The best way to reduce income taxes is with year-end tax planning. Don’t wait until February when you begin preparation of 2019 tax returns; that’s too late for many tax savings strategies.
If you have an S-Corp that is eligible for trader tax status (TTS), don’t miss that section further down below, which includes essential year-end transactions, including formal payroll tax compliance for officer compensation. That unlocks the health insurance and or retirement plan deductions.
Defer income and accelerate tax deductions
Consider the time-honored strategy of deferring income and accelerating tax deductions if you don’t expect your taxable income to decline in 2020. We expect tax rates to be the same for 2020, although the IRS will adjust the tax brackets for inflation. Enjoy the time-value of money with income deferral.
Year-end tax planning is a challenge for traders because they have wide fluctuations in trading results, making it difficult to forecast their income. Those expecting to be in a lower tax bracket in 2020 should consider income deferral strategies. Conversely, a 2019 TTS trader with ordinary losses, waiting to be in a higher tax bracket in 2020, might want to consider income acceleration strategies.
Taxpayers with trader tax status in 2019 should consider accelerating trading business expenses, such as purchasing business equipment with full expensing.
Don’t assume that accelerating itemized deductions is also a smart move; there may be two problems. TCJA suspended and curtailed various itemized deductions after 2017, so there is no sense in expediting a non-deductible item. Even with the acceleration of deductible expenses, many taxpayers will be better off using the 2019 standard deduction of $24,400 married or $12,200 single. If itemized deductions are below the standard deduction, consider a strategy to “bunch” them into one year and take the standard deduction in other years.
Accelerate income and defer certain deductions
A TTS trader with substantial ordinary losses (Section 475) under the “excess business loss limitation” (EBL, see below) should consider accelerating income to soak up the allowable business loss, instead of having an NOL carryover. Try to advance enough income to use the standard deduction and take advantage of lower tax brackets. Be sure to stay below the thresholds for unlocking various types of AGI-dependent deductions and credits.
Roth IRA conversion: Convert a traditional IRA into a Roth IRA before year-end to accelerate income. The conversion income is taxable in 2019, but the 10% excise tax on early withdrawals before age 59½ is avoided providing you pay the conversion taxes from outside the Roth plan. One concern is that TCJA repealed the recharacterization option; you can no longer reverse it if the plan assets decline after conversion. There isn’t an income limit for making Roth IRA conversions, whereas there is for making regular Roth IRA contributions. For example, a taxpayer filing single has a $405,000 TTS/475 ordinary loss. However, the excess business loss limitation is $255,000, and $150,000 is an NOL carryover. Consider a Roth conversion to soak up most of the $255,000 allowed business loss, and leave enough income to use the standard deduction and lower tax brackets.
Sell winning positions: Another way a trader can accelerate income is to sell open winning positions to realize capital gains.
Consider selling long-term capital gain positions. The 2019 long-term capital gains rates are 0% for taxable income under $39,375 single, and $78,750 married filing jointly. The 15% capital gains rate applies to taxable income up to $434,550 for filing single and $488,850 married filing jointly. The top bracket rate of 20% applies above those amounts.
Net investment tax: Investment fees and expenses are not deductible for calculating net investment income (NII) for the Affordable Care Act (ACA) 3.8% net investment tax (NIT) on unearned income. NIT only applies to individuals with NII and modified adjusted gross income (AGI) exceeding $200,000 single, $250,000 married filing jointly, or $125,000 married filing separately. The IRS does not index these ACA thresholds for inflation. NII includes capital gains and Section 475 ordinary income.
Business expenses and itemized deduction vs. standard deduction
Business expenses: TTS traders are entitled to deduct business expenses and home-office deductions from gross income. The home office deduction requires income, except for the mortgage interest and real property tax portion. The SALT cap on state and local taxes does not apply to the home office deduction. TCJA expanded full expensing of business property; traders can deduct 100% of these costs in the year of acquisition, providing they place the item into service before year-end. If you have TTS in 2019, considering going on a shopping spree before January 1. There is no sense deferring TTS expenses because you cannot be sure you will qualify for TTS in 2020.
