I prompted Bing’s ChatGPT to write blog posts on “trader tax benefits” and “trader tax status.” See my comments in yellow highlight. I also used Grammarly. ChatGPT did a good job, but gave rudimentary advice. There are nuances in our content that ChatGPT missed. GreenTraderTax and my Forbes articles are a source for ChatGPT’s blog posts.
Trader Tax Benefits:
If you are an active trader buying and selling securities for a living, you may wonder how to save money on taxes. One way to do that is to qualify for trader tax status (TTS), which allows you to deduct various business expenses and take advantage of unique tax treatments. This blog post will explain TTS, its benefits, and how to qualify.
What is trader tax status?
Trader tax status is a designation that the IRS grants to certain traders who meet specific criteria. It is not an election you can make; you must prove (assess) that you are eligible based on your trading activity and intention. Trader tax status allows you to treat your trading income and expenses as a business rather than an investor. You can deduct your trading-related expenses on Schedule C, such as commissions (wrong), software, education, interest, and home office. (Deduct brokerage commissions from sales proceeds and add them to cost basis when reporting capital gains and losses or Section 475 income.)
You can also elect to use Section 475 mark-to-market accounting, which converts your capital gains and losses into ordinary income and losses. Section 475 can help you avoid the wash sale rule and the $3,000 capital loss limitation. Additionally, if you form an LLC or a corporation and elect S-corp status, you can deduct health insurance premiums and retirement plan contributions as employee benefits.
How to qualify for trader tax status?
The IRS does not have a clear-cut definition of trader tax status, but it does provide some guidelines based on court cases and rulings. Generally, you must meet the following requirements:
– You trade substantially, regularly, frequently, and continuously throughout the year. You have to meet no specific number of trades or hours, but the IRS expects you to trade almost every day that the market is open and execute hundreds of transactions per year.
– You seek to profit from short-term price swings of securities rather than dividends, interest, or long-term appreciation. You typically hold your positions for less than a day or a few days at most (an average holding period of fewer than 31 days per the Endicott court is required).
– You intend to trade as a business, not as a hobby or a passive investment. You have a trading plan, a trading account separate from your (investment) account, and a dedicated workspace or office.
It would be best if you met these criteria consistently throughout the year. You may not qualify for trader tax status if you start or stop trading during the year or have significant gaps in your trading activity. (Part-year TTS qualification is okay.)
What are the benefits of trader tax status?
Trader tax status can provide significant tax savings for active traders. Here are some of the main benefits:
– You can deduct your trading expenses on Schedule C, reducing your adjusted gross income (AGI) and self-employment tax. These expenses include commissions (not brokerage commissions), software, subscriptions, education, interest, margin fees, and home office costs.
– You can elect Section 475 mark-to-market accounting, which allows you to report your trading gains and losses as ordinary income and losses on Form 4797. This way, you can avoid the wash sale rule, which disallows losses on (substantially identical) securities you buy back within 30 days (before or after). You can also fully deduct (within Excess Business Loss EBL and net operating loss NOL limitations) your trading losses against any income without being subject to the $3,000 capital loss limitation or the 3% (2%) AGI threshold for itemized deductions. (The 2017 Tax Cuts and Jobs Act TCJA suspended 2% miscellaneous itemized deductions from 2018 through 2025.)
– You can qualify for the 20% qualified business income (QBI) deduction if you have Section 475 income and your taxable income is below a certain threshold ($164,900 for single filers and $329,800 for married filing jointly in 2021). The QBI deduction reduces your taxable income by 20%, which lowers your effective tax rate.
– You can form an LLC or a corporation and elect S-corp status, which allows you to pay yourself a reasonable salary and deduct health insurance premiums and retirement plan contributions as employee benefits. These deductions also reduce your AGI and your self-employment tax.
Conclusion
Trader tax status is a valuable tax benefit for active traders who meet specific criteria. It allows you to deduct various business expenses and take advantage of unique tax treatments that lower your taxable income and tax liability. However, qualifying for trader tax status is tricky; you must (be ready to) prove (in an IRS exam) that you trade as a business with sufficient frequency, volume, and consistency. You must also comply with various rules and regulations regarding accounting methods, entity structures, and tax filings. Therefore, it is best to consult a professional trader tax advisor who can help you determine if you are eligible for trader tax status and how to maximize its benefits.
Trader Tax Status:
If you are an active trader who buys and sells securities for a living, you might be interested in trader tax status (TTS). (The intention of making a living is good enough). TTS is a special designation that allows you to deduct your trading expenses as business expenses and enjoy other tax benefits. However, only some people who trade qualify for TTS. You must meet certain criteria and follow specific rules to claim this status.
What are the benefits of trader tax status?
Trader tax status comes with several advantages, such as:
– You can deduct your trading-related expenses, such as margin interest, education, software, data feeds, subscriptions, home office, and more. These expenses are reported on Schedule C or the pass-through entity tax return, reducing your taxable income.
– You can elect Section 475 mark-to-market (MTM) accounting for your trading securities. You can treat your open positions as sold at fair market value on the last day of the year and report the unrealized gains or losses as ordinary income or loss. (Section 475 realized gains and losses are ordinary gains or losses, too.) This way, you can avoid the wash sale rules that defer losses on securities and the $3,000 capital loss limitation. Although this is uncertain, you might also qualify for the 20% qualified business income deduction on your Section 475 income.
– (Using an S-Corp), you can set up a retirement plan for yourself and your spouse (if applicable) and make tax-deductible contributions. A retirement plan can help you save for your future and lower your tax bill.
How do you qualify for trader tax status?
There is no election or application for trader tax status. It is based on your facts and circumstances and how you conduct your trading activity. The IRS needs to define TTS clearly, but it has provided some guidelines and court cases to help you determine eligibility.
According to the IRS, to qualify for trader tax status, you must:
– Trade substantially, regularly, frequently, and continuously. You need to meet no fixed number of trades or hours per day or week, but generally, the more trades and time you devote to trading, the better. A good rule of thumb is to average at least four daily transactions and 15 hours per week. (Green looks for a frequency of nearly four days a week with trade executions.)
– Seek to profit from short-term price swings of securities. It would be best if you did not hold securities for long-term appreciation or income. Your holding period should be less than 31 days on average.
– Have the intention to trade as a business. You should treat your trading activity as a serious and professional endeavor, not a hobby or a personal investment. You should have a separate trading account (or accounts), a dedicated workspace, a written trading plan, and proper records and reports.
How do you claim trader tax status?
If you meet the criteria for trader tax status, you can claim it on your tax return by reporting your trading expenses on Schedule C or the pass-through entity tax return. I would also like to ask you to please attach a statement explaining why you qualify for TTS and how you calculated your costs.
Suppose you want to elect Section 475 MTM accounting for your trading securities. In that case, you must file a timely election statement with the IRS by April 15 of the current year (or March 15 for partnerships and S corporations). You should also attach a copy of the election statement to your tax return. (New entities can elect Section 475 by internal resolution within 75 days of inception.)
If you want to set up a retirement plan for yourself and your spouse (if applicable), you must do so by December 31 of the current year. (A SEP IRA can wait until the tax return due date.) You can choose from various plans, such as a Solo 401(k), a SEP IRA, or a defined benefit plan. You should consult a tax professional to determine which plan is best for you and how much you can contribute.
Conclusion
Trader tax status is a valuable tax benefit for active traders who qualify. It allows you to deduct your trading expenses as business expenses and elect Section 475 MTM accounting for your trading securities. It also enables you to set up a retirement plan for yourself and your spouse (if applicable) and make tax-deductible contributions. (You need a TTS S-Corp to deduct a retirement plan and 2% owner health insurance premiums.)
However, trader tax status is not automatic or easy to obtain. You must meet certain criteria and follow specific rules to claim this status. You must also keep accurate records and reports of your trading activity and expenses. You should seek professional advice from a CPA or a tax attorney specializing in trader taxation before claiming TTS on your tax return.
Use Green’s 2023 Trader Tax Guide to receive the tax breaks you’re entitled to on your 2022 tax returns and execute tax strategies and elections for tax-year 2023. Our guide covers the impact of recent tax laws on traders.
BUSINESS TRADERS FARE BETTER
Investors have restricted investment interest expense deductions. The Tax Cuts & Jobs Act (TCJA) suspended investment fees and expenses for 2018 through 2025. Investors have a capital-loss limitation against ordinary income ($3,000 per year) and wash-sale (WS) loss adjustments, which can trigger capital gains taxes on phantom income. Investors benefit from lower long-term capital gains rates on positions held for 12 months or more before a sale (0%, 15%, and 20%). If traders have long-term investment positions, this is also available to them.
Traders eligible for trader tax status (TTS) are entitled to many tax advantages. A sole proprietor (individual) TTS trader deducts business expenses, startup costs, margin interest, and home-office expenses. TTS allows them to elect Section 475 MTM ordinary gain or loss treatment promptly. To deduct health insurance and retirement plan contributions, a TTS trader needs an S-Corp to create earned income with officer compensation. TTS traders use a pass-through entity (partnership or S-Corp) to arrange a state and local tax (SALT) cap workaround in many states.
TTS is different from the election of Section 475 MTM accounting. TTS is like an undergraduate university, and Section 475 is like graduate school. The 475 election converts new capital gains and losses into ordinary gains and losses, avoiding the $3,000 capital loss limitation. Only qualified business traders may use Section 475 MTM; investors may not. Section 475 trades are also exempt from WS loss adjustments. The 20% deduction on qualified business income (QBI) includes Section 475 ordinary income but excludes capital gains, interest, and dividend income.
A business trader can assess and claim TTS business expenses after year-end and even go back three open tax years. TTS does not require an election. But business traders may only use Section 475 MTM if they filed an election on time, either by April 18, for 2022 and 2023, or within 75 days of inception of a new taxpayer (i.e., a new entity). For more on TTS, see Chapter 1; for Section 475, see Chapter 2.
CAN TRADERS DEDUCT TRADING LOSSES?
Deducting trading losses depends on the instrument traded, the trader’s tax status, and various elections.
Many traders bought this guide, hoping to find a way to deduct their trading losses. Maybe they qualify for TTS, but that only gives them the right to take trading business expenses on Form 1040/Schedule C.
Securities, Section 1256 contracts, ETNs, and cryptocurrency trading receive default capital gain/loss treatment. Suppose a TTS trader did not file a Section 475 election on securities and commodities on time (i.e., by April 18, 2022) or have Section 475 from a prior year, they are stuck with capital loss treatment on securities and Section 1256 contracts. Section 475 does not apply to ETN prepaid forward contracts (not securities) or cryptocurrencies (intangible property).
Capital losses offset capital gains without limitation, whether short-term or long-term, but a net capital loss on Schedule D is limited to $3,000 per year against other income. Excess capital losses carry over to the subsequent tax year(s).
Once taxpayers get in the capital loss carryover trap, they often face a problem: how to use up the capital loss carryover in the following year(s). If a taxpayer elects Section 475 by April 18, 2023, the 2023 TTS trading gains will be ordinary rather than capital, thereby not utilizing the capital loss carryover. Once a trader has a capital loss carryover hole, they need a capital gains ladder to climb out of it and a Section 475 election to prevent digging an even bigger one. The IRS allows revocation of Section 475 elections if a Section 475 trader later decides they want capital gain/loss treatment again. Chapter 2 covers this topic in depth.
Traders with capital losses from Section 1256 contracts (such as futures) might be lucky if they had gains in Section 1256 contracts in the prior three tax years. On the top of Form 6781, traders can file a Section 1256 loss carryback election. This election allows taxpayers to offset their current-year net 1256 losses against prior-year net 1256 gains to receive a refund of taxes paid in prior years. TTS traders may elect Section 475 MTM on commodities, including Section 1256 contracts. Still, most elect it on securities only to retain the lower 60/40 capital gains tax rates on Section 1256 gains, where 60% is considered a long-term capital gain, even on day trades. The other 40% fall under ordinary income rates.
Taxpayers with losses trading forex contracts in the off-exchange Interbank market may be in luck. Section 988 for forex transactions receives ordinary gain or loss treatment by default, which means the capital-loss limitation doesn’t apply. However, the forex loss isn’t considered a business loss without TTS. It can’t be included in a net operating loss (NOL) carryforward calculation — potentially making it a wasted loss since it also can’t be added to the capital-loss carryover. If the taxpayer has another source of taxable income, the ordinary loss offsets it; the concern is when there is negative taxable income.
A TTS trader using Section 475 on securities has ordinary loss treatment, which avoids wash-sale loss adjustments and the $3,000 capital loss limitation. Section 475 ordinary losses offset income of any kind. However, Section 475 losses and TTS business expenses are subject to the excess business loss (EBL) limitation for tax years 2022 and 2023. Anything over the EBL threshold is a net operating loss (NOL) carryforward.
Those not using Section 475 must deal with wash-sale loss adjustments.
WASH-SALE LOSSES
Day and swing traders inevitably trigger many WS loss adjustments amounting to tens or hundreds of thousands of dollars. Create a WS loss when you take a loss on a security and repurchase it within 30 days (after or before).
A wash sale reduces the cost basis on the position sold and adds the WS loss to the replacement position’s cost basis, creating phantom taxable income and capital gains taxes.
It’s okay to incur WS losses during the year but try to avoid delaying the WS losses to the following year. Deferring a loss from November to December is acceptable; however, postponing a loss from December 2022 to January 2023 is not.
You can “break the WS chain” at year-end. For example, sell your entire position in security A by Dec. 20, 2022, and don’t repurchase it for 30 days — around Jan. 21, 2023. Waiting allows you to deduct the whole year of WS losses in 2022. See more about WS in Chapter 4.
EXCESS BUSINESS LOSS LIMITATION
In 2018, TCJA introduced an excess business loss (EBL) limitation. TCJA also repealed NOL carrybacks (except for farmers) and limited NOL carryforwards to 80% of the subsequent year’s taxable income. Add EBL over the threshold to the NOL carryforward.
The 2020 CARES Act suspended TCJA’s EBL, and NOL changes for 2018, 2019, and 2020 and allowed five-year NOL carrybacks (i.e., a 2020 NOL carryback to 2015). TCJA’s EBL and NOL carryforward rules apply for tax years 2021 through 2028.
