Tag Archives: trader tax status

Traders Should Focus On Q4 Estimated Taxes Due Jan. 15

September 25, 2020 | By: Robert A. Green, CPA

Many traders have substantial trading gains for 2020 YTD, and they might owe 2020 estimated taxes paid to the IRS quarterly. Unlike wages, taxes aren’t withheld from trading gains. Others can wait on tax payments until April 15, 2021, when they file their 2020 tax return or extension.

The first two-quarters of estimated tax payments were due July 15, 2020 (the postponed date due to Covid), Q3 was due on Sept. 15, 2020, and Q4 is due on Jan. 15, 2021. Many new traders didn’t submit estimated payments for the first three quarters, waiting to see what Q4 brings. With full transparency at year-end, traders can make Q4 payments with more clarity. Some traders view estimated taxes similar to a margin loan with interest rates of 5% for Q1 and Q2, and 3% for Q3.

The safe-harbor rule for paying estimated taxes says there’s no penalty for underpayment if the payment equals 90% of the current-year tax bill or 100% of the previous year’s amount (whichever is lower). If your prior-year adjusted gross income (AGI) exceeded $150,000 or $75,000 if married filing separately, then the safe-harbor rate rises to 110%. 

Suppose your 2019 tax liability was $40,000, and AGI was over $150,000. Assume 2020 taxes will be approximately $100,000, and you haven’t paid estimates going into Q4. Using the safe-harbor rule, you can spread out the payment, submitting $44,000 (110% of $40,000) with a Q4 voucher on Jan. 15, 2021, and paying the balance of $56,000 by April 15, 2021. This is an excellent option to consider instead of sending $90,000 in Q4 (90% of $100,000). Consider setting aside that tax money due April 15 rather than risking it in the financial markets in Q1 2021. I’ve seen some traders lose their tax money owed and get into trouble with the IRS. 

In the above example, the trader should calculate the underpayment of estimated tax penalties for Q1, Q2, and Q3 on the 2020 Form 2210. Consider using Form 2210’s Annualized Income Installment Method (page 4) if the trader generated most of his trading income later in the year. The default method on 2210 allocates the annual income to each quarter, respectively.

If your 2019 income tax liability is significantly higher than your 2020 tax liability, consider covering 90% of the current year’s taxes with estimated taxes. Check your state’s estimated tax rules, too.

Learn more about estimated taxes at https://www.irs.gov/businesses/small-businesses-self-employed/estimated-taxes.

Employees have another way to avoid underpayment of estimated tax penalties on non-wage income. They can ask employers to increase their wage tax withholding in November and December, which the IRS treats as equally made throughout the year.

Darren Neuschwander CPA contributed to this blog post.

Will The IRS Deny Tax Benefits To Traders Due To Covid?

September 14, 2020 | By: Robert A. Green, CPA | Read it on

So far, 2020 has been a highly volatile year in the financial markets due to significant uncertainty over Covid-19, a shock to the economy, and job losses. As the virus spread in the U.S, millions of displaced Americans turned to trading in financial markets as a means of making a new living. Some became active enough to qualify for trader tax status (TTS) benefits, which requires regular, frequent, and continuous trading. However, will the IRS deny TTS to Covid-19 traders if they only carry on a trading business during the pandemic for a short time?

I’m not as worried about existing traders from 2019 who incurred massive trading losses in Q1 2020 during the Covid correction and stopped trading at that time. Hopefully, they made a Section 475 ordinary loss election due by the July 15, 2020 deadline, which is conditional on eligibility for TTS. These pre-Covid traders were in business for more than 15 months, so their TTS/475 ordinary loss deduction should be safe.

I am more concerned with the millions of newcomer traders who opened online trading accounts offering free or low commissions in 2020. Many rookies have significant trading gains year-to-date, even after the recent sell-off. In the trading business, gains can turn into losses with a substantial correction. When that happens, TTS traders count on Section 475 for tax-loss or fire-loss insurance: The trading house burns down, and you can file for a refund with the IRS. The CARES Act permits five-year net operating loss (NOL) carryback refund claims for 2020, 2019, and 2018 tax returns.

Some rookie traders start off meeting the IRS requirements for TTS. Those rules are vague, so see GreenTraderTax’s golden rules for TTS. I wonder how IRS agents will consider the Covid pandemic when assessing TTS. Consider a furloughed worker who started trading at home full time in mid-2020. Was the trader’s intention to create a new business for the long-term, or to buy time and make some extra money before returning to his or her career after the pandemic subsides? TTS requires the intention to run a business from catching daily market movements, not from making investments for appreciation.

If a new trader started trading on June 1, 2020, but stops or significantly slows down trading when returning to work in November 2020, will the IRS deny TTS because he only traded actively for five months? The IRS agent might cite the landmark tax court case Chen vs. Commissioner, where TTS was denied. Chen only carried on TTS for three months.

I analyzed the Chen case in my trader tax guide; here’s an excerpt. 

Chen vs. Commissioner

Comments from a senior IRS official about the Chen tax court case point out the IRS doesn’t respect individual traders who are brand new to trading activity and who enter and exit it too quickly. Chen only traded for three months before losing his trading money, thereby leaving his trading activity. Chen kept his software engineering job during his three months of trading.

The Chen case indicates the IRS wants to see a more extended time to establish TTS. Some IRS agents like to intimidate taxpayers with a full year requirement, but the law does not require that. Hundreds of thousands of businesses start and fail within three months, and the IRS doesn’t challenge them on business status. The IRS is rightfully more skeptical of traders vs. investors, perhaps even more so during the pandemic. The longer a trader can continue his business trading activity, the better his chances are with the IRS. We often ask clients about their trading activities in the prior and subsequent years as we prepare their tax returns for the year that just ended. Vigorous subsequent-year trading activities and gains add credibility to the tax return being filed. We mention these points in tax return footnotes, too. Traders can start their trading business in Q4 and continue it into the subsequent year.

