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GTT RESOURCES: CFMA

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Commodity Futures Modernization Act of 2000 (CFMA)

Traders have a large variety of new financial products to trade: ETFs, E-Minis, single-stock futures, plenty of new indices, and options and futures on almost everything. Learn how all these new products are taxed – as securities or commodities – and consider that commodities have lower tax rates.

Good news! The Commodity Futures Modernization Act of 2000 (CFMA) created an entire new batch of financial products to trade, and the new indices created from the act are taxed as commodities, which have lower tax rates then securities.

Before you start incorporating some of the new financial products into your trading program it’s wise to see how these new products are taxed by the IRS. In general, all new products are either taxed as “securities” or “commodities” and the latter have lower tax rates. So when given the opportunity to trade a new product that is equivalent in all respects except tax treatment, it will pay tax-wise to chose the “commodity” taxed vehicle.

If you are a business trader, understand ahead of time how incorporating some of these new products into your trading program may affect your trader tax status and election for mark-to-market accounting (MTM).

For example, if you elected MTM for your securities trading business only (and not for commodities) and you revise your business plan to trade E-Minis almost exclusively, you won’t have ordinary loss protection on the E-Minis, as they are taxed as commodities.

Note: An edited version of this page content was published in the August 2003 issue of Active Trader magazine (in the "Business of Trading" section written by our Robert A. Green, CPA): "What's the Difference? Besides stocks, traders have a wide range of financial products to trade. In the eyes of the IRS, though, all these products fall into one of two categories: securities or commodities. Why you may think the difference is inconsequential, products classified as commodities have tax benefits securities do not have."

We updated this page to reflect the new, lower tax rates put in effect after passage of the 2003 Tax Act: 35 percent on ordinary income and 15 percent on long-term capital gains. We point out the significantly lower tax rates that apply to commodities traders (23 percent) vs. securities traders (35 percent). Click here for the details.

Commodity Futures Modernization Act (CFMA) of 2000
H.R. 5660 Dec 14, 2000. The most significant aspect of this legislation was the legal creation of the single-stock future contract and taxation of broad based indices.

Taxation under the CFMA of 2000
Technical Explainations of the Tax Provisions of CFMA. If you want to learn more about the taxation of commodities, this is an excellent resource.

Products are more complex, but taxes have gotten simpler!
In the old days, before the Internet revolutionized online trading in 1997, a trader’s business and tax universe was in balance.

The SEC and CFTC kept to their respective turfs for securities and commodities, respectively, and the IRS taxed all instruments as either securities or commodities. The lines of demarcation were clear for all. Most traders focused on securities or commodities trading and few actively traded both.

Wow, have things changed with the passage of the CFMA and the simultaneous creation of an entire assortment of new product "hybrids."

Commodity exchanges created products to appeal to securities traders
The online trading revolution brought tremendous growth in the securities markets with the advent of hot IPOs. Trading in tech and NASDAQ stocks were all the rage in the late 1990s.
By 2000, the stock market bubble burst and securities and commodities exchanges actively began to compete for customers by creating new products that mirrored products created by the other exchange.

Commodities exchanges felt they missed the stock market windfall, so they rushed to market new flavors of “broad based” stock indices. Commodity exchanges were successful, partially because of the tax advantages for commodities traders (over securities traders).

Act and you shall find!
These new hybrid products created with the CFMA raised the ire of the SEC. This new Act solved many of the outstanding regulatory and tax treatment issues raised by these new products.

The CFMA established a framework for joint regulation (by the SEC and the CFTC) of single-stock futures and narrow-based security indexes.

IRS issues were also solved because the CFMA updated the IRS definition of “nonequity options” in IRC section 1256 contracts (commodities). Now, both the IRS and regulatory definitions of “broad based” indices are the same – 10 or more stocks in an index. This is great news for traders because now almost all indices are “broad based” and taxed at the lower commodity tax rates (see below).

Regulatory wise, broad-based security indices, which are not considered security futures products, continue to trade under the sole jurisdiction of the CFTC. Security futures products (i.e., single-stock futures) are subject to the joint jurisdiction of the CFTC and the SEC.