See more about EBL and its thresholds in Chapter 2.
TAX TREATMENT ON FINANCIAL PRODUCTS
There are complexities in sorting through different tax-treatment rules and tax rates. It often takes work to tell what falls into each category. To help our readers with this, we cover the many trading instruments and their tax treatment in Chapter 3. Here’s a brief breakdown.
Securities have realized gain and loss treatment and are subject to WS rules and the $3,000 per year capital loss limitation on individual tax returns. Realization means income or loss when sold instead of mark-to-market (MTM) accounting. A Section 475 MTM election on securities avoids this issue.
Section 1256 contracts — including regulated futures contracts on U.S. commodities exchanges — are marked to market by default, so there are no wash-sale adjustments, and they receive lower 60/40 capital gains tax rates. Most TTS traders skip a Section 475 election on commodities to retain lower 60/40 capital gains rates.
Options have a wide range of tax treatments. An option is a derivative of an underlying financial instrument, and the tax treatment is generally the same. Equity options are taxed the same as equities, which are securities. Index options are derivatives of indexes, and broad-based indexes (stock index futures) are Section 1256 contracts. Simple and complex equity option trades have special tax rules on holding periods, adjustments, and more.
Forex receives ordinary gain or loss treatment on realized trades (including rollovers) unless a trader makes a contemporaneous capital gains election. In some cases, lower 60/40 capital gains tax rates on majors may apply under Section 1256(g).
Physical precious metals are collectibles; if a trader holds these capital assets for more than one year, sales are subject to the collectibles’ capital gains rate capped at 28%.
Cryptocurrencies are intangible property taxed like securities on Form 8949, but wash-sale loss and Section 475 rules do not apply because they are not securities.
Foreign futures are taxed like securities unless the IRS issues a revenue ruling allowing Section 1256 tax benefits.
ENTITIES FOR TRADERS
Entities can solidify TTS, unlock health insurance and retirement plan deductions, gain flexibility with a Section 475 election or revocation, prevent wash-sale losses with individual and IRA accounts, enhance a QBI deduction on Section 475 income less trading expenses, and provide a SALT cap workaround. An entity return consolidates trading activity on a pass-through tax return, making life easier for traders, accountants, and the IRS. Trading in an entity allows separation from individual investments.
An LLC with an S-Corp election is generally the best choice for a single or married couple seeking health insurance and retirement plan deductions.
A spousal-member LLC taxed as a partnership can segregate business trading from investments to perfect use of TTS and Section 475 and provide a SALT cap workaround, turning non-deductible state and local taxes as itemized deductions into tax-deductible business expenses. See Chapter 7.
RETIREMENT PLANS FOR TRADERS
TTS S-Corps can unlock a retirement plan deduction by paying sufficient officer compensation in December 2022 when results for the year are evident.
Consider a Solo 401(k) retirement plan with an elective deferral amount up to a maximum of $20,500 (or $27,000 if age 50 or older with the $6,500 catch-up provision). The Solo 401(k) also has a profit-sharing plan (PSP) up to a maximum of $40,500.
The IRS raised the 401(k) elective deferral for 2023 to $22,500 and the catch-up contribution to $7,500. See Chapter 8.
DEDUCTION ON QUALIFIED BUSINESS INCOME
In 2018, TCJA introduced a new tax deduction for pass-through businesses, including sole proprietors, partnerships, and S-Corps. Subject to haircuts and limitations, a pass-through business could be eligible for a 20% deduction on qualified business income (QBI).
Because TTS traders are considered a “specified service trade or business” (SSTB), taxable income above the following thresholds is not deductible: $340,100/$170,050 (married/other taxpayers) for 2022 and $364,200/$182,100 (married/other taxpayers) for 2023.
There is also a phase-out range above the threshold of $100,000/$50,000 (married/other taxpayers). The W-2 wage and property basis limitations apply within the phase-out range. TTS traders with an S-Corp usually have wages, whereas sole proprietor traders do not.
QBI for traders includes Section 475 ordinary income and loss and trading business expenses. QBI excludes capital gains and losses, Section 988 forex income or loss, dividends, and interest income.
For more information, see Chapter 7 and Chapter 17.
SALT CAP WORKAROUND
TCJA capped state and local income, sales, and property taxes (SALT) at $10,000 per year ($5,000 for married filing separately) and did not index it for inflation. About 29 states enacted SALT cap workaround laws.
Generally, elect to make a pass-through entity (PTE) payment on a partnership or S-Corp tax return filed by a business. It doesn’t work with a sole proprietorship filing a Schedule C. PTE is a business expense deduction shown on the state K-1 like a withholding credit. Most states credit the individual’s state income tax liability with the PTE amount. Essentially, convert a non-deductible SALT itemized deduction (over the cap) into a business expense deduction from gross income.
DESK REFERENCE
Some readers use our guide as a desk reference to quickly find answers to specific questions. Others read this guide in its entirety. To accommodate desk-reference readers, we edit each chapter to stand alone, which inevitably means some chapters contain information covered in others.
June 18, 2022 | By: Robert A. Green, CPA
| Read it on
If you are eligible for trader tax status (TTS), consider setting up a trading business to maximize tax benefits. Some traders benefit from an LLC; others don’t need one.
Deduct trading business expenses.
Elect Section 475 MTM for exemption from wash sales and the capital loss limitation.
Be eligible for a 20% qualified business income QBI deduction on Section 475/TTS income.
Deduct health insurance and high-deductible retirement plan contributions.
Deduct state and local taxes (SALT) as a pass-through entity (PTE) business expense avoiding the $10,000 SALT cap.
How to be eligible for trader tax status
Volume: Make four trades per day, 16 trades per week, 60 a month, and 720 per year on an annualized basis (Poppe court). Count each open and closing transaction separately.
Frequency: Executes trades on nearly four weekly days, around a 75% frequency rate.
Holding period: In the Endicott court, the IRS said the average holding period must be 31 days or less. That’s a bright-line test.
Trade full-time or part-time. For a good portion of the day, the markets are open.
Hours: Spend more than four hours daily, almost every market day, working on the trading business — all time counts.
Avoid sporadic lapses: Once TTS commences, avoid lapses in the trading during the year. Trading must be regular, frequent, and continuous.
Intend to run a business and make a living. It doesn’t have to be a primary living.
Operations: Have significant business equipment, business services, and a home office.
Account size: Securities traders need to have $25,000 on deposit with a U.S.-based broker to achieve pattern day trader (PDT) status. For the minimum account size, we like to see more than $15,000.
A third party creates the automated trading system (ATS) with entry and exit signals and mechanical execution. Some ATS don’t come with automatic execution, and traders significantly depart from ATS signals so that the trader can count those trades. A self-created ATS counts for TTS. Many traders come from the tech world and design and code an ATS.
A trade copying service does not count for TTS unless you depart from recommended trades significantly.
An individual TTS trader deducts business expenses, startup costs, and home office deductions on a Schedule C (Profit or Loss From Business – Sole Proprietorship) as part of the 1040 filing.
Traders don’t have revenue on Schedule C; they report trading gains and losses on other tax forms.
Schedule C expenses are an above-the-line deduction from gross income.
TTS Schedule C expenses also reduce self-employment income (SEI). However, trading income is not SEI unless you are a full futures exchange member per Section 1402(i).
Trading income is net investment income (NII) for the 3.8% net investment tax on NII over ACA thresholds.
Individual brokerage account
You can establish an individual brokerage account(s) in the trader’s name and social security number.
You can also use a joint individual account, but first, list the trader’s name and social security number.
If the husband trades the spouse’s account, neither can qualify for TTS.
Individuals pay non-professional rates for real-time data, whereas entities might owe higher professional rates.
No election or filing need for TTS
There isn’t a tax election for claiming TTS — it’s determined based on facts and circumstances assessed at year-end.
A TTS trader can elect Section 475 to treat MTM as ordinary gain or loss. But the 475 election is due early in the tax year.
TTS is like undergraduate school, and Section 475 is like grad school. You can claim TTS after the fact, but not 475. That hurts many traders in 2022, especially if they rack up massive losses and miss the 475-election deadline for existing individuals due by April 18, 2022. (March 15 for partnerships and S-Corps).
Single-member LLC
If you want asset protection, consider a single-member LLC (SMLLC) taxed as a “disregarded entity.” That’s a “tax nothing” in the eyes of the IRS. You still file as a TTS sole proprietor on Schedule C.
Traders don’t have investors or clients; that would be an investment management business subject to liability concerns.
A TTS trader might hire employees, lease an office, co-locate automated trading equipment with a broker, and use massive leverage. These traders should consider liability protection using an SMLLC. Consult an attorney.
An SMLLC can also elect S-Corp or C-Corp tax status.
Business expenses with trader tax status
Tax-deductible business expenses include home-office, education, startup expenses, organization expenses, margin interest, tangible property expense, Section 179 (100%) or 100% bonus depreciation, amortization on software, self-created automated trading systems, mentors, seminars, market data, charting services, stock borrow fees, and much more.
TTS traders are entitled to make a Section 475 election, but investors may not.
The election exempts securities trades from wash-sale loss (WS) adjustments, which can defer tax losses to the subsequent year and the $3,000 capital loss limitation. Ordinary loss treatment is better; it can generate tax refunds faster.
A TTS/475 trader is eligible for a 20% qualified business income (QBI) deduction if under the taxable income threshold for a “specified service trade or business” (SSTB). QBI includes 475 ordinary income less TTS expenses, excluding capital gains and portfolio income.
Section 475 election process
The deadline for a TTS trader to elect Section 475 for 2022 has passed; it was April 18, 2022, for individuals and March 15, 2022, for existing partnerships and S-Corps.
A partnership or S-Corp formed during the tax year is considered a “new taxpayer,” which can elect Section 475 internally within 75 days of inception. A new entity comes in handy for selecting 475 later in the year.
TCJA introduced a tax benefit for pass-through businesses, which includes a TTS trader with Section 475 income: whether doing business as a sole proprietor, partnership, or S-Corp.
Section 199A provides a 20% QBI deduction on a “specified service trade or business” (SSTB), and TTS trading is an SSTB.
SSTBs are subject to a taxable income threshold, phase-out range, and an income cap. The phase-out range has wage and property limitations, too.
As an SSTB, TTS traders have a taxable income (TI) cap of $440,100/$220,050 (married/other taxpayers) for 2022. The phase-out range below the cap is $100,000/$50,000 (married/other taxpayers), in which the QBI deduction phases out for SSTB. The W-2 wage and property basis limitations also apply within the phase-out range.
For example, on $100,000 of TTS/475 income, the trader might get a $20,000 tax deduction.
LLC taxed as a partnership
A TTS trader can organize a spousal-member LLC and file as a partnership. Only one spouse needs to be an active trader.
LLC/partnerships file a Form 1065 partnership tax return and issue Schedule K-1s to owners.
LLC/partnerships must qualify for TTS; otherwise, they are investment companies.
With TTS, report business expenses on page one of 1065. List net 475 income or loss, less TTS expenses on line one of the Schedule K-1 “ordinary business income (loss).” Use separate K-1 line items for portfolio income, including capital gains and losses, interest, and dividends.
The owner reports Schedule K-1 ordinary business income (loss) on Form 1040 Schedule E in the active column.
It’s not a passive activity in Section 469 under the “trading rule” exception. However, losses are limited to “basis” (your net investment in the partnership). (Sole proprietor TTS traders also need a basis for deducting losses.)
Report capital gains/losses and portfolio income separately on 1040—schedule B for interest and dividend income and Schedule D for capital gains and losses from partnerships.
If the partnership agreement provides for it, the partner can also deduct “unreimbursed partnership expenses” (UPE), including home office expenses, on Schedule E page 2. (It’s more formal with an S-Corp.)
An LLC/partnership provides a ring-fencing solution and the SALT cap workaround strategy. It cannot generate earned income for the health and retirement plan deductions; you need an S-Corp for employee benefits.
Ring-fence trading from investments with a partnership or S-Corp
If you trade substantially-identical positions that you invest in a taxable account, it could invite the IRS to play havoc with reclassification. It can also undermine eligibility for TTS. For example, you invest in Apple and Microsoft equities for the long-term and also trade Apple and Microsoft equity options around those investment positions.
A partnership or S-Corp can fix this problem. The entity can ring-fence TTS/475 trading positions, segregating them from overlapping investments on the individual level. But that isn’t easy if you want to maximize portfolio margining.
This entity solution prevents the IRS from reclassifying TTS positions out of Section 475 ordinary losses into a capital loss limitation and, alternatively, reclassifying unrealized long-term capital gains into MTM income.
If you don’t have overlapping investments, you don’t need a ring-fencing entity solution.
Avoid permanent wash sale losses between taxable and IRA accounts
If you trade substantially-identical positions that you also invest in IRAs, it could trigger losses for permanent wash sale loss adjustments (WS). Brokers don’t recognize this problem on 1099-Bs; the IRS permits them to take a narrow view of WS.
Take a loss on X in a taxable account and repurchase X within 30 days before or after in an IRA, and it’s a permanent WS loss. There is no way to record the WS cost basis adjustments in the IRAs; hence it’s permanent. Conversely, with WS in taxable accounts, you defer the loss to the replacement position, which the broker does on the 1099-B.
There are three ways to avoid these IRA-generated WS. Use a do not trade or invest list to prevent overlap, elect 475 on trades, or use a ring-fencing entity solution. If you only trade an IRA account, there is no WS; it’s only a problem between taxable vs. IRS accounts with overlap.
SALT cap workaround laws
In 2018, TCJA capped SALT itemized deductions at $10,000 per year, including state and local income taxes, property, and sales taxes. Over 20 states provide relief with SALT cap workaround laws. Business owners of partnerships or S-Corps are entitled to make SALT payments through the entity and get a credit on their individual tax returns. That converts non-deductible SALT into a business expense.
Search “SALT cap workaround” with your state. Act on time to get this deduction; it requires planning.
Organize a single-member or spousal-member LLC and elect S-Corp status with the IRS within 75 days of inception (date on the certificate of formation).
Alternatively, in a subsequent year, the LLC can submit an S-Corp election by March 15.
Owners must be U.S. residents.
