March 17, 2021: Tax Day for individuals extended to May 17: Treasury, IRS extend filing and payment deadline. “The Treasury Department and Internal Revenue Service announced today that the federal income tax filing due date for individuals for the 2020 tax year will be automatically extended from April 15, 2021, to May 17, 2021. The IRS will be providing formal guidance in the coming days. Individual taxpayers can also postpone federal income tax payments for the 2020 tax year due on April 15, 2021, to May 17, 2021, without penalties and interest, regardless of the amount owed. This relief does not apply to (2021) estimated tax payments that are due on April 15, 2021. The IRS urges taxpayers to check with their state tax agencies for those details.” (IRS Issue Number: IR-2021-59). Intuit: State Tax Deadline Updates. The postponement does not apply to C-Corps, trusts, and estates.
March 29, 2021: The good news is the 475 election is due May 17, 2021, with the 2020 tax return or extension. The IRS issued formal guidance Notice 2021-21, “Relief For Form 1040 Filers Affected By Ongoing Coronavirus Disease 2019 Pandemic.” The IRS notice states, “Finally, elections that are made or required to be made on a timely filed Form 1040 series (or attachment to such form) will be timely made if filed on such form or attachment, as appropriate, on or before May 17, 2021.” The IRS notice also postponed the 2020 IRA and HSA contribution tax deadline to May 17, 2021.
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Even though it’s too late to elect Section 475 MTM for tax-year 2020, the opportunity for 2021 is available now. In this blog post, I will cover the scenarios that make it prudent to obtain Section 475 for tax-year 2021 and how to make the election.
Before I dive in, let’s review the deadlines, because they are approaching rapidly. Traders eligible for trader tax status (TTS) can elect 2021 Section 475 MTM on securities and/or commodities by April 15, 2021, for individuals and March 15, 2021, for partnerships and S-Corps. (The IRS postponed the April 15, 2021 tax deadline until June 15, 2021, for residents of Texas,Oklahoma, and Louisiana, after a federal disaster declaration in February 2021 due to winter storms. This postponement also applies to the Section 475 election. The delay includes various 2020 business returns due on March 15 like partnerships and S-Corps.)
Why is Section 475 so attractive? It exempts securities trades from wash sale loss adjustments and the capital-loss limitation against other income; which is what I call “tax-loss insurance.” Profitable TTS/475 traders are eligible for the 20% qualified business income (QBI) deduction if under the QBI taxable income threshold (see below). Who should make the Section 475 election? Capital gains are needed to absorb capital losses, so if you have capital loss carryovers or significant unrealized capital losses on segregated investment positions, the MTM election would be a gamble. If a TTS trader has new trading losses in 2021 YTD before the election deadline, then a 2021 Section 475 MTM election is generally preferred since it allows ordinary loss treatment and does not add to capital loss carryovers.
Existing Individuals and Entities
To make the election, simply write this statement on a sheet of paper with your name and social security number (or entity EIN) up top.
“Under IRC 475(f), the Taxpayer at this moment elects to adopt the mark-to-market method of accounting for the tax year ended December 31, 2021, and subsequent tax years. The election applies to the following trade or business: Trader in Securities as a sole proprietor (for securities and not Section 1256 contracts).”
Attach the 475 election statement to your 2020 tax return or extension. (See Tips For Traders: Preparing 2020 Tax Returns, Extensions, and 475 Elections.) If you plan to e-file your 2020 tax return or extension, but cannot include the 475 election statement in the e-filing, then submit the 475 election statement with a cover letter to the IRS before the 2020 tax deadline.
If you want to apply Section 475 to 1256 contracts, revise the statement to include commodities. (Generally, retaining lower 60/40 capital gains rates on 1256 contracts is the better choice.)
The election statement is just the first part of the process — and the most crucial part. You also have to file a timely 2021 Form 3115 with your 2021 tax return in 2022 and fax a duplicative copy to the IRS.
You can revoke a Section 475 election by the due dates in a mirror process. Section 475 MTM does not apply to duly segregated investment positions (more on that below).
New Entities
The 475 election process is different for a new taxpayer, a newly formed entity, or first-time individual tax return filer. You must place the statement below in your books and records within 75 days of your new entity’s inception (new LLC/partnership or S-Corp). It’s safest to use the date you obtained the employer identification number (EIN).
“Under IRC 475(f), the Taxpayer at this moment elects to adopt the mark-to-market method of accounting for the tax year ended December 31, 2021, and subsequent tax years. The election applies to the following trade or business: Trader in Securities as an entity (for securities only and not Section 1256 contracts).”
A new taxpayer does not need to file a Form 3115 for an internal Section 475 MTM election. The new entity adopts the 475 MTM accounting method from inception.
If you want to include Section 1256 contracts in the 475 election, then revise the election statement to include “commodities” (Section 1256 contracts). This action is wise if you have significant losses in the first 75 days in these contracts.
20% Deduction on Qualified Business Income
The Tax Cuts and Jobs Act of 2017 introduced a new tax deduction for pass-through businesses, including sole proprietors, partnerships, and S-Corps. Subject to haircuts and limitations, a pass-through business could be eligible for a 20% deduction on qualified business income (QBI).
Traders eligible for TTS are considered a “specified service activity,” which means if their taxable income is above an income cap, they won’t receive a QBI deduction. The taxable income (TI) cap is $426,600/$213,300 (married/other taxpayers) for 2020, and $429,800/$214,900 (married/other taxpayers) for 2021. The phase-out range below the cap is $100,000/$50,000 (married/other taxpayers). The W-2 wage and property basis limitations also apply within the phase-out range. Investment managers are specified service activities, too.
QBI for traders includes Section 475 ordinary income and loss and trading business expenses. QBI excludes capital gains and losses, Section 988 forex ordinary income or loss, dividends, and interest income.
TCJA favors non-service businesses, which are not subject to an income cap. The W-2 wage and property basis limitations apply above the TI threshold of $326,600/$163,300 (married/other taxpayers) for 2020 and $329,800/$164,900 (married/other taxpayers) for 2021. The IRS adjusts the annual TI threshold for inflation each year.
Sole proprietor TTS traders cannot pay themselves wages, so they likely cannot use the phase-out range, and the threshold is their cap.
Segregation of Investments
Suppose a trader holds investment positions in equities and trades substantially identical securities positions in equities or equity options using TTS and Section 475. The IRS could recharacterize trades as investments, or vice versa, whichever suits them best. For example, the IRS could reclassify an investment position in Apple equity currently deferred for long-term capital gains into Section 475 MTM ordinary income at year-end. Alternatively, the IRS could recharacterize Section 475 MTM ordinary losses on Apple options as capital losses triggering a $3,000 capital-loss limitation.
Traders with overlap between investing and trading activity should consider ringfencing TTS/475 trading into an entity and conducting their investment activity on the individual level. That solution would fix the potential IRS problem.
Here’s an example: Joe owns an investment portfolio of equities. He leverages his investments using portfolio margining to trade equity options around those investment positions to manage risk on the portfolio and collect option premium. Joe is not selling naked options because he holds equity investments and trades in the same brokerage account. Joe needs to choose between using Section 475 or portfolio margining.
475 Fixes Wash Sales With IRAs For TTS Trades
If there is an overlap in securities traded in taxable accounts vs. what’s invested in IRAs, the trader has to avoid triggering permanent wash-sale losses throughout the year. If a trader takes a loss in a taxable account and buys back a substantially identical securities position 30 days before or after in an IRA account, the loss becomes permanent.
Traders can fix this problem with a “do not invest” list to avoid such overlap. One strategy is to trade equities and equity options in taxable accounts and invest in ETFs, mutual funds, and REITs in IRAs.
TTS traders can make a Section 475 election to do away with wash sales between trades and the IRAs, so overlap is not a problem.
Consider all IRA accounts for married filing joint, including traditional IRAs, Roth IRAs, rollover IRAs, and SEP IRAs. Don’t include qualified plans like 401(k) or solo 401(k) plans.
Most traders are not aware of the nuances of triggering permanent wash sales between taxable and IRA accounts. IRS rules for broker-issued 1099-Bs have a narrow view of wash sales; they call for wash-sale loss adjustments on “identical symbols” for the one account. Conversely, IRS wash sale rules for taxpayers have a broader view: Calculate wash sales on “substantially identical positions” (between equities and equity options) on all individual brokerage accounts, including IRAs. Consider using trade accounting software that’s compliant with IRS wash-sale rules for taxpayers.