Chen messed up many things in this case. First and foremost, he lied to the IRS about electing Section 475 MTM ordinary loss treatment on time and then used 475 MTM when he wasn’t eligible. Chen should have been subject to a $3,000 capital loss limitation rather than deducting a massive 475 ordinary loss triggering a huge tax refund. Second, he brought a losing case to tax court and made the mistake of representing himself. Once Chen was busted on the phony MTM election, he caved in on all points, including TTS. Chen did not have many TTS business expenses, so he figured it wasn’t worth continuing to fight.

Even though he only traded for three months while keeping his full-time job, it doesn’t mean he didn’t start a new business — intending to change careers to business trading — and make a substantial investment of time, money, and activity. Tax code or case law doesn’t state that a business must be carried on for a full year or as the primary means of making a living. Countless companies startup and fail in a few short months, and many times the entrepreneur hasn’t left his or her job while experimenting as a businessperson. Chen may have won TTS had he been upfront with the IRS and engaged a tax attorney or trader tax expert to represent him in court.

TTS tax benefits

  1. TTS traders deduct business expenses, startup costs, and home office expenses. Without TTS, investors may only deduct margin interest expense to the extent they have investment income as an itemized deduction. Many use the standard deduction instead.
  2. TTS traders are entitled to elect the robust Section 475 mark-to-market accounting, which converts capital gains and losses into ordinary gains and losses. Short-term capital gains on securities are ordinary income; whereas, 475 ordinary business losses generate tax refunds much faster than a $3,000 capital loss limitation. Section 475 also exempts securities trades from onerous wash sale loss rules, a headache for active traders, which causes phantom income and potentially excess tax liability. The 20% qualified business income (QBI) deduction applies to 475 net income if the taxpayer is under a taxable income threshold. QBI excludes capital gains. Individuals had to elect 475 for 2020 by the postponed deadline of July 15, 2020. A new LLC partnership or S-Corp can select 475 within 75 days of inception.
  3. With a TTS S-Corp, traders can deduct health insurance and retirement plan contributions.

I consult new traders on TTS. It’s incredible how many of these traders, from all walks of life, ages and careers, have made small fortunes since April. Others incurred substantial losses. During my tax consultations, many clients tell me they don’t want to return to their jobs if and when called back, and that TTS trading is their new career, which they cherish.

In The Tax Moves Day Traders Need to Make Now, Laura Saunders and Mischa Frankl-Duval report on this very issue (Wall Street Journal, Sept. 11, 2020), warning taxpayers to be careful when thinking about claiming TTS.

Our own Darren Neuschwander, CPA, was interviewed for the piece, stating he has seen a rise in inquiries about trader tax status this year. “The requirements for this break haven’t been clarified by the IRS, but they are stiff. Among other things, traders often need to trade for at least four hours a day, for an average of four days a week, and make at least 720 trades a year,” Neuschwander said.

Also, see my interview in theWall Street Journal’s July 5, 2020 article, The Benefits of Calling Yourself a ‘Trader’ for Tax Purposes by Nick Ravo.

How To Be Eligible For Substantial Tax Savings As A Trader

August 27, 2020 | By: Robert A. Green, CPA | Read it on

There are tax advantages for traders who are eligible for trader tax status (TTS).

  • Learn how to qualify for TTS; no election is required.
  • Automated trading systems can qualify for TTS, providing the trader is significantly involved with the creation. Trade copying software might not be eligible.
  • Learn how to deduct TTS business expenses, startup costs, and home office expenses.
  • Consider a Section 475 election for exemption from wash sales and the $3,000 capital loss limitation and be eligible for a 20% qualified business income deduction on 475 net income if under the QBI income threshold.
  • A TTS S-Corp unlocks health insurance and retirement plan deductions.
  • A TTS LLC/partnership segregates TTS/475 trading from investments made on the individual level.

How to qualify for TTS

Let’s start by taking a deep dive into GreenTraderTax.com golden rules for TTS qualification. Statutory tax law is lacking on TTS, so we analyze tax court cases for traders, and rely on decades-long experience performing tax compliance services for traders.

  1. Volume of trades

The 2015 tax court case Poppe vs. Commission is a useful reference. Poppe made 720 total trades per year/60 per month. We recommend an average of four transactions per day, four days per week, 16 trades per week, 60 trades a month, and 720 per year on an annualized basis. Count each open and closing trade separately, not round trips. Some traders scale into and out of trades, and you can count each of those trades separately.

As an example, the securities markets are open approximately 250 days, but let’s account for some personal days or holidays, and figure you’re available to trade 240 days per year. A 75% frequency of 240 days equals 180 days per year, so 720 total trades divided by 180 trading days equals four trades per day.

What counts? If you initiate a trade order and the broker breaks down the lot sizes without your involvement, it’s wise not to include the extra volume of trades in this case.

Options traders have multi-legged positions on “complex trades.” I believe you may count each trade confirmation of a complex options trade if you enter the trades separately, although the tax court has not addressed that issue yet. Most traders enter a complex options trade, and the broker breaks down the legs, so you cannot count the legs separately. Trade executions count, not unexecuted trades.

  1. Frequency of trades

Execute trades on close to four days per week, around a 75% frequency rate. The tax courts require “regular, frequent, and continuous” qualification for TTS. If you enter or exit a trading business during the year, then maintain the frequency rate during the TTS period. Time off from the execution of trades should be for a reasonable amount of vacations and other non-working days. Think of TTS like it’s a job, only the markets are your boss.

In the following trader tax court cases, the IRS denied TTS to options traders, including Holsinger, Assaderaghi, Endicott, and Nelson. They only traded on two to three days per week; hence, I suggest executing trades on close to four days per week.

  1. Holding period

The IRS stated that the average holding period is the most crucial TTS factor. In the Endicott court, the IRS said the average holding period must be 31 days or less. That’s a bright-line test.

If your average holding period is more than 31 days, it’s disqualifying for TTS, even if all your other TTS factors are favorable.