An LLC/S-Corp can achieve the ring-fencing and SALT cap workaround solutions of partnerships previously discussed. Consider an S-Corp if you also want health insurance and retirement plan deductions.
TTS traders with significant health insurance (HI) premiums should consider an S-Corp to arrange an AGI tax deduction.
The trader or spouse might have another source of self-employment income to deduct HI. A spouse might have HI coverage for the family in their job. Cobra is not deductible HI since it’s employer-provided.
Add reimbursement of HI premiums to officer compensation, and that portion of salary is not subject to payroll taxes (social security and Medicare). The trader then can take an AGI deduction for the HI premiums on their Form 1040. (It’s quirky).
A TTS sole proprietor or partnership cannot deduct HI based on trading income.
Retirement plan contribution/deduction with an S-Corp
Traders need “earned income” to make and deduct retirement plan contributions and health insurance premiums; however, trading income is unearned.
TTS sole proprietors and partnerships cannot create earned income, whereas S-Corps can pay officer compensation, generating earned income.
Payroll taxes apply on officer compensation (wages): 12.4% FICA capped on salaries up to $147,000 for 2022, and the 2.9% Medicare is unlimited. There’s a 0.9% surtax over the ACA income threshold.
Upper-income traders convert Medicare tax on unearned income (net investment tax) into Medicare on earned income, so it’s not redundant.
Annual payroll at year-end
TTS traders should fund retirement plan contributions from net income, not losses.
It’s okay to have a loss generated by the HI reimbursement portion of compensation.
It’s best to wait on the execution of an annual paycheck until early December when there is transparency for the year.
Solo 401(k) elective deferral
If you have sufficient trading profits for the year, consider establishing a Solo 401(k) retirement plan before year-end.
Start with the 100% deductible elective deferral (ED; $20,500 for 2022) and pay it through payroll. Deduct it on the annual W-2.
Taxpayers 50 years and older have a “catch-up provision” of $6,500, raising the 2022 ED limit to $27,000 annually.
The ED can be contributed to a Roth IRA, forgoing the tax deduction on the contribution. Roth plans are permanently tax-free, whereas traditional programs provide deferral of income.
Solo 401(k) profit-sharing plan
Consider a 25% deductible Solo 401(k) profit-sharing plan (PSP) contribution if you have sufficient trading gains. Increase payroll in December 2022 for a performance bonus. You don’t have to pay into the retirement plan until the due date of the S-Corp tax return (including extensions by September 15, 2023).
The maximum PSP amount for 2022 is $40,500, increased by $2,000 from 2021.
The total 2022 limit for a Solo 401(k) is $67,500 ($20,500 ED, $6,500 catch-up ED, and $40,500 PSP).
Traders are eligible for some business tax benefits and have unique needs. For example, their income is unearned, yet it can qualify for QBI deductions with a 475 election and the SALT cap workaround as capital gains or 475 income. Creating earned income for employee benefits requires the S-Corp. A local accountant might follow their intuition and give wrong advice. TTS benefits are quirky and challenging to arrange correctly. This blog post should help and consider a consultation with a trader tax expert.
March 1, 2021 | By: Robert A. Green, CPA
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March 17, 2021: Tax Day for individuals extended to May 17: Treasury, IRS extend filing and payment deadline. “The Treasury Department and Internal Revenue Service announced today that the federal income tax filing due date for individuals for the 2020 tax year will be automatically extended from April 15, 2021, to May 17, 2021. The IRS will be providing formal guidance in the coming days. Individual taxpayers can also postpone federal income tax payments for the 2020 tax year due on April 15, 2021, to May 17, 2021, without penalties and interest, regardless of the amount owed. This relief does not apply to (2021) estimated tax payments that are due on April 15, 2021. The IRS urges taxpayers to check with their state tax agencies for those details.” (IRS Issue Number: IR-2021-59). Intuit: State Tax Deadline Updates. The postponement does not apply to C-Corps, trusts, and estates.
March 29, 2021: The good news is the 475 election is due May 17, 2021, with the 2020 tax return or extension. The IRS issued formal guidance Notice 2021-21, “Relief For Form 1040 Filers Affected By Ongoing Coronavirus Disease 2019 Pandemic.” The IRS notice states, “Finally, elections that are made or required to be made on a timely filed Form 1040 series (or attachment to such form) will be timely made if filed on such form or attachment, as appropriate, on or before May 17, 2021.” The IRS notice also postponed the 2020 IRA and HSA contribution tax deadline to May 17, 2021.
Original post:
Traders use various tax forms as the IRS hasn’t created specialized tax forms for individual trading businesses. Traders enter gains and losses, portfolio income, and business expenses on different forms. It’s often confusing. Which form should forex traders use? Which form is correct for securities traders using the Section 475 MTM method? Can one report trading gains directly on a Schedule C? The different reporting strategies for various types of traders make tax time not so cut-and-dry.
Sole Proprietor Trading Business
Trader tax status (TTS) constitutes business expense treatment and unlocks an assortment of meaningful tax benefits for active traders who qualify. The first step is to determine eligibility. Our golden rules require four trades per day, close to four days per week, and an average holding period under 31 days. See all the requirements at Trader Tax Status: How To Qualify.
If a trader qualifies for TTS, he can claim some tax breaks after the fact (such as business expense treatment) and elect and set up other benefits (such as Section 475 MTM and employee-benefit plans) on a timely basis. You can assess and claim TTS business expense deductions for all or part of 2020.
Other sole-proprietorship businesses report revenue, cost of goods sold, and expenses on Schedule C. But TTS business traders report only trading business expenses on Schedule C. Trading gains and losses are reported on various forms, depending on the situation.
Trading Gains and Losses
Sales of securities must be first reported (line by line) on Form 8949 based on the realization method with cost basis adjustments, including wash sale (WS) losses. Form 8949 then feeds into Schedule D short-term capital gains using the ordinary tax rate and long-term capital gains for securities held 12 months using the lower capital gains rate. Capital losses offset capital gains in full, and net capital losses are limited to $3,000 per year against ordinary income (the rest is a capital loss carryover to subsequent years).
Some brokers provide Form 8949 in addition to Form 1099-B. Consider using trade accounting software to calculate WS loss adjustments. See Form 8949 & 1099-B Issues.
TTS traders who use Section 475 MTM accounting on securities report their TTS trades (line by line) on Form 4797 Part II. “MTM” means open positions are marked-to-market at year-end. Form 4797 Part II has business ordinary loss treatment and avoids the capital loss limitation and wash-sale loss adjustments. Form 4797 losses are included in net operating loss (NOL) calculations. Consider using trade accounting software to generate Form 4797 for Section 475 trades. Without wash sale losses, the trader will be departing from the 1099-B and should explain that in a tax return footnote.
Section 1256 contracts (i.e., regulated futures contracts) use MTM accounting and are reported on Form 6781 (unless the TTS trader elected Section 475 for commodities/futures; in that case Form 4797 is used). Section 1256 traders rely on a one-page Form 1099-B showing their net trading gain or loss (“aggregate profit or loss on contracts”). They may simply enter that amount in summary form on Form 6781 Part I. There are no wash-sale losses on 1256 contracts.
Section 1256 contracts have lower 60/40 capital gains tax rates: 60% (including day trades) subject to lower long-term capital gains rates, and 40% taxed as short-term capital gains using the ordinary rate. At the maximum tax bracket for 2020, the blended 60/40 rate is 26.8% — 10.2% lower than the highest ordinary rate of 37%. See Section 1256 Contracts.
If the trader had a significant Section 1256 loss in 2020, she should consider carrying back those losses three tax years but only apply against Section 1256 gains in those years. To obtain this election, check box D labeled “Net section 1256 contracts loss election” on the top of Form 6781. You can make this election with a tax return filed on time, including extensions. Forex traded in the Interbank market uses Section 988 ordinary gain or loss treatment. Forex traders who don’t qualify for TTS should use line 8 (other income or loss) on 2020 Schedule 1 (Form 1040). TTS forex traders should use Form 4797, Part II ordinary gain or loss. What’s the difference? Form 4797 Part II losses contribute to NOL carryforwards against any type of income, whereas Form 1040’s “other losses” do not. The latter is wasted if the taxpayer has a negative income.
In that case, a contemporaneous forex capital gains election is better on the Section 988 trades. If the taxpayer filed the Section 988 opt-out (capital gains) election, she should use Form 8949 for minor currencies and Form 6781 for major currencies. Forex uses summary reporting. See Forex.
Selling, exchanging, or using cryptocurrency triggers capital gains and losses. The IRS treats cryptocurrencies as intangible property. The realization method applies to short-term vs. long-term capital gains and losses, and there is no WS or 475 on intangible property. Report a capital gain or loss on each transaction, including cryptocurrency-to-currency sales, crypto-to-crypto trades, and purchases of goods or services using crypto. Answer the IRS question about cryptocurrency on the 2020 Form 1040 page 1 up top.
TTS allows a trader to add a Schedule C to deduct business expenses, including these items:
“Tangible personal property” up to $2,500 per item for equipment and furniture.
Section 179 (100%) depreciation on fixed assets. Otherwise, bonus and regular depreciation.
Amortization of start-up costs (Section 195), organization costs (Section 248), and software.
Education expenses paid and courses taken after the commencement of TTS. Otherwise, pre-business education may not be deductible. (Alternatively, include pre-business education in Section 195 start-up costs.)
Subscriptions, scanners, publications, market data, professional services, chat rooms, mentors, coaches, supplies, phone, travel, seminars, conferences, assistants, and consultants.
Home-office expenses for the business portion of the home.
Margin interest expenses.
Stock-borrow fees for short-sellers.
Internal-use software for self-created automated trading systems.
Home office (HO) expenses are first reported on Form 8829. HO is one of the most significant tax deductions for traders. It requires trading gains to unlock most of the deduction; mortgage interest and real estate tax portions of HO do not require income.
When commencing TTS, look back six months to capitalize Section 195 start-up costs, including trading education expenses. The trader can expense (amortize) up to $5,000 in the first year and the balance over 15 years.
Make Schedule C Look Better
The IRS may view a trading business’s Schedule C as unprofitable even if it has significant net trading gains on other forms and is profitable after expenses.
To mitigate this red flag, transfer a portion of business trading gains to Schedule C “Other Income” (not revenue) to zero the expenses out but not show a net profit. Showing a profit could cause the IRS to inquire about self-employment (SE) tax on self-employment income (SEI). Trading expenses reduce SEI, but trading gains and losses are not SEI. Learn how to do this transfer strategy in Green’s 2021 Trader Tax Guide.
Section 475 MTM Accounting
Only TTS traders can elect and use Section 475, not investors. Section 475 trades are exempt from WS loss adjustments on securities. Section 475 ordinary losses are also not subject to the $3,000 capital loss limitation against ordinary income. Section 475 losses and TTS expenses contribute to net operating losses (NOLs). Hence our phrase “tax loss insurance.”
We usually recommend a Section 475 election on securities only to retain lower 60/40 capital gains rates on Section 1256 contracts (commodities).
Profitable traders might also benefit from Section 475. TCJA introduced a 20% deduction on qualified business income (QBI) in pass-through businesses, and TTS traders with 475 elections are eligible for the deduction. QBI includes Section 475 income less TTS expenses. However, QBI excludes capital gains and other portfolio income. TTS traders are a “specified service activity,” which means if their taxable income is above an income cap, they won’t receive a QBI deduction. The 2020 taxable income (TI) cap is $426,600/$213,300 (married/other taxpayers). The phase-out range below the cap is $100,000/$50,000 (married/other taxpayers). The W-2 wage and property basis limitations also apply within the phase-out range. Use Form 8995 or Form 8995-A for QBI deductions.
Section 475 Election Procedures
To obtain Section 475 as an individual, you must file a 2021 Section 475 election statement with your 2020 tax return or extension due by April 15, 2021. Existing partnerships and S-Corps must file a Section 475 election statement by March 15, 2021.
“New taxpayers” like new entities file an internal Section 475 MTM election resolution within 75 days of inception.
Traders who filed a 475 election for 2020 on time (by July 15, 2020, for individuals) must complete the process by sending a Form 3115 with the 2020 tax return and a duplicate to the national office.
Learn more about Section 475, the pros, cons, and nuances in Green’s 2021 Trader Tax Guide. The guide includes the election statement to use with your filing.
Tax Extensions
The 2020 income tax returns for individuals are due by April 15, 2021 — however, most active traders aren’t ready to file a complete tax return by then. Some brokers issue corrected 1099-Bs right up to the deadline or even beyond. Many partnerships and S-Corps file extensions by March 15, 2021, and don’t issue final Schedule K-1s to investors until after April 15.
The excellent news is traders don’t have to rush the completion of their tax returns by April 15. They may want to consider sending a one-page automatic extension along with payment of taxes owed to the IRS and state.
The IRS postponed the April 15, 2021 tax deadline until June 15, 2021, for residents of Texas,Oklahoma, and Louisiana, after a federal disaster declaration in February 2021 due to winter storms. This postponement also applies to the Section 475 election. The delay includes various 2020 business returns due on March 15 like partnerships and S-Corps.
Traders can request an automatic six-month extension on Form 4868 to file their federal income tax return by Oct. 15, 2021. States also provide tax extensions, with some states accepting the federal election; however, if the taxpayer owes state taxes, a state tax voucher/extension form is required.
The Form 4868 instructions point out how easy it is to get this automatic extension — no reason is required. It’s an extension of time to file a complete tax return, not an extension of time to pay taxes owed. The taxpayer should estimate and report what he thinks he owes for 2020 based on his received tax information.
See how the IRS assesses late-filing penalties and late-payment penalties on page two of Form 4868. If a taxpayer cannot pay the taxes owed, he should estimate the balance due by April 15 and report it on the extension.
Even if a taxpayer cannot pay the balance due, he should at least file Form 4868 by April 15, 2021. Merely filing the extension will avoid the late-filing penalties of 5% per month up to 25%, which are 10 times higher than the late-payment penalty of 0.5% per month up to 25%. The IRS charges interest, too.
