Tag Archives: Section 475

Hope For Active Crypto Traders With Massive Losses

June 16, 2018 | By: Robert A. Green, CPA | Read it on

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.

Section 475 MTM

June 10, 2018 | By: Robert A. Green, CPA

Robert Green explains how traders, eligible for trader tax status (TTS), are entitled to elect Section 475 MTM ordinary gain or loss treatment. It 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

April 6, 2017 | By: Robert A. Green, CPA

Forbes

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.

Traders Expo Las Vegas 2016: Trader Tax Law Update

December 1, 2016 | By: Robert A. Green, CPA

Uploaded to YouTube by MoneyShow on Nov 22, 2016

Right before the end of the year, trader tax expert Robert Green will review trader tax status (business expenses), the tax treatment of different financial products including securities, futures, options and ETFs, critical tax elections, wash sale loss limitations, entities with retirement plan deductions, Obamacare taxes, and year-end tax planning.

These Tax Errors Will Cost Professional Traders Dearly

August 15, 2016 | By: Robert A. Green, CPA

In our 81-minute video, trader tax expert Robert A. Green, CPA explains the below-listed errors and how to avoid them. We provide a timestamp and an orange header for each chapter.

(00:00:00) Opening remarks.
(00:02:03) Mistakenly believing you can rely on securities Form 1099-B.
(00:06:57) Messing up Form 8949 cost-basis reporting.
(00:15:38) Overlooking reporting of rebate income.
(00:18:27) Mishandling trader tax status.
(00:23:25) Errors in preparing Schedule C.
(00:31:23) Not including a note raises a red flag.
(00:36:00) Overlooking or messing up a Section 475 election.
(00:45:09) Messing up Form 4797 and overlooking a Section 481(a) adjustment.
(00:49:44) Commingling Section 475 trades with investment positions.
(00:52:31) Overlooking or messing up capital loss carryovers.
(00:56:35) Overlooking the election to carry back a Section 1256 loss.
(00:58:14) Using the wrong tax treatment on various financial instruments.
(01:01:45) Mishandling foreign transactions.
(01:05:45) Errors with home office deductions.
(01:07:50) Making mistakes on education expenses.
(01:10:16) Paying self-employment tax when not owed.
(01:12:02) Deducting employee benefit plans when not allowed.
(01:13:34) Taking an early withdrawal from an IRA may cost you dearly.
(01:15:38) Overlooking or messing up Obamacare taxes.
(01:18:51) Closing remarks.

Section 481(a) Positive Adjustment Spread Period Changes

May 26, 2016 | By: Robert A. Green, CPA

According to tax research service Thomson Reuters CheckPoint, “Under the new procedures for filing a Form 3115 for tax year 2015 and forward, the four-year spread period generally applicable to a positive Section 481(a) adjustment has been modified as De minimis § 481(a) adjustment amount increased. Under a de minimis provision, positive adjustment may be spread over one year (versus four years) at the taxpayer’s election. The new procedures increases the de minimis threshold to $50,000 from $25,000. The election is made on the new Form 3115 (Rev 12-2015), Part IV, Line 27.”

This means that a trader with a Section 481(a) income adjustment up to $50,000 can elect to report the entire amount of income in the current tax year rather than spread the income over four years. The IRS is probably hoping fewer taxpayers defer income and some may forget to report that income in subsequent tax years. 

According to Green’s 2016 Trader Tax Guide, “Form 3115 (Change in Accounting Method) includes a section for reporting a Section 481(a) adjustment, which is required when a change of accounting is made. The rest of the multi-page Form 3115 relates to tax law and code sections, etc. In the case of changing to Section 475 MTM, a trader’s section 481(a) adjustment is his unrealized business trading gain or loss as of Dec. 31 of the prior tax year. A section 481(a) loss is deductible in full; whereas a gain of more than $25,000 must be prorated over four tax years.” Effective for 2015 tax filings, the $25,000 is changed to $50,000. 

For example: If a trader’s 2015 Section 481(a) adjustment is $40,000, on their 2015 Form 3115 they may elect to report the full income. Conversely, if the income adjustment is $60,000 they would have to spread it over four years reporting $15,000 each year.