It’s more natural for day traders and swing traders to meet the holding period requirement. In the holding period analysis, don’t count segregated investment accounts and retirement accounts; only count TTS positions.

Monthly options traders face challenges in holding periods. They may have average holding periods of over one month if they trade monthly and longer expirations and keep them over a month. Holsinger was a monthly options trader, and his holding periods averaged one to two months. More often now, TTS traders are focused on trading weekly options expirations, and many of them are eligible for TTS.

Consider the following example of a trader in equities and equity options. If he holds 80% of his trades for one day and the other 20% for 35 days, then the average holding period is well under 31 days. It’s not evident if the IRS might apply weighted averages to the average holding period.

  1. Trades full time or part-time

Full-time options traders actively trading significant portfolios may not qualify because they don’t have enough volume and frequency, and their average holding period is over 31 days. On the other hand, a part-time trader with a full-time job may qualify as a day and swing trader in securities, meeting all our golden rules.

Part-time and money-losing traders face more IRS scrutiny, and individuals face more scrutiny than entity traders.

  1. Time spent

A TTS trader should spend more than four hours per day, almost every market day working on his trading business. All-time counts, including the execution of trade orders, research, administration, accounting, education, travel, meetings, and more. Most active business traders spend more than 40 hours per week in their trading business. Part-time traders usually spend more than four hours per day.

In one tax exam our firm handled, the IRS agent brought up the “material participation” standard in the passive loss activity rules (Section 469), which require 500 hours of work per year (as a general rule). Most business traders easily surpass 500 hours of work. However, Section 469 doesn’t apply to trading businesses, under its “trading rule” exemption. Without this exemption, taxpayers could generate passive-activity income by investing in hedge funds, and the IRS did not want that.

  1. Avoid sporadic lapses

A trader should have few to no sporadic lapses in the trading business during the year. The IRS has successfully denied TTS in a few tax court cases by arguing the trader had too many periodic lapses in trading, such as taking several months off during the year. Traders can take vacations, sick time, and personal time off just like everyone else. Some traders take a break from active trading to recover from recent losses and learn new trading methods and markets.

Carefully explain breaks in trading to the IRS in tax-return footnotes. Retooling and education during a setback in trade executions still may count for the continuous business activity (CBA) standard, although the IRS has not given credence to CBA for traders in tax court to date. I recommend traders keep proper records of their time spent as support.

Comments from an IRS official about the Chen tax court case point out the IRS doesn’t respect individual traders who are new to trading activity and who enter and exit it too quickly. Chen only traded for three months, while maintaining his fulltime job as a software engineer. He claimed an enormous NOL tax refund based on a massive TTS/475 ordinary loss. The IRS caught him lying about making a timely 475 election, and Chen conceded TTS and the entire case. It’s better to carry on a trading business for a more extended time than Chen did.

Some traders must temporarily stop for several months for health reasons. It’s not clear if the IRS will respect that as a valid interruption of a trading business activity. That seems unfair, but it may be the reality.

Many traders are home from their day jobs with Covid-19 and can carry on a trading business now. But will that active trading continue for the rest of 2020 and into 2021? I’ve noticed a proliferation of “Covid-19 traders,” who started active trading after the Covid correction in March 2020. Many have done well. Employers furloughed or laid-off them off from day jobs, or they have flexible job hours at home. They were attracted to volatility, accessible trading apps, and zero or low commissions.

  1. Intention to run a business

Traders must have the intention to run a trading business — trading his or her own money — but it doesn’t have to be one’s exclusive or primary means of making a living. The keyword is “a” living, which means it can be a supplemental living.

Many traders enter an active trading business while still working a full-time job. Advances in technology and flexible job schedules make it possible to carry on both activities simultaneously.

It’s not a good idea to try to achieve TTS within a business entity, already principally conducting a different type of business activity. It’s better to form a new trading entity. Trading an existing business’s available working capital seems like a treasury function and sideline, which can deny trader tax breaks if the IRS takes a look.

Filing as a sole proprietor on a Schedule C is allowed and used by many, but it’s not the best tax filing strategy for a part-time trader. An individual tax return shows a taxpayer’s job and other business activities or retirement, which may undermine TTS in the eyes of the IRS. The IRS tends to think trading is a secondary activity, and it may seek to deny TTS. It’s best to form a new, separate entity dedicated to trading only.

Several years ago, we spoke with one IRS agent who argued the trader did not make a living since he had perennial trading losses. That’s okay because the rule looks to intention, not the actual results. The hobby-loss limitations don’t apply to TTS traders because trading is not recreational or personal. Part-time traders often tell me they operate a business to make a supplemental living and intend to leave their job to trade full-time when they become profitable enough.

  1. Operations

A TTS trader has significant business equipment, education, business services, and a home office. Most business traders have multiple monitors, computers, mobile devices, cloud services, trading services, and subscriptions, education expenses, high-speed broadband, wireless, and a home office and/or outside office. Some have staff.

The IRS needs to see that a taxpayer claiming TTS has a realistic trading business operation.

How can one run a business without a dedicated space? Casual investors rarely have as busy an office set up as business traders do. Why would a long-term investor need multiple monitors?

If a trader uses a home-office space exclusively for business rather than personal use, the tax return should reflect this because it is not only a valid home-office deduction, but it also further supports the fact there is a legitimate business activity being conducted. The home-office deduction is no longer a red flag with the IRS, and it is not a complicated calculation. Most of the home-office deduction requires income, in this case, TTS trading gains. Some TTS traders just use a laptop, and that’s okay.

  1. Account size

Securities traders need to have $25,000 on deposit with a U.S.-based broker to achieve “pattern day trader” (PDT) status. With this status, he or she can day trade using up to 4:1 margin rather than 2:1. Without PDT status, securities traders, which include equities and equity options, will have a more challenging time qualifying for TTS. I like to see more than $15,000 account size for trading futures, forex, or cryptocurrency.

Adequate account size also depends on one’s overall net worth and cash flow. Millionaires may need larger account sizes, whereas some unemployed traders without much cash flow or very young traders may get by with smaller account sizes. A trader may also be able to factor in capital invested in equipment and startup costs.

