Category: 2017 Tax Cuts and Jobs Act (TCJA)

2017 Tax Cuts and Jobs Act and related IRS regulations

How Covid-19 Tax Relief & Aid Legislation Impacts Traders (Updates)

May 31, 2020 | By: Robert A. Green, CPA | Read it on

Tax tips for the July 15 deadline, extensions, 475 elections, NOL carrybacks, CARES relief, and more.

Update June 29: “IRS today announced the tax filing and payment deadline of July 15 will not be postponed. Individual taxpayers unable to meet the July 15 due date can request an automatic extension of time to file until Oct. 15 – it is not an extension to pay any taxes due. For people facing hardships, including those affected by COVID-19, who cannot pay in full, the IRS has several options available to help.” (See Taxpayers should file by July 15 tax deadline; automatic extension to Oct. 15 available.)

Watch our Webinar or recording Last-Minute Tax Tips & Extensions For Traders.

Original post

Congress postponed the tax filing and payment deadline from April 15 to July 15, 2020, for 2019 individual tax returns, extensions, and 2020 elections (i.e., Section 475). That’s good news for sole proprietor traders.

The July 15 deadline also applies to calendar-year 2019 C-Corps, U.S. residents abroad, estates, trusts, gift tax returns, information returns, IRA, and HSA contributions originally due April 1, or later.

Partnerships and S-Corps
Calendar-year 2019 partnership and S-Corp tax returns and 2020 Section 475 elections for partnerships and S-Corps were due March 16, 2020. These pass-through tax returns and entity 475 elections are not eligible for the July 15 postponement deadline because the March 16 deadline was before April 1. IRS virus relief guidance mentions pass-through entities, but that’s for a fiscal-year partnership or S-Corp tax return due on or after April 1, 2020.

Traders have calendar-year partnerships and S-Corps, so their entities are not eligible for the July 15 postponement relief. Some asked our firm if their existing partnership or S-Corp could take advantage of the postponed deadline for making a 2020 Section 475 MTM election. The answer is no.

Extensions for individual taxpayers
If you need more time to file your 2019 individual income tax return, file an automatic extension (Form 4868) for three additional months until October 15, 2020.

If you cannot pay the taxes you owe for 2019, then it’s essential to file the one-page extension to avoid IRS late-filing penalties of 5% per month for up to five months. The IRS charges this penalty based on the tax balance due. On Form 4868, enter your estimate of total tax liability for 2019, total 2019 payments, including overpayment credits, balance due, and the amount you’re paying. “If your return is more than 60 days late, the minimum penalty is $330 (adjusted for inflation) or the balance of the tax due on your return, whichever is smaller.” Even if you cannot pay any amount due, filing the extension on time avoids the late-filing penalty.

The IRS also charges late-payment penalties if the taxpayer does not pay at least 90% of their 2019 tax liability by the postponed deadline of July 15, 2020. The late-payment penalty is 0.5% per month, for up to five months, for a maximum of 2.5%. It’s ten times less than the late-filing penalty. For example, if the taxpayer owes $50,000 by July 15 but doesn’t pay it until October 15, 2020, the total penalty is $750 (three months of 0.5% equals 1.5% times $50,000).

The IRS allows the taxpayer to request abatement of late-payment and late-filing penalties based on a “reasonable cause.” Contracting coronavirus in your family or being negatively impacted by the virus might constitute a reasonable cause. “Attach a statement to your return, fully explaining the reason. Don’t attach the statement to Form 4868.”

The IRS calculates penalties and interest based on the tax payment paid after July 15.

The current interest rate on late payments is 4.5%, and the IRS does not forgive interest charges.

2020 estimated taxes
Treasury also postponed Q1 and Q2 quarterly estimated tax payments for 2020 until July 15, 2020. The original due dates were April 15 for Q1 and June 15 for Q2. Third and fourth quarters keep their original due dates of September 15, 2020, and January 15, 2021, respectively.

Mark your payment memo “2020 Form 1040-ES,” so the IRS does not confuse it with 2019 tax payments. Consider overpaying the 2019 extension, planning for an overpayment credit to apply to 2020 estimated taxes.

States also postponed the deadline
All states with a personal income tax have extended their April 15 due dates. See AICPA state filing conformity chart that they update.

Check if your state is decoupling from CARES, such as for NOL carrybacks. That’s happened in prior stimulus legislation.

Consider a section 475 election by July 15
If you have 2020 YTD trading losses and are eligible for trader tax status (TTS) as a sole proprietor, consider a 475 election on securities and or commodities due by July 15, 2020, the postponed tax deadline. Many traders have massive trading losses in 2020, and they desperately need a 475 election for ordinary loss treatment to unlock NOL carryback refunds.

Section 475 ordinary losses offset all types of income, which navigates around the $3,000 capital loss limitation. Section 475 securities trades are also exempt from wash-sale loss adjustments, which can create phantom income and capital gains taxes. I call Section 475, “tax loss insurance.” I generally recommend 475 for securities only to retain lower 60/40 capital gains rates on commodities (Section 1256 contracts). Section 475 does not apply to segregated investment positions so that you can enjoy deferral and long-term capital gains treatment, too.

There’s also a 20% QBI deduction on 475 income, net of TTS expenses. QBI excludes capital gains and portfolio income. Trading is a “specified service activity,” so you must be under the taxable income threshold of $326,600/$163,300 (married/other taxpayers) for 2020 to be eligible for the QBI tax deduction on TTS/475 income.

Be careful to follow the election rules properly. Attach a 2020 Section 475 election statement to your 2019 individual income tax return or extension filed by July 15, 2020.

E-filing an extension is convenient, but taxpayers cannot attach an election statement to an e-filed extension. Print the extension, attach the election, and mail or fax them together to the IRS.

If you are ready to file your tax return by July 15, there might be a problem: Most tax preparation software programs for consumers don’t include 475 elections. Either mail the 2019 tax return with 2020 Section 475 election statement attached, or e-file the tax return and send the election to the IRS separately by July 15. (See an example election statement and information about Form 3115 in Green’s 2020 Trader Tax Guide, chapter 2.)

CARES allows five-year NOL carrybacks
Starting with the 2018 tax year, TCJA repealed two-year NOL carrybacks and only allowed NOL carryforwards limited to 80% of the subsequent year’s taxable income. TCJA introduced the “excess business loss” (EBL) limitation, where aggregate business losses over an EBL threshold ($500,000 for married and $250,000 for other taxpayers for 2018) were considered an NOL carryforward. TCJA deferred losses into the future.

CARES suspended TCJA’s EBL limitation for 2018, 2019, and 2020. It also allows five-year NOL carrybacks for 2018, 2019, and 2020 and/or 100% application of NOL carryforwards.

Business owners should consider amending 2018 and 2019 tax returns to remove EBL limitations and consider five-year NOL carryback refund claims. It’s too late to elect 475 ordinary loss treatment for 2018 and 2019; a 2019 Section 475 election was due April 15, 2019. 2020 NOL carrybacks must wait until 2021 unless Congress speeds up that process with more virus legislation.

Businesses have until June 30, 2020, to file a 2018 Form 1045 (quickie refund) for a 2018 NOL carryback. They should get moving on these NOL carrybacks ASAP. Otherwise, they need Form 1040-X, which allows the IRS more time to process the refund.

TTS traders with Section 475 ordinary losses and those without 475 but who have significant NOLs from expenses (i.e., borrow fees on short-selling) should consider NOL carrybacks. If Congress changes the rules again (see below), your refund claim should be respected by the IRS as you filed based on current law in effect at the time.

The House passed new virus legislation
The House recently passed new virus legislation, backtracking on CARES business loss relief. However, the Senate rejected taking up this new House legislation. The House law restricts taxpayers to carry back NOLs from 2019 and 2020 only to tax years beginning on or after January 1, 2018.

The House legislation retains EBL limitations for 2018, 2019, and 2020 and it lifts the SALT limitation for 2020 and 2021. Proponents of the House bill argued that CARES business loss relief mostly benefits the wealthy. Proponents of CARES claim small businesses, plenty of which are not wealthy, need NOL carryback refunds to replenish their capital to remain in business — a goal for virus relief. Opponents of the House bill say lifting SALT helps mostly upper-income taxpayers. Pundits expect Congress to enact more virus legislation, so stay tuned.