Many traders made massive trading gains in 2020 with an explosion of new pandemic-fueled traders and market volatility. Some used the estimated tax payment “safe harbor” exception to cover their 2019 tax liability with a Q4 2020 estimated tax payment made by Jan. 15, 2021. They plan to pay the balance of taxes owed by April 15, 2021. They should consider setting aside and protecting those tax payments. See Traders Should Focus On Q4 Estimated Taxes Due January 15.
Some traders will risk those 2020 tax payments in the markets right up to the deadline, and they should be careful not to lose them because that will cause significant tax trouble with the IRS and state.
Partnerships and S-Corps
The 2020 partnership and S-Corp tax extensions are due March 15, 2021. They are easy to prepare since they pass income and loss to the owner, usually an individual. Generally, pass-through entities are tax-filers but not taxpayers.
S-Corps and partnerships use Form 7004 (Application for Automatic Extension of Time To File Certain Business Income Tax, Information, and Other Returns). Extensions give six additional months to file a federal tax return — by Sept. 15, 2021. Your must file the partnership or S-Corp extension on time. Otherwise, late-filing penalties apply $210 per month per owner up to 12 months. See the Form 1065 and 1120S instructions for further details about penalties.
Some states require a state extension, whereas others accept a federal extension. Some states have S-Corp franchise taxes, excise taxes, minimum taxes, and payments usually due to the extensions by March 15. LLCs filing as partnerships may have minimum taxes or annual reports due to the extension by March 15. States assess penalties and interest, often based on payments due.
Recent Tax Law Changes
The 2017 Tax Cuts And Jobs Act (TCJA) introduced an “excess business loss” limitation: $500,000 married and $250,000 other taxpayers for 2018, and it’s indexed for inflation each year. Business losses exceeding the EBL limitation are a NOL carryforward. TCJA also suspended NOL carrybacks, allowing NOL carryforwards with 80% limits against subsequent year’s taxable income. The rest carries forward indefinitely.
The 2020 CARES Act provided temporary tax relief: It suspended TCJA’s EBL rules for 2018 through 2020 and allowed five-year NOL carrybacks for 2018, 2019, and 2020. TCJA EBL and NOL rules apply again in 2021.
We expect tax legislation in 2021 that impacts traders, so stay tuned to our blog post for updates.
Takeaway
Traders should focus on the big picture of filing a 2020 automatic extension by the April 15, 2021 deadline. With or without sufficient payment of taxes, filing the extension avoids the late-filing penalty of 5% per month, assessed on the tax balance due. Try to pay 90% of the tax liability to avoid the late-payment penalty of 0.5% per month. Traders unsure of TTS qualification can leave out Schedule C trading expenses from the tax liability calculations used for the extension filing and settle that issue before filing the complete tax return later. The most important issue might be a 2021 Section 475 election due with the 2020 extension by April 15, 2021, for individuals, and March 15, 2021, for partnerships and S-Corps. Overpaying the extension payment is wise for profitable traders to apply the overpayment credit towards 2021 quarterly estimated taxes. It also leaves a cushion on 2020 taxes.
Green’s 2021 Trader Tax Guide is ready! Our 2021 guide covers the 2017 Tax Cuts and Jobs Act (TCJA) and the 2020 Coronavirus Aid, Relief, and Economic Security (CARES) Act’s impact on investors, traders, and investment managers.
Purchase the paperback version on Amazon here. Purchase the online version for immediate access here. Watch our Webinar covering the highlights of Green’s 2021 Trader Tax Guidehere.
The highlights of this year’s guide are included below.
TAX CUTS AND JOBS ACT
Tax Cuts and Jobs Act (TCJA) was enacted on Dec. 22, 2017, and the law changes took effect in the 2018 tax year.
Like many small business owners, traders eligible for trader tax status (TTS) restructured their business to take advantage of TCJA. Two tax changes caught their eye: The 20% deduction on qualified business income (QBI) in pass-through entities, and suspended investment fees and expenses, which makes TTS even more crucial. (TCJA continues to allow itemized deductions for investment-interest expenses.)
TCJA didn’t change trader tax matters, including business expense treatment, Section 475 MTM ordinary gain or loss treatment, and wash-sale loss adjustments on securities; it didn’t change TTS S-Corps’, Solo 401(k) retirement contributions and health-insurance deductions, either. TCJA also retains the lower Section 1256 60/40 capital gains tax rates; the Section 1256 loss carryback election; Section 988 forex ordinary gain or loss; and tax treatment on financial products including options, ETFs, ETNs, swaps, precious metals, and more.
CORONAVIRUS AID, RELIEF, AND ECONOMIC SECURITY ACT
The 2020 Coronavirus Aid, Relief, and Economic Security Act (CARES) overrode TCJA’s limitations on tax losses. CARES suspended TCJA’s “excess business loss” limitation for 2018, 2019, and 2020. CARES also provided for five-year NOL carrybacks, whereas TCJA suspended NOL carrybacks. Traders with trader tax status and Section 475 ordinary loss treatment consider NOL carrybacks for 2018, 2019, and 2020. Learn more about CARES’ impact on traders in Chapter 18.
BUSINESS TRADERS FARE BETTER
By default, the IRS lumps all traders into “investor tax status,” and investors get penalized in the tax code — more so with TCJA. Investors have restricted investment interest expense deductions, and investment fees and expenses are suspended. Investors have capital-loss limitations against ordinary income ($3,000 per year), and wash-sale loss deferrals; they do not have the Section 475 MTM election option or health insurance and retirement plan deduction strategies. Investors benefit from lower long-term capital gains rates (0%, 15%, and 20%) on positions held for 12 months or more before sale. If active traders have segregated long-term investment positions, this is available to them as well.
Business traders eligible for TTS are entitled to many tax breaks. A sole proprietor (individual) TTS trader deducts business expenses, startup costs, and home office expenses, and is entitled to elect Section 475 MTM ordinary gain or loss treatment. However, to deduct health insurance and retirement plan contributions, a TTS trader needs an S-Corp to create earned income with officer compensation.
Don’t confuse TTS with the related tax-treatment election of Section 475 MTM accounting. The 475 election converts new capital gains and losses into business ordinary gains and losses, avoiding the $3,000 capital loss limitation. Only qualified business traders may use Section 475 MTM; investors may not. Section 475 trades are also exempt from wash-sale loss adjustments. The 20% deduction on qualified business income includes Section 475 ordinary income but excludes capital gains, interest, and dividend income. The QBI deduction for TTS/475 traders is subject to a taxable income threshold and cap.
A business trader can assess and claim TTS after year-end and even going back three open tax years. But business traders may only use Section 475 MTM if they filed an election on time, either by April 15 of the current year (July 15, 2020, for 2020, with three-month postponement under CARES) or within 75 days of inception of a new taxpayer (i.e., a new entity). For more on TTS, seeChapter 1.
CAN TRADERS DEDUCT TRADING LOSSES?
Deducting trading losses depends on the instrument traded, the trader’s tax status, and various elections.
Many traders bought this guide hoping to find a way to deduct their 2020 trading losses. Maybe they qualify for TTS, but that only gives them the right to deduct trading business expenses.
Securities, Section 1256 contracts, ETNs, and cryptocurrency trading receive capital gain/loss treatment by default. If a TTS trader did not file a Section 475 election on securities and/or commodities on time (i.e., by July 15, 2020, or April 15, 2021, for 2021), or have Section 475 from a prior year, he is stuck with capital loss treatment on securities and Section 1256 contracts. Section 475 does not apply to ETN prepaid forward contracts, which are not securities, or cryptocurrencies, which are intangible property.
Capital losses offset capital gains without limitation, whether short-term or long-term, but a net capital loss on Schedule D is limited to $3,000 per year against other income. Excess capital losses are carried over to the subsequent tax year(s).
Once taxpayers get in the capital loss carryover trap, a problem they often face is how to use up the carryover in the following year(s). If a taxpayer elects Section 475 by April 15, 2021, the 2021 TTS trading gains will be ordinary rather than capital. Remember, only capital gains can offset capital loss carryovers. That creates a predicament addressed in Chapter 2on Section 475 MTM. Once a trader has a capital loss carryover hole, she needs a capital gains ladder to climb out of it and a Section 475 election to prevent digging an even bigger one. The IRS allows revocation of Section 475 elections if a Section 475 trader later decides she wants capital gain/loss treatment again.
Traders with capital losses from Section 1256 contracts (such as futures) may be in luck if they had gains in Section 1256 contracts in the prior three tax years. On the top of Form 6781, traders can file a Section 1256 loss carryback election. This allows taxpayers to offset their current-year losses against prior-year 1256 gains to receive a refund of taxes paid in prior years. Business traders may elect Section 475 MTM on Section 1256 contracts, but most elect it on securities only so they can retain the lower 60/40 capital gains tax rates on Section 1256 gains, where 60% is considered a long-term capital gain, even on day trades. The other 40% fall under ordinary income rates.
Taxpayers with losses trading forex contracts in the off-exchange Interbank market may be in luck. By default, Section 988 for forex transactions receives ordinary gain or loss treatment, which means the capital-loss limitation doesn’t apply. However, without TTS, the forex loss isn’t a business loss and therefore can’t be included in a net operating loss (NOL) calculation — potentially making it a wasted loss since it also can’t be added to the capital loss carryover. If the taxpayer has another source of taxable income, the forex ordinary loss offsets it; the concern is when there is negative taxable income. Forex traders can file a contemporaneous “capital gains and losses” election in their books and records to opt out of Section 988, which is wise when capital loss carryovers exist. (Contemporaneous means in advance — not after the fact using hindsight.) In some cases, this election qualifies for Section 1256(g) lower 60/40 capital gains tax rates on major currency pairs.
A TTS trader using Section 475 on securities has ordinary loss treatment, which avoids wash-sale loss adjustments and the $3,000 capital loss limitation. Section 475 ordinary losses offset income of any kind.
The CARES Act allows taxpayers to submit five-year NOL carryback refund claims for the tax years 2018, 2019, and 2020 (i.e., a 2020 NOL carries back to 2015). Or taxpayers may choose to carry the NOL forward. TCJA tax-loss limitation provisions will apply again in 2021, allowing only NOL carryforwards used against 80% of the subsequent year’s taxable income.
TCJA’s “excess business loss” (EBL) limitation also returns in 2021: $500,000 married and $250,000 other taxpayers (2018 limits). In 2021, taxpayers may add an EBL to a NOL carryforward. CARES suspended EBL rules for 2018, 2019, and 2020. See TCJA changes in Chapter 17 and CARES changes in Chapter 18.
TAX TREATMENT ON FINANCIAL PRODUCTS
There are complexities in sorting through different tax-treatment rules and tax rates. It’s often hard to tell what falls into each category. To help our readers with this, we cover the many trading instruments and their tax treatment in Chapter 3. Here’s a brief breakdown.
Securities have realized gain and loss treatment and are subject to wash-sale rules and the $3,000 per year capital loss limitation on individual tax returns.
Section 1256 contracts — including regulated futures contracts on U.S. commodities exchanges — are marked to market by default, so there are no wash-sale adjustments, and they receive lower 60/40 capital gains tax rates.
Options have a wide range of tax treatment. An option is a derivative of an underlying financial instrument and the tax treatment is generally the same. Equity options are taxed the same as equities, which are securities. Index options are derivatives of indexes, and broad-based indexes (stock index futures) are Section 1256 contracts. Simple and complex equity option trades have special tax rules on holding period, adjustments, and more.
Forex receives ordinary gain or loss treatment on realized trades (including rollovers), unless a contemporaneous capital gains election is filed. In some cases, lower 60/40 capital gains tax rates on majors may apply under Section 1256(g).
Physical precious metals are collectibles; if these capital assets are held for more than one year, sales are subject to the collectibles capital gains rate capped at 28%.
Cryptocurrencies are intangible property taxed like securities on Form 8949, but wash-sale loss and Section 475 rules do not apply because they are not securities.
Foreign futures are taxed like securities unless the IRS issues a revenue ruling allowing Section 1256 tax benefits.
Several brokerage firms classify options on exchange-traded notes (ETNs) and exchange-traded funds (ETFs) structured as publicly traded partnerships as “equity options” taxed as securities. There is substantial authority to treat these CBOE-listed options as “non-equity options” eligible for Section 1256 contract treatment. Volatility ETNs have special tax treatment: ETNs structured as prepaid forward contracts are not securities, whereas, ETNs structured as debt instruments are.
Don’t solely rely on broker 1099-Bs: There are opportunities to switch to lower 60/40 tax capital gains rates in Section 1256, use Section 475 ordinary loss treatment if elected on time, and report wash-sale losses differently. Vital 2021 tax elections need to be made on time. See Chapter 3.
ENTITIES FOR TRADERS
Entities can solidify TTS, unlock health insurance and retirement plan deductions, gain flexibility with a Section 475 election or revocation, prevent wash-sale losses with individual and IRA accounts, and enhance a QBI deduction on Section 475 income less trading expenses. An entity return consolidates trading activity on a pass-through tax return, making life easier for traders, accountants, and the IRS. Trading in an entity allows individually held investments to be separate from business trading. It operates as a separate taxpayer yet is inexpensive and straightforward to set up and manage.
An LLC with S-Corp election is generally the best choice for a single or married couple seeking health insurance and retirement plan deductions. See Chapter 7.
RETIREMENT PLANS FOR TRADERS
Annual tax-deductible contributions up to $63,500 for 2020 and $64,500 for 2021 to a TTS S-Corp Solo 401(k) retirement plan generally save traders significantly more in income taxes when compared to the costs of payroll taxes (FICA and Medicare). Trading gains aren’t earned income, so traders use an S-Corp to pay officer compensation.
There’s also an option for a Solo 401(k) Roth for the elective-deferral portion only: If you are willing to forgo the tax deduction, you’ll enjoy permanent tax-free status on contributions and growth within the plan. See Chapter 8.
20% DEDUCTION ON QUALIFIED BUSINESS INCOME
TCJA introduced a new tax deduction for pass-through businesses, including sole proprietors, partnerships, and S-Corps. Subject to haircuts and limitations, a pass-through business could be eligible for a 20% deduction on qualified business income (QBI).
