Tag Archives: TTS

End of Year Trader Tax Tips

September 5, 2014 | By: Robert A. Green, CPA

Washington negotiates the Bush-era tax cuts going into year-end 2012. Wash-sale losses can be better than capital-loss carryovers. Convert wash sales to Section 475 ordinary losses on Jan. 1. Accelerate business expenses with trader tax status. Entities are better for business traders.

Tax Compliance

September 4, 2014 | By: Robert A. Green, CPA

Tax compliance includes tax planning and annual tax return preparation, including investor K-1s at year-end. After year-end, general partners of hedge funds need to provide investors with annual income tax reports. Schedule K-1s pass through all items of income, loss and expense, retaining their underlying character of income or loss. Underlying character includes lower 60/40 tax rates on Section 1256 contracts (futures), short-term or long-term capital gains or losses on securities or ordinary income or loss from Section 988 forex.

Carried-interest tax break
The carried-interest tax break can be used in hedge funds, but it cannot be used in separately managed accounts (SMAs). If carried interest provisions are included in the fund’s operating agreement and PPM, the general partner investor is allocated a partnership K-1 share of each item of income — let’s say 20% — in lieu of the fund paying an outside advisor an incentive fee. Generally, the general partner and investors receive tax breaks in connection with carried interest. The advisor receives a share of lower tax rates on 60/40 or long-term capital gains, and the investor avoids investment expense treatment, which often is disallowed for AMT or doesn’t exceed the 2% of AGI limitation for miscellaneous itemized deductions.

Carried interest remains high on the list of “tax loopholes” facing repeal in discussions for tax reform, but we have written many blogs and articles defending it. Carried interest can be arranged in offshore funds with a mini-feeder structure. There are other nuances in connection with self-employment tax and the ObamaCare 3.8% Medicare tax on unearned income (investment income). We cover all these issues on our blog and in Green’s Trader Tax Guide.

Tax treatment elections
There are different types of tax treatment elections that can be made and it’s important to make the right decisions on time. In some cases, these tax elections should be contemplated in the development process and included in the private placement memorandum. For example, investors with large capital loss carryovers may be searching for hedge funds that will generate capital gains rather than Section 475 MTM ordinary income on securities or Section 988 ordinary income on forex. You can have capital gains treatment on both securities and forex.

Most investors benefit from trader tax status (TTS), so if your fund qualifies, it’s generally a good idea to claim that status. With TTS, the advisor and investors get business expense treatment without passive loss activity limitations. (One exception: non-active owners report investment interest expense as itemized deductions.) That means investors get the full benefit of advisory fees paid “above the line” (from gross income) rather than face many restrictions as itemized deductions below the line. With TTS, the fund is entitled to elect Section 475 mark-to-market (MTM) (on securities only), which exempts the fund from dreaded wash sales at year-end, plus Section 475 receives business ordinary loss treatment, avoiding capital loss limitations. Some managers skip a Section 475 election because they don’t want to be burdened with contemporaneous segregation rules for investments vs. business positions and they don’t want MTM to apply at year-end, so they can defer capital gains to the next tax year(s). Otherwise, they would pass MTM income to investors who might want redemptions to pay taxes and the manager has not yet sold those underlying shares. TTS and Section 475 issues are highly nuanced and often misunderstood, so advisors should discuss them with us in advance. Some hedge funds have TTS and Section 475 MTM on one portfolio, and they properly segregate an investment portfolio without TTS, where they generate long-term capital gains. (Read our blog IRS warns Section 475 traders for more about segregation of investments.)

Our tax compliance service includes everything  you need
Our CPAs plan and prepare tax compliance for hedge funds, management companies and the individuals owning the management company. We help managers plan their tax matters in a way that suits their needs and their investors’ needs. While some tax breaks help both the manager and investors, others may help only one of them, while still others may help one at the expense of the other. For example, if the fund doesn’t qualify for trader tax status, carried interest helps both the manager and the investors. But in a futures fund with lower 60/40 tax rates, carried interest may only help the manager.

Green, Neuschwander & Manning, LLC knows every state very well. Use our professionals to conceive and structure the best tax plans for your fund and get them incorporated into the fund documents; then, use our CPAs to execute those plans and tax elections on a timely basis.