CARES tax relief and economic aid
CARES offered tax relief and economic aid to employees, independent contractors, sole proprietors, and other types of small businesses. However, traders don’t fit into usual categories, so there are issues in applying for some CARES tax relief and aid.

Traders generate “unearned income,” and the CARES Act focuses on “earned income” (jobs). Traders eligible for trader tax status (TTS) operating in an S-Corp might be able to receive state and federal unemployment benefits if they close their trading business due to the negative impact of the pandemic.

TTS traders don’t qualify for a loan under the SBA Paycheck Protection Program (PPP), or any other SBA loan because trading is considered a “speculative business,” which the SBA bars from its lending programs.

TTS traders might be eligible for NOL carrybacks, relaxed retirement plan distributions, and recovery rebates.

Taxpayers negatively impacted by Covid-19 can take a withdrawal from an IRA or qualified retirement plan of up to a maximum of $100,000 in 2020 and be exempt from the 10% excise tax on “early withdrawals.” The taxpayer has the option of returning (rolling over) the funds within three years or paying income taxes on the 2020 distribution over three years. CARES also suspended required minimum distributions for 2020.

Here’s an example
My client, Josh, was recently laid off due to Covid-19. He is collecting state unemployment insurance plus federal pandemic relief of $600 per week. Josh is eligible for the $100,000 early withdrawal from his employer 401(k), and he can pay taxes or roll it over during the following three years, depending on how things work out. Josh plans to use a 401(k) early withdrawal of $50,000 to finance a new TTS sole proprietorship.

Josh’s TTS Schedule C does not conflict with his unemployment insurance benefits because he is buying and selling capital assets and not collecting a salary. Josh plans to submit a Section 475 election on securities only for 2020, due by July 15, 2020. He wants tax loss insurance and to be eligible for a 20% QBI deduction.

Next year, after Josh’s unemployment insurance ends, he might form a TTS S-Corp to have a salary in December to unlock health-insurance and retirement-plan deductions. S-Corp salary would conflict with unemployment insurance. (It’s always best to check with your state.) The financial markets are highly volatile in 2020, so there’s an opportunity for traders, especially with zero commissions. Josh operates his trading business from home, where he is safer from the pandemic. Brokers have reported strong growth in new trading accounts.

See blog posts:
April 15 Tax Deadline Moved To July 15 (Live Updates)
Massive Market Losses? Elect 475 For Enormous Tax Savings
How Traders Should Mine the CARES Act For Tax Relief & Aid
Tax Extensions: 12 Tips To Save You Money
IRS Coronavirus Tax Relief

Darren Neuschwander CPA contributed to this blog post.

 

How Traders Should Mine the CARES Act For Tax Relief & Aid

April 10, 2020 | By: Robert A. Green, CPA | Read it on

The CARES Act provides tax relief and economic aid to employees, independent contractors, sole proprietors, and other types of small businesses. However, traders don’t fit into usual small-business categories, so there are issues in applying for some CARES aid.

Traders eligible for trader tax status (TTS) operating in an S-Corp might be able to receive state and federal unemployment benefits. TTS S-Corps might not qualify for a forgivable loan under the Small Business Administration Paycheck Protection Program because trading is a “speculative business.” TTS traders structured as sole proprietors, partnerships, or S-Corps might be eligible for five-year NOL carrybacks, relaxed retirement plan distributions, and recovery rebates.

A trader’s capital gains and Section 475 ordinary income are different from wages, earned income, and self-employment income (SEI) required for many of the business-related benefits under CARES. TTS sole proprietors report business expenses on Schedule C, but trading gains and losses go on other tax forms, including Schedule D (capital gains and losses) or Form 4797 (Section 475 ordinary gain or loss). In the eyes of government agencies, trading generates investment income derived from the sale of capital assets; it’s not a usual small business with revenue.

State and federal unemployment benefits
CARES provides Federal Pandemic Unemployment Compensation (FPUC). The Department of Labor says, “states will administer an additional $600 weekly payment to certain eligible individuals who are receiving other benefits.” CARES also gives states the option of extending unemployment compensation to independent contractors and other workers who are ordinarily ineligible for unemployment benefits. (See Unemployment Insurance Relief During COVID-19 Outbreak, which lists contact information for state unemployment insurance offices.)

TTS S-Corps pay officer compensation to the owner/trader to arrange deductions for owner health insurance premiums and/or a high-deductible retirement plan contribution. Few TTS S-Corps hire outside employees, although some employ a spouse or an adult child.

Many of these TTS S-Corps paid state unemployment insurance (SUI) on officer wages, and if terminated or furloughed, these employees might be eligible to collect SUI and FPUC. SUI premiums are a minor cost in most states. In New York state, the 2020 wage base per employee is limited to $11,600. The NYSUI premium for a new business is 3.2%, which is $371 on the wage base amount. Employers can claim exemption from paying SUI on officer/owner compensation in most states.

TTS sole proprietor and partnership traders will likely face challenges applying for SUI and FPUC because they didn’t pay for SUI premiums. They also don’t have self-employment income as sole proprietors and partners. Most TTS traders worked from a home office and continued to trade throughout the coronavirus crisis. An employer or client has not terminated or furloughed them during the crisis. If you think you might be eligible for SUI and FPUC, apply at your state unemployment office.

SBA Paycheck Protection Program (PPP)
According to the AICPA’s SBA issues details for Paycheck Protection Program loans, “The CARES Act established the PPP as a new 7(a) loan option overseen by the Treasury Department and backed by the SBA [Small Business Administration], which is authorized to provide a 100% guarantee to lenders on loans issued under the program. The full principal amount of the loans may qualify for loan forgiveness if the borrower maintains or rehires staff and maintains compensation levels. However, not more than 25% of the loan forgiveness amount may be attributable to nonpayroll costs. Independent contractors and self-employed individuals can apply for PPP loans beginning April 10. Under the PPP, the maximum loan amount is the lesser of $10 million or an amount calculated using a payroll-based formula specified in the CARES Act. Note: You can access free loan calculators on the AICPA’s PPP resource page.” (See the SBA Paycheck Protection Program.)

Most payroll service providers can provide the payroll documentation needed for this program. (For example, Paychex emailed its clients several COVID-19 resources and tools.)

You may only include payroll to employees in the monthly payroll tax base; the SBA does not allow independent contractors in the calculation. (See https://home.treasury.gov/system/files/136/PPP–Fact-Sheet.pdf and https://taxfoundation.org/sba-paycheck-protection-program-cares-act/)

Most TTS sole proprietors and TTS partnerships don’t hire outside employees. The IRS doesn’t permit sole proprietors or partnerships to pay salaries to owners. Therefore, most TTS sole proprietors and partnerships don’t have a monthly payroll cost required for an SBA PPP loan application. TTS S-Corps might pay officer compensation to the owner, usually in Q4, when there is the transparency of trading profits for the year.

However, the SBA likely considers a TTS trading business to be a “speculative business,” which is not eligible for an SBA loan. The list of speculative businesses includes “dealing in stocks, bonds, commodity futures, and other financial instruments.” (See SBA SOP 50 10 5(B).)

Recovery rebates
Taxpayers under a threshold for adjusted gross income (AGI) are eligible for an advance tax refund of a 2020 tax credit. There’s a reduction of the payment in a phase-out range above the threshold. So the IRS can pay the direct deposit to a taxpayer’s bank account or mail a check faster, it looks to the taxpayer’s 2018 or 2019 tax return filing. (For social security recipients who don’t file a tax return, the IRS looks at their SSA Form 1099.) Treasury promised to provide a Website to enter direct deposit information if the prior-year tax return did not provide that information.

Retirement plan distributions
Taxpayers negatively impacted by COVID-19 can take a withdrawal from an IRA or qualified retirement plan of up to a maximum of $100,000 in 2020 and be exempt from the 10% excise tax on “early withdrawals.” The taxpayer has the option of returning (rolling over) the funds within three years or paying income taxes on the 2020 distribution over three years. CARES also suspended required minimum distributions for 2020. (Update May 4, 2020: IRS Website Coronavirus-related relief for retirement plans and IRAs questions and answers.)

