Trader tax laws and benefits are complex and nuanced. Far too many traders and tax preparers don’t know the laws or misapply them on tax returns. Why pay tens of thousands of tax dollars more than you should?
It’s wise to educate yourself before risking your capital and it’s wise to do the same before planning and filing tax returns. To help with the latter, I’ve assembled a list of the most common mistakes made by traders and tax preparers.
Big picture items
1. Not claiming trader tax status, business expense treatment. (Or claiming this status when not entitled to it.) Business traders can save an average of $5,000 or more using business expense treatment. Business expenses are 100% deductible from gross income, whereas investment expenses are considered miscellaneous itemized deductions and are only deductible “below the line” in excess of 2% of adjusted gross income (AGI) and added back for the Alternative Minimum Tax (AMT), also known as the nasty second tax regime. Business expenses allow home-office deductions, education expenses, and startup costs, whereas investment expenses do not. Also, traders may claim trader tax status after the fact, including on amended tax return filings for the past three open tax years.
2. Not filing the Section 475 MTM ordinary loss election on securities and getting stuck with the puny $3,000 capital loss limitation, wash sale loss headaches, and extra tax costs. Many traders and accountants mishandle the Section 475 election statement (due by April 15 of the current tax year for existing individuals and partnerships) or they botch perfecting the election on a Form 3115 filing. One mix up can jeopardize ordinary gain or loss treatment. The biggest pitfall for traders is not deducting trading losses when they otherwise could. Section 475 does not apply to segregated investments or Section 1256 contracts when elected on securities only.
Unfortunately, you can’t fix a missed or botched Section 475 election; you need to focus on climbing out of the capital loss carryover hole you dug. You can form a new entity and use the “new taxpayer” exception allowing an internal Section 475 election within 75 days of inception.
3. Making the wrong decision about the forex Section 988 opt-out election and reporting forex incorrectly. Spot and forward forex receives Section 988 ordinary gain or loss treatment (which generally is better than a capital loss limitation). At any time during the tax year, traders are entitled to file an internal “contemporaneous” opt-out election to have capital gains treatment instead. That’s helpful if you have capital loss carryovers. If you trade in major forex currencies and don’t “take or make delivery” of the underlying currency, the opt-out election subjects forex forwards — and we make a case for spot forex too — to the lower Section 1256(g) 60/40 tax rates. That reduces the highest tax rates by 12%!
Forex reporting depends on whether you file the Section 988 opt-out election and whether you qualify for trader tax status. Section 988 without trader tax status is line 21 of Form 1040, and with that status its Form 4797 Part II. Section 988 losses over $50,000 require “tax shelter” Form 8886. Many IRS agents are confused over tax treatment for spot forex, plus forex brokers aren’t supposed to issue 1099-Bs for spot forex. Make sure to read brokers’ tax reports correctly. For example, rollover interest is part of trading gain or loss. If you opt-out of Section 988 and choose Section 1256(g), use mark-to-market at year-end on Form 6781. Thankfully, summary reporting applies on forex.
4. Not forming a trading entity to unlock AGI deductions for retirement plans and health insurance premiums. These AGI deductions can save $2,000 to $17,000 or more in taxes, but sole proprietor retail traders can’t get them in connection with trading gains. By forming a simple pass-through entity like a partnership, LLC, or S-Corp, business traders can take advantage of these deductions.
Tax reporting errors and compliance headaches
5. Reporting trading gains and losses on Schedule C, almost guaranteeing an IRS notice or exam. Items must be reported in the correct place. While business expenses are reported on Schedule C, trading gains and losses are reported on other tax forms like 8949, 6781, and 4797.
6. Using our transfer-of-income strategy incorrectly, or not using it at all. The transfer is executed differently for sole proprietors vs. entities. You need this transfer to unlock the home-office deduction, Section 179 depreciation, and AGI deductions, and to reduce the IRS red flag factors on Schedule C and entities.
7. Using the wrong solution for securities trade accounting and calculating gains and losses incorrectly, especially wash sales. Many traders and preparers botch IRS cost-basis reporting on Form 8949 and the reconciliation with Form 1099-B. Some traders fail to report non-1099-B items like stock options on Form 8949. We recommend TradeLog software to handle this after downloading actual trades, rather than inputting 1099-B information.
8. Botching tax treatment between securities, Section 1256 contracts, forex, ETFs, options, precious metals, foreign futures, and more.
9. Misreporting Section 1256 contracts such as securities on Form 8949 rather than on Form 6781, thereby losing lower 60/40 treatment. Not all brokers report Section 1256 contracts correctly, especially instruments that aren’t clearly designated as such including some E-mini indexes and options on those indexes.
