Tag Archives: 1256

The New York Times

September 9, 2014 | By: Robert A. Green, CPA

The New York Times, Jan. 30, 2021, By Ann Carrns: So You Just Made a Lot of Money on GameStop. There’s One Catch: Taxes. Some investors may have notched tens of thousands of dollars in profits. Depending on when they sell the stock, they may owe hefty capital gains taxes.

  • “That’s my concern,” said Darren Neuschwander, managing member of Green, Neuschwander & Manning, which specializes in tax compliance for traders. Younger investors new to trading, he said, may not fully consider taxes and may be tempted to spend much of their windfall. “They better be putting some aside.”

The New York Times, July 11, 2011, By Andrew Ross Sorkin: An Addition to the List of Tax Loopholes.  Interview with Robert Green, CPA about the history and future status of lower 60/40 tax rates.

  • Mr. Sorkin quoted me and used some content from a draft version of my blog “Are lower 60/40 tax rates on futures in jeopardy?”, 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 suggested adding 60/40 futures tax rates to the list of tax loopholes being bandied about by the President and Democrats in connection with the contentious debt-ceiling debate. Conversely, I’m in the Republican camp on taxes — I don’t want tax hikes now, but I support meaningful tax reform efforts.
  • 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, which showed that 80 percent of trading volumes 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?

June 23, 2011: The New York Times published a very similar article to my blog “Who’s The AIG In This Financial Greek Tragedy?” A week before, I invited Ms. Louise Story of NYT to read my blog and pursue the story too. CNBC published this NYT story on their front page, see http://www.cnbc.com/id/43506232.

Derivatives Cloud the Possible Fallout From a Greek Default. By LOUISE STORY, Published: June 22, 2011. “It’s the $616 billion question: Does the euro crisis have a hidden A.I.G.?”

Forex Tax Treatment & Planning

September 7, 2014 | By: Robert A. Green, CPA

When it comes to taxes, forex traders can have the best of both worlds: ordinary loss treatment and lower 60/40 tax rates on gains.

Presented by Robert A. Green, CPA

Green explains forex tax and regulatory treatment, plus planning opportunities.
Read forex tax treatment in our Trader Tax Center.

Tax Treatment For Foreign Futures (Recording)

September 6, 2014 | By: Robert A. Green, CPA

Don’t assume foreign futures are like U.S. futures automatically qualifying for Section 1256 lower 60/40 tax rates.  Foreign futures must obtain CFTC, and IRS approval in a revenue ruling.

Join Robert Green CPA to discuss:

*Section 1256 offers up to 12% lower capital gains tax rates on short-term trading with its attractive 60/40 tax rates.

*Learn about the “qualified board or trade” (QBE) requirement for Section 1256.

*Review the long list of national QBEs, and the short list of foreign QBEs.

*Learn what’s required for a foreign exchange to qualify for QBE/1256 status (a CFTC no action letter and IRS revenue ruling).

*Avoid misstatements and learn how to determine if your foreign exchange and products have Section 1256 treatment.

Questions & Answers

Forex

August 29, 2014 | By: Robert A. Green, CPA

“Forex” refers to the foreign exchange market (also known as the “Interbank” market) where participants trade currencies, including spot, forwards, or over-the-counter (OTC) option contracts. Forex differs from trading currency-regulated futures contracts (RFCs). Currency RFCs are considered Section 1256 contracts reported on Form 6781 with lower 60/40 capital gains tax treatment.

Forex tax treatment. By default, forex transactions start off receiving ordinary gain or loss treatment, as dictated by Section 988 (foreign currency transactions). The good news is Section 988 ordinary losses offset ordinary income in full and are not subject to the $3,000 capital loss limitation — that’s a welcome relief for many new forex traders who have initial losses and offset the losses against wage and other income.

Section 988 allows investors and business traders — but not manufacturers — to internally file a contemporaneous “capital gains election” to opt-out of Section 988 into capital gain or loss treatment. This is a way to generate capital gains to use up capital loss carryovers, which otherwise may go wasted for years.

The capital gains election on forex forwards allows the trader to use Section 1256(g) treatment with lower 60/40 capital gains rates on major currency pairs if the trader doesn’t take or make delivery of the underlying currency. The definition of a “major currency pair” is a forex pair that also trades as a regulated futures contract on U.S. futures exchanges. There are lists of currency pairs that trade on U.S. futures exchanges available on the Internet (search FX products on CME).

Spot vs. forwards. Most online trading platforms and brokers only offer forex spot contracts. Because guidance from the IRS isn’t clear, most retail off-exchange forex traders are unsure how to handle spot forex. Our extensive work in this area has led us to believe that in many cases, spot forex can be treated like forex forwards, qualifying for lower 60/40 tax rates in Section 1256(g) on major currency pairs only. If you have significant trading gains on spot forex contracts, these tax rates may be very desirable. We layout a case for Section 1256(g) treatment on spot forex transactions, with certain conditions and restrictions. It’s important to use proper tax return footnote disclosure.

