bill is already in the works, and Republicans may need Democrats to pass it through regular order. There will be surprises from the IRS in their regulations and guidance, too. Tax planning is difficult until all these issues become settled.

Consider a consultation with Green Trader Tax to discuss the impact of the “Tax Cut And Jobs Act” on your investment activities.

Learn more about the new law and tax strategies for investors, traders and investment managers in Green’s 2018 Trader Tax Guide.

 


Traders Should Be Entitled To The Pass-Through Tax Deduction

December 20, 2017 | By: Robert A. Green, CPA

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Congress passed the “Tax Cut and Jobs Act” (Act) on Dec. 20, and the President signed it into law on Dec. 22, 2017. The new law adopted the Senate Amendment for the 20% pass-through deduction, but it’s not clear how a trading company can use it. Traders should consider other smart moves as the Act suspended investment expenses, retained investment interest expense, and repealed NOL carrybacks.

Changes to pass through rules
The Conference Report (CR) decided on a 20% pass-through deduction vs. the Senate Amendment’s 23%. To meet the House halfway, the CR lowered the Senate’s taxable income (TI) threshold for “specified service activities” (SSA) to $157,500 single and $315,000 married. The CR retained the Senate phase-out range of $50,000 single and $100,000 married, above the TI threshold. For example, if an individual’s TI is over $207,500 single or $415,000 married, he or she won’t get any pass-through deduction on domestic “qualified business income” (QBI) in an SSA. But, individuals are entitled to a 20% deduction for QBI in a non-SSA at higher income levels, subject to the 50%-wage limitation above the threshold. (See examples in the Joint Explanatory Statement, p. 28-37.) The CR added an alternative wage limitation: 25% of wages plus 2.5% of “unadjusted basis, immediately after acquisition, of all qualified property,” which includes real estate and other tangible property. The House bill had a capital factor, which recognized investment in equipment.

I still have a few critical questions about the new law’s impact on TTS trading companies and TTS hedge funds.

1. Are TTS trading companies and TTS hedge funds an SSA?

In earlier posts, I thought a trading company was likely an SSA because “trading” is mentioned in the SSA definition.

The Joint Explanatory Statement definition of an SSA: “A specified service trade or business means any trade or business involving the performance of services in the fields of health, law, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities. For this purpose a security and a commodity have the meanings provided in the rules for the mark-to-market accounting method for dealers in securities (sections 475(c)(2) and 475(e)(2), respectively).”

I wonder if the following part of the SSA definition applies to a hedge fund: “the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners.” A one-person TTS trading company does not market to investors, so they don’t have a reputation or brand intangible asset, and this part of the definition should not apply to them.

A management company provides the performance of investing, investment management and trading services to a hedge fund. The hedge fund is the customer in receipt of those services. A management company is a general partner of the hedge fund organized as a limited partnership, and the general partner can bring TTS to the hedge fund level. An outside manager would not suffice for the hedge fund achieving TTS.

The Act’s definition of SSA is a bit different, p. 33-34 states: ‘‘(2) SPECIFIED SERVICE TRADE OR BUSINESS.—The term ‘specified service trade or business’ means any trade or business— (A) which is described in section 1202(e)(3)(A) (applied without regard to the words ‘engineering, architecture,’) or which would be so described if the term ‘employees or owners’ were substituted for ‘employees’ there in, or (B) which involves the performance of services that consist of investing and investment management, trading, or dealing in securities (as defined in section 475(c)(2)), partnership interests, or commodities (as defined in section 475(e)(2)).”

The “specified service activity” term and definition stress the “performance of services” listing various types of service providers. A one-person TTS S-Corp trades for its account; it does not perform trading services for customers.

Even if a hedge fund is considered a non-SSA, an active or non-active owner is unlikely to achieve a 20% pass-through deduction due to the 50% wage limitation, or the alternative 25% wage limitation plus 2.5% of the unadjusted qualified property. Hedge funds don’t pay wages, and they don’t own significant qualified property. The management company pays compensation and has business equipment; not the hedge fund.

If the IRS considers a TTS S-Corp a non-SSA, there would likely be a 20% pass-through deduction above the SSA income threshold. The TTS S-Corp pays officer compensation of $146,000 to maximize a Solo 401(k) contribution of $55,000 (under age 50, 2018 limit). The 50% wage limitation would be $73,000 (50% of $146,000). $73,000 divided by the 20% deduction is net income of $365,000 in the TTS S-Corp. A spouse might also receive compensation. The Act requires a taxpayer to calculate QBI and the wage limitations on each interest in a pass-through entity, separately.

2. Can TTS trading income, including Section 475 ordinary income, be treated as “qualified business income” (QBI)?

The pass-through deduction formula is very complicated. In rough summary, it’s a 20% pass-through deduction calculated on the lower of combined QBI from domestic sources or taxable income less net capital gains. (See the Joint Explanatory Statement, p. 28-40.)

The QBI exclusion list does not mention Section 475 ordinary income, so it seems appropriate to include it in QBI. Only a TTS trader may elect Section 475. I covered this issue in my blog post Section 475 Traders May Be Eligible For Pass-Through Tax CutsSteven Rosenthal, Senior Fellow, Urban-Brookings Tax Policy Center, weighed in then, and I confirmed this with him again after enactment of the Act: “Section 475 treats the gain as ordinary income,” he says. “Section 64 provides that gain that is ordinary income shall not be treated as gain from the sale of a capital asset.” Mr. Rosenthal thinks Section 475 ordinary income is QBI under the Act for this reason and “because it’s not on the QBI exclusion list.”

QBI should also include ordinary income on a rental real estate activity. The media quoted several tax experts saying rental companies should benefit from the pass-through deduction, which means they consider rental income to be QBI. Those tax experts implied rental real estate companies are likely non-SSA and the 2.5% qualified property factor will lead to more active and passive owners being eligible for the 20% pass-through deduction.

If investors in the rental real estate activity can achieve the pass-through deduction on a non-SSA, then TTS traders with Section 475 should have non-SSA with QBI treatment, too. One company invests in real estate, the other in securities, and both have ordinary income. Neither entity performs services for clients.

The CR used the Senate Amendment’s definition of “Treatment of investment income” — the QBI exclusion list (full list included below). The Senate Amendment and CR deleted “short-term capital gains” (STCG) from (1), but left “long-term capital gains and losses.” Oddly, the Act itself left in STCG to (1). Rushing may have led to errors.

The CR states an exclusion of “investment-related” items.  A TTS trader or TTS hedge fund has “business-related” activity. I wonder if this could open the door to a TTS trader or TTS hedge fund having QBI on short-term capital gains that are business related. Perhaps, business-related Section 1256 capital gains with 60/40 rates should be included in QBI, too. There is a 60% long-term capital gain portion, but it’s not “long-term capital gains” that are “investment-related.”