Examples
Joe Trader has a $100,000 Q1 2021 trading loss in securities, and he elects Section 475 by April 15, 2021, to offset the ordinary loss against wage income of $150,000. Without the election, Joe would have a $3,000 capital loss limitation against wages and a $97,000 capital loss carryover to 2022. Instead, he used his full trading loss in 2021.
Nancy Trader has a $50,000 Q1 2021 trading gain and annual wages of $60,000. She might be eligible to receive a QBI deduction of $10,000 (20% x $50,000 QBI 475 net income).
Section 475 is a consequential election for TTS traders with many advantages but consider your circumstances and the nuances first. We cover various Section 475 scenarios and more in-depth information on 475 elections in Green’s 2021 Trader Tax Guide (see Chapter 2 on MTM).
March 1, 2021 | By: Robert A. Green, CPA
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March 17, 2021: Tax Day for individuals extended to May 17: Treasury, IRS extend filing and payment deadline. “The Treasury Department and Internal Revenue Service announced today that the federal income tax filing due date for individuals for the 2020 tax year will be automatically extended from April 15, 2021, to May 17, 2021. The IRS will be providing formal guidance in the coming days. Individual taxpayers can also postpone federal income tax payments for the 2020 tax year due on April 15, 2021, to May 17, 2021, without penalties and interest, regardless of the amount owed. This relief does not apply to (2021) estimated tax payments that are due on April 15, 2021. The IRS urges taxpayers to check with their state tax agencies for those details.” (IRS Issue Number: IR-2021-59). Intuit: State Tax Deadline Updates. The postponement does not apply to C-Corps, trusts, and estates.
March 29, 2021: The good news is the 475 election is due May 17, 2021, with the 2020 tax return or extension. The IRS issued formal guidance Notice 2021-21, “Relief For Form 1040 Filers Affected By Ongoing Coronavirus Disease 2019 Pandemic.” The IRS notice states, “Finally, elections that are made or required to be made on a timely filed Form 1040 series (or attachment to such form) will be timely made if filed on such form or attachment, as appropriate, on or before May 17, 2021.” The IRS notice also postponed the 2020 IRA and HSA contribution tax deadline to May 17, 2021.
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Traders use various tax forms as the IRS hasn’t created specialized tax forms for individual trading businesses. Traders enter gains and losses, portfolio income, and business expenses on different forms. It’s often confusing. Which form should forex traders use? Which form is correct for securities traders using the Section 475 MTM method? Can one report trading gains directly on a Schedule C? The different reporting strategies for various types of traders make tax time not so cut-and-dry.
Sole Proprietor Trading Business
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. Our golden rules require four trades per day, close to four days per week, and an average holding period under 31 days. See all the requirements at Trader Tax Status: How To Qualify.
If a trader qualifies for TTS, he can claim some tax breaks after the fact (such as business expense treatment) and elect and set up other benefits (such as Section 475 MTM and employee-benefit plans) on a timely basis. You can assess and claim TTS business expense deductions for all or part of 2020.
Other sole-proprietorship businesses report revenue, cost of goods sold, and expenses on Schedule C. But TTS business traders report only trading business expenses on Schedule C. Trading gains and losses are reported on various forms, depending on the situation.
Trading Gains and Losses
Sales of securities must be first reported (line by line) on Form 8949 based on the realization method with cost basis adjustments, including wash sale (WS) losses. Form 8949 then feeds into Schedule D short-term capital gains using the ordinary tax rate and long-term capital gains for securities held 12 months using the lower capital gains rate. Capital losses offset capital gains in full, and net capital losses are limited to $3,000 per year against ordinary income (the rest is a capital loss carryover to subsequent years).
Some brokers provide Form 8949 in addition to Form 1099-B. Consider using trade accounting software to calculate WS loss adjustments. See Form 8949 & 1099-B Issues.
TTS traders who use Section 475 MTM accounting on securities report their TTS trades (line by line) on Form 4797 Part II. “MTM” means open positions are marked-to-market at year-end. Form 4797 Part II has business ordinary loss treatment and avoids the capital loss limitation and wash-sale loss adjustments. Form 4797 losses are included in net operating loss (NOL) calculations. Consider using trade accounting software to generate Form 4797 for Section 475 trades. Without wash sale losses, the trader will be departing from the 1099-B and should explain that in a tax return footnote.
Section 1256 contracts (i.e., regulated futures contracts) use MTM accounting and are reported on Form 6781 (unless the TTS trader elected Section 475 for commodities/futures; in that case Form 4797 is used). Section 1256 traders rely on a one-page Form 1099-B showing their net trading gain or loss (“aggregate profit or loss on contracts”). They may simply enter that amount in summary form on Form 6781 Part I. There are no wash-sale losses on 1256 contracts.
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, the blended 60/40 rate is 26.8% — 10.2% lower than the highest ordinary rate of 37%. See Section 1256 Contracts.
If the trader had a significant Section 1256 loss in 2020, she should consider carrying back those losses three tax years but only apply against Section 1256 gains in those years. To obtain this election, check box D labeled “Net section 1256 contracts loss election” on the top of Form 6781. You can make this election with a tax return filed on time, including extensions. Forex traded in the Interbank market uses Section 988 ordinary gain or loss treatment. Forex traders who don’t qualify for TTS should use line 8 (other income or loss) on 2020 Schedule 1 (Form 1040). TTS forex traders should use Form 4797, Part II ordinary gain or loss. What’s the difference? Form 4797 Part II losses contribute to NOL carryforwards against any type of income, whereas Form 1040’s “other losses” do not. The latter is wasted if the taxpayer has a negative income.
In that case, a contemporaneous forex capital gains election is better on the Section 988 trades. If the taxpayer filed the Section 988 opt-out (capital gains) election, she should use Form 8949 for minor currencies and Form 6781 for major currencies. Forex uses summary reporting. See Forex.
Selling, exchanging, or using cryptocurrency triggers capital gains and losses. The IRS treats cryptocurrencies as intangible property. The realization method applies to short-term vs. long-term capital gains and losses, and there is no WS or 475 on intangible property. Report a capital gain or loss on each transaction, including cryptocurrency-to-currency sales, crypto-to-crypto trades, and purchases of goods or services using crypto. Answer the IRS question about cryptocurrency on the 2020 Form 1040 page 1 up top.
TTS allows a trader to add a Schedule C to deduct business expenses, including these items:
“Tangible personal property” up to $2,500 per item for equipment and furniture.
Section 179 (100%) depreciation on fixed assets. Otherwise, bonus and regular depreciation.
Amortization of start-up costs (Section 195), organization costs (Section 248), and software.
Education expenses paid and courses taken after the commencement of TTS. Otherwise, pre-business education may not be deductible. (Alternatively, include pre-business education in Section 195 start-up costs.)
Subscriptions, scanners, publications, market data, professional services, chat rooms, mentors, coaches, supplies, phone, travel, seminars, conferences, assistants, and consultants.
Home-office expenses for the business portion of the home.
Margin interest expenses.
Stock-borrow fees for short-sellers.
Internal-use software for self-created automated trading systems.
Home office (HO) expenses are first reported on Form 8829. HO is one of the most significant tax deductions for traders. It requires trading gains to unlock most of the deduction; mortgage interest and real estate tax portions of HO do not require income.
When commencing TTS, look back six months to capitalize Section 195 start-up costs, including trading education expenses. The trader can expense (amortize) up to $5,000 in the first year and the balance over 15 years.
Make Schedule C Look Better
The IRS may view a trading business’s Schedule C as unprofitable even if it has significant net trading gains on other forms and is profitable after expenses.
To mitigate this red flag, transfer a portion of business trading gains to Schedule C “Other Income” (not revenue) to zero the expenses out but not show a net profit. Showing a profit could cause the IRS to inquire about self-employment (SE) tax on self-employment income (SEI). Trading expenses reduce SEI, but trading gains and losses are not SEI. Learn how to do this transfer strategy in Green’s 2021 Trader Tax Guide.
