Tag Archives: tax changes

The American Rescue Plan Act of 2021 Impacts Traders

June 21, 2021 | By: Robert A. Green, CPA

On March 11, 2021, Congress and President Biden enacted “The American Rescue Plan Act of 2021” (ARP). In this post, I focus on the provisions that could impact traders, including recovery rebates for individuals, EBL extension, child tax credit, loan forgiveness, and more. The quotations included under each topic are from the “American Rescue Plan Act Roadmap” published by Bloomberg Tax & Accounting.

Many of the ARP tax benefits are subject to income thresholds. Traders have widely fluctuating income and losses from year to year, and they might qualify for some of these tax benefits. ARP includes business and health care benefits, but most don’t apply to solo TTS traders.

2021 Recovery Rebates to Individuals

“Provides a $1,400 refundable tax credit to individuals ($2,800 for joint filers) with up to $75,000 in adjusted gross income (or $112,500 for heads of household and $150,000 for married couples filing jointly). Provides $1,400 for dependents (both child and non-child). The credit will be phased out entirely for those with incomes above $80,000 (or $120,000 for heads of household and $160,000 for married couples filing jointly). The credit is reduced between $75,000 and $80,000 (or $112,500 and $120,000 for heads of household and $150,000 and $160,000 for married couples filing jointly).”

Extension of Limitation on Excess Business Losses (EBL)

A trader eligible for trader tax status (TTS) using a Section 475 election for ordinary loss treatment might exceed the EBL threshold. The excess is a net operating loss (NOL) carry forward. The original 2018 EBL threshold was $500,000/$250,000 married/other taxpayers, and it’s adjusted for inflation.

“Extends for an additional year (through 2026) the denial of a current-year deduction for business losses of a noncorporate taxpayer to the extent they exceed business income plus a threshold amount.”

Suspension of Income Tax on Portion of Unemployment Compensation

Many traders collected unemployment compensation in 2020, as they lost their jobs during the Covid pandemic. Some commenced a TTS trading activity after the Covid crash in March 2020; it’s important to note trading gains do not conflict with unemployment insurance benefits. A TTS S-Corp with officer compensation, however, does conflict with unemployment benefits.

“For 2020, excludes from gross income up to $10,200 of unemployment compensation received for individuals with adjusted gross income of less than $150,000.”

Child Tax Credit

“Increases the child tax credit amount for 2021 only, to $3,600 for children under 6, and to $3,000 for children ages 6 to 17; expands definition of ‘qualifying child’ to include 17-year-olds.”

Credits for Paid Sick and Family Leave for Certain Self-Employed Individuals

“Extends the refundable paid sick time and paid family leave credits established by the Families First Coronavirus Response Act through September 30, 2021. For purposes of the family leave credit, between April 1, 2021, and September 30, 2021, eligible wages are increased to $12,000 from $10,000. Extends eligibility to additional self-employed workers.”

Student Loan Forgiveness

“For eligible student loans discharged in 2021-2025, the discharged amounts are excluded from income. The exclusion from income does not apply to the discharge of a loan made by certain lenders if the discharge is on account of services performed for the lender.”

Links

FACT SHEET: The American Rescue Plan Will Deliver Immediate Economic Relief to Families (U.S. Department of the Treasury, March 18, 2021)

The American Rescue Plan (Whitehouse.Gov). Consumer-friendly approach. 

Tax provisions in the American Rescue Plan Act (Journal of Accountancy, Feb. 27, 2021)

 

CARES Act Allows 5-Year NOL Carrybacks For Immediate Tax Refunds

April 9, 2020 | By: Robert A. Green, CPA | Read it on

Live Updates:

April 13: “IRS Provides NOL Guidance and Deadline Extension:  Rev. Proc. 2020-24 issues guidance on IRC Sec. 172(b)(1), amended by Sec. 2303 of the CARES Act, which requires taxpayers to carry back NOLs arising in tax years beginning in 2018, 2019, and 2020 to the five preceding tax years, unless the taxpayer elects to waive or reduce the carryback period.” (Checkpoint.)

April 9: 
IRS provides guidance under the CARES Act to taxpayers with net operating losses. IR-2020-67, April 9, 2020 — “The Internal Revenue Service today issued guidance providing tax relief under the CARES Act for taxpayers with net operating losses. Recently the IRS issued tax relief for partnerships filing amended returns.”

