Tax Forms And Compliance

Tax compliance is complex for traders with lots of different tax forms.

The IRS hasn’t created specialized tax forms for individual trading businesses. Traders enter gains and losses, portfolio income, and business expenses on various forms. It’s often confusing. Which form should be used if the taxpayer is a forex trader? Which form is correct for securities traders using the Section 475 MTM method? Can one report trading gains directly on a Schedule C? The different reporting strategies for the various types of traders make tax time not so cut-and-dry.

Sole proprietor trading business

Other sole-proprietorship businesses report revenue, cost of goods sold, and expenses on Schedule C. But business traders qualifying for trader tax status (TTS) report only trading business expenses on Schedule C. Trading gains and losses are reported on various forms, depending on the situation. In an entity, all trading gains, losses, and business expenses are consolidated on the entity tax return — a partnership Form 1065 or S-Corp Form 1120-S. That’s one reason why we recommend entities for TTS traders.

Sales of securities must be first reported on Form 8949, which then feeds into Schedule D (cash method) with capital losses limited to $3,000 per year against ordinary income (the rest is a capital loss carryover). Capital losses are unlimited against capital gains. (We cover Form 8949 in Chapter 4.)

Business traders who elect and use Section 475 MTM on securities report their business trades (line by line) on Form 4797 Part II. MTM means open business trades are marked-to-market at year-end based on year-end prices. Business traders still report sales of segregated investments in securities (without MTM) on Form 8949. Form 4797 Part II (ordinary gain or loss) has business ordinary loss treatment and avoids the capital loss limitation and wash-sale loss treatment. Form 4797 losses are counted in net operating loss (NOL) calculations.

Section 1256 contract traders (i.e., futures) should use Form 6781 (unless they elected Section 475 for commodities/futures; in that case, Form 4797 is used). Section 1256 traders don’t use Form 8949 — they rely on a one-page Form 1099-B showing their net trading gain or loss (“aggregate profit or loss on contracts”). Simply enter that amount in summary form on Form 6781 Part I.

If the trader has a large Section 1256 loss, he should consider carrying back those losses three tax years, but only applied against Section 1256 gains in those years. To obtain this election, check box D labeled “Net section 1256 contracts loss election” on the top of Form 6781.

Forex traders with Section 988 ordinary gains or losses who don’t qualify for TTS should use line 8 (other income or loss) on 2020 Schedule 1 (Form 1040). TTS traders should use 2020 Form 4797, Part II ordinary gain or loss. What’s the difference? Form 4797 Part II losses contribute to NOL carryforwards against any type of income, whereas Form 1040’s “other losses” do not. The latter can be wasted if the taxpayer has negative income. In that case, a contemporaneous capital gains election is better on the Section 988 trades. If the taxpayer filed the contemporaneous Section 988 opt-out (capital gains) election, she should use Form 8949 for minor currencies and Form 6781 for major currencies. Forex uses summary reporting. (We cover forex tax treatment in Chapter 3 and forex accounting treatment in Chapter 4.)

For more information, see Green’s Trader Tax Guide. See Chapter 6 on Trader Tax Return Reporting Strategies.