Section 475 MTM Accounting
Only TTS traders can elect and use Section 475, not investors. Section 475 trades are exempt from WS loss adjustments on securities. Section 475 ordinary losses are also not subject to the $3,000 capital loss limitation against ordinary income. Section 475 losses and TTS expenses contribute to net operating losses (NOLs). Hence our phrase “tax loss insurance.”
We usually recommend a Section 475 election on securities only to retain lower 60/40 capital gains rates on Section 1256 contracts (commodities).
Profitable traders might also benefit from Section 475. TCJA introduced a 20% deduction on qualified business income (QBI) in pass-through businesses, and TTS traders with 475 elections are eligible for the deduction. QBI includes Section 475 income less TTS expenses. However, QBI excludes capital gains and other portfolio income. TTS traders are a “specified service activity,” which means if their taxable income is above an income cap, they won’t receive a QBI deduction. The 2020 taxable income (TI) cap is $426,600/$213,300 (married/other taxpayers). The phase-out range below the cap is $100,000/$50,000 (married/other taxpayers). The W-2 wage and property basis limitations also apply within the phase-out range. Use Form 8995 or Form 8995-A for QBI deductions.
Section 475 Election Procedures
To obtain Section 475 as an individual, you must file a 2021 Section 475 election statement with your 2020 tax return or extension due by April 15, 2021. Existing partnerships and S-Corps must file a Section 475 election statement by March 15, 2021.
“New taxpayers” like new entities file an internal Section 475 MTM election resolution within 75 days of inception.
Traders who filed a 475 election for 2020 on time (by July 15, 2020, for individuals) must complete the process by sending a Form 3115 with the 2020 tax return and a duplicate to the national office.
Learn more about Section 475, the pros, cons, and nuances in Green’s 2021 Trader Tax Guide. The guide includes the election statement to use with your filing.
Tax Extensions
The 2020 income tax returns for individuals are due by April 15, 2021 — however, most active traders aren’t ready to file a complete tax return by then. Some brokers issue corrected 1099-Bs right up to the deadline or even beyond. Many partnerships and S-Corps file extensions by March 15, 2021, and don’t issue final Schedule K-1s to investors until after April 15.
The excellent news is traders don’t have to rush the completion of their tax returns by April 15. They may want to consider sending a one-page automatic extension along with payment of taxes owed to the IRS and state.
The IRS postponed the April 15, 2021 tax deadline until June 15, 2021, for residents of Texas,Oklahoma, and Louisiana, after a federal disaster declaration in February 2021 due to winter storms. This postponement also applies to the Section 475 election. The delay includes various 2020 business returns due on March 15 like partnerships and S-Corps.
Traders can request an automatic six-month extension on Form 4868 to file their federal income tax return by Oct. 15, 2021. States also provide tax extensions, with some states accepting the federal election; however, if the taxpayer owes state taxes, a state tax voucher/extension form is required.
The Form 4868 instructions point out how easy it is to get this automatic extension — no reason is required. It’s an extension of time to file a complete tax return, not an extension of time to pay taxes owed. The taxpayer should estimate and report what he thinks he owes for 2020 based on his received tax information.
See how the IRS assesses late-filing penalties and late-payment penalties on page two of Form 4868. If a taxpayer cannot pay the taxes owed, he should estimate the balance due by April 15 and report it on the extension.
Even if a taxpayer cannot pay the balance due, he should at least file Form 4868 by April 15, 2021. Merely filing the extension will avoid the late-filing penalties of 5% per month up to 25%, which are 10 times higher than the late-payment penalty of 0.5% per month up to 25%. The IRS charges interest, too.
Many traders made massive trading gains in 2020 with an explosion of new pandemic-fueled traders and market volatility. Some used the estimated tax payment “safe harbor” exception to cover their 2019 tax liability with a Q4 2020 estimated tax payment made by Jan. 15, 2021. They plan to pay the balance of taxes owed by April 15, 2021. They should consider setting aside and protecting those tax payments. See Traders Should Focus On Q4 Estimated Taxes Due January 15.
Some traders will risk those 2020 tax payments in the markets right up to the deadline, and they should be careful not to lose them because that will cause significant tax trouble with the IRS and state.
Partnerships and S-Corps
The 2020 partnership and S-Corp tax extensions are due March 15, 2021. They are easy to prepare since they pass income and loss to the owner, usually an individual. Generally, pass-through entities are tax-filers but not taxpayers.
S-Corps and partnerships use Form 7004 (Application for Automatic Extension of Time To File Certain Business Income Tax, Information, and Other Returns). Extensions give six additional months to file a federal tax return — by Sept. 15, 2021. Your must file the partnership or S-Corp extension on time. Otherwise, late-filing penalties apply $210 per month per owner up to 12 months. See the Form 1065 and 1120S instructions for further details about penalties.
Some states require a state extension, whereas others accept a federal extension. Some states have S-Corp franchise taxes, excise taxes, minimum taxes, and payments usually due to the extensions by March 15. LLCs filing as partnerships may have minimum taxes or annual reports due to the extension by March 15. States assess penalties and interest, often based on payments due.
Recent Tax Law Changes
The 2017 Tax Cuts And Jobs Act (TCJA) introduced an “excess business loss” limitation: $500,000 married and $250,000 other taxpayers for 2018, and it’s indexed for inflation each year. Business losses exceeding the EBL limitation are a NOL carryforward. TCJA also suspended NOL carrybacks, allowing NOL carryforwards with 80% limits against subsequent year’s taxable income. The rest carries forward indefinitely.
The 2020 CARES Act provided temporary tax relief: It suspended TCJA’s EBL rules for 2018 through 2020 and allowed five-year NOL carrybacks for 2018, 2019, and 2020. TCJA EBL and NOL rules apply again in 2021.
We expect tax legislation in 2021 that impacts traders, so stay tuned to our blog post for updates.
Takeaway
Traders should focus on the big picture of filing a 2020 automatic extension by the April 15, 2021 deadline. With or without sufficient payment of taxes, filing the extension avoids the late-filing penalty of 5% per month, assessed on the tax balance due. Try to pay 90% of the tax liability to avoid the late-payment penalty of 0.5% per month. Traders unsure of TTS qualification can leave out Schedule C trading expenses from the tax liability calculations used for the extension filing and settle that issue before filing the complete tax return later. The most important issue might be a 2021 Section 475 election due with the 2020 extension by April 15, 2021, for individuals, and March 15, 2021, for partnerships and S-Corps. Overpaying the extension payment is wise for profitable traders to apply the overpayment credit towards 2021 quarterly estimated taxes. It also leaves a cushion on 2020 taxes.
November 11, 2020 | By: Robert A. Green, CPA
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Year-end tax planning for traders varies based on eligibility for trader tax status (TTS) in 2020 and 2021. There are different strategies to consider for investors, TTS traders using the capital gains method, and TTS traders using Section 475 MTM ordinary gain and loss treatment.
In this blog post, I examine all three groups and touch on the topics of new traders, S-Corps for employee benefits, Roth IRA conversions, and navigating the SALT cap.
Investors The 2017 Tax Cuts And Jobs Act (TCJA) suspended investment fees and expenses for investors, and the 2020 Coronavirus Aid, Relief, and Economic Security (CARES) Act did not change that. After TCJA, the only itemized deductions for investors are margin interest expense limited to investment income and stock-borrow fees. TCJA roughly doubled the standard deduction: with an inflation adjustment for 2020, it’s $24,800 married, $12,400 single, and $18,650 head of household. TCJA’s $10,000 cap on state and local taxes (SALT) leads many taxpayers to use the standard deduction.
TTS traders are better off; they deduct trading business expenses, startup costs, and home office expenses from gross income (Schedule C for sole proprietors). Brokerage commissions are transaction costs deducted from trading gains or losses; they are not separate expenses.
In 2020 with Covid-19 stay-at-home orders and remote work, many new traders entered the markets. Some achieved TTS for a partial year in 2020, whereas others won’t qualify until 2021. If your TTS commences in January 2021, you can capitalize on some hardware, software, and other intangible costs incurred in 2020 for depreciation and amortization expense with TTS’s commencement in early 2021. For example, computers, monitors, and home office furniture contribute to these costs at fair market value for TTS expensing in 2021. Some expenses like subscriptions, education, and software can be capitalized as Section 195 startup costs. Section 195 allows expensing up to $5,000 in 2021, with the rest deducted straight-line over 15 years. We allow TTS traders to go back six months before TTS inception for Section 195 costs and even further back for hardware costs.
