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EDUCATION
CENTER
GTT RESOURCES: CFMA
See our Updated Trader
Tax Center pages.
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.
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