The 20% deduction is on the lower of QBI or modified taxable income less net capital gains. For example, if a trader has QBI consisting of all business-related capital gains, and it’s his only TI, then he won’t get a deduction since modified TI less net capital gains might be zero. If the trader has significant other income, it could be different.

It’s much better for a TTS trader to elect Section 475 to have ordinary income: It’s safer to assume QBI includes Section 475 and that modified TI does not subtract Section 475 ordinary income.

See the definition (5) below. Forex trading is “directly related to the business needs of the business activity.” Some forex traders might want to retain Section 988 ordinary income treatment rather than file a contemporaneous capital gains election.

CR “Treatment of investment income: Qualified items do not include specified investment-related income, deductions, or loss. Specifically, qualified items of income, gain, deduction and loss do not include (1) any item taken into account in determining net long-term capital gain or net long-term capital loss, (2) dividends, income equivalent to a dividend, or payments in lieu of dividends, (3) interest income other than that which is properly allocable to a trade or business, (4) the excess of gain over loss from commodities transactions, other than those entered into in the normal course of the trade or business or with respect to stock in trade or property held primarily for sale to customers in the ordinary course of the trade or business, property used in the trade or business, or supplies regularly used or consumed in the trade or business, (5) the excess of foreign currency gains over foreign currency losses from section 988 transactions, other than transactions directly related to the business needs of the business activity, (6) net income from notional principal contracts, other than clearly identified hedging transactions that are treated as ordinary (i.e., not treated as capital assets), and (7) any amount received from an annuity that is not used in the trade or business of the business activity. Qualified items under this provision do not include any item of deduction or loss properly allocable to such income.” 

How to proceed
For 2018, trader tax status (TTS) traders should consider a partnership or S-Corp for business expenses, and a Section 475 election on securities for exemption from wash sale losses and ordinary loss treatment (tax loss insurance). Consider a TTS S-Corp for employee benefit plan deductions including health insurance and a high-deductible retirement plan, since a TTS spousal partnership or TTS sole proprietor cannot achieve employee benefit deductions. Consider this the cake. It puts you in position for potentially qualifying for a 20% QBI-deduction on Section 475 ordinary income in a TTS trading pass-through entity – icing on the cake. If a TTS trader’s taxable income is under the specified service activity (SSA) threshold of $315,000 married, and $157,500 other taxpayers, he or she might get the 20% QBI-deduction in partnerships or S-Corps. QBI includes Section 475 ordinary income, and it excludes capital gains. It might be a challenge for a TTS sole proprietor to claim the pass-through deduction, because Schedule C has trading expenses, only, and trading gains are on other tax forms. Trading in a C-Corp could be costly.

If you are interested in this 20% deduction for a trading or non-trading business, I suggest a  consultation with me soon.


How Businesses Can Save Taxes For 2017 Before Year-End

October 16, 2017 | By: Robert A. Green, CPA

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The tax reform framework favors businesses by drastically cutting tax rates on corporations from 35% to 20% and pass-through entities from 39.6% to 25%. Pass-through entities (PTEs) include sole proprietorships, S-Corps, LLCs taxed as partnerships, general partnerships, and limited partnerships. These entities pass income and loss to the owner’s tax return. It’s wise for businesses to consider deferring income to take advantage of lower business tax rates in 2018 and accelerate business expenses to 2017. Even if Congress fails to pass tax reform, you’ll benefit from the time value of money.

Based on the tax reform framework, it’s uncertain if a trading business would be eligible for the lower PTE rate. There are nuances to consider for a trading business eligible for trader tax status (TTS) vs. a non-trading business. Officer compensation and employee benefit deductions work differently for S-Corps, partnerships, and C-Corps.

Officer compensation for a TTS trading business
I recommend an S-Corp structure for a TTS business to unlock employee benefit deductions including health insurance and retirement plans. You need to execute 2017 officer compensation with these deductions included before year-end, so don’t miss the boat!

W-2 wages should include health insurance premiums for 2% or more owners, which means the trader/owner and spouse if both provide services. (Attribution rules apply.) The health insurance premium component is not subject to payroll taxes. The S-Corp owner takes an AGI deduction for health insurance premiums on the individual tax return.

Some traders use a dual entity structure: A trading partnership and separate management company organized as a C-Corp or S-Corp. The management company should execute year-end payroll and health insurance deductions. A C-Corp management company may deduct health insurance premiums and health reimbursement accounts directly on the corporate tax return and don’t include it in payroll like the S-Corp. The trading partnership should pay administration fees to the management company before year-end.

Officer compensation for a non-trading business
The IRS requires S-Corps with underlying earned income (i.e., investment advisory fees or consulting fees) to have “reasonable compensation.” Current industry practice is 25% to 50% of net income before officer compensation. The IRS does not require a trading S-Corp to have reasonable compensation because it has underlying unearned income. However, the IRS does look for officer compensation on all S-Corp tax returns.

An LLC with earned income filing a partnership return or general partnership should use “guaranteed payments” for officer compensation. A partnership tax return with underlying earned income may arrange health insurance and retirement plan deductions in a similar manner to S-Corps. The IRS does not permit an investment company, not eligible for TTS, to have guaranteed payments and employee benefit deductions.

If the S-Corp, TTS or non-trading business, is profitable, consider a Solo 401(k) retirement plan contribution. Execute the 100% deductible elective deferral portion through officer compensation in payroll. This wage component is subject to payroll taxes.

Establish a high-deductible retirement plan
Eligible trading businesses and other businesses should consider a Solo 401(k) retirement plan. For 2017, S-Corp officer wages of $144,000 unlock the maximum $54,000 contribution/deduction or $60,000 if age 50 or older with the $6,000 catch-up provision. The 100%-deductible elective deferral up to $18,000, or $24,000 with the catch-up provision, provides the greatest income tax savings vs. payroll tax costs. You can set wages to cover the elective deferral amount, which limits payroll taxes. The 25%-deductible profit-sharing plan up to $36,000 is good if you have sufficient cash flow to invest in tax-free compounded growth within the plan.

Businesses that achieve consistently high income can arrange a $100,000+ contribution/deduction with a defined-benefit plan (DBP) if the owners are close to age 50. Business owners should work with an actuary on complex DBP calculations.

Solo 401(k) and defined benefit plans must be established before year-end, but you can do most of the funding in the new year. Setting up a DBP can take several weeks, so get started by early December.