Investors and TTS traders using the default realization method (not Section 475 MTM) should consider “tax-loss selling” before year-end to reduce capital gains income and the related tax liability. However, be careful to avoid wash-sale loss adjustments on securities at year-end 2020, which defer the tax loss to 2021. For example, suppose you realize a capital loss on Dec. 15, 2020, in Exxon and repurchase a substantially identical position (Exxon stock or option) 30 days before or after that date. In that case, it’s a wash-sale (WS) loss adjustment. The WS loss defers to 2021 when it is added to the replacement position’s cost basis. The rules are different for brokers vs. taxpayers, so avoid permanent WS between taxable and IRA accounts. Section 1256 contracts have MTM by default, so WS is a moot point on futures. (See more on WS on our website.)
If you expect a net capital loss for 2020 over the $3,000 capital loss limitation against other income, then you’ll have a capital loss carryover (CLCO) to 2021 and subsequent years. You can use up a CLCO with capital gains in the following years. For example, if your CLCO is $25,000 going into 2021, and you have 2021 capital gains of $30,000, then you’ll have $5,000 of net capital gains for 2021.
If you incur a significant capital loss in Section 1256 contracts, consider a 1256 loss carryback election made on Form 6781 filed with your 2020 tax return. That allows you to amend the prior three-year tax returns to apply the 1256 loss against 1256 gains only.
If your 2020 taxable income is considerably under the capital gains tax bracket of $80,000 for married and $40,000 for unmarried individuals, then your long-term capital gains (LTCG) tax rate is 0%. For example, assume your taxable married-filing-joint income is $50,000 as of late December 2020. You can sell investments held over 12 months with up to $30,000 of capital gains at a 0% tax rate. Don’t cut it too close, though: If your taxable income is $80,500, it will trigger the 15% rate on all LTCG. The 0% rate applies to Section 1256 contracts: 60% uses the LTCG rate, and 40% the short-term rate, which is the ordinary rate.
There is also the Affordable Care Act (ACA) 3.8% net investment tax (NIT) on net investment income (NII) for upper-income taxpayers with modified AGI above $250,000 married and $200,000 single. Tax-loss selling and other deductions lower AGI and NII, which can help avoid or reduce NIT.
President-elect Joe Biden’s Tax Plan proposed raising the top LTCG rate of 20% to a maximum ordinary rate of 39.6% (up from 37%), applying only to taxpayers with income over $1 million. Passing Biden’s tax plan will be difficult if the Senate remains under Republican control.
Traders who have massive trading gains in 2020 should focus on 2020 Q4 estimated taxes due Jan. 15, 2021. Using the safe-harbor exception to cover 2019 tax liabilities, some traders can defer much of their tax payments to April 15, 2021. Just don’t lose the tax money in the markets in Q1 2021; consider setting it aside. (See Traders Should Focus On Q4 Estimated Taxes Due January 15.)
Traders eligible for TTS If a trader qualifies for TTS in 2020, he or she can deduct trading business expenses, startup costs, and home-office expenses. The trader did not have to elect TTS or create an entity. (Section 475 requires a timely election.) It’s okay to commence TTS during the year, although we prefer not later than Sept. 30; otherwise, the IRS could challenge TTS for Q4 or less. (See How To Be Eligible For Substantial Tax Savings As A Trader.)
TTS traders planning to upgrade computers and other expenses should consider accelerating business expenses before year-end. New equipment and furniture need be purchased and put to use before year-end. TCJA mostly provides full expensing with tangible property expense up to $2,500 per item, Section 179 (100%) depreciation, or bonus depreciation.
TTS traders with Section 475 MTM TTS traders using section 475 mark-to-market (MTM) accounting report ordinary gains or losses on Form 4797. Section 475 trades are not subject to WS or a capital-loss limitation so that an ordinary loss can offset income of any kind. MTM reports unrealized gains and losses at year-end, so the taxpayer doesn’t have to do tax-loss selling on TTS trading positions.
Many TTS traders also have segregated investment positions, so they should consider WS and tax-loss selling on investment positions. Investments are not subject to Section 475, meaning you can defer capital gains and achieve the LTCG rate on investment positions if held 12 months. If you trade in substantially identical positions that you also invest in, the IRS can attempt to recharacterize TTS trades vs. investments. Avoid that issue by considering a TTS LLC/partnership or TTS LLC/S-Corp for 2021 to ring-fence trading positions.
If you have significant Section 475 ordinary losses for 2020, the CARES Act provides substantial relief. The CARES Act allows a five-year net operating loss (NOL) carryback applied against income of any kind. CARES also temporarily reversed TCJA’s “excess business loss” (EBL) limitation of $500,000 married and $250,000 for other taxpayers (2018 limits and adjusted each year for inflation). Under TCJA, you have to add EBL amounts to NOL carryforwards.
For example, a TTS/475 trader filing single with a $300,000 ordinary loss and $25,000 TTS expenses would have a 2020 NOL of approximately $325,000. The $250,000 EBL limitation does not apply. This trader can carry back the 2020 NOL five years and use it against any type of income. Alternatively, if preferred, the taxpayer can elect to carry it forward instead. TCJA NOL rules apply again in 2021, limiting NOLs to 80% of taxable income with the remainder carried over to subsequent years. Under its latest Covid-19 relief bills, the House proposed revising the NOL and EBL rules, reapplying EBL to all years, and limiting the number of NOL carryback years. Many taxpayers already filed NOL carryback returns under CARES, so it’s hard to reverse those rules now.
If a TTS trader has significant TTS/475 income, they might be eligible for a 20% “qualified business income” (QBI) deduction. Sole proprietors only get this QBI deduction if they are under the QBI taxable income threshold of $326,600 married and $163,300 for other taxpayers (2020 threshold adjusted for inflation). Determine the QBI deduction on the lower of taxable income or QBI. Suppose you have a TTS S-Corp with officer compensation. In that case, there is also a phase-out/phase-in range based on wages and qualified property for an additional $100,000 married and $50,000 other taxpayers.
New traders No matter when you started trading, you can claim TTS eligibility and add a Schedule C for the TTS expense deductions for all or part of the year. (See Will The IRS Deny Tax Benefits To Traders Due To Covid?)
It’s now too late in 2020 to form a new entity that can qualify for TTS, as we like to see entity trading for at least all of Q4. Instead, consider a Section 475 election for 2021, due by April 15, 2021, for individuals and March 15, 2021, for existing partnerships and S-Corps. (See Traders Elect 475 For Enormous Tax Savings.)
S-Corps for employee benefits A TTS S-Corp can unlock officer health insurance (HI) and retirement plan deductions using officer payroll. The insurance premium can be added to officer payroll on the W-2. That opens an AGI deduction for HI on the officer’s tax return. The officer HI compensation is not subject to payroll tax (social security and Medicare).
If profitable as of early December 2020, the S-Corp can pay additional compensation up to a maximum of $150,000 to maximize a Solo 401(k) retirement plan contribution. For 2020, it combines a 100% deductible “elective deferral” (ED) contribution of $19,500 with a 25% deductible profit-sharing plan contribution (PSP) up to a maximum of $37,500. There is also an ED “catch-up provision” of $6,500 for 2020 for taxpayers age 50 and over. Together, the maximum 2020 tax-deductible contribution is $57,000, and when including the catch-up provision, it’s $63,500. The ED portion can be a Roth, so there would be no tax deduction but permanent tax-free status. The PSP must be traditional, though.
Payroll tax includes 12.4% social security taxes but not exceeding the social security base amount of $137,700 for 2020. Medicare tax of 2.9% is unlimited without a base. The employer and employee each pay half the payroll taxes, and the employer deducts its 50% share.
Joe Biden’s tax Plan proposes to subject earned income over $400,000 to payroll taxes. Social security taxes (FICA) only apply to the SSA base amount of $137,700 for 2020 and $142,800 for 2021. Biden’s plan creates a donut hole, but it should not affect traders since they only need $150,000 of wages to maximize a Solo 401(k) retirement plan. A TTS S Corp is not subject to IRS “reasonable compensation” rules as its underlying income is unearned.