What doesn’t qualify for TTS

Don’t count these four types of trading activity for TTS qualification:

  • Automated trading systems (ATS) without much involvement by the trader (but a trader creating an ATS qualifies);
  • A trade copying software or service;
  • Engaging a professional outside investment manager;
  • And trading in retirement funds.

Do not include these trades in the golden rule calculations.

  1. Outside-developed automated trading systems

These programs are becoming more popular. An entirely canned ATS with little to no involvement by the trader doesn’t qualify for TTS. The IRS may view an outside-developed ATS the same as a trader who uses a broker to make most buy/sell decisions and executions.

If the trader can show he’s very involved with the design and building of the ATS, then the IRS may count the ATS-generated trades in the TTS analysis. That includes but is not limited to writing the code or algorithms and setting the entry and exit signals. Self-creation of the ATS needs to be significant to count for TTS. Just making a few choices among options offered in an outside-developed ATS building-block service does not qualify for TTS.

Some traders don’t have programming experience, but they have financial and trading experience. They design the ATS to do what they do manually as a trader and hire an outside programmer to translate their specifications into a computer language.

It’s helpful if the trader can show he spends more than four hours per day working in his trading business, including time for ATS maintenance, back-testing, and modifications. I have not yet seen the IRS challenge ATS for TTS in exams or court cases, but I feel it may react this way when it comes up.

If traders spend a lot of money on an ATS that doesn’t qualify as part of their trading business, then those expenses are suspended investment expenses under TCJA. Traders need to know the IRS may connect the dots and realize they are using an ATS. A full-scale exam can uncover these facts. Consider the analogy of an airplane pilot using manual and automated systems. A trader needs to be a pilot in the cockpit, not in the cabin as a passenger.

  1. Trade copying software or service

Some traders use trade copying software or service (TCS). Trade copying is similar to using a canned ATS or outside adviser, where the copycat trader might not qualify for TTS on those trades. As an example, a trade coaching and education company offers a TCS that suggests several trades each day, with exact entry and exit points and stop-loss orders. The trader decides which trades to make and executes them manually.

If the trader follows the TCS tightly and does not significantly depart from its suggestions, then an IRS agent might feel that he or she does not qualify for TTS. On the other hand, if the trader cherry-picks a minor percentage of the suggested trades, sets different stop-loss orders, and waits longer on entry and exit executions, then he or she might qualify for TTS. The TCS vendor might state they are not providing investment management services, but that does not mean their customer achieves TTS using the TCS.

  1. Engaging a money manager

Hiring a registered investment adviser (RIA) or commodity trading adviser (CTA) — whether they are duly registered or exempt from registration — to trade one’s account doesn’t count toward TTS qualification. However, hiring an employee or independent contractor under the trader’s supervision to help trade should qualify, providing the taxpayer is a competent trader. There are decades-old tax court cases that show using outside brokers and investment advisers to make trading decisions undermines TTS.

There are differences between hiring an independent investment manager vs. a supervised assistant trader. If the engaged trader is a registered investment adviser, he’s clearly in the business of being an external manager, and TTS is not achievable. But if the person only assists a retail trader under the account holder’s direction and supervision, it may be possible to achieve TTS. It’s okay to have a co-pilot in the TTS cockpit.

With married couples, if spouse A has an individual brokerage account in his or her name only and gives power of attorney to spouse B to trade it, the IRS won’t grant TTS even if spouse B meets all the golden rules for TTS. Spouse B is not an owner of the account, so that the IRS will treat spouse A as an investor and spouse B as an investment manager. Married couples can solve this problem by using a joint individual account or trading in a spousal-owned entity.

  1. Trading retirement funds

You can achieve TTS through taxable trading accounts only. Trading activity in non-taxable retirement accounts doesn’t count for purposes of TTS qualification. Trading in retirement plans can be an excellent way to build tax-free compounded returns, especially if the taxpayer doesn’t qualify for TTS in their taxable accounts.

It is possible to trade retirement accounts and, at the same time, qualify for TTS in taxable accounts.

Caution: it’s dangerous to trade substantially identical positions between an individual taxable account and IRA accounts since this can trigger a permanent wash-sale (WS) loss in a taxable account that moves into the IRA. Avoid permanent WS losses in IRAs with a Section 475 election on the taxable account or use a Do Not Trade List to avoid overlap in the IRAs.

Sole proprietorship with TTS

An individual TTS trader deducts business expenses, startup costs, and home office deductions on a Schedule C (Profit or Loss From Business – Sole Proprietorship) 1040 filing. Traders don’t have revenue on Schedule C; report trading gains and losses on other tax forms. Schedule C expenses are an above-the-line deduction from gross income. TTS Schedule C expenses reduce self-employment income (SEI). Although, trading income is not SEI, and traders don’t owe SE tax in connection with trading income. There isn’t a tax election for claiming TTS. — it’s determined based on facts and circumstances assessed at year-end. You can claim TTS after-the-fact; you don’t have to formalize it in advance.

Business expenses include home-office, education, startup expenses, organization expenses, margin interest, tangible property expense, Section 179 (100%) or 100% bonus depreciation, amortization on software, self-created automated trading systems, chat rooms, mentors, seminars, market data, charting services, stock borrow fees, and much more.

Section 475 tax benefits

TTS traders are entitled to make a Section 475 election, but investors may not. The 475 election exempts securities trades from wash-sale loss (WS) adjustments, which can defer tax losses to the subsequent year, and the $3,000 capital loss limitation. Ordinary loss treatment is better; it can generate tax refunds faster than capital loss carryovers. There are also benefits on 475 income: a 20% QBI deduction if under the taxable income threshold for a service business.

The deadline for an individual to elect Section 475 for 2020 has passed; it was July 15, 2020, the postponed deadline. A partnership or S-Corp formed during the tax year is considered a “new taxpayer,” which can elect Section 475 internally within 75 days of inception. A new entity comes in handy for electing 475 after July 15, 2020. It’s too late to select 475 for 2019; that election deadline was April 15, 2019.

