Category: Trader Tax

Uncertainty About Using QBI Tax Treatment For Traders

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

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

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

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

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

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

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

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

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

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

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

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

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

(A): Stocks and securities.

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

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

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

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

Notice how Section 199A regs reference Section 864:

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

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

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

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

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

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

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

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

The 199A regs state:

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

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

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

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

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

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

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

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

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

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


How To Qualify For Trader Tax Status For Huge Savings

February 9, 2019 | By: Robert A. Green, CPA | Read it on

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. 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.

Section 475 gives a TTS trader “tax loss insurance,” exemption from wash sale loss adjustments on securities and ordinary loss treatment, avoiding the capital loss limitation. With Section 475 income, you might also become eligible for the 20% qualified business income deduction, although QBI treatment is currently uncertain for TTS traders.

There’s no election for TTS
There’s no election for TTS; it’s an optional tax status based on facts and circumstances only. A trader may qualify for TTS one year but not the next.

TTS qualification can be for part of a year, as well. Perhaps a taxpayer qualified for TTS in 2017 and quit or suspended active trading on June 30, 2018. Include the period of qualification on Schedule C or the pass-through entity tax return and deduct business expenses for the partial-year period. If elected, use Section 475 for trades made during the TTS period, too.

Business expense treatment
Qualifying for TTS means a trader can use business treatment for trading expenses. TTS is also a precondition for electing Section 475 MTM ordinary gain and business loss treatment.

Business expense treatment under Section 162 allows for full ordinary deductions, including home-office, education, Section 195 start-up expenses, Section 248 organization expenses, margin interest, tangible property expense, Section 179 (100%) depreciation, amortization on software, seminars, market data, stock borrow fees, and much more. As an example of the potential savings, if TTS business expenses and home office deductions are $20,000, and the taxpayer’s federal and state tax bracket is 35%, then income tax savings is about $7,000.

TCJA suspended “certain (all) miscellaneous itemized deductions subject to the 2% floor,” including investment fees and expenses, commencing in 2018. The only remaining itemized deductions for investors are investment-interest expenses, which are limited to investment income, and stock borrow fees deducted as “other itemized deductions.” TCJA gives more incentive for traders to try to qualify for TTS.

How to qualify
It’s not easy to qualify for TTS. Currently, there’s no statutory law with objective tests for eligibility. Subjective case law applies. Leading tax publishers have interpreted case law to show a two-part test to qualify for TTS:

  1. Taxpayers’ trading activity must be substantial, regular, frequent, and continuous.
  2. The taxpayer must seek to catch swings in 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 words “substantial, regular, frequent, and continuous” are robust terms, yet case law doesn’t give a bright-line test with exact numbers.

The publication mentions holding period, frequency, and dollar amount of trades, as well as time devoted by the taxpayer. It also says the intention to make a livelihood, an essential element in defeating the hobby-loss rules. Trading is not personal or recreational, which are the key terms used in hobby-loss case law.

Golden Rules
We base our golden rules on trader tax court cases and our vast experience with IRS and state controversy for traders. The trader:

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 his trading business. All-time in the trading activity counts, including execution of trade orders, research, administration, accounting, education, travel, meetings, and more.

Few sporadic lapses: Has infrequent lapses in the trading business during the year. Traders can take vacations, sick time, and personal time off just like everyone else.

Frequency: Executes trades on close to four days per week, every week. Recent tax-court cases show that to help prevent IRS challenge of a TTS claim; it is wise to trade close to four days per week or 75% of available trading days — even if this requires the taxpayer to make smaller trades with reduced risk on otherwise non-trading days.

Volume: Makes 720 total trades per year (Poppe court) on an annualized basis. The buy and sell count as two total trades.  The court mentioned Poppe having 60 trades per month. During the year, it’s crucial to consider the volume of trades daily. We recommend 720 trades per year — about four trades per day, four days per week, 16 trades per week, and 60 trades a month.