An S-Corp accountable reimbursement plan can be used to pay the officer shareholder for home-office and other employee expenses. The IRS requires reimbursement before the year-end 2020.
Partners in LLCs taxed as partnerships can deduct “unreimbursed partnership expenses” (UPE). That is how they usually deduct home office expenses. UPE is more convenient than using an S-Corp accountable plan because the partner can arrange the UPE after year-end.
Roth IRA conversions You may wish to convert a traditional IRA into a Roth IRA before the year-end. The conversion income is taxable in 2020. Avoid the 10% excise tax on early withdrawals before age 59 1⁄2 by paying the Roth conversion taxes outside the Roth plan. TCJA repealed the recharacterization option, so you can no longer reverse the conversion if the plan assets decline. Roth IRA conversions have no income limit, unlike regular Roth IRA contributions.
“More states are expected to pass laws letting businesses avoid the limit on personal tax deductions for state and local taxes, following IRS guidance approving the workaround. Already, states including New Jersey and Connecticut softened the blow of the $10,000 SALT cap with provisions for pass-through businesses like partnerships and S corporations, which are taxed normally at the owner level. The IRS said Monday in a notice that forthcoming proposed rules will allow the states’ workaround, which involves an entity-level tax that is offset by a corresponding individual income tax credit.
“The agency in 2019 killed off (T.D. 9864) a different workaround some states tried, which would have allowed state tax credits for donations made to charitable funds.”
More states might enact this workaround before the year-end 2020. Before you pay Q4 2020 estimated taxes due by Jan. 15, 2021, see if your state allows or requires your partnership or S-Corp to pay taxes for your benefit. Connecticut’s workaround law is mandatory.
Consider our 2020 tax compliance service, which includes year-end tax planning and 2020 tax return preparation. We accept new clients for our tax compliance service, providing you are a retail trader, a proprietary trader, or an investment manager. Most of our trader clients are eligible for trader tax status (TTS) benefits. We are pleased to invite traders who fall short of TTS in 2020 to use our 2020 tax compliance service. Perhaps, you will qualify for TTS in 2021 and need a 475 election then, too. By email, please request a new client evaluation (NCE).
Darren Neuschwander, CPA contributed to this blog post.
September 14, 2020 | By: Robert A. Green, CPA
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So far, 2020 has been a highly volatile year in the financial markets due to significant uncertainty over Covid-19, a shock to the economy, and job losses. As the virus spread in the U.S, millions of displaced Americans turned to trading in financial markets as a means of making a new living. Some became active enough to qualify for trader tax status (TTS) benefits, which requires regular, frequent, and continuous trading. However, will the IRS deny TTS to Covid-19 traders if they only carry on a trading business during the pandemic for a short time?
I’m not as worried about existing traders from 2019 who incurred massive trading losses in Q1 2020 during the Covid correction and stopped trading at that time. Hopefully, they made a Section 475 ordinary loss election due by the July 15, 2020 deadline, which is conditional on eligibility for TTS. These pre-Covid traders were in business for more than 15 months, so their TTS/475 ordinary loss deduction should be safe.
I am more concerned with the millions of newcomer traders who opened online trading accounts offering free or low commissions in 2020. Many rookies have significant trading gains year-to-date, even after the recent sell-off. In the trading business, gains can turn into losses with a substantial correction. When that happens, TTS traders count on Section 475 for tax-loss or fire-loss insurance: The trading house burns down, and you can file for a refund with the IRS. The CARES Act permits five-year net operating loss (NOL) carryback refund claims for 2020, 2019, and 2018 tax returns.
Some rookie traders start off meeting the IRS requirements for TTS. Those rules are vague, so see GreenTraderTax’s golden rules for TTS. I wonder how IRS agents will consider the Covid pandemic when assessing TTS. Consider a furloughed worker who started trading at home full time in mid-2020. Was the trader’s intention to create a new business for the long-term, or to buy time and make some extra money before returning to his or her career after the pandemic subsides? TTS requires the intention to run a business from catching daily market movements, not from making investments for appreciation.
If a new trader started trading on June 1, 2020, but stops or significantly slows down trading when returning to work in November 2020, will the IRS deny TTS because he only traded actively for five months? The IRS agent might cite the landmark tax court case Chen vs. Commissioner, where TTS was denied. Chen only carried on TTS for three months.
I analyzed the Chen case in my trader tax guide; here’s an excerpt.
Chen vs. Commissioner
Comments from a senior IRS official about the Chen tax court case point out the IRS doesn’t respect individual traders who are brand new to trading activity and who enter and exit it too quickly. Chen only traded for three months before losing his trading money, thereby leaving his trading activity. Chen kept his software engineering job during his three months of trading.
The Chen case indicates the IRS wants to see a more extended time to establish TTS. Some IRS agents like to intimidate taxpayers with a full year requirement, but the law does not require that. Hundreds of thousands of businesses start and fail within three months, and the IRS doesn’t challenge them on business status. The IRS is rightfully more skeptical of traders vs. investors, perhaps even more so during the pandemic. The longer a trader can continue his business trading activity, the better his chances are with the IRS. We often ask clients about their trading activities in the prior and subsequent years as we prepare their tax returns for the year that just ended. Vigorous subsequent-year trading activities and gains add credibility to the tax return being filed. We mention these points in tax return footnotes, too. Traders can start their trading business in Q4 and continue it into the subsequent year.
Chen messed up many things in this case. First and foremost, he lied to the IRS about electing Section 475 MTM ordinary loss treatment on time and then used 475 MTM when he wasn’t eligible. Chen should have been subject to a $3,000 capital loss limitation rather than deducting a massive 475 ordinary loss triggering a huge tax refund. Second, he brought a losing case to tax court and made the mistake of representing himself. Once Chen was busted on the phony MTM election, he caved in on all points, including TTS. Chen did not have many TTS business expenses, so he figured it wasn’t worth continuing to fight.
Even though he only traded for three months while keeping his full-time job, it doesn’t mean he didn’t start a new business — intending to change careers to business trading — and make a substantial investment of time, money, and activity. Tax code or case law doesn’t state that a business must be carried on for a full year or as the primary means of making a living. Countless companies startup and fail in a few short months, and many times the entrepreneur hasn’t left his or her job while experimenting as a businessperson. Chen may have won TTS had he been upfront with the IRS and engaged a tax attorney or trader tax expert to represent him in court.
TTS tax benefits
TTS traders deduct business expenses, startup costs, and home office expenses. Without TTS, investors may only deduct margin interest expense to the extent they have investment income as an itemized deduction. Many use the standard deduction instead.
TTS traders are entitled to elect the robust Section 475 mark-to-market accounting, which converts capital gains and losses into ordinary gains and losses. Short-term capital gains on securities are ordinary income; whereas, 475 ordinary business losses generate tax refunds much faster than a $3,000 capital loss limitation. Section 475 also exempts securities trades from onerous wash sale loss rules, a headache for active traders, which causes phantom income and potentially excess tax liability. The 20% qualified business income (QBI) deduction applies to 475 net income if the taxpayer is under a taxable income threshold. QBI excludes capital gains. Individuals had to elect 475 for 2020 by the postponed deadline of July 15, 2020. A new LLC partnership or S-Corp can select 475 within 75 days of inception.
With a TTS S-Corp, traders can deduct health insurance and retirement plan contributions.
I consult new traders on TTS. It’s incredible how many of these traders, from all walks of life, ages and careers, have made small fortunes since April. Others incurred substantial losses. During my tax consultations, many clients tell me they don’t want to return to their jobs if and when called back, and that TTS trading is their new career, which they cherish.
In The Tax Moves Day Traders Need to Make Now, Laura Saunders and Mischa Frankl-Duval report on this very issue (Wall Street Journal, Sept. 11, 2020), warning taxpayers to be careful when thinking about claiming TTS.
August 27, 2020 | By: Robert A. Green, CPA
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There are tax advantages for traders who are eligible for trader tax status (TTS).
Learn how to qualify for TTS; no election is required.
Automated trading systems can qualify for TTS, providing the trader is significantly involved with the creation. Trade copying software might not be eligible.
Learn how to deduct TTS business expenses, startup costs, and home office expenses.
Consider a Section 475 election for exemption from wash sales and the $3,000 capital loss limitation and be eligible for a 20% qualified business income deduction on 475 net income if under the QBI income threshold.
