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If you don’t qualify for trader tax status, don’t buy into an expensive “tax-avoidance” (perhaps illegal) entity scheme, even if the salesmen call themselves trader tax experts. Most aren’t CPAs or tax attorneys. These salesmen often pitch two types of incorrect information.
1. An entity doesn’t need trader tax status
Telling unsuspecting and new traders that they don’t need to qualify for trader tax status in order to arrange for and claim trader tax-related benefits within an entity structure is an incorrect statement of tax law. Trader tax status-related tax benefits include business expense deductions. New traders are particularly interested in deducting education, start-up costs, travel, seminars and home office deductions, and all those items aren’t deductible under the default investor tax status. A trader must qualify for trader tax status in an entity or as an individual to deduct these and other business deductions.
These unscrupulous salesmen acknowledge that trader tax status is difficult to qualify for and they mistakenly — either on purpose or through ignorance — advise their potential clients to cover up non-qualification for trader tax status by organizing their trading activities within a single or dual-entity scheme, which they happen to sell for thousands of dollars.
These salesmen’s pitch books often say “hobby loss” rules apply to traders, but that’s incorrect too. Hobby loss rules are a part of Section 469 passive-activity loss rules and under the “trading rule, ” investment and business trading companies are exempt from Section 469.
Some salespeople have been heard to say traders need as few as 50 trades within a profitable entity to claim business expense treatment. This is entirely outside the law. Trader tax court cases such as Holsinger and Moller indicate that traders need closer to 500 round turn trades per year on a frequent, regular and consistent manner. (We offer plenty of other factors in Green’s 2010 Trader Tax Guide.)
Whether a trader organizes trading activity in a sole proprietorship (unincorporated business) or within a general partnership, LLC or S-corp, the rules are the same: THE TRADER (INDIVIDUAL OR ENTITY) MUST QUALIFY FOR TRADER TAX STATUS. The IRS will probably consider this scheme a “tax avoidance” scam and take serious action against the taxpayer and the promoter. Be aware that these salesmen offer free initial consultations and tax questionnaires in order to reel in captive clients to their schemes. Perhaps these salesmen figure if they can sell a dual-entity complex structure that no other CPA will approve, they can also capture these clients for annual tax preparation, accounting and planning services. This scheme is a huge part of these salesmen’s business model. We’ve heard that some of these salesmen offer to share professional service revenues with education and seminar companies; something that’s rarely disclosed to the customer. For CPA firms, that would run afoul of CPA codes of ethics , but again most of these promoters are not CPAs and are not bound by a code of ethics. What good is an initial free consultation if it comes with bad advice that costs traders thousands in fees and causes tax trouble and expense with the IRS? Nothing comes free and if it sounds too good to be true, it’s probably false.
Why are traders buying into this bad advice? At trade shows, conferences and educational firms, most attendees are new to trading. Most don’t qualify for trader tax status, which is getting harder to qualify for these days. We tell clients to pursue other strategies based on investor tax status and to hold off on an entity until they qualify. But that answer is not what many new traders want to hear as they want a tax deduction for their education, travel, seminars and start-up costs. That’s where these salesmen step in. They make their pitch and many traders figure it may be too good to be true, but it sounds reasonable and a firm featured at a seminar must be credible. Even if they have doubts, some traders figure they can roll the tax dice — a big mistake in our view!
Wash sale and MTM gross misstatements of law
As part of their pitch on their Web sites and Webcasts – which we have documented – the promoters first point out that “wash sale loss” deferrals on securities are a big problem for active traders. The promoters go on to hook traders with some very dangerous misstatements of tax law in connection with wash sales and ordinary tax loss treatment.
The promoters state that individuals have great trouble qualifying for trader tax status and therefore they can’t become exempt from wash sales as individuals. They go on to say by simply setting up an entity (LLC, C-corp or dual-entity combination), the trader can skip trader tax status as a requirement within the entity and can claim exemption from wash sales and use ordinary loss treatment.
This is completely wrong and extremely dangerous. Although tax law may be somewhat vague on how to qualify for trader tax status, the law is crystal clear on wash sales and when a trader may use ordinary loss treatment.
Section 475 clearly states the only way for a trader to be exempt from wash sales and to use ordinary gain or loss treatment instead – and imputing sales on open positions at year-end – is to qualify for and properly elect Section 475(f) mark-to-market (MTM) accounting on time (usually by April 15th of the current tax year). Section 475(f) expressly states that this special tax treatment is reserved for a qualifying “dealer in securities or commodities” and was expanded in 1997 to “traders in securities or commodities.” Tax law clearly defines a “trader in securities or commodities” as an individual or entity that qualifies for trader tax status. Entities or individuals that fail trader tax status may not use Section 475 MTM, which means they are forced to report wash sales and use the restrictive capital loss treatment (not business ordinary loss treatment). This is “Trader Tax 101” – not knowing these basics means the promoter isn’t a “trader tax expert.” As pointed out below, most hedge funds are investment companies that fail trader tax status and these hedge funds must report wash sales.