Methods for determining when an index is broad or narrow-based (for tax and regulatory purposes) are discussed at http://www.cftc.gov/sfp/sfpbackground.htm.

For indices excluded from the definition of narrow-based security index see http://www.cftc.gov/sfp/sfpcontractsapprovedprecfma.htm.

Under the CFMA almost all indices are now “broad based” commodities
The main effect of the CFMA was to significantly expand the definition of a “broad based” index, which is considered a commodity. “Narrow based” indices are considered securities.

Among assorted rules under the CFMA, the main rule states a “broad based” index is comprised of 10 or more securities; likewise, nine or fewer securities are a “narrow based” index.

Under the CFMA, almost all futures and options on stock indices, and smaller variations of indices (commonly known as “E-Minis”), are considered “broad based” indices, treated as commodities.

This is good news, because commodities have lower tax rates than securities and now almost all indices are commodities.

At the time of writing this article, we did not find one index that is considered “narrow based” and taxed as a security.

Single stock futures are taxed like securities
The IRS states that, "a gain or loss on the sale, exchange, or termination of a securities futures contract generally has the same character as gain or loss from transactions in the underlying security."

"For example, if the underlying asset would be a capital asset in the hands of the taxpayer, gain or loss from the sale of the contract is a capital gain or loss. This rule does not apply to securities futures contracts that are not capital assets (they are inventory assets), nor does it apply to products identified as hedging transactions, or any income derived in connection with a contract that would otherwise not produce a capital gain. Except as provided in the regulations, capital gain or loss from the sale, exchange or termination of a securities futures contract to sell property is treated as short-term capital gain or loss."

"A securities futures contract generally is defined as a contract of sale for future delivery of a single security or a narrow-based security index."

For more information on single-stock futures, click here.

Securities traders pay higher taxes
Before the mid-1980s, the IRS treated all buyer and sellers of “capital assets” (securities and commodities) in the same manner.

Securities trading “realized” gains are “short-term” capital gains subject to “ordinary” (marginal) tax rates, with the exception being that if you hold a security position open for 12 months or longer, you benefit from a lower long-term capital gains tax rates (20 percent vs. 38.6 percent). To pay for long-term capital gains rates, Congress subjects securities traders to the onerous wash-sale loss and straddle-loss deferral rules. Few securities traders keep positions open for 12 months, so they pay the higher tax rate and are also penalized with wash sale and straddle rules. This is simply not fair, but it is the rule.

In general, “securities” include: stocks, stock options (equity options), narrow-based indices, single-stock futures (taxed like their underlying stocks), mutual funds, exchange traded funds (QQQs, iShares, SPDRs, etc.) and bonds.

The taxability of options on ETF shares, where the underlying portfolio or index is “broad based” is currently uncertain and requires guidance from the IRS.

Commodities traders pay lower taxes
In the mid-1980s, Congress and the IRS significantly changed the tax code to provide for important differences between securities and commodities taxation.

Shrewd commodities traders were setting up complex straddles (offsetting positions) to avoid taxes by accelerating realized losses in the current tax year and deferring the offsetting unrealized gains positions to the next tax year.

Congress and the IRS passed IRC Code section 1256 to close this tax shelter. Section 1256 defines commodities and sets forth beneficial tax treatment for commodities.

Form 6781 apportions commodities gains and losses to Schedule D (Capital Gains and Losses) with 60 percent long-term and 40 percent short-term. Securities trading gains are all short-term on Schedule D, unless a trader holds a security open for 12 months or longer (a rarity for traders).

As mentioned previously, long-term capital gains rates are significantly lower than short-term rates. The 2003 Tax Act lowered long-term rate to 15 percent and the short-term rate to 35 percent.

Tax rates on commodities vs. securities, pre- and post-2003 Tax Act:

Commodities are section 1256 contracts taxed 60 percent at long-term capital gains tax rates and 40 percent at short-term capital gains tax rates (i.e., ordinary income tax rates).