A TTS S-Corp unlocks health insurance and retirement plan deductions.
A TTS LLC/partnership segregates TTS/475 trading from investments made on the individual level.
How to qualify for TTS
Let’s start by taking a deep dive into GreenTraderTax.com golden rules for TTS qualification. Statutory tax law is lacking on TTS, so we analyze tax court cases for traders, and rely on decades-long experience performing tax compliance services for traders.
Volume of trades
The 2015 tax court case Poppe vs. Commission is a useful reference. Poppe made 720 total trades per year/60 per month. We recommend an average of four transactions per day, four days per week, 16 trades per week, 60 trades a month, and 720 per year on an annualized basis. Count each open and closing trade separately, not round trips. Some traders scale into and out of trades, and you can count each of those trades separately.
As an example, the securities markets are open approximately 250 days, but let’s account for some personal days or holidays, and figure you’re available to trade 240 days per year. A 75% frequency of 240 days equals 180 days per year, so 720 total trades divided by 180 trading days equals four trades per day.
What counts? If you initiate a trade order and the broker breaks down the lot sizes without your involvement, it’s wise not to include the extra volume of trades in this case.
Options traders have multi-legged positions on “complex trades.” I believe you may count each trade confirmation of a complex options trade if you enter the trades separately, although the tax court has not addressed that issue yet. Most traders enter a complex options trade, and the broker breaks down the legs, so you cannot count the legs separately. Trade executions count, not unexecuted trades.
Frequency of trades
Execute trades on close to four days per week, around a 75% frequency rate. The tax courts require “regular, frequent, and continuous” qualification for TTS. If you enter or exit a trading business during the year, then maintain the frequency rate during the TTS period. Time off from the execution of trades should be for a reasonable amount of vacations and other non-working days. Think of TTS like it’s a job, only the markets are your boss.
In the following trader tax court cases, the IRS denied TTS to options traders, including Holsinger, Assaderaghi, Endicott, and Nelson. They only traded on two to three days per week; hence, I suggest executing trades on close to four days per week.
Holding period
The IRS stated that the average holding period is the most crucial TTS factor. In the Endicott court, the IRS said the average holding period must be 31 days or less. That’s a bright-line test.
If your average holding period is more than 31 days, it’s disqualifying for TTS, even if all your other TTS factors are favorable.
It’s more natural for day traders and swing traders to meet the holding period requirement. In the holding period analysis, don’t count segregated investment accounts and retirement accounts; only count TTS positions.
Monthly options traders face challenges in holding periods. They may have average holding periods of over one month if they trade monthly and longer expirations and keep them over a month. Holsinger was a monthly options trader, and his holding periods averaged one to two months. More often now, TTS traders are focused on trading weekly options expirations, and many of them are eligible for TTS.
Consider the following example of a trader in equities and equity options. If he holds 80% of his trades for one day and the other 20% for 35 days, then the average holding period is well under 31 days. It’s not evident if the IRS might apply weighted averages to the average holding period.
Trades full time or part-time
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 our golden rules.
Part-time and money-losing traders face more IRS scrutiny, and individuals face more scrutiny than entity traders.
Time spent
A TTS trader should spend more than four hours per day, almost every market day working on his trading business. All-time counts, including the 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 the “material participation” standard in the passive loss activity 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 businesses, 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.
Avoid sporadic lapses
A trader should have few to no sporadic lapses in the trading business during the year. The IRS has successfully denied TTS in a few tax court cases by arguing the trader had too many periodic lapses 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 trading methods and markets.
Carefully explain breaks in trading to the IRS in tax-return footnotes. Retooling and education during a setback in trade executions still may count for the continuous business activity (CBA) standard, although the IRS has not given credence to CBA for traders in tax court to date. I recommend traders keep proper records of their time spent as support.
Comments from an IRS official about the Chen tax court case point out the IRS doesn’t respect individual traders who are new to trading activity and who enter and exit it too quickly. Chen only traded for three months, while maintaining his fulltime job as a software engineer. He claimed an enormous NOL tax refund based on a massive TTS/475 ordinary loss. The IRS caught him lying about making a timely 475 election, and Chen conceded TTS and the entire case. It’s better to carry on a trading business for a more extended time than Chen did.
Some traders must temporarily stop for several months for health reasons. It’s not clear if the IRS will respect that as a valid interruption of a trading business activity. That seems unfair, but it may be the reality.
Many traders are home from their day jobs with Covid-19 and can carry on a trading business now. But will that active trading continue for the rest of 2020 and into 2021? I’ve noticed a proliferation of “Covid-19 traders,” who started active trading after the Covid correction in March 2020. Many have done well. Employers furloughed or laid-off them off from day jobs, or they have flexible job hours at home. They were attracted to volatility, accessible trading apps, and zero or low commissions.
Intention to run a business
Traders must have the intention to run a 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 keyword is “a” living, which means it can be a supplemental living.
Many traders enter an active trading business while still working a full-time job. Advances in technology and flexible job schedules make it possible to carry on both activities simultaneously.
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 deny trader tax breaks if the IRS takes a look.
Filing as a sole proprietor on a Schedule C is allowed and used by many, but it’s not the best tax filing strategy for a part-time trader. An individual tax return shows a taxpayer’s job and other business activities or retirement, which may undermine TTS in the eyes of the IRS. The IRS tends to think trading is a secondary activity, and it may seek to deny TTS. It’s best to form a new, separate entity dedicated to trading only.
Several years ago, we spoke with one IRS agent who argued the trader did not make a living since he had perennial trading losses. That’s okay because the rule looks to intention, not the actual results. The hobby-loss limitations don’t apply to TTS traders because trading is not recreational or personal. Part-time traders often tell me they operate a business to make a supplemental living and intend to leave their job to trade full-time when they become profitable enough.
Operations
A TTS trader 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 and/or outside office. Some have staff.
The IRS needs to see that a taxpayer claiming TTS has a realistic trading business operation.
How can one run a business without a dedicated space? Casual investors rarely have as busy an office set up as business traders do. Why would a long-term investor need multiple monitors?
If a trader uses a home-office space exclusively for business rather than personal use, the tax return should reflect this because it is not only a valid home-office deduction, but it also further supports the fact there is a legitimate business activity being conducted. The home-office deduction is no longer a red flag with the IRS, and it is not a complicated calculation. Most of the home-office deduction requires income, in this case, TTS trading gains. Some TTS traders just use a laptop, and that’s okay.
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, he or she can day trade using up to 4:1 margin rather than 2:1. Without PDT status, securities traders, which include equities and equity options, will have a more challenging time qualifying for TTS. I like to see more than $15,000 account size for trading futures, forex, or cryptocurrency.
Adequate account size also depends on one’s overall net worth and cash flow. Millionaires may need larger account sizes, whereas some unemployed traders without much cash flow or very young traders may get by with smaller account sizes. A trader may also be able to factor in capital invested in equipment and startup costs.
What doesn’t qualify for TTS
Don’t count these four types of trading activity for TTS qualification:
Automated trading systems (ATS) without much involvement by the trader (but a trader creating an ATS qualifies);
A trade copying software or service;
Engaging a professional outside investment manager;
And trading in retirement funds.
Do not include these trades in the golden rule calculations.
Outside-developed automated trading systems
These programs are becoming more popular. An entirely canned ATS with little to no involvement by the trader doesn’t qualify for TTS. The IRS may view an outside-developed ATS the same as a trader who uses a broker to make most buy/sell decisions and executions.
If the trader can show he’s very involved with the design and building of the ATS, then the IRS may count the ATS-generated trades in the TTS analysis. That includes but is not limited to writing the code or algorithms and setting the entry and exit signals. Self-creation of the ATS needs to be significant to count for TTS. Just making a few choices among options offered in an outside-developed ATS building-block service does not qualify for TTS.
Some traders don’t have programming experience, but they have financial and trading experience. They design the ATS to do what they do manually as a trader and hire an outside programmer to translate their specifications into a computer language.
It’s helpful if the trader can show he spends more than four hours per day working in his trading business, including time for ATS maintenance, back-testing, and modifications. I have not yet seen the IRS challenge ATS for TTS in exams or court cases, but I feel it may react this way when it comes up.