Continue qualification for trader tax status
Traders should maintain eligibility for TTS as long as possible, whether as a sole proprietor, S-Corp, or partnership. If you formed a trading S-Corp mid-year 2017, it helps deflect potential IRS challenges if you continue into 2018.

Convert a 2017 wash sale loss into a 2018 ordinary loss
If you have wash sale loss deferrals at year-end on trading positions in your account, claim sole proprietor TTS for 2017 and 2018 if possible. A Section 475 election for 2018 will convert the wash sale loss deferral on TTS positions into an ordinary loss on Jan. 1, 2018. That’s much better than a capital loss in 2018.

The IRS said it might change the effective date of a Section 475 MTM election to “freeze and mark” the day it’s elected, rather than taking effect retroactively on Jan. 1. The IRS also said it might change the character of Section 481(a) adjustment (required for a Section 475 election) to capital gains and losses, rather than ordinary income or loss.

Accounting methods
Businesses may select an accounting method for recognizing the timing of revenues and expenses. Most small businesses choose the cash method, which reports revenues when collected and expenses when paid. It’s a more straightforward accounting system, providing flexibility in tax planning. Companies with inventory may or must use the accrual method, which records revenue when earned and expenses when incurred. Cash method taxpayers can defer gross revenues and accelerate expenses more easily than accrual method taxpayers.

Employees should talk to their employers about deferring their bonus to 2018. If you own a small business, consider postponing completion of client engagements and invoice them in 2018. Cash method taxpayers can hold off on collection efforts until 2018.

Be aware of the “constructive receipt of income” rules: If you receive income for services, you have to report it. (You cannot put a check in a drawer and report it later!) If a customer attempts to pay you for services and you decline receipt, it may be constructive receipt of income.

Maximize tangible property expenses (TPE)
Businesses can expense new tangible property items up to $2,500 per item, a great way to defer income. Purchase and begin using TPE items before year-end. Arrange separate invoices for each item not exceeding $2,500 and be sure to make the de minimis safe harbor election with your tax return filing.

Section 179 (100%) depreciation
For equipment, furniture and fixtures above the tangible property threshold ($2,500), use Section 179 depreciation allowing 100% depreciation expense in the first year. The Protecting Americans From Tax Hikes (PATH) Act of 2015 made permanent generous Section 179 limits. The 2017 limit is $510,000 on new and used equipment including off-the-shelf computer software. Buildings do not qualify for this deduction. The IRS limits the use of Section 179 depreciation by requiring income to offset the deduction. Look to business trading gains, other business income or wages, from either spouse, if filing jointly.

Additions and improvements to office
Consider an addition or improvements to your home office like constructing more space, replacing windows, walls, and flooring. Depreciate residential real property over 39 years on a straight-line basis. If you rent or own an outside office, depreciation rules are more attractive. PATH created “qualified improvement property” — a new class of nonresidential real property, excluding additions like increasing square footage. Use 50% bonus depreciation on qualified improvement property placed in service in 2017. PATH extended bonus depreciation through 2019.

Home office expenses
“Use or lose” an S-Corp accountable plan before year-end for reimbursing business expenses paid individually, including home office expenses. LLC Operating Agreements and partnership agreements may provide that partners should deduct home office expenses as “unreimbursed partnership expenses” (UPE) on their individual tax returns.

Capitalize expenses for a new business
If you plan to become eligible for TTS or another type of business in early 2018, consider capitalizing late-year 2017 purchases for business expense deductions in 2018. I suggest this strategy for Section 195 start-up costs including training and mentors, Section 248 organization costs for a new entity, and internal-use software including automated trading systems. Otherwise, you might not get any tax deduction for these items in 2017. (Learn more about these deductions in my blog post Top 10 Tax Deductions For Active Traders.)

Maximize net operating losses
If you have an NOL generated in 2017, try to enhance it as much as possible and consider the two-year NOL carryback option — an excellent way to achieve quick tax refunds. Earlier tax blueprints discussed repealing NOL carrybacks and retaining the 20-year NOL carry forward.

Avoid passive-activity losses on pass-through entities
Consider selling some passive loss activities to convert suspended tax losses carried over from prior years into realized losses in the current year. Alternatively, you could spend more time on the business to meet material participation requirements, which generate non-passive losses. Passive-activity entity income or loss is part of net investment income (NII) for calculating the 3.8% net investment tax, which applies to upper-income taxpayers (modified AGI of $200,000 single, $250,000 married, and not indexed for inflation).

Shifting income to family members with gifts and wages
The 2017 annual gift tax exclusion is $14,000 per person, per donor. The current tax reform framework repeals the federal estate tax starting in 2018, so the “unified credit” against the estate tax may become moot. The unified credit is reduced by annual gift amounts made over the gift tax exclusion. Twenty states currently have estate or inheritance taxes.

Shifting income to family members can be a smart strategy. Be aware of the “kiddie tax” rules, which limit the benefit of moving too much investment income to young children, including qualifying young-adult children.

Paying wages for teenage and adult children is an efficient way to avoid the kiddie tax rules, which apply to unearned income. According to IRS.gov, “Payments for the services of a child under age 18 who works for his or her parent in a trade or business are not subject to social security and Medicare taxes if the trade or business is a sole proprietorship or a partnership in which each partner is a parent of the child.” Also, you will save federal and state unemployment insurance and state workmen’s compensation on children under age 21.

Manage debt cancellation income (DCI) properly
DCI is excludable from gross income providing the debtor is insolvent or filed for bankruptcy. If you are not insolvent or bankrupt, try to defer DCI taxable income to 2018.

Stay tuned for tax reform developments
Wait for final tax legislation expected in November 2017 to see how the anti-abuse measures work on preventing wealthy business owners from recharacterizing their individual (personal) income as business income to qualify for lower PTE rates up to 25% vs. the top ordinary rate of 35%. Will tax reform allow a trading company, perhaps with Section 475 ordinary income, to use the lower business tax rate of 25% on pass-through entities? Will employee benefit plan deductions for health insurance and retirement plans continue? (Stay tuned on our blog and see How Tax Reform Framework Impacts Traders And Investors.)

See my last blog post How Individuals Can Save Taxes For 2017 Before Year-End.

If you have any questions on tax planning, contact your tax advisor for help. I’m encouraging our clients to sign up for our tax compliance service soon to begin year-end tax planning before Dec. 5, 2017.

Attend our Webinar or watch the recording after: How To Save Taxes For 2017 Before Year-End.


How Individuals Can Save Taxes For 2017 Before Year-End

October 14, 2017 | By: Robert A. Green, CPA

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Forbes

How Individuals Can Save On 2017 Taxes Before The End Of The Year.