We’ve learned from discussions with the IRS Chief Counsel’s office on forex taxation that the authors of Section 988 never contemplated retail trading in spot forex transactions. IRS attorneys figured the spot forex marketplace was for corporations to exchange currency in the ordinary course of their trade or business. Those transactions would be the ordinary gain or loss per Section 988. Manufacturers and other global businesses transact in the Interbank market (to hedge and exchange currency). Why would they want to file a capital gains election to opt-out of Section 988? Only traders or investors holding forex as a capital asset can file that capital gains election per Section 988.

IRS attorneys understood that professional forex traders were trading forex forwards, and there was a clear pathway into Section 1256(g). Also, spot forex isn’t mentioned in Section 1256(g). That makes sense since retail spot forex trading began around 2000, whereas Section 1256(g) was added around 1986.

To gain entry into Section 1256(g), the IRS requires that spot forex settle in cash and be traded in the Interbank marketplace, but it’s debatable what constitutes this marketplace. Please read our blog post, A Case For Retail Forex Traders Using Section 1256(g) Lower 60/40 Tax Rates.

For more information, see Green’s Trader Tax Guide

Section 1256 Contracts

| By: Robert A. Green, CPA

Section 1256 contracts include:

  • U.S. regulated futures contracts (RFCs) and options on U.S. RFCs
  • U.S. broad-based indexes made up of 10 or more underlying securities – also known as stock index futures
  • options on U.S. broad-based indexes
  • foreign futures if granted Section 1256 treatment in an IRS revenue ruling
  • non-equity options (a catchall)
  • CBOE-listed options on commodity ETF publicly traded partnerships
  • CBOE-listed options on precious metals ETF publicly traded trusts
  • CBOE-listed options on volatility ETN prepaid forward contracts
  • forward forex contracts with the opt-out election into Section 1256(g) on the major pairs, for which futures trade (we make a case for spot forex, too)
  • forex OTC options (Wright court)

Section 1256 contracts have lower 60/40 capital gains tax rates: 60% (including day trades) subject to lower long-term capital gains rates, and 40% taxed as short-term capital gains using the ordinary rate. At the maximum tax bracket for 2020 and 2021, the blended 60/40 rate is 26.8% — 10.2% lower than the highest ordinary bracket of 37%.

There are significant tax savings throughout the income brackets. The LTCG rate in the lowest two ordinary brackets is 0%. (See our table below.) Regular state tax rates apply because they do not include a long-term rate.

Section 1256 contracts are marked-to-market (MTM) daily. MTM reports both realized activity from throughout the year and unrealized gains and losses on open trading positions at year-end for tax purposes.

With MTM and summary reporting, brokers can issue simple one-page 1099-Bs reporting “aggregate profit or loss on contracts” after taking into account realized and unrealized gains and losses. That amount is reported on Form 6781 Part I, which breaks it down to the 60/40 split and then moves the amounts to Schedule D capital gains/losses.

There is a Section 1256 loss carryback election.

Section 1256 tax rates vs. ordinary rates (2020 rates)

Ordinary
Rates
Long-Term
Capital Gains
Rates
40%
Short-Term
Rates
60%
Long-Term
Rates
Blended
60/40
Rates
Savings
In
Rates
10% 0% 4.0% 0% 4.0% 6.0%
12% 0% 4.8% 0% 4.8% 7.2%
22% 15% 8.8% 9% 17.8% 4.2%
24% 15% 9.6% 9% 18.6% 5.4%
32% 15% 12.8% 9% 21.8% 10.2%
35% 15% 14.0% 9% 23.0% 12.0%
37% 20% 14.8% 12% 26.8% 10.2%

For more information, see Green’s Trader Tax Guide

Exchange-Traded Funds (ETFs)

August 28, 2014 | By: Robert A. Green, CPA

Securities, commodities, and precious metals ETFs use different structures, and tax treatment varies.

Securities ETFs usually are regulated investment companies (RICs). Like mutual fund RICs, securities ETFs pass through their underlying ordinary and qualifying dividends to investors. Selling a securities ETF is deemed a security sale, calling for short- and long-term capital gains tax treatment using the realization method. A securities ETF is a security, so wash-sale loss adjustments or Section 475 apply if elected.

Commodities/Futures ETFs. Regulators do not permit commodities/futures ETFs to use the RIC structure, so usually, they are structured as publicly traded partnerships (PTPs). Commodities/Futures ETFs issue annual Schedule K-1s passing through their underlying Section 1256 tax treatment to investors, as well as other taxable items. Selling a commodities ETF is deemed a sale of a security and calls for short- and long-term capital gains tax treatment using the realization method. Wash-sale loss adjustments or Section 475 apply if elected because a commodities ETF PTP is widely held.