If traders spend a lot of money on an ATS that doesn’t qualify as part of their trading business, then those expenses are suspended investment expenses under TCJA. Traders need to know the IRS may connect the dots and realize they are using an ATS. A full-scale exam can uncover these facts. Consider the analogy of an airplane pilot using manual and automated systems. A trader needs to be a pilot in the cockpit, not in the cabin as a passenger.
Trade copying software or service
Some traders use trade copying software or service (TCS). Trade copying is similar to using a canned ATS or outside adviser, where the copycat trader might not qualify for TTS on those trades. As an example, a trade coaching and education company offers a TCS that suggests several trades each day, with exact entry and exit points and stop-loss orders. The trader decides which trades to make and executes them manually.
If the trader follows the TCS tightly and does not significantly depart from its suggestions, then an IRS agent might feel that he or she does not qualify for TTS. On the other hand, if the trader cherry-picks a minor percentage of the suggested trades, sets different stop-loss orders, and waits longer on entry and exit executions, then he or she might qualify for TTS. The TCS vendor might state they are not providing investment management services, but that does not mean their customer achieves TTS using the TCS.
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. However, hiring an employee or independent contractor under the trader’s supervision to help trade should qualify, providing the taxpayer is a competent trader. There are decades-old tax court cases that show using outside brokers and investment advisers to make trading decisions undermines TTS.
There are differences between hiring an independent investment manager vs. a supervised assistant trader. If the engaged trader is a registered investment adviser, he’s clearly in the business of being an external manager, and TTS is not achievable. But if the person only assists a retail trader under the account holder’s direction and supervision, it may be possible to achieve TTS. It’s okay to have a co-pilot in the TTS cockpit.
With married couples, if spouse A has an individual brokerage account in his or her name only and gives power of attorney to spouse B to trade it, the IRS won’t grant TTS even if spouse B meets all the golden rules for TTS. Spouse B is not an owner of the account, so that the IRS will treat spouse A as an investor and spouse B as an investment manager. Married couples can solve this problem by using a joint individual account or trading in a spousal-owned entity.
Trading retirement funds
You can achieve TTS through taxable trading accounts only. Trading activity in non-taxable retirement accounts doesn’t count for purposes of TTS qualification. Trading in retirement plans can be an excellent way to build tax-free compounded returns, especially if the taxpayer doesn’t qualify for TTS in their taxable accounts.
It is possible to trade retirement accounts and, at the same time, qualify for TTS in taxable accounts.
Caution: it’s dangerous to trade substantially identical positions between an individual taxable account and IRA accounts since this can trigger a permanent wash-sale (WS) loss in a taxable account that moves into the IRA. Avoid permanent WS losses in IRAs with a Section 475 election on the taxable account or use a Do Not Trade List to avoid overlap in the IRAs.
Sole proprietorship with TTS
An individual TTS trader deducts business expenses, startup costs, and home office deductions on a Schedule C (Profit or Loss From Business – Sole Proprietorship) 1040 filing. Traders don’t have revenue on Schedule C; report trading gains and losses on other tax forms. Schedule C expenses are an above-the-line deduction from gross income. TTS Schedule C expenses reduce self-employment income (SEI). Although, trading income is not SEI, and traders don’t owe SE tax in connection with trading income. There isn’t a tax election for claiming TTS. — it’s determined based on facts and circumstances assessed at year-end. You can claim TTS after-the-fact; you don’t have to formalize it in advance.
Business expenses include home-office, education, startup expenses, organization expenses, margin interest, tangible property expense, Section 179 (100%) or 100% bonus depreciation, amortization on software, self-created automated trading systems, chat rooms, mentors, seminars, market data, charting services, stock borrow fees, and much more.
Section 475 tax benefits
TTS traders are entitled to make a Section 475 election, but investors may not. The 475 election exempts securities trades from wash-sale loss (WS) adjustments, which can defer tax losses to the subsequent year, and the $3,000 capital loss limitation. Ordinary loss treatment is better; it can generate tax refunds faster than capital loss carryovers. There are also benefits on 475 income: a 20% QBI deduction if under the taxable income threshold for a service business.
The deadline for an individual to elect Section 475 for 2020 has passed; it was July 15, 2020, the postponed deadline. A partnership or S-Corp formed during the tax year is considered a “new taxpayer,” which can elect Section 475 internally within 75 days of inception. A new entity comes in handy for electing 475 after July 15, 2020. It’s too late to select 475 for 2019; that election deadline was April 15, 2019.
I usually recommend 475 on securities only to retain lower 60/40 capital gains rates on Section 1256 contracts. Section 475 does not apply to segregated investment positions. Avoid overlap of substantially identical positions in what you trade versus what you invest in taxable accounts, as that allows the IRS to recharacterize trades vs. investments. You can fix this potential problem by ring-fencing TTS/475 in a new entity and leaving investment positions on the individual level.
The qualified business income deduction
TCJA introduced a tax benefit for pass-through businesses, which includes a TTS trader with Section 475 income, whether doing business as a sole proprietor, partnership, or S-Corp. Section 199A provides a 20% QBI deduction on a “specified service trade or business” (SSTB), and TTS trading is an SSTB. SSTBs are subject to a taxable income threshold, phase-out range, and an income cap. The phase-out has wage and property limitations, too.
LLC taxed as an S-Corp
Organize a single-member or spousal-member LLC and elect S-Corp status with the IRS within 75 days of inception. Alternatively, in a subsequent year, the LLC can submit an S-Corp election by March 15. Owners must be U.S. residents. The S-Corp can elect Section 475 internally within 75 days of inception.
TTS traders with significant health insurance (HI) premiums should consider an S-Corp to arrange a tax deduction through officer compensation. Otherwise, the trader or spouse might have another source of self-employment income to deduct HI. A spouse might have HI coverage for the family in their job. Cobra is not deductible HI since its employer provided. A TTS sole proprietor or partnership cannot deduct HI based on trading income.
Traders need earned income to make and deduct HI and retirement plan contributions; however, trading income is unearned. TTS sole proprietors and partnerships cannot create earned income, whereas S-Corps can pay officer compensation, generating earned income.
Payroll taxes apply on officer compensation (wages), except for the HI component of salary: 12.4% FICA capped on wages up to $137,700 for 2020, and the 2.9% Medicare is unlimited.
TTS traders should fund retirement plan contributions from net income, not losses. It’s best to wait on the execution of an annual paycheck until early December when there is transparency for the year.
If you have sufficient trading profits for the year, consider establishing a Solo 401(k) retirement plan before year-end. Start with the 100% deductible elective deferral (ED; $19,500 for 2020) and pay it through payroll since on the annual W-2. Taxpayers 50 years and older have a “catch up provision” of $6,500, raising the 2020 ED limit to $26,000 per year. Contribute the elective deferral to a Solo 401(k) Roth or traditional account.
If you have significant trading gains, consider increasing payroll to unlock a Solo 401(k) profit-sharing plan (PSP) contribution. You don’t have to pay into the retirement plan until the due date of the S-Corp tax return (including extensions by September 15). The maximum PSP amount is $37,500 on wages of $150,000 ($37,500 divided by 25% equals $150,000). The total limit for a Solo 401(k) is $63,500 ($19,500 ED, $6,500 catch-up ED, and $37,500 PSP).
LLC taxed as a partnership
A TTS trader can organize a spousal-member LLC and file as a partnership. LLC/partnerships file a Form 1065 partnership tax return and issue Schedule K-1s to owners. LLC/partnerships must qualify for TTS; otherwise, they are investment companies.
A partnership is useful for ring-fencing TTS/475 trading from individual taxable, and IRA accounts for avoiding wash sale losses and the IRS reclassifying investment positions as TTS/475 positions.
Active trading gained popularity in 2020, and many people are eligible for trader tax status benefits.
Purchase the online PDF version in our Green & Company, Inc. store. Amazon offers a paperback version.
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Use Green’s 2023 Trader Tax Guide to receive every trader tax break you’re entitled to on your 2022 tax returns. Learn intelligent moves to make in 2023. Whether you self-prepare your tax returns or engage a CPA firm, this guide can help you optimize your tax savings. Even though it may be too late for some tax breaks on 2022 tax returns, you can still use this guide to execute these tax strategies and elections for tax-year 2023.