October through December is an excellent time to consider year-end tax planning moves to save taxes for 2017. Once tax season gets underway in Q1 2018, it’s too late for these smart ideas.

As tax reform advances through Congress, it’s safe to assume your tax rates may be lower in 2018 and some of your expenses will likely be repealed to pay for tax rate cuts. It’s probably wise to use the time-honored strategy of deferring income and accelerating payments to deduct them while you can. Even if Congress fails to pass tax reform, you’ll benefit from the time value of money.

Repealing most itemized deductions
In exchange for lowering corporate tax rates, the tax reform framework repeals most itemized deductions for individuals starting in 2018. The two notable exceptions are deductions for mortgage interest expenses and charitable contributions. Tax reform compensates for middle-income folks by doubling the standard deduction. You should try to pay all 2017 expenditures before year-end to get the deduction while you can and reduce 2017 income.

The tax reform framework repeals “miscellaneous itemized deductions,” which include investment expenses, tax compliance fees and unreimbursed employee business expenses deducted on Form 2106. You should try to pay service providers for 2017 services by year-end. Traders who are eligible for trader tax status (TTS) have business expense treatment, bypassing miscellaneous itemized deductions.

Investment advisory fees, including management fees and incentive fees, are investment expenses, which face repeal in 2018. Brokerage commissions are not investment expenses. Transaction costs are adjustments to proceeds and cost basis, reflected in capital gains and losses. The current framework was silent about earlier blueprints to repeal carried-interest tax breaks for hedge fund managers. I expect these changes would impact the investment management industry, which may consider changes to business models to achieve better tax efficiency.

Employees should submit expenses to employers for reimbursement before year-end since accountable plans have “use it or lose it” rules. Under current law, miscellaneous itemized deductions are deductible above a 2% AGI threshold, and they are not deductible for AMT. If your employer doesn’t have an accountable plan, encourage them to consider one for 2017 and 2018.

Accelerate state and local tax deductions
The current tax reform framework repeals itemized deductions for state and local taxes including income, real estate, property and sales and use taxes. States without an individual income tax, including Texas, Florida, and Washington, have real estate and sales and use taxes. For 2017, you can elect to claim sales and use taxes as an itemized deduction instead of state income taxes. If you are thinking about buying an expensive item that is subject to sales and use tax, consider purchasing it before year-end. Accountants are looking into ways for a business to treat some state and local taxes as a business expense.

The tax reform framework repeals state and local tax deductions and AMT starting in 2018, so your best chance at a deduction might be to pay state and local taxes due by Dec. 31, 2017. This is a change from previous tax years when individuals may have postponed state and local taxes to avoid AMT. Be sure to check the latest developments on tax reform before you make this decision close to Dec. 31 since there is blowback on the repeal of state and local taxes, and I expect there could be changes.

Casualty loss deductions
The tax reform framework repeals the casualty loss itemized deduction for 2018, so try to complete your claims to support a 2017 tax deduction. The 2017 disaster tax relief bill for Hurricanes Harvey, Irma and Maria victims exempts qualified disaster-related personal casualty losses from the 10% AGI threshold. Victims don’t have to itemize; they can add this casualty loss to their standard deduction, and that part is deductible for AMT. (Hopefully, Congress applies this same relief to victims of the California wildfires.)

Maximize charitable contributions
You should make tax-deductible donations before year-end by check and credit card. Property donations of clothing, household goods, and appreciated securities can also be deducted. The itemized deduction is calculated based on fair market value (FMV), or another acceptable method. The FMV of clothing and household goods is usually a small fraction of the purchase price. When you deduct the FMV of appreciated securities, you avoid capital gains taxes. For charitable donations over $250, the IRS requires a written acknowledgment letter. Expect a reduction of the contribution amount based on the value of goods and services you receive, for example at a charity dinner.

The IRS permits individuals age 70½ or older to make charitable gifts up to $100,000 per person, per year, directly from their IRAs, and this generates several tax benefits. The strategy is more tax efficient than taking an income distribution and potentially losing some of the deduction with the Pease itemized deduction limitation for upper-income taxpayers or using the standard deduction. Avoiding an IRA withdrawal lowers AGI, which may unlock middle-income deductions and credits and avert net investment tax (NIT). The charitable donation amount also counts toward meeting the required minimum distribution (RMD) rule. You may not receive goods and services in connection with this donation from the IRA, other than an intangible religious benefit.

Other itemized-deduction limitations
Upper-income individuals should be aware of the 2017 Pease itemized deduction limitation, indexed for inflation: $261,500 single and $313,800 married filing joint for 2017. It wipes away many of your itemized deductions.

The AGI percentage threshold for medical expenses is 10%, and for miscellaneous itemized deductions it’s 2%. Investment interest expenses are limited to investment income, and an investment interest carryover likely won’t be beneficial in 2018 since tax reform repeals it.

Capital gains and net investment tax
The tax reform framework omitted capital gains tax cuts. Previous blueprints applied lower long-term capital gains rates to all capital gains, dividends and interest income, but I expect the current law to continue.

Many investors hoped Republicans would repeal the Obamacare 3.8% net investment tax (NIT) on unearned income, but they retained NIT in the healthcare bills and tax reform framework. Consider reducing income under the thresholds for triggering NIT (modified AGI of $200,000 single, $250,000 married, and not indexed for inflation), or defer net investment income to 2018. The repeal of investment expenses in 2018 will likely also repeal them as a deduction from net investment income (NII), used to calculate NIT.

Tax loss selling
A taxpayer with capital gains can reduce taxes by selling losing securities positions, realizing capital losses, before year-end. This continues to be a smart strategy in 2017, however, if you already have a $3,000 capital loss limitation, tax loss selling won’t help.

Wash sale loss adjustments
Be careful not to trigger a wash sale loss adjustment at year-end by buying back a substantially identical position 30 days before or after realizing a tax loss on a security. In a taxable account, a wash sale loss adjustment from December is deferred to January, adding the tax loss to the replacement position’s cost basis. It accelerates income, when your plan may be to delay income. Congress doesn’t want taxpayers to realize “tax losses” that are not “economic losses.”

If you realize a tax loss in an individual taxable account and buy back a substantially identical position in a traditional IRA or Roth IRA, you will never get the benefit of that tax loss. Avoid this catastrophic problem with “Do Not Trade Lists” between your IRA and taxable accounts.

In taxable accounts, avoid wash-sale loss adjustments at year-end by “breaking the chain.” Sell open positions and don’t get back into substantially identical positions for 30 days before and after selling them. For example, sell the entire position on Dec. 15 and don’t repurchase it until Jan. 16. In December, use trade accounting software to identify potential wash sale loss adjustments so you can break the chain before year-end.