Traders eligible for TTS are a “specified service activity,” which means if their taxable income is above an income cap, they won’t receive a QBI deduction. The taxable income (TI) cap is $426,600/$213,300 (married/other taxpayers) for 2020, and $429,800/$214,900 (married/other taxpayers) for 2021. The phase-out range below the cap is $100,000/$50,000 (married/other taxpayers). The W-2 wage and property basis limitations also apply within the phase-out range. Investment managers are specified service activities, too.
QBI for traders includes Section 475 ordinary income and loss and trading business expenses. QBI excludes capital gains and losses, Section 988 forex ordinary income or loss, dividends, and interest income.
TCJA favors non-service businesses, which are not subject to an income cap. The W-2 wage and property basis limitations apply above the TI threshold of $326,600/$163,300 (married/other taxpayers) for 2020, and $329,800/$164,900 (married/other taxpayers) for 2020. The IRS adjusts the annual TI threshold for inflation each year.
Sole proprietor TTS traders cannot pay themselves wages, so they likely cannot use the phase-out range, and the threshold is their cap. For more information, see Chapter 7 and Chapter 17.
AFFORDABLE CARE ACT
TCJA and CARES did not change the Affordable Care Act’s (ACA) 3.8% Medicare tax on unearned income. The net investment tax (NIT) applies on net investment income (NII) for individual taxpayers with modified AGI over $250,000 (married) and $200,000 (single). The threshold is not indexed for inflation. Traders can reduce NIT by deducting TTS trading expenses, including salaries paid to them and their spouses. Traders may also reduce NII with investment expenses that are allowed on Schedule A, such as investment-interest expense. Investment fees and other investment expenses suspended from Schedule A also are not deductible for NII.
ACA’s individual health insurance mandate and shared responsibility fee for non-compliance, exchange subsidies, and premium tax credits continue to apply for 2020 and 2021. However, TCJA reduced the shared responsibility fee to $0 starting in 2019.
For more information, see Chapter 9 and Chapter 15.
INVESTMENT MANAGEMENT CARRIED INTEREST
TCJA modified the carried interest tax break for investment managers in investment partnerships, lengthening their holding period on profit allocation of long-term capital gains (LTCG) from one year to three years. If the manager also invests capital in the partnership, she has LTCG on that interest after one year. The three-year rule only applies to the investment manager’s profit allocation — carried interest. Investors still have LTCG based on one year.
Investment partnerships include hedge funds, commodity pools, private equity funds, and real estate partnerships. Many hedge funds don’t hold securities for more than three years, whereas, private equity, real estate partnerships, and venture capital funds do.
Investors also benefit from carried interest in investment partnerships. TCJA suspended investment fees and expenses. Separately managed account investors are out of luck as investors pay investment fees, but hedge fund investors can limit the negative impact by using carried-interest tax breaks. The carried interest reduces a hedge fund investor’s capital gains instead of having a suspended incentive fee deduction.
INTERNATIONAL TAX MATTERS
When it comes to global tax matters, we focus on the following types of traders: U.S. residents living abroad, U.S. residents with international investments, U.S. residents moving to U.S. territories like Puerto Rico (with substantial tax breaks), U.S. residents surrendering citizenship or green cards, and nonresident aliens investing in the U.S. with individual U.S. brokerage accounts or through an entity. See Chapter 14.
November 11, 2020 | By: Robert A. Green, CPA
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Year-end tax planning for traders varies based on eligibility for trader tax status (TTS) in 2020 and 2021. There are different strategies to consider for investors, TTS traders using the capital gains method, and TTS traders using Section 475 MTM ordinary gain and loss treatment.
In this blog post, I examine all three groups and touch on the topics of new traders, S-Corps for employee benefits, Roth IRA conversions, and navigating the SALT cap.
Investors The 2017 Tax Cuts And Jobs Act (TCJA) suspended investment fees and expenses for investors, and the 2020 Coronavirus Aid, Relief, and Economic Security (CARES) Act did not change that. After TCJA, the only itemized deductions for investors are margin interest expense limited to investment income and stock-borrow fees. TCJA roughly doubled the standard deduction: with an inflation adjustment for 2020, it’s $24,800 married, $12,400 single, and $18,650 head of household. TCJA’s $10,000 cap on state and local taxes (SALT) leads many taxpayers to use the standard deduction.
TTS traders are better off; they deduct trading business expenses, startup costs, and home office expenses from gross income (Schedule C for sole proprietors). Brokerage commissions are transaction costs deducted from trading gains or losses; they are not separate expenses.
In 2020 with Covid-19 stay-at-home orders and remote work, many new traders entered the markets. Some achieved TTS for a partial year in 2020, whereas others won’t qualify until 2021. If your TTS commences in January 2021, you can capitalize on some hardware, software, and other intangible costs incurred in 2020 for depreciation and amortization expense with TTS’s commencement in early 2021. For example, computers, monitors, and home office furniture contribute to these costs at fair market value for TTS expensing in 2021. Some expenses like subscriptions, education, and software can be capitalized as Section 195 startup costs. Section 195 allows expensing up to $5,000 in 2021, with the rest deducted straight-line over 15 years. We allow TTS traders to go back six months before TTS inception for Section 195 costs and even further back for hardware costs.
Investors and TTS traders using the default realization method (not Section 475 MTM) should consider “tax-loss selling” before year-end to reduce capital gains income and the related tax liability. However, be careful to avoid wash-sale loss adjustments on securities at year-end 2020, which defer the tax loss to 2021. For example, suppose you realize a capital loss on Dec. 15, 2020, in Exxon and repurchase a substantially identical position (Exxon stock or option) 30 days before or after that date. In that case, it’s a wash-sale (WS) loss adjustment. The WS loss defers to 2021 when it is added to the replacement position’s cost basis. The rules are different for brokers vs. taxpayers, so avoid permanent WS between taxable and IRA accounts. Section 1256 contracts have MTM by default, so WS is a moot point on futures. (See more on WS on our website.)
If you expect a net capital loss for 2020 over the $3,000 capital loss limitation against other income, then you’ll have a capital loss carryover (CLCO) to 2021 and subsequent years. You can use up a CLCO with capital gains in the following years. For example, if your CLCO is $25,000 going into 2021, and you have 2021 capital gains of $30,000, then you’ll have $5,000 of net capital gains for 2021.
If you incur a significant capital loss in Section 1256 contracts, consider a 1256 loss carryback election made on Form 6781 filed with your 2020 tax return. That allows you to amend the prior three-year tax returns to apply the 1256 loss against 1256 gains only.
If your 2020 taxable income is considerably under the capital gains tax bracket of $80,000 for married and $40,000 for unmarried individuals, then your long-term capital gains (LTCG) tax rate is 0%. For example, assume your taxable married-filing-joint income is $50,000 as of late December 2020. You can sell investments held over 12 months with up to $30,000 of capital gains at a 0% tax rate. Don’t cut it too close, though: If your taxable income is $80,500, it will trigger the 15% rate on all LTCG. The 0% rate applies to Section 1256 contracts: 60% uses the LTCG rate, and 40% the short-term rate, which is the ordinary rate.
There is also the Affordable Care Act (ACA) 3.8% net investment tax (NIT) on net investment income (NII) for upper-income taxpayers with modified AGI above $250,000 married and $200,000 single. Tax-loss selling and other deductions lower AGI and NII, which can help avoid or reduce NIT.
President-elect Joe Biden’s Tax Plan proposed raising the top LTCG rate of 20% to a maximum ordinary rate of 39.6% (up from 37%), applying only to taxpayers with income over $1 million. Passing Biden’s tax plan will be difficult if the Senate remains under Republican control.
Traders who have massive trading gains in 2020 should focus on 2020 Q4 estimated taxes due Jan. 15, 2021. Using the safe-harbor exception to cover 2019 tax liabilities, some traders can defer much of their tax payments to April 15, 2021. Just don’t lose the tax money in the markets in Q1 2021; consider setting it aside. (See Traders Should Focus On Q4 Estimated Taxes Due January 15.)
Traders eligible for TTS If a trader qualifies for TTS in 2020, he or she can deduct trading business expenses, startup costs, and home-office expenses. The trader did not have to elect TTS or create an entity. (Section 475 requires a timely election.) It’s okay to commence TTS during the year, although we prefer not later than Sept. 30; otherwise, the IRS could challenge TTS for Q4 or less. (See How To Be Eligible For Substantial Tax Savings As A Trader.)
TTS traders planning to upgrade computers and other expenses should consider accelerating business expenses before year-end. New equipment and furniture need be purchased and put to use before year-end. TCJA mostly provides full expensing with tangible property expense up to $2,500 per item, Section 179 (100%) depreciation, or bonus depreciation.
TTS traders with Section 475 MTM TTS traders using section 475 mark-to-market (MTM) accounting report ordinary gains or losses on Form 4797. Section 475 trades are not subject to WS or a capital-loss limitation so that an ordinary loss can offset income of any kind. MTM reports unrealized gains and losses at year-end, so the taxpayer doesn’t have to do tax-loss selling on TTS trading positions.
Many TTS traders also have segregated investment positions, so they should consider WS and tax-loss selling on investment positions. Investments are not subject to Section 475, meaning you can defer capital gains and achieve the LTCG rate on investment positions if held 12 months. If you trade in substantially identical positions that you also invest in, the IRS can attempt to recharacterize TTS trades vs. investments. Avoid that issue by considering a TTS LLC/partnership or TTS LLC/S-Corp for 2021 to ring-fence trading positions.
If you have significant Section 475 ordinary losses for 2020, the CARES Act provides substantial relief. The CARES Act allows a five-year net operating loss (NOL) carryback applied against income of any kind. CARES also temporarily reversed TCJA’s “excess business loss” (EBL) limitation of $500,000 married and $250,000 for other taxpayers (2018 limits and adjusted each year for inflation). Under TCJA, you have to add EBL amounts to NOL carryforwards.
For example, a TTS/475 trader filing single with a $300,000 ordinary loss and $25,000 TTS expenses would have a 2020 NOL of approximately $325,000. The $250,000 EBL limitation does not apply. This trader can carry back the 2020 NOL five years and use it against any type of income. Alternatively, if preferred, the taxpayer can elect to carry it forward instead. TCJA NOL rules apply again in 2021, limiting NOLs to 80% of taxable income with the remainder carried over to subsequent years. Under its latest Covid-19 relief bills, the House proposed revising the NOL and EBL rules, reapplying EBL to all years, and limiting the number of NOL carryback years. Many taxpayers already filed NOL carryback returns under CARES, so it’s hard to reverse those rules now.
If a TTS trader has significant TTS/475 income, they might be eligible for a 20% “qualified business income” (QBI) deduction. Sole proprietors only get this QBI deduction if they are under the QBI taxable income threshold of $326,600 married and $163,300 for other taxpayers (2020 threshold adjusted for inflation). Determine the QBI deduction on the lower of taxable income or QBI. Suppose you have a TTS S-Corp with officer compensation. In that case, there is also a phase-out/phase-in range based on wages and qualified property for an additional $100,000 married and $50,000 other taxpayers.
New traders No matter when you started trading, you can claim TTS eligibility and add a Schedule C for the TTS expense deductions for all or part of the year. (See Will The IRS Deny Tax Benefits To Traders Due To Covid?)
It’s now too late in 2020 to form a new entity that can qualify for TTS, as we like to see entity trading for at least all of Q4. Instead, consider a Section 475 election for 2021, due by April 15, 2021, for individuals and March 15, 2021, for existing partnerships and S-Corps. (See Traders Elect 475 For Enormous Tax Savings.)
S-Corps for employee benefits A TTS S-Corp can unlock officer health insurance (HI) and retirement plan deductions using officer payroll. The insurance premium can be added to officer payroll on the W-2. That opens an AGI deduction for HI on the officer’s tax return. The officer HI compensation is not subject to payroll tax (social security and Medicare).
If profitable as of early December 2020, the S-Corp can pay additional compensation up to a maximum of $150,000 to maximize a Solo 401(k) retirement plan contribution. For 2020, it combines a 100% deductible “elective deferral” (ED) contribution of $19,500 with a 25% deductible profit-sharing plan contribution (PSP) up to a maximum of $37,500. There is also an ED “catch-up provision” of $6,500 for 2020 for taxpayers age 50 and over. Together, the maximum 2020 tax-deductible contribution is $57,000, and when including the catch-up provision, it’s $63,500. The ED portion can be a Roth, so there would be no tax deduction but permanent tax-free status. The PSP must be traditional, though.
Payroll tax includes 12.4% social security taxes but not exceeding the social security base amount of $137,700 for 2020. Medicare tax of 2.9% is unlimited without a base. The employer and employee each pay half the payroll taxes, and the employer deducts its 50% share.
Joe Biden’s tax Plan proposes to subject earned income over $400,000 to payroll taxes. Social security taxes (FICA) only apply to the SSA base amount of $137,700 for 2020 and $142,800 for 2021. Biden’s plan creates a donut hole, but it should not affect traders since they only need $150,000 of wages to maximize a Solo 401(k) retirement plan. A TTS S Corp is not subject to IRS “reasonable compensation” rules as its underlying income is unearned.
An S-Corp accountable reimbursement plan can be used to pay the officer shareholder for home-office and other employee expenses. The IRS requires reimbursement before the year-end 2020.
Partners in LLCs taxed as partnerships can deduct “unreimbursed partnership expenses” (UPE). That is how they usually deduct home office expenses. UPE is more convenient than using an S-Corp accountable plan because the partner can arrange the UPE after year-end.
Roth IRA conversions You may wish to convert a traditional IRA into a Roth IRA before the year-end. The conversion income is taxable in 2020. Avoid the 10% excise tax on early withdrawals before age 59 1⁄2 by paying the Roth conversion taxes outside the Roth plan. TCJA repealed the recharacterization option, so you can no longer reverse the conversion if the plan assets decline. Roth IRA conversions have no income limit, unlike regular Roth IRA contributions.
“More states are expected to pass laws letting businesses avoid the limit on personal tax deductions for state and local taxes, following IRS guidance approving the workaround. Already, states including New Jersey and Connecticut softened the blow of the $10,000 SALT cap with provisions for pass-through businesses like partnerships and S corporations, which are taxed normally at the owner level. The IRS said Monday in a notice that forthcoming proposed rules will allow the states’ workaround, which involves an entity-level tax that is offset by a corresponding individual income tax credit.