The 18 chapters cover trader tax status, Section 475 MTM, tax treatment (equities, 1256 contracts, options, ETFs, ETNs, forex, precious metals, cryptocurrencies, etc.), accounting for trading gains and losses, trading business expenses, tips for preparing tax returns, tax planning, entity solutions, retirement plan strategies, IRS and state tax controversy, traders in tax court, proprietary trading, investment management, international tax, ACA Net Investment Income Tax, short selling, Tax Cuts and Jobs Act, CARES Act, and recent tax law changes.
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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.
June 16, 2018 | By: Robert A. Green, CPA
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The AICPA recently asked the IRS to permit cryptocurrency traders, eligible for trader tax status (TTS), to use a Section 475 MTM election on securities and commodities providing for ordinary gain or loss treatment.
In my March 2018 blog post Cryptocurrencies: Trader Tax Status Benefits And Section 475 Issues, I suggested crypto TTS traders consider filing a protective 2018 Section 475 election on securities and commodities, due by April 17, 2018, in case the IRS allowed it. Many crypto traders had significant losses in early 2018 with the market correction, and with a 475 election, they might avoid the $3,000 capital loss limitation using ordinary loss treatment. I said it hinged on whether the IRS changed its designation of crypto from intangible property to a security or a commodity.
The AICPA letter* implied that the IRS could keep its current classification of crypto as intangible property, yet still permit the use of Section 475. However, it does raise other questions: The AICPA letter did not distinguish between securities and commodities, whereas, Section 475 does. TTS traders may elect Section 475 on securities only, commodities only, or both, and that has other tax implications.
If the IRS considers crypto a security, then Section 1091 wash-sale loss rules for securities would apply. Wash-sale loss adjustments are a headache and can be costly. (If you buy back a losing trade 30 days before or after, you must defer the wash-sale loss to the replacement position’s cost basis.) As intangible property, crypto is not currently subject to wash-sale losses. A Section 475 election on securities exempts TTS traders from making wash-sale loss adjustments.
If the IRS considers crypto a commodity, then a TTS trader should be able to elect Section 475 on commodities. However, that election has other tax consequences: If you trade Section 1256 contracts, including futures, you will surrender the lower 60/40 capital gains rates on 1256 contracts. For that reason, most traders elect Section 475 on securities only.
AICPA letter excerpt 8. Traders and Dealers of Virtual Currency
“Overview: Taxpayers considered dealers and traders who engage in buying and selling securities in the ordinary course of business to customers may make a ‘mark-to-market’ election under section 475. This election recognizes ordinary gains or losses on the deemed sales involved in the mark-to-market process. The securities holdings on the last day of the year are deemed as sold for their fair market value resulting in both ordinary income and ordinary expenses the same as for any other trade or business. Taxpayers who trade virtual currencies perform this activity on virtual currency exchanges that contain all the robust trading features available on trading platforms for securities and commodities, including the same level of liquidity. In this context, virtual currencies are akin to securities and commodities. This particular issue is also under consideration by the Commodity Futures Trading Commission.
Suggested FAQ
Q-22: May taxpayers who trade virtual currency elect the mark-to-market rules under section 475 if they otherwise qualify as a dealer or trader?
A-22: Yes. The nature of virtual currency trading is akin to dealers and traders of securities and commodities and a taxpayer may elect mark-to-market treatment. The taxpayer must otherwise qualify as a dealer or trader in order to make the election.
* The IRS has made no indication that they intend to adopt all, or any, of the many excellent recommendations from the AICPA.
SEC update
On June 14, CNBC reported, “The SEC’s point man on cryptocurrencies and initial coin offerings (ICOs) says that bitcoin and ether are not securities but that many, but not all, ICOs are securities and will come under the regulatory control of the SEC and relevant securities laws.”
The official explained what constitutes a security in the eyes of the SEC. An initial coin offering is likely a security because a third-party company, which is not decentralized ownership, sells an investment product to the public. The sponsor uses the money raised for its internal use. The buyer/investor expects a profit — a return on the investment. Conversely, bitcoin and ether are likely not securities because there was no ICO, ownership is decentralized, and they were not sold as investments.
June 2018: Robert Green explains how traders eligible for trader tax status are entitled to elect Section 475 MTM ordinary gain or loss treatment. This exempts trades from the capital-loss limitation and wash-sale losses, and Section 475 income likely qualifies for the 20% pass-through deduction under the new tax law.
If You Can’t Deduct All Your Trading Losses Consider Section 475 Election
Individuals qualifying for trader tax status (TTS) with a significant trading loss in the first quarter of 2017, should consider a 2017 Section 475 MTM election, due by April 18, 2017. (S-Corps and partnerships had to make this election by March 15, 2017.) Profitable traders should consider the election, too.
Avoid loss limitations including a $3,000 capital loss limitation for 2017, capital loss carryovers to 2018, and wash sale loss adjustments. The Section 475 election converts capital losses into unlimited ordinary business losses, which may generate tax savings immediately. For example, a $50,000 Section 475 ordinary loss offsets wage income without limitation, whereas a capital loss is limited to $3,000 against other income, including wages. I refer to Section 475 as “tax loss insurance,” and it’s one of the most attractive tax benefits for TTS traders. April 18th is the deadline, so make the right decision and act fast.
Here are two scenarios where the election is wise
1. TTS individual trader has trading losses of $50,000 for Q1 2017, comprised of $25,000 losses in securities, and $25,000 losses in futures (Section 1256 contracts). He also has a capital loss carryover of $100,000 from 2016 into 2017.
Starting the year 2017, this trader hoped to generate capital gains to use up his capital loss carryover, figuring the next $100,000 of capital gains is tax-free. But, things went awry, and he generated trading losses in 2017.
Smart move: File a 2017 Section 475 MTM election on securities and Section 1256 contracts by April 18, 2017. It doesn’t make sense adding to a significant capital loss carryover. Next, create an LLC trading company, which files a partnership or S-Corp tax return. That entity may generate capital gains to pass through to the individual level to use up the $100,000 capital loss carryover. If the trading entity incurs trading losses, it can elect Section 475 internally, within 75 days of its inception. Plan to revoke the individual Section 475 election on Section 1256 contracts by April 15, 2018, for 2018.
2. TTS sole proprietor trader has trading gains of $40,000 for YTD 2017 in securities and Section 1256 contracts. She does not have a capital loss carryover or unrealized capital losses, so she has a clean slate for electing Section 475. She also trades IRA accounts, so she faces a potential wash sale loss problem. If she incurs a trading loss in her taxable trading account and buys back a substantially identical position 30-days before or after in her IRA account, she will never get the benefit of that tax loss in either taxable or IRA accounts. That’s far worse than a deferred wash sale loss at year end. (Broker 1099Bs don’t account for wash sales between taxable and IRA accounts, whereas the IRS requires taxpayers to do so.)
Smart move: File a 2017 Section 475 MTM election on securities only, not including Section 1256 contracts, by April 18, 2017. She retains lower 60/40 capital gains tax rates on Section 1256 contracts, with 60% being a long-term capital gain taxed at lower rates. The Section 475 election on securities exempts her from wash sale loss adjustments in her taxable accounts, which also prevents wash sale losses with her IRA trading accounts. If she incurs a significant trading loss later in the year in her taxable accounts, she will be glad to have ordinary loss treatment rather than a capital loss limitation.
Section 475 MTM election statement
Type the below statement on a sheet of paper with your name and social security number (or entity EIN) up top.
“Under IRC 475(f), the Taxpayer at this moment elects to adopt the mark-to-market method of accounting for the tax year ended Dec. 31, 2017, 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 want to include Section 1256 contracts, modify the language accordingly. For external Section 475 MTM elections, this is just the first part of the election process – and the most important part. You also have to file a timely 2017 Form 3115 with your 2017 tax return in 2018 (with a duplicate copy to the IRS National Office).
Learn more about Section 475 MTM in Green’s 2017 Trader Tax Guide. There are many nuances, myths, and scenarios to consider.
Section 475 could be an important election for you, so get it right! Don’t be one of the thousands who complain they missed the boat, which sails on April 18th or messes up the process. If you already filed your 2016 tax return or extension, you should send the IRS a letter by April 18, 2017, explaining you left out the election. Consult a trader tax expert, preferably us.
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