Taxpayers invested in commodities/futures ETFs may need to make some cost-basis adjustments on Form 8949 to capital gains and losses, ensuring they don’t double count some of the Schedule K-1 pass-through items. For example, if the K-1 passes through Section 1256 income to Form 6781, the taxpayer should also add that income to the cost basis on Form 8949. Otherwise, it will be double-counted, causing an overstatement of tax liability. Form 1099-Bs and trade accounting solutions do not make these cost-basis adjustments from K-1 income/loss, so be sure to adjust Form 8949 accordingly.

Physically backed precious metals ETFs. These ETFs may not use the RIC structure either. Although they could use the PTP structure, they usually choose the publicly traded trust (PTT) structure (also known as a grantor trust). A PTT issues an annual Schedule K-1, passing through tax treatment to the investor, which, in this case, is the “collectibles” capital gains rate on sales of physically-backed precious metals (such as gold bullion). Selling a precious metal ETF is deemed a sale of a precious metal, which is a collectible. If collectibles are held over one year (long-term), sales are taxed at the “collectibles” capital gains tax rate — capped at 28%. (If the ordinary rate is lower, use it.) That rate is higher than the top regular long-term capital gains rate of 20% (2020 and 2021). Short-term capital gains are taxed at the ordinary rate. Physically backed precious metals ETFs are not securities, so they are not subject to wash-sale loss adjustments or Section 475 if elected. (For more information, see our blog Tax Treatment for Precious Metals, which includes discussion on all sorts of precious metal ETFs.)

For more information, see Green’s Trader Tax Guide

Tax treatment for foreign futures

June 2, 2014 | By: Robert A. Green, CPA

EY Global Tax Alerts: (My list below of foreign futures exchanges granted Section 1256 treatment by the IRS is the same as the EY list, which is unchanged on foreign exchanges since 2013.)

– Updated 2019 US Section 1256 qualified board or exchange list
– Updated 2018 US Section 1256 qualified board or exchange list
– Updated 2017 US Section 1256 qualified board or exchange list
– Updated 2016 US Section 1256 qualified board or exchange list

A leading global broker Newedge promised Section 1256 treatment for foreign futures traded on Euronext Paris and Euronext Amsterdam exchanges. Our blog helped them retract that promise and agree those exchanges don’t have Section 1256 treatment.

Section 1256 offers up to 12% lower capital gains tax rates on short-term trading with its attractive 60/40 tax rates. It includes regulated futures contracts (RFCs), broad-based stock indices, options on those indices, options on futures, nonequity options, certain off-exchange foreign currency contracts and a few other items. But it can be a hard club to get into. Among Section 1256 contracts, regulated futures contracts, nonequity options and securities futures contracts must be traded on or subject to the rules of a “qualified board or exchange” (QBE). U.S. exchanges make the list pretty easily, but foreign exchanges don’t. Let’s look at the QBE requirement in more detail.

QBE
Section 1256 includes a list of those exchanges that are considered QBEs. Imagine Section 1256 being a popular club with a bouncer at the door holding a VIP guest list. If the exchange or board of trade you trade on is not on the QBE list, then the contracts you trade are excluded from Section 1256 tax treatment — even if they are regulated futures contracts.

QBEs include national securities exchanges registered with the SEC (category 1), domestic boards of trade designated as a “contract market” by the CFTC (category 2) or any other exchange or board of trade or other market (worldwide) that the CFTC and Treasury determines has rules adequate to carry out the purposes of Section 1256 (category 3).

According to Section 1256, contracts on category 1 and 2 exchanges are deemed RFCs if the contract “(A) with respect to which the amount required to be deposited and the amount which may be withdrawn depends on a system of marking to market, and (B) is traded on or subject to the rules of a qualified board or exchange.” (This doesn’t include securities futures contracts.)

The first step in finding out if a product qualifies for Section 1256 is to see if its exchange is on the QBE list. Don’t jump to that conclusion just because you received a 1099B reporting Section 1256 treatment. E&Y’s “Updated 2013 US IRC Section 1256 qualified board or exchange list” is a handy reference.

Notice the North American Derivatives Exchange (Nadex) — a domestic board of trade — is a category 2 because it’s a CFTC-regulated “Designated Contract Market” (DCM). In part two of this blog series, I discuss whether Nadex binary and variable payout options meet the definition of Section 1256 contracts, as either a regulated futures contract, or nonequity option.