“The agency in 2019 killed off (T.D. 9864) a different workaround some states tried, which would have allowed state tax credits for donations made to charitable funds.”
More states might enact this workaround before the year-end 2020. Before you pay Q4 2020 estimated taxes due by Jan. 15, 2021, see if your state allows or requires your partnership or S-Corp to pay taxes for your benefit. Connecticut’s workaround law is mandatory.
Consider our 2020 tax compliance service, which includes year-end tax planning and 2020 tax return preparation. We accept new clients for our tax compliance service, providing you are a retail trader, a proprietary trader, or an investment manager. Most of our trader clients are eligible for trader tax status (TTS) benefits. We are pleased to invite traders who fall short of TTS in 2020 to use our 2020 tax compliance service. Perhaps, you will qualify for TTS in 2021 and need a 475 election then, too. By email, please request a new client evaluation (NCE).
Darren Neuschwander, CPA contributed to this blog post.
September 14, 2020 | By: Robert A. Green, CPA
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So far, 2020 has been a highly volatile year in the financial markets due to significant uncertainty over Covid-19, a shock to the economy, and job losses. As the virus spread in the U.S, millions of displaced Americans turned to trading in financial markets as a means of making a new living. Some became active enough to qualify for trader tax status (TTS) benefits, which requires regular, frequent, and continuous trading. However, will the IRS deny TTS to Covid-19 traders if they only carry on a trading business during the pandemic for a short time?
I’m not as worried about existing traders from 2019 who incurred massive trading losses in Q1 2020 during the Covid correction and stopped trading at that time. Hopefully, they made a Section 475 ordinary loss election due by the July 15, 2020 deadline, which is conditional on eligibility for TTS. These pre-Covid traders were in business for more than 15 months, so their TTS/475 ordinary loss deduction should be safe.
I am more concerned with the millions of newcomer traders who opened online trading accounts offering free or low commissions in 2020. Many rookies have significant trading gains year-to-date, even after the recent sell-off. In the trading business, gains can turn into losses with a substantial correction. When that happens, TTS traders count on Section 475 for tax-loss or fire-loss insurance: The trading house burns down, and you can file for a refund with the IRS. The CARES Act permits five-year net operating loss (NOL) carryback refund claims for 2020, 2019, and 2018 tax returns.
Some rookie traders start off meeting the IRS requirements for TTS. Those rules are vague, so see GreenTraderTax’s golden rules for TTS. I wonder how IRS agents will consider the Covid pandemic when assessing TTS. Consider a furloughed worker who started trading at home full time in mid-2020. Was the trader’s intention to create a new business for the long-term, or to buy time and make some extra money before returning to his or her career after the pandemic subsides? TTS requires the intention to run a business from catching daily market movements, not from making investments for appreciation.
If a new trader started trading on June 1, 2020, but stops or significantly slows down trading when returning to work in November 2020, will the IRS deny TTS because he only traded actively for five months? The IRS agent might cite the landmark tax court case Chen vs. Commissioner, where TTS was denied. Chen only carried on TTS for three months.
I analyzed the Chen case in my trader tax guide; here’s an excerpt.
Chen vs. Commissioner
Comments from a senior IRS official about the Chen tax court case point out the IRS doesn’t respect individual traders who are brand new to trading activity and who enter and exit it too quickly. Chen only traded for three months before losing his trading money, thereby leaving his trading activity. Chen kept his software engineering job during his three months of trading.
The Chen case indicates the IRS wants to see a more extended time to establish TTS. Some IRS agents like to intimidate taxpayers with a full year requirement, but the law does not require that. Hundreds of thousands of businesses start and fail within three months, and the IRS doesn’t challenge them on business status. The IRS is rightfully more skeptical of traders vs. investors, perhaps even more so during the pandemic. The longer a trader can continue his business trading activity, the better his chances are with the IRS. We often ask clients about their trading activities in the prior and subsequent years as we prepare their tax returns for the year that just ended. Vigorous subsequent-year trading activities and gains add credibility to the tax return being filed. We mention these points in tax return footnotes, too. Traders can start their trading business in Q4 and continue it into the subsequent year.
Chen messed up many things in this case. First and foremost, he lied to the IRS about electing Section 475 MTM ordinary loss treatment on time and then used 475 MTM when he wasn’t eligible. Chen should have been subject to a $3,000 capital loss limitation rather than deducting a massive 475 ordinary loss triggering a huge tax refund. Second, he brought a losing case to tax court and made the mistake of representing himself. Once Chen was busted on the phony MTM election, he caved in on all points, including TTS. Chen did not have many TTS business expenses, so he figured it wasn’t worth continuing to fight.
Even though he only traded for three months while keeping his full-time job, it doesn’t mean he didn’t start a new business — intending to change careers to business trading — and make a substantial investment of time, money, and activity. Tax code or case law doesn’t state that a business must be carried on for a full year or as the primary means of making a living. Countless companies startup and fail in a few short months, and many times the entrepreneur hasn’t left his or her job while experimenting as a businessperson. Chen may have won TTS had he been upfront with the IRS and engaged a tax attorney or trader tax expert to represent him in court.
TTS tax benefits
TTS traders deduct business expenses, startup costs, and home office expenses. Without TTS, investors may only deduct margin interest expense to the extent they have investment income as an itemized deduction. Many use the standard deduction instead.
TTS traders are entitled to elect the robust Section 475 mark-to-market accounting, which converts capital gains and losses into ordinary gains and losses. Short-term capital gains on securities are ordinary income; whereas, 475 ordinary business losses generate tax refunds much faster than a $3,000 capital loss limitation. Section 475 also exempts securities trades from onerous wash sale loss rules, a headache for active traders, which causes phantom income and potentially excess tax liability. The 20% qualified business income (QBI) deduction applies to 475 net income if the taxpayer is under a taxable income threshold. QBI excludes capital gains. Individuals had to elect 475 for 2020 by the postponed deadline of July 15, 2020. A new LLC partnership or S-Corp can select 475 within 75 days of inception.
With a TTS S-Corp, traders can deduct health insurance and retirement plan contributions.
I consult new traders on TTS. It’s incredible how many of these traders, from all walks of life, ages and careers, have made small fortunes since April. Others incurred substantial losses. During my tax consultations, many clients tell me they don’t want to return to their jobs if and when called back, and that TTS trading is their new career, which they cherish.
In The Tax Moves Day Traders Need to Make Now, Laura Saunders and Mischa Frankl-Duval report on this very issue (Wall Street Journal, Sept. 11, 2020), warning taxpayers to be careful when thinking about claiming TTS.
August 27, 2020 | By: Robert A. Green, CPA
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There are tax advantages for traders who are eligible for trader tax status (TTS).
Learn how to qualify for TTS; no election is required.
Automated trading systems can qualify for TTS, providing the trader is significantly involved with the creation. Trade copying software might not be eligible.
Learn how to deduct TTS business expenses, startup costs, and home office expenses.
Consider a Section 475 election for exemption from wash sales and the $3,000 capital loss limitation and be eligible for a 20% qualified business income deduction on 475 net income if under the QBI income threshold.
A TTS S-Corp unlocks health insurance and retirement plan deductions.
A TTS LLC/partnership segregates TTS/475 trading from investments made on the individual level.
How to qualify for TTS
Let’s start by taking a deep dive into GreenTraderTax.com golden rules for TTS qualification. Statutory tax law is lacking on TTS, so we analyze tax court cases for traders, and rely on decades-long experience performing tax compliance services for traders.
Volume of trades
The 2015 tax court case Poppe vs. Commission is a useful reference. Poppe made 720 total trades per year/60 per month. We recommend an average of four transactions per day, four days per week, 16 trades per week, 60 trades a month, and 720 per year on an annualized basis. Count each open and closing trade separately, not round trips. Some traders scale into and out of trades, and you can count each of those trades separately.
As an example, the securities markets are open approximately 250 days, but let’s account for some personal days or holidays, and figure you’re available to trade 240 days per year. A 75% frequency of 240 days equals 180 days per year, so 720 total trades divided by 180 trading days equals four trades per day.
What counts? If you initiate a trade order and the broker breaks down the lot sizes without your involvement, it’s wise not to include the extra volume of trades in this case.
Options traders have multi-legged positions on “complex trades.” I believe you may count each trade confirmation of a complex options trade if you enter the trades separately, although the tax court has not addressed that issue yet. Most traders enter a complex options trade, and the broker breaks down the legs, so you cannot count the legs separately. Trade executions count, not unexecuted trades.
Frequency of trades
Execute trades on close to four days per week, around a 75% frequency rate. The tax courts require “regular, frequent, and continuous” qualification for TTS. If you enter or exit a trading business during the year, then maintain the frequency rate during the TTS period. Time off from the execution of trades should be for a reasonable amount of vacations and other non-working days. Think of TTS like it’s a job, only the markets are your boss.
In the following trader tax court cases, the IRS denied TTS to options traders, including Holsinger, Assaderaghi, Endicott, and Nelson. They only traded on two to three days per week; hence, I suggest executing trades on close to four days per week.
Holding period
The IRS stated that the average holding period is the most crucial TTS factor. In the Endicott court, the IRS said the average holding period must be 31 days or less. That’s a bright-line test.
If your average holding period is more than 31 days, it’s disqualifying for TTS, even if all your other TTS factors are favorable.
It’s more natural for day traders and swing traders to meet the holding period requirement. In the holding period analysis, don’t count segregated investment accounts and retirement accounts; only count TTS positions.
Monthly options traders face challenges in holding periods. They may have average holding periods of over one month if they trade monthly and longer expirations and keep them over a month. Holsinger was a monthly options trader, and his holding periods averaged one to two months. More often now, TTS traders are focused on trading weekly options expirations, and many of them are eligible for TTS.
Consider the following example of a trader in equities and equity options. If he holds 80% of his trades for one day and the other 20% for 35 days, then the average holding period is well under 31 days. It’s not evident if the IRS might apply weighted averages to the average holding period.
Trades full time or part-time
Full-time options traders actively trading significant portfolios may not qualify because they don’t have enough volume and frequency, and their average holding period is over 31 days. On the other hand, a part-time trader with a full-time job may qualify as a day and swing trader in securities, meeting all our golden rules.
Part-time and money-losing traders face more IRS scrutiny, and individuals face more scrutiny than entity traders.
Time spent
A TTS trader should spend more than four hours per day, almost every market day working on his trading business. All-time counts, including the execution of trade orders, research, administration, accounting, education, travel, meetings, and more. Most active business traders spend more than 40 hours per week in their trading business. Part-time traders usually spend more than four hours per day.
In one tax exam our firm handled, the IRS agent brought up the “material participation” standard in the passive loss activity rules (Section 469), which require 500 hours of work per year (as a general rule). Most business traders easily surpass 500 hours of work. However, Section 469 doesn’t apply to trading businesses, under its “trading rule” exemption. Without this exemption, taxpayers could generate passive-activity income by investing in hedge funds, and the IRS did not want that.
Avoid sporadic lapses
A trader should have few to no sporadic lapses in the trading business during the year. The IRS has successfully denied TTS in a few tax court cases by arguing the trader had too many periodic lapses in trading, such as taking several months off during the year. Traders can take vacations, sick time, and personal time off just like everyone else. Some traders take a break from active trading to recover from recent losses and learn new trading methods and markets.
Carefully explain breaks in trading to the IRS in tax-return footnotes. Retooling and education during a setback in trade executions still may count for the continuous business activity (CBA) standard, although the IRS has not given credence to CBA for traders in tax court to date. I recommend traders keep proper records of their time spent as support.
Comments from an IRS official about the Chen tax court case point out the IRS doesn’t respect individual traders who are new to trading activity and who enter and exit it too quickly. Chen only traded for three months, while maintaining his fulltime job as a software engineer. He claimed an enormous NOL tax refund based on a massive TTS/475 ordinary loss. The IRS caught him lying about making a timely 475 election, and Chen conceded TTS and the entire case. It’s better to carry on a trading business for a more extended time than Chen did.
Some traders must temporarily stop for several months for health reasons. It’s not clear if the IRS will respect that as a valid interruption of a trading business activity. That seems unfair, but it may be the reality.
Many traders are home from their day jobs with Covid-19 and can carry on a trading business now. But will that active trading continue for the rest of 2020 and into 2021? I’ve noticed a proliferation of “Covid-19 traders,” who started active trading after the Covid correction in March 2020. Many have done well. Employers furloughed or laid-off them off from day jobs, or they have flexible job hours at home. They were attracted to volatility, accessible trading apps, and zero or low commissions.
Intention to run a business
Traders must have the intention to run a trading business — trading his or her own money — but it doesn’t have to be one’s exclusive or primary means of making a living. The keyword is “a” living, which means it can be a supplemental living.
Many traders enter an active trading business while still working a full-time job. Advances in technology and flexible job schedules make it possible to carry on both activities simultaneously.
It’s not a good idea to try to achieve TTS within a business entity, already principally conducting a different type of business activity. It’s better to form a new trading entity. Trading an existing business’s available working capital seems like a treasury function and sideline, which can deny trader tax breaks if the IRS takes a look.
Filing as a sole proprietor on a Schedule C is allowed and used by many, but it’s not the best tax filing strategy for a part-time trader. An individual tax return shows a taxpayer’s job and other business activities or retirement, which may undermine TTS in the eyes of the IRS. The IRS tends to think trading is a secondary activity, and it may seek to deny TTS. It’s best to form a new, separate entity dedicated to trading only.
Several years ago, we spoke with one IRS agent who argued the trader did not make a living since he had perennial trading losses. That’s okay because the rule looks to intention, not the actual results. The hobby-loss limitations don’t apply to TTS traders because trading is not recreational or personal. Part-time traders often tell me they operate a business to make a supplemental living and intend to leave their job to trade full-time when they become profitable enough.
Operations
A TTS trader has significant business equipment, education, business services, and a home office. Most business traders have multiple monitors, computers, mobile devices, cloud services, trading services, and subscriptions, education expenses, high-speed broadband, wireless, and a home office and/or outside office. Some have staff.
The IRS needs to see that a taxpayer claiming TTS has a realistic trading business operation.
How can one run a business without a dedicated space? Casual investors rarely have as busy an office set up as business traders do. Why would a long-term investor need multiple monitors?