Section 475 and Section 481(a) adjustments
When a trader with trader tax status (TTS) elects Section 475 mark-to-market (MTM) ordinary gain or loss treatment, the IRS requires a Section 481(a) adjustment on income tax Form 3115 (Application for Change in Accounting Method) and Form 4797 (Sales of Business Property).

The trader is changing accounting method from the cash method on Dec. 31 to the Section 475 MTM method on Jan. 1. If the trader has open TTS securities positions on Dec. 31 the Section 481(a) adjustment is the unrealized gain or loss on TTS positions on Dec. 31. Gain is a positive adjustment and loss is a negative adjustment. Segregated investment positions in securities are not included in the Section 481(a) adjustment. Section 1256 contracts like futures are already subject to MTM so they also are not included in the 481(a) adjustment.

 

IRS Considering “Freeze And Mark” For Section 475 Election

May 10, 2016 | By: Robert A. Green, CPA

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

According to Tax Notes article “IRS Considering ‘Freeze and Mark’ for Trader Election” dated Jan. 20, 2016, Robert Williams, branch 3 senior counsel, IRS Office of Associate Chief Counsel (Financial Institutions and Products), said he was optimistic, though cautious, that updated Section 475 regulations will come out by June 30, 2016.

The Tax Notes article mentioned a few significant potential changes that would affect traders in making a new Section 475 election. If codified by the IRS, I expect these changes won’t apply retroactively, so traders who made a 2016 Section 475 election by April 18 should not be affected.

Clarification of the character of income or loss of a Section 481(a) adjustment: The IRS may clarify that it’s a capital gain or loss, rather than an ordinary income or loss, which is the current interpretation. Many traders have benefited from ordinary loss treatment, especially when a Section 481(a) adjustment included wash sale loss deferrals on open trading business positions.

No election deadline: The changes may allow existing taxpayers to make a new Section 475 election throughout the tax year. Currently,  the election deadline is April 15 for existing partnerships and individuals and March 15 for S-Corps. Many existing taxpayers will appreciate doing away with the deadline.

No retroactive application: Williams discussed applying ordinary income or loss treatment on the election date and going forward, and doing away with retroactive application of ordinary income or loss to Jan. 1.

Under current law, when a trader elected Section 475 by April 18, 2016 for 2016 (normally April 15), the election was retroactive to Jan. 1, 2016, so all 2016 trading gains and losses are ordinary income and loss. If a trader qualified for trader tax status (TTS) at year-end 2015, he also makes a Section 481(a) adjustment on Jan. 1, 2016 for unrealized gains or losses on open trading positions on Dec. 31, 2015.

Traders have been able to use hindsight between Jan. 1 and April 15 to make a last-minute decision about electing Section 475. For example, if they have a large trading loss in Q1, they may elect Section 475 to lock in ordinary loss treatment for that loss, and plan to revoke Section 475 in the subsequent year to get back to capital gains treatment to use up capital loss carryovers. That type of hindsight may be lost with these potential updates in the law.

 

 

Safeguard Use Of Section 475 By Trading In An Entity

| By: Robert A. Green, CPA

Section 475 “tax loss insurance” is a fantastic tax benefit for active securities traders qualifying for trader tax status (TTS). Many individual taxpayers have been using it successfully for years. I’ve exhorted the benefits since 1997, when Congress enacted Section 475 tax law for traders.

Some Section 475 provisions are vague
Increasingly, my firm’s tax compliance CPAs have noticed problems with the nuances of Section 475, including some of the rule sections, which are too vague. The IRS acknowledged this with its “Section 475 Clean Up Project” and read our comment letter to the IRS. The IRS said the project is being completed and to expect updated Section 475 regulations in the summer of 2016. (I cover the changes being discussed at tax attorney conferences in my next blog post IRS Considering “Freeze and Mark” for Section 475 Election.)

One of the problems with Section 475 regulations has to do with segregation of investments. Segregation should be done in form and substance and that can be confusing. A prior IRS proposed regulation called for designation of investment accounts, but that was not sufficient as traders could use substance to trump form.

This problem arises when a trader uses Section 475 and also holds investment positions in substantially identical positions. Traders can’t elect Section 475 by account. The law makes the election by taxpayer identification number, which means the election applies to all active trading accounts and investment accounts containing active trading.

