EDUCATION CENTER
Tips for Handling IRS Notices & Exams

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Recently the IRS has been making life more difficult for traders. In 2009, it announced major new tax-exam programs on the upper income. “Upper income” is defined as those making more than $250,000 per year. Those making more than $1 million per year face even more scrutiny.

The IRS has indicated more audits are coming. It’s facing more pressure than in prior decades to “close the tax gap” and improve taxpayer compliance. Plus, advanced new IRS computer systems seem trigger-happy these days, sending out tax notices left and right, especially on Schedule C (used by sole proprietors). These mini tax exams are stressful, costly and unfair.

Many traders pushed the envelope on qualifying for trader tax status and using tax treatment elections they were not entitled to, like Section 475 MTM ordinary loss treatment. The IRS busted these taxpayers, and the traders wouldn’t accept huge tax bills so they proceeded recklessly into tax court. As expected, they lost their weak cases and set a bad precedent for other traders. (One such case that comes to mind this past year is Richard Kay, Jr. v. Commissioner, TC Memo 2011-159.)

We hope more traders assess trader tax status properly. Don’t play the audit lottery by trying to cheat the IRS and your state on tax treatment. This gives the trading industry a bad name and makes our job more difficult. If you have trouble with the IRS or your state, please consult with us, and if you can’t afford us, maybe TradersAdvocacy.org can help.

One of our competitors has caused our industry a lot of damage. They told traders who don’t qualify for trader tax status they could deduct large amounts spent on education. In one case recently, we heard they told a trader to deduct $30,000 and the trader only had five trades during the year, even though a business trader needs closer to 500 round-turn trades per year! Education expense is clearly disallowed as an investment expense under Section 274(h)(7) and a dual-entity scheme cannot fix this problem either. Be very wary of trader tax advisers that are not CPA firms (the firm I mentioned is not a CPA firm). If you work with a bad-apple firm, watch out because the IRS may bust them and ask for their client lists.

The IRS also announced closer examination of pass-through entities, C-Corps, global businesses (on transfer pricing) and foreign offshore accounts. In 2013, the IRS announced several high-profile prosecutions of U.S. residents and offshore banks who allegedly conspired to evade U.S. taxes.

IRS COST-BASIS REPORTING
The big news for 2011 and 2012 is new IRS rules for cost-basis reporting from securities brokers. Congress and the IRS felt compliance was very lacking on taxpayers and brokers reporting trading gains and losses for securities, and they wanted brokers to report cost-basis and holding period information, designating short-term vs. long-term capital gains and losses.

Taxpayers are forced to deal with a challenging new tax form 8949, which captures the beefed-up Form 1099-B cost-basis and holding period information. We expect many taxpayers and brokers will make errors on Form 8949 and 1099-Bs and key reconciliations — the purpose of Form 8949 — will be off. That will invite IRS tax notices and perhaps tax exams. Random tax notices will likely occur to measure compliance with the new rules. See “The cost-basis saga continues” for more about problems on Form 8949.

TAX NOTICES AND EXAMS
If the IRS or your state’s department of revenue contacts you with questions or a notice of tax due, or to schedule an exam, don’t panic or reply on your own. Consult a trader tax professional and proceed under this person’s advice, either representing yourself (the inexpensive approach) or by engaging the expert as your tax representative, with power of attorney. Your direction should depend upon your financial resources and the complexity of your case.

EXAMS, APPEALS, AND TAX COURT
If you have a difficult agent and supervisor in the exam process who refuse to understand the nuances of trader tax, it’s often wise to “agree to disagree” at the exam level and take your case to the next level — the appeals process.

The last resort is tax court — often an expensive and more grueling process than a tax exam. If you go to tax court, you must show you acted in one manner or another contemporaneously and that you didn’t change your position in hindsight, which costs the IRS a lot of money.

This is an excerpt from chapter 10 in Green’s 2013 Trader Tax Guide

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