The six-month extension of time for filing NOL forms: In Notice 2020-26 (PDF), “the IRS grants a six-month extension of time to file Form 1045 or Form 1139, as applicable, with respect to the carryback of a net operating loss that arose in any taxable year that began during the calendar year 2018 and that ended on or before June 30, 2019.  Individuals, trusts, and estates would file Form 1045 (PDF), and corporations would file Form 1139 (PDF).” (The IRS is temporarily allowing taxpayers to fax in these forms.)

Good news: TTS traders have until June 30, 2020, to file a 2018 Form 1045 for a 2018 NOL. They should get moving on these NOL carrybacks ASAP. Otherwise, they need Form 1040X which takes longer to process by the IRS.

March 28: On March 27, 2020, President Trump signed into law the Coronavirus Aid, Relief, and Economic Security (CARES) Act. This bill includes significant economic aid and tax relief provisions. Some tax relief applies retroactively to 2018, 2019, and 2020. Today, I focus on NOL carrybacks.

If you have a net operating loss (NOL) from business activities in 2018, 2019, and 2020, you should consider filing NOL carryback claims going back five years. 

Active traders who are eligible for trader tax status (TTS) are considered businesses with NOLs. A TTS trader might have significant trading expenses or Section 475 ordinary losses comprising an NOL. 

CARES temporarily suspends tax-loss limitations from the Tax Cuts and Jobs Act (TCJA) for 2018, 2019, and 2020. TCJA had repealed two-year NOL carrybacks, only allowing NOL carryforwards limited to 80% of the subsequent year’s taxable income. As you may remember, TCJA introduced the excess business loss (EBL) limitation, where aggregate business losses over an EBL threshold ($500,000 for married and $250,000 for other taxpayers for 2018) were considered an NOL carryforward. 

CARES lifts these TCJA limitations and allows taxpayers to recalculate 2018 and 2019 NOLs and file refund claims going back five years for immediate tax relief. Taxpayers will be able to carryback 2020 NOLs five years, too, but not until they file 2020 tax returns in 2021. 

TTS traders with Section 475 ordinary losses and those without 475 but who have significant NOLs from expenses (i.e., borrow fees on short-selling) should consider NOL carrybacks, too. 

Here’s an example

Joe Smith, a TTS trader with Section 475, filed a 2018 income tax return showing a $400,000 NOL. Joe’s NOL came from trading expenses ($50,000) and Section 475 trading losses ($350,000); he had no other income or loss.

Under TCJA, Joe’s only option is an NOL carryforward; therefore, his draft 2019 tax return has a low income, utilizing a small portion of his NOL. Joe has more trading losses and expenses YTD for 2020, so he is holding a deferred tax asset. Joe is thrilled that CARES opens the door to NOL carrybacks because he had substantial taxable income from other activities in years previous to 2018. 

We await IRS and state guidance on CARES to indicate precisely how Joe and his tax preparer should proceed with NOL recalculation and carryback returns. We have questions:

  1. Must taxpayers with EBL limitations amend 2018 tax returns to remove EBL and recalculate NOLs? Is CARES retroactive application to 2018 and 2019 an optional or mandatory requirement? Some taxpayers might prefer to leave things the way they are under TCJA.
  2. CARES allows taxpayers to carryback NOLs from 2018, 2019, and 2020 five years. Usually, tax years close after three years, so how will this work for 2018 NOL five-year carrybacks? For example, 2016 income tax returns filed by April 15, 2017, might close three years after by April 15, 2020. Is that postponed to July 15, 2020, with the IRS relief? Can a taxpayer go back five years before 2018? 
  3. The usual tax deadline for filing a 2018 Form 1045 (Application for Tentative Refund) for NOL carrybacks was Dec. 31, 2019. Will this deadline be extended? (We prefer using this form since the IRS must address the form within 90 days.) Alternatively, taxpayers may use Form 1040X (Amended U.S. Individual Income Tax Return) for each NOL carryback year, which often takes the IRS six months or more to address and pay the refunds. Will the form be expedited during this unprecedented time? There are other procedural questions beyond the scope of this blog post.
  4. Which states will conform with CARES on these tax changes, especially NOL carryback refund claims? During the Great Recession of 2008 and 2009, stimulus tax legislation allowed generous NOL carrybacks. However, some states decoupled from federal law on those changes. For example, California did not allow NOL carrybacks at all, and it restricted NOL carryforwards in several ways. 

Stay tuned to our blog post as we seek answers to these questions. I plan to cover other CARES tax changes that affect TTS traders, too. 

March 27: Congress and President Trump enacted into law the Coronavirus Aid, Relief, and Economic Security (CARES) Act. This “virus bill” includes significant economic aide and tax provisions to help all taxpayers. The House did not make any changes to the Senate version.