Foreign exchanges with QBE status
These category 3 foreign QBEs received a CFTC exemption (“no action letter”) and Treasury/IRS determination granting them QBE status published in a required revenue ruling:

• International Futures Exchanges (Bermuda) Ltd.(inactive)
• Mercantile Division of the Montreal Exchange (inactive)
• Mutual Offset System (Rev. Rul. 87-43). A partnership between Chicago Mercantile Exchange and Singapore International Monetary Exchange Limited
ICE Futures Rev Rul 2007-26

o Per RIA, “a United Kingdom Recognized Investment Exchange that was (1) a wholly-owned subsidiary of a U.S. parent corporation, and (2) overseen by the U.K.’s Financial Services Authority, provided that the exchange continued to comply with all CFTC conditions necessary to retain its no-action relief permitting it to make its electronic trading and matching system available in the U.S.”

Dubai Mercantile Rev. Rul. 2009-4
ICE Futures Canada Rev. Rul. 2009-24
• London International Financial Futures and Options Exchange (LIFFE) Rev. Rul. 2010-3

o Per RIA, “Is a regulated exchange of the United Kingdom … Exchange offered electronic trading of commodity futures contracts and other futures and options contracts. Contracts were cleared and settled by Clearing House, a CFTC-regulated Derivatives Clearing Organization. The CFTC had granted Exchange no-action relief permitting it to make its electronic trading and matching system available in the U.S.”

Eurex Deutschland Rev. Rul. 2013-5

o Per RIA, “Is a regulated exchange of Germany, as long as: either CFTC continues to allow Eurex to provide direct access to its electronic trading and order matching system from U.S. under existing no action letter, pending CFTC approval of Order of Registration, or Eurex holds valid Order of Registration as foreign boards of trade (FBOT). IRS grants consent to taxpayers to change to Section 1256 mark to market method for 1st taxable year during which taxpayer holds Eurex Deutschland Contract that was entered on or after 3/1/2013.”

CFTC looks abroad
The CFTC’s reach is global — protecting customers located in the U.S. trading on foreign exchanges.

The CFTC website (international foreign products) says “These regulations are designed to carry out Congress’s intent that foreign futures and foreign options products offered or sold in the U.S. be subject to regulatory safeguards comparable to those applicable to domestic transactions. As set forth in CFTC Regulation 30.4, any domestic or foreign person engaged in activities like those of a futures commission merchant (FCM), introducing broker (IB), commodity pool operator (CPO), or commodity trading advisor (CTA) must register in the appropriate capacity or seek an exemption from registration under CFTC Regulation 30.5 or CFTC Regulation 30.10.”

The first step in finding out if Section 1256 applies is to look up the CFTC no action letter with 30.5 or 30.10 exemption. The CFTC publishes current and pending no action letters at “Foreign Government Agencies and SROs that have Received CFTC Orders under CFTC Regulation 30.10” and “Pending Requests for CFTC Regulation 30.10 Exemption.”

Treasury’s determination is published
The second step is to look up the IRS revenue ruling. The IRS has a two-step process for these determinations.

1. The foreign exchange must submit a private letter ruling requesting QBE status. If the IRS is satisfied that the exchange has sufficient rules for application of Section 1256, it publishes a revenue ruling. The revenue ruling applies to the commodity futures contracts and futures contract options only entered on the named exchange, and not any affiliated exchanges (Note 1). For example, Section 1256 applies for futures traded on Eurex Deutschland, but not for futures traded on an affiliate of Eurex Deutschland.

2. The IRS looks to see if the exchange obtained a CFTC exemption (no action letter). Section 738 of the Dodd-Frank Act gives the CFTC authority to adopt rules and regulations that require registration of a foreign board of trade that provides U.S. participants direct access to the board of trade’s electronic trading system. This proposed registration system is supposed to replace the no-action letter process.

Mergers, partnerships and cooperation lead to questions about QBE status
There have been several cross-border mergers and acquisitions, partnerships and other cooperation agreements between U.S., EU and Asian exchanges and foreign boards of trade. These mergers and affiliations are confusing brokers, who are then confusing their clients. Keep things simple and clear: make sure you see an IRS revenue ruling in the exact name of the exchange you trade on.

When a U.S. QBE has a “mutual offset agreement” with a non-QBE foreign exchange, the IRS treats trades executed on the foreign exchange that are assumed by the U.S. QBE as Section 1256. But trades executed on the U.S. QBE that are assumed by the foreign exchange are not considered Section 1256. This was the case with the CME/SIMEX Mutual Offset System (Rev. Rul. 87-43).

If a U.S. QBE acquires a foreign non-QBE, generally the foreign regulator oversees the foreign non-QBE. The foreign non-QBE does not inherit the U.S. exchange’s QBE status. The foreign exchange must have it’s own CFTC exemption (no-action letter) and request a formal determination by Treasury for foreign QBE status. The ICE Futures 2009 revenue ruling listed above is a similar case. (Note 2 confirmation from IRS)

Dodd Frank rules for swaps
As of 2011, the Dodd-Frank Act requires privately negotiated derivatives contracts to clear on derivatives exchanges or boards of trade. The CFTC is trying to coordinate these rules with similar ones enacted in the EU. Among other things, the CFTC wants EU swaps exchanges to report on trading activities by Americans. Dodd-Frank law and IRS proposed regulations exclude swap contracts from Section 1256.