Net operating losses
The 2017 Tax Cuts and Jobs Act repealed NOL carrybacks and applied NOL carryforwards up to 80% of the following year’s taxable income, but CARES temporarily suspended this. It allows five-year carrybacks for NOLs in 2018, 2019, and 2020 and/or 100% application of NOL carryforwards against subsequent year’s taxable income.

Traders should consider getting started on 2018 and 2019 NOL carrybacks for quick tax refunds right away.

Section 475 traders generate ordinary losses, which comprises NOLs, whereas capital losses do not contribute to NOLs. CARES does not allow taxpayers to file a retroactive 475 election for 2018 and 2019. On April 9, 2020, the IRS postponed the 2020 Section 475 election deadline for individuals from April 15 to July 15, 2020. (See live updates on CARES Act Allows 5-Year NOL Carrybacks For Immediate Tax Refunds and Massive Market Losses? Elect 475 For Enormous Tax Savings.)

Excess business losses
CARES suspended TCJA’s excess business loss (EBL) limitation for 2018, 2019, and 2020. That change might lead to a reduction of tax liability in those years and also increase NOL carrybacks. The EBL threshold for 2018 was $500,000 for married and $250,000 for other taxpayers. Amounts over the EBL limitation were NOL carryforwards under TCJA.

CARES is new legislation, and tax professionals have many questions that the Treasury Department and the IRS will likely answer soon. Stay tuned to our blog post to see how CARES and related virus legislation impacts TTS traders. Also, see CARES Act tax provisions aim to stabilize pandemic-ravaged economy.

If you need our help with CARES tax relief, contact us soon. For CARES payroll-related aid, contact your payroll service provider. For unemployment insurance benefits, contact your state unemployment insurance office.

CPAs Darren Neuschwander and Adam Manning contributed to this blog post.

A Rationale For Using QBI Tax Treatment For Traders

June 4, 2019 | By: Robert A. Green, CPA | Read it on

There are two opposing arguments made by tax professionals for applying Section 199A qualified business income (QBI) treatment on 2018 tax returns for traders with trader tax status (TTS).

Those for say Section 199A applies because Section 864(b)(2) is limited to nonresident traders only. U.S. resident TTS traders meet the requirements of Section 864(c)(3) “Other income from sources within United States.” As a result, a U.S. resident TTS trader has effectively connected income (ECI) and therefore, QBI. In this blog post, I refer to this stance as the affirmative or positive rationale.

Those against say Section 199A does not apply to U.S. resident TTS traders because Section 864(b)(2) applies to all traders. This scenario means that “trading for taxpayer’s own account” does not constitute ECI and therefore, QBI does not apply. In this blog post, I refer to this stance as the contrary or negative argument.

Here is what we know. Section 199A labeled TTS trading a “specified service trade or business” (SSTB). The contrary argument would lead to conflict: Why would 199A recognize TTS trading as an SSTB, if 864(b)(2) denied a QBI deduction to U.S. resident TTS traders? With the positive rationale, QBI includes TTS trading business expenses and Section 475 ordinary income/loss. QBI expressly excludes capital gains/losses, interest and dividend income, and forex and swap contract ordinary income/loss. A taxable income threshold, phase-in range, and income cap apply to SSTBs, which leads to some high-income taxpayers not receiving a 20% QBI deduction. (The QBI deduction rules are complex and beyond the scope of this blog post.)

Many traders filed 2018 tax extensions on March 15 (entities) and April 15 (individuals). Their tax preparers are waiting to resolve uncertainty over this issue before the tax return deadlines of Sept. 16, 2019, for partnerships and S-Corps and Oct. 15, 2019, for individual sole proprietorships.

A positive rationale to apply 199A to U.S. resident TTS traders
If you search the 199A final regs, you will find mention of 864(c) beneath the heading “Interaction of Sections 875(1) and 199A.” Section 875(1) states “a nonresident alien individual or foreign corporation shall be considered as being engaged in a trade or business within the United States if the partnership of which such individual or corporation is a member is so engaged.”

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

A U.S. resident TTS trader meets the definition of Section 864(c)(3) “Other income from sources within United States.”

“All income, gain, or loss from sources within the United States (other than income, gain, or loss to which paragraph (2) applies) shall be treated as effectively connected with the conduct of a trade or business within the United States.”

A U.S. resident TTS trader has Section 162 trade or business expenses. It’s consistent with 199A stating a TTS trading activity is an SSTB.

A U.S. resident TTS trader also meets the definition of 864(c)(2) “Periodical, etc., income from sources within United States—factors.”

“In determining whether income from sources within the United States of the types described in section 871(a)(1), section 871(h) , section 881(a), or section 881(c), or whether gain or loss from sources within the United States from the sale or exchange of capital assets, is effectively connected with the conduct of a trade or business within the United States, the factors taken into account shall include whether—

(A) The income, gain, or loss is derived from assets used in or held for use in the conduct of such trade or business, or

(B) The activities of such trade or business were a material factor in the realization of the income, gain, or loss. In determining whether an asset is used in or held for use in the conduct of such trade or business or whether the activities of such trade or business were a material factor in realizing an item of income, gain, or loss, due regard shall be given to whether or not such asset or such income, gain, or loss was accounted for through such trade or business.”

A U.S. resident TTS trading business uses the capital for the sale of capital assets to derive its income, and money is a material factor.

Section 871(a)(2) provides that a nonresident individual residing in the U.S. for more than 183 days per year is subject to a 30% tax on U.S.-source capital gains. (A tax treaty may provide relief.)

Some accountants think that Section 864(b)(2) prevents all traders, U.S. residents, and nonresidents, from using QBI treatment.

“Section 864(b) – the term a “trade or business within the U.S.” does not include:

Section 864(b)(1) – Performance of personal services for foreign employer.

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

(A): Stocks and securities.
(i)   In general. Trading in stocks or securities through a resident broker, commission agent, custodian, or other independent agent.
(ii)   Trading for taxpayer’s own account. Trading in stocks or securities for the taxpayer’s own account, whether by the taxpayer or his employees or through a resident broker, commission agent, custodian, or other agent, and whether or not any such employee or agent has discretionary authority to make decisions in effecting the transactions. This clause shall not apply in the case of a dealer in stocks or securities.
(C) Limitation. Subparagraphs (A)(i) and (B)(i) (for commodities) shall apply only if, at no time during the taxable year, the taxpayer has an office or other fixed place of business in the United States through which or by the direction of which the transactions in stocks or securities, or in commodities, as the case may be, are effected.”

The (C) Limitation relates to (i) nonresident investors engaging a U.S. broker. This exception applies if the nonresident does not have an office in the U.S. The exemption does not apply to (ii) “trading for taxpayer’s own account.”

In the 1.864-2 reg, there are several examples under “trading for taxpayer’s own account,” and all of the cases are for nonresident individuals and nonresident partnerships. If you read 864(b)(2)(A)(ii) as applying to nonresidents only, then it supports the affirmative rationale for using 199A on U.S. resident TTS traders.

Reg § 1.864-2(a) states:

“(a) In general. As used in part I (section 861 and following) and part II (section 871 and following), subchapter N, chapter 1 of the Code, and chapter 3 (section 1441 and following) of the Code, and the regulations thereunder, the term “engaged in trade or business within the United States” does not include the activities described in paragraphs (c) (trading in stocks or securities) and (d) (trading in commodities) of this section, but includes the performance of personal services within the United States at any time within the taxable year except to the extent otherwise provided in this section.”

The code sections in this heading are all for nonresidents:
861 – Income from sources within the United States
871 – Tax on nonresident alien individuals
Subchapter N – Tax based on income from sources within or without the United States
Chapter 3 – Withholding of tax on nonresident aliens and foreign corporations
1441: Withholding and reporting requirements for payments to a foreign person

Reg § 1.864-2(c) is for “trading in stocks or securities,” and (d) is for “trading in commodities.” Those sections discuss nonresident individuals and nonresident partnerships with U.S. brokerage accounts and explain that no matter how significant the volume of trades, that a nonresident trader does not have ECI in the U.S. This reg displays several examples, and all of them are for nonresidents. Again, this reg and related code Section 864(b)(2) is for nonresident traders only. A U.S. resident TTS trader is covered in Section 864(c), not in Section 864(b)(2).