Pre-2003 Tax Act:
60 percent multiplied by maximum long-term capital gains tax rate of 20 percent = 12 percent.
40 percent multiplied by maximum short-term capital gains tax rate (ordinary rate) of 38.6 percent = 15.44 percent.
Net 60/40 blended tax rate = 27.44 percent.

Post-2003 Tax Act: (the 60/40 split survived a last-minute attack from the Senate)
60 percent multiplied by maximum long-term capital gains tax rate of 15percent = 9 percent.
40 percent multiplied by maximum short-term capital gains tax rate (ordinary rate) of 35 percent = 14 percent.
Net 60/40 blended tax rate = 23 percent.

The 2003 Tax Act provides a rate reduction for commodities traders of 4.44 percent.

Securities are usually all short-term for traders, because they hold positions for less than 12 months.

Pre-2003 Tax Act:
Maximum short-term capital gains tax rate (ordinary rate) of 38.6 percent.

Post-2003 Tax Act:
Maximum short-term capital gains tax rate (ordinary rate) of 35 percent.

The 2003 Tax Act provides a rate reduction for securities traders of 3.6 percent (for short-term tax rates).
For investors, long-term capital gains tax rates were reduced by 5 percent or more.

Notice that the reductions for securities traders (3.6 percent), commodities traders/investors (4.44 percent) and securities long-term investors (5 percent) are similar. It is important to note the net tax rates, which are significantly better for commodities traders vs. securities traders (23 percent vs. 35 percent, respectively).

Effective dates: The ordinary income tax rate reduction changes are effective Jan. 1, 2003. The long-term capital gains rate reduction changes are effective for sales and exchanges after May 5, 2003. For more information about the new tax laws, click here.

Commodities defined
The definition of “commodities” in IRC Section 1256 include: any regulated futures contract, any foreign currency contract, any non-equity option, any dealer equity option and any dealer securities futures contract.

The big news in the CFMA is the updated definition for “non-equity options,” which include “broad-based” indices. “Narrow based” indices are considered “equity options” and taxed as securities. Options relating to broad-based groups of stocks and broad-based stock indices will continue to be treated as “non-equity options” under section 1256.

Congress helped traders tax-wise
I applaud Congress for acting in a smart manner in their passage of the CFMA.

Traders are not investing in long-term securities, but instead looking to trade any feasible instrument for a quick swing in price for profit.

For traders, it’s a zero sum game. Now with the CFMA, all those new indices are treated as commodities and commodity tax law is better for traders. Commodities are marked-to-market at the end of each day (which is the way a trader thinks), and the tax rates are lower.

Congress needs to do more work and help more traders avoid the tax pitfalls of securities taxation. Traders can help themselves with an IRC Section 475 mark-to-market election to avoid wash sales, straddle rules and capital-loss limitations.

Special rules for currency trading
Currency traders transact in contracts on regulated commodities exchanges (regulated futures contracts [RFC] on currencies – Section 1256 commodities) or in the non-regulated "interbank" market (a collection of banks giving third-party prices on foreign current contracts [FCC] and other forward contracts).

Currency traders are taxed similar to commodities traders, except that interbank currency traders must "elect out" of IRC section 988 (the ordinary gain or loss rules for special currency transactions) if they want the tax-beneficial "60/40" capital gains rate treatment of IRC section 1256. The principal intention of IRC section 988 is taxation on foreign currency transactions in a taxpayer's normal course of transacting global business.

Most currency traders will want to make this election for the tax-beneficial treatment of section 1256 (lower tax rates on gains).

For more information on currency trading, click here.

Bottom line
For tax purposes, don’t be alarmed when you see an ever-growing list of financial products to trade. How an item is taxed is not dependent on the type of exchange it trades on. The current law that matters is the CFMA, and the law actually simplified tax matters. Almost all indices are 10 or more stocks (broad-based) and taxed like commodities. Single-stock futures and ETFs are taxed like securities. When you have a choice, choose the commodity for lower tax rates (60/40).

If you have any questions on the CFMA, contact us at info@greencompany.com or call us.

Ready for a consultation with a GTT CPA

 

     

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GreenTrader blog archive, Forbes blog, Benzinga blog.

 




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