Securities Brokers Don’t Tell The Full Story About Wash Sale Losses

January 20, 2016 | By: Robert A. Green, CPA

Click to read Green’s blog post on Forbes: Securities Brokers Don’t Tell The Full Story About Wash Sale Losses

It’s an inconvenient truth for brokers that the IRS asks them to report wash sale losses on 1099-Bs differently from the way traders must report wash sale adjustments on income tax returns. Brokers are correct in preparing 1099-Bs, but incorrect in telling clients they should import 1099-Bs into their income tax filings. [...] Click here

 

 

barrons

Thanks @twcarey for covering this tax story in Barron’s (1/23/16) “Two New Mobile Investing Apps for Millennials,” Divy introduces investing as a social exercise while Clink emphasizes regular savings. Plus, tax advice. Click here for excerpt. 

 


Don’t Solely Rely On 1099-Bs For Wash Sale Loss Adjustments

January 5, 2016 | By: Robert A. Green, CPA

Click to read Green's blog post: Wash Sale Loss Adjustments Can Be A Big Tax Return Headache

Click to read Green’s blog post: Wash Sale Loss Adjustments Can Be A Big Tax Return Headache

Broker-issued Form 1099-Bs for securities provide cost-basis reporting information, but they don’t provide taxpayers everything they need for tax reporting if the taxpayer has multiple trading accounts or trades equities and equity options.

Brokers calculate wash sales based on identical positions (an exact symbol only) per separate brokerage account. But the wash sale loss rules for taxpayers, Section 1091, requires taxpayers to calculate wash sales based on substantially identical positions (between equities and equity options and equity options at different exercise dates) across all their individual accounts including IRAs — even Roth IRAs.

The best accounting solution for generating a correct and compliant Form 8949 is trade accounting software that’s compliant with Section 1091. Don’t just rely on a Form 1099-B (exception: if there is only one brokerage account, the trading is only in equities, not equity options and there are no cost-basis adjustments including wash sale losses).

Many tax preparers and taxpayers continue to disregard Section 1091 rules, even after acknowledging differences with broker 1099-B rules. They do so at their peril if caught by the IRS.

Securities accounting is challenging
Securities brokers are making advances in tax-compliance reporting. It’s due to Congressional legislation and implementation of IRS cost-basis reporting regulations for which phase-in commenced in 2011. Phase-in is almost complete: Equity option transactions and simple debt instruments acquired on January 1, 2014 or later were reported for the first time on 1099-Bs for tax year 2014. The only cost-basis reporting item remaining to be phased-in is reporting complex debt instruments starting on January 1, 2016 or later. Tax-year 2015 1099-Bs should be the same as in 2014.

Taxpayers report proceeds, cost basis, wash sale loss and other adjustments, holding period and capital gain or loss – short term vs. long-term (held over 12 months) on Form 8949. According to the form’s instructions, taxpayers without wash sale and other adjustments to cost-basis may simply enter totals from broker 1099-Bs directly on Schedule D and skip filing a Form 8949. After all, the IRS gets a copy of the 1099-B with all the details.

But this Form 8949 instruction leads many taxpayers and tax preparers astray with taxpayers thinking they don’t have wash sales when in fact they do have many to report in compliance with IRS wash sale rules for taxpayers, which differ from IRS rules for brokers.

Form 8949 problems: apples vs. oranges with 1099-Bs
In accordance with IRS rules for brokers, a 1099-B reports wash sales per that one brokerage account based on identical positions. The wash sale rules are different for taxpayers, who must calculate wash sales based on substantially identical positions across all their accounts including joint, spouse and IRAs. With different rules for brokers vs. taxpayers (apples vs. oranges), it’s expected that in many cases broker-issued 1099-Bs might report different wash sale losses than a taxpayer must report on Form 8949. A broker may report no wash sales when in fact a taxpayer may have many wash sale losses. A taxpayer may permanently lose a wash sale loss between a taxable and IRA account, but a broker will never report that on a 1099-B. In some cases, a broker can report a wash sale loss deferral at year-end, but the taxpayer may have absorbed the wash sale loss in another account, thereby eliminating this tax problem at year-end.

This problem of different rules on wash sales for brokers vs. taxpayers is still widely unknown by many taxpayers and tax preparers. Far too many continue to omit Form 8949 or file an incorrect Form 8949 relying solely on broker 1099-B reporting when they should be using securities trade accounting software to properly calculate and report wash sale loss adjustments.