Don’t solely look at a broker’s tax report or 1099-B for identifying potential wash sale losses. The IRS requires taxpayers to assess wash sales across all brokerage accounts, whereas, brokers only look at a single brokerage account. Brokers calculate wash sales based on an exact symbol (identical position), whereas, taxpayers must base wash sales on “substantially identical positions,” an equity and its equity options, at different expiration dates. Many active securities traders are surprised with big tax bills on April 15 because they mishandled wash sale losses at year-end.

Mark-to-market accounting
Section 1256 contracts, which include futures and broad-based indexes, and Section 475 trades for traders with trader tax status (TTS), are both mark-to-market (MTM) code sections. MTM imputes sales of open positions at year-end, so you are reporting realized and unrealized gains and losses. That negates the need to do tax loss selling. MTM comes with Section 1256 by default, and Section 1256 is capital gain and loss treatment.

Individual TTS traders had to elect Section 475 ordinary gain or loss treatment for 2017 by April 18, 2017, or have elected it in a prior year. Existing partnerships and S-Corps had to elect it by March 15, 2017. The next opportunity to file a Section 475 election is for 2018, or within 75 days of inception for a new entity. I call Section 475 “tax loss insurance” because it exempts traders from the capital loss limitation and wash sale loss adjustments.

Try to be eligible for middle-income tax benefits
Each of these tax breaks has different AGI phase-out ranges. Try to reduce your 2017 AGI to maximize deductions for education, and student loan interest, increase child care credits and the personal exemptions and lower AMT and NIT taxes. You may need to prepare a draft tax return to see where you stand on all these moving parts.

Avoid the highest individual ordinary tax rate
Upper-income individuals should try to avoid the top tax bracket of 39.6%, which starts at taxable income of $418,400 for single filers and $470,700 for married filers. The second bracket is 35%, which the tax reform framework uses as its top bracket for 2018. The tax reform framework empowered Congress to add back a higher top bracket for 2018 to ensure tax reform is progressive. Tax writers have not yet committed to the bracket income ranges, which could make all the difference.

Maximize use of the 0% long-term capital gains brackets
Long-term capital gain rate brackets correlate with ordinary rates for 2017. The 20% capital gains rate applies in the 39.6% ordinary-income tax bracket. The 15% capital gains rate applies to ordinary rates over 15% and under 39.6%. The 0% capital gains rate applies for the 10% and 15% ordinary brackets. If you are in the 10% and 15% ordinary tax brackets, try to sell long-term capital gains before year-end to take advantage of zero capital gains taxes. (State taxes may apply.)

There’s a long-term capital gains rate component in Section 1256 contracts: 60% long-term capital gains and 40% short-term capital gains. The blended 60/40 capital gains rate for the 10% bracket is 4%, and for the 15% bracket, it’s 6%. There is no sense in postponing income if you can pay such a low tax rate.

Arrange required minimum distributions
Take RMDs from traditional IRA, Solo 401(k) plan, and employer retirement plans. Commence RMDs by April 1 of the year following the calendar year in which you reach age 70½. Per IRS.gov, “If you do not take any distributions, or if the distributions are not large enough, you may have to pay a 50% excise tax on the amount not distributed as required.”

Avoid estimated tax underpayment penalties
Many traders and small business owners don’t pay quarterly estimated taxes in Q1, Q2, and Q3 since they might lose significant money in Q4, so strategies to avoid underpayment penalties are helpful. Consider increasing federal and state tax withholding on paychecks before year-end as the IRS and states treat W-2 tax withholding as being made throughout the year.

Fully fund health plans
If you have a health savings account, be sure to pay the maximum allowed contribution for 2017 before year-end. (Self-only is $3,400, family coverage is $6,750, and $1,000 catch-up contributions are allowed for age 55 or older.) Increase your employer’s health flexible spending account for 2018 if you had too little funding in 2017.

Income acceleration strategy
If you’re in a low tax bracket for 2017 and expect to be in a higher tax bracket for subsequent years, including retirement years, consider a Roth IRA conversion before year-end 2017.

This is often a wise move since Roth IRAs are permanently tax-free, whereas traditional IRAs are only temporarily tax-free. Be careful not to take early withdrawals from any of your Roth IRAs for at least five years, and before you reach age 59½, otherwise you may trigger taxation on nonqualified distributions. Roth IRAs are not subject to RMD rules, which apply to traditional IRAs and qualified plans. If the Roth IRA account substantially drops in value after the conversion date, you can reverse the conversion by Oct. 15, 2018.

In my next post, I cover year-end tax planning for businesses, including traders with trader tax status: How Businesses Can Save Taxes For 2017 Before Year-End.

If you have any questions on tax planning, contact your tax advisor for help. I’m encouraging our clients to sign up for our tax compliance service soon to begin year-end tax planning before Dec. 5, 2017.

Darren Neuschwander CPA contributed to this blog post.

Attend our Webinar or watch the recording after: How To Save Taxes For 2017 Before Year-End.

 


How Tax Reform Framework Impacts Traders And Investors

September 29, 2017 | By: Robert A. Green, CPA

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Forbes

On Sept. 27, the Big Six tax writers released an updated Unified Framework for tax reform making concrete steps forward on corporate and individual tax rates. As expected, they left many details and decisions to Congress on which deductions, credits, and industry-specific tax incentives to repeal to offset the massive reduction in tax rates granted to corporations and pass-throughs (PTE). Over the coming months, tax lobbyists will inevitably hover over tax writers like bees. Until we see the final bill, it’s hard to assess its impact on traders and investors.

Capital gains and investment income tax cuts retracted
I searched the nine-page framework document and was surprised not to find any mention of capital gains. I find that odd considering earlier blueprints promised investors lower capital gains rates on “all” capital gains, dividends, and interest income. “All” includes short-term capital gains and non-qualifying dividends. At first, I wondered if it was an oversight, or because they felt it was unworthy of inclusion in the overview. I became concerned they may have scrapped these tax cuts for traders and investors since they have to scale back some tax cuts for budget reconciliation. I confirmed my suspicions when I saw the following tweet after writing this article: Wall Street Journal tax journalist, “Richard Rubin (@RichardRubinDC) 9/28/17, 11:54 AM @SpeakerRyan on lack of capital gains tax cut: You just can’t do everything you want to do.”

Comparing the framework to earlier versions
BNA’s Comparison Chart of Trump Tax Plan and House Republican Blueprint is an excellent resource. According to “Savings and Investment Income” on p. 3:

Current law: “Long-term capital gain and qualified dividends taxed at rates of 0%, 15%, and 20%. (Top rate plus NIIT equals 23.8%.) Short-term capital gain, interest income and non-qualified dividends taxed at ordinary rates.”