Tax edge: Count on us to handle all the tax matters correctly, including carried-interest tax breaks, the S-corp self-employment tax loophole, the new 3.8% Medicare tax on unearned income, trader tax status/Section 475 MTM accounting, lower 60/40 Section 1256(g) forex tax treatment breaks, forex tax treatment, ETF and ETF option tax treatment, international tax planning including PFIC and QEF elections, mini-master feeders, tax changes and more.

One big tax change started on Jan. 1, 2013: the Medicare 3.8% tax on unearned income, principally investment income. (Read about that in our Trader Tax Center page for Net Investment Tax.)

For more information on our tax strategies for investment managers, see Green’s Trader Tax Guide, our blog and Webinars.

Ready For Help?

Tax compliance, planning and annual tax return preparation services:
Green, Neuschwander will prepare the federal and all required state tax returns for your hedge funds and other investment vehicles. We also can prepare the tax returns for your management companies and your individual return. Click Tax Compliance (Preparation and Planning) and choose Investment Management.

If you have any questions or would like a quote, please email us at info@gnmtradertax.com or call us.

We look forward to working with you soon.

Sincerely,
Robert A. Green, CPA & Darren L. Neuschwander, CPA
Managing Members of Green, Neuschwander & Manning, LLC (GNMTraderTax)

 

Trader Tax Status

August 27, 2014 | By: Robert A. Green, CPA

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

Qualifying for TTS means a trader can use business treatment for trading expenses. Business expenses include home office, education, Section 195 startup expenses, Section 248 organization expenses, margin interest, tangible property expense, Section 179 (100%) or 100% bonus depreciation, amortization on software, self-created automated trading systems (Section 174), seminars, market data, stock borrowing fees, and much more. If TTS business expenses and home office deductions are $20,000 and the taxpayer’s federal and state tax bracket is 40%, income tax savings are about $8,000.

Securities traders with TTS should consider a timely election of Section 475 ordinary gain or loss treatment, due by April 15, 2024, for individuals and March 15, 2024, for existing partnerships or S-Corps. A 2023 Section 475 election was due by April 18, 2023, for individuals and March 15, 2023, for existing entities. I call Section 475 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, whereas QBI excludes capital gains and losses. QBI has income thresholds and a cap for trading, which is a specified service trade or business (SSTB).

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

A TTS partnership or S-Corp can do the SALT cap workaround solution. 

Go to “Explore Trader Tax Status” to learn about business expenses, how to qualify for TTS, the Section 475 election and benefits, and employee benefit plan deductions.

For more information, see Green’s Trader Tax Guide Chapter 1 on Trader Tax Status.

Section 475 MTM Accounting

| By: Robert A. Green, CPA

Traders eligible for trader tax status (TTS) have the option to make a timely election for the Section 475 accounting method on securities and/or commodities. Section 475 is mark-to-market (MTM) accounting with ordinary gain or loss treatment. Without it, securities traders use the realization (cash) method with capital gains and loss treatment, including wash sale loss adjustments and the annual $3,000 capital loss limitation. We call it tax-loss insurance.

Caution: Sole proprietor (individual) TTS traders who missed the Section 475 MTM election date (April 18, 2023, for 2023) can’t use ordinary-loss treatment and are stuck with capital gains and losses, perhaps capital-loss carryovers. You might prefer to skip a 475 election for 2024, due by April 15, 2024, if you need capital gains to use up capital loss carryovers from 2023, as 475 is ordinary income, especially if you have capital gains in Q1 2024. (We review the decision-making in Green’s 2024 Trader Tax Guide, chapter 2.)

A new entity (new taxpayer) could deliver Section 475 MTM on trading losses generated in the entity account if it filed an internal Section 475 MTM election within 75 days of inception. A new entity should be in business for a minimum of Q4 to establish TTS.

Ordinary losses offset all types of income (wages, portfolio income, and capital gains) on a joint or single filing, whereas capital losses only offset capital gains. 

Starting in 2021, Section 475 ordinary losses and business expenses are subject to the 2017 Tax Cuts and Jobs Act (TCJA) “excess business loss” limitation (EBL). Ordinary business losses over the EBL threshold are NOL carryforwards. The inflation-adjusted EBL limit is $578,000/$289,000 (married/other taxpayers) for 2023 and $610,000/$305,000 (married/other taxpayers) for 2024. The TCJA repealed NOL carrybacks (except for farmers) and limited NOL carryforwards to 80% of the subsequent year’s taxable income.