Many foreign exchanges don’t want U.S. filings
NYC tax attorney Roger Lorence heard from Treasury and IRS officials that several foreign exchanges and boards of trade fear getting involved with the U.S. Treasury and IRS — perhaps due to controversial U.S. FATCA and FBAR reporting — so they don’t want a CFTC exemption and Treasury determination granting them QBE status. But perhaps they will change their minds if Americans demanding QBE status become a major part of their business activity.

Note 1: Preamble to Proposed Regulation § 1.1256(g)-1 

(Part D, 9/16/2011)
D. Qualified Board or Exchange
Section 1256(g)(7)(C) provides that a qualified board or exchange includes any other exchange, board of trade, or other market which the Secretary determines has rules adequate to carry out the purposes of section 1256. Section 1.1256(g)-1(a) of the proposed regulations specifies that such determinations are only made through published guidance in the Federal Register or in the Internal Revenue Bulletin. 

Robert Green observation: The proposed reg requires publishing in the Federal Register or Internal Revenue Bulletin, whereas the current 1.1256 regulation requires publishing in an IRS Revenue Ruling. Either way, qualification for Section 1256 requires Treasury/IRS to make a formal determination and publish it for public consumption. Notice the IRS published some of the above Revenue Rulings in the IR Bulletin, whereas others we published as pdf files only. More consistency in publishing would be better.

Since section 1256(g)(7) was adopted, the Treasury Department and the IRS have issued determinations for six* entities, all of them foreign futures exchanges. See Rev. Rul. 2010-3 (2010-1 CB 272 (London International Financial Futures and Options Exchange)), Rev. Rul. 2009-24 (2009-2 CB 306 (ICE Futures Canada)), Rev. Rul. 2009-4 (2009-1 CB 408 (Dubai Mercantile Exchange)), Rev. Rul. 2007-26 (2007-1 CB 970 (ICE Futures)), Rev. Rul. 86-7 (1986-1 CB 295 (The Mercantile Division of the Montreal Exchange)), and Rev. Rul. 85-72 (1985-1 CB 286 (International Futures Exchange (Bermuda))). The IRS has followed a two step process for making each of the six qualified board or exchange determinations under section 1256(g)(7). See § 601.601(d)(2)(ii)(b).

*Robert Green observation: Eurex Deutschland (Rev. Rul. 2013-5) was published after this preamble date of 9/16/2011.

In the first step, the exchange submitted a private letter ruling to the IRS requesting a determination that the exchange is a qualified board or exchange within the meaning of section 1256(g)(7)(C). Once the IRS determined that the exchange had rules sufficient to carry out the purposes of section 1256, the Treasury Department and the IRS published a revenue ruling announcing that the named exchange was a qualified board or exchange. The revenue rulings apply to commodity futures contracts and futures contract options of the type described under the CEA that are entered into on the named exchange. The revenue ruling does not apply to contracts that are entered into on another exchange that is affiliated with the named exchange.

Robert Green observation: The above important sentences in bold are current law, they are not something new in Proposed Regulation § 1.1256(g)-1.

In determining whether a foreign exchange is a qualified board or exchange under section 1256(g)(7)(C), the Treasury Department and the IRS have looked to whether the exchange received a CFTC “direct access” no-action relief letter permitting the exchange to make its electronic trading and matching system available in the United States, notwithstanding that the exchange was not designated as a contract market pursuant to section 5 of the CEA. Section 738 of the Dodd-Frank Act, however, provides the CFTC with authority to adopt rules and regulations that require registration of a foreign board of trade that provides United States participants direct access to the foreign board of trade’s electronic trading system. In formulating these rules and regulations, the CFTC is directed to consider whether comparable supervision and regulation exists in the foreign board of trade’s home country. Pursuant to section 738, the CFTC has proposed a registration system to replace the direct access no-action letter process. Under the proposed registration system, a foreign board of trade operating pursuant to an existing direct access no-action relief letter must apply through a limited application process for an “Order of Registration” which will replace the foreign board of trade’s existing direct access no-action letter. Many of the proposed requirements for and conditions applied to a foreign board of trade’s registration will be based upon those applicable to the foreign board of trade’s currently granted direct access no-action relief letter.