March 25: Senate Passes Updated Economic Relief Plan (CARES Act) for Individuals and Businesses (Tax Foundation). The final version of the law includes the tax-loss provisions covered in the March 20 update below. Here are the code sections from Thomson Reuters CheckPoint:

  • “NOLs arising in a tax year beginning after December 31, 2018 and before January 1, 2021 can be carried back to each of the five tax years preceding the tax year of such loss. (Code Sec. 172(b)(1) as amended by Act Sec. 2303(b)(1))
  • temporarily removes the taxable income limitation to allow an NOL to fully offset income. (Code Sec. 172(a), as amended by Act Sec. 2303(a)(1))
  • temporarily modifies the loss limitation for noncorporate taxpayers so they can deduct excess business losses arising in 2018, 2019, and 2020. (Code Sec. 461(l)(1), as amended by Act Sec. 2304(a))
  • temporarily and retroactively increases the limitation on the deductibility of interest expense under Code Sec. 163(j)(1) from 30% to 50% for tax years beginning in 2019 and 2020. (Code Sec. 163(j)(10)(A)(i) as amended by Act Sec. 2306(a)).” (See special rules for partnerships.)

March 20: Congress should proceed with new legislation like the Coronavirus Aid, Relief, and Economic Security Act, to provide additional tax relief, beyond the Treasury Department moving the April 15 tax deadline to July 15, 2020.

Senate Majority Leader Mitch McConnell’s CARES Act bill temporarily suspends the Tax Cuts and Jobs Act (TCJA) business loss limitations, including reauthorizing NOL five-year carrybacks, repealing the excess business loss (EBL) limitation, and loosening the business interest expense limitation. That’s fantastic news, as businesses need tax relief for losses ASAP. Here are the related CARES Act provisions:

  • 2203: Section 172(b)(1) – “Net operating loss carrybacks and carryovers” – Special Rule for losses arising in 2018, 2019, and 2020, such loss shall be a net operating loss carryback to each of the five taxable years preceding the taxable year of such loss.
  • 2203: Temporary repeal of 80% income limitation to deduct a 2018 and forward NOL for year beginning before 2021.
  • 2204: Repeal of 461(l) for 2018, 2019 and 2020 – excess business losses.
  • 2206: 163(j) special rules for 2019 and 2020, increasing ATI percentage from 30% to 50% for limitation on business interest.

CPA industry groups are also asking Congress to raise the $3,000 capital loss limitation, which was never indexed for inflation.

Treasury Secretary Steven Mnuchin announced President Trump’s directive to move the April 15 tax deadline to July 15, 2020, thereby postponing tax filings and tax payments for all taxpayers. Mnuchin said the extension would give “all taxpayers and business this additional time” to file returns and make tax payments “without interest or penalties.” I expect Treasury and the IRS will issue specific guidance soon. Hopefully, all states will follow suit with this federal change, so taxpayers don’t face conflicting rules.

Traders and 475 elections: Although it’s not guaranteed, I think the IRS might accept a 2020 Section 475 election submitted by July 15, 2020, since that is the new tax filing date. It would afford traders 90 days of additional hindsight. IRS FAQs might not address elections, although the CARES Act includes moving of election deadlines, too. If you have a massive Q1 2020 trading loss as a TTS trader, and you are counting on an NOL carryforward, or carryback if allowed, then it might be wise to file an extension by April 15, 2020, and attach a 2020 Section 475 election statement. I think you should be able to revise the election by July 15, 2020, if warranted. (See Massive Market Losses? Elect 475 For Enormous Tax Savings.)

March 19: Senator John Thune introduced a two-page bill Tax Filing Relief for America Act “To extend the due date for the return and payment of Federal income taxes to July 15, 2020, for taxable year 2019.” Treasury and the IRS recently issued guidance to delay certain tax payments for 90 days until July 15, 2020. Still, Treasury did not postpone the April 15 tax filing deadline, putting an undue burden on taxpayers and accountants. Thune’s legislation syncs tax filings with tax payments in a simple manner, whereas Treasury’s guidance is causing tremendous confusion. Senate Majority Leader Mitch McConnell introduced the Coronavirus Aid, Relief, and Economic Security Act, which incorporates Thune’s bill. Thanks to the AICPA for pushing Congress and Treasury hard to get this critical April 15 tax relief. Why rush an April 15 tax filing, exposing clients and accountants to coronavirus, if Treasury already postponed tax payments? See the AICPA Coronavirus Resource Center.

For prior updates, see Updated: April 15 Tax Deadline Moved To July 15.

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.