How will active traders make out with coming tax changes?

The current debt-ceiling battle between Democrats and Republicans promises to include meaningful tax reform. 

To slow growth of the deficit, Democrats agree to cut some spending, but only if the government agrees to significantly raise revenues too, and that means collecting more taxes. Democrats don’t want to raise taxes though, as tax hikes are a political third rail. Instead, they suggest “cleaning up the code” by closing tax loopholes (untaxed offshore corporate profits, big oil and hedge fund tax breaks, among others), ending tax expenditures (most itemized deductions and some credits), and getting tougher on enforcement. 

The sore spot of tax change for Democrats, including President Obama, is finally allowing the Bush-era tax rates (and cuts) to end as originally scheduled for upper-income taxpayers. But President Obama wanted to extend these tax breaks for taxpayers’ making under $250,000 per year. He avoided havoc in the last lame duck session of Congress by crafting a two-year extension for these tax breaks until Dec. 31, 2012, which is just after the next election. Will tax reform wait until 2013? It may or may not be dragged into ongoing debt-ceiling procedures and commissions sooner. 

I expect Tea Party Republicans to continue their efforts in blocking material tax increases of any kind. “Taxed Enough Already” (TEA) means no tax hikes. The Tea party argues that we have a spending problem and governments should significantly cut spending.

The political center found a way out of the debt-ceiling standoff, calling for tax reform rather than tax hikes. When Republicans hear the term “tax reform,” they think of the Deficit Commission’s findings suggesting a significant reduction of income tax rates, as a trade-off to closing tax loopholes and breaks. Democrats focus on closing tax loopholes with a less-aggressive reduction in tax rates. Republicans forecast tax revenue growth through tax reform supply-side economics. Democrats hope tax reform raises tax revenues by preventing corporations and individuals from continuing to game the tax system. Obviously, this will be another battle. 

A major overhaul of the tax code has been due for some time. It’s undeniably a monstrosity of pork-barrel politics, filled with carrots and sticks handed out by government officials – otherwise politely referred to as “fiscal policy.” Will stripping down the code strip politicians of their political power to hand out breaks and influence political donations? 

Let me now forecast what may happen with tax reform and explain how it may affect traders. 

Are lower 60/40 tax rates on futures in jeopardy?
I’ll start with my blog dated July 12. Here’s an excerpt. 

Andrew Ross Sorkin of the New York Times interviewed me about the history and future status of lower 60/40 tax rates. Read his article “An Addition to the List of Tax Loopholes” published July 11. Mr. Sorkin quoted me and used some content from a draft version of this blog, which I sent to him while he worked on his article. While our articles are similar in content, we reach an opposite conclusion. 

Mr. Sorkin told me that some in Congress are looking at the Section 1256 60/40 tax rates, which implies to me they are thinking about getting rid of them. He mentioned they saw a recent CFTC report showing that 80 percent of trading volume on commodities exchanges are short-term trading. Which begs question: Why do futures traders receive the 60 percent long-term capital gains benefit? The remaining 40 percent is subject to short-term capital gains rates — the higher ordinary income tax rates. Why should futures traders and commodities exchanges enjoy this tax break, when securities traders and exchanges don’t? 

The President’s Deficit Commission recommends tax reform, simplifying the tax code and repealing many special tax breaks. It suggests one reduced tax rate applied to all types of income, not distinguishing between ordinary and long-term capital gains. This would mean a repeal of 60/40 tax breaks. But, the Deficit Commission’s recommendations overall are good for traders because the Commission suggests a top marginal tax rate of 23 percent, which is the current 60/40 top blended tax rate now. In effect, securities traders could get a tax cut, using the same tax rate that futures traders use now. Yes, investors would lose many itemized deductions in order to flatten the tax code so rates can be reduced, but business traders would still be able to keep their business tax deductions. Although the Deficit Commission didn’t gain much traction to start, it seems to be getting its rightful consideration now as part of the intense debt ceiling and deficit stand-off. 

What does “flattening” of the tax code mean?
If Congress flattens the tax code as part of Tax Reform, then many types of itemized deductions may be repealed. Popular itemized deductions include state and local income taxes, real estate taxes, mortgage and investment interest, charitable contributions, investment expenses, employee-business expenses and tax preparation fees. 