The IRS has conditioned a foreign exchange’s qualified board or exchange status under section 1256(g)(7)(C) on the exchange continuing to satisfy all CFTC conditions necessary to retain its direct access no-action relief letter. Consequently, if the CFTC adopts the proposed registration system, an exchange that has previously received a qualified board or exchange determination under section 1256(g)(7)(C) must obtain a CFTC Order of Registration in order to maintain its qualified board or exchange status. The IRS will continue to evaluate the CFTC’s rules in this regard to determine if any changes to the IRS’s section 1256(g)(7)(C) guidance process are warranted.

Note 2: Confirmation with IRS
Our tax attorney Roger Lorence spoke with an IRS official responsible for Section 1256 issues, and he confirmed that: “A foreign board or exchange must get a revenue ruling if they have a CFTC 30.10 ruling to receive 1256 treatment for their qualifying contracts. A foreign board that receives a revenue ruling is covered on 1256 but related foreign exchanges are not covered – the revenue ruling only applies to the exchange covered in that ruling. Affiliated foreign exchanges must get their own revenue ruling to qualify under 1256.”

Thank you to our tax attorneys Mark Feldman and Roger Lorence and my co-managing member Darren Neuschwander, CPA for their help with this blog.

Why do forex forward dealers issue 1099s, yet spot forex brokers do not?

August 16, 2012 | By: Robert A. Green, CPA

Did you receive a Form 1099 from your forex broker or bank this year? If you traded forex spot, you most likely did not. Conversely, if you traded forex forwards, you probably did receive a 1099, the kind used for Section 1256 contracts, like futures. But, how does this affect your tax filings?

1099 rules
The rules state that a 1099 should be issued for forex forwards, treating them like Section 1256(g) foreign currency contracts. Those same rules state 1099 should not be issued for forex spot trading. Some taxpayers mistakenly think if they don’t receive a 1099, they don’t have to report anything. That is very wrong — you need to report your trading gains and losses and other income, whether you receive a 1099 or not. That includes income from foreign brokers, too. If the 1099 is wrong, you must report the correct amount. It’s best to ask your broker or bank to correct the 1099 when you identify an error.

Spot vs. forwards
Most online forex traders have accounts with retail off-exchange forex brokers, most of whom only offer trading in the forex spot market. Spot settles in one to two days, whereas forwards settle in over two days. Brokers use the terminology T+1 for trade date plus one for a one-day settlement.

Retail forex brokers are not direct participants in the Interbank foreign exchange market. Rather, they are customers of Interbank forex dealers, and they make a derivative market for retail spot traders. Some of these retail forex brokers square their books on customer trades, and net the difference in the Interbank market, while others simply behave like a “house,” acting as market makers for their clients.

Professional and institutional forex traders like larger hedge funds have access to trading directly with forex dealers in the Interbank market. These forex dealers offer well-heeled clients access to forex forwards and options in addition to spot trading. Because forwards settle in over two days, they require more credit from traders, as they are high-leverage activities.

Rolling spot contracts
A leading forex dealer offers a “rolling spot” trading program. Instruments traded in this program are treated like forwards for purposes of 1099 issuance. CFTC Chairman Gary Gensler called these contracts futures-like. We understand that other forex dealers offer similar trading products, too.

These “rolling spot” forex contracts don’t have a fixed settlement date, as they are open ended contracts. While technically they could settle during a spot term of one to two days, they primarily settle during a forward term over two days. This dealer says these contracts act more like a forward contract than a spot contract, and therefore they issued a 1099 for forwards. That called for using a 1099 for Section 1256g (foreign currency contracts), which requires reporting of realized and unrealized gains and losses. This forex dealer marked open positions to market at year-end, too. But, forex by default has Section 988 ordinary gain or loss treatment.

1099s don’t dictate tax treatment
It’s very important to note that Form 1099s don’t dictate tax treatment. 1099 issuance rules call for 1099s based on a default standard — investor status. One of our clients received a 1099 from this dealer showing a $100,000+ loss treated as Section 1256g. But this client never filed an opt-out election from Section 988 into Section 1256g. Does the issuance of this 1099 dictate the taxpayer’s tax treatment, or do his own facts, circumstances and elections dictate tax treatment? Good news, it’s the latter. See the example footnote below that we plan to include with this client’s 2011 income tax return. In this case, the client prefers Section 988 ordinary loss treatment, rather than Section 1256 capital loss treatment subject to the $3,000 loss limitation against ordinary income. Taxpayers don’t want broker-issued 1099s to force them into worse tax treatment.

Section 475 MTM traders don’t let 1099s dictate tax treatment, either
For over a decade our Section 475 MTM business securities traders report their trading gains and losses with ordinary gain or loss treatment on Form 4797, Part II. They mark open trading business positions to market at year-end and report them as well. This tax treatment departs significantly from 1099s issued for a default investor using the cash method of accounting. The IRS understands the difference.