We feel very bad for the unsuspecting clients tricked by these promoters. If they get examined by the IRS – and that may happen if the IRS busts these promoters and under certain circumstances may be able to request their client lists – traders who fall short of trader tax status but used an entity to get around those rules will face thousands if not hundreds of thousands of dollars in back taxes, interest and penalties for using a tax-avoidance scheme. Traders who feel they’re in trouble here should consult a real trader tax expert and consider filing amended tax returns. That may reduce penalties. Traders who know these schemes are wrong and play the audit lottery will face very stiff penalties and tax-trouble.
2. Dual-entity scheme with C-corp
Sometimes salesmen offer a scheme involving a second entity (a C-corp) to traders uncomfortable with the first option above.
The idea behind this bad idea is using a C-corp to navigate around the non-qualification for trader tax status problem. This scam is more complex and nuanced and it’s been around on the seminar circuit for over 10 years.
Technically, a C-corp doesn’t distinguish between business (Section 162) and investment expenses (Section 212). This scheme completely fails because it’s impossible to deliver Section 162 business ordinary loss treatment to the individual owner unless the trader qualifies for trader tax status (back to the same inconvenient truth). Paying thousands of dollars for this complex and nuanced deception and tax trouble is simply not worth it.
If you don’t think you qualify for trader tax status and you hear these pitches from salesmen, we highly recommend walking away. If you already bought into these scams, inquire about these problems in writing to these salesmen. Engage an attorney for help if needed. If you have gotten into tax trouble on these schemes by claiming business expenses when you aren’t entitled to them, we suggest filing amended tax returns. Ask these firms for your money back, too.
The correct tax laws and reasons these scams fail
A trading entity without trader tax status is an investment company subject to Section 212 investment income and expense tax treatment. An investment company can’t deduct Section 162 trade or business expenses.
It’s very costly tax-wise and probably dubious to create tax-deductible retirement plans and health insurance premiums in an investment company. That’s because the earned income fee is an investment expense and the fee income is considered gross income. This raises gross and taxable income since investment expenses are often restricted, whereas with trader tax status in an entity, the gross income is unchanged.
Adding a C-corp to the mix doesn’t work either. Losses are trapped in a C-corp and tax losses don’t flow through to a trader’s individual tax return where they can generate immediate tax benefits.
The promoters of these schemes figure they can close the C-corps down the road and receive ordinary loss treatment at that time. They are very wrong. When closing an investment company C-corp, Section 1244 stock rules for ordinary loss treatment can’t be used because the investment company fails the gross receipts test, having portfolio rather than business income.
If the dual-entity C-corp charges a management or administration fee to the LLC trading company, the IRS can claim that the losses show it’s a tax sham with no business purpose, since the owner of both companies arranged for the C-corp to lose money. If the LLC pays a large fee to the C-corp to be profitable, the LLC can’t deduct the fees as business expenses because it fails trader tax status, and it passes through investment expenses for the entire amount. We cover more details on these C-corp problems in Green’s 2010 Trader Tax Guide (excerpt included below). Bottom line, the C-corp can’t be used to cover up lack of trader tax status. It won’t generate business expense or ordinary loss treatment without trader tax status.
The salesmen’s pitch books harp on “income splitting” benefits with a C-corp, as C-corps have lower tax rates on the first $50,000 of taxable income. But this doesn’t work in practice for traders, because they are subject to double federal and state taxation, which in most states makes it cost much more than a simple pass-through entity. It’s important to note that the Bush Tax cuts, including the qualifying dividend (lower long-term capital gains tax rate) expire in 2011, with the dividends tax rate returning to marginal ordinary tax rates. That 2011 tax law change will make double taxation much costlier.
C-corps can have medical-reimbursement plans (MRPs). Partnerships and other pass-through entities may have the bigger fringe benefit plans (AGI deductions) such as retirement-plan contributions and 100 percent health-insurance premium deductions. We noticed some salesmen tell unsuspecting clients in pitch books that medical expenses are only deductible as itemized deductions in excess of 7.5 percent of AGI income, indicating it’s a big problem. The salesmen leave out the fact that health-insurance premiums are 100 percent deductible from AGI, providing a trader has earned income, which can easily be arranged with a simple pass-through entity. Most traders are reimbursed for most of their medical expenses through health insurance coverage and they wind up with few out-of-pocket medical expenses. These traders don’t need an expensive structure including a C-corp with MRP. A health savings account (HSA) with a pass-through structure can also duplicate advantages of a MRP.
In our experience, one out of 1,000 traders may need a C-corp added to their mix. Why do these salesmen recommend that complex and costly second entity to almost every trader that they come into contact with?