I usually recommend 475 on securities only to retain lower 60/40 capital gains rates on Section 1256 contracts. Section 475 does not apply to segregated investment positions. Avoid overlap of substantially identical positions in what you trade versus what you invest in taxable accounts, as that allows the IRS to recharacterize trades vs. investments. You can fix this potential problem by ring-fencing TTS/475 in a new entity and leaving investment positions on the individual level.

The qualified business income deduction

TCJA introduced a tax benefit for pass-through businesses, which includes a TTS trader with Section 475 income, whether doing business as a sole proprietor, partnership, or S-Corp. Section 199A provides a 20% QBI deduction on a “specified service trade or business” (SSTB), and TTS trading is an SSTB. SSTBs are subject to a taxable income threshold, phase-out range, and an income cap. The phase-out has wage and property limitations, too.

LLC taxed as an S-Corp

Organize a single-member or spousal-member LLC and elect S-Corp status with the IRS within 75 days of inception. Alternatively, in a subsequent year, the LLC can submit an S-Corp election by March 15. Owners must be U.S. residents. The S-Corp can elect Section 475 internally within 75 days of inception.

TTS traders with significant health insurance (HI) premiums should consider an S-Corp to arrange a tax deduction through officer compensation. Otherwise, the trader or spouse might have another source of self-employment income to deduct HI. A spouse might have HI coverage for the family in their job. Cobra is not deductible HI since its employer provided. A TTS sole proprietor or partnership cannot deduct HI based on trading income.

Traders need earned income to make and deduct HI and retirement plan contributions; however, trading income is unearned. TTS sole proprietors and partnerships cannot create earned income, whereas S-Corps can pay officer compensation, generating earned income.

Payroll taxes apply on officer compensation (wages), except for the HI component of salary: 12.4% FICA capped on wages up to $137,700 for 2020, and the 2.9% Medicare is unlimited.

TTS traders should fund retirement plan contributions from net income, not losses. It’s best to wait on the execution of an annual paycheck until early December when there is transparency for the year.

If you have sufficient trading profits for the year, consider establishing a Solo 401(k) retirement plan before year-end. Start with the 100% deductible elective deferral (ED; $19,500 for 2020) and pay it through payroll since on the annual W-2. Taxpayers 50 years and older have a “catch up provision” of $6,500, raising the 2020 ED limit to $26,000 per year. Contribute the elective deferral to a Solo 401(k) Roth or traditional account.

If you have significant trading gains, consider increasing payroll to unlock a Solo 401(k) profit-sharing plan (PSP) contribution. You don’t have to pay into the retirement plan until the due date of the S-Corp tax return (including extensions by September 15). The maximum PSP amount is $37,500 on wages of $150,000 ($37,500 divided by 25% equals $150,000). The total limit for a Solo 401(k) is $63,500 ($19,500 ED, $6,500 catch-up ED, and $37,500 PSP).

LLC taxed as a partnership

A TTS trader can organize a spousal-member LLC and file as a partnership. LLC/partnerships file a Form 1065 partnership tax return and issue Schedule K-1s to owners. LLC/partnerships must qualify for TTS; otherwise, they are investment companies.

A partnership is useful for ring-fencing TTS/475 trading from individual taxable, and IRA accounts for avoiding wash sale losses and the IRS reclassifying investment positions as TTS/475 positions.

Active trading gained popularity in 2020, and many people are eligible for trader tax status benefits.

This article references to content in Green’s 2020 Trader Tax Guide.

Watch our related recording: How To Be Eligible For Substantial Tax Savings As A Trader

How To Set Up A Trading Business For Optimal Tax Savings (MoneyShow)

July 15, 2020 | By: Robert A. Green, CPA

If you are eligible for “trader tax status” (TTS), consider setting up a trading business to maximize tax benefits. Join Robert A. Green CPA of GreenTraderTax.com to learn how to deduct trading business expenses, elect Section 475 MTM for tax losses or a 20% QBI deduction, and deduct health insurance and retirement plan contributions.

This is one segment of MoneyShow’s August 3-5 Virtual Event.

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How To Qualify For Substantial Tax Savings As A Trader

February 5, 2020 | By: Robert A. Green, CPA | Read it on

Trader tax status (TTS) constitutes business expense treatment and unlocks an assortment of meaningful tax benefits for those who qualify. The first step is to determine eligibility. If you do qualify for TTS, you can claim some tax breaks such as business expense treatment after the fact and elect and set up other breaks — like Section 475 MTM and employee-benefit plans — on a timely basis.

Business expenses include home-office, education, startup expenses, organization expenses, margin interest, tangible property expense, Section 179 (100%) or 100% bonus depreciation, amortization on software, self-created automated trading systems, seminars, market data, stock borrow fees, and much more. The Tax Cuts & Jobs Act suspended “certain miscellaneous itemized deductions subject to the 2% floor,” including investment fees and expenses, commencing in 2018.

Securities traders with TTS should consider electing Section 475 ordinary gain or loss treatment by April 15 (individuals) and March 16, 2020 (existing partnerships or S-Corps). I call it tax-loss insurance: It exempts securities trades from wash sale loss adjustments and the $3,000 capital loss limitation. Profitable 475 traders are eligible for the 20% qualified business income (QBI) deduction. QBI excludes capital gains and losses.

A TTS S-Corp unlocks deductions for health insurance premiums and high-deductible retirement plan contributions.

Traders who do not qualify for TTS aren’t eligible for any of these tax benefits.

How to qualify
It’s not easy to be eligible for TTS. Currently, there’s no statutory law with objective tests for eligibility. Subjective case law applies a two-part test:

  1. Taxpayers’ trading activity must be substantial, regular, frequent, and continuous.
  2. A taxpayer must seek to catch swings in daily market movements and profit from these short-term changes rather than profiting from long-term holding of investments.

Golden rules
Volume, frequency, and average holding period are the “big three” because they are more accessible for the IRS to verify.