TCJA also offers a 20% qualified business income (QBI) tax deduction for pass-through business partnerships and S-Corps, including sole proprietors. TTS trading is a specified service trade or business, so there is an income threshold and cap. QBI includes 475 ordinary income, excluding capital gains and losses, portfolio income, and forex. TTS expenses are negative QBI. A profitable TTS/475 trader is eligible for the QBI deduction, provided their taxable income is not over the QBI thresholds.

By making a 475 election on securities only, TTS traders retain lower 60/40 capital gains rates on Section 1256 contracts (futures).

Securities traders can segregate investment positions for long-term capital gains. If there is an overlap in securities trades vs. taxable investment positions, consider an entity for ring-fencing TTS/475 from segregated investment positions on the individual level.

Section 475 election procedures

Existing taxpayer individuals who qualify for TTS and want Section 475 must file a 2024 Section 475 election statement with their 2023 tax return or extension by April 15, 2024. The second step of a 2024 Section 475 election is to file a 2024 Form 3115 with the 2024 tax return in 2025. (Existing partnerships and S-Corps will file similarly by March 15, 2024.)

Revised excerpt from Green’s Trader Tax Guide Chapter 2 Section 475 MTM Accounting

Trader Tax Status: How To Qualify

| By: Robert A. Green, CPA

It’s challenging to be eligible for trader tax status (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 helpful reference. Poppe made 720 total trades per year or 60 per month. We recommend an average of four transactions 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 transaction separately, not round-trip. Scaling in and out counts, too.
  • Frequency: Execute trades on nearly four weekly days, 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; the markets are open almost daily. Part-time and money-losing traders face more IRS scrutiny, and individuals face more scrutiny than entity traders. Part-year qualification for TTS is okay.
  • Hours: Spends more than four hours daily, almost every market day, working on their trading business—all-time counts.
  • Avoid sporadic lapses: A trader has few to no intermittent stoppages in the trading business during the year. Vacations are okay. 
  • Intention: Has the intention to run a business and make a living. It doesn’t have to be your primary living.
  • Operations: Has significant business equipment, education, business services, and a home office.
  • 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 want to see more than $15,000 for the minimum account size.

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

  1. Outside-developed automated trading systems: A computerized trading service (ATS) with little trader involvement doesn’t qualify for TTS. On the other hand, if the trader can show they are 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 the ATS-generated trades in the TTS analysis.
  2. Trade copying service: Some traders use “trade copying software” (TCS). Trade copying is similar to 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 (RIA) or commodity trading adviser (CTA)—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.

There is significant content in Green’s Trader Tax GuideChapter 1 Trader Tax Status, for each of the above bullet points. 

IRS Warns Section 475 Traders

August 13, 2014 | By: Robert A. Green, CPA

The IRS Chief Counsel (ICC) recently gave auditors advice on challenging Section 475 mark-to-market (MTM) traders trying to game the system with segregated investment positions. Section 475 MTM means ordinary gain or business loss treatment, whereas investment positions are capital gain or loss treatment. It’s important not to mix up the two on tax return filings. If you are unclear on your situation, check with one of our CPAs.

In new IRS Chief Counsel Advice 201432016, the IRS focuses on options created on “basket transactions,” which I feel are rarely used tax avoidance schemes. During the past decade, some very large hedge funds parked their trading activity inside of banks and arranged option transactions with the banks to reclaim their trading profits after year-end. These hedge funds avoided application of Section 475 MTM income on their trading gains during the tax year, and replaced it with an option allowing them tax deferral and long-term capital gains tax rates in the following year(s). They converted 40% ordinary tax rates to 20% capital gains rates and received a tax deferral to boot. Their tax savings from these transactions was in the billions of dollars and it attracted the attention of Congress and the IRS. The hedge funds’ arguments about “economic substance” sound pretty hollow to me in relation to tax savings from this tax avoidance scheme. The IRS wants to treat these segregated option transactions as part of the trader’s Section 475 MTM ordinary income trading activities, since they see a connection to those activities (see rules below). To learn more about these schemes, read Hedge Fund Chief Testifies at Senate Tax-Avoidance Hearing (New York Times, July 22, 2014).

There’s a lesson for retail traders using Section 475
We haven’t seen retail traders attempt these complex schemes with bank counterparties. Yet it’s a good time to revisit the segregation rules in Section 475 MTM. It’s a nuanced area of the law and it can have significant consequences on tax returns for business traders who have investments.

