We are pleased to feature our first course in our new GreenTraderTax video series.
Click each lesson below and total course time is 60 minutes.
We are pleased to feature our first course in our new GreenTraderTax video series.
Click each lesson below and total course time is 60 minutes.
Trader tax status (TTS) drives many key business tax breaks like business expenses, business ordinary trading losses with the Section 475 election and through an S-Corp, employee benefit deductions for retirement plans and health-insurance premiums. These items are deducted from gross income without restriction, whereas investment expenses are subject to itemized deductions, AMT preferences, and Pease limitations, and there are limitations on capital losses and wash sale loss deferral adjustments. Unfortunately, only a small fraction of active traders qualify for TTS, and the rules are vague and confusing to understand. In this blog post, learn how to be eligible for TTS.
TTS is good before and after tax reform:
Congress and President Trump are working on tax reform in 2017, and considering delays; I expect changes won’t be effective until 2018. Don’t wait for concrete plans, get started on 2017 tax planning based on current law, and hopefully, tax reform will favor your planning.
TTS is a case in point: It works perfectly for 2017, and tax reform should be the icing on the cake offering a lower tax rate on business income, hopefully, available to a TTS company. Tax reform may also repeal investment expense deductions, thereby making TTS even more attractive. (Read Consider Smart Tax Moves Now That Work With Possible Reform).
The first step is to determine if you qualify for TTS. If you do, you can claim some tax breaks such as business expense treatment after the fact, and make an election and set up other breaks — like Section 475 MTM and employee-benefit plans — on a timely basis.
There’s no election for TTS:
There’s no election for TTS; it’s an optional tax status based on facts and circumstances. A trader may qualify for TTS one year but not the next. It’s analogous to taking bread out of the oven each year to see if it rose to the level of bread (TTS) or if it’s flat bread (investor tax status). If you elected Section 475 and later don’t qualify for TTS, you must suspend use of Section 475 treatment until you requalify since Section 475 is conditional on qualification for TTS.
You can also qualify for TTS for part of a year. Perhaps you qualified for TTS in 2016 and quit or suspended active trading on June 30, 2017. Or you began active trading on July 1, 2017. Include the period of qualification on Schedule C or the pass-through entity tax return and deduct business expenses during that part-year period. If elected, use Section 475 for the TTS time, too.
TTS uses business expenses:
Qualifying for TTS means you can use business treatment for trading expenses as opposed to the default investment treatment. Business expense treatment under Section 162 gives full ordinary deductions, including home-office, education, Section 195 start-up expenses, Section 248 organization expenses, margin interest, tangible property expensing, Section 179 (100%) depreciation, amortization on software, seminars, market data, stock borrow fees and much more. (Watch my Webinar recording Top 11 Tax Deductions For Active Traders and see how a TTS trader has tax savings of $38,500 vs. an investor with no savings.)
Conversely, investment expenses don’t allow home-office, education, start-up, and organization costs, and they are only allowed as a miscellaneous itemized deduction in excess of 2% of adjusted gross income (AGI), and not deductible against the alternative minimum tax (AMT). The IRS further restricts investment expenses with the “Pease” itemized deduction limitation for taxpayers with AGI’s over $313,800 (married) and $261,500 (single), based on 2017 thresholds. Many states limit itemized deductions too. The bottom line is business expense treatment is much better.
You can claim TTS after year-end; you don’t need to make an election in advance like Section 475 MTM and the forex election to opt out of Section 988. You can claim TTS for the tax year that just ended and even for the prior three tax years with amended returns by including a Schedule C as a sole proprietor on individual accounts or for entities by changing the character of expenses on Schedule K-1s. (Note: Filing amended tax returns may increase your odds of IRS questions or exam so be sure of your status.)
Full-time traders often qualify for TTS, but it’s harder for part-time traders. The bar is raised in the eyes of the IRS — especially if you have significant trading losses with business ordinary loss treatment (Section 475) rather than capital loss limitations.
IRS case law and Publication 550:
It’s not easy to be eligible for TTS. Currently, there’s no statutory law with objective tests. Subjective case law applies. Leading tax publishers have interpreted case law to show a two-part test:
1. Taxpayers’ trading activity must be substantial, regular, frequent and continuous.
2. The taxpayer must seek to catch the swings in the daily market movements and profit from these short-term changes rather than profiting from the long-term holding of investments.
IRS agents often refer to Chapter 4 in IRS Publication 550, “Special Rules for Traders.” Here’s an excerpt: The following facts and circumstances should be considered in determining if your activity is a securities trading business.
- Typical holding periods for securities bought and sold.
- The frequency and dollar amount of your trades during the year.
- The extent to which you pursue the activity to produce income for a livelihood
- The amount of time you devote to the activity.
The IRS does not define the words “substantial, regular, frequent, and continuous” and case law also doesn’t give a bright-line test with exact numbers.
My Golden Rules on how to qualify for TTS:
I base my Golden Rules on trader tax court cases and our CPA firm’s vast experience with IRS and state controversy for traders. The trader:
- Trades full time or part time, all day, every day. Part-time and money-losing traders face more IRS scrutiny and individuals face more scrutiny than entities. 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 my golden rules.
- Hours: Spends more than four hours per day, almost every market day working on his trading business. All time counts, including 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 “material participation” 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 activities, 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.
- Few to no occasional lapses: The IRS has successfully denied TTS in a few tax court cases by arguing the trader had too many breaks 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 methods and markets. Explain these breaks to the IRS in tax-return footnotes. Retooling and education during an occasional break may be acceptable. Keep good records of your time spent.
- Frequency: Executes trades on close to four days per week, every week. It’s wise to prevent an IRS challenge by trading close to four days per week or 75% of available trading days — even if you need to make smaller executions with reduced risk on otherwise non-trading days. It’s not a good idea to have the tax tail wag the dog, and any trading you do for TTS should have an actual economic risk.
Holsinger, Assaderaghi, Endicott and Nelson, options traders with less activity than equity or futures traders, only traded around 40% of available trading days, which is two days per week. Three days per week may be cutting it too close, so try to get closer to four. While we feel the IRS should also count working days when you don’t have an execution, it currently does not as evidenced by the Assaderaghi, Endicott and Nelson cases.
- Volume: Makes 720 total trades per year (Poppe court) on an annualized basis. If you start July 1, then you need 360 executions, half of the 720. The court mentioned Poppe having 60 trades per month as being sufficient volume. Count the buy and sell, or open and close, as two total trades.
The markets are open approximately 250 days per year, and with personal days and holidays, you might be able to trade on 240 days. With a 75% frequency, you would trade on 180 days per year, so 720 total trades divided by 180 trading days equals four trades per trading day.
Some traders scale into trades and executions are broken down into smaller lot sizes. Options traders have multi-legged positions on complex trades. We believe you may count each trade confirmation of a complex trade, providing you make the executions separately, although this has not come up in tax court cases. If you initiate a trade and the broker breaks down the lot sizes without your involvement, the IRS may reject counting the extra volume of trades in this case.
Forex and futures trades aren’t listed line by line on tax returns (unlike securities trades), so the IRS doesn’t see those numbers. Report an actual number in your tax return footnotes about TTS.
- Proceeds: Have proceeds in the millions of dollars per year on equities. More traders are using options and futures, which have lower proceed values. Explain this well in footnotes since proceeds for futures and forex are not reported on 1099s, and the IRS won’t see the proceeds amount. Proceeds on a Form 1099-B provide the IRS with a quick indication about qualification for TTS.
- Holding period: Over the years, the IRS stated that holding period is the most important factor, and in the Endicott court, the IRS said average holding period must be 31 days or less. That’s a bright-line test and the only one.
Active traders usually make day trades or swing trades. Don’t hold many trading positions over a month, unless you segregate them as investments. Exclude investments from average holding period calculations. Investment positions are also not subjected to MTM in Section 475 (if elected), which then allows for deferral at year-end and perhaps lower long-term capital gains tax rates if held 12 months.
Options traders may have average holding periods of over one month if they trade monthly options and keep them open for one or more months. (Note: Holsinger was an options trader and his holding periods averaged between one to two months.)
Many options traders qualify for TTS by trading weekly options, thereby shortening their average holding periods to under 31 days. Their other challenge is frequency, as many still only execute trades on two to three days per week, rather than the requirement closer to four days per week. It’s a challenge for options traders to be that frequent. Some fill in the blanks by trading securities, futures and or forex.