Trump campaign tax plan: “Maximum rate of 20%.” (Current law.)

Trump administration tax reform outline: “Not specifically addressed.” (This omission was the first indication they were backtracking.)

House Republican Blueprint: “Deduction for 50% of net capital gains, dividends, and interest income, leading to rates of 6%, 12.5%, and 16.5%.” The House Blueprint A Better Way “provides for reduced tax on investment income. Families and individuals will be able to deduct 50% of their net capital gains, dividends, and interest income, leading to basic rates of 6%, 12.5%, and 16.5% on such investment income depending on the individual’s tax bracket.”

The new framework doesn’t mention any of these provisions. It only states: “The committees also may consider methods to reduce the double taxation of corporate earnings.”

The new framework omits mention of “carried interest” tax breaks for hedge funds and private equity firms. Does omission indicate they are backtracking on a repeal of this tax break? Perhaps not, as it may not have been worthy of mention since the broad statements about closing industry-specific tax breaks may include carried interest. Hedge funds and private equity have significant lobbying efforts in D.C. Carried-interest for hedge fund managers is like sweat-equity for founders of start-ups.

Pass-through vs. corporations
The new framework’s top tax rate for corporations is 20%, PTE 25%, and individuals 35%. Taxpayers and their advisers will want to consider reorganization to maximize tax benefits. It would be nice to know all this before year-end to reorganize by the start of 2018.

The framework narrowed the definition of which businesses may qualify for the PTE rate: “The business income of small and family-owned businesses conducted as sole proprietorships, partnerships and S corporations.” Traders, eligible for trader tax status (TTS), are small, family-owned businesses.

The framework also calls for measures to prevent abuse of the PTE rate: “the committees [i.e., Ways and Means, and the Senate Finance Committee] will adopt measures to prevent the recharacterization of personal income into business income to prevent wealthy individuals from avoiding the top personal tax rate.” We have to wait for the committees to define “wealthy” in this context. I hope the tax writers don’t consider TTS trading gains as personal income rather than business income.

When the prior framework was released, journalists jumped on the fact that individuals would recast themselves as PTE or corporations to avoid the higher individual rate. Independent contractors are already a significant trend for employers to avoid payroll taxes, unemployment insurance, and employee benefit plans. Employees like the business status to deduct business expenses, reducing income taxes and self-employment taxes.

Treasury Secretary Stephen Mnuchin recently suggested service companies, like accounting, law and financial firms, shouldn’t be eligible for the PTE rate. I disagree. Service companies could recast as software-to-service or house intellectual property in a corporation to collect royalties rather than service revenues. Congress should not be picking winners and losers and penalizing service companies who are stellar performers in the American economy with tremendous job creation. Congress should keep the PTE rules straightforward and easy to enforce in the interests of tax simplification.

Some tax writers floated the idea of a 70/30 split of wage income vs. business income as a way to prevent abuse. For example, if an S-Corp has a net income before officer compensation of $1 million, the IRS would require the owner/officer to have “reasonable compensation” of $700,000, subjected to the individual rate up to 35%. The net income of $300,000 would be business income subjected to the PTE rate up to 25%.

With this labor/capital split, the effective PTE rate would be 32%.

This is calculated as follows: (70% wages x 35% individual rate) + (30% business income x 25% PTE rate) = 32% (only 3% less than the top individual rate of 35%). The Obamacare Medicare surcharge of 3.8% applies on the $700,000 of wages, which could negate much of the PTE tax benefit in an S-Corp. With a 70/30 split, many taxpayers may not find much tax savings using a PTE. If the committees use percentage allocation, I hope it’s more like 50/50. Perhaps, a corporation is better.

A trading S-Corp only wants enough officer compensation to unlock a retirement plan deduction, and IRS rules for reasonable compensation don’t apply since the entity does not have earned income. We don’t know yet how tax reform may impact trading companies. If they must use a 70/30 split, traders might have to report more compensation than they want, which triggers more payroll taxes and the individual rate. We don’t even know if the IRS will allow traders to be eligible for the PTE rate on trading income including Section 475 ordinary income. We also need to confirm that retirement plan and health insurance deductions will still be permissible for trading companies in 2018.

There is another glaring omission in the new framework: the health insurance premium deduction in a PTE. The framework repeals medical itemized deductions, but it does not address health insurance premiums deducted from adjusted gross income (AGI). “The framework retains tax benefits that encourage work, higher education and retirement security.” In prior blueprints, they included health insurance premiums next to retirement deductions.

I don’t expect the final bill to address trading businesses, as current law is shy on these issues, too. The IRS has to codify the legislation and write regulations, and that will take a long time. Traders should consult their CPAs and tax attorneys.

With reasonable compensation rules for a PTE, and perhaps none for a corporation, it could make the corporate structure more attractive. The devil will be in the details of final legislation, and tax writers better carefully think out incentives and “Freakonomics,” how incentives sometimes have the reverse effect. To date, corporations have been a bad choice of entity for a trading business due to double taxation, no pass-through of trading losses and expenses, no lower 60/40 rates in Section 1256, and more. Corporations have been good as management companies.

Budget reconciliation
Congressional tax writers are under enormous pressure to whittle down earlier vows to squeeze trillions of dollars in tax cuts into a 1.5 trillion-deficit placeholder negotiated for the 2018 budget. They scheduled the budget vote for Oct. 5, 2017. The Big Six plan to use “budget reconciliation,” affording them a majority vote procedure for Senate Republicans to pass tax reform and cuts without any support from Democrats.

Senator John McCain (R-AZ), who voted “no” on both health care repeal and replace bills, said the main reason was he wants “regular order” which requires a bi-partisan 60-vote cloture vote, and he recently said the same goes for tax reform. Senator Bob Corker (R-TN) told reporters, “What I can tell you is that I’m not about to vote for any bill that increases our deficit, period.”

In a letter to Republican leaders, 45 of the 48 Democratic senators requested bi-partisan negotiations, stating Republicans should not use budget reconciliation to pass tax reform. Democrats wrote they wouldn’t support tax cuts for the top 1% and they don’t agree on deficit-financing to pay for tax cuts.  Despite President Trump’s rhetoric about tax cuts not helping him and his family, and other billionaires in the top 1%, it’s not the case.

The effective tax rate for billionaires is close to the long-term capital gains rate of 20%, 15% before 2013. Long-term capital gains are their primary source of income, as many don’t take much compensation. These billionaires pay AMT because the AMT rate of 28% is higher than the long-term capital gains rate. To limit AMT and avoid estate taxes, many billionaires contribute significant amounts of their net worth to charity. The framework repeals AMT and estate tax, which is a massive tax cut for billionaires, including President Trump and his family. The framework doesn’t mention “step-up in basis” rules where heirs can avoid capital gains taxes. Billionaires and the wealthy own valuable corporations and pass-through entities so they will get lower tax rates on that front, too.