Volume: The 2015 tax court case Poppe vs. Commission is a useful reference. Poppe made 720 total trades per year/60 per month. We recommend an average of four trades per day, four days per week, 16 trades per week, 60 a month, and 720 per year on an annualized basis. Count each open and closing trade separately, not round trip. Scaling in and out counts, too.

Frequency: Executes trades on close to four days per week, around a 75% frequency rate.

Holding period: In the Endicott court, the IRS said the average holding period must be 31 days or less. That’s a bright-line test.

Trades full time or part-time, for a good portion of the day, almost every day the markets are open. Part-time and money-losing traders face more IRS scrutiny, and individuals face more scrutiny than entity traders.

Hours: Spends more than four hours per day, almost every market day working on the trading business — all time counts.

Avoid sporadic lapses: Has few to no intermittent lapses in the trading business during the year.

Intention: Has the intention to run a business and make a living. It doesn’t have to be a primary living.

Operations: Has significant business equipment, education, business services, and a home office.

Account size: Has a material account size. Securities traders need to have $25,000 on deposit with a U.S.-based broker to achieve pattern day trader (PDT) status. For the minimum account size, we like to see more than $15,000.

What doesn’t qualify?
These four types of trading activity do not count for TTS qualification.

  1. Outside-developed automated trading systems (ATS). A computerized trading service with little to no human involvement doesn’t qualify for TTS. On the other hand, if the trader can show he’s very involved with the creation of the ATS — perhaps by writing the code or algorithms, setting the entry and exit signals, and turning over only execution to the program — the IRS may count those trades.
  2. Trade copying service. Some traders use trade copying software. Trade copying is similar to using a canned ATS or outside adviser, where the copycat trader might not qualify for TTS on those trades.
  3. Engaging a money manager. Hiring a registered investment adviser or commodity trading adviser — whether they are duly registered or exempt from registration — to trade one’s account doesn’t count toward TTS qualification.
  4. Trading retirement funds. Achieve TTS through trading in taxable accounts. Trading activity in non-taxable retirement accounts doesn’t count for purposes of TTS qualification.

For more in-depth information on TTS, see Green’s 2020 Trader Tax Guide Chapter 1 “Trader Tax Status.”

 

Home Office Tax Deductions Are Fantastic: Learn How To Do It

August 24, 2019 | By: Robert A. Green, CPA | Read it on

Since 1999, the home-office deduction is no longer a red flag — millions of Americans benefit from this deduction each year. Countless taxpayers run businesses from home, and the IRS understands this. The income-requirement rule also limits the use of this deduction for profitable enterprises, which appeases IRS concerns about abuse and hobby-loss businesses. Before the IRS liberalized home-office deduction rules in 1999, a more stringent requirement was that business taxpayers needed to meet clients in their home office. Now, the only requirement is administration work, and another principal office outside the home doesn’t negate the deduction.

Many small-business owners, including traders eligible for trader tax status (TTS), operate from a home office. Some of them also conduct their business from job locations using cloud computing, apps, and mobile devices. They can qualify for the home office expense deduction in this situation, as well. The IRS does not permit investors to take a home office deduction.

Convert personal home costs into business expense deductions. This same concept applies to many other items such as phone, Internet, furniture, fixtures, and more. Keep in mind that business income or TTS trading gains are needed to unlock most home-office deductions. If a business doesn’t have sufficient net income, the otherwise allowable home office deductions are carried over to the following tax years. (In this situation, hopefully, the person remains in the business and has net income in subsequent years to use the carryovers.)

There are several special requirements and rules for the home office deduction. A home office must be exclusively and regularly used for business, meaning children and guests can’t use this room. Report “indirect expenses” on Form 8829 and include every expense and cost related to the home. For example, include depreciation or rent, utilities, insurance, repairs and maintenance, security, cleaning, lawn care, and more.

Include mortgage interest and real property taxes, too, and this home-office portion doesn’t require income. The remaining part of mortgage interest expense and real property taxes are Schedule A itemized deductions.

Real property taxes on Schedule A are part of the new tax law (TCJA) SALT limitation. However, the home office portion or real property tax is not subject to the SALT limitation.

To calculate the home-office deduction, take the square footage of the home office (and all related business areas such as storage, hallways, and bathrooms). Divide that by the total square footage of the home (10-15% is customary). Alternatively, taxpayers can do the apportionment based on the room’s method. Form 8829 multiplies the home-office percentage by the indirect expenses. If the business files a partnership return, report home-office expenses as unreimbursed partnership expenses (UPE) on Schedule E. For S-Corps, use an accountable reimbursement plan before year-end.

Per Thomson Reuters/Tax & Accounting Client Letter (see list below):

“Sales of homes with home offices. If you sell-at a profit-a home that contains, or contained, a home office, the otherwise available $250,000/$500,000 exclusion for gain on the sale of a principal residence won’t apply to the portion of your profit equal to the amount of depreciation you claimed on the home office.”

Depreciation expenses on the home office over the years save taxes at ordinary income tax rates. Recapture of depreciation on a sale of the principal residence is taxed up to a 25% capital gains rate, which is unique to Section 1250 property. Tax deferral is another value. The rest of the home enjoys the exclusion of capital gain up to the limit.

If a taxpayer sells his principal residence at a loss, the net loss is not deductible. However, the recapture of depreciation income might not exceed the loss amount, meaning there is no taxable income from depreciation recapture to report on the tax return.

TCJA capped state and local income taxes, sales taxes, real property taxes, and personal property taxes (SALT) itemized deductions on Schedule A at $10,000 per year (any combination thereof), and $5,000 for married filing separately. TCJA also reduced itemized deduction limits on mortgage interest expenses and casualty losses.

Home office tax benefits for employees
Employers require some employees to work from a home office. The new tax law (TCJA) suspended unreimbursed employee business expenses as itemized deductions. That leaves only one other way to arrange a tax benefit for home office expenses. An employee can seek reimbursement from an employer for home office expenses through an accountable reimbursement plan. The employer deducts home office expenses and does not include this payment on the employee’s W-2 as taxable income.