If a trader uses a home-office space exclusively for business rather than personal use, the tax return should reflect this because it is not only a valid home-office deduction, but it also further supports the fact there is a legitimate business activity being conducted. The home-office deduction is no longer a red flag with the IRS, and it is not a complicated calculation. Most of the home-office deduction requires income, in this case, TTS trading gains. Some TTS traders just use a laptop, and that’s okay.
Account size
Securities traders need to have $25,000 on deposit with a U.S.-based broker to achieve “pattern day trader” (PDT) status. With this status, he or she can day trade using up to 4:1 margin rather than 2:1. Without PDT status, securities traders, which include equities and equity options, will have a more challenging time qualifying for TTS. I like to see more than $15,000 account size for trading futures, forex, or cryptocurrency.
Adequate account size also depends on one’s overall net worth and cash flow. Millionaires may need larger account sizes, whereas some unemployed traders without much cash flow or very young traders may get by with smaller account sizes. A trader may also be able to factor in capital invested in equipment and startup costs.
What doesn’t qualify for TTS
Don’t count these four types of trading activity for TTS qualification:
Automated trading systems (ATS) without much involvement by the trader (but a trader creating an ATS qualifies);
A trade copying software or service;
Engaging a professional outside investment manager;
And trading in retirement funds.
Do not include these trades in the golden rule calculations.
Outside-developed automated trading systems
These programs are becoming more popular. An entirely canned ATS with little to no involvement by the trader doesn’t qualify for TTS. The IRS may view an outside-developed ATS the same as a trader who uses a broker to make most buy/sell decisions and executions.
If the trader can show he’s very involved with the design and building of the ATS, then the IRS may count the ATS-generated trades in the TTS analysis. That includes but is not limited to writing the code or algorithms and setting the entry and exit signals. Self-creation of the ATS needs to be significant to count for TTS. Just making a few choices among options offered in an outside-developed ATS building-block service does not qualify for TTS.
Some traders don’t have programming experience, but they have financial and trading experience. They design the ATS to do what they do manually as a trader and hire an outside programmer to translate their specifications into a computer language.
It’s helpful if the trader can show he spends more than four hours per day working in his trading business, including time for ATS maintenance, back-testing, and modifications. I have not yet seen the IRS challenge ATS for TTS in exams or court cases, but I feel it may react this way when it comes up.
If traders spend a lot of money on an ATS that doesn’t qualify as part of their trading business, then those expenses are suspended investment expenses under TCJA. Traders need to know the IRS may connect the dots and realize they are using an ATS. A full-scale exam can uncover these facts. Consider the analogy of an airplane pilot using manual and automated systems. A trader needs to be a pilot in the cockpit, not in the cabin as a passenger.
Trade copying software or service
Some traders use trade copying software or service (TCS). Trade copying is similar to using a canned ATS or outside adviser, where the copycat trader might not qualify for TTS on those trades. As an example, a trade coaching and education company offers a TCS that suggests several trades each day, with exact entry and exit points and stop-loss orders. The trader decides which trades to make and executes them manually.
If the trader follows the TCS tightly and does not significantly depart from its suggestions, then an IRS agent might feel that he or she does not qualify for TTS. On the other hand, if the trader cherry-picks a minor percentage of the suggested trades, sets different stop-loss orders, and waits longer on entry and exit executions, then he or she might qualify for TTS. The TCS vendor might state they are not providing investment management services, but that does not mean their customer achieves TTS using the TCS.
Engaging a money manager
Hiring a registered investment adviser (RIA) or commodity trading adviser (CTA) — whether they are duly registered or exempt from registration — to trade one’s account doesn’t count toward TTS qualification. However, hiring an employee or independent contractor under the trader’s supervision to help trade should qualify, providing the taxpayer is a competent trader. There are decades-old tax court cases that show using outside brokers and investment advisers to make trading decisions undermines TTS.
There are differences between hiring an independent investment manager vs. a supervised assistant trader. If the engaged trader is a registered investment adviser, he’s clearly in the business of being an external manager, and TTS is not achievable. But if the person only assists a retail trader under the account holder’s direction and supervision, it may be possible to achieve TTS. It’s okay to have a co-pilot in the TTS cockpit.
With married couples, if spouse A has an individual brokerage account in his or her name only and gives power of attorney to spouse B to trade it, the IRS won’t grant TTS even if spouse B meets all the golden rules for TTS. Spouse B is not an owner of the account, so that the IRS will treat spouse A as an investor and spouse B as an investment manager. Married couples can solve this problem by using a joint individual account or trading in a spousal-owned entity.
Trading retirement funds
You can achieve TTS through taxable trading accounts only. Trading activity in non-taxable retirement accounts doesn’t count for purposes of TTS qualification. Trading in retirement plans can be an excellent way to build tax-free compounded returns, especially if the taxpayer doesn’t qualify for TTS in their taxable accounts.
It is possible to trade retirement accounts and, at the same time, qualify for TTS in taxable accounts.
Caution: it’s dangerous to trade substantially identical positions between an individual taxable account and IRA accounts since this can trigger a permanent wash-sale (WS) loss in a taxable account that moves into the IRA. Avoid permanent WS losses in IRAs with a Section 475 election on the taxable account or use a Do Not Trade List to avoid overlap in the IRAs.
Sole proprietorship with TTS
An individual TTS trader deducts business expenses, startup costs, and home office deductions on a Schedule C (Profit or Loss From Business – Sole Proprietorship) 1040 filing. Traders don’t have revenue on Schedule C; report trading gains and losses on other tax forms. Schedule C expenses are an above-the-line deduction from gross income. TTS Schedule C expenses reduce self-employment income (SEI). Although, trading income is not SEI, and traders don’t owe SE tax in connection with trading income. There isn’t a tax election for claiming TTS. — it’s determined based on facts and circumstances assessed at year-end. You can claim TTS after-the-fact; you don’t have to formalize it in advance.
Business expenses include home-office, education, startup expenses, organization expenses, margin interest, tangible property expense, Section 179 (100%) or 100% bonus depreciation, amortization on software, self-created automated trading systems, chat rooms, mentors, seminars, market data, charting services, stock borrow fees, and much more.
Section 475 tax benefits
TTS traders are entitled to make a Section 475 election, but investors may not. The 475 election exempts securities trades from wash-sale loss (WS) adjustments, which can defer tax losses to the subsequent year, and the $3,000 capital loss limitation. Ordinary loss treatment is better; it can generate tax refunds faster than capital loss carryovers. There are also benefits on 475 income: a 20% QBI deduction if under the taxable income threshold for a service business.
The deadline for an individual to elect Section 475 for 2020 has passed; it was July 15, 2020, the postponed deadline. A partnership or S-Corp formed during the tax year is considered a “new taxpayer,” which can elect Section 475 internally within 75 days of inception. A new entity comes in handy for electing 475 after July 15, 2020. It’s too late to select 475 for 2019; that election deadline was April 15, 2019.
I usually recommend 475 on securities only to retain lower 60/40 capital gains rates on Section 1256 contracts. Section 475 does not apply to segregated investment positions. Avoid overlap of substantially identical positions in what you trade versus what you invest in taxable accounts, as that allows the IRS to recharacterize trades vs. investments. You can fix this potential problem by ring-fencing TTS/475 in a new entity and leaving investment positions on the individual level.
The qualified business income deduction
TCJA introduced a tax benefit for pass-through businesses, which includes a TTS trader with Section 475 income, whether doing business as a sole proprietor, partnership, or S-Corp. Section 199A provides a 20% QBI deduction on a “specified service trade or business” (SSTB), and TTS trading is an SSTB. SSTBs are subject to a taxable income threshold, phase-out range, and an income cap. The phase-out has wage and property limitations, too.
LLC taxed as an S-Corp
Organize a single-member or spousal-member LLC and elect S-Corp status with the IRS within 75 days of inception. Alternatively, in a subsequent year, the LLC can submit an S-Corp election by March 15. Owners must be U.S. residents. The S-Corp can elect Section 475 internally within 75 days of inception.
TTS traders with significant health insurance (HI) premiums should consider an S-Corp to arrange a tax deduction through officer compensation. Otherwise, the trader or spouse might have another source of self-employment income to deduct HI. A spouse might have HI coverage for the family in their job. Cobra is not deductible HI since its employer provided. A TTS sole proprietor or partnership cannot deduct HI based on trading income.
Traders need earned income to make and deduct HI and retirement plan contributions; however, trading income is unearned. TTS sole proprietors and partnerships cannot create earned income, whereas S-Corps can pay officer compensation, generating earned income.
Payroll taxes apply on officer compensation (wages), except for the HI component of salary: 12.4% FICA capped on wages up to $137,700 for 2020, and the 2.9% Medicare is unlimited.
TTS traders should fund retirement plan contributions from net income, not losses. It’s best to wait on the execution of an annual paycheck until early December when there is transparency for the year.
If you have sufficient trading profits for the year, consider establishing a Solo 401(k) retirement plan before year-end. Start with the 100% deductible elective deferral (ED; $19,500 for 2020) and pay it through payroll since on the annual W-2. Taxpayers 50 years and older have a “catch up provision” of $6,500, raising the 2020 ED limit to $26,000 per year. Contribute the elective deferral to a Solo 401(k) Roth or traditional account.
If you have significant trading gains, consider increasing payroll to unlock a Solo 401(k) profit-sharing plan (PSP) contribution. You don’t have to pay into the retirement plan until the due date of the S-Corp tax return (including extensions by September 15). The maximum PSP amount is $37,500 on wages of $150,000 ($37,500 divided by 25% equals $150,000). The total limit for a Solo 401(k) is $63,500 ($19,500 ED, $6,500 catch-up ED, and $37,500 PSP).
LLC taxed as a partnership
A TTS trader can organize a spousal-member LLC and file as a partnership. LLC/partnerships file a Form 1065 partnership tax return and issue Schedule K-1s to owners. LLC/partnerships must qualify for TTS; otherwise, they are investment companies.
A partnership is useful for ring-fencing TTS/475 trading from individual taxable, and IRA accounts for avoiding wash sale losses and the IRS reclassifying investment positions as TTS/475 positions.
Active trading gained popularity in 2020, and many people are eligible for trader tax status benefits.
February 5, 2020 | By: Robert A. Green, CPA
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Trader tax status (TTS) constitutes business expense treatment and unlocks an assortment of meaningful tax benefits for those who qualify. The first step is to determine eligibility. If you do qualify for TTS, you can claim some tax breaks such as business expense treatment after the fact and elect and set up other breaks — like Section 475 MTM and employee-benefit plans — on a timely basis.
Business expenses include home-office, education, startup expenses, organization expenses, margin interest, tangible property expense, Section 179 (100%) or 100% bonus depreciation, amortization on software, self-created automated trading systems, seminars, market data, stock borrow fees, and much more. The Tax Cuts & Jobs Act suspended “certain miscellaneous itemized deductions subject to the 2% floor,” including investment fees and expenses, commencing in 2018.
Securities traders with TTS should consider electing Section 475 ordinary gain or loss treatment by April 15 (individuals) and March 16, 2020 (existing partnerships or S-Corps). I call it tax-loss insurance: It exempts securities trades from wash sale loss adjustments and the $3,000 capital loss limitation. Profitable 475 traders are eligible for the 20% qualified business income (QBI) deduction. QBI excludes capital gains and losses.
A TTS S-Corp unlocks deductions for health insurance premiums and high-deductible retirement plan contributions.
Traders who do not qualify for TTS aren’t eligible for any of these tax benefits.
How to qualify
It’s not easy to be eligible for TTS. Currently, there’s no statutory law with objective tests for eligibility. Subjective case law applies a two-part test:
Taxpayers’ trading activity must be substantial, regular, frequent, and continuous.
A taxpayer must seek to catch swings in daily market movements and profit from these short-term changes rather than profiting from long-term holding of investments.
Golden rules
Volume, frequency, and average holding period are the “big three” because they are more accessible for the IRS to verify.
Volume: The 2015 tax court case Poppe vs. Commission is a useful reference. Poppe made 720 total trades per year/60 per month. We recommend an average of four trades per day, four days per week, 16 trades per week, 60 a month, and 720 per year on an annualized basis. Count each open and closing trade separately, not round trip. Scaling in and out counts, too.
Frequency: Executes trades on close to four days per week, around a 75% frequency rate.
Holding period: In the Endicott court, the IRS said the average holding period must be 31 days or less. That’s a bright-line test.
Trades full time or part-time, for a good portion of the day, almost every day the markets are open. Part-time and money-losing traders face more IRS scrutiny, and individuals face more scrutiny than entity traders.
Hours: Spends more than four hours per day, almost every market day working on the trading business — all time counts.
Avoid sporadic lapses: Has few to no intermittent lapses in the trading business during the year.
Intention: Has the intention to run a business and make a living. It doesn’t have to be a primary living.
Operations: Has significant business equipment, education, business services, and a home office.
Account size: Has a material account size. Securities traders need to have $25,000 on deposit with a U.S.-based broker to achieve pattern day trader (PDT) status. For the minimum account size, we like to see more than $15,000.
What doesn’t qualify? These four types of trading activity do not count for TTS qualification.
Outside-developed automated trading systems (ATS). A computerized trading service with little to no human involvement doesn’t qualify for TTS. On the other hand, if the trader can show he’s very involved with the creation of the ATS — perhaps by writing the code or algorithms, setting the entry and exit signals, and turning over only execution to the program — the IRS may count those trades.
Trade copying service. Some traders use trade copying software. Trade copying is similar to using a canned ATS or outside adviser, where the copycat trader might not qualify for TTS on those trades.
Engaging a money manager. Hiring a registered investment adviser or commodity trading adviser — whether they are duly registered or exempt from registration — to trade one’s account doesn’t count toward TTS qualification.
Trading retirement funds. Achieve TTS through trading in taxable accounts. Trading activity in non-taxable retirement accounts doesn’t count for purposes of TTS qualification.
January 7, 2020 | By: Robert A. Green, CPA
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Use Green’s 2020 Trader Tax Guide to receive every trader tax break you’re entitled to on your 2019 tax returns. Our 2020 guide covers the 2017 Tax Cuts and Jobs Act’s impact on investors, traders, and investment managers. Learn various smart moves to make in 2020.