AMT and state and local taxes
If Congress repeals AMT, the second tax regime intended to ensure that wealthy taxpayers pay their fair share, it makes sense to repeal state and local taxes, which are one of the largest AMT preference items. To repeal the deduction alone would unlock much greater deductibility since AMT would no longer put a cap on it. That would wind up being a tax cut, rather than a tax increase, as intended. There’s already been significant blowback from members of Congress in high-tax states. Leadership is bending to that pressure. Will a tax increase turn into a tax cut on this measure? Or, will tax writers retain state and local tax deductions and AMT, too. Closing this deal will be tough.

There are a few other things I don’t like about the new framework. As with previous blueprints, it’s heavy on marketing content to convince working people that tax reform is for them rather than wealthy individuals and companies. I don’t like the double-talk. For example, the framework makes a big deal about lowering the top individual tax rate to 35%, but then it empowers tax writers to add a new higher rate without giving any details. It states it’s converting to a “territorial tax system” from a “worldwide tax system,” no longer taxing American companies abroad, but then it introduces a minimum tax on global income.

Timing and tax planning
The framework’s only retroactive provision is “full expensing,” active on the framework-date of Sept. 27, 2017. Other provisions won’t take effect until 2018. The Big Six is encouraging businesses to purchase equipment and other deductible assets before year-end to spur growth in the economy. It will help them argue growth pays for the tax cuts rather than deficit spending. The budget gives Republicans in both the House and the Senate a deadline of Nov. 13 to release legislative text on tax reform.

I am anxious to read final tax reform legislation so we can start crunching numbers to determine the winners and losers and help clients with tax planning for 2018. There will be surprises in the outcomes, “believe me.”

Taxpayers should commence 2017 year-end tax planning with the assumption that Obamacare taxes remain in place, only tax reform’s “full expensing” may start Sept. 27, 2017, and otherwise, tax reform, if passed, won’t be active until 2018.


Tax Reform Is Uncertain So Reconsider Your Investment Strategy

August 31, 2017 | By: Robert A. Green, CPA

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Read Robert’s blog post on Forbes.

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Many American taxpayers are tracking developments in tax reform plans, yet it’s uncertain if it will happen. Consider the adage: “Don’t let the tail wag the dog.” The tail is tax reform, and the dog is your investment strategy.

Some invested in the “Trump trade” — a surge in market prices based on perceived corporate tax cuts and deregulation — and they are waiting to sell winning positions after they expect Congress to lower tax rates. Companies are deferring revenues and accelerating expenses to postpone income to 2018 when lower tax rates may apply.

So, what’s an investor to do during this time of uncertainty? If you feel market conditions are right for selling individual securities or other financial instruments, then you should sell. Don’t wait for lower tax rates, which may not be as good as expected, or not come at all.

Long-term vs. short-term capital gains
The 2017 tax rates on long-term capital gains, held 12 months, are reasonable by historical standards. In the 10% and 15% ordinary tax brackets, long-term capital gains rates are 0%. In the 25% through 35% brackets, the long-term rate is 15%, and in the 39.6% bracket, it’s 20%. In Trump’s tax plan, the top long-term capital gains rate is 20%, and in the House plan, it’s 16.5%. If an investor holding a long-term capital gain believes the price may decline soon, they should consider selling that position in 2017 because a 2018 capital gains rate may not generate tax savings. It would create tax deferral for one year.

Conversely, investors holding short-term winning positions under 12 months may prefer to wait and see if tax reform delivers lower capital gains rates on short-term capital gains. The House Republican Blueprint stated: “Deduction for 50% of net capital gains, dividends, and interest income, leading to rates of 6%, 12.5%, and 16.5%.” Current law subjects short-term capital gains, interest income, and non-qualified dividends to ordinary rates. I expect Congress to clarify this issue along with other details in September and October. (See Comparison Chart of Trump Tax Plan and House Republican Blueprint.)

Investors should try to avoid wash sale loss adjustments on securities at year-end. Wash sales can increase capital gains subject to 2017 tax rates and postpone losses to 2018 when lower rates may apply. (A wash sale loss occurs when an investor realizes a capital loss and buys back a substantially identical position 30 days before or after. The loss is added to the replacement position’s cost basis.)

Deferral of capital gains is not possible for investors using Section 1256 MTM on futures, broad-based indexes, and non-equity options. It’s also not possible for traders in securities using Section 475 MTM. (Mark-to-market accounting reports realized and unrealized gains and losses.)

Obamacare net investment tax
It’s uncertain if Congress will repeal the Obamacare 3.8% net investment tax (NIT) for funding Obamacare expenditures. The Obamacare repeal and replace bill included a repeal of NIT, but that bill failed in the Senate. Although tax reform plans include repeal of NIT, it might survive final negotiations in pursuit of making tax reform revenue neutral. Only the wealthy (the upper 2% of Americans) pay NIT. It’s not a business tax cut that Republicans can argue spurs job creation. President Trump doesn’t want Congress to give up on a new Obamacare repeal and replace bill.

Decision-making example
If you sell a security for a $100,000 capital gain in 2017 and owe the top long-term capital gains rate of 20% and the 3.8% NIT, your federal tax liability is $23,800. That leaves you with $76,200 (assuming there is no state tax). If tax reform fails entirely or comes up short of expectation, the Trump trade could reverse course. Investors might then sell positions at lower prices, yet similar tax rates may apply.

Tax reform may be a massive tax cut on short-term capital gains, so investors may want to wait for details including legislative language to clarify this question. Traders in securities include day traders and swing traders, and they are not going to modify their holding periods for tax reasons.

Selling tax reform to the American people
It’s going to be a challenge for the White House and Congress to sell the American public on the need for tax reform including massive tax cuts at a time when many U.S. public companies have high net profits after tax and record-high stock prices. The proposals provide similar tax cuts to wealthy business owners operating through pass-through entities including LLCs, partnerships, and S-Corps.

Supporters say the tax cuts will bring economic growth because companies will invest their tax savings in U.S. job creation and wage hikes. But, opponents say this is wishful thinking: The current productivity trend is for U.S. companies to invest in robots and other automation, replacing human workers. Plus, the offshoring trend continues to make sense, given record low U.S. unemployment rates and considering that the House dropped its controversial border adjustment tax. Both sides will present studies buttressing their position.