Our below Thomson Reuters/Tax & Accounting Client Letter for “telecommuting employees” states:

“The convenience of the employer requirement is satisfied if: you maintain your home office as a condition of employment-in other words, if your employer specifically requires you to maintain the home office and work there; your home office is necessary for the functioning of your employer’s business; or your home office is necessary to allow you to perform your duties as an employee properly. The convenience of the employer requirement means that you must maintain your home office for your employer’s convenience, and not for your own. This requirement isn’t satisfied if your use of a home office is merely “appropriate and helpful” in doing your job.”

Client Letters from Thomson Reuters/Tax & Accounting:

  • Home office expense deduction for a self-employed taxpayer
  • Exclusion of gain on sale or exchange of principal residence
  • How the home sale exclusion applies to a residence used for residential and business (nonresidential) purposes or to produce rental income
  • Office at home for telecommuting employees
  • Converting a home into rental property

For access to these Client Letters from Thomson Reuters/Tax & Accounting, please join our email list. We send bulk emails a few times per month and include links to Client Letters.

How To Qualify For Trader Tax Status For Huge Savings

February 9, 2019 | By: Robert A. Green, CPA | Read it on

Trader tax status (TTS) constitutes business expense treatment and unlocks an assortment of meaningful tax benefits for active traders who qualify. The first step is to determine eligibility. If you do qualify for TTS, you can claim some tax breaks such as business expense treatment after the fact and elect and set up other breaks — like Section 475 MTM and employee-benefit plans — on a timely basis.

Section 475 gives a TTS trader “tax loss insurance,” exemption from wash sale loss adjustments on securities and ordinary loss treatment, avoiding the capital loss limitation. With Section 475 income, you might also become eligible for the 20% qualified business income deduction, although QBI treatment is currently uncertain for TTS traders.

There’s no election for TTS
There’s no election for TTS; it’s an optional tax status based on facts and circumstances only. A trader may qualify for TTS one year but not the next.

TTS qualification can be for part of a year, as well. Perhaps a taxpayer qualified for TTS in 2017 and quit or suspended active trading on June 30, 2018. Include the period of qualification on Schedule C or the pass-through entity tax return and deduct business expenses for the partial-year period. If elected, use Section 475 for trades made during the TTS period, too.

Business expense treatment
Qualifying for TTS means a trader can use business treatment for trading expenses. TTS is also a precondition for electing Section 475 MTM ordinary gain and business loss treatment.

Business expense treatment under Section 162 allows for full ordinary deductions, including home-office, education, Section 195 start-up expenses, Section 248 organization expenses, margin interest, tangible property expense, Section 179 (100%) depreciation, amortization on software, seminars, market data, stock borrow fees, and much more. As an example of the potential savings, if TTS business expenses and home office deductions are $20,000, and the taxpayer’s federal and state tax bracket is 35%, then income tax savings is about $7,000.

TCJA suspended “certain (all) miscellaneous itemized deductions subject to the 2% floor,” including investment fees and expenses, commencing in 2018. The only remaining itemized deductions for investors are investment-interest expenses, which are limited to investment income, and stock borrow fees deducted as “other itemized deductions.” TCJA gives more incentive for traders to try to qualify for TTS.

How to qualify
It’s not easy to qualify for TTS. Currently, there’s no statutory law with objective tests for eligibility. Subjective case law applies. Leading tax publishers have interpreted case law to show a two-part test to qualify for TTS:

  1. Taxpayers’ trading activity must be substantial, regular, frequent, and continuous.
  2. The taxpayer must seek to catch swings in daily market movements and profit from these short-term changes rather than profiting from the long-term holding of investments.

IRS agents often refer to Chapter 4 in IRS Publication 550, “Special Rules for Traders.” Here’s an excerpt:

The following facts and circumstances should be considered in determining if your activity is a securities trading business.

  • Typical holding periods for securities bought and sold.
  • The frequency and dollar amount of your trades during the year.
  • The extent to which you pursue the activity to produce income for a livelihood.
  • The amount of time you devote to the activity. 

The words “substantial, regular, frequent, and continuous” are robust terms, yet case law doesn’t give a bright-line test with exact numbers.

The publication mentions holding period, frequency, and dollar amount of trades, as well as time devoted by the taxpayer. It also says the intention to make a livelihood, an essential element in defeating the hobby-loss rules. Trading is not personal or recreational, which are the key terms used in hobby-loss case law.

Golden Rules
We base our golden rules on trader tax court cases and our vast experience with IRS and state controversy for traders. The trader:

Trades full time or part time, for a good portion of the day, almost every day the markets are open. Part-time and money-losing traders face more IRS scrutiny, and individuals face more scrutiny than entity traders.

Hours: Spends more than four hours per day, almost every market day working on his trading business. All-time in the trading activity counts, including execution of trade orders, research, administration, accounting, education, travel, meetings, and more.

Few sporadic lapses: Has infrequent lapses in the trading business during the year. Traders can take vacations, sick time, and personal time off just like everyone else.

Frequency: Executes trades on close to four days per week, every week. Recent tax-court cases show that to help prevent IRS challenge of a TTS claim; it is wise to trade close to four days per week or 75% of available trading days — even if this requires the taxpayer to make smaller trades with reduced risk on otherwise non-trading days.

Volume: Makes 720 total trades per year (Poppe court) on an annualized basis. The buy and sell count as two total trades.  The court mentioned Poppe having 60 trades per month. During the year, it’s crucial to consider the volume of trades daily. We recommend 720 trades per year — about four trades per day, four days per week, 16 trades per week, and 60 trades a month.

The markets are open approximately 250 days, and with personal days and holidays, you might be able to trade on 240 days. A 75% frequency equals 180 days per year, so 720 total trades divided by 180 trading days equals four trades per day.

Holding period: Makes mostly day trades or swing trades. The IRS stated that the holding period is the most critical factor, and in the Endicott court, the IRS said average holding period must be 31 days or less. That’s a bright-line test.

Intention: Has the intention to run a business and make a living. Traders must have the intention to run a separate trading business — trading his or her own money — but it doesn’t have to be one’s exclusive or primary means of making a living. The key word is “a” living, which means it can be a supplemental living.

Operations: Has significant business equipment, education, business services, and a home office. Most business traders have multiple monitors, computers, mobile devices, cloud services, trading services, and subscriptions, education expenses, high-speed broadband, wireless, and a home office.

Account size: Has a material account size. Securities traders need to have $25,000 on deposit with a U.S.-based broker to achieve “pattern day trader” (PDT) status. We like to see more than $15,000 for trading other financial instruments.

What doesn’t qualify?
Don’t count these three types of trading activity for TTS qualification: Automated trading without much involvement by the trader (but a trader creating his or her program qualifies); engaging a professional outside investment manager; and trading in retirement funds. Do not include these trades in the golden rule calculations.

1. Automated trading. An entirely canned automated trading service — sometimes referred to as an “expert adviser” program in the forex area — with little to no involvement by the trader doesn’t help TTS; in fact, it can undermine it. The IRS may view this type of automated trading service the same as a trader who uses a broker to make most buy and sell decisions and executions. On the other hand, if the trader can show he’s very involved with the automated trading program or service — perhaps by writing the code or algorithms, setting the entry and exit signals, and turning over only execution to the program — the IRS may not count the automated trading activity against the trader.

Some traders use a “trade copying” service and copy close to 100% of the trades. Trade copying can be similar to using a canned automated service or outside adviser, where the copycat trader does not qualify for TTS on those trades.

2. Engaging a money manager. Hiring a registered investment adviser (RIA) or commodity trading adviser (CTA) — whether they are duly registered or exempt from registration — to trade one’s account doesn’t count toward TTS qualification.

3. Trading retirement funds. Achieve TTS through trading taxable accounts. Trading activity in non-taxable retirement accounts doesn’t count for purposes of TTS qualification.

For more in-depth information on trader tax status, see Green’s 2019 Trader Tax Guide.

Tax Notes

June 21, 2018 | By: Robert A. Green, CPA

Securities Traders Should Get QBI Deduction, CPA Says

SUMMARY BY TAX ANALYSTS (4/11/19)
An individual has asserted that a U.S. resident trader in securities with trader tax status and a section 475 election for ordinary income and loss should be eligible for the qualified business income deduction under proposed regulations (REG-134652-18), noting that section 199A’s interaction with section 864(c) could preclude the deduction.

FULL TEXT PUBLISHED BY TAX ANALYSTS

Robert A. Green, CPA, info@greentradertax.com

I believe a U.S. resident trader in securities with trader tax status, and a Section 475 election for ordinary income/loss, should be eligible for a QBI deduction. Section 199A regs define a trading business as a “specified service trade or business” (SSTB), including trading for its own account. It also includes Section 475 ordinary income/loss in QBI. That indicates potential eligibility for a QBI deduction.

However, Section 199A‘s interaction with Section 864(c) might deny a QBI deduction for traders. 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. However, “trader in securities or commodities” are covered under Section 864(b)(2), not 864(c).

I hope that tax attorneys in the IRS Office of Chief Counsel will answer this question for traders.

Groups Urge IRS to Rethink 199A Business Income Rules

By Eric Yauch, August 30, 2018
https://www.taxnotes.com/tax-notes-today/exemptions-and-deductions/groups-urge-irs-rethink-199a-business-income-rules/2018/08/30/28d21

…Trading Income

Above the taxable income cap set for service businesses, owners of trading and investment management companies can’t use the QBI deduction. But for a married trader earning $300,000 a year — just under one of the income thresholds —the couple is entitled to a QBI deduction on service businesses, according to Robert Green of GreenTraderTax.

Green said that before the proposed regulations were released, some other tax experts argued that a hedge fund wouldn’t be a barred service activity in section 199A because technically a management company was providing the service, and the hedge fund was merely receiving it.

Green said that to claim trader tax status and elect section 475 — which treats capital gain and loss as ordinary income and loss — a taxpayer must trade its own funds, and typically a management company would be a partner in a hedge fund and would be trading for the fund.

The proposed regulations clarified that the hedge fund in that scenario wouldn’t qualify for the deduction above the service business income cap. But because section 475 is ordinary income, taxpayers below the thresholds can likely get a deduction on that trading income, because QBI excludes capital gain, Green said.

Green said some managers may decide to receive an incentive fee instead of carried interest of capital gains because the incentive fee is includable in management company QBI, whereas the profit allocation of capital gain is not. The investors may not appreciate that change because they can’t deduct investment fees, but they can get the benefit of a carveout of capital gains, he added.

Attractiveness of S Corporations After 2017

https://www.taxnotes.com/taxpractice/exemptions-and-deductions/attractiveness-s-corporations-after-2017/

By D. LARRY CRUMBLEY and JAMES R. HASSELBACK, February 26, 2018

Authors based below content on Robert A. Green’s blog posts referenced in footnote 13. 

“There are suggestions that trader tax status (TTS) should consider an S corporation for business expenses, and a section 475 election on securities for exemption from the wash sale losses and ordinary loss treatment (tax loss insurance). A TTS S corporation allows employee benefit plan deductions (for example, health insurance and high-deductible retirement plans). The new law is unclear regarding whether section 475(f) 12 income is QBI or a specified service activity. TTS business-related capital gains probably will not be included in QBI.”13

Footnotes:

12 – A section 475(f) election (mark-to-market election) allows a trader to treat gains and losses from the sales of securities as ordinary gains and losses (except for securities held for investment).

13 – Robert A. Green, “How Traders Can Get the 20% QBI Deduction Under New Law,” Forbes, Jan. 12, 2018; and Green, “Traders Should Be Entitled to the Pass-Through Tax Deduction,” Forbes, Dec. 12, 2017.