Whether you prepare your 2019 tax returns as a trader or investor, this guide can help. Even though it may be too late for some tax breaks on 2019 tax returns, you can still use this guide to execute these tax strategies and elections for tax-year 2020.
Tax Cuts and Jobs Act
Tax Cuts and Jobs Act (TCJA) was enacted on Dec. 22, 2017, and the law changes took effect in the 2018 tax year.
Like many small business owners, traders eligible for trader tax status (TTS) restructured their business for 2019 and 2020 to take advantage of TCJA. Two tax changes caught their eye: The 20% deduction on qualified business income (QBI) in pass-through entities, and suspended investment fees and expenses, which makes TTS even more crucial. (TCJA continues to allow itemized deductions for investment-interest expenses and stock borrow fees.)
TCJA didn’t change trader tax matters, including business expense treatment, Section 475 MTM ordinary gain or loss treatment, and wash-sale loss adjustments on securities; it didn’t change TTS S-Corps’, Solo 401(k) retirement contributions and health insurance deductions, either. TCJA also retains the lower Section 1256 60/40 capital gains tax rates; the Section 1256 loss carryback election; Section 988 forex ordinary gain or loss; and tax treatment on financial products including options, ETFs, ETNs, swaps, precious metals, and more.
2018 and 2019 tax forms
TCJA required significant revisions to the 2018 income tax forms. Some of those changes confused taxpayers, so the IRS revised the 2019 tax forms. The redesigned two-page 2018 Form 1040 resembled a postcard because the IRS moved many sections to six new 2018 Schedules (Form 1040). It was a block-building approach with the elimination of Form 1040-EZ and 1040-A.
The 2019 Form 1040 has three schedules, not six. The IRS moved some items back onto the Form 1040.
The IRS significantly changed Schedule A (Itemized Deductions). TCJA suspended “certain miscellaneous itemized deductions subject to the 2% floor.” These deductions were included in “Job Expenses and Certain Miscellaneous Deductions” on the 2017 Schedule A, lines 21 through 24. The revised 2018 Schedule A deleted these deductions, including job expenses, investment fees and expenses, and tax compliance fees and expenses.
The 2017 Schedule A also had “Other Miscellaneous Deductions,” not subject to the 2% floor, on line 28. That’s where investors reported stock-borrow fees, which are not investment fees and expenses. The 2018 Schedule A changed the name to “Other Itemized Deductions” on line 16.
TCJA introduced a new 20% deduction on qualified business income for 2018, but the IRS did not draft a tax form for it. Taxpayers used a worksheet for the calculation and reported a “qualified business income deduction” on the 2018 Form 1040, page 2, line 9. For 2019, the IRS introduced Form 8995 (Qualified Business Income Deduction Simplified Computation) and Form 8995-A (Qualified Business Income Deduction).
Business traders fare better
By default, the IRS lumps all traders into “investor tax status,” and investors get penalized in the tax code — more so with TCJA. Investors have restricted investment interest expense deductions, and investment fees and expenses are suspended. Investors have capital-loss limitations against ordinary income ($3,000 per year), and wash-sale loss deferrals; they do not have the Section 475 MTM election option or health insurance and retirement plan deduction strategies. Investors benefit from lower long-term capital gains rates (0%, 15%, and 20%) on positions held 12 months or more before sale. If active traders have segregated long-term investment positions, this is available to them as well.
Business traders eligible for TTS are entitled to many tax breaks. A sole proprietor (individual) TTS trader deducts business expenses and is entitled to elect Section 475 MTM ordinary gain or loss treatment. However, to deduct health insurance and retirement plan contributions, a TTS trader needs an S-Corp to create earned income with officer compensation.
Don’t confuse TTS with the related tax-treatment election of Section 475 MTM accounting. The 475 election converts new capital gains and losses into business ordinary gains and losses, avoiding the $3,000 capital loss limitation. Only qualified business traders may use Section 475 MTM; investors may not. Section 475 trades are also exempt from wash-sale loss adjustments. The 20% deduction on qualified business income includes Section 475 ordinary income but excludes capital gains, interest, and dividend income.
A business trader can assess and claim TTS after year-end and even going back three open tax years. But business traders may only use Section 475 MTM if they filed an election on time, either by April 15 of the current year (i.e., April 15, 2019 for 2019) or within 75 days of inception of a new taxpayer (i.e., a new entity). For more on TTS, see Chapter 1.
Can traders deduct trading losses?
Deducting trading losses depends on the instrument traded, the trader’s tax status, and various elections.
Many traders bought this guide hoping to find a way to deduct their 2019 trading losses. Maybe they qualify for TTS, but that only gives them the right to deduct trading business expenses.
Securities, Section 1256 contracts, ETNs, and cryptocurrency trading receive capital gain/loss treatment by default. If a TTS trader did not file a Section 475 election on securities and/or commodities on time (i.e., by April 15, 2019), or have Section 475 from a prior year, he is stuck with capital loss treatment on securities and Section 1256 contracts. Section 475 does not apply to ETN prepaid forward contracts, which are not securities, or cryptocurrencies, which are intangible property.
Capital losses offset capital gains without limitation, whether short-term or long-term, but a net capital loss on Schedule D is limited to $3,000 per year against other income. Excess capital losses are carried over to the subsequent tax year(s).
Once taxpayers get in the capital loss carryover trap, a problem they often face is how to use up the carryover in the following year(s). If a taxpayer elects Section 475 by April 15, 2020, the 2020 business trading gains will be ordinary rather than capital. Remember, only capital gains can offset capital loss carryovers. That creates a predicament addressed in Chapter 2on Section 475 MTM. Once a trader has a capital loss carryover hole, she needs a capital gains ladder to climb out of it and a Section 475 election to prevent digging an even bigger one. The IRS allows revocation of Section 475 elections if a Section 475 trader later decides he or she wants capital gain/loss treatment again.
Traders with capital losses from Section 1256 contracts (such as futures) may be in luck if they had gains in Section 1256 contracts in the prior three tax years. On the top of Form 6781, traders can file a Section 1256 loss carryback election. This allows taxpayers to offset their current-year losses against prior-year 1256 gains to receive a refund of taxes paid in prior years. Business traders may elect Section 475 MTM on Section 1256 contracts, but most elect it on securities only so they can retain the lower 60/40 capital gains tax rates on Section 1256 gains, where 60% is considered a long-term capital gain, even on day trades.
Taxpayers with losses trading forex contracts in the off-exchange Interbank market may be in luck. By default, Section 988 for forex transactions receives ordinary gain or loss treatment, which means the capital-loss limitation doesn’t apply. However, without TTS, the forex loss isn’t a business loss and therefore can’t be included in a net operating loss (NOL) calculation — potentially making it a wasted loss since it also can’t be added to the capital loss carryover. If taxpayer has another source of taxable income, the forex ordinary loss offsets it; the concern is when there is negative taxable income. Forex traders can file a contemporaneous “capital gains and losses” election in their books and records to opt out of Section 988, which is wise when capital loss carryovers exist. Contemporaneous means in advance — not after the fact using hindsight. In some cases, this election qualifies for Section 1256(g) lower 60/40 capital gains tax rates on major pairs, not minors.
A TTS trader using Section 475 on securities has ordinary loss treatment, which avoids wash-sale loss adjustments and the $3,000 capital loss limitation. Section 475 ordinary losses offset income of any kind, and a net operating loss carries forward to subsequent tax year(s). TCJA’s “excess business loss” (EBL) limitation for 2019 is $510,000 married and $255,000 other taxpayers applies to Section 475 ordinary losses and trading expenses. Add an EBL to an NOL carryforward. See TCJA changes in Chapter 17.
Tax treatment on financial products
There are complexities in sorting through different tax-treatment rules and tax rates. It’s often hard to tell what falls into each category. To help our readers with this, we cover the many trading instruments and their tax treatment in Chapter 3.
Securities have realized gain and loss treatment and are subject to wash-sale rules and the $3,000 per year capital loss limitation on individual tax returns.
Section 1256 contracts — including regulated futures contracts on U.S. commodities exchanges — are marked to market by default, so there are no wash-sale adjustments, and they receive lower 60/40 capital gains tax rates.
Options have a wide range of tax treatment. An option is a derivative of an underlying financial instrument and the tax treatment is generally the same. Equity options are taxed the same as equities, which are securities. Index options are derivatives of indexes, and broad-based indexes are Section 1256 contracts. Simple and complex equity option trades have special tax rules on holding period, adjustments, and more.
Forex receives ordinary gain or loss treatment on realized trades (including rollovers), unless a contemporaneous capital gains election is filed. In some cases, lower 60/40 capital gains tax rates on majors may apply.
Physical precious metals are collectibles; if these capital assets are held over one year, sales are subject to the collectibles capital gains rate capped at 28%.
Cryptocurrencies are intangible property taxed like securities on Form 8949, but wash-sale loss and Section 475 rules do not apply because they are not securities.
Foreign futures are taxed like securities unless the IRS issues a revenue ruling allowing Section 1256 tax benefits.
Several brokerage firms classify options on volatility exchange-traded notes (ETNs) and options on volatility exchange-traded funds (ETFs) structured as publicly traded partnerships as “equity options” taxed as securities. There is substantial authority to treat these CBOE-listed options as “non-equity options” eligible for Section 1256 contract treatment. Volatility ETNs have special tax treatment: ETNs structured as prepaid forward contracts are not securities, whereas, ETNs structured as debt instruments are.
Don’t solely rely on broker 1099-Bs: There are opportunities to switch to lower 60/40 tax capital gains rates in Section 1256, use Section 475 ordinary loss treatment if elected on time, and report wash-sale losses differently. Vital 2020 tax elections need to be made on time. See Chapter 3.
Entities for traders
Entities can solidify TTS, unlock health insurance and retirement plan deductions, gain flexibility with a Section 475 election or revocation, prevent wash-sale losses with individual and IRA accounts, and enhance a QBI deduction on Section 475 income less trading expenses. An entity return consolidates trading activity on a pass-through tax return, making life easier for traders, accountants, and the IRS. Trading in an entity allows individually held investments to be separate from business trading. It operates as a separate taxpayer yet is inexpensive and straightforward to set up and manage.
An LLC with S-Corp election is generally the best choice for a single or married couple seeking health insurance and retirement plan deductions. See Chapter 7.
Retirement plans for traders
Annual tax-deductible contributions up to $62,000 for 2019 and $63,500 for 2020 to a TTS S-Corp Solo 401(k) retirement plan generally saves traders significantly more in income taxes than it costs in payroll taxes (FICA and Medicare). Trading gains aren’t earned income, so traders use an S-Corp to pay officer compensation.
There’s also an option for a Solo 401(k) Roth: If you are willing to forgo the tax deduction, you’ll enjoy permanent tax-free status on contributions and growth within the plan. See Chapter 8.
20% deduction on qualified business income
TCJA introduced a new tax deduction for pass-through businesses, including sole proprietors, partnerships and S-Corps. Subject to haircuts and limitations, a pass-through business could be eligible for a 20% deduction on qualified business income (QBI).
Traders eligible for TTS are a “specified service activity,” which means if their taxable income is above an income cap, they won’t receive a QBI deduction. The taxable income (TI) cap is $421,400/$210,700 (married/other taxpayers) for 2019, and $426,600/$213,300 (married/other taxpayers) for 2020. The phase-out range below the cap is $100,000/$50,000 (married/other taxpayers), in which the QBI deduction phases out for specified service activities. The W-2 wage and property basis limitations also apply within the phase-out range. Investment managers are specified service activities, too.
QBI for traders includes Section 475 ordinary income and loss and trading business expenses. QBI excludes capital gains and losses, Section 988 forex and swap ordinary income or loss, dividends, and interest income.
TCJA favors non-service businesses, which are not subject to an income cap. The W-2 wage and property basis limitations apply above the TI threshold of $321,400/$160,700 (married/other taxpayers) for 2019, and $326,600/$163,300 (married/other taxpayers) for 2020. The IRS adjusts the annual TI income threshold for inflation each year. For more information, see Chapter 17.
Affordable Care Act
TCJA did not change the Affordable Care Act’s (ACA) 3.8% Medicare tax on unearned income. The net investment tax (NIT) applies on net investment income (NII) for individual taxpayers with modified AGI over $250,000 (married) and $200,000 (single). The threshold is not indexed for inflation. Traders can reduce NIT by deducting TTS trading expenses, including salaries paid to them and their spouses. Traders may also reduce NII with investment expenses that are allowed on Schedule A, such as investment-interest expense and stock borrow fees. Investment fees and other investment expenses suspended from Schedule A also are not deductible for NII.
ACA’s individual health insurance mandate and shared responsibility fee for non-compliance, exchange subsidies, and premium tax credits continue to apply for 2019 and 2020. However, TCJA reduced the shared responsibility fee to $0 starting in 2019.
For more information, see Chapter 9 and Chapter 15.
Investment management carried interest
TCJA modified the carried interest tax break for investment managers in investment partnerships, lengthening their holding period on profit allocation of long-term capital gains (LTCG) from one year to three years. If the manager also invests capital in the partnership, he or she has LTCG after one year on that interest. The three-year rule only applies to the investment manager’s profit allocation — carried interest. Investors still have LTCG based on one year.
Investment partnerships include hedge funds, commodity pools, private equity funds, and real estate partnerships. Many hedge funds don’t hold securities for more than three years, whereas, private equity, real estate partnerships, and venture capital funds do.
Investors also benefit from carried interest in investment partnerships. TCJA suspended “certain miscellaneous itemized deductions subject to the 2% floor,” which includes investment fees and expenses. Separately managed account investors are out of luck, but hedge fund investors can limit the negative impact by using carried-interest tax breaks. Carried interest reduces a hedge fund investor’s capital gains instead of having a suspended incentive fee deduction.
International tax matters
When it comes to global tax matters, we focus on the following types of traders: U.S. residents living abroad, U.S. residents with international investments, U.S. residents moving to U.S. territories like Puerto Rico (with substantial tax breaks), U.S. residents surrendering citizenship or green cards, and nonresident aliens investing in the U.S. with individual U.S. brokerage accounts or through an entity. See Chapter 14.
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