- Intention: Has the plan to run a business and make a living. You must have the intention to run a separate trading business — trading your money — but it doesn’t have to be your exclusive or primary means of making a living. The key word is “a” living, which means it can be supplemental income for your livelihood.
Many traders enter an active trading activity while still performing their full-time job. It’s possible to carry on both activities simultaneously using advances in technology and flexible job schedules.
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 undermine trader tax status.
While filing as a sole proprietor on a Schedule C is allowed and used by many, it’s not the best tax filing strategy. Your tax return shows your job and other business activities or retirement, and that may undermine TTS in the eyes of the IRS. The IRS tends to think trading is a secondary activity, and they may seek to deny TTS. It’s best to form a new, separate entity dedicated to trading only.
- Operations: Has significant business equipment, education, business services and a home office. Most business traders have multiple monitors, computers, mobile devices, trading services and subscriptions, education expenses, high-speed broadband, wireless and a home office. Some have staff. The IRS needs to see that you have a serious trading business operation. How can you run a business without an office? Casual investors rarely have as elaborate an office set up as business traders do. Why would a long-term investor need multiple monitors? If you use the office exclusively for business rather than personal use, don’t skip reporting a valid home-office deduction.
- 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, they can day trade using up to 4:1 margin rather than 2:1. Without PDT status, securities traders, which include equities and equity options, can’t day trade and they will have a hard time qualifying for TTS. The $25,000 amount seems substantial enough to impress the IRS.
Many new traders don’t want to risk $25,000 on day trading securities; they prefer to trade futures or forex, all allowing mini-account sizes of $5,000 or less. A small account size won’t impress the IRS — you probably need more capital to qualify. We like to see over $15,000 for futures or forex accounts.
What doesn’t qualify for TTS:
Three factors don’t qualify for TTS: Automated trading without much involvement by the trader (but creating your program qualifies); engaging a professional outside investment manager; and trading in retirement funds. Don’t include these trades in the golden rule calculations.
This blog post is a partial excerpt from Green’s 2017 Trader Tax Guide. There’s more to learn about TTS in the guide.
Consider a 30-minute paid consultation with Robert A. Green, CPA to discuss: Whether you qualify for trader tax status; if you should elect mark-to-market accounting; if you benefit from an entity and which type of company; and more trader tax benefits.
Active traders qualifying for trader tax status (TTS) maximize these deductions in the following ways:
1. Home-office (HO) deductions
Use the square footage or rooms method to allocate every expense of your home including mortgage interest, real estate taxes, rent, utilities, repairs and maintenance, insurance and depreciation. The IRS limits use of HO expenses by requiring business income to offset the deduction, except for the mortgage interest and real estate tax portion. Link the HO Form 8829 to TTS trading gains or transfer some to Schedule C to unlock the HO deduction. If you have trading losses, carry over unallowed HO deductions to subsequent tax year(s). Converting personal home expenses to business use is great.
2. Additions and improvements to office
Consider an addition or improvements to your home office like building more space, replacing windows, walls, and flooring. Depreciate residential real property over 39 years on a straight-line basis. If you rent or own an outside office, depreciation rules are more attractive. The Protecting Americans From Tax Hikes (PATH) Act of 2015 created “qualified improvement property.” It’s a new class of nonresidential real property, excluding additions like increasing square footage. Use 50% bonus depreciation on qualified improvement property placed in service in 2016. PATH extended bonus depreciation through 2019.
3. Tangible property expensing
Expense new tangible property items up to $2,500 per item. Before 2015, the IRS threshold for capitalization with depreciation vs. full expensing was $500. When you purchase a new trading computer system its best to arrange separate invoices for each item not exceeding $2,500.
4. Section 179 (100%) depreciation
For equipment, furniture and fixtures above the tangible property threshold ($2,500), use Section 179 depreciation allowing 100% depreciation expense in the first year. PATH made permanent generous Section 179 limits. The 2016 limit is $500,000 on new and used equipment including off-the-shelf computer software. The IRS limits the use of Section 179 depreciation by requiring income to offset the deduction. Look to business trading gains, other business income or wages, from either spouse, if filing joint.
5. Automated trading systems
Increasingly, traders are writing computer code for developing automated trading systems. The IRS allows a few different choices for expensing “internal-use software.” If you qualify for TTS before incurring software development costs, deduct them like other research expenses in Section 174(a) in the year paid. If you don’t qualify for TTS before incurring software development costs, capitalize them under Section 174(b). Two choices: When you complete the software and qualify for TTS, amortize (expense) the intangible asset over 60 months. Or, wait until you place the software in service with qualification for TTS to amortize (expense) the intangible asset over 36 months. Traders may qualify for TTS using automated trading systems providing they write the code or have other significant involvement with creation and modification of the automated trading systems. Conversely, if a trader purchases an off-the-shelf automated trading system providing entry and exit signals and trade execution, the trader probably doesn’t get credit for the volume and frequency of trades made by the automated trading system.
6. Education, mentoring and seminars
All three are considered education expenses and tax deductibility hinges on qualification for TTS. Education business expenses paid after the start of your business are allowed for maintaining and improving your business. Learning a new business before starting that business is not allowed as a business expense. If you are learning about investing while carrying on an investment activity, that education expense is not allowed as a Section 212 investment expense by Section 274(h)(7). Tip: If you pay for trading education services before qualifying for TTS, consider using Section 195 start-up expenditures treatment below.
7. Section 195 start-up expenditures
Go back a reasonable period (six months) before qualifying for TTS to capitalize a reasonable amount ($15,000) of start-up costs. Start-up expenses include costs to investigate and inquire about a new business. Costs capitalized in Section 195 would have to qualify as a business expense if paid after business commencement. Section 195 allows an expense allowance in the first year up to $5,000. Start a calendar year business late in the year and still get the full $5,000 expense allowance. Amortize the remainder of the costs over 180 months on a straight-line basis. If you exit the trading business, you may write off the unamortized balance.
8. Organization costs
Under Section 248 for corporations and Section 709 for partnerships, treat expenses to organize or form an entity in a similar manner as Section 195 start-up expenditures. There is a separate first-year expense allowance up to $5,000, and the balance is amortizable over 180 months on a straight-line basis.
9. Health insurance premiums
Deduct health insurance premiums from individual AGI if you have an S-Corp trading company paying you W-2 wages which include your premiums. The plan must be in association with your small business and not a third-party employer plan for you or your spouse. Deduct health insurance premiums during the entity period, not before. This S-Corp wage component for health insurance premiums is not subject to social security and Medicare taxes, so enjoy the income tax savings with no offsetting payroll tax costs. A C-Corp management company deducts health insurance premiums on the corporate tax return.
10. Retirement plans
Most traders with TTS should consider a Solo 401(k) retirement plan. Consistently high-income traders with TTS should consider a defined benefit plan if they are close to age 50. Retail traders need an entity like an S-Corp trading company or C-Corp management company to arrange retirement plan deductions since sole proprietor traders don’t have earned income required for employee benefit plan deductions. With one exception: Futures traders using full exchange membership have self-employment income (Section 1402i).
Solo 410(k) plan: S-Corp officer wages of $140,000 unlock the maximum $53,000 contribution/deduction or $59,000 if age 50 or older with the $6,000 catch-up provision. The 100%-deductible elective deferral up to $18,000, or $24,000 with the catch-up provision, provides the greatest income tax savings vs. payroll tax costs. The 25%-deductible profit-sharing plan up to $35,000 is good if you have sufficient cash flow to invest in tax-free compounded growth within the plan.
Defined-benefit plan (DBP): With consistent high trading income, arrange a $100,000 plus contribution/deduction with a defined-benefit plan. Work with an actuary on complex DBP calculations.
Business traders have a wide variety of other expenses including independent contractors and employees for trade assistance and IT, market data providers, charting software, chat rooms and trading groups, subscriptions, books, periodicals, attorneys, accountants, tax advisors and more.
Commissions are not expenses; they are part of the trading capital gain or loss.
Business expenses are deductible “above the line” from gross income, whereas investment expenses face significant limitations “below the line.” Section 212 investment expenses exclude home office, start-up expenditures, employee benefits and education. They are part of miscellaneous itemized deductions, which must first exceed a 2% of AGI threshold. Upper-income taxpayers face additional limitations: a Pease itemized deduction phase-out and AMT taxes since investment expenses are an AMT preference item.