All business traders using or considering Section 475 MTM should learn its segregation of investment rules. (One way to prevent this problem is to conduct your business trading activity in an entity separate from individual and IRA investment accounts. The entity has a different taxpayer identification number, so there is no connection in the activity.)

We’ve recommended Section 475 MTM since 1997 when Congress expanded it for traders. The biggest tax benefit is unrestricted business ordinary loss treatment, with taxpayers escaping the onerous rules for wash-sale loss deferrals and the capital loss limitation ($3,000 against ordinary income per year on individual tax returns). Section 475 MTM can be the ticket to receiving huge tax refunds, often on NOL carryback returns.

An example of investments vs. business trades
Many traders want to make long-term investments as well in order to benefit from deferral on taxable income (until sale) and to hold investment securities 12 months for lower long-term capital gains tax rates (currently up to 20% vs. 39.6% the ordinary tax rate on short-term capital gains).

Each year we run into a handful of confusing situations on what’s considered a trading position vs. an investment position. Here’s a common example: A trader may want to house his investment portfolio inside a business trading account for portfolio margining purposes and hyperactively trade stock options around his core investment stock positions.

Suppose a trader holds Apple stock as an investment and trades Apple options for business around it to manage risk. Apple stock and Apple stock options are substantially identical positions for purposes of wash sales and Section 475 MTM. By doing this type of commingling activity, the trader may inadvertently subject his Apple stock investment to Section 475 MTM treatment at year-end, thereby losing deferral on the stock and subjecting his gains to ordinary rates rather than lower long-term capital gains rates.

There are all sorts of scenarios that can come up and in some cases it appears to benefit the taxpayer. It’s important to keep in mind that the IRS is entitled to apply the rules in a way that does not prejudice the government’s position. In the previous example, if the trader had a material loss in the Apple stock held for investment, the IRS is entitled to bar the application of Section 475 on that losing investment position. The IRS can have its cake and can eat it too.

Segregation of investment position rules
Per Thomson Reuters/Tax & Accounting, “Any securities held by the trader are subject to marking unless they fall within the exception to marking under Code Sec. 475(f)(1)(B). In the case of traders, there is only one exception to marking. Under that exception, two requirements must be met. First, it must be established to IRS’s satisfaction that the security has no connection to the activities of such person as a trader. (Code Sec. 475(f)(1)(B)(i)) Second, any such security must be clearly identified in such person’s records as being described in Code Sec. 475(f)(1)(B)(i) before the close of the day on which it was acquired, originated or entered into (or such other time as IRS may by regs prescribe). (Code Sec. 475(f)(1)(B)(ii)) An identification that a security is held for investment for financial reporting purposes is not sufficient for Code Sec. 475 purposes. (Rev Rul 97-39, 1997-2 CB 62).

Generally, gains and losses recognized under Code Sec. 475 are ordinary income or loss to a trader that has made an election under Code Sec. 475(f). (Code Sec. 475(d)(3)(A)(i) and Code Sec. 475(f)(1)(D)) However, Code Sec. 475(d)(3)(B) provides exceptions to the automatically ordinary rule under Code Sec. 475(d)(3)(A). If a taxpayer can establish that it held securities as hedges, or that the securities were not held in connection with its trading business, or that a security is improperly identified (see Code Sec. 475(d)(2) ), then gains and losses are not automatically ordinary. (Code Sec. 475(d)(3)(B)(i), Code Sec. 475(d)(3)(B)(ii) and Code Sec. 475(d)(3)(B)(iii)) Character must then be determined by other relevant Code sections.”

Many hedge funds and some traders skip a Section 475 election because they don’t want to be burdened with identifying investments on the time and date of purchase. They establish a trade and may let their profits run and morph the position into an investment position for long-term capital gain and deferral.

How Section 475 MTM and the segregation rules work
A business trader using Section 475 MTM has ordinary gain or loss treatment, plus open business positions are marked-to-market as imputed sales at year-end. On the first day of the subsequent year, the trader imputes a purchase of that same position at the same year-end price.

Duly segregated investment positions are not subject to Section 475 MTM. For example, a business trader organized as a sole proprietor may have a business trading account at Interactive Brokers and a segregated investment account held jointly with his spouse at Fidelity for making long-term investments. Like all professionals, it’s expected that a business trader would have investments, too.