Employee business expenses: Ask your employer if they have an “accountable plan” for reimbursing employee-business costs. You must “use it or lose it” before the year-end. TCJA suspended unreimbursed employee business expenses. A TTS S-Corp should use an accountable plan to reimburse employee business expenses since the trader/owner is an employee of the S-Corp.
Unreimbursed partnership expenses: 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 the year-end. The IRS doesn’t want S-Corps to use UPE.
SALT cap: TCJA’s most contentious provision was capping state and local income, sales, and property taxes (SALT) at $10,000 per year ($5,000 for married filing separately) – and not indexing it for inflation. Many high-tax states continue to contest the SALT cap, but they haven’t prevailed in court. The IRS reinforced the new law by blocking various states’ attempts to recast SALT payments as charitable contributions, or payroll tax as a business expense. Stay tuned to news updates about SALT.
Investment fees and expenses: TCJA suspended all miscellaneous itemized deductions subject to the 2% floor, which includes investment fees and expenses. TCJA left just two itemized deductions for investors: Investment-interest expenses limited to investment income, with the excess as a carryover, and stock borrow fees for short-sellers.
Standard deduction: TCJA roughly doubled the 2018 standard deduction and suspended and curtailed several itemized deductions. The 2019 standard deduction is $12,200 single, $24,400 married, and $18,350 head of household. There is an additional standard deduction of $1,300 for the aged or the blind. Many more taxpayers will use the standard deduction, which might simplify their tax compliance work. For convenience sake, some taxpayers may feel inclined to stop tracking itemized deductions because they figure they will use the standard deduction. Don’t overlook the impact of these deductions on state tax filings where you might get some tax relief for itemizing deductions.
Estimated income taxes and AMT
Estimated income taxes: If you already reached the SALT cap, you don’t need to prepay 2019 state estimated income taxes by December 31, 2019. Pay federal and state estimated taxes owed when due by January 15, 2020, with the balance of your tax liabilities payable by April 15, 2020. You can gain six months of additional time by filing an automatic extension on time, but late-payment penalties and interest will apply on any tax balance due. (See Tax Extensions: 12 Tips To Save You Money.)
Many traders skip making quarterly estimated tax payments during the year, figuring they might incur trading losses later in the year. Catch up with the Q4 estimate due by January 15. Some rely on the safe harbor exception to cover their prior year taxes. TTS S-Corp traders should consider withholding additional taxes on year-end paychecks in connection with retirement plan contributions, which helps avoid underestimated tax penalties since the IRS treats wage withholding as being made throughout the year.
AMT: In prior years, taxpayers had to figure out how much they could prepay their state without triggering alternative minimum tax (AMT) since state taxes are not deductible for AMT taxable income. It’s easier in 2019 with SALT capped at $10,000 and because TCJA raised the 2019 AMT exemptions to $510,300 single and $1,020,600 married filing jointly. Taxpayers subject to AMT should not accelerate AMT preference items.
Avoid wash sale loss adjustments
Wash sales: Taxpayers must report wash sale (WS) loss adjustments on securities based on substantially identical positions across all accounts, including IRAs. Conversely, brokers assess WS only on identical positions per the one account. Active securities traders should use a trade accounting program or service to identify potential WS loss problems, especially going into year-end.
In taxable accounts, a trader can break the chain by selling the position before year-end and not repurchasing a substantially identical position 30 days before or after in any of his taxable or IRA accounts. Avoid WS between taxable and IRA accounts throughout the year, as that is otherwise a permanent WS loss. (Starting a new entity effective January 1, 2020, can break the chain on individual account WS at year-end 2019 provided you don’t purposely avoid WS with the related party entity.)