Learn how to qualify for TTS on GreenTraderTax.com.
Related Webinar & Recording: Top 10 Tax Deductions For Active Traders
According to Tax Notes article “IRS Considering ‘Freeze and Mark’ for Trader Election” dated Jan. 20, 2016, Robert Williams, branch 3 senior counsel, IRS Office of Associate Chief Counsel (Financial Institutions and Products), said he was optimistic, though cautious, that updated Section 475 regulations will come out by June 30, 2016.
The Tax Notes article mentioned a few significant potential changes that would affect traders in making a new Section 475 election. If codified by the IRS, I expect these changes won’t apply retroactively, so traders who made a 2016 Section 475 election by April 18 should not be affected.
Clarification of the character of income or loss of a Section 481(a) adjustment: The IRS may clarify that it’s a capital gain or loss, rather than an ordinary income or loss, which is the current interpretation. Many traders have benefited from ordinary loss treatment, especially when a Section 481(a) adjustment included wash sale loss deferrals on open trading business positions.
No election deadline: The changes may allow existing taxpayers to make a new Section 475 election throughout the tax year. Currently, the election deadline is April 15 for existing partnerships and individuals and March 15 for S-Corps. Many existing taxpayers will appreciate doing away with the deadline.
No retroactive application: Williams discussed applying ordinary income or loss treatment on the election date and going forward, and doing away with retroactive application of ordinary income or loss to Jan. 1.
Under current law, when a trader elected Section 475 by April 18, 2016 for 2016 (normally April 15), the election was retroactive to Jan. 1, 2016, so all 2016 trading gains and losses are ordinary income and loss. If a trader qualified for trader tax status (TTS) at year-end 2015, he also makes a Section 481(a) adjustment on Jan. 1, 2016 for unrealized gains or losses on open trading positions on Dec. 31, 2015.
Traders have been able to use hindsight between Jan. 1 and April 15 to make a last-minute decision about electing Section 475. For example, if they have a large trading loss in Q1, they may elect Section 475 to lock in ordinary loss treatment for that loss, and plan to revoke Section 475 in the subsequent year to get back to capital gains treatment to use up capital loss carryovers. That type of hindsight may be lost with these potential updates in the law.
Section 475 “tax loss insurance” is a fantastic tax benefit for active securities traders qualifying for trader tax status (TTS). Many individual taxpayers have been using it successfully for years. I’ve exhorted the benefits since 1997, when Congress enacted Section 475 tax law for traders.
Some Section 475 provisions are vague
Increasingly, my firm’s tax compliance CPAs have noticed problems with the nuances of Section 475, including some of the rule sections, which are too vague. The IRS acknowledged this with its “Section 475 Clean Up Project” and read our comment letter to the IRS. The IRS said the project is being completed and to expect updated Section 475 regulations in the summer of 2016. (I cover the changes being discussed at tax attorney conferences in my next blog post IRS Considering “Freeze and Mark” for Section 475 Election.)
One of the problems with Section 475 regulations has to do with segregation of investments. Segregation should be done in form and substance and that can be confusing. A prior IRS proposed regulation called for designation of investment accounts, but that was not sufficient as traders could use substance to trump form.
This problem arises when a trader uses Section 475 and also holds investment positions in substantially identical positions. Traders can’t elect Section 475 by account. The law makes the election by taxpayer identification number, which means the election applies to all active trading accounts and investment accounts containing active trading.
Traders can solve this problem by housing the trading business using Section 475 in a separate legal entity and holding investments in individual accounts. This is the only way to fully segregate investments from trading. (Read my recent blog post Active Traders Should Consider An Entity For Tax Savings for other reasons to form an entity.)
Misidentified investment positions
Many individuals trade substantially identical positions between Section 475 active trading accounts and taxable investment accounts, including joint and spousal accounts. For example, they trade Apple options in a Section 475 account and also hold Apple equity in segregated investment accounts.
The IRS can view this trading as gaming the system, with the trader deducting ordinary losses on Apple options but deferring taxes on unrealized long-term capital gains in Apple equity held as an investment. Because Apple options and Apple equity are substantially identical positions, the IRS has the power in Section 475 regulations to treat either the Apple options or the Apple equity as “misidentified investment positions,” which means it can apply Section 475(d)(2). (Learn more about that Section 475 penalty in my blog post IRS Plays Havoc with Traders Misidentifying Investments.)
Experienced trader tax preparers and IRS agents may seek other ways to address this problem, including reclassifying Section 475 ordinary losses on Apple options as investment capital losses, which then triggers capital loss limitations and wash sale loss adjustments on substantially identical positions across all accounts. Or if it’s better for the IRS position, reclassifying Apple equity investments as Section 475 trades, triggering Section 475 MTM ordinary income treatment, thereby losing tax deferral and missing out on lower long-term capital gains rates on realization.
An entity solves the problem
Traders can avoid this problem by ring-fencing Section 475 trades in separate entity accounts and holding investments in individual accounts. A separate legal entity has a different taxpayer identification number vs. an individual taxpayer social security number.
Don’t transfer investment positions into the entity, as that brings the same problem to the entity-level: having trading and investment accounts and or positions on the same taxpayer identification number.
I suggest that traders using portfolio margining on investment positions make the following decision. Either bring investments into the trading entity for portfolio margining and don’t elect Section 475 in the entity or leave the investments out of the entity and elect Section 475.
A newly formed entity may elect Section 475 by placing a resolution in its own books and records within 75 days of inception. Existing taxpayers must elect Section 475 by making an election statement with the IRS by the due date of the prior year tax return, and later file a timely Form 3115 for the year of the election. (Read my blog post Traders: Consider Ordinary Loss Election By Tax Deadline for more details on making the election.)
IRS scrutinizes individuals with large Section 475-related NOL tax refunds
It’s been over a decade since Chen vs. Commission (2004), but an IRS official recently reiterated the importance of that landmark tax court case, deeming similar cases “Chen cases.”
The IRS official was referring to sole proprietor (individual) traders reporting large Schedule C and Form 4797 (Section 475) ordinary losses on individual tax returns and filing for large NOL carryback refunds claims with the IRS. All the cases in my Green’s 2016 Trader Tax Guide, including Assaderaghi, Nelson, Endicott and Holsinger are similar: individuals with Schedule C and Form 4797 losses.
It’s much better to file as an entity trader with Section 475 ordinary loss treatment. The tax refund is the same, but you substantially reduce your chances of IRS exam and denial of TTS, which is required for use of Section 475.
Section 475 tax benefits
Securities traders qualifying for TTS benefit from a Section 475 election. Section 475 securities trades are exempt from wash sale loss adjustments and a capital loss limitation. Section 475 has business ordinary loss treatment, which offsets income of any kind and contributes to net operating losses (NOLs), which may be carried back two years and/or forward 20 years. Short-term capital gains and Section 475 MTM gains are taxed at the ordinary tax rate, so Section 475 is recommended for securities traders.
Conversely, Section 1256 contract traders (futures and more) generally don’t want Section 475 since they would lose lower 60/40 capital gains tax rates in Section 1256 (60% is a long-term capital gain taxed at lower rates and 40% is a short-term capital gain).
Traders can elect Section 475 on securities only, retaining Section 1256 treatment on futures. Section 475 does not apply to segregated investments. Traders value ordinary loss treatment: It’s free tax loss insurance for securities traders.
I’ve been advising traders on tax matters for over 30 years and I’ve seen many ups and downs in the financial markets. I’ve seen professional traders with wide fluctuations of income and loss, too. It’s important to avoid the dreaded $3,000 capital loss limitation against other income and benefit from Section 475 ordinary business loss treatment to generate immediate tax refund relief.
Traders who qualify for trader tax status (TTS) and have a large trading loss in 2016 should consider filing a 2016 Section 475 MTM (ordinary loss treatment) election statement with their extension or return by the April 18, 2016 due date. Section 475 exempts traders from the capital loss limitation and wash sale loss rules. It’s too late to elect Section 475 for 2015: that election was due last April 15, 2015.
Section 475 allows a choice: an election on securities only, Section 1256 contracts only, or both. Specify such in the election statement. Only traders who qualify for trader tax status may use Section 475 and it applies to active trading in that business activity as a sole proprietor individual or on the entity level. Section 475 doesn’t apply to segregated investment positions, so traders may use long-term capital gains benefits on investments.