Example tax return footnote for a forex client who received a Form 1099
Taxpayer received a Form 1099 treating his forex contracts like forwards (or forward-like). 1099 issuance rules state that a 1099 should be issued for forex forwards, treating them like Section 1256(g) foreign currency contracts. Those same rules say no 1099 should be issued for spot forex.

As agreed by the issuer of this 1099, Form 1099s do not dictate the taxpayer’s tax treatment, as the issuer is generally not aware of the taxpayer’s facts, circumstances and tax-treatment elections.

By default, forex spot and forward contracts have Section 988 ordinary gain or loss treatment. Traders holding these forex contracts as capital assets may file an internal contemporaneous “capital gains election” pursuant to IRC § 988(a)(1)(B) to opt out of section 988 and into capital gains and loss treatment. If such an election is made, then for forex forwards — and forward-like forex contracts, including spot forex in some cases — taxpayers may use Section 1256(g) (foreign currency contract) treatment, providing it’s in major currencies for which regulated futures contracts trade on U.S. futures exchanges, and the taxpayer does not take or make delivery of the underlying currency. See Treas. Reg. § 1.988-3(b).

Section 988 reports realized gains and losses only, whereas Section 1256(g) reports realized, plus mark-to-market unrealized gains and loss treatment at year-end, too. Section 988 is ordinary gain or loss treatment, whereas Section 1256(g) has lower 60/40 tax rates, with 60% a long-term capital gain, and 40% short-term capital gain treatment.

Taxpayer did not file an internal opt-out election from Section 988, and therefore he must report using the default Section 988 ordinary gain or loss treatment for realized gains or losses, only. If the taxpayer is an investor, he reports that ordinary gain or loss on line 21 of Form 1040 (Other Income or Loss). If the taxpayer qualifies for trader tax status (business treatment), he reports the Section 988 ordinary gain or loss on Form 4797, Part II ordinary gain or loss.

In order for the IRS to match the 1099 filed to taxpayer’s return, we report the Form 1099 (for 1256 contracts) on Form 6781 Part I, and next, we zero the same amount out off of Form 6781, so we can transfer the amount to the correct form and line of the tax return. Forex is reported in summary fashion, not line-by-line fashion as done for securities. The amount we transfer to the correct form and line is the realized gain or loss, only. Only Form 6781 includes year-end unrealized gains and losses too on a mark-to-market basis.

Bottom line
1099 issuance rules have always been confusing and misunderstood by taxpayers. When you receive a W-2, you simply report the tax information provided. It’s rare to find errors. Conversely, when you receive a Form 1099 from a broker or bank, you should not just report what’s displayed. You need to consider your own facts, circumstances and tax-treatment elections to report your correct taxable income, loss and expense. This year, securities traders face a barrage of problems with new IRS cost-basis reporting rules for 1099-B issuers. We are finding huge problems on these 1099s. (See our earlier blogs on this.) When it comes to taxes, take the control away from your broker and consult a trader tax expert when needed.

Are Lower 60/40 Tax Rates On Futures In Jeopardy?

July 12, 2011 | By: Robert A. Green, CPA

Forbes

Hey Mr. President, Traders Need Tax Breaks Too

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 suggested adding 60/40 futures tax rates to the list of tax loopholes being bandied about by the President and Democrats in connection with the contentious debt-ceiling debate. Conversely, I’m in the Republican camp on taxes — I don’t want tax hikes now, but I support meaningful tax reform efforts. 

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, which showed that 80 percent of trading volumes 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 has his sights on tax expenditures and special tax breaks for “those that can afford it” including hedge fund managers, oil companies and private-jet manufacturers. Is the President going to include commodities exchanges and futures traders on that list too?

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. 

Republicans say they won’t budge on tax hikes unless it’s part of Deficit Commission tax reform, with corresponding rate reduction. Will 60/40 tax breaks face the chopping block in that debate? President Obama included repeal of lower 60/40 tax rates for dealers only in his last two budgets. To date, Congress did not include those provisions in any tax bill and it has not been enacted. I covered this on my blog in 2009 .

Back to Mr. Sorkin’s NYT article
After our call, I sent him Green’s 2011 Trader Tax Guide and included this note. 

• I don’t see how President Obama can justify keeping lower 60/40 tax rates to benefit futures traders and commodities exchanges in his home state while pushing hard to raise taxes on securities hedge-fund managers often in Connecticut and New York City. Many securities hedge-fund managers don’t receive carried interest tax breaks with lower 15 percent long-term capital gains tax rates because they mostly generate short-term capital gains taxed at higher ordinary tax rates. Repealing carried interest also subjects the income to self-employment taxes. 

• I think your story could cause a firestorm. We could be witnessing the first preparations for a broadside against lower 60/40 tax rates for futures traders. It will be very interesting to see the politics on this one as they are counter-intuitive with this tax break being a little to close to Chicago’s Democratic stronghold. 