10. Misreporting ETFs and ETF options and not adding Schedule K-1 pass-through income to cost basis. ETFs and ETF options are generally taxed as securities, and commodity ETFs often pass through Section 1256 income or loss on a K-1. Options on commodity ETFs can be considered Section 1256 contracts. It’s a pain to deal with numerous ETF K-1s at tax time.
11. Not filing a 1099-Misc for fees paid to service providers, including you for administration. Sole proprietors or entities paying service providers $600 or more by check or cash must issue a Form 1099-Misc. It’s better to file a 1099-Misc. late subject to a penalty of $50 rather than encourage the IRS to catch you and assess much higher penalties.
12. Misreporting education expenses. Pre-business education expenses — including seminars, trade shows, and travel — are generally not allowed as investment expenses. Education is allowed as a business expense but only if incurred after qualifying for trader tax status. Try to squeeze a reasonable amount of pre-business education into Section 195 startup costs to expense once you achieve trader tax status. Don’t fall prey to those promising better results using dual entity schemes including a C-Corp.
13. Not filing a tax return due to negative income and trading losses. Expect a “jeopardy” (made up) tax assessment notice from the IRS. If you trade securities, the IRS doesn’t see the full picture, even with new cost-basis reporting. The IRS may think you made a lot of money and will hit you with a huge tax bill. Not filing can cause you to lose capital loss carryovers for previous years. With 1099s filed by brokers, there is no place to hide.
14. Mishandling tax notices and IRS exams. Generally, IRS and state agents don’t understand a trading business. It’s not a passive loss activity or hobby loss activity, and various items are reported in different areas with complex and nuanced tax treatment and elections. State tax rules for entities usually make exceptions for trading businesses, but that is not always apparent. Before a tax exam gets out of control, consult with a trader tax expert to get it on the right path.
15. Being non-compliant on FBAR and other foreign tax reporting such as Form 8938 (foreign financial assets). Congress and the IRS are very concerned about tax cheats using offshore bank accounts, structures, and schemes. Not filing foreign bank account reports (FBAR) on time or correctly can be costly: Back taxes, penalties, interest, and even criminal proceedings could be the result. Consider the IRS’s Offshore Voluntary Disclosure Initiative (OVDI). (Note that this program is NOT amnesty; in some cases, it’s a mistake to enter OVDI when there’s a better way to come clean.) Generally, opening offshore entities doesn’t help reduce taxes as they are treated as disregarded entities or they are subject to passive foreign investment company rules. Avoiding the Commodity Futures Trading Commission’s rules for retail forex trading by using offshore accounts or entities doesn’t work.
Entities and retirement plans
16. Forming the wrong type of entity, and in the wrong state. If you live, work, and trade in your home state and want to form a pass-through entity, it’s best to form it there. Don’t fall prey to promoters in Nevada harping on the benefits of corporations formed in Nevada. If you don’t register that Nevada entity in your home state, you won’t have asset protection in your home state. A Nevada LLC filing as a partnership passes through its income to your home state.
17. Tapping into IRA and other retirement funds incorrectly, causing IRS penalties and trouble. Don’t get busted by the IRS for misusing your retirement funds. See our blog dated Jul. 24, 2013 “Learn the DOs and DON’Ts of using IRAs and other retirement plans in trading activities and alternative investments” for more on this topic.
18. Triggering wash sale losses in IRAs which are permanently lost. Far too many traders make this tragic mistake. When you buy back a “substantially identical” security position in any of your IRAs 30 days before or after selling it for a loss in any of your taxable accounts, you can kiss that tax loss goodbye forever. It applies across husband and wife individual and joint accounts. Normally, wash sales are only a deferral problem, but in this case it’s a permanent problem. Abstain from trading substantially identical positions in your IRA accounts or house your active trading in an entity, which is a different taxpayer for purposes of the wash sale rules. A Section 475 election also solves this problem.
19. Choosing the wrong type of retirement plan. The Individual 401(k) plan for business traders is best. It combines a 100% deductible 401(k) elective deferral — where the biggest tax savings lies — with a 20% deductible profit-sharing plan. Don’t forget to open this plan before year-end, even with no money contributed.
20. Paying self-employment (SE) taxes on trading gains. Only full members of futures exchanges owe SE taxes on futures trading gains. Too many traders pay SE taxes on these gains and the IRS doesn’t challenge it. Watch out for the new ObamaCare 3.8% Medicare surtax on unearned income starting in 2013.
Common mistakes cost traders tens of thousands of dollars per year on their tax returns. Don’t be penny wise and pound foolish. Spend a few dollars to buy premium trader tax guides to learn how to avoid these mistakes. Consider engaging a trader tax expert to help with your tax return elections, planning, and preparation. Use the right trade accounting software for securities. Some mistakes you can fix on tax returns on extension or on amended tax return filings. Other mistakes can’t be fixed, and you should focus on tax strategies to dig out of that hole.