WS losses might be preferable to capital loss carryovers at year-end 2019 for TTS traders. A Section 475 election in 2020 converts year-end 2019 WS losses on TTS positions (not investment positions) into ordinary losses in 2020. That’s better than a capital loss carryover into 2020, which might give you pause to making a Section 475 election. You want a clean slate with no remaining capital losses before electing Section 475 ordinary income and loss. (See How To Avoid Taxes On Wash Sale Losses.)
Trader tax status and Section 475
Trader tax status: If you qualify for TTS (business expense treatment — no election needed) in 2019, accelerate trading expenses into that qualification period as a sole proprietor or entity. If you don’t qualify until 2020, try to defer trading expenses until then. You may also capitalize and amortize (expense) Section 195 startup costs and Section 248 organization costs in the new TTS business, going back six months before commencement. TTS is a prerequisite for electing and using Section 475 MTM. (See How Traders Get Enormous Tax Deductions, And Investors Do Not.)
Section 475 MTM: TTS traders choose Section 475 on securities for exemption from wash-sale loss rules and the $3,000 capital loss limitation — and to be eligible for the 20% QBI deduction. To make a 2019 Section 475 election, existing individual taxpayers had to file an election statement with the IRS by April 15, 2019 (March 15 for existing S-Corps and partnerships). If they filed that election statement on time, they need to complete the election process by submitting a 2019 Form 3115 with their 2019 tax return. Those who missed the 2019 election deadline may want to consider the election for 2020. Capital loss carryovers are a concern; use them up against capital gains but not Section 475 ordinary income. Once you make a 475 election, it remains in effect; you don’t have to elect it every year. You are entitled to revoke a 475 election, in the same manner, you elect it. If you stop qualifying for TTS, then 475 treatment is suspended until you requalify.
If you make a Section 475 election by April 15, 2020, it takes effect on January 1, 2020. In converting from the realization (cash) method to the mark-to-market (MTM) method, you need to make a Section 481(a) adjustment on January 1, 2020. It’s unrealized capital gains, and losses on open TTS securities positions held on December 31, 2019. Do not apply Section 475 to investment positions. If you are not a TTS trader as of year-end 2019, then you won’t have a Section 481(a) adjustment. (See Section 481(a) Positive Adjustment Spread Period Changes.)
A “new taxpayer” entity can elect Section 475 within 75 days of inception. That would come in handy if you missed the individual sole proprietor deadline (April 15, 2019) for choosing Section 475. Forming a new entity on November 1, 2019, or later, is too late for establishing TTS for the 2019 short calendar year. Consider waiting until January 1, 2020, for starting a new entity with TTS and electing Section 475.
20% deduction on qualified business income
In August 2018, the IRS issued proposed reliance regulations (Proposed §1.199A) for the TCJA’s 20% deduction on qualified business income (QBI) in pass-through entities. On January 18, 2019, the IRS issued the final 199A regs. The proposed and final regulations confirm that traders eligible for TTS are a “specified service activity,” which means if their taxable income is above an income cap, they won’t receive a QBI deduction. The 2019 taxable income (TI) cap is $421,400/$210,700 (married/other taxpayers). The phase-out range below the cap is $100,000/$50,000 (married/other taxpayers), in which the QBI deduction phases out for specified service activities. The W-2 wage and property basis limitations also apply within the phase-out range. Investment managers are specified service activities, too.
QBI includes Section 475 ordinary income and loss, and trading business expenses. QBI excluded capital gains and losses, Section 988 forex and swap ordinary income or loss, dividends, and interest income. Our firm took a favorable position on QBI for traders. (See A Rationale For Using QBI Tax Treatment For Traders.)
TCJA favors non-service businesses, which are not subject to an income cap. The W-2 wage and property basis limitations apply above the 2019 TI threshold of $321,400/$160,700 (married/other taxpayers). The IRS adjusts the annual TI income threshold for inflation each year.