The markets are open approximately 250 days, and with personal days and holidays, you might be able to trade on 240 days. A 75% frequency equals 180 days per year, so 720 total trades divided by 180 trading days equals four trades per day.

Holding period: Makes mostly day trades or swing trades. The IRS stated that the holding period is the most critical factor, and in the Endicott court, the IRS said average holding period must be 31 days or less. That’s a bright-line test.

Intention: Has the intention to run a business and make a living. Traders must have the intention to run a separate 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 key word is “a” living, which means it can be a supplemental living.

Operations: 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.

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. We like to see more than $15,000 for trading other financial instruments.

What doesn’t qualify?
Don’t count these three types of trading activity for TTS qualification: Automated trading without much involvement by the trader (but a trader creating his or her program qualifies); engaging a professional outside investment manager; and trading in retirement funds. Do not include these trades in the golden rule calculations.

1. Automated trading. An entirely canned automated trading service — sometimes referred to as an “expert adviser” program in the forex area — with little to no involvement by the trader doesn’t help TTS; in fact, it can undermine it. The IRS may view this type of automated trading service the same as a trader who uses a broker to make most buy and sell decisions and executions. On the other hand, if the trader can show he’s very involved with the automated trading program or service — perhaps by writing the code or algorithms, setting the entry and exit signals, and turning over only execution to the program — the IRS may not count the automated trading activity against the trader.

Some traders use a “trade copying” service and copy close to 100% of the trades. Trade copying can be similar to using a canned automated service or outside adviser, where the copycat trader does not qualify for TTS on those trades.

2. 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.

3. Trading retirement funds. Achieve TTS through trading taxable accounts. Trading activity in non-taxable retirement accounts doesn’t count for purposes of TTS qualification.

For more in-depth information on trader tax status, see Green’s 2019 Trader Tax Guide.


Highlights From Green’s 2019 Trader Tax Guide

January 15, 2019 | By: Robert A. Green, CPA | Read it on

Use Green’s 2019 Trader Tax Guide to receive every trader tax break you’re entitled to on your 2018 tax returns. Our 2019 guide covers the 2017 Tax Cuts and Jobs Act’s impact on investors, traders, and investment managers. Learn various smart moves to make in 2019.

Whether you prepare your 2018 tax returns as a trader or investor, this guide can help. Even though it may be too late for some tax breaks on 2018 tax returns, you can still use this guide to execute these tax strategies and elections for tax-year 2019.

Tax Cuts and Jobs Act

Tax Cuts and Jobs Act (TCJA) was enacted on Dec. 22, 2017, and the law changes take effect in the 2018 tax year.

Like many small business owners, traders eligible for trader tax status (TTS) restructured their business for 2018 and 2019 to take advantage of TCJA. TCJA 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, wash-sale loss adjustments on securities, Solo 401(k) retirement contributions, and health insurance deductions for S-Corp TTS traders. 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.

Tax forms changed with TCJA for 2018

TCJA required significant revisions to 2018 income tax forms. The redesigned two-page 2018 Form 1040 resembles a postcard because the IRS moved many sections to six new 2018 Schedules (Form 1040). It’s a block-building approach with the elimination of Form 1040-EZ and 1040-A.

See the new 2018 Schedule 1 (Form 1040) for reporting “Additional Income” including state tax refunds, Schedule C, D, E, Form 4797 (Section 475), and Other Income/Loss (Section 988 forex) on line 21. Schedule 1 (Form 1040) is also for reporting “Adjustments To Income,” previously called items of “adjusted gross income” (AGI).

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 deletes 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, but the IRS did not draft a tax form for it. A taxpayer must use a worksheet for the calculation and report a “qualified business income deduction” on the 2018 Form 1040, page 2, line 9.

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 ($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 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.

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 17, 2018, for 2018) or within 75 days of inception of a new taxpayer (i.e., a new entity).