The essential point is that the 199A regs do not state to “substitute qualified trade or business for nonresident or foreign” in Section 864(b) – so that code section remains applicable to nonresident traders only. The 199A regs required this substitution for 864(c) only.

Tax attorney Johnny Lyle J.D. weighs in:

“To read IRC Section 864(b) into the equation, you have to determine that the language ‘In the case of a qualified trade or business (within the meaning of section 199A) engaged in trade or business within the United States during the taxable year…’ requires you to determine ‘qualified trade or business under Section 199A,’ but then turn around and determine ‘trade or business within the United States’ under IRC Section 864(b),” Lyle said.

Further, Treasury Regulation Section 1.864-4, titled “U.S. source income effectively connected with U.S. business” states: “This section applies only to a nonresident alien individual or a foreign corporation that is engaged in a trade or business in the United States at some time during a taxable year beginning after December 31, 1966, and to the income, gain, or loss of such person from sources within the United States.”

Treasury Regulation Section 1.864-2, titled “Trade or business within the United States” uses only nonresident aliens and foreign corporations in its examples.

Lyle said two arguments could be made regarding Congress using the language specifically referencing IRC Section 864(c) in IRC Section 199A. First, if Congress wanted to incorporate Section 864(b) into the equation, it would have said effectively connected with the conduct of a trade or business within the United States (within the meaning of section 864) without reference to 864(c). Second, under the Treasury Regulations, 864(b) only applies to nonresident aliens. Therefore, the restriction in 864(b)(2)(A)(ii) would only apply to nonresident aliens, and a taxpayer who was a day trader, but not a nonresident alien, would not be excluded from ECI.

“If Congress intended to exclude all trader income, it would have done so under IRC Section 199A(c)(3)(B) rather than a more roundabout, back door way, rendering IRC Section 199A(d)(2)(B) meaningless,” Lyle said. “If Congress wanted to specifically incorporate Section 864(b), it would have worded it this way: …effectively connected (within the meaning of section 864(c)) with the conduct of a trade or business within the United States (within the meaning of section 864(b)), determined by substituting ‘qualified trade or business (within the meaning of section 199A)’ for ‘nonresident alien individual or a foreign corporation’ or for ‘a foreign corporation’ each place it appears.”

It gives me some pause that some big-four accountants prepared a few 2018 hedge fund partnership K-1s without applying 199A tax treatment. Their K-1 notes indicated reliance on Sections 864(c) and or 864(b) to skip the application of 199A. When we asked some big-four tax partners for clarification, they said they were not wedded to that position. Did these accountants take an easy way out, by reading Section 864(b)(2) out of context? The hedge fund investors would have been hurt with QBI treatment since they would have QBI losses from TTS trading business expenses. The hedge fund had capital gains, which QBI excludes. The hedge fund did not elect Section 475 ordinary income or loss, which QBI includes.

On the other side of the debate, I’ve seen some K-1s from proprietary trading firms, and all of those K-1s did report 199A information. They reported QBI income since they elected Section 475 on securities. I asked their tax preparers about it, and they said 864(b)(2) applies to foreign partnerships, not these U.S. trading partnerships.

I spoke with a tax attorney in IRS Office of Chief Counsel listed on the Section 199A regs, and he thought the positive rationale makes sense. He even accommodated my request to add Section 475 by name to inclusion in QBI in the final 199A regs. The IRS attorney did not raise Section 864(c) or 864(b)(2) as being a problem for U.S. resident TTS traders.

It’s time to complete 2018 tax returns even with remaining uncertainty. I suggest that U.S. resident TTS traders, living, working, and trading in the U.S. consider applying 199A to their trading business. Consult your tax advisor.

CPAs Darren Neuschwander and Adam Manning, and tax attorney Johnny Lyle contributed to this blog post.

See my prior blog posts on 199A for traders at https://greentradertax.com/uncertainty-about-using-qbi-tax-treatment-for-traders/

Uncertainty About Using QBI Tax Treatment For Traders

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

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

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

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

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

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

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

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

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

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

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

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

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

(A): Stocks and securities.

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

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

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

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

Notice how Section 199A regs reference Section 864:

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

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

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

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

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

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

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

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

The 199A regs state:

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

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

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

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

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

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

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

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

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

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

IRS Confirms Section 475 Is Eligible For QBI Tax Deduction

January 21, 2019 | By: Robert A. Green, CPA | Read it on

Good news for traders: Section 199A final regs confirm QBI includes Section 475 ordinary income and loss.

On Jan. 18, 2019, the IRS issued final 199A regs for the 2017 Tax Cuts and Jobs Act (TCJA) 20% qualified business income (QBI) deduction. The final regs update the August 2018 proposed/reliance 199A regs and confirm that QBI includes Section 475 ordinary income/loss.

Based on our interpretation of TCJA and the proposed/reliance regs, we figured QBI included Section 475 ordinary income/loss, but it was uncertain. Our previous content stated that QBI “likely” included Section 475 ordinary income/loss. The final and proposed/reliance regs each state that QBI expressly excludes capital gains and losses, and also excludes Section 954 items of ordinary income, including forex Section 988 and notional principal contracts.

Making our case to the IRS
After noticing that the proposed/reliance regs were silent about Section 475 income/loss, I contacted one of the lawyers at the Office of Chief Counsel listed on the 199A proposed regs.

The attorney called me back after he saw my interview in Tax Notes, “Groups Urge IRS to Rethink 199A Business Income Rules.” I presented our firm’s rationale for including Section 475 ordinary income/loss in QBI for TTS traders and suggested he read and watch our content. The IRS attorney said my rationale sounded “plausible” in his opinion.

Excerpts from final regs
Final 199A regs, p. 55-56:

“Given the specific reference to section 1231 gain in the proposed regulations, other commenters requested guidance with respect to whether gain or loss under other provisions of the Code would be included in QBI. One commenter asked for clarification about whether real estate gain, which is taxed at a preferential rate, is included in QBI. Additionally, other commenters requested clarification regarding whether items treated as ordinary income, such as gain under sections 475, 1245, and 1250, are included in QBI.

To avoid any unintended inferences, the final regulations remove the specific reference to section 1231 and provide that any item of short-term capital gain, short-term capital loss, long-term capital gain, or long-term capital loss, including any item treated as one of such items under any other provision of the Code, is not taken into account as a qualified item of income, gain, deduction, or loss. To the extent an item is not treated as an item of capital gain or capital loss under any other provision of the Code, it is taken into account as a qualified item of income, gain, deduction, or loss unless otherwise excluded by section 199A or these regulations.

Similarly, another commenter requested clarification regarding whether income from foreign currencies and notional principal contracts are excluded from QBI if they are ordinary income. Section 199A(c)(3)(B)(iv) and §1.199A-3(b)(3)(D) provide that any item of gain or loss described in section 954(c)(1)(C) (transactions in commodities) or section 954(c)(1)(D) (excess foreign currency gains) is not included as a qualified item of income, gain, deduction, or loss. Section 199A(c)(3)(B)(v) and §1.199A-3(b)(3)(E) provide any item of income, gain, deduction, or loss described in section 954(c)(1)(F) (income from notional principal contracts) determined without regard to section 954(c)(1)(F)(ii) and other than items attributable to notional principal contracts entered into in transactions qualifying under section 1221(a)(7) is not included as a qualified item of income, gain, deduction, or loss. The statutory language does not provide for the ability to permit an exception to these rules based on the character of the income. Accordingly, income from foreign currencies and notional principal contracts described in the listed sections is excluded from QBI, regardless of whether it is ordinary income.”

Parsing the language in the final 199A regs
In the proposed 199A regs, QBI excluded all capital gains and losses, and ordinary income/loss items expressly listed in Section 954. Section 954 does not include Section 475 ordinary income/loss. In the proposed regs, QBI expressly included Section 1231 losses from the sale of business property, whereas, QBI excluded Section 1231 capital gains. Section 475 ordinary income/loss is similar to Section 1231 ordinary losses, and it’s not in Section 954, so we determined that QBI likely included Section 475 ordinary income/loss.

The final 199A regs acknowledge the uncertainty and tax writers fixed it in the above language. They opened the door for Section 1231 losses to include more items like Section 475 ordinary income/loss, reiterating that it must not be on the Section 954 list, which Section 475 is not.