Taxpayers might be able to increase the QBI deduction with smart year-end planning. If taxable income falls within the phase-out range for a specified service activity, or even above for a non-service business, you might need higher wages, including officer compensation, to avoid a W-2 wage limitation on the QBI deduction. Deferring income can also help get under various QBI restrictions and thresholds.
Net operating losses and the Section 1256 loss carryback election
Net operating losses: Section 475 ordinary losses and TTS business expenses contribute to net operating loss (NOL) carryforwards, which are limited to 80% of taxable income in the subsequent year(s). Get immediate use of some or all of NOLs with a Roth IRA conversion before year-end and other income acceleration strategies. TCJA repealed NOL carrybacks after 2017 with one exception; farmers may carry back an NOL two tax years. TCJA made NOL carryforwards unlimited, changing the carryforward period from 20 years. Repealing NOL carrybacks negatively impacts TTS traders using 475 ordinary loss treatment. We helped traders obtain significant NOL refunds before 2018, which helped them remain in business. An “excess business loss” (EBL) over the limitation is an NOL carryforward, and accelerating non-business income won’t avoid EBL. (See EBL below.)
Section 1256 loss carryback election: The only remaining carryback for traders is a Section 1256 loss carryback to the prior three tax years, offset against 1256 gains, not other types of income. Any loss remaining is carried forward. Consider making a Section 1256 loss carryback election on a 2019 Form 6781 timely filed with a 2019 tax return.
There are other tax advantages to trading Section 1256 contracts. They have lower 60/40 capital gains tax rates, meaning 60% (including day trades) use the lower long-term capital gains rate, and 40% use the short-term rate, which is the ordinary tax rate. At the maximum tax brackets for 2019, the top Section 1256 contract tax rate is 26.8% —10.2% lower than the highest ordinary rate of 37%. Section 1256 tax rates are 4.2% to 12% lower vs. ordinary rates depending on which tax bracket applies. Section 1256 contracts are marked-to-market (MTM), so you don’t have to do tax-loss selling at year-end. (See Trading Futures & Other Section 1256 Contracts Has Tax Advantages.)
Limitations on excess business losses and business interest expense
Excess business loss limitation: TCJA included an “excess business loss” (EBL) limitation of $500,000/$250,000 (married/other taxpayers) for 2018. (The 2019 inflation-adjusted limit is $510,000/$255,000 (married/other taxpayers). Aggregate EBL from all pass-through businesses: A profitable company can offset another business with losses to remain under the limit. Include wage income in aggregate EBL. Other types of income and non-business losses do not affect the EBL calculation (i.e., capital gains and losses). EBL over the limit is an NOL carryforward.
Example of EBL limitation: TTS/475 trader filing single has an ordinary loss of $500,000 for 2019. It’s considered a business loss. He has income from wages of $100,000, so his net EBL is $400,000. The 2019 EBL limitation is $255,000 and the 2019 NOL carryover to 2020 is $145,000 ($400,000 minus $255,000).
Business interest expense: TCJA introduced a limitation on deducting business interest expense in Section 163(j). The 30% limitation should not impact most TTS traders because the $25 million three-year average “gross receipts” threshold applies to net trading gains, not proceeds. That’s good news because if gross receipts used total sales proceeds on trades, then a TTS trader with trading losses might have a business interest expense limitation. With net trading gains being the standard, only more substantial hedge funds might be impacted.
S-Corp officer compensation, health insurance, and retirement plan deductions
TTS traders need an S-Corp trading company to arrange health insurance and retirement plan deductions. These deductions require earned income or self-employment income, and trading gains are not that. S-Corp salary is considered earned income.
2019 S-Corp: The S-Corp must execute officer compensation, in conjunction with employee benefit deductions, through formal payroll tax compliance before the year-end 2019. Otherwise, traders miss the boat. TTS is an absolute must since an S-Corp investment company cannot have tax-deductible wages, health insurance, and retirement plan contributions. This S-Corp is not required to have “reasonable compensation” as other types of businesses are, so a TTS trader may determine officer compensation based on how much to reimburse for health insurance, and how much they want to contribute to a retirement plan. Keep an eye out for the QBI deduction; if you are in the QBI phase-out range, you might wish to have higher wages to increase a QBI deduction. For payroll tax compliance services, I recommend paychex.com; they have a dedicated team for our TTS S-Corp clients. Sole proprietor and partnership TTS traders cannot pay salaries to 2% or more owners.