Traders can solve this problem by housing the trading business using Section 475 in a separate legal entity and holding investments in individual accounts. This is the only way to fully segregate investments from trading. (Read my recent blog post Active Traders Should Consider An Entity For Tax Savings for other reasons to form an entity.)

Misidentified investment positions
Many individuals trade substantially identical positions between Section 475 active trading accounts and taxable investment accounts, including joint and spousal accounts. For example, they trade Apple options in a Section 475 account and also hold Apple equity in segregated investment accounts.

The IRS can view this trading as gaming the system, with the trader deducting ordinary losses on Apple options but deferring taxes on unrealized long-term capital gains in Apple equity held as an investment. Because Apple options and Apple equity are substantially identical positions, the IRS has the power in Section 475 regulations to treat either the Apple options or the Apple equity as “misidentified investment positions,” which means it can apply Section 475(d)(2). (Learn more about that Section 475 penalty in my blog post IRS Plays Havoc with Traders Misidentifying Investments.)

Experienced trader tax preparers and IRS agents may seek other ways to address this problem, including reclassifying Section 475 ordinary losses on Apple options as investment capital losses, which then triggers capital loss limitations and wash sale loss adjustments on substantially identical positions across all accounts. Or if it’s better for the IRS position, reclassifying Apple equity investments as Section 475 trades, triggering Section 475 MTM ordinary income treatment, thereby losing tax deferral and missing out on lower long-term capital gains rates on realization.

An entity solves the problem
Traders can avoid this problem by ring-fencing Section 475 trades in separate entity accounts and holding investments in individual accounts. A separate legal entity has a different taxpayer identification number vs. an individual taxpayer social security number.

Don’t transfer investment positions into the entity, as that brings the same problem to the entity-level: having trading and investment accounts and or positions on the same taxpayer identification number.

I suggest that traders using portfolio margining on investment positions make the following decision. Either bring investments into the trading entity for portfolio margining and don’t elect Section 475 in the entity or leave the investments out of the entity and elect Section 475.

A newly formed entity may elect Section 475 by placing a resolution in its own books and records within 75 days of inception. Existing taxpayers must elect Section 475 by making an election statement with the IRS by the due date of the prior year tax return, and later file a timely Form 3115 for the year of the election. (Read my blog post Traders: Consider Ordinary Loss Election By Tax Deadline for more details on making the election.)

IRS scrutinizes individuals with large Section 475-related NOL tax refunds
It’s been over a decade since Chen vs. Commission (2004), but an IRS official recently reiterated the importance of that landmark tax court case, deeming similar cases “Chen cases.”

The IRS official was referring to sole proprietor (individual) traders reporting large Schedule C and Form 4797 (Section 475) ordinary losses on individual tax returns and filing for large NOL carryback refunds claims with the IRS. All the cases in my Green’s 2016 Trader Tax Guide, including Assaderaghi, Nelson, Endicott and Holsinger are similar: individuals with Schedule C and Form 4797 losses.

It’s much better to file as an entity trader with Section 475 ordinary loss treatment. The tax refund is the same, but you substantially reduce your chances of IRS exam and denial of TTS, which is required for use of Section 475.

Section 475 tax benefits
Securities traders qualifying for TTS benefit from a Section 475 election. Section 475 securities trades are exempt from wash sale loss adjustments and a capital loss limitation. Section 475 has business ordinary loss treatment, which offsets income of any kind and contributes to net operating losses (NOLs), which may be carried back two years and/or forward 20 years. Short-term capital gains and Section 475 MTM gains are taxed at the ordinary tax rate, so Section 475 is recommended for securities traders.

Conversely, Section 1256 contract traders (futures and more) generally don’t want Section 475 since they would lose lower 60/40 capital gains tax rates in Section 1256 (60% is a long-term capital gain taxed at lower rates and 40% is a short-term capital gain).

Traders can elect Section 475 on securities only, retaining Section 1256 treatment on futures. Section 475 does not apply to segregated investments. Traders value ordinary loss treatment: It’s free tax loss insurance for securities traders.

I’ve been advising traders on tax matters for over 30 years and I’ve seen many ups and downs in the financial markets. I’ve seen professional traders with wide fluctuations of income and loss, too. It’s important to avoid the dreaded $3,000 capital loss limitation against other income and benefit from Section 475 ordinary business loss treatment to generate immediate tax refund relief.