There’s an important caveat
Section 199A interacts with a modified Section 864(c), and Section 864 might deny QBI treatment to TTS traders and hedge funds. On the one hand, there is a rationale for QBI treatment for TTS traders, as expressed in this blog post, and Section 864 conflicts with that case. There are unresolved questions which I expect to write a blog post about it soon. Considering conflicts with Section 864, I think QBI treatment for traders is uncertain at this time.

How QBI might work for a TTS trading business
The proposed and final 199A regs state that traders eligible for trader tax status are a “specified service trade or business” (SSTB), so the SSTB taxable income (TI) cap applies. Taxpayers who make one dollar over the TI cap will not be allowed a QBI deduction on SSTB QBI. On the other hand, non-SSTB activity is not restricted to the TI cap, although the W-2 wage and property limitations apply over the TI threshold.

For 2018, the SSTB TI cap is $415,000/$207,500 (married/other taxpayers). The phase-out range below the cap is $100,000/$50,000 (married/other taxpayers), in which the QBI deduction phases out for an SSTB. The 50% W-2 wage and property basis limitations also apply within the phase-out range. For 2018, the TI threshold is $315,000/$157,500 (married/other taxpayers): If a taxpayer is below the TI threshold, there are no phase-out, wage or property limitations for SSTB and non-SSTB.

For 2019, the SSTB TI cap increases to $421,400/$210,700 (married/other taxpayers) based on the inflation adjustment. The phase-out range remains the same, so for 2019, the TI threshold is $321,400/$160,700 (married/other taxpayers).

Hedge funds with TTS and Section 475 ordinary income/loss should report QBI, too. Investors in these hedge funds are eligible for a QBI deduction if they are under the TI cap. Even without a 475 election, trading SSTB has QBI losses from trading expenses.

Investment managers are also SSTB, and they have QBI from advisory fees. Carried interest as a profit allocation of Section 475 ordinary income/loss is QBI, too. Carried interest in capital gains is not.

It’s more crucial to qualify for TTS than ever before
TTS allows business expense treatment, whereas, TCJA suspended “certain miscellaneous itemized deductions subject to the 2% floor,” which includes investment fees and investment expenses. TCJA still allows investors itemized deductions for investment-interest expenses limited to investment income, and stock borrow fees as other itemized deductions. TTS business expenses allow a long list of deductions from gross income, including home office, and that’s far better!

TTS traders may elect Section 475 mark-to-market (MTM) accounting on securities and or commodities (Section 1256 contracts). Securities traders appreciate that Section 475 trades are exempt from dreaded wash-sale loss adjustments and the $3,000 capital loss limitation. I call it “tax loss insurance,” because 475 ordinary losses lead to much faster tax refunds. (TCJA did repeal NOL carrybacks, forcing NOL carryforwards, instead.) TTS traders are entitled to segregate investment positions to achieve lower tax rates on long-term capital gains. TTS traders prefer to skip Section 475 on commodities to retain lower 60/40 capital gains rates on Section 1256 contracts.

Now with final 199A regs, there’s still uncertainty for QBI treatment for TTS traders. Profitable TTS traders might want to consider a Section 475 election to be perhaps eligible for a potential QBI deduction. In some years, the trader might be under the TI cap, allowing a QBI deduction, and in other years, he might have a (good) problem of exceeding the cap for no QBI deduction.

Married taxpayers should consider filing separately, as that might unlock a QBI deduction for one spouse since the other spouse might have income exceeding the SSA income cap. TCJA equalized the tax rates for filing jointly vs. separately.

TTS traders with Section 475 ordinary losses might be unhappy. For example, assume a trader has $100,000 of QBI from a consulting business. She also has TTS/Section 475 ordinary losses of $40,000, so her aggregate QBI is $60,000, which reduces the QBI deduction.

Section 199A regs are complicated
There are complex issues over what constitutes an SSTB vs. non-SSTB, how to calculate the W-2 wage and property limitations, definitions of QBI, and more.

Taxpayers have to calculate the QBI deduction on whichever is lower: aggregate QBI or taxable income minus net capital gains/losses.

If you expect to receive a 2018 Schedule K-1 containing QBI tax information, then consider filing an automatic extension by April 15. I assume that many pass-through entities won’t issue final 2018 Schedule K-1s until after that date. It’s great that the IRS issued the final 199A regs now, but there are still conflicts and unresolved questions. Look for QBI items on partnership Schedule K-1 line 20 “Other Information” marked with various codes for 199A items of income, wages, property and more. See the K-1 instructions for line 20.

Elect Section 475 on time
Individual TTS traders need to file a 2019 Section 475 election statement with the IRS by April 15, 2019. Existing partnerships and S-Corps need to file a 2019 Section 475 election statement with the IRS by March 15, 2019. New taxpayers (i.e., new entities) may elect Section 475 within 75 days of inception by internal election. Existing taxpayers have a second step to file a Form 3115 with their 2019 tax return.

Learn more about TTS, Section 475, QBI and entity solutions in Green’s 2019 Trader Tax Guide.

Darren L. Neuschwander, CPA contributed to this blog post.

I revised this blog post on March 5, 2019, in conjunction with my new blog post Uncertainty About Using QBI Tax Treatment For Traders. 

New Tax Law Favors Hedge Funds Over Managed Accounts

August 28, 2018 | By: Robert A. Green, CPA | Read it on

Hedge fund investors benefited from tax advantages over separately managed accounts (SMA) for many years. The 2017 Tax Cuts and Jobs Act (TCJA) widened the difference by suspending all miscellaneous itemized deductions, including investment fees. SMA investors are out of luck, but hedge fund investors can limit the negative impact using carried-interest tax breaks. TCJA provided a new 20% deduction on qualified business income, which certain hedge fund investors might be eligible for if they are under income caps for a service business.

TCJA penalizes investors with separately managed accounts
SMA investors cannot claim trader tax status (TTS) since an outside manager conducts the trading, not the investor. Therefore, investment expense treatment applies for advisory fees paid.

Beginning in 2018, TCJA suspended all miscellaneous itemized deductions for individuals, which includes investment fees and expenses. If a manager charges a 2% management fee and a 20% incentive fee, an individual may no longer deduct those investment fees for income tax purposes. Before 2018, the IRS allowed miscellaneous itemized deductions greater than 2% of AGI, but no deduction was allowed for alternative minimum tax (AMT); plus, there was a Pease itemized deduction limitation. (Taxpayers are still entitled to deduct investment fees and expenses for calculating net investment income for the Net Investment Tax.)

For example: Assume an SMA investor has net capital gains of $110,000 in 2018. Advisory fees are $30,000, comprised of $10,000 in management fees and $20,000 in incentive fees. Net cash flow on the SMA for the investor is $80,000 ($110,000 income minus $30,000 fees). The SMA investor owes income tax on $110,000 since TCJA suspended the miscellaneous itemized deduction for investment fees and expenses. If the individual’s federal and state marginal tax rates are 40%, the tax hike might be as high as $12,000 ($30,000 x 40%). (See Investment Fees Are Not Deductible But Borrow Fees Are.)

Investment managers do okay with SMAs
In the previous example, the investment manager reports service business revenues of $30,000. Net income after deducting business expenses is subject to ordinary tax rates.

An investment manager for an SMA is not eligible for a carried-interest share in long-term capital gains, or 60/40 rates on Section 1256 contracts, which have lower tax rates vs. ordinary income. Only hedge fund managers as owners of the investment fund may receive carried interest, a profit allocation of capital gains and portfolio income.

Additionally, if the manager is an LLC filing a partnership tax return, net income is considered self-employment income subject to SE taxes (FICA and Medicare). If the LLC has S-Corp treatment, it should have a reasonable compensation, which is subject to payroll tax (FICA and Medicare).

Hedge funds provide tax advantages to investors
Carried interest helps investors and investment managers. Rather than charge an incentive fee, the investment manager, acting as a partner in the hedge fund, is paid a special allocation (“profit allocation”) of capital gains, Section 475 ordinary income, and other income.