Health insurance deduction: A TTS S-Corp may only deduct health insurance for the months the S-Corp was operational and qualified for TTS. Employer-provided health insurance, including Cobra, is not deductible. A TTS S-Corp doesn’t need to be profitable for the health insurance deduction.
Health Savings Account: A taxpayer can deduct a contribution to a health savings account (HSA) without needing TTS eligibility or earned income. HSA contribution limits for 2019 are $3,500 individual and $7,100 for family coverage. There’s an additional $1,000 for age 55 or older. Fully fund and utilize the HSA before year-end.
Flexible Spending Account: Some employers offer a flexible spending account (FSA) for covering health care copayments, deductibles, some drugs, and other health care costs. Fully fund and utilize the FSA before year-end.
Solo 401(k) retirement plan: A TTS S-Corp formed later in the year can unlock a retirement plan deduction for an entire year by paying sufficient officer compensation in December when results for the year are evident. Traders should only fund a retirement plan from trading income, not losses.
You must establish (open) a Solo 401(k) retirement plan for a TTS S-Corp with a financial intermediary before the year-end 2019. Plan to pay the 2019 100%-deductible elective deferral amount up to a maximum of $19,000 (or $25,000 if age 50 or older) with December payroll. That elective deferral is due by the end of January 2020. You can fund the 25% profit-sharing plan (PSP) portion of the S-Corp Solo 401(k) up to a maximum of $37,000 by the due date of the 2019 S-Corp tax return, including extensions, which means September 15, 2020. The maximum PSP contribution requires wages of $148,000 ($37,000 divided by 25% defined contribution rate). Do tax planning calculations to see the projected outcome of income tax savings vs. payroll tax costs for the various options.
Consider a Solo 401(k) Roth, where the contribution is not deductible, but the contribution and growth within the Roth are permanently tax-free. Traditional plans have a tax deduction upfront, and all distributions are subject to ordinary income taxes in retirement. Traditional retirement plans have required minimum distributions (RMD) by age 70 ½, whereas Roth plans don’t have RMD.
Setting up a TTS S-Corp for 2020
If you missed out on employee benefits in 2019, then consider an LLC with S-Corp election for 2020. If you wait to start your entity formation process on January 1, 2020, you won’t be ready to trade in an entity account on January 1, 2020. Instead, you can form a single-member LLC by mid-December 2019, obtain the employee identification number (EIN), and open the LLC brokerage account before year-end. The single-member LLC is a disregarded entity for 2019, which avoids an entity tax return filing for the 2019 partial year. If desired, add your spouse as a member of the LLC on January 1, 2020, which means the LLC will file a partnership return. If you want health insurance and retirement plan deductions, then your single-member or spousal-member LLC should submit a 2020 S-Corp election by March 15, 2020. The S-Corp should also consider making a Section 475 MTM election on securities only for 2020 by March 15.
Tax-loss selling of financial instruments
If you own an investment or trading portfolio, you have the opportunity to reduce capital gains taxes via “tax-loss selling.” If you realized significant short-term capital gains year-to-date in 2019 and have open positions with substantial unrealized capital losses, you should consider selling (realizing) some of those losses to reduce 2019 capital gains taxes. Don’t repurchase the losing position 30 days before or after, as that would negate the tax loss with wash-sale loss rules.
The IRS has rules to prevent the deferral of income and acceleration of losses in offsetting positions that lack sufficient economic risk. These rules include straddles, the constructive sale rule, and shorting against the box. Also, be aware of “constructive receipt of income” — you cannot receive payment for services, turn your back on that income, and defer it to the next tax year.