The biggest problem for investors and traders occurs when they’re unable to deduct trading losses on tax returns, significantly increasing tax bills or missing opportunities for tax refunds. Investors are stuck with this problem, but business traders with TTS can avoid it by filing timely elections for business ordinary tax-loss treatment: Section 475 mark-to-market (MTM) for securities and/or Section 1256 contracts if elected. (Section 1256 contracts include futures, broad-based indexes, options on futures, options on broad-based indexes and several other instruments.)
By default, securities and Section 1256 investors are stuck with capital-loss treatment, meaning they’re limited to a $3,000 net capital loss against ordinary income. The problem is that their trading losses may be much higher and not useful as a tax deduction in the current tax year. Capital losses first offset capital gains in full without restriction. After the $3,000 loss limitation against other income is applied, the rest is carried over to the following tax years. Many traders wind up with little money to trade and unused capital losses. It can take a lifetime to use up their capital loss carryovers. What an unfortunate waste! Why not get a tax refund from using Section 475 MTM right away?
Business traders qualifying for TTS have the option to elect Section 475 MTM accounting with ordinary gain or loss treatment in a timely fashion. When traders have negative taxable income generated from business losses, Section 475 accounting classifies them as net operating losses (NOLs). Caution: Individual business traders who miss the Section 475 MTM election date (April 18 for 2016) can’t claim business ordinary-loss treatment on trading losses for the current tax year. They will be stuck with capital-loss carryovers.
A new entity set up after April 18, 2016 can deliver Section 475 MTM for the rest of 2016 on trading losses generated in the entity account if the entity files an internal Section 475 MTM election within 75 days of inception. The new entity using Section 475 does not change the character of capital loss treatment on the individual accounts before or after entity inception. The entity is meant to be a fix for going forward; it’s not a means to clean up the past problems of capital loss treatment.
Ordinary trading losses can offset all types of income (wages, portfolio income, and capital gains) for you and your spouse on a joint filing, whereas capital losses only offset capital gains. Plus, business expenses and business ordinary trading losses comprise a NOL, which can be carried back two tax years and/or forward 20 tax years. It doesn’t matter if you are a trader or not in a carryback or carryforward year. Business ordinary trading loss treatment is the biggest contributor to federal and state tax refunds for traders.
There are many nuances and misconceptions about Section 475 MTM, and it’s important to learn the rules. For example, you’re entitled to contemporaneously segregate investment positions that aren’t subject to Section 475 MTM treatment, meaning at year-end you can defer unrealized gains on properly segregated investments. You can have the best of both worlds — ordinary tax losses on business trading and deferral with lower long-term capital gains tax rates on segregated investment positions. We generally recommend electing Section 475 on securities only, so you retain lower 60/40 capital gains rates on Section 1256 contracts. Far too many accountants and traders confuse TTS and Section 475; they are two different things, yet very connected.
Section 475 Election Procedures
Section 475 MTM is optional with TTS. Existing taxpayer individuals and partnerships that qualify for TTS and want Section 475 must file a 2016 Section 475 election statement with their 2015 tax return or extension by April 18, 2016 (April 19, 2016 if you live in Maine or Massachusetts). Existing S-Corps file in the same manner by March 15, 2016.
Election statement. The MTM election statement is one simple paragraph; unfortunately the IRS hasn’t created a tax form for it. It’s a version of the following: “Pursuant to Section 475(f), the Taxpayer hereby elects to adopt the mark-to-market method of accounting for the tax year ended Dec. 31, 2016 and subsequent tax years. The election applies to the following trade or business: Trader in Securities as a sole proprietor (for securities only and not Section 1256 contracts).” If you expect to have a loss in trading Section 1256 contracts, you can modify the parenthetical reference to say “for securities and Section 1256 contracts.” But remember, you’ll give up the lower 60/40 tax rates on Section 1256 contracts. If you trade in an entity, delete “as a sole proprietor” in the statement.
Form 3115 filing. Don’t forget an important second step: Existing taxpayers complete the election process by filing a Form 3115 (change of accounting method) with the election-year tax return. A 2016 MTM election filed by April 18, 2016 is reported and perfected on a 2016 Form 3115 filed with your 2016 tax returns in 2017 – by the due date of the return including extensions. Many accountants and taxpayers confuse this two-step procedure and they file the Form 3115 as step one on the election statement date. The IRS usually sends back the Form 3115, which can jeopardize ordinary-loss treatment.
If you have an individual $50,000 capital-loss carryover going into 2016, and you lose $50,000 in Q1 2016, it’s probably wise to elect Section 475 MTM as a sole proprietor for business ordinary loss treatment — and related tax relief — rather than digging a bigger hole of unutilized capital losses.
You can form a new entity for a “do over” to get back to capital gains treatment, so you can use up your capital loss carryovers. You have 75 days of additional hindsight once the entity commences business to file an internal Section 475 MTM election resolution for the entity trading. You’re hoping to generate capital gains in the entity to use up your remaining capital-loss carryovers and put off the Section 475 MTM election to the following entity year.
For more information on Section 475 and trader tax status, read Green’s 2016 Trader Tax Guide.
Executive summary and what’s new in this guide
Use Green’s 2016 Trader Tax Guide to receive every trader tax break you’re entitled to this tax season. Whether you self-prepare your tax returns using consumer tax preparation software or app, engage a CPA firm or local tax storefront, this guide can help everyone through the process. Many of our tax compliance clients use it to take advantage of our offerings, as an educated consumer is the best customer.
Unfortunately, it may be too late for some tax breaks on your 2015 tax return if you wait until you’re actually filing your taxes. If this is the case, then use this guide to execute these tax strategies — including forming an entity with employee-benefit plan deductions — and elections on time for tax-year 2016.
Business traders are far better off than investors in the tax code
By default, the IRS lumps all traders into “investor tax status,” and investors get penalized in the tax code with restricted investment interest and investment expenses, capital-loss limitations ($3,000 per year), wash-sale loss deferrals, no Section 475 mark-to-market (MTM) election and no employee-benefit plans (retirement and health insurance deductions). Business traders who qualify for trader tax status (TTS), though, are entitled to these tax breaks.
Don’t confuse TTS with the related tax-treatment election of Section 475 MTM accounting, which converts new capital gains and losses into business ordinary gains and losses. Only qualified business traders may use Section 475 MTM; investors may not.
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, 2015 for 2015), or within 75 days of inception of a new taxpayer (i.e., a new entity). For more on TTS, see Chapter 1.
Investment expenses are limited to 2% of adjusted gross income (AGI) and they are not deductible for the Alternative Minimum Tax (AMT). Plus, investment expenses exclude home office, education and startup expenses, all important business deductions for qualifying business traders.
Can you deduct 2015 trading losses?
Many traders bought this guide hoping to find a way to deduct their 2015 trading losses. Maybe they qualify for TTS, but that only gives them the right to deduct their trading business expenses.
Securities trading and Section 1256 contract trading receive capital gain/loss treatment by default, and there’s a $3,000 capital loss limitation against ordinary income. Yes, Section 475 MTM would have made those losses business ordinary losses, but you had to file the Section 475 MTM election by April 15, 2015 as an “existing taxpayer.” (New taxpayers may elect Section 475 internally within 75 days of inception.) If you did not do this, you’re stuck with capital loss treatment and your next problem is how to use up a capital loss carryover in the next year(s). If you elect Section 475 by April 15, 2016, your 2016 business trading gains will be ordinary rather than capital. Remember, you need capital gains to use up capital loss carryovers. That creates a predicament that we address in Chapter 2 on Section 475 MTM. Once a trader has a capital loss carryover hole, he needs a capital gains ladder to climb out of that hole and a Section 475 election to prevent digging a bigger hole. An entity is better for electing and revoking Section 475 as needed. In 2015, the IRS changed the law to allow revocation of Section 475 elections.
If you have losses from trading Section 1256 contracts (like futures), you may be in luck if you have Section 1256 gains in the prior three tax years. On the top of Form 6781, you can file a Section 1256 loss carryback election. 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 tax rates on Section 1256 gains. Sixty percent is a long-term capital gain even on day trades.
