Tax Planning

Saving more in taxes requires tax planning during the year.

While TCJA did not change trader tax status, Section 475 MTM, wash-sale loss rules on securities, and more, there is still plenty to consider.

There are 2020 inflation adjustments in income and capital gains tax brackets, various income thresholds and caps, retirement plan contribution limits, standard deductions, and more. See the 2020 Tax Brackets at TaxFoundation.org.

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 2021. We expect tax rates to be the same for 2021, although the IRS will adjust the tax brackets for inflation. Enjoy the time-value of money with income deferral.

Taxpayers with trader tax status in 2020 should consider accelerating trading business expenses, such as purchasing business equipment with full expensing.

Accelerate income and defer certain deductions

A TTS trader with substantial ordinary losses (Section 475) under the “excess business loss limitation” (EBL) should consider accelerating income to soak up the allowable business loss to avoid 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.

You may wish to convert a traditional IRA into a Roth IRA before year-end to accelerate income.

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 2020 long-term capital gains rates are 0% for taxable income in the 10% and 12% ordinary brackets. The 15% capital gains rate applies to the middle brackets, and the top capital gains rate of 20% applies in the top 37% bracket.

Estimated income taxes and amt

If you have reached the SALT cap, you don’t need to prepay 2020 state estimated income taxes by Dec. 31, 2020. Pay federal and state estimated taxes owed when due by Jan. 15, 2021, with the balance of your tax liabilities payable by April 15, 2021. 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 at https://tinyurl.com/12-tax-tips.)

Many traders skip making quarterly estimated tax payments during the year, figuring they might incur trading losses later in the year. They can catch up with the Q4 estimate due by Jan. 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.

Avoid wash sale loss adjustments

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, 2021, can break the chain on individual account WS at year-end 2020 provided you don’t purposely avoid WS with the related party entity.)

WS losses might be preferable to capital loss carryovers at year-end 2020 for TTS traders. A Section 475 election in 2021 converts year-end 2020 WS losses on TTS positions (not investment positions) into ordinary losses in 2021. That’s better than a capital loss carryover into 2021, which might give you pause to making a 2021 Section 475 election. You want a clean slate with no remaining capital losses before electing Section 475 ordinary income and loss. (See https://tinyurl.com/wash-sale-loss for more details.)

Trader tax status and Section 475

If you qualify for TTS in 2020, you may accelerate trading expenses into that qualification period as a sole proprietor or entity. If you don’t qualify until 2021, you should 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.

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 2020 Section 475 election, existing individual taxpayers have to file an election statement with the IRS by April 15, 2020 (March 15 for existing S-Corps and partnerships). If they file that election statement on time, they need to complete the election process by submitting a 2020 Form 3115 with their 2020 tax return. Those who missed the 2020 election deadline may want to consider the election for 2021. Capital loss carryovers are a concern — use them up against capital gains but not Section 475 ordinary income. The 475 election remains in effect each year until you revoke it in the same manner. If you do not qualify for TTS, then 475 treatment is suspended until you requalify.

A Section 475 election made by April 15, 2021, takes effect on Jan. 1, 2021. In converting from the realization (cash) method to the mark-to-market (MTM) method, you need to make a Section 481(a) adjustment on Jan. 1, 2021. It’s unrealized capital gains and losses on open TTS securities positions held on Dec. 31, 2020. Don’t apply Section 475 to investment positions. If you’re not a TTS trader at year-end 2020, you won’t have a Section 481(a) adjustment. A “new taxpayer” entity can elect Section 475 within 75 days of inception — a good option for those who miss the individual sole proprietor deadline (April 15, 2020). Forming a new entity on Nov. 1, 2020, or later is too late for establishing TTS for the year. Consider waiting until Jan. 1, 2021, to start a new TTS entity and elect Section 475.

Officer compensation, health insurance, 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. Unlike trading gains, S-Corp salary is considered earned income.

S-Corps must execute officer compensation in conjunction with employee benefit deductions through formal payroll tax compliance before the year-end 2020. Otherwise, traders miss the boat. TTS is a 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,” so a TTS trader may determine officer compensation based on how much to reimburse for health insurance, and how much she wants to contribute to a retirement plan. 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; it has a dedicated team for our TTS S-Corp clients. Sole proprietor and partnership TTS traders cannot pay salaries to 2% or more owners.

Setting up a TTS s-corp for 2021

If you missed out on employee benefits in 2020, then consider an LLC with S-Corp election for 2021. You can form a single-member LLC by mid-December 2020, obtain the employee identification number (EIN), and open the LLC brokerage account before year-end to begin trading in it on Jan. 1, 2021. The single-member LLC is a disregarded entity for 2020, which avoids an entity tax return filing for the 2020 partial year. A spouse can be added as a member of the LLC on Jan. 1, 2021, which means the LLC will file a partnership return for 2021. If you want health insurance and retirement plan deductions, then your single-member or spousal-member LLC should submit a 2021 S-Corp election within 75-days of Jan. 1, 2021. The S-Corp should also consider making a Section 475 MTM election on securities only for 2021 within 75 days of Jan. 1, 2021.

For more information, see Green’s Trader Tax Guide, Chapter 9, Tax Planning. 

 

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