I expect a firestorm from taxpayers and industry lobbyists crying bloody murder of their precious tax breaks. The politics on this battle will be at odds too. State and local taxes are higher in Democratic-leaning states, and real estate taxes and mortgage interest deductions are integral to the real estate industry, which remains in dire condition. Government austerity will hurt the poor and charity will be more important than ever, so repealing that deduction may not be wise either.

Many itemized deductions are already restricted with the nasty alternative minimum tax (AMT) second tax regime. Tax reform proposals include a repeal of AMT, but repealing itemized deductions may have the same effect anyway.

Trader tax status with business expense treatment should remain the best ticket
I’ve always pointed out that business traders are much better off tax-wise vs. investors, because unlimited business tax deductions are far better than restricted investment expenses. Business expenses include many items that investment expenses do not, including home-office, education, seminars, start-up costs and more. Investment expenses are limited to 2 percent of adjusted gross income (AGI) and the amount over that threshold is an AMT preference — in other words not deductible for AMT tax calculations.

I expect that tax reform will increase the relative tax benefit of business tax status. Tax reform may repeal most or all investment expenses, while safeguarding business deductions. 

Congress may tinker with depreciation and other expensing rules, like extending useful lives — a la the corporate jet brouhaha during debt-ceiling negotiations — and reduce accelerated depreciation tables. However, I expect that Congress will be reluctant to de-stimulate business and jobs. Remember, President Obama improved “expensing rules” as part of his stimulus legislation. 

Will the lower long-term capital gains tax rate survive?
The Deficit Commission suggested an aggressive reduction of income tax rates to 23 percent. The Commission proposed one tax rate to make its math work as well as simplify the tax code — another important element of tax reform. That does away with lower long-term capital gains tax rates.

The Commission argues that more than one rate muddies up the tax code. The long-term rate carrot is offset with tax sticks including the puny $3,000 net capital loss limitation. Wash sales, straddles, and offsetting position loss deferral rules are also a stick, but they have more to do with deferral of unrealized gains and losses on securities.

I doubt Congress will ultimately agree on one tax rate. Republicans are pushing for zero taxes on capital gains and at a minimum they will insist on keeping a lower tax rate on long-term capital gains. I also doubt Democrats will agree on lowering tax rates to 23 percent. President Obama seems bent on insisting — out of fairness — that upper-income taxpayers finally surrender their Bush-era tax rates. It would seem odd to raise upper-income taxpayers to 41.6 percent (with phase-outs) and then lower them to 29 percent under tax reform. For this reason, it makes more sense discussing tax reform sooner rather than later and not arguing over the contentious Bush-era tax rates separately. 

Other tax savings ideas for traders under tax reform
If Congress repeals most itemized deductions under tax reform, taxpayers should try to reclassify or restructure itemize deductions as business expenses. First, you need to have a business, and many Americans are interested in a new business anyway – either as a side business or to replace a fleeting job. 

Trading can be a business, but you need to qualify for trader tax status, and that’s not easy. Learn all about trading businesses in our content, including Green’s 2011 Trader Tax Guide. 

Some CPAs and tax attorneys are starting to argue that some state income taxes might be associated – in other words deducted – with a sole proprietorship Schedule C business. After all, the business income is the income that triggers those state income taxes. More work needs to be done here, so don’t take this deduction without checking with a professional.

You can follow similar logic with interest deductions. Why not convert a higher-interest rate mortgage loan (say 4 to 5 percent) into a materially lower interest rate home-equity loan, which could be just more than 2 percent (many HELOCs are at one point under prime rate). You need to use the loan proceeds for your business activity, in order to then deduct business interest expenses without restriction. Check with a professional on this too. 

Home office deductions should survive tax reform, and they include real estate taxes and mortgage interest too. 

Bottom line
Significant tax reform and changes are expected soon and traders should position themselves as best they can. Hopefully, Congress will start on the fringes and not mess with business tax rules, as that is the cornerstone of our economy. Stay tuned.