How do these salesmen respond to challenging questions?
We’ve heard from traders who have questioned these salesmen, raising our challenges to their above strategies. These traders told us the (non-CPA) salesmen dismiss our statements as being a “difference of opinion.” In order for a taxpayer to be able to rely on advice, the advice must be considered to have “substantial authority.” Otherwise the taxpayer will be subject to penalties. It is clear to our CPAs and tax attorneys that these non-CPA salesmen’s views do not have substantial authority. We suggest asking these salesmen for substantial authority to support their strategies in writing. They would need to engage a competent tax attorney to support their frivolous positions and I highly doubt competent tax attorneys would sign a reckless opinion like this, risking their own careers.
Other resources
The sad truth: It’s harder to claim business treatment for trading than for other types of business activities. It’s wiser to deal with this reality up front than to waste thousands of dollars on foolish tax-avoidance schemes that won’t stand up to IRS exam scrutiny.
Note that tax exams are on the rise and traders stand out like a sore thumb. In fact, when the IRS busts promoters for selling tax avoidance schemes, they often compel promoters to turn over their firm’s client lists. See several articles on the Internet about this including this one.
Our answers make sense when you look at the investment management business marketplace. Consider that hedge funds are set up as entities, yet most hedge funds don’t qualify for trader tax status (in their funds). These non-qualifying hedge funds, using leading CPA firms preparing their tax returns, issue K-1s to their investors reporting all expenses as Section 212 investment expenses, and not as Section 162 business expenses. These “investment company” hedge funds use more restrictive capital loss treatment because they aren’t entitled to elect Section 475 mark-to-market (MTM) ordinary gain or loss accounting, as that special tax election is reserved only for entities who qualify for trader tax status.
Entire tax treatises and tax research materials prepared by leading tax publishers like CCH and RIA are titled “Investment Company” materials. This tax research addresses the key differences between section 212 investment income and expenses vs. Section 162 ordinary and necessary business treatment.
IRS Publication 550 for Investors with Chapter 4 “Special Rules for Traders” focuses on qualification for trader tax status. There isn’t one mention in the tax code or these IRS publications that formation of an entity alone trumps Section 212 treatment and would therefore deliver Section 162 trade or business treatment. Ask these salesmen for a tax opinion or statement to back up their schemes.
Almost all tax court cases relating to traders are about traders who fail to qualify for trader tax status and the court rules they therefore can’t use business expense treatment. Many traders in those tax court cases had formed entities and still failed to qualify for trader tax status. Tax bills are huge since investment expenses are very restricted vs. business expenses. (Read about the Holsinger case inGreen’s 2010 Trader Tax Guide.)
The best entities for traders
If a trader qualifies for trader tax status and can benefit from an entity, he only needs one simple low-cost entity like a husband/wife general partnership, which has no state filing fees and or state minimum taxes. The biggest state marketplaces for traders are California, Texas, Illinois and New York, and they are all expensive for LLCs vs. general partnerships.
Promoters harp on two very expensive dual-entities schemes: The more expensive LLC filing a partnership tax return, and the C-corp scheme (facing double taxable and disallowed losses).
The cash flow savings pitch
Some salesmen promise tax efficiency to save cash flow for a trading business. This is another pitch that doesn’t add up and in fact is the reverse of what they promise. Most new traders don’t have sufficient funds to invest in their trading activity and they face great challenges in qualifying for trader tax status. Why do these salesmen want to take thousands of dollars from the aspiring trader who doesn’t qualify for trader tax status for entities they don’t need, which then renders them more seriously under-capitalized? Wouldn’t traders be far better served retaining those thousands of dollars to finance their minimum account sizes? After all, a trader needs $25,000 to be a pattern day trader and close to $20,000 to qualify for trader tax status in futures and forex. The IRS doesn’t respect mini and micro accounts for assessing trader tax status.
The clean up
Our CPAs are often asked by frustrated clients to clean up messes caused by these promoters. We usually close down excess entities, try to salvage one, or start over. Amended tax returns may be necessary as well.
More details
We cover trader tax status and entities in detail in Green’s 2010 Trader Tax Guide. Here are some excerpts from Chapter 4 on Entities, specifically on the problems with C-corps:
Although entities aren’t absolutely necessary for business traders to deduct business expenses and elect Section 475 MTM, they’re very helpful in reducing IRS challenges of trader tax status (which are on the rise). Plus, entities are useful in unlocking adjusted gross income (AGI) tax deductions including retirement plans and health-insurance premiums. Entities help most business traders, especially part-time and money-losing traders deflect IRS questions scrutinizing trader tax status. Because the entity return is filed separately, the IRS won’t also see your W-2 (wages) from another full-time job or easily question the validity of a money-losing sole-proprietorship business.