Can traders deduct trading losses?

Deducting trading losses depends on the instrument traded, the trader’s tax status, and various elections.

Many traders are hoping to find a way to deduct their 2018 trading losses. Maybe they qualify for TTS, but that only gives them the right to deduct trading business expenses.

Securities, Section 1256 contracts, ETN prepaid forward contracts, 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 17, 2018), 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, 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, 2019, the 2019 business trading gains will be ordinary rather than capital. Remember, only capital gains can offset capital loss carryovers. Once a trader has a capital loss carryover hole, he or 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. Even so, an entity is still better for electing and revoking Section 475 as needed.

Traders with capital losses from trading Section 1256 contracts (such as futures) might 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 of $500,000 married and $250,000 other taxpayers applies to Section 475 ordinary losses and trading expenses. Add an EBL to an NOL carryforward.

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.

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 an 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 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).

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 2019 tax elections need to be made on time.

Entities for traders

Entities can solidify TTS, unlock health insurance and retirement plan deductions, gain flexibility with a Section 475 election or revocation, and prevent wash-sale losses with individual and IRA accounts. 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.

Retirement plans for traders

Annual tax-deductible contributions up to $62,000 for 2019 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.

20% deduction on qualified business income

In August 2018, the IRS issued proposed reliance regulations (Proposed §1.199A) for TCJA’s 20% deduction on qualified business income (QBI). (Postscript: On Jan. 18, 2019, the IRS issued final 199A regs.) The final regs confirm that TTS traders are a “specified service activity,” which means if their taxable income is above an income cap, they won’t get any QBI deduction. The 2018 taxable income (TI) cap is $415,000/$207,500 (married/other taxpayers). The phase-out range below the cap is $100,000/$50,000 (married/other taxpayers), in which the QBI deduction phases out for specified service activities. The W-2 wage and property basis limitations also apply within the phase-out range. TTS hedge funds and investment managers are specified service activities, too. The final 199A regs preamble confirm that QBI includes Section 475 ordinary income, whereas, TCJA expressly excluded capital gains and losses from it. (See our more recent blog posts, IRS Confirms Section 475 Is Eligible For QBI Tax Deduction and Uncertainty About Using QBI Tax Treatment For Traders.)

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 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 2018 and 2019. However, TCJA reduced the shared responsibility fee to $0 starting in 2019.

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 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 investment fee deduction.

Family office

Restructuring investment fees and expenses into a management company might achieve business expense treatment providing it’s a genuine family office with substantial staff rendering financial services to extended family members and outside clients.

The IRS might assert the family office is managing “one’s own investments,” not for outside clients, so the management company is also an investment company with non-deductible investment expenses.

Learn more about and purchase Green’s 2019 Trader Tax Guide and see the Table of Contents.


How To Become Eligible For Trader Tax Status Benefits

June 5, 2017 | By: Robert A. Green, CPA

Forbes

Click to read on Forbes.

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. 


Top 10 Tax Deductions For Active Traders

May 31, 2016 | By: Robert A. Green, CPA

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

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


IRS Considering “Freeze And Mark” For Section 475 Election

May 10, 2016 | By: Robert A. Green, CPA

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

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.

 

 


Safeguard Use Of Section 475 By Trading In An Entity

| By: Robert A. Green, CPA

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: Consider Ordinary Loss Election By Tax Deadline

March 22, 2016 | By: Robert A. Green, CPA

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

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.

Key strategy
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.

 


Green’s 2016 Trader Tax Guide

December 24, 2015 | By: Robert A. Green, CPA

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20%-Off Promotion Through Jan. 31.

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

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

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.

Obamacare taxes

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

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

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.

Investment management

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.


IRS Increases “Expensing” Amount To $2,500

December 3, 2015 | By: Robert A. Green, CPA

Click to read Green's blog post

Click to read Green’s blog post

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.”

 


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