Mr. Sorkin concluded that futures traders are getting a special hard-to-defend tax break.

I told Mr. Sorkin the history of 60/40
President Reagan’s major tax reform in the early 80s to reduce sky-high tax rates was a similar debate. Repeal tax expenditures and tax shelters as a trade-off to lower tax rates. Professional commodities traders were gaming/avoiding the tax system badly. They put on long and short trades at the same time and closed out losing trades before year-end, while deferring profitable trades and related taxes to subsequent years. Many never paid taxes and yet made a fortune. 

Congress said the jig was up and enacted mark-to-market (MTM) accounting, an economic system to report both realized and unrealized gains and losses at year-end. Chairman of Ways & Means Dan Rostenkowski (D-Ill.) saved the day for his local commodities traders and campaign contributors. Rostenkowski may have asked: how can commodities traders receive a long-term capital gains rate — which requires a 12-month holding period — if they have to mark to market before year-end? In that case, every trade is short-term and taxed at higher ordinary income tax rates. The horse trading commenced and no one was better at it than Rostenkowski. Traders probably had 80 percent short-term trading at that time, so it should have been a 20/80 blended rate. Rostenkowski negotiated 60 percent long-term for his loyal constituents.

Futures traders are sometimes worse off 
Having to pay taxes on unrealized gains is a burden when traders wind up with realized losses on those same exact positions. An unrealized gain on Dec. 31 can melt away quickly in January. To counter this, the Section 1256 election allows futures traders to carry back futures tax losses three tax years, but only applied against futures tax gains. Often futures traders overlook this election, or they don’t have sufficient futures gains in earlier years. 

There’s other collateral tax damage too. Those with memberships on futures or options exchanges are subject to self-employment (SE) taxes (social security and Medicare) on their trading gains too (Section 1402i); other types of traders are exempt from SE taxes. SE taxes on the SE base are currently 15.3 percent. Adding that amount to the 23 percent current blended income tax rate equals 38.3 percent.

Traders are the lifeblood of markets
As I pointed out vigorously in our blog “Financial-Transactions Tax Update”, business traders are the infrastructure — the “market-makers” — of the financial markets and without their liquidity, we could all face a “flash crash” at any given moment. Farmers, retail investors, mutual funds, pension funds, and small and large businesses use the futures markets to hedge their positions, and they need a properly functioning futures market at all times. Yes traders are being unfairly attacked on all fronts — FTT, futures tax rates, Dodd-Frank Fin Reg and more. 

The $3,000 capital loss limitation
For individuals — including those using pass-through entities — net capital losses are limited to $3,000 per year, and that puny loss limitation has never been indexed for inflation. Most other clauses in the tax code are indexed, like the AMT patch each year, tax brackets, credits, standard deductions and more. 

Business traders are unfairly lumped with investors and forced to suffer through capital loss limitations and wash sale loss deferrals. Congress designed these “tax sticks” to help offset the “tax carrot” of lower long-term capital gains tax rates. But, business and active traders rarely benefit from lower long-term capital gains rates. 

Give all business traders 60/40 rates
It’s not fair to call the futures 60/40 split a tax loophole. In fact, Congress should allow securities traders the same split rates too. If not, then allow all business traders to use business ordinary loss treatment without limitation by default. Securities traders are caught between a rock and a hard place, with the $3,000 capital loss limitation and the highest ordinary rates.

Will the President add 60/40 to his list of undue tax breaks?
Now that Mr. Sorkin and some in Congress have added futures tax rates to their list of tax loopholes, I wonder if President Obama will take their bait. Doing so will surely awaken the ire of Chicago commodities exchanges and generate heat on Illinois politicians. 

This is not the first broadside against futures tax rates. In 2003, during the eleventh hour of the Bush Tax Cut conferee negotiations between the Senate and House bills, a few Democratic senators tried to repeal 60/40 tax rates. The public never witnessed this broadside, but the Chicago exchanges cried foul and the House didn’t yield, thereby safeguarding 60/40. As we face the end of the Bush-era tax cuts, why revisit this issue again?

If the President doesn’t include futures traders on his list of “undue tax breaks” what does that tell you? That either he doesn’t agree, or he doesn’t want to upset his hometown exchanges and fellow politicians. Would that put Democrats on a potential hypocritical attack on carried interest and the Bush tax cuts for the upper income? One fear is the President might seek to repeal many tax breaks as a trade-off for keeping the Bush-era tax rates for all taxpayers, including the upper-income. That’s not much of a rate reduction and it will represent a huge tax hike for futures traders.

In the end, I like Deficit Commission tax reform ideas with a low 23 percent rate for everyone and business tax deductions safeguarded. As you can see, tax change is a difficult and nuanced undertaking and significant tax reform will take some time.