President Trump held a pep rally for tax reform in Missouri on Aug. 30. The president argued that tax reform helps businesses, which will surely use the savings to hire workers, raise wages, and increase paychecks. The White House said it wants employees to see bigger paychecks starting in January 2018, which will help when they turn out for the mid-term elections in November 2018.

But, the most significant tax most middle-income employees have on paychecks is payroll taxes, not income taxes. The payroll tax has two components: 12.4% social security up to the SSA base amount, and 2.9% Medicare without any limit. Congress raises the SSA base most years: For 2017, the SSA base is $127,200, up 7% from $118,500 in 2016. That translates to a tax hike of $1,079 for 2017. In 2007, the SSA base was $97,500. If Republicans want to help workers as they say, why don’t they reduce payroll taxes?

President Trump and Treasury Secretary Steven Mnuchin say tax reform with tax cuts will spur growth rates to more than 3% for many years. Many economists disagree, although the government just revised up the Q2 2017 growth rate to 3%, and that’s an outlier over the past decade. When Congress’s independent body, the CBO, scores the tax cut bill, it probably won’t use dynamic scoring with 3% growth rates over a prolonged period. Tax cuts are likely to be scored as revenue negative, which means they incur deficit spending.

If you take away the tax cuts for business and just simplify the tax code by closing many loopholes and deductions, there may not be as much support for the bill.  There are lots of winners and losers in tax reform, including voters in high-tax states losing state and local tax deductions.

Democrats claim Republican tax reform proposals focus on tax cuts for the wealthy. Senate Minority Leader Chuck Schumer (D-NY) indicated Congressional Democrats and Independents might oppose an increase in the debt ceiling if it’s used to finance tax cuts for the wealthy.

The details are missing, and it’s getting late
Treasury Secretary Mnuchin and National Economic Council Director Gary Cohn promised more information on tax reform in September with passage promised before the end of 2017. Let’s see what legislative language they and the other Big Six tax writers offer in September and October with a crowded legislative calendar including the 2018 budget, increase in the debt ceiling, and several emergency measures including Hurricane Harvey and North Korea.

The expected pathway for tax cuts is Senate budget reconciliation, where Senate rules allow a 51-majority vote, rather than 60 votes needed for cloture (moving forward). Without any Democrats expected to support the Republican bill, the Senate can’t get to 60 votes required for the regular procedure. Using budget reconciliation requires the provision to balance. Otherwise, it’s temporary (sunsets) in 10 years. President Trump has berated Senate Majority Leader Mitch McConnell to change Senate rules, but McConnell won’t budge, so far. Ten-year tax cuts are good for some, but some corporations may not want to build new factories considering that a new Congress and President could repeal and replace these tax cuts.

As we learned with the failure of the majority vote for the Obamacare repeal and replace bill, it only takes three of the 52 Republican senators to vote a bill down if there is no support from Democrats or Independents. Uncertainties and speculation surround the upcoming vote on tax reform, but one thing is sure: We all must be ready for a September and October showdown. Don’t count your tax cut chickens until they hatch and keep an eye out for the Trump trade.

 


Traders Need Fair Tax Reform

August 7, 2017 | By: Robert A. Green, CPA

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Please sign our petition: Traders Need Fair Tax Reform

Forbes

A Tax Reform Wish List For Traders

Dear U.S. Senate, House of Representatives, Treasury Secretary Steven Mnuchin and National Economic Council Director Gary Cohn:

As you deliberate on tax reform, I ask that you consider the needs of traders.

There are hundreds of thousands of small-business traders around the country and probably tens of thousands in your state. Traders provide for their families and pay billions in taxes. One of the brightest stars of the economy is America’s financial market, and as market makers providing liquidity, traders earn their share of America’s success.

Here’s a prioritized list of traders’ needs in tax reform:

• Trader tax status: The tax cornerstone is “trader tax status” (TTS), which delivers business expense treatment. To be eligible for TTS, a trader needs about four trades per day, four days per week with holding periods under 31 days. There are other factors explained in IRS Pub. 550. Please safeguard trading business expenses.

• Section 475 MTM: In 1997, Congress expanded Section 475 to traders in securities and commodities. Use of Section 475 requires eligibility for TTS. MTM (mark-to-market accounting) imputes sales of open positions at year-end, so the taxpayer reports realized and unrealized gains and losses. MTM is the epitome of “tax simplification,” doing away with complicated rules for wash sale loss adjustments, straddles losses, and tax deferral. Also, Section 475 trades are exempt from the $3,000 capital loss limitation against other income. Please safeguard the use of Section 475 MTM for TTS traders, make it easier to elect, and apply it to most financial instruments.

• Section 1256 MTM: Futures and other Section 1256 contracts are subject to MTM reporting with lower 60/40 tax rates. Section 1256 does not require TTS or an election; all investors use it by default. I ask that you consider bringing more financial instruments into Section 1256 MTM and safeguard this code section in tax reform.

• Lower tax rate on business income: One of the most significant tax reform proposals is a lower tax rate on “business income,” applied to corporations and pass-through entities (PTE). It’s vital to include PTE as most small businesses operate as a PTE. Please prevent discrimination against a trading business PTE with TTS and Section 475 MTM ordinary income; it deserves the lower tax rate on business income just like other small businesses.

• Lower tax rate on investment income: Tax reform proposals include a lower tax rate on investment income. Alternatively, the House proposed a 50% exclusion of investment income taxed at ordinary rates. These proposals include all capital gains, dividends, and interest income. Current law limits a lower capital gains tax rate to long-term capital gains and qualified dividends. Please support extending the lower rate or 50% exclusion to all capital gains.

• Net operating losses (NOLs): One tax reform proposal repeals the two-year NOL carryback, retaining the 20-year NOL carry forward. Please don’t support this change as it defeats the primary purpose of NOL law. When a small business incurs a substantial loss generating an NOL, the business is likely dependent on a quick NOL carryback tax refund to replenish itself and retain its employees.

• Cost-basis reporting: In 2011, Congress implemented cost-basis reporting rules, beefing up broker 1099Bs to include cost basis and holding period information on securities. But, there’s a problem: IRS wash-sale loss adjustment rules for brokers differ from rules for taxpayers. (Wash sale definition: If a taxpayer buys back a losing position 30 days before or after, the IRS wants the tax loss deferred to the replacement position.) Most taxpayers and their tax preparers are not compliant with taxpayer rules; they cut corners relying on broker 1099Bs. One way to alleviate this problem is for Congress to expand the use of Section 475 MTM and Section 1256 MTM, which exempts those trades from wash sale loss adjustments.

Traders support tax reform legislation, and they respectfully request your consideration of these important issues that will affect their small businesses.

Thank you for your time.


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