Traders Should Be Entitled To The Pass-Through Tax Deduction

December 20, 2017 | By: Robert A. Green, CPA

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Congress passed the “Tax Cut and Jobs Act” (Act) on Dec. 20, and the President signed it into law on Dec. 22, 2017. The new law adopted the Senate Amendment for the 20% pass-through deduction, but it’s not clear how a trading company can use it. Traders should consider other smart moves as the Act suspended investment expenses, retained investment interest expense, and repealed NOL carrybacks.

Changes to pass through rules
The Conference Report (CR) decided on a 20% pass-through deduction vs. the Senate Amendment’s 23%. To meet the House halfway, the CR lowered the Senate’s taxable income (TI) threshold for “specified service activities” (SSA) to $157,500 single and $315,000 married. The CR retained the Senate phase-out range of $50,000 single and $100,000 married, above the TI threshold. For example, if an individual’s TI is over $207,500 single or $415,000 married, he or she won’t get any pass-through deduction on domestic “qualified business income” (QBI) in an SSA. But, individuals are entitled to a 20% deduction for QBI in a non-SSA at higher income levels, subject to the 50%-wage limitation above the threshold. (See examples in the Joint Explanatory Statement, p. 28-37.) The CR added an alternative wage limitation: 25% of wages plus 2.5% of “unadjusted basis, immediately after acquisition, of all qualified property,” which includes real estate and other tangible property. The House bill had a capital factor, which recognized investment in equipment.

I still have a few critical questions about the new law’s impact on TTS trading companies and TTS hedge funds.

1. Are TTS trading companies and TTS hedge funds an SSA?

In earlier posts, I thought a trading company was likely an SSA because “trading” is mentioned in the SSA definition.

The Joint Explanatory Statement definition of an SSA: “A specified service trade or business means any trade or business involving the performance of services in the fields of health, law, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities. For this purpose a security and a commodity have the meanings provided in the rules for the mark-to-market accounting method for dealers in securities (sections 475(c)(2) and 475(e)(2), respectively).”

I wonder if the following part of the SSA definition applies to a hedge fund: “the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners.” A one-person TTS trading company does not market to investors, so they don’t have a reputation or brand intangible asset, and this part of the definition should not apply to them.

A management company provides the performance of investing, investment management and trading services to a hedge fund. The hedge fund is the customer in receipt of those services. A management company is a general partner of the hedge fund organized as a limited partnership, and the general partner can bring TTS to the hedge fund level. An outside manager would not suffice for the hedge fund achieving TTS.

The Act’s definition of SSA is a bit different, p. 33-34 states: ‘‘(2) SPECIFIED SERVICE TRADE OR BUSINESS.—The term ‘specified service trade or business’ means any trade or business— (A) which is described in section 1202(e)(3)(A) (applied without regard to the words ‘engineering, architecture,’) or which would be so described if the term ‘employees or owners’ were substituted for ‘employees’ there in, or (B) which involves the performance of services that consist of investing and investment management, trading, or dealing in securities (as defined in section 475(c)(2)), partnership interests, or commodities (as defined in section 475(e)(2)).”

The “specified service activity” term and definition stress the “performance of services” listing various types of service providers. A one-person TTS S-Corp trades for its account; it does not perform trading services for customers.

Even if a hedge fund is considered a non-SSA, an active or non-active owner is unlikely to achieve a 20% pass-through deduction due to the 50% wage limitation, or the alternative 25% wage limitation plus 2.5% of the unadjusted qualified property. Hedge funds don’t pay wages, and they don’t own significant qualified property. The management company pays compensation and has business equipment; not the hedge fund.

If the IRS considers a TTS S-Corp a non-SSA, there would likely be a 20% pass-through deduction above the SSA income threshold. The TTS S-Corp pays officer compensation of $146,000 to maximize a Solo 401(k) contribution of $55,000 (under age 50, 2018 limit). The 50% wage limitation would be $73,000 (50% of $146,000). $73,000 divided by the 20% deduction is net income of $365,000 in the TTS S-Corp. A spouse might also receive compensation. The Act requires a taxpayer to calculate QBI and the wage limitations on each interest in a pass-through entity, separately.

2. Can TTS trading income, including Section 475 ordinary income, be treated as “qualified business income” (QBI)?

The pass-through deduction formula is very complicated. In rough summary, it’s a 20% pass-through deduction calculated on the lower of combined QBI from domestic sources or taxable income less net capital gains. (See the Joint Explanatory Statement, p. 28-40.)