Let’s turn the earlier example into a hedge fund scenario. The hedge fund initially allocates net capital gains of $110,000, and $10,000 of management fees to the investor on a preliminary Schedule K-1. Next, a profit allocation clause carves out 20% of capital gains ($20,000) from the investor’s K-1 and credits it to the investment manager’s K-1. The final investor K-1 has $90,000 of capital gains and an investment expense of $10,000, which is suspended as an itemized deduction on the investor’s individual tax return. Carried interest helps the investor by turning a non-deductible incentive fee of $20,000 into a reduced capital gain of $20,000. Carried interest is imperative for investors in a hedge fund that is not eligible for TTS business expense treatment. With a 40% federal and state tax rate, the tax savings on using the profit allocation instead of an incentive fee is $8,000 ($20,000 x 40%). To improve tax savings for investors, hedge fund managers might reduce management fees and increase incentive allocations.

TCJA modified carried interest rules for managers
Hedge fund managers must now hold an underlying position in the fund for three tax years to benefit from long-term capital gains allocated through profit allocation (carried interest). The regular holding period for long-term capital gains is one year. I’m glad Congress did not outright repeal carried interest, as that would have unduly penalized investors. The rule change trims the benefits for managers and safeguards the benefits for investors. The three-year holding period does not relate to Section 1256 contracts with lower 60/40 capital gains rates, where 60% is a long-term capital gain, and 40% is short-term.

Trader tax status and Section 475 tax advantages
If a hedge fund qualifies for TTS, then it allocates deductible business expenses to investors, not suspended investment expenses. I expect many hedge funds will still use a profit allocation clause since it might bring tax advantages to the investment manager — a share of long-term capital gains, and a reduction of payroll taxes on earned income vs. not owing payroll taxes on short-term capital gains.

TCJA 20% QBI deduction on pass-through entities
The TCJA included a lucrative new tax cut for pass-through entities. An individual taxpayer may deduct whichever is lower: either 20% of qualified business income (QBI) from pass-through entities or 20% of their taxable income minus net capital gains, subject to other limitations, too. (Other QBI includes qualified real estate investment trust REIT dividends and qualified publicly traded partnership PTP income.)

The proposed QBI regulations confirm that traders eligible for TTS are considered a service business (SSTB). Upper-income SSTB owners won’t get a deduction on QBI if their taxable income (TI) exceeds the income cap of $415,000/$207,500 (married/other taxpayers). The phase-out range is $100,000/$50,000 (married/other taxpayers) below the income cap, in which the QBI deduction phases out for SSTBs. The W-2 wage and property basis limitations apply within the phase-out range, too.

Hedge funds with TTS are an SSTB if the fund is trading for its account through an investment manager partner. A hedge fund with TTS is entitled to elect Section 475 ordinary income or loss. Hedge fund QBI likely includes Section 475 ordinary income. QBI excludes all capital gains, commodities and forex transactions, dividends, and interest. The SSTB taxable income thresholds and cap apply to each investor in the hedge fund; some may get a QBI deduction, whereas, others may not, depending on their TI, QBI aggregation, and more. (See How Traders Can Get 20% QBI Deduction Under IRS Proposed Regulations.)

The proposed QBI regulations also describe investing and investment management as an SSTB. QBI includes advisory fee revenues for investment managers earned from U.S. clients, but not foreign clients. QBI must be from domestic sources. I presume QBI should exclude a carried-interest share (profit allocation) of capital gains but will include a carried-interest percentage of Section 475 ordinary income.

TCJA might impact the investment management industry
Many investors are upset about losing a tax deduction for investment fees and expenses. Some just realized it. I recently received an email from an investor complaining to me about TCJA’s suspension of investment fees and expenses. He was about to sign an agreement with an investment manager for an SMA but scrapped the deal after learning he could not deduct investment fees. Most hedge funds only work with larger accounts and adhere to rules for accredited investors and qualified clients who can pay performance fees or profit allocations.

Larger family offices may have a workaround for using business expense treatment without TTS, as I address on my blog post How To Avoid IRS Challenge On Your Family Office.

Managed accounts vs. hedge fund
Investment managers handle two types of investors: separately managed accounts (SMAs) and hedge funds (or commodity or forex pools). In an SMA, the client maintains a retail customer account, granting trading power to the investment manager. In a hedge fund, the investor pools his money for an equity interest in the fund, receiving an annual Schedule K-1 for his allocation of income and expense. It’s different with offshore hedge funds.

In an SMA, the investor deals with accounting (including complex trade accounting on securities), not the investment manager. In a hedge fund, the investment manager is responsible for complicated investor-level accounting, and the fund sends investors a Schedule K-1 that is easy to input to tax returns.

There are several other issues to consider with SMAs vs. hedge funds; tax treatment is just one critical element. “SMAs provide transparency, and this is important to many clients, particularly tax-exempts or fiduciary accounts,” says NYC tax attorney Roger D. Lorence.

Roger D. Lorence contributed to this blog post.

 

How Traders Can Get 20% QBI Deduction Under IRS Proposed Regulations

August 15, 2018 | By: Robert A. Green, CPA | Read it on

See my March 5, 2019 blog post Uncertainty About Using QBI Tax Treatment For Traders.

The IRS recently released proposed reliance regulations (Proposed §1.199A) for the 2017 Tax Cuts and Jobs Act’s new 20% deduction on qualified business income (QBI) in pass-through entities.

The proposed regulations confirm that traders eligible for trader tax status (TTS) are a service business (SSTB). Upper-income SSTB owners won’t get a deduction on QBI if their taxable income (TI) exceeds the income cap of $415,000 married, and $207,500 for other taxpayers. The phase-out range is $100,000/$50,000 (married/other taxpayers) below the income cap, in which the QBI deduction phases out for SSTBs. The W-2 wage and property basis limitations apply within the phase-out range, too. Hedge funds eligible for TTS and investment managers are also SSTBs.

The new law favors non-service business (non-SSTB), which don’t have an income cap, but do have the W-2 wage and property basis limitations above the TI threshold of $315,000/$157,500 (married/other taxpayers). The 2018 TI income cap, phase-out range, and threshold will be adjusted for inflation in each subsequent year.

A critical question for traders
The proposed regulations do not answer this essential question: What types of trading income are included in QBI? The proposed regulations define a trading business, so I presume tax writers contemplated some types of ordinary income might be included in QBI. They probably wanted to limit tax benefits for traders by classifying trading as an SSTB subject to the income cap.

In my Jan. 12, 2018 blog post, How Traders Can Get The 20% QBI Deduction Under New Law, I explained how the statute excluded certain “investment-related” items from QBI, including capital gains, dividends, interest, annuities and foreign currency transactions. That left the door open for including Section 475 ordinary income for trading businesses. After reading the proposed regulations, I feel that door is still open.

Trading is a service business
See the proposed regulations, REG-107892-18, page 67. The Act just listed the word “trading,” whereas, the proposed regulations describe trading in detail and cite TTS court cases.

“b. Trading: Proposed §1.199A-5(b)(2)(xii) provides that any trade or business involving the “performance of services that consist of trading” means a trade or business of trading in securities, commodities, or partnership interests. Whether a person is a trader is determined taking into account the relevant facts and circumstances. Factors that have been considered relevant to determining whether a person is a trader include the source and type of profit generally sought from engaging in the activity regardless of whether the activity is being provided on behalf of customers or for a taxpayer’s own account. See Endicott v. Commissioner, T.C. Memo 2013-199; Nelson v. Commissioner, T.C. Memo 2013-259, King v. Commissioner, 89 T.C. 445 (1987). A person that is a trader under these principles will be treated as performing the services of trading for purposes of section 199A(d)(2)(B).”

QBI excludes certain items
See REG-107892-18, page 30: “Section 199A(c)(3)(B) provides a list of items that are not taken into account as qualified items of income, gain, deduction, and loss, including capital gain or loss, dividends, interest income other than interest income properly allocable to a trade or business, amounts received from an annuity other than in connection with a trade or business, certain items described in section 954, and items of deduction or loss properly allocable to these items.”

See REG-107892-18, page 144: “Items not taken into account” in calculating QBI. Here’s an excerpt of the list.

 “(A) Any item of short-term capital gain, short-term capital loss, long-term capital gain, long-term capital loss, including any item treated as one of such items, such as gains or losses under section 1231 which are treated as capital gains or losses.

(B) Any dividend, income equivalent to a dividend, or payment in lieu of dividends.

(C) Any interest income other than interest income which is properly allocable to a trade or business. For purposes of section 199A and this section, interest income attributable to an investment of working capital, reserves, or similar accounts is not properly allocable to a trade or business.

