Tag Archives: tax changes

Uncertainty About Using QBI Tax Treatment For Traders

March 6, 2019 | By: Robert A. Green, CPA | Read it on

See our more recent blog post: A Rationale For Using QBI Tax Treatment For Traders.

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.

How To Make The Cut For Trump’s Business Tax Cuts

April 26, 2017 | By: Robert A. Green, CPA

Forbes

How To Make The Cut For Trump’s Business Tax Cuts

Imagine the gold rush that will happen if Trump’s tax plan to lower business tax rates to 15% comes to fruition. Employees will seek to recast themselves as a business, and active traders will try to get the business rate on trading gains. Don’t buy your gold picks and shovels until Congress and the President enact a bill; the devil will be in the details.

Under current law, the corporate tax rate starts at 15% on the first $50,000 of net income and the rate quickly rises to 35%. Imagine all corporate net income taxed at 15%, based on a territorial tax system.

Trump includes owners of pass-through entities (PTE) in his business tax cut plan, which most small businesses use, including LLCs taxed as partnerships or S-Corps. PTEs avoid double taxation by passing through income and loss to the owner’s tax return, where Trump’s individual tax rates will range from 10% to 35%. Trump narrows seven brackets to three: 10%, 25%, and 35%. Individual business owners may potentially save up to 20% on business income.

That’s a huge draw, and the media expects millions of taxpayers to consider reorganization of their businesses, jobs and other activities to cash-in on the Trump tax cuts for business. Treasury Secretary Steven Mnuchin said there would be limits to prevent freelance workers and wealthy taxpayers from misusing entities to benefit from the 15% business tax rate.

The IRS has rules for independent contractors vs. employees
For many decades, the IRS through the tax code, regulations, and audit manuals restrict employers and employees from restructuring as independent contractors (IC), operating as sole proprietors, LLCs or corporations. Employees have sought to reduce their 50% share of payroll taxes, unlock business expenses, home office deductions and high-deductible retirement plans. Employees currently have limited miscellaneous itemized deductions, which Trump’s plan fully repeals. Employers reduce their 50% share of payroll taxes, state unemployment insurance, workmen’s compensation and avoid providing expensive employee benefit plans including health insurance, retirement plan contributions and more. In an audit, the IRS or state tax authorities seek to reclassify ICs as employees. (Read Independent Contractor (Self-Employed) or Employee? and IRS 20 Factor Test – Independent Contractor or Employee?)

The IRS challenges hybrid relationships
Some highly-compensated employees will consider a hybrid structure: Remaining an employee for base salary and employee benefits and setting up a business for receiving performance pay like a bonus, which the employer recharacterizes as something else. For example, maybe house intellectual property (IP) in a PTE and lease it to the employer company in a separate business relationship. That sounds aggressive, and the IRS challenged these hybrid structures in the past.

Highly-paid employees will pay 35% tax rates on marginal income, while small businesses pay 15%. The 20% difference will encourage employees to pursue business dreams. Go for it, that’s the point!

S-Corps are useful for saving payroll taxes
Many technology workers qualify as ICs. They form an LLC to render services to several different clients and work with flexibility and control on a short-term project-by-project basis. That passes muster with the IRS for IC classification.

Most of these ICs select an S-Corp structure to take advantage of the S-Corp payroll tax reduction strategy. S-Corps don’t pass through self-employment income (SEI) to trigger self-employment tax (SE tax), the equivalent of the payroll tax, which includes Social Security and Medicare taxes. SE or payroll tax is 15.3% of wages up to the SSA base amount of $127,200 (2017 limit) and the 2.9% Medicare portion is unlimited. Partnerships pass through SEI.

The IRS knows about the S-Corp SE tax reduction loophole, and Democrats tried to repeal it during the Obama term. Maybe the Trump tax cuts will close this loophole since they are looking to close tax expenditures to help finance the lower business tax rate. To keep this tax break within reason, the IRS requires “reasonable compensation” for officer/owners with the related payroll taxes. Industry guidance suggests 25% of S-Corp net income paid as owner compensation.

Partnerships may become preferable
With Trump’s 15% business tax rate, business taxpayers may prefer a multi-member LLC filing a partnership return instead of an S-Corp. The IRS does not currently require partnerships to pay reasonable compensation because a service company filing a partnership return has SEI for working partners. (It’s conceivable that Trump tax cuts may require PTE to have a reasonable compensation for working owners, so some income is subject to the higher individual rate.)

When choosing between a partnership or S-Corp, compare payroll taxes, business taxes, and individual taxes and see which delivers the lowest total tax.

Traders may qualify for Trump’s business rate
If an active trader qualifies for trader tax status (TTS), they have business expense treatment as a sole proprietor filing a Schedule C. Traders report trading gains and losses on different tax forms: Schedule D for securities with the realization method and Section 1256 Contracts, and Form 4797 for Section 475 elections.

The IRS does not deem trading gains as “business income,” rather it’s income from a capital asset activity. It’s too early to tell if the Trump tax plan will allow trading income to qualify as business income in a PTE.

Trump’s tax plan continues the current long-term capital gains rate regime with a top rate of 20%. The plan also repeals the 3.8% Obamacare Net Investment Tax. The IRS should still tax short-term capital gains with ordinary tax rates.

TTS traders currently form an S-Corp to unlock employee benefit plan deductions including health insurance and retirement plan contributions.

Many PTE elect Section 475 MTM ordinary gain or loss treatment to be exempt from capital loss limitations and wash sale loss adjustments. Even if the Trump business tax cut definition of business income doesn’t include short-term capital gains from active trading, I hope a PTE with TTS can treat Section 475 MTM ordinary income as business income, which makes more sense.

Traders may benefit from a dual entity solution
If the Trump business tax cuts don’t allow trading gains, then consider a dual entity solution. A partnership trading company that pays administration and license fees for IP to a management company structured as a partnership or S-Corp. The management company should benefit from the business tax rate as it receives fees not trading income. Report trading business expenses on the trading partnership, not the management company to maximize net business income. Fees must be reasonable, which puts a cap on them.

Individual tax return changes
Trump’s tax plan repeals many deductions, including all itemized deductions other than mortgage interest and charitable contributions. Mnuchin mentioned allowing retirement plan deductions but did not mention health insurance deductions, both of which are not itemized deductions.

Commentators complained about the repeal of state and local taxes which could spur upper-income individuals to move to tax-free states which lean Republican. The current AMT tax regime doesn’t allow state and local tax deductions, which has already significantly reduced these deductions for upper-income taxpayers. The Trump plan repeals the AMT tax.

Repeal of investment expenses
The investment management industry will be upset about the apparent repeal of investment interest and investment expense deductions, both itemized deductions. Trump campaigned on repealing “carried interest” tax breaks for hedge fund and private equity fund managers. That may reclassify “profit allocations” of capital gains into investment advisory fees. Investors won’t get a tax deduction for management fees and incentive fees.

Traders don’t have investment expense treatment; they have business expense treatment including margin interest, stock borrow fees, home office deduction, education and much more.

Trader tax status and Section 475 MTM is currently a big tax saver, and it should become even more so in the Trump tax cuts. Stay tuned!

Darren Neuschwander CPA contributed to this blog post.