The QBI exclusion list does not mention Section 475 ordinary income, so it seems appropriate to include it in QBI. Only a TTS trader may elect Section 475. I covered this issue in my blog post Section 475 Traders May Be Eligible For Pass-Through Tax CutsSteven Rosenthal, Senior Fellow, Urban-Brookings Tax Policy Center, weighed in then, and I confirmed this with him again after enactment of the Act: “Section 475 treats the gain as ordinary income,” he says. “Section 64 provides that gain that is ordinary income shall not be treated as gain from the sale of a capital asset.” Mr. Rosenthal thinks Section 475 ordinary income is QBI under the Act for this reason and “because it’s not on the QBI exclusion list.”

QBI should also include ordinary income on a rental real estate activity. The media quoted several tax experts saying rental companies should benefit from the pass-through deduction, which means they consider rental income to be QBI. Those tax experts implied rental real estate companies are likely non-SSA and the 2.5% qualified property factor will lead to more active and passive owners being eligible for the 20% pass-through deduction.

If investors in the rental real estate activity can achieve the pass-through deduction on a non-SSA, then TTS traders with Section 475 should have non-SSA with QBI treatment, too. One company invests in real estate, the other in securities, and both have ordinary income. Neither entity performs services for clients.

The CR used the Senate Amendment’s definition of “Treatment of investment income” — the QBI exclusion list (full list included below). The Senate Amendment and CR deleted “short-term capital gains” (STCG) from (1), but left “long-term capital gains and losses.” Oddly, the Act itself left in STCG to (1). Rushing may have led to errors.

The CR states an exclusion of “investment-related” items.  A TTS trader or TTS hedge fund has “business-related” activity. I wonder if this could open the door to a TTS trader or TTS hedge fund having QBI on short-term capital gains that are business related. Perhaps, business-related Section 1256 capital gains with 60/40 rates should be included in QBI, too. There is a 60% long-term capital gain portion, but it’s not “long-term capital gains” that are “investment-related.”

The 20% deduction is on the lower of QBI or modified taxable income less net capital gains. For example, if a trader has QBI consisting of all business-related capital gains, and it’s his only TI, then he won’t get a deduction since modified TI less net capital gains might be zero. If the trader has significant other income, it could be different.

It’s much better for a TTS trader to elect Section 475 to have ordinary income: It’s safer to assume QBI includes Section 475 and that modified TI does not subtract Section 475 ordinary income.

See the definition (5) below. Forex trading is “directly related to the business needs of the business activity.” Some forex traders might want to retain Section 988 ordinary income treatment rather than file a contemporaneous capital gains election.

CR “Treatment of investment income: Qualified items do not include specified investment-related income, deductions, or loss. Specifically, qualified items of income, gain, deduction and loss do not include (1) any item taken into account in determining net long-term capital gain or net long-term capital loss, (2) dividends, income equivalent to a dividend, or payments in lieu of dividends, (3) interest income other than that which is properly allocable to a trade or business, (4) the excess of gain over loss from commodities transactions, other than those entered into in the normal course of the trade or business or with respect to stock in trade or property held primarily for sale to customers in the ordinary course of the trade or business, property used in the trade or business, or supplies regularly used or consumed in the trade or business, (5) the excess of foreign currency gains over foreign currency losses from section 988 transactions, other than transactions directly related to the business needs of the business activity, (6) net income from notional principal contracts, other than clearly identified hedging transactions that are treated as ordinary (i.e., not treated as capital assets), and (7) any amount received from an annuity that is not used in the trade or business of the business activity. Qualified items under this provision do not include any item of deduction or loss properly allocable to such income.” 

How to proceed
For 2018, trader tax status (TTS) traders should consider a partnership or S-Corp for business expenses, and a Section 475 election on securities for exemption from wash sale losses and ordinary loss treatment (tax loss insurance). Consider a TTS S-Corp for employee benefit plan deductions including health insurance and a high-deductible retirement plan, since a TTS spousal partnership or TTS sole proprietor cannot achieve employee benefit deductions. Consider this the cake. It puts you in position for potentially qualifying for a 20% QBI-deduction on Section 475 ordinary income in a TTS trading pass-through entity – icing on the cake. If a TTS trader’s taxable income is under the specified service activity (SSA) threshold of $315,000 married, and $157,500 other taxpayers, he or she might get the 20% QBI-deduction in partnerships or S-Corps. QBI includes Section 475 ordinary income, and it excludes capital gains. It might be a challenge for a TTS sole proprietor to claim the pass-through deduction, because Schedule C has trading expenses, only, and trading gains are on other tax forms. Trading in a C-Corp could be costly.

If you are interested in this 20% deduction for a trading or non-trading business, I suggest a  consultation with me soon.

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