If you have losses trading spot or forward forex contracts in the Interbank market, you 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. But without TTS, the loss isn’t a business loss and if you have negative taxable income, the negative part is often wasted — it’s not a business net operating loss (NOL) or capital loss carryover. Forex traders can file a contemporaneous “capital gains and losses” election in their own books and records to opt out of Section 988, which is wise if you have capital loss carryovers. Contemporaneous means in advance, not after the fact using hindsight. In some cases, this election qualifies for Section 1256(g) lower 60/40 tax rates. See Chapter 3 for more details.
IRS cost-basis saga continues
Accounting for trading gains and losses is the responsibility of securities traders; they must report each securities trade and related wash-sale loss adjustments on IRS Form 8949 in compliance with Section 1091, which then feeds into Schedule D (capital gains and losses). Form 8949 came about after the IRS beefed up compliance for securities brokers starting in 2011, causing headaches, confusion and additional tax compliance cost. Congress found tax reporting for securities to be inadequate and thought many taxpayers were under reporting capital gains. The cost-basis rules are almost fully phased-in. Options and less complex fixed income securities acquired on Jan. 1, 2014 or later were reported for the first time on Form 1099-Bs for 2014. Inclusion of complex debt instruments on 1099-Bs is delayed until Jan. 1, 2016. There are no changes with 1099-Bs between 2015 and 2014 tax years.
Broker-issued securities Form 1099-Bs provide cost-basis reporting information, but they don’t provide taxpayers everything they need for tax reporting if the taxpayer has multiple trading accounts or trades equities and equity options. Brokers calculate wash sales based on identical positions (an exact symbol only) per separate brokerage account. But Section 1091 requires taxpayers to calculate wash sales based on substantially identical positions (between equities and equity options and equity options at different exercise dates) across all their accounts including IRAs — even Roth IRAs. The best accounting solution for generating a correct and compliant Form 8949 is software that’s compliant with Section 1091. Don’t just rely on a Form 1099-B (exception: if there is only one brokerage account, the trading is only in equities, not equity options and there are no cost-basis adjustments including wash sale losses). See Chapter 4 for more about these changes and common taxpayer and tax preparer mistakes. Many tax preparers and taxpayers continue to disregard Section 1091 rules, even after acknowledging differences with broker 1099-B rules. They do so at their peril if caught by the IRS.
Option traders generally don’t day trade; rather they execute both simple and complex trades over weekly and monthly time horizons. While many option traders may execute trades only a few days per week, they have a position on almost every day of the week. But three recent trader tax court cases for option traders (Assaderaghi, Nelson and Endicott) indicate the IRS requires more frequency than just trading two days per week. See Chapter 11 for details on these three cases. While trading monthly options may be a challenge for claiming TTS, in the past year we’ve noticed more clients trading weekly options, which is better for TTS. Some options traders set aside capital for active trading in equities, which helps them qualify for TTS.
Futures and forex traders
Futures traders, other Section 1256 contract traders and forex traders have it much easier. Futures brokers report Section 1256 contracts in summary fashion, with mark-to-market accounting for realized and unrealized gains and losses, on a simple one-page 1099-B. Taxpayers can rely on a futures 1099-B to report net “aggregate profit and loss” on Form 6781, Part I. See Chapter 4.
Spot forex is not a “covered security” and it’s not by default a Section 1256 contract. Therefore, spot forex brokers should not issue a 1099-B. Spot forex brokers do offer online tax reports and taxpayers should report the summary amount, with or without attachment of those reports on their tax returns. Section 1091 does not apply to Section 1256 contracts and forex, saving futures and forex traders headaches on wash sales.
Differences for various instruments
There are complexities in sorting through different tax-treatment rules and tax rates. It’s often hard to tell what falls into each category, but in Chapter 3 we cover the many trading instruments and their tax treatment.
Securities have realized gain and loss treatment and they are subject to wash-sale rules and the $3,000 per year capital loss limitation on individual tax returns. Section 1256 contracts — including futures — are marked to market at year-end, so there are no wash-sale adjustments and they have lower 60/40 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 you file a contemporaneous capital gains election and in some cases navigate into lower 60/40 tax rates. Physical precious metals are collectibles and if these capital assets are held over one year, sales are subject to the taxpayer’s ordinary rate capped at 28% (the collectibles rate). Bitcoin is an intangible asset taxed like securities. Nadex binary options tax treatment is unclear and we make a case to tax them like swaps with ordinary income or loss. Foreign futures are taxed like securities unless the IRS issues a revenue ruling allowing Section 1256 tax benefits (but that is rare). See Chapter 3 for various tax treatments.
Updates on Section 475 MTM elections
Since Congress changed the 1997 tax law to allow business traders to elect Section 475 MTM, GreenTraderTax has helped thousands of business traders save a fortune in taxes by simply making this free election on time and filing a Form 3115 for automatic change of accounting method (free of IRS fees). We refer to Section 475 as free “tax loss” insurance. If you suffer a trading loss of $100,000, you can receive a full business loss deduction against any kind of income in the current year, or with a NOL two-year carryback and/or 20-year carry forward. Section 475 also exempts traders from wash sale reporting for securities trades reported and marked-to-market on Form 4797. Wash sales still apply to investments in securities. If you have a large capital loss carryover, you need to follow our special strategies for considering and electing Section 475 MTM, since Section 475 ordinary income can’t be offset with capital loss carryovers.
The Poppe tax court ruling in October 2015 exposed weaknesses in the Section 475 MTM election process for existing taxpayers. We include a full analysis of the Poppe case in Chapter 11 and tell traders how to better support their Section 475 election in Chapter 2.
The Poppe tax court also lowered the volume of trades needed to qualify for TTS to 720 trades. Our 2015 guide suggested a volume of 1,000 total trades. It’s still not clear how the IRS wants to count lot size breakdowns and legs of complex option trades. See Chapter 1.
IRS warns Section 475 traders
Increasingly, the IRS is focusing in on a delicate issue for traders: whether or not they properly segregate investment positions from trading positions in form and substance. The Assaderaghi, Nelson and Endicott tax court cases highlight this problem, where the traders owned significant investment portfolios and traded around those positions with options. Sole proprietor traders often have investment positions in trading accounts or in separate accounts designated as investment accounts. Not properly segregating investment positions can poison the well for claiming TTS, and gives the IRS a case to claim the trader is really an investor. It can also confuse application of Section 475 MTM treatment separate from capital gains treatment for investments. Some traders attempt to take Section 475 ordinary loss treatment on investment positions, which is not allowed. Or they avoid mark-to-market at year-end on trading positions. There are many nuances and this code section is widely misunderstood by other tax professionals. For more information, see our blog posts IRS Plays Havoc with Traders Misidentifying Investments and IRS Warns Section 475 Traders. See Chapter 2 for the full details on Section 475 MTM.
Business traders should use entity
Many traders start off with individual accounts, joint accounts and IRAs. Why should they consider an entity trading account? Business traders solidify TTS, unlock employee-benefit deductions, gain flexibility with a Section 475 election or revocation and prevent wash-sale losses with individual and IRA accounts. The IRS can apply Section 267 related party transaction rules if a trader purposely tries to avoid a wash sale loss between an entity and individual account. An entity return consolidates your trading activity on a pass-through tax return (partnership Form 1065 or S-Corp 1120-S), making life easier for you, your accountant and the IRS. Individually held investments are separate from business trading in the entity, which is a different taxpayer. The entity is simple and inexpensive to set up and operate. For more details on entities, see Chapter 7.
Retirement plans for traders can be used several ways. You can trade in the retirement plan, build it up with annual tax-deductible contributions, borrow money from a qualified plan (not an IRA) to start a trading business and convert it to a Roth IRA for permanent tax-free build-up. There are plenty of pitfalls to avoid like early withdrawals subject to ordinary income tax rates and 10% excise tax penalties, and penalties on prohibited transactions. Avoid IRA-owned LLCs and self-dealing as that blows up the IRA. Tax-free compounded returns in retirement plans are valuable and trading losses are deductible in the sense that future retirement plan distributions are lower.
Annual tax-deductible contributions to retirement plans generally save traders more in income taxes than they cost in self-employment (SE) or payroll taxes. Trading gains are not earned income, so traders use entities to create earned income by paying compensation to themselves through an S-Corp. trading company or S-Corp or C-Corp management company. Compensation payments can also reduce the Obamacare 3.8% Medicare tax on unearned income (Net Investment Tax). A married couple working in the business can save well over $10,000 by establishing defined-contribution Solo 401(k) plans for each of them. Defined-benefit plans can save much more; we cover defined benefit plans in depth in Chapter 8. (One exception: Members of a futures exchange are subject to SE taxes on their trades made on those exchanges.) We also cover tax problems caused when a retirement plan invests in publicly traded partnerships like MLPs. That can generate Unrelated Business Income Tax (UBIT) requiring a Form 990 tax filing with a large tax bill that comes as a nasty surprise to many IRA investors. Chapter 8 delves into various retirement plan options and provides the math so you can see exactly how this tax savings strategy works.