(D) Any item of gain or loss described in section 954(c)(1)(C) (transactions in commodities) or section 954(c)(1)(D) (excess foreign currency gains) applied in each case by substituting “trade or business” for “controlled foreign corporation.”

(E) Any item of income, gain, deduction, or loss taken into account under section 954(c)(1)(F) (income from notional principal contracts) determined without regard to section 954(c)(1)(F)(ii) and other than items attributable to notional principal contracts entered into in transactions qualifying under section 1221(a)(7).

(F) Any amount received from an annuity which is not received in connection with the trade or business.”

Section 954 is for “foreign base company income,” and tax writers used it for convenience sake to define excluded items including transactions in commodities, foreign currencies (forex) and notional principal contracts (swaps). The latter two have ordinary income, but they are excluded from QBI.

Section 475 ordinary income
The new tax law excluded specific “investment-related” items from QBI. In earlier blog posts, I wondered if QBI might include “business-related” capital gains. The proposed regulations dropped the term “investment-related,” which seems to close that door of possibility.

I searched the QBI proposed regulations for “475,” and there were 20 results, and each instance defined securities or commodities using terminology in Section 475. None of the search results discussed 475 ordinary income and its impact on QBI. The proposed regulations seem to allow the inclusion of Section 475 ordinary income in QBI.

TTS traders are entitled to elect Section 475 on securities and/or commodities (including Section 1256 contracts). For existing taxpayers, a 2018 Section 475 election filing with the IRS was due by March 15, 2018, for partnerships and S-Corps, and by April 17, 2018, for individuals. New taxpayers (i.e., a new entity) may elect Section 475 internally within 75 days of inception. Section 475 is tax loss insurance: Exempting 475 trades from wash sale losses on securities and the $3,000 capital loss limitation. With the new tax law, there’s now likely a tax benefit on 475 income with the QBI deduction.

Section 1231 ordinary income
See REG-107892-18, page 37: “Exclusion from QBI for certain items.”

“a. Treatment of section 1231 gains and losses. (Excerpt)
Specifically, if gain or loss is treated as capital gain or loss under section 1231, it is not QBI. Conversely, if section 1231 provides that gains or losses are not treated as gains and losses from sales or exchanges of capital assets, section 199A(c)(3)(B)(i) does not apply and thus, the gains or losses must be included in QBI (provided all other requirements are met).”

If you overlay Section 475 on top of the above wording for Section 1231, there is a similar result: Section 475 ordinary income is not from the sale of a capital asset, and it should be included in QBI since it’s not expressly excluded.

Section 1231 is depreciable business or real property used for at least a year. A net Section 1231 loss is reported on Form 4797 Part II ordinary income or loss. Section 475 ordinary income or loss for TTS traders is reported on Form 4797 Part II, too. A net Section 1231 gain is a long-term capital gain.

Section 64 defines ordinary income
“The term ordinary income includes any gain from the sale or exchange of property which is neither a capital asset nor property described in section 1231(b). Any gain from the sale or exchange of property which is treated or considered, under other provisions of this subtitle, as ordinary income shall be treated as gain from the sale or exchange of property which is neither a capital asset nor property described in section 1231(b).”

The tax code does not define business income.

TTS traders with 475 ordinary income
A TTS trader, filing single, has QBI of $100,000 from Section 475 ordinary income, and his taxable income minus net capital gains is $80,000. He is under the TI threshold of $157,500 for single, so there is no phase-out of the deduction, and W-2 wage or property basis limitations do not apply. His deduction on QBI is $16,000 (20% x $80,000) since TI minus net capital gains is $80,000, which is lower than QBI of $100,000.

If his TI is greater than $157,500 but less than the income cap of $207,500 for a service business, then the deduction on QBI phases-out and the W-2 wage and property basis limitations apply inside the phase-out range.

If his TI is higher than the income cap of $207,500, there is no deduction on QBI in a trading service business.

Anti-abuse measures
The proposed regulations prevent “cracking and packing” schemes where an SSTB might contemplate spinning-off non-SSTBs to achieve a QBI deduction on them. “Proposed §1.199A-5(c)(2) provides that an SSTB includes any trade or business with 50 percent or more common ownership (directly or indirectly) that provides 80 percent or more of its property or services to an SSTB. Additionally, if a trade or business has 50 percent or more common ownership with an SSTB, to the extent that the trade or business provides property or services to the commonly-owned SSTB, the portion of the property or services provided to the SSTB will be treated as an SSTB (meaning the income will be treated as income from an SSTB).”

Other anti-abuse measures prevent employees from recasting themselves as independent contractors and then working for their ex-employer, which becomes their client.

Aggregation, allocation and QBI losses
There are QBI aggregation and allocation rules which come in handy for leveling out W-2 wage and property basis limitations among commonly owned non-SSTBs. If you own related businesses and one has too much payroll and property, and the other not enough, you don’t need to restructure to improve wage and property basis limitations. Aggregation rules allow you to combine QBI, wage and property basis limitations to maximize the deduction on aggregate QBI. Allocation rules are a different way to accomplish a similar result.

There are also rules for how to apply and allocate QBI losses to other businesses with QBI income and carrying over these losses to subsequent tax year(s).

Section 199A is a complicated code section requiring significant tax planning and compliance. The proposed regulations close loopholes, favor some types of businesses and prevent gaming of the system, which otherwise would invite excessive entity restructuring.

Hedge funds and investment managers
If a hedge fund qualifies for TTS, the fund is trading for its account through an investment manager partner. As a TTS trading business, the hedge fund is an SSTB.

A hedge fund with TTS is entitled to elect Section 475 ordinary income or loss. A hedge fund with TTS and Section 475 has ordinary income, which is likely includible in QBI. The SSTB taxable income thresholds and cap apply to each investor in the hedge fund; some may get a QBI deduction, whereas, others may not, depending on their TI, QBI aggregation and more.

The proposed regulations also describe investing and investment management as an SSTB (p. 66-67). I presume a carried-interest share (profit allocation) of capital gains should be excluded from QBI, but a carried-interest percentage of Section 475 ordinary income is likely included in QBI. Incentive fees and management fees are also included for management companies, which are SSTBs. QBI must be from domestic sources.

Service businesses
The proposed regulations state: “The definition of an SSTB for purposes of section 199A is (1) any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, 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, and (2) any trade or business that 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 proposed regulations exempted some types of service businesses from SSTBs, including real estate agents and brokers, insurance agents and brokers, property managers, and bankers taking deposits or making loans. It also narrowed SSTBs — for example, sales of medical equipment are not an SSTB, even though physician health care services are. Performing artists are service businesses, but not the maintenance and operation of equipment or facilities for use in the performing arts.

The proposed regulations significantly narrowed the catch-all category of SSTBs based on the “reputation and skill” of the owner. The updated definition is “(1) receiving income for endorsing products or services; (2) licensing or receiving income for the use of an individual’s image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity; or (3) receiving appearance fees or income (including fees or income to reality performers performing as themselves on television, social media, or other forums, radio, television, and other media hosts, and video game players).”

Proposed vs. final regulations
The IRS stated that taxpayers are entitled to rely on these “proposed reliance regulations” pending finalization. The IRS is seeking comments, and they scheduled a public hearing for Oct. 16, 2018.

The 2017 Tax Cuts and Jobs Act was a significant piece of legislation for this Congress and President. I presume the IRS will attempt to issue final regulations in time for the 2018 tax-filing season, which starts in January 2019. The IRS needs to produce tax forms for the 2018 QBI deduction, and that is best accomplished after finalization of the regulations. Tax software makers need time to program these rules, too.

The new tax law reduced tax compliance for employees by suspending many itemized deductions. They may have a “postcard return.” However, the new law and proposed regulations significantly increase tax compliance for business owners, many of whom would like to get a 20% deduction on QBI in a pass-through entity.

See IRS FAQs and several examples on Basic questions and answers on new 20% deduction for pass-through businesses. 

Darren Neuschwander CPA contributed to my blog post.

 

Investment Fees Are Not Deductible But Borrow Fees Are

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

The Tax Cuts and Jobs Act suspended “certain miscellaneous itemized deductions subject to the two-percent floor,” which includes “investment fees and expenses.” However, the new law retained “other miscellaneous deductions” not subject to the two-percent floor, including short-selling expenses like stock borrow fees.

