EDUCATION CENTER
Trader Tax Return Reporting Strategies

The IRS hasn’t created specialized tax forms for trading businesses as it has done for just about every other type of business. For example, other soleproprietorship businesses report revenues, cost of goods sold, and expenses on Schedule C. But for business traders only expenses are reported on Schedule C. Trading gains and losses are reported on various forms, depending on the situation.

New for 2011 tax returns: Securities must be first reported on new tax Form 8949, which then feeds into Schedule D (cash method) with capital losses limited to $3,000 per year (the rest is a capital loss carryover). Business traders who timely elect Section 475 MTM on securities report their trades (line by line) on Form 4797 Part II, rather than Form 8949. Form 4797 Part II has unlimited business ordinary loss treatment and avoids capital loss limitations, which is the case with Schedule D.

Futures traders should use Form 6781, unless the futures trader elected Section 475 (in that case, use Form 4797). Futures traders don’t use Form 8949.

In the forex arena, if the trader doesn’t qualify for trader tax status, by default without an opt-out (capital gains) election he should use line 21 (other gross income or loss) of Form 1040; qualifying business traders report on Form 4797. It can be confusing because the Section 475 MTM and Section 988 elections don’t have tax forms; traders must figure it out on their own. New taxpayers file Section 475 MTM elections internally, but existing taxpayers file a statement by a due date with the IRS and perfect it later on with a timely-filed Form 3115 filing.

INCLUDE FOOTNOTES
Always include well-written tax-return footnotes. They should explain trader tax law and benefits, why and how the taxpayer qualifies for trader tax status (business treatment), whether he or she elected Section 475 MTM or opted out of Section 988, and other tax treatment, such as the income-transfer strategy.

SEPARATE ENTITIES CAN DEFLECT IRS QUESTIONS
Entities have several benefits over sole-proprietor schedule Cs, including the “red-flag” factor. A partnership tax return Form 1065 shows trading gains, losses, and expenses on one set of forms, plus the IRS won’t see the taxpayer’s other activities.

A Form 1065 partnership tax return is filed for a general partnership or multi-member LLC choosing to be taxed as a partnership. Form 1120S is filed for an S-corporation and a single-member LLC electing to be taxed as an S-Corp. Forms 1065 and 1120S issue Schedule K-1s to the owners, so taxes are paid at the owner level rather than at entity level, thereby avoiding double taxation. Ordinary income or loss (mostly business expenses) is summarized on Form 1040 Schedule E rather than in detail on Schedule C (hence less IRS attention). Section 179 is broken out separately on Schedule E, along with unreimbursed partnership expenses (UPE) including home-office expenses.

This is an excerpt from Green’s 2012 Trader Tax Guide • Copyright © 2012