The Obamacare 3.8% Medicare tax on unearned income started in 2013 for taxpayers with AGI over $250,000 (married) and $200,000 (single). In this guide, we focus on what affects traders and investment managers in particular. One key point is that the net investment income tax (NIT) applies on net investment income (NII). Traders can reduce it by deducting their trading and investment expenses, including salaries paid to them and their spouses. There are complex IRS regulations for the three buckets in NII: portfolio, rents and royalties (1), passive entities and investment companies (2), and capital gains and losses (3). Generally, taxpayers can’t use a loss from one bucket against income in another bucket.
Business traders fare well with the final regulations for NII (after we fought for changes to the proposed regulations). With the final regulations, business traders are not disenfranchised from using their business trading losses and expenses for calculating NII. Just be sure to prepare Form 8960 (NIT) correctly.
The Obamacare individual health insurance mandate and related tax penalties for non-compliance, exchange subsidies and premium tax credits applied for the first time on 2014 individual income tax returns. Learn about the Obamacare tax forms and strategies for traders in applying for insurance on Obamacare exchanges to maximize their chance of receiving subsidies and premium tax credits. Trading businesses are generally single or spousal-owned with no or few outside employees so they are exempt from the Obamacare employer mandate/employer penalty effective in 2015/2016. The employer mandate applies on employers with 50 or more employees.
For more information, see Chapter 9 and Chapter 15.
Tax planning is important for traders and we include many smart tax-planning ideas in this year’s guide. See Chapter 9.
Words of caution on TTS
Many IRS and state agents don’t understand or respect individuals pursuing qualification as a trading business. While there is no bright line test for TTS, recent trader tax court cases better defined the volume of total trades required (720 per year per Poppe court), frequency of trades (3-4 days per week) and average holding period (under 31 days per Endicott court). Once an exam starts, it can snowball into other issues. IRS and some state agents often want to challenge TTS if the trader is not a full-time, extremely active trader. And the IRS or state agent can ask about TTS and other issues for the years before and after the tax year examined. Learn tips for dealing with the IRS and states in Chapter 10.
In the past, too many traders brought weak cases to tax court and have failed to defend themselves properly. That was certainly the case again recently with Poppe, Assaderaghi, Nelson and Endicott. Serving up easy wins in exams, appeals, private letter rulings and tax court encourages the IRS and states to further question business traders based on bad legal precedent. When TTS is too difficult to achieve, consider the alternative strategies discussed in Chapter 9. It’s also very important to have good CPAs and tax attorneys who are experts in trader tax law in your corner.
Watch out for bad tax advice: Over the years, other service providers suggested traders could easily deduct pre-business education expenses using C-Corps. This advice is very wrong. We cover what’s allowed and what’s not in Chapter 5.
Proprietary trading vs. retail trading is covered in Chapter 12. The challenge for proprietary traders is deducting their business expenses, including home-office expenses. They’re allowed to deduct these expenses even if they trade from the firm’s office whether they are independent contractors or LLC members. We also address how to handle education/prop trading firm hybrids and writing off education or lost deposits. One problem for prop traders who are members of an LLC is the Schedule K-1 does not pass through self-employment income so they can’t make retirement plan contributions or deduct health insurance premiums.
The Poppe tax court construed his proprietary trading firm arrangement to be a disguised retail customer account. This ruling should be a huge concern for the proprietary trading firm industry, especially since regulators warned clearing firms about disguised customer accounts in the past. By agreement, prop traders do not trade their own capital in a retail customer account. They trade a firm sub-account with firm capital and far higher inter-firm leverage than is available with a retail customer account.
More traders are rising to the ranks of investment managers. Investment managers seek better tax treatment by using carried-interest (profit allocation) tax breaks passed through in their investment funds. There are tax advantages to receiving a share of capital gains (profit allocation) from fund investors rather than incentive fees from the fund, which otherwise are subject to ordinary tax rates and payroll taxes. Investment managers reduce payroll tax on management fees by using S-Corps. In recent years, both of these breaks have survived repeal talk, but that may not last with tax reform discussions in 2016. TTS, Section 475 MTM and other tax treatment elections are important considerations for hedge fund managers. Learn more about investment management taxation in Chapter 13.
International tax matters
U.S. traders move abroad, others make international investments and non-resident aliens invest in the U.S. How are their taxes handled? When it comes to international 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 tax possessions like Puerto Rico (with huge tax breaks); U.S. residents surrendering citizenship or green cards; and non-resident aliens investing in the U.S. with individual accounts or through an entity.
Many traders living in the U.S. have offshore trading and bank accounts to trade on foreign markets. Some offshore brokers encourage traders to form foreign entities as a requirement to get access or to set up a foreign brokerage account, in some cases to avoid CFTC rules limiting forex leverage or Reg T margin rules on securities. Look before you leap: Tax compliance for a foreign entity is significant and there are few to no tax advantages for traders.
Traders with foreign accounts need to learn about Foreign Bank Account Reporting (FBAR), Form 8938 (Statement of Specified Foreign Financial Assets), controlled foreign corporations (CFC), foreign disregarded entities, Passive Foreign Investment Companies (PFIC), tax treaties and more.
Chapter 14 touches upon these topics, along with the IRS’s “come clean” OVDP program, the Foreign Account Tax Compliance Act and CFTC regulations.
In general, a business must capitalize property for purposes of depreciation. For smaller purchases, the IRS allows expensing under its Tangible Property Regulations, since it’s inconvenient to maintain depreciation records on small amounts. The IRS increased the de minimis expensing amount to $2,500 from $500. Although the IRS mentions this rule change is effective for 2016, IRS Notice 2015-82 & News Release IR 2015-133 point out it’s Ok to use for open tax years. That means it’s an excellent year-end tax strategy for 2015.
For example, if a business trader purchases a new workstation in December 2015 for $7,500, try to break down the purchase into separate items with each invoice being under $2,500. For example, purchase the computer separate from the monitors and other equipment. With all items on separate invoices under $2,500, the entire $7,500 can be a 2015 business expense without any capitalization for fixed assets and related depreciation. That leads to faster expensing, tax benefits and less compliance work.
“There is no specific requirement that it must be on separate invoices,” said Darren Neuschwander, CPA. “It can all be on one invoice, but it may draw more IRS attention and require more time to breakout. Separate invoices is good practical guidance to avoid this issue. Under the change, the new $2,500 threshold applies to any such item substantiated by an invoice.”
Learn more in our Dec. 3, 2015 Webinar recording: Year-End Tax Planning For Traders. Scroll to 42:07 to 48:35 in “Trader Tax Status.” It starts with “Great news about…“Expensing.”
The IRS and some states have been playing havoc with traders in exams, claiming traders did not properly comply with Section 475 rules for segregation of investment positions from trading positions. Noncompliance gives the agent license to drag misidentified investment positions into Section 475 mark-to-market (MTM), or to boot misidentified trading losses out of Section 475 into capital loss treatment subject to the $3,000 capital loss limitation. Both of these types of exam changes cause huge tax bills, penalties and interest.
Traders don’t want to lose capital gains deferral and lower long-term capital gains rates on investment positions in securities. With misidentified investments the IRS has the power to drag those positions into Section 475 subjecting them to MTM and ordinary income tax rates.
Section 475 improper identification
Section 475 contains a clause to limit unrealized losses on investment positions dragged into Section 475. Under Section 475(d)(2) (which is applicable to traders pursuant to Section 475(f)(1)(D)), if a security was misidentified as an investment, then there is Section 475 MTM unrealized loss recognition only against other Section 475 gains, and any excess unrealized losses are deferred until the security is actually sold. Limiting MTM treatment on unrealized losses on investment positions is not much different from unrealized capital losses on those same positions.
Carefully identify investments
If you claim trader tax status and use Section 475 MTM, you can prevent this problem by carefully identifying each investment position on a contemporaneous basis. When you receive confirmation of the purchase of an investment position, email yourself to identify it as investment position as that constitutes a timestamp in your books and records. Don’t hold onto winning Section 475 trading positions and morph them into investment positions, as that does not comply with the rules. If identifying each separate investment is inconvenient, then ring-fence investments into identified investment accounts vs. active trading accounts. Use “Do Not Trade” lists for investing vs. trading accounts so you don’t trade the same symbol in both accounts.
But this compliance is not enough. If you hyperactively trade around your investments, the IRS can say you failed to segregate the investment in substance.
Section 475 clean up project
In 2015, the IRS acknowledged lingering problems with Section 475 and announced a Clean Up Project welcoming comments from tax professionals. I started a successful petition on Rally Congress to fix Section 475 and TTS rules and also sent a cover letter and comments to the IRS. The American Bar Association ABA Comments on Mark-to-Market Rules Under Section 475 are good. See my blog post in Aug. 2014 IRS warns Section 475 traders, which focuses on the segregation of investment issue.
Individuals have a problem
Section 475 misidentification of investments is a huge problem for individual sole proprietor traders who have both trading and investment positions. Section 475 is very valuable since it exempts trades from wash sale loss rules and the $3,000 capital loss limitation allowing full net operating loss (NOL) treatment for losses which generates huge tax refunds. A capital loss limitation is the biggest pitfall for traders.
Individuals often have a few trading accounts and also several investment accounts. Married couples may each have individual accounts, some joint accounts and IRA accounts. They may buy and hold popular equities in investment accounts and then hyperactively trade those same symbols in their designated trading accounts.
Entities navigate around the problem
The simple fix is to form an entity like a single-member or spousal-member LLC with an S-Corp election. Conduct all business trading with Section 475 on securities in those entity accounts. (The entity may elect Section 475 MTM internally within 75 days of inception of the entity.) Trader tax status, business expenses and Section 475 trading gains and losses are reported on the S-Corp tax return.
It’s wise to avoid investment positions in the entity accounts. But some traders want to use portfolio margining, and brokers don’t allow that between individual and entity accounts, so they want to transfer some large investment positions into the entity accounts. That can become a problem for Section 475 segregation of investment rules, especially if you trade the same symbols. Consult a trader tax expert.
Keep investments in your individual investment accounts. The individual and entity accounts are not connected for purposes of Section 475 rules since they’re separate taxpayer identification numbers.
The entity also looks much better in the eyes of the IRS claiming trader tax status and using Section 475 ordinary loss treatment. Plus, an S-Corp trading company can have employee-benefit plan deductions — health insurance and high-deductible Solo 401(k) retirement plan) — whereas a sole proprietor trader may not.
Tax court cases are for individual traders
A senior IRS official stated at an industry conference that the IRS is going after (auditing) “Chen cases,” referring to the landmark Chen tax court case. Chen was a part-time individual trader for just three months and he deducted TTS expenses and a huge Section 475 ordinary loss requesting a huge tax refund. The court denied TTS and use of Section 475.
Other recent trader tax court cases are individual traders claiming large TTS expenses and Section 475 losses. I covered these cases on my blog: see posts for Poppe, Assaderaghi, Nelson, Endicott, Holsinger and Chen (covered in my guides). Some of these traders may have been okay if they used an entity, however many did not qualify for trader tax status, and several botched or lied about electing Section 475.
In my blog post on the Poppe case, I point out that individuals face pitfalls in electing Section 475. The IRS granted Poppe TTS but denied Section 475 ordinary loss treatment because he botched or lied about the Section 475 election and he never filed a Form 3115. A new entity wouldn’t have that problem.
Wash sale losses are similar
Section 1091 wash sale rules are similar, yet different in one important aspect from Section 475 rules. While the entity is a different taxpayer from the individual for wash sale loss purposes, the IRS can apply Section 267 related party transaction rules to connect the entity and individual accounts if the trader purposely tries to avoid wash sale losses between the entity and individual accounts. I have not seen Section 267 mentioned in connection with Section 475 segregation rules.
Section 475 tax loss insurance is a huge tax break for traders who qualify for trader tax status but be careful with properly identifying investments. Be safe on using TTS and Section 475 by trading in an entity. Now is a good time to form one for 2016.
In light of the William F. Poppe vs. Commissioner court case, there’s good news for retail traders on the volume of trades needed to qualify for trader tax status.
There’s also troubling news. The IRS denied Poppe his Section 475 election because he could not prove compliance with the two-step election process. Traders should be more diligent in documenting their election. The consequence was that instead of deducting his $1 million trading loss as an ordinary loss, Poppe was stuck with a $3,000 capital loss limitation and a capital loss carryover.
The court construed Poppe’s proprietary trading firm arrangement to be a disguised retail customer account. This ruling should be a huge concern for the proprietary trading firm industry, especially since regulators warned clearing firms about disguised customer accounts in the past. By agreement, prop traders do not trade their own capital in a retail customer account. They trade a firm sub-account with firm capital and far higher inter-firm leverage than is available with a retail customer account.
Qualification for trader tax status
The Poppe court awarded trader tax status (TTS) with 720 trades (60 trades per month). That’s less than our 2015 golden rule calling for 1,000 trades per annum on an annualized basis. Poppe seems to have satisfied our other golden rules on frequency, holding period, intention to run a business, serious account size, serious equipment, business expenses, and more. Plus, Poppe had a good background as a stockbroker.
In some years, Poppe was a teacher and part-time trader, fitting trading into his schedule. It helped that Poppe made a lot of money trading in a few years in comparison to his teacher’s salary.
Botched Section 475 election
Poppe had large trading losses ($1 million in 2007) for which he claimed Section 475 ordinary business loss treatment rather than a puny $3,000 capital loss imitation against other income. But like other recent tax court cases (Assaderaghi, Nelson, Endicott, Holsinger and Chen), the court busted Poppe for either lying to the IRS about making a timely Section 475 election or making a valid election but not being able to prove it to the IRS. Poppe never filed a required Form 3115 to perfect the Section 475 election, which begs the question: Did he ever file an election statement on time?
The case opinion states that Poppe intended to elect Section 475 for 2003 and he filed his 2003 tax return late in 2005 omitting a required 2003 Form 3115. Poppe’s tax preparer reported 2003 Section 475 trading gains on Schedule C. That’s incorrect: Section 475 trading gains are reported on Form 4797 Part II ordinary gain or loss. This botched reporting indicates to me that Poppe’s tax preparer did not understand Section 475 tax law and it probably buttressed the IRS win.
Many traders are in the same predicament as Poppe and should do their best to document the election filing in case the IRS challenges it later on. We document the process for our clients and ask them to document their filings, too. Send yourself an email with the relevant facts as email has a timestamp. Safeguard a copy of the election and Form 3115 in your permanent files.
One learning moment in the Poppe case is how to properly make a timely Section 475 election and to avoid pitfalls in botching the election process.
Section 475 tax loss insurance
By default, investors and traders in securities and Section 1256 contracts have capital gain and loss treatment, as opposed to ordinary gain or loss treatment. Capital losses offset capital gains without limitation, but a net capital loss is limited to $3,000 per year against other income with the remainder of capital losses carried over to the subsequent tax year(s).
Traders qualifying for TTS may file a timely election for Section 475 ordinary gain or loss treatment (on securities only or Section 1256 contracts, too). Generally, traders prefer to retain Section 1256 treatment with lower 60/40 capital gains rates. Section 475 exempts traders from wash-sale loss treatment on securities and capital loss limitations. It’s known as “tax loss insurance” since it allows full business ordinary loss treatment comprising NOLs generating NOL tax refunds.
A sole proprietor (unincorporated) trader makes an individual-level Section 475 election. A proprietary trading firm or hedge fund makes an entity-level Section 475 election. A partner in a proprietary trading firm or hedge fund cannot override the firm’s Section 475 election or lack of an election made on the entity-level.
Warning: Don’t botch the election
Botching the election empowers the IRS to deny use of Section 475 serving up a simple win for the IRS in tax court. Even when a taxpayer properly makes a Section 475 election, an IRS agent may challenge his or her qualification for TTS, which pulls the rug out from under using Section 475. (Each tax year TTS must be assessed as a prerequisite to using Section 475.)
Section 475 election two-step process
The first step is for the trader to file a timely election statement early in the current tax year to prevent the trader from using hindsight about the election later.
An “existing taxpayer” (who filed a tax return before) must file an election statement with the IRS (that means “external”) by the due date of the prior year tax return not including extensions: April 15 for individuals and partnerships and March 15 for S-Corps. (Note that in 2017, the partnership due date changes to March 15.) Attach the Section 475 election statement to the tax return or extension filing. I suggest documenting this first step in your books and records including emailing a copy to yourself and your accountant. Don’t count on the IRS for keeping a copy of the election statement.
An existing taxpayer’s second step is to file a Form 3115 (Change Of Accounting Method) with appropriate Section 481(a) adjustment by the due date of the election-year tax return including extensions. The complex Form 3115 must be filed in duplicate: one copy with the timely filed tax return and a second copy to the IRS national office.
Example of existing taxpayer: A sole proprietor trader files a 2015 Section 475 election by April 15, 2015, attaching the election statement to his 2014 federal tax extension filed on time by mail. (You can’t attach an election to an e-filed extension.) Second step: The accountant prepares a 2015 Form 3115 to accompany the 2015 Form 1040 filed by Oct. 15, 2016 with a valid extension filed by April 15, 2016.
Why the two steps? So taxpayers can make a very simple election filing with little hindsight but to allow sufficient time to prepare a complex Form 3115 with the tax return filing after year-end.
Common errors with Section 475 elections
Many local accountants are confused about the two-step process. Some think only one step is required: either filing the Form 3115 in lieu of the election statement, or the election statement as part of a Form 3115 filing with the tax return. They don’t comply with both required steps and that botches the election.
Section 475 “new taxpayer” exception
There is an important exception to the election process for “new taxpayers” such as a new entity. A new taxpayer may file the Section 475 election statement within its own books and records (internally) within 75 days of inception of the new entity.
Existing taxpayers who miss the external 475 election by April 15 should consider forming a new entity to make an internal Section 475 election within 75 days of inception, which is later in the year. A new taxpayer “adopts” Section 475 from inception as opposed to changing its accounting method so they don’t have the second step of filing a Form 3115 with Section 481(a) adjustment (converting realization/cash method to MTM on Jan. 1).
The entity provides better flexibility in making, revoking, and ending Section 475 elections with closure of the entity. With fewer steps to follow, the internal election for new taxpayers is a better choice for prevailing with the IRS.
Poppe’s errors on Section 475
Poppe was not able to verify the external 475 election statement (step one) or a Form 3115 filing (step two). It wasn’t just a question of being late on a Form 3115 filing, Poppe never filed a Form 3115 and he was an existing taxpayer individual.
Traders should file the external Section 475 election statement with certified return receipt. But that may not be enough because it only verifies a mailing, which also contains the tax return or extension. The IRS recognized this problem and suggests that taxpayers include a perjury statement on Form 3115 stating they filed the 475 election statement on time.
Is there any relief from the IRS?
My partner Darren Neuschwander, CPA spoke with an IRS official in the Form 3115 area a few years ago who said the IRS had granted some relief to a few traders providing they were only a little late with their Form 3115 filing and they filed the election statement on time. The IRS official pointed out there is no relief for filing the initial election statement late.
But Poppe was not a little late — he never filed a Form 3115, even with the case being heard years later. It’s wise to file Form 3115 on time per the written rules and not rely on hearsay about possible relief from IRS officials, which may no longer be granted after the Poppe decision. Consult your trader tax advisor.
Poppe’s mental incapacity argument didn’t work
The Poppe case shows that it doesn’t work to claim reasonable cause on noncompliance due to mental incapacity if the taxpayer can’t demonstrate the same mental incapacity in a job, business, or trading. Poppe tried to raise this issue for special relief and the IRS said no because he wasn’t mentally impaired as a teacher and as an active trader.
Per Thomson Reuters, “Poppe argued that his actions met the requirements of the ‘substantial compliance’ doctrine, under which perfect compliance with a tax provision isn’t required. But the Court said that the substantial compliance doctrine does not apply to the Code Sec. 475(f) election and that, even if it did, Poppe failed to meet many of Rev Proc 99-17 ‘s requirements and thus hadn’t substantially complied.”
Proprietary trading account or disguised customer account?
In 2007 (the IRS exam year), Poppe lost $1 million trading with a proprietary trading firm that cleared through Goldman Sachs Execution & Clearing (GSEC). This is the tax loss at the center of this case.
On his original tax return filing, Poppe reported this loss (assumed) on Schedule E page 2, as an ordinary loss flowing through to him as a partner in a partnership. If the proprietary trading firm qualified for TTS and filed a timely Section 475 election on the firm level, then trading losses allocated to partners would have ordinary loss treatment.
Poppe attached a partner Schedule K-1 to his tax return even though it is not required. But during the exam, the IRS was unable to find Poppe’s K-1 in the partnership tax return filings where it is required to be attached. This begs the question: Did Poppe fabricate his own Schedule K-1? That would be illegal. Or did the firm present Poppe with a Schedule K-1 only to retract it in their partnership tax filing later on? (IRS computers match K-1s reported on partner’s individual tax returns with partnership tax filings looking for incorrect reporting.)
Prop trading firm arrangements, agreements, tax treatment and regulatory issues are murky. Perhaps Poppe never formally signed the prop trading firm’s LLC Operating Agreement. The case states Poppe couldn’t satisfy the IRS that he was a partner in the firm. If not an LLC member, perhaps he was an independent contractor, which is the second business model for proprietary trading firms.
Poppe claimed he was a Class B member of the firm. Generally, the main owners (Class A members) are allocated firm-wide trading losses on their K-1s since they own the firm’s capital in their capital accounts, which provide tax basis for deducting trading losses. Generally, Class B members don’t have capital accounts so they aren’t allocated losses since they wouldn’t have tax basis to deduct losses, which would then be suspended to subsequent years when they might have capital.
Instead of paying into firm capital, Class B members pay “deposits” to the firm. This is where the confusion mainly lies. The firm applies these deposits to cover the prop trader’s trading losses incurred in a firm sub-account. Prop traders are entitled to deduct lost deposits as business bad debts, which are ordinary business losses. Perhaps Poppe should have considered lost deposit bad debt tax treatment instead of using an incorrect K-1 and later relying on an alleged Section 475 election as a retail individual trader.
I’ve been covering the proprietary trading industry since the late 1990s. Around 2000, some people questioned whether proprietary trading firm arrangements were really “disguised” retail customer accounts. Reg T margin rules allow 4:1 margin on pattern day trader (PDT) customer accounts requiring a $25,000 minimum account size. Otherwise, retail investors are limited to 2:1 margin on securities. The big attraction of proprietary trading firms is they offer proprietary traders (LLC members or independent contractors) far greater leverage (greater than 10:1 in some cases) on their deposits made with the firm. Some proprietary trading firms have minimum deposit amounts as low as $2,000.
If the firm’s profit sharing arrangement is more than 80% sharing to the prop trader, FINRA’s Regulatory Notice 10-18 issued to clearing firms stated it’s one of several signs it may be a disguised retail customer account. Read my June 2010 blog post FINRA’s notice to prop traders. Poppe had 90% profit sharing and perhaps that led the IRS to conclude it was a disguised retail customer account. GSEC is a popular clearing firm for proprietary trading firms and I don’t believe it services individual retail customers. Goldman Sachs brokerage firm has high standards for opening individual retail customer accounts.
The Poppe opinion states: “The parties stipulated that all transactions and capital in the GSEC account belonged to petitioner (Poppe).” Perhaps the parties preferred this tact so they could ague the case over Poppe’s alleged Section 475 election as a retail trader. In my view, the word “stipulate” means the parties agreed on facts as a pre-condition to negotiating a settlement. But it’s not necessarily the true facts.
Should prop traders file Section 475 elections as a backup position in case the IRS later considers them a disguised retail customer account? I imagine plenty proprietary trading firms and prop traders are in tax controversy (exams, appeals or tax court) now and I suggest they consider contacting our CPA firm for help soon.
I’m happy to see a new trader tax court case moving the goal posts back to 720 trades from 1,000. That opens the door for more traders. I am not surprised that another trader (and his accountant) botched the complex Section 475 election process and later tried to bamboozle the IRS about it in order to get a huge tax benefit. Proprietary trading firm arrangements with prop traders are murky and the IRS may turn up the heat on them both soon.
For more information, check out T.C. Memo. 2015-205.
Darren Neuschwander CPA contributed to this blog post.