While individual taxpayers may no longer deduct investment fees and expenses on Schedule A starting in 2018, they are still entitled to deduct investment interest expenses, up to net investment income, as calculated on Form 4952.

The new law (page 95) has a complete list of suspended miscellaneous itemized deductions including “expenses for the production or collection of income.” That list does not include short-selling expenses. Section 67(b) excludes certain deductions from the “2-percent floor on miscellaneous itemized deductions;” including (8) “any deduction allowable in connection with personal property used in a short sale.”

DHN_AW_logo_Daily_News

This blog post was their Top Story on July 16

Carrying charges vs. itemized deductions
Because investment fees and expenses are no longer deductible, some accountants might consider a Section 266 election to capitalize investment management fees as “carrying charges” to deduct them from capital gains and losses. But that won’t work: The IRS said taxpayers could not capitalize investment management fees under Section 266 because they are managerial rather than transactional.

Short-sellers probably could capitalize borrow fees under Section 266 because they are transactional. However, it’s safer to deduct these short-sale costs as “Other Miscellaneous Deductions” on Schedule A (Itemized Deductions) line 28. The new tax law suspended the Pease itemized deduction limitation, so the deduction has full effect on lowering taxable income. One concern: The IRS lists all Section 67(b) exclusion items in the instructions for Schedule A line 28, but it left out (8) for short-sale expenses. The code has substantial authority, and it’s reasonable to conclude that Schedule A instructions for other miscellaneous deductions on line 28 are not an exhaustive list.

Stock borrow fees
Short selling is not free; a trader needs the broker to arrange a loan of stock.

Brokers charge short sellers “stock borrow fees” or “loan premiums.” Tax research indicates these payments are “fees for the temporary use of property.” Watch out: Some brokers refer to stock borrow fees as “interest expense,” which confuses short sellers.

For tax purposes, stock borrow fees are “other miscellaneous deductions” on Schedule A line 28 for investors. Borrow fees are business expenses for traders qualifying for trader tax status (TTS). Borrow fees are not interest expense, so investors should not include them in investment interest expense deductions on Schedule A line 14.

It’s a significant distinction that has a profound impact on tax returns because investment expenses face greater limitations in 2017, and suspension in 2018 vs. investment interest expenses which are deductible up to investment income. Other miscellaneous deductions, including borrow fees, reported on Schedule A line 28 remain fully deductible for regular and alternative minimum tax (AMT).

Investment management fees cannot be capitalized
In a 2007 IRC Chief Counsel Memorandum, the IRS denied investors from capitalizing investment management fees paid to a broker as carrying charges under Section 266. Investors wanted to avoid alternative minimum tax (AMT) and other limitations on miscellaneous itemized deductions, the rules in effect before 2018. The problem is worse in 2018 with investment expenses entirely suspended.

The memo stated:

  • “Consulting and advisory fees are not carrying charges because they are not incurred independent of a taxpayer’s acquiring property and because they are not a necessary expense of holding property.
  • Stated differently, consulting and advisory fees are not strictly analogous to common carrying costs, such as insurance, storage, and transportation.”

Borrow fees might be able to be capitalized
Borrow fees seem to meet the requirements raised in the 2007 IRS Chief Counsel Memorandum for capitalization as carrying charges under Section 266. (It’s safer to deduct them as “other misc. deductions” on Schedule A line 28.)

Treasury Regulations under 1.266-1(b)(1) highlight several types of expenses that qualify as carrying charges, including taxes on various types of property, loan interest for financing property, costs to construct or improve the property, and expenses to store personal property.

A short seller cannot execute a short sale without borrowing securities and incurring borrow fees; they are a “necessary expense of holding” the position open, and “not independent” of the short-sale transaction. Borrow fees are not for the “management of property,” they are for the “acquisition, financing, and holding” of property.

Investment fees vs. brokerage commissions
Investors engage outside investment advisors and pay them advisory fees including management fees and/or incentive fees. Other investors may pay a broker a flat or fixed fee. These costs are managerial and not transactional, based on how many trades the manager makes. They cannot be capitalized under Section 266 according to the above IRS memorandum.

Brokerage commissions are transaction costs deducted from sales proceeds and added to cost basis on brokers’ trade confirmations and Form 1099-Bs. This tax reporting for brokerage commissions resembles a carrying charge.

Short-seller payments in lieu of dividends
When traders borrow shares to sell short, they receive dividends that belong to the lender — the rightful owner of the shares. After the short seller gets these dividends, the broker uses collateral in the short seller’s account to remit a “payment in lieu of dividend” to the rightful owner to make the lender square in an economic sense.

Section 263(h) “Payments in lieu of dividends in connection with short sales” require the mandatory capitalization of these payments if a short seller holds the short position open for 45 days or less (one year in the case of an extraordinary dividend).

If a short seller holds the short sale open for more than 45 days, payments in lieu of dividends are deductible as investment interest expense.

Investment interest expenses
Section 163(d)(3)(c) states, “For purposes of this paragraph, the term ‘interest’ includes any amount allowable as a deduction in connection with personal property used in a short sale.” A broad reading of “any amount” could be construed as opening the door to borrow fees, but I doubt that. “Any amount” refers to dividends in lieu of dividends held more than 45 days.

Under certain conditions, Section 266 allows capitalization of interest to finance a property.  Short sellers and others might want to consider the possibility of a Section 266 election on investment interest expense, too — especially if they plan a standard deduction or don’t have sufficient investment income. Excess interest is a carryover to subsequent tax years.

Transactional vs. managerial expenses
The following investment expenses seem transactional, and therefore eligible for capitalization in Section 266: Storage of precious metals or cryptocurrency, borrow fees on short sales, excess risk fees on short sales, and margin interest expenses.

The following investment expenses seem to be managerial rather than transactional, and therefore cannot be treated as carrying charges under Section 266: Investment management fees, fixed or flat fees paid to brokers, computers, equipment, software, charting, education, mentors, coaching, monthly data feed fees, market information, subscriptions, travel, meals, supplies, chatrooms, office rent, staff salaries and employee benefits, accounting, tax and legal services, and most other trading-related expenses.

Section 266 election statement and tax reporting

Consider filing a Section 266 election statement with your tax return, including on an extension.

  • “For tax-year 2018, taxpayer herewith elects under Code Section 266 and IRS Regulations 1.266-1 to capitalize short-selling expenses as carrying costs applied to capital gains and losses.”

Explain the election and tax treatment in a tax return footnote.

Report short-selling expenses for realized (closed) short sales as “expenses of sale or exchange” on Form 8949 (Sales and Other Dispositions of Capital Assets) in column (g) “adjustment to gain or loss.” Defer borrow fees paid on unrealized (open) short sales until realized (closed) in the subsequent year.

Consult a trader tax expert on using this potential alternative solution. If you get full deductibility on Schedule A, it’s safer to skip Section 266 capitalization, which the IRS might scrutinize.

Trader tax status
If a short-seller qualifies for trader tax status, then stock borrow fees and other short-selling expenses are deductible as business expenses from gross income.

If a TTS trader engages an outside investment manager, then investment advisory fees remain investment expenses.

Retirement accounts
Investors engage investment managers for taxable and retirement accounts. TCJA suspended investment fees and expenses for taxable accounts, but the new tax law did not repeal investment fees and expenses for tax-deferred retirement accounts. If your retirement account engages an outside investment manager, seek to pay their investment fees and costs directly from the retirement plan. Not all brokerage firms will cooperate if you use a manager other than the firm’s wealth management arm. An expense in a tax-deferred retirement plan is equivalent to a tax-deferred cost. Caution: Don’t have your retirement plan pay fees to you, or family, as investment managers. The IRS will deem it self-dealing and a prohibited transaction, which might blow up your retirement plan. (See The DOs and DON’Ts of using IRAs and other retirement plans in trading activities and alternative investments.)

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

Webinar July 19, 2018: Investment Fees Are Not Deductible But Borrow Fees Are. Recording available afterward. Click here.

Related blog posts: Short Selling: How To Deduct Stock Borrow Fees and Short Selling: IRS Tax Rules Are Unique.

 

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.