Tax-loss selling is inefficient for short-term positions that reduce long-term capital gains. It’s also a moot point with Section 1256 and Section 475 positions since they are mark-to-market positions reporting realized and unrealized gains and losses.
Married couples should compare filing joint vs. separate
Each year, married couples choose between “married filing jointly” (MFJ) vs. “married filing separately” (MFS). TCJA fixed several inequities in filing status, including the tax brackets by making single, MFJ and MFS equivalent, except for divergence at the top rate of 37% for single filers, retaining some of the marriage penalty. There are other issues to consider, too.
Married couples may be able to improve QBI deductions, AGI, and other income-threshold dependent deductions, and credits with MFS in 2019. It’s wise to enter each spouse’s income, gain, loss, and expense separately and have the tax planning and preparation software compare MFJ vs. MFS. In a community property state, there are special rules for allocating income between spouses.
Filing MFS might unlock a QBI deduction, where one spouse might price the other spouse out of a QBI deduction based on exceeding the income cap for a specified service activity.
Miscellaneous considerations for individuals
Sell off passive-loss activities to utilize suspended passive-activity losses.
Maximize contributions to retirement plans. That lowers AGI and other income thresholds, which can unlock more of a QBI deduction, reduce net investment tax, and unlock credits and other tax benefits. Consider non-deductible IRA contributions.
The IRS has many obstacles to deferring income, including passive-activity loss rules, a requirement that certain taxpayers use the accrual method of accounting and limitations on charitable contributions. TCJA allows more businesses to use the cash method.
Consider a charitable remainder trust to bunch philanthropic contributions for itemizing deductions. (Ask Fidelity or Schwab about it.)
Donate appreciated securities to charity: You get a charitable deduction at the FMV and avoid capital gains taxes. (This is a favorite strategy by billionaires, and you can use it, too.)
Retirees must take required minimum distributions (RMD) by age 70½ unless it’s a Roth IRA. Per TCJA, consider directing your traditional retirement plan to make “qualified charitable distributions” (QCD). That satisfies the RMD rule with the equivalent of an offsetting charitable deduction, allowing you to take the standard deduction rather than itemize charitable contributions.
TCJA improves family tax planning: Section 529 qualified tuition plans now can be used to pay for tuition at an elementary or secondary public, private or religious school, up to $10,000 per year (check with your state). The 2019 annual gift exclusion is $15,000, and its $155,000 to noncitizen spouses; the 2019 unified credit for federal estate tax is $11.40 million per person, and “step-up in basis” rules still avoid capital gains taxes on inherited appreciated property. TTS traders should also consider hiring adult children as employees. (See How To Save Taxes With Children.)
TCJA created Qualified Opportunity Zones (QOZ) “to spur economic development and job creation in distressed communities throughout the country and U.S. possessions by providing tax benefits to investors who invest eligible capital into these communities. Taxpayers may defer tax on eligible capital gains by making an appropriate investment in a Qualified Opportunity Fund and meeting other requirements,” per Opportunity Zones Frequently Asked Questions.)
Adam Manning CPA contributed to this blog post.
This blog post is an updated version of chapter 9 on tax planning in Green’s 2019 Trader Tax Guide. Free upgrade: If you purchase Green’s 2019 Trader Tax Guide after October 15, 2019, we will email you online access to Green’s 2020 Trader Tax Guide around the middle of January 2020.
Our CPAs are standing by in November and December to help clients with 2019 year-end tax planning. Our tax compliance service includes tax planning and preparation, and we look forward to helping you execute the above tax strategies. Please contact us soon.
Consider a 45-minute consultation with Robert A. Green, CPA to discuss eligibility for TTS and if an entity if helpful to you. Upgrade to our entity formation service after, if warranted.
Join my upcoming Webinar on November 13, 2019, or watch the recording after to learn more about this content: Tax Planning At Year-End Generates The Most Savings
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