Business traders often use entities to contribute to a retirement plan, which otherwise isn’t possible unless a trader has other sources of earned income or is a member of a futures exchange. Some traders are interested in launching an investment-management business in the future, and trading in an entity can help constitute a performance record. Finally, many types of entities are useful for asset protection and/or business continuity. A separate legal entity gives the presumption of business purpose, but a trader still must achieve trader tax status.
ENTITIES ENGINEER EARNED INCOME
If a trader doesn’t have earned income, he may want to consider the following tax strategy, which isn’t 100-percent clear in the tax law. Form a separate legal entity if you want to contribute to a tax-deductible retirement plan (or even a tax-free retirement plan such as a Roth IRA). The entity is used to engineer earned income — to turn a portion of non-earned income trading gains into earned income.
Caution: IRS regulations do not allow investment partnerships to issue guaranteed payments (which are earned income) to owners. This could cause the IRS to challenge this strategy. However, various court cases (including Armstrong vs. Phinney) state that the IRS regulation is incorrect.
PASS-THROUGH ENTITIES ARE BEST
A separate pass-through entity passes all items of income, loss, and expense directly to the trader’s individual tax return, so there’s no double-federal-taxation, as taxes are paid on the owner-level only. States have very low levels of minimum taxes, franchise taxes, or annual reports for LLCs or S-corps.
• All tax character is detailed on the entity level and then passed through in summary form (maintaining its character) to the owner’s individual tax return.
• Dividend and interest income is reported on individual Form 1040 Schedule B.
• Capital gains and losses are reported on individual Form 1040 Schedule D and Section 475 MTM gains and losses are reported on individual Form 1040 Form 4797. The line-by-line reporting is reported on the entity tax return, with summary reporting on the individual return.
• Business expenses are reported in summary manner on individual Form 1040 Schedule E, with expense details reported on the entity return.
• Summary reporting on the individual return without using a Schedule C means fewer questions from the IRS.
Some traders with investor tax status may want to consider an entity, even though they can’t efficiently use the AGI deduction strategies. If they benefit from investment-expense treatment (i.e., they don’t trigger the alternative minimum tax and they’re well over the 2-percent AGI limitation), it looks better to consolidate all those expenses on an entity return and pass them through in summary form to the individual return. It resembles a hedge-fund investment and looks quite normal to the IRS. Otherwise, the IRS might nit pick at investment-expense details on Schedule A.
C CORPORATIONS ARE THE WORST
• Paying out salaries or administration fees to avoid double taxation (triggered with C-corps) causes payroll or SE tax that otherwise might not be due, since retirement-plan deduction strategies usually only require a small portion of trading gains to be converted into earned income.
• The $3,000 capital loss isn’t allowed in a C-corp. Losses are trapped in C-corps until the entity is closed, so traders can’t immediately benefit from losses. You can’t sell tax losses in an entity to another party.
• Lower 60/40 futures tax rates aren’t allowed in C-corps.
• Dual entity schemes using a C-corp are often expensive and can have many tax pitfalls. Why use two entities at twice the cost?
• In some cases, C-corps can be attractive as a second entity, providing the administrative service to a pass-through trading company for fringe benefit plans such as a medical-reimbursement plan. Health-insurance premiums are deductible with pass-through entity structures (on the individual return).
• If C-corp tax rates become materially less than the highest individual marginal tax rates (which are scheduled to rise in 2011 on the upper income), there may be opportunities for tax savings.
• Dual-entity schemes marketed by other firms aren’t a good idea. Some accountants recommend C-corps to cover up weak trader-tax status cases. C-corps don’t have the same concept of business vs. investment expenses. But this strategy still fails when a second trading entity such as an LLC pays fees to the C-corp to zero out income after using the C-corp to pay expenses. The LLC partnership return has a restricted investment expense deduction in this case.
Some suggest another ill-advised angle: Paying a small amount of fees while letting the C-corp build up a higher amount of expenses (which become losses), trying to achieve business ordinary-loss write offs in closing the C-corp in a later year based on Section 1244 ordinary-loss tax treatment. Note that a trading C-corp alone doesn’t qualify for Section 1244 stock-loss treatment, as it fails the necessary business revenues qualification for Section 1244. A dual entity scheme paying fees only to the C-corp (by the trading LLC) might qualify for Section 1244 stock treatment. However, we expect the IRS to treat this scenario as a sham transaction, because the C-corp never achieved business purpose — with the plan of having more expenses than revenues (net losses).
Alternatively, the IRS may argue the fees paid to the C-corp were below market rate and need to be restated upwards — after all, in an arm’s length transaction, an independent company would charge a customer more than the cost of its expenses. Consult a trader tax expert. It’s better to address whether or not you qualify for trader tax status and plan accordingly around that determination in a more honest approach. Paying thousands of dollars for dual entity schemes up front and having costly tax problems later on isn’t worth it.