It’s important for the business trader to contemporaneously segregate investment positions from business positions in “form and substance.” Form means a separate account and substance means don’t trade substantially identical positions with business trading positions. While proposed IRS regulations required a separate account, that rule never became final law, so a trader can have investment positions within a business trading account. Just make sure to email yourself contemporaneously when purchasing an investment position. Don’t trade around investment positions with your business positions, as that runs afoul of the substance rule. The lines of distinction can be blurred in some cases and you should consult a trader tax expert about it.

Read Green’s 2014 Trader Tax Guide Chapter 2 on Section 475 MTM to learn more.

Recent trader tax court cases
In recent trader tax court cases covered on our blog, Assaderaghi, Nelson and Endicott, the IRS won denial of trader tax status partially because these option traders did not segregate active option trading from investing in stocks (similar to the example above). However, even if these traders did follow segregation rules and our above guidance, I still don’t think they traded options enough to qualify for trader tax status. They also sought Section 475 MTM ordinary loss treatment on stock investments, which is not possible.

Bottom line
Section 475 MTM is fantastic for most business traders — we call it “tax loss insurance.” But the fine print requires discipline on dealing with investments. It’s best to trade in a separate entity to skip these handcuffs.

 

IRS Exams: How To Defend Trader Tax Breaks And Win (Recording)

August 11, 2014 | By: jparasole

Join CPAs Robert A. Green and Amanda Smitson, and tax attorney Mark Feldman.

IRS tax notices often question trader tax status (TTS) and the right to deduct trading business expenses on a Schedule C for individuals or pass-through entity tax returns. The IRS figures it can force limited investment expense treatment on Schedule A and a capital loss limitation instead of unlimited Section 475 MTM ordinary business losses which are conditional on qualifying for TTS.  The IRS has recently been victorious against traders Assaderaghi, Nelson and Endicott in tax court, so we prepared some tips for other traders facing an exam. In this Webinar, we will cover:

* How to file a trader tax return without red flags.

* How to reply to tax notices.

* How to keep an IRS exam limited in scope and under control for winning. 

* Big issues like trader tax status, a Section 475 election, cost-basis accounting and IRS matching tax returns with 1099Bs from brokers.   

* How to stay in bounds on tax filings so you don’t invite scrutiny. 

* When to “agree to disagree” with your IRS agent and move on to appeals, where you may have a much better chance of success.   

* How to write a winning appeals letter. 

* The pros and cons of tax court. 

* Learn how to file a petition for a tax court “small case”, and attempt to negotiate a settlement back in appeals. 

* Who should represent you in tax court. 

* The consequences of not filing tax returns, filing late, installment payment agreements and not dealing with IRS collections. 

Handling tax compliance right significantly reduces your chances of having problems with the IRS. 

Questions and Answers.

Trading Business Expenses

August 10, 2014 | By: jparasole

Traders eligible for trader tax status (TTS) can deduct all reasonable business expenses.

Business deductions include:

  • Tangible personal property like a computer, up to $2,500 per item, providing the taxpayer files a Sec. 1.263(a)-1(f)) safe harbor election with the tax return.
  • Section 179 (100%), 100% bonus, or regular depreciation on computers, equipment, furniture, and fixtures (over $2,500 per item).
  • Amortization of startup costs (Section 195), organization costs (Section 248), and software.
  • Education expenses paid and courses taken after the commencement of the trading business activity. 
  • Section 195 startup costs may include education expenses within six months of beginning TTS.
  • Books/publications, market data, charting services, online and professional services, cloud services, chat rooms, mentors, coaches, supplies, phone, Internet, travel, meals, seminars, conferences, assistants, consultants, office rent, and more.
  • Home office expenses for the business use portion of a trader’s home (share of rent, mortgage interest, real estate tax, depreciation on home, utilities, repairs, insurance, and all other home costs).
  • Margin interest expenses (not limited to investment income).
  • Interest expense on trading capital
  • Stock-borrow fees and other costs for short sellers. 
  • Self-created software for automated trading systems.

Business deductions don’t include the following:

  • Vehicles 
  • Commissions
  • Employee-benefit plan deductions (TTS S-Corps can arrange health insurance and retirement plan contributions in connection with officer compensation)

For more information, see Green’s Trader Tax Guide Chapter 5 on Trading Business Expenses.