A predicament for some tax preparers who do understand the problem is that calculating wash sales correctly leads to un-reconciled differences between Form 8949 and 1099-Bs. Some tax preparers don’t want to draw attention to those differences, fearing IRS notices generated from IRS 1099-B automated matching programs. It’s ironic that the mission of Congress in cost basis legislation was to “close the tax gap” providing more opportunities for matching 1099-Bs, but it may lead to a mess of un-reconciled differences. To better close the tax gap, Congress should realign broker and taxpayer wash sale rules to be the same.

There is one scenario where a taxpayer can solely rely on a 1099-B and skip filing Form 8949 by entering 1099-B amounts on Schedule D: when the taxpayer has only one brokerage account and trades equities only with no trading in equity options, which are substantially identical positions. Plus, the taxpayer must not have any wash sale loss or other adjustments. In that narrow case, there are apples vs. apples — only one account and substantially identical is the same as identical.

This problem of apples vs. oranges is biggest for individuals who tend to have multiple accounts. There is a solution for traders who qualify for TTS. Trade in an entity and elect Section 475 MTM, which is exempt from wash sale rules. Keep investment accounts with far less wash sale loss activity on the individual level.

Section 1091 wash sale rules
Per IRS Publication 550: A wash sale occurs when you (a taxpayer) sell or trade stock or securities at a loss and within 30 days before or after the sale you:

  • Buy substantially identical stock or securities,
  • Acquire substantially identical stock or securities in a fully taxable trade,
  • Acquire a contract or option to buy substantially identical stock or securities, or
  • Acquire substantially identical stock for your individual retirement account (IRA) or Roth IRA.

Wash-sale rules differ between brokers and taxpayers
IRS regulations require brokers to calculate and report wash sales per account based on identical positions (it’s reiterated in Form 1099-B instructions). Here is an example of broker rules: an account holder sells 1,000 shares of Apple stock for a loss and buys back 1,000 shares of Apple stock 30 days before or 30 days after. That’s a wash-sale loss deferred (added) to the replacement position cost-basis. But, if the account holder buys back Apple options instead of Apple stock, according to broker rules it’s not a wash sale because an option is not “identical” to the same company’s stock. Broker computer systems are programmed to calculate wash sales based on an identical symbol, and stock and options and options at different exercise dates have different symbols.

IRS regulations for Section 1091 require taxpayers to calculate wash sales based on “substantially identical” positions. That’s very different from the rule for brokers that require “identical” positions. This can be a big problem or challenge for active traders who trade stocks and options, or just options but with constant changes in exercise dates. Starting in 2014, 1099-Bs included equity options for the first time.

Many brokers report “disallowed wash sales for the year” on 1099-Bs rather than “actual wash sales” at year-end. This causes confusion and anxiety for many taxpayers, who draw the wrong conclusion and may think they have a huge problem at year-end, when they may not. The “disallowed wash sales for the year” number may count the same wash sale over and over throughout the year. What counts more is what wash sales are deferred at year-end, and what ones were permanently lost to IRA accounts.

Don’t get into trouble with the IRS
Many traders and local tax preparers who are not that savvy to the wash sale rules may leap to import 1099-Bs into TurboTax or choose to enter totals directly on Schedule D, omitting Form 8949, but they will probably not comply with Section 1091. In effect, they are using broker rules and unknowingly or willfully disregarding Section 1091. While tax preparers may be covered for malpractice, they will have Circular 230 penalties and ignorance is not an acceptable excuse.

Consider a Section 475 election
Business traders qualifying for TTS are entitled to elect Section 475 mark-to-market (MTM) accounting elected on a timely basis, which exempts them from wash sale loss adjustments and the capital loss limitation. Section 475 business trades are not reported on Form 8949; they use Form 4797 Part II (ordinary gain or loss). Although Section 475 extricates traders from the compliance headaches of Form 8949, it does not change their requirement for line-by-line reporting on Form 4797. We recommend trade accounting software to generate Form 4797. If you elect Section 475, you’ll need that software to calculate your Section 481(a) adjustment, too. (Learn more about the Section 481(a) adjustment in Green’s 2016 Trader Tax Guide Chapter 2.)

Accounting software and services for traders
When it comes to a trading activity, it’s wise to do separate accounting for trading gains and losses vs. expenses. A consumer off-the-shelf accounting program is fine for keeping track of expenses, non-trading income, home office deductions and itemized deductions. But when it comes to trade accounting for securities, these programs are inadequate — you need a specialized securities trade accounting program and/or accounting firm, or in limited cases brokerage firm reporting may be sufficient. On our Website accounting services page, learn more about trade accounting software. Choose our professional accounting service using this software.

Futures accounting isn’t required, as you can rely on the tightly controlled one-page 1099-B with summary reporting, using MTM reporting. Although spot forex accounting could be a nightmare if you try to do it yourself, you can rely on the broker’s annual tax reports and should use summary reporting. Spot forex is not a “covered security,” so there are no Form 1099-Bs.


Green’s 2016 Trader Tax Guide

December 24, 2015 | By: Robert A. Green, CPA

ttg_cover-200x258_2016

20%-Off Promotion Through Jan. 31.

Executive summary and what’s new in this guide 

Use Green’s 2016 Trader Tax Guide to receive every trader tax break you’re entitled to this tax season. Whether you self-prepare your tax returns using consumer tax preparation software or app, engage a CPA firm or local tax storefront, this guide can help everyone through the process. Many of our tax compliance clients use it to take advantage of our offerings, as an educated consumer is the best customer.

Unfortunately, it may be too late for some tax breaks on your 2015 tax return if you wait until you’re actually filing your taxes. If this is the case, then use this guide to execute these tax strategies — including forming an entity with employee-benefit plan deductions — and elections on time for tax-year 2016.

Business traders are far better off than investors in the tax code

By default, the IRS lumps all traders into “investor tax status,” and investors get penalized in the tax code with restricted investment interest and investment expenses, capital-loss limitations ($3,000 per year), wash-sale loss deferrals, no Section 475 mark-to-market (MTM) election and no employee-benefit plans (retirement and health insurance deductions). Business traders who qualify for trader tax status (TTS), though, are entitled to these tax breaks.

Don’t confuse TTS with the related tax-treatment election of Section 475 MTM accounting, which converts new capital gains and losses into business ordinary gains and losses. Only qualified business traders may use Section 475 MTM; investors may not.

A business trader can assess and claim TTS after year-end and even going back three open tax years. But business traders may only use Section 475 MTM if they filed an election on time, either by April 15 of the current year (i.e., April 15, 2015 for 2015), or within 75 days of inception of a new taxpayer (i.e., a new entity). For more on TTS, see Chapter 1.

Investment expenses are limited to 2% of adjusted gross income (AGI) and they are not deductible for the Alternative Minimum Tax (AMT). Plus, investment expenses exclude home office, education and startup expenses, all important business deductions for qualifying business traders.

Can you deduct 2015 trading losses?

Many traders bought this guide hoping to find a way to deduct their 2015 trading losses. Maybe they qualify for TTS, but that only gives them the right to deduct their trading business expenses.

Securities trading and Section 1256 contract trading receive capital gain/loss treatment by default, and there’s a $3,000 capital loss limitation against ordinary income. Yes, Section 475 MTM would have made those losses business ordinary losses, but you had to file the Section 475 MTM election by April 15, 2015 as an “existing taxpayer.” (New taxpayers may elect Section 475 internally within 75 days of inception.) If you did not do this, you’re stuck with capital loss treatment and your next problem is how to use up a capital loss carryover in the next year(s). If you elect Section 475 by April 15, 2016, your 2016 business trading gains will be ordinary rather than capital. Remember, you need capital gains to use up capital loss carryovers. That creates a predicament that we address in Chapter 2 on Section 475 MTM. Once a trader has a capital loss carryover hole, he needs a capital gains ladder to climb out of that hole and a Section 475 election to prevent digging a bigger hole. An entity is better for electing and revoking Section 475 as needed. In 2015, the IRS changed the law to allow revocation of Section 475 elections.

If you have losses from trading Section 1256 contracts (like futures), you may be in luck if you have Section 1256 gains in the prior three tax years. On the top of Form 6781, you can file a Section 1256 loss carryback election. Business traders may elect Section 475 MTM on Section 1256 contracts, but most elect it on securities only so they can retain the lower 60/40 tax rates on Section 1256 gains. Sixty percent is a long-term capital gain even on day trades.

If you have losses trading spot or forward forex contracts in the Interbank market, you may be in luck. By default, Section 988 for forex transactions receives ordinary gain or loss treatment, which means the capital loss limitation doesn’t apply. But without TTS, the loss isn’t a business loss and if you have negative taxable income, the negative part is often wasted — it’s not a business net operating loss (NOL) or capital loss carryover. Forex traders can file a contemporaneous “capital gains and losses” election in their own books and records to opt out of Section 988, which is wise if you have capital loss carryovers. Contemporaneous means in advance, not after the fact using hindsight. In some cases, this election qualifies for Section 1256(g) lower 60/40 tax rates. See Chapter 3 for more details.

IRS cost-basis saga continues

Accounting for trading gains and losses is the responsibility of securities traders; they must report each securities trade and related wash-sale loss adjustments on IRS Form 8949 in compliance with Section 1091, which then feeds into Schedule D (capital gains and losses). Form 8949 came about after the IRS beefed up compliance for securities brokers starting in 2011, causing headaches, confusion and additional tax compliance cost. Congress found tax reporting for securities to be inadequate and thought many taxpayers were under reporting capital gains. The cost-basis rules are almost fully phased-in. Options and less complex fixed income securities acquired on Jan. 1, 2014 or later were reported for the first time on Form 1099-Bs for 2014. Inclusion of complex debt instruments on 1099-Bs is delayed until Jan. 1, 2016. There are no changes with 1099-Bs between 2015 and 2014 tax years.

Broker-issued securities Form 1099-Bs provide cost-basis reporting information, but they don’t provide taxpayers everything they need for tax reporting if the taxpayer has multiple trading accounts or trades equities and equity options. Brokers calculate wash sales based on identical positions (an exact symbol only) per separate brokerage account. But Section 1091 requires taxpayers to calculate wash sales based on substantially identical positions (between equities and equity options and equity options at different exercise dates) across all their accounts including IRAs — even Roth IRAs. The best accounting solution for generating a correct and compliant Form 8949 is software that’s compliant with Section 1091. Don’t just rely on a Form 1099-B (exception: if there is only one brokerage account, the trading is only in equities, not equity options and there are no cost-basis adjustments including wash sale losses). See Chapter 4 for more about these changes and common taxpayer and tax preparer mistakes. Many tax preparers and taxpayers continue to disregard Section 1091 rules, even after acknowledging differences with broker 1099-B rules. They do so at their peril if caught by the IRS.

Option traders

Option traders generally don’t day trade; rather they execute both simple and complex trades over weekly and monthly time horizons. While many option traders may execute trades only a few days per week, they have a position on almost every day of the week. But three recent trader tax court cases for option traders (Assaderaghi, Nelson and Endicott) indicate the IRS requires more frequency than just trading two days per week. See Chapter 11 for details on these three cases. While trading monthly options may be a challenge for claiming TTS, in the past year we’ve noticed more clients trading weekly options, which is better for TTS. Some options traders set aside capital for active trading in equities, which helps them qualify for TTS.

Futures and forex traders

Futures traders, other Section 1256 contract traders and forex traders have it much easier. Futures brokers report Section 1256 contracts in summary fashion, with mark-to-market accounting for realized and unrealized gains and losses, on a simple one-page 1099-B. Taxpayers can rely on a futures 1099-B to report net “aggregate profit and loss” on Form 6781, Part I. See Chapter 4.

Spot forex is not a “covered security” and it’s not by default a Section 1256 contract. Therefore, spot forex brokers should not issue a 1099-B. Spot forex brokers do offer online tax reports and taxpayers should report the summary amount, with or without attachment of those reports on their tax returns. Section 1091 does not apply to Section 1256 contracts and forex, saving futures and forex traders headaches on wash sales.

Differences for various instruments

There are complexities in sorting through different tax-treatment rules and tax rates. It’s often hard to tell what falls into each category, but in Chapter 3 we cover the many trading instruments and their tax treatment.

Securities have realized gain and loss treatment and they are subject to wash-sale rules and the $3,000 per year capital loss limitation on individual tax returns. Section 1256 contracts — including futures — are marked to market at year-end, so there are no wash-sale adjustments and they have lower 60/40 tax rates. Options have a wide range of tax treatment. An option is a derivative of an underlying financial instrument and the tax treatment is generally the same. Equity options are taxed the same as equities, which are securities. Index options are derivatives of indexes, and broad-based indexes are Section 1256 contracts. Simple and complex equity option trades have special tax rules on holding period, adjustments and more. Forex receives ordinary gain or loss treatment on realized trades (including rollovers) unless you file a contemporaneous capital gains election and in some cases navigate into lower 60/40 tax rates. Physical precious metals are collectibles and if these capital assets are held over one year, sales are subject to the taxpayer’s ordinary rate capped at 28% (the collectibles rate). Bitcoin is an intangible asset taxed like securities. Nadex binary options tax treatment is unclear and we make a case to tax them like swaps with ordinary income or loss. Foreign futures are taxed like securities unless the IRS issues a revenue ruling allowing Section 1256 tax benefits (but that is rare). See Chapter 3 for various tax treatments.

Updates on Section 475 MTM elections

Since Congress changed the 1997 tax law to allow business traders to elect Section 475 MTM, GreenTraderTax has helped thousands of business traders save a fortune in taxes by simply making this free election on time and filing a Form 3115 for automatic change of accounting method (free of IRS fees). We refer to Section 475 as free “tax loss” insurance. If you suffer a trading loss of $100,000, you can receive a full business loss deduction against any kind of income in the current year, or with a NOL two-year carryback and/or 20-year carry forward. Section 475 also exempts traders from wash sale reporting for securities trades reported and marked-to-market on Form 4797. Wash sales still apply to investments in securities. If you have a large capital loss carryover, you need to follow our special strategies for considering and electing Section 475 MTM, since Section 475 ordinary income can’t be offset with capital loss carryovers.

The Poppe tax court ruling in October 2015 exposed weaknesses in the Section 475 MTM election process for existing taxpayers. We include a full analysis of the Poppe case in Chapter 11 and tell traders how to better support their Section 475 election in Chapter 2.

The Poppe tax court also lowered the volume of trades needed to qualify for TTS to 720 trades. Our 2015 guide suggested a volume of 1,000 total trades. It’s still not clear how the IRS wants to count lot size breakdowns and legs of complex option trades. See Chapter 1.

IRS warns Section 475 traders

Increasingly, the IRS is focusing in on a delicate issue for traders: whether or not they properly segregate investment positions from trading positions in form and substance. The Assaderaghi, Nelson and Endicott tax court cases highlight this problem, where the traders owned significant investment portfolios and traded around those positions with options. Sole proprietor traders often have investment positions in trading accounts or in separate accounts designated as investment accounts. Not properly segregating investment positions can poison the well for claiming TTS, and gives the IRS a case to claim the trader is really an investor. It can also confuse application of Section 475 MTM treatment separate from capital gains treatment for investments. Some traders attempt to take Section 475 ordinary loss treatment on investment positions, which is not allowed. Or they avoid mark-to-market at year-end on trading positions. There are many nuances and this code section is widely misunderstood by other tax professionals. For more information, see our blog posts IRS Plays Havoc with Traders Misidentifying Investments and IRS Warns Section 475 Traders. See Chapter 2 for the full details on Section 475 MTM.

Business traders should use entity

Many traders start off with individual accounts, joint accounts and IRAs. Why should they consider an entity trading account? Business traders solidify TTS, unlock employee-benefit deductions, gain flexibility with a Section 475 election or revocation and prevent wash-sale losses with individual and IRA accounts. The IRS can apply Section 267 related party transaction rules if a trader purposely tries to avoid a wash sale loss between an entity and individual account. An entity return consolidates your trading activity on a pass-through tax return (partnership Form 1065 or S-Corp 1120-S), making life easier for you, your accountant and the IRS. Individually held investments are separate from business trading in the entity, which is a different taxpayer. The entity is simple and inexpensive to set up and operate. For more details on entities, see Chapter 7.

Retirement plans

Retirement plans for traders can be used several ways. You can trade in the retirement plan, build it up with annual tax-deductible contributions, borrow money from a qualified plan (not an IRA) to start a trading business and convert it to a Roth IRA for permanent tax-free build-up. There are plenty of pitfalls to avoid like early withdrawals subject to ordinary income tax rates and 10% excise tax penalties, and penalties on prohibited transactions. Avoid IRA-owned LLCs and self-dealing as that blows up the IRA. Tax-free compounded returns in retirement plans are valuable and trading losses are deductible in the sense that future retirement plan distributions are lower.

Annual tax-deductible contributions to retirement plans generally save traders more in income taxes than they cost in self-employment (SE) or payroll taxes. Trading gains are not earned income, so traders use entities to create earned income by paying compensation to themselves through an S-Corp. trading company or S-Corp or C-Corp management company. Compensation payments can also reduce the Obamacare 3.8% Medicare tax on unearned income (Net Investment Tax). A married couple working in the business can save well over $10,000 by establishing defined-contribution Solo 401(k) plans for each of them. Defined-benefit plans can save much more; we cover defined benefit plans in depth in Chapter 8. (One exception: Members of a futures exchange are subject to SE taxes on their trades made on those exchanges.) We also cover tax problems caused when a retirement plan invests in publicly traded partnerships like MLPs. That can generate Unrelated Business Income Tax (UBIT) requiring a Form 990 tax filing with a large tax bill that comes as a nasty surprise to many IRA investors. Chapter 8 delves into various retirement plan options and provides the math so you can see exactly how this tax savings strategy works.

Obamacare taxes

The Obamacare 3.8% Medicare tax on unearned income started in 2013 for taxpayers with AGI over $250,000 (married) and $200,000 (single). In this guide, we focus on what affects traders and investment managers in particular. One key point is that the net investment income tax (NIT) applies on net investment income (NII). Traders can reduce it by deducting their trading and investment expenses, including salaries paid to them and their spouses. There are complex IRS regulations for the three buckets in NII: portfolio, rents and royalties (1), passive entities and investment companies (2), and capital gains and losses (3). Generally, taxpayers can’t use a loss from one bucket against income in another bucket.

Business traders fare well with the final regulations for NII (after we fought for changes to the proposed regulations). With the final regulations, business traders are not disenfranchised from using their business trading losses and expenses for calculating NII. Just be sure to prepare Form 8960 (NIT) correctly.

The Obamacare individual health insurance mandate and related tax penalties for non-compliance, exchange subsidies and premium tax credits applied for the first time on 2014 individual income tax returns. Learn about the Obamacare tax forms and strategies for traders in applying for insurance on Obamacare exchanges to maximize their chance of receiving subsidies and premium tax credits. Trading businesses are generally single or spousal-owned with no or few outside employees so they are exempt from the Obamacare employer mandate/employer penalty effective in 2015/2016. The employer mandate applies on employers with 50 or more employees.

For more information, see Chapter 9 and Chapter 15.

Tax planning

Tax planning is important for traders and we include many smart tax-planning ideas in this year’s guide. See Chapter 9.

Words of caution on TTS

Many IRS and state agents don’t understand or respect individuals pursuing qualification as a trading business. While there is no bright line test for TTS, recent trader tax court cases better defined the volume of total trades required (720 per year per Poppe court), frequency of trades (3-4 days per week) and average holding period (under 31 days per Endicott court). Once an exam starts, it can snowball into other issues. IRS and some state agents often want to challenge TTS if the trader is not a full-time, extremely active trader. And the IRS or state agent can ask about TTS and other issues for the years before and after the tax year examined. Learn tips for dealing with the IRS and states in Chapter 10.

In the past, too many traders brought weak cases to tax court and have failed to defend themselves properly. That was certainly the case again recently with Poppe, Assaderaghi, Nelson and Endicott. Serving up easy wins in exams, appeals, private letter rulings and tax court encourages the IRS and states to further question business traders based on bad legal precedent. When TTS is too difficult to achieve, consider the alternative strategies discussed in Chapter 9. It’s also very important to have good CPAs and tax attorneys who are experts in trader tax law in your corner.

Watch out for bad tax advice: Over the years, other service providers suggested traders could easily deduct pre-business education expenses using C-Corps. This advice is very wrong. We cover what’s allowed and what’s not in Chapter 5.

Proprietary trading

Proprietary trading vs. retail trading is covered in Chapter 12. The challenge for proprietary traders is deducting their business expenses, including home-office expenses. They’re allowed to deduct these expenses even if they trade from the firm’s office whether they are independent contractors or LLC members. We also address how to handle education/prop trading firm hybrids and writing off education or lost deposits. One problem for prop traders who are members of an LLC is the Schedule K-1 does not pass through self-employment income so they can’t make retirement plan contributions or deduct health insurance premiums.

The Poppe tax court construed his proprietary trading firm arrangement to be a disguised retail customer account. This ruling should be a huge concern for the proprietary trading firm industry, especially since regulators warned clearing firms about disguised customer accounts in the past. By agreement, prop traders do not trade their own capital in a retail customer account. They trade a firm sub-account with firm capital and far higher inter-firm leverage than is available with a retail customer account.

Investment management

More traders are rising to the ranks of investment managers. Investment managers seek better tax treatment by using carried-interest (profit allocation) tax breaks passed through in their investment funds. There are tax advantages to receiving a share of capital gains (profit allocation) from fund investors rather than incentive fees from the fund, which otherwise are subject to ordinary tax rates and payroll taxes. Investment managers reduce payroll tax on management fees by using S-Corps. In recent years, both of these breaks have survived repeal talk, but that may not last with tax reform discussions in 2016. TTS, Section 475 MTM and other tax treatment elections are important considerations for hedge fund managers. Learn more about investment management taxation in Chapter 13.

International tax matters

U.S. traders move abroad, others make international investments and non-resident aliens invest in the U.S. How are their taxes handled? When it comes to international tax matters, we focus on the following types of traders: U.S. residents living abroad; U.S. residents with international investments; U.S. residents moving to tax possessions like Puerto Rico (with huge tax breaks); U.S. residents surrendering citizenship or green cards; and non-resident aliens investing in the U.S. with individual accounts or through an entity.

Many traders living in the U.S. have offshore trading and bank accounts to trade on foreign markets. Some offshore brokers encourage traders to form foreign entities as a requirement to get access or to set up a foreign brokerage account, in some cases to avoid CFTC rules limiting forex leverage or Reg T margin rules on securities. Look before you leap: Tax compliance for a foreign entity is significant and there are few to no tax advantages for traders.

Traders with foreign accounts need to learn about Foreign Bank Account Reporting (FBAR), Form 8938 (Statement of Specified Foreign Financial Assets), controlled foreign corporations (CFC), foreign disregarded entities, Passive Foreign Investment Companies (PFIC), tax treaties and more.

Chapter 14 touches upon these topics, along with the IRS’s “come clean” OVDP program, the Foreign Account Tax Compliance Act and CFTC regulations.


S-Corps: Use Accountable Plan Before Year-End

December 16, 2015 | By: Robert A. Green, CPA

One formality of using an S-Corp is that it should have an accountable plan for reimbursing employee expenses, including the employee’s home-office deduction. Without an accountable plan, employees report unreimbursed employee business expenses on Form 2106, which is part of miscellaneous itemized deductions only deductible in excess of 2% of AGI and not deductible for AMT. With proper usage of an accountable plan, the S-Corp reports the deductions on its tax return.

Expense reporting is more relaxed with partnership tax structures. Partners may report unreimbursed partnership expenses (UPE) on their individual tax return Schedule E, including home office deductions from Form 8829. S-corporation shareholders generally cannot deduct unreimbursed business expenses on Schedule E because the shareholders are categorized as employees when performing services for the corporation.

If you don’t have an accountable plan, draft one as soon as possible and use it before year-end. For home office deductions, reference Form 8829 as a guide for the S-Corp for reimbursement.

Click here for a sample accountable plan.

Learn more about accountable plans on our recommended payroll service provider’s Website at http://www.paychex.com/articles/finance/using-accountable-plans-benefits-both-employers-and-employees.

If you need help with an accountable plan, email us at info@gnmtradertax.com or contact your assigned CPA in our firm.


IRS Increases “Expensing” Amount to $2,500

December 3, 2015 | By: Robert A. Green, CPA

Click to read Green's blog post

Click to read Green’s blog post

In general, a business must capitalize property for purposes of depreciation. For smaller purchases, the IRS allows expensing under its Tangible Property Regulations, since it’s inconvenient to maintain depreciation records on small amounts. The IRS increased the de minimis expensing amount to $2,500 from $500. Although the IRS mentions this rule change is effective for 2016, IRS Notice 2015-82 & News Release IR 2015-133 point out it’s Ok to use for open tax years. That means it’s an excellent year-end tax strategy for 2015.

For example, if a business trader purchases a new workstation in December 2015 for $7,500, try to break down the purchase into separate items with each invoice being under $2,500. For example, purchase the computer separate from the monitors and other equipment. With all items on separate invoices under $2,500, the entire $7,500 can be a 2015 business expense without any capitalization for fixed assets and related depreciation. That leads to faster expensing, tax benefits and less compliance work.

“There is no specific requirement that it must be on separate invoices,” said Darren Neuschwander, CPA. “It can all be on one invoice, but it may draw more IRS attention and require more time to breakout. Separate invoices is good practical guidance to avoid this issue. Under the change, the new $2,500 threshold applies to any such item substantiated by an invoice.”

Learn more in our Dec. 3, 2015 Webinar recording: Year-End Tax Planning For Traders. Scroll to 42:07 to 48:35 in “Trader Tax Status.” It starts with “Great news about…“Expensing.”

 


IRS plays havoc with traders misidentifying investments

November 23, 2015 | By: Robert A. Green, CPA

Click to read Green's blog post

Click to read Green’s blog post

The IRS and some states have been playing havoc with traders in exams, claiming traders did not properly comply with Section 475 rules for segregation of investment positions from trading positions. Noncompliance gives the agent license to drag misidentified investment positions into Section 475 mark-to-market (MTM), or to boot misidentified trading losses out of Section 475 into capital loss treatment subject to the $3,000 capital loss limitation. Both of these types of exam changes cause huge tax bills, penalties and interest.

Traders don’t want to lose capital gains deferral and lower long-term capital gains rates on investment positions in securities. With misidentified investments the IRS has the power to drag those positions into Section 475 subjecting them to MTM and ordinary income tax rates.

Section 475 improper identification
Section 475 contains a clause to limit unrealized losses on investment positions dragged into Section 475. Under Section 475(d)(2) (which is applicable to traders pursuant to Section 475(f)(1)(D)), if a security was misidentified as an investment, then there is Section 475 MTM unrealized loss recognition only against other Section 475 gains, and any excess unrealized losses are deferred until the security is actually sold. Limiting MTM treatment on unrealized losses on investment positions is not much different from unrealized capital losses on those same positions.

Carefully identify investments
If you claim trader tax status and use Section 475 MTM, you can prevent this problem by carefully identifying each investment position on a contemporaneous basis. When you receive confirmation of the purchase of an investment position, email yourself to identify it as investment position as that constitutes a timestamp in your books and records. Don’t hold onto winning Section 475 trading positions and morph them into investment positions, as that does not comply with the rules. If identifying each separate investment is inconvenient, then ring-fence investments into identified investment accounts vs. active trading accounts. Use “Do Not Trade” lists for investing vs. trading accounts so you don’t trade the same symbol in both accounts.

But this compliance is not enough. If you hyperactively trade around your investments, the IRS can say you failed to segregate the investment in substance.

Section 475 clean up project
In 2015, the IRS acknowledged lingering problems with Section 475 and announced a Clean Up Project welcoming comments from tax professionals. I started a successful petition on Rally Congress to fix Section 475 and TTS rules and also sent a cover letter and comments to the IRS. The American Bar Association ABA Comments on Mark-to-Market Rules Under Section 475 are good. See my blog post in Aug. 2014 IRS warns Section 475 traders, which focuses on the segregation of investment issue.

Individuals have a problem
Section 475 misidentification of investments is a huge problem for individual sole proprietor traders who have both trading and investment positions. Section 475 is very valuable since it exempts trades from wash sale loss rules and the $3,000 capital loss limitation allowing full net operating loss (NOL) treatment for losses which generates huge tax refunds. A capital loss limitation is the biggest pitfall for traders.

Individuals often have a few trading accounts and also several investment accounts. Married couples may each have individual accounts, some joint accounts and IRA accounts. They may buy and hold popular equities in investment accounts and then hyperactively trade those same symbols in their designated trading accounts.

Entities navigate around the problem
The simple fix is to form an entity like a single-member or spousal-member LLC with an S-Corp election. Conduct all business trading with Section 475 on securities in those entity accounts. (The entity may elect Section 475 MTM internally within 75 days of inception of the entity.) Trader tax status, business expenses and Section 475 trading gains and losses are reported on the S-Corp tax return.

It’s wise to avoid investment positions in the entity accounts. But some traders want to use portfolio margining, and brokers don’t allow that between individual and entity accounts, so they want to transfer some large investment positions into the entity accounts. That can become a problem for Section 475 segregation of investment rules, especially if you trade the same symbols. Consult a trader tax expert.

Keep investments in your individual investment accounts. The individual and entity accounts are not connected for purposes of Section 475 rules since they’re separate taxpayer identification numbers.

The entity also looks much better in the eyes of the IRS claiming trader tax status and using Section 475 ordinary loss treatment. Plus, an S-Corp trading company can have employee-benefit plan deductions — health insurance and high-deductible Solo 401(k) retirement plan) — whereas a sole proprietor trader may not.

Tax court cases are for individual traders
A senior IRS official stated at an industry conference that the IRS is going after (auditing) “Chen cases,” referring to the landmark Chen tax court case. Chen was a part-time individual trader for just three months and he deducted TTS expenses and a huge Section 475 ordinary loss requesting a huge tax refund. The court denied TTS and use of Section 475.

Other recent trader tax court cases are individual traders claiming large TTS expenses and Section 475 losses. I covered these cases on my blog: see posts for Poppe, Assaderaghi, Nelson, Endicott, Holsinger and Chen (covered in my guides). Some of these traders may have been okay if they used an entity, however many did not qualify for trader tax status, and several botched or lied about electing Section 475.

In my blog post on the Poppe case, I point out that individuals face pitfalls in electing Section 475. The IRS granted Poppe TTS but denied Section 475 ordinary loss treatment because he botched or lied about the Section 475 election and he never filed a Form 3115. A new entity wouldn’t have that problem.

Wash sale losses are similar
Section 1091 wash sale rules are similar, yet different in one important aspect from Section 475 rules. While the entity is a different taxpayer from the individual for wash sale loss purposes, the IRS can apply Section 267 related party transaction rules to connect the entity and individual accounts if the trader purposely tries to avoid wash sale losses between the entity and individual accounts. I have not seen Section 267 mentioned in connection with Section 475 segregation rules.

Bottom line
Section 475 tax loss insurance is a huge tax break for traders who qualify for trader tax status but be careful with properly identifying investments. Be safe on using TTS and Section 475 by trading in an entity. Now is a good time to form one for 2016.


Defined-benefit plans offer huge tax breaks

| By: Robert A. Green, CPA

Click to read Green's blog post

Click to read Green’s blog post

Consistently high-income business owners, including trading businesses with owner/employees close to age 50, should consider a defined-benefit retirement savings plan (DBP) for significantly higher income tax and payroll tax savings vs. a defined-contribution retirement savings plan (DCP) like a Solo 401(k).

DBP calculations are complex
DBP calculations are more complex than a DCP profit-sharing plan. With a DBP, an actuary is required to consider various factors in calculating retirement benefits and annual contributions to the DBP.

The first factor is three-year average annual compensation and the IRS limit is $265,000 (2015/2016 limits). W-2 compensation may be higher, but the actuary may only input the IRS limit. Compensation determines the accumulated retirement benefit and retirement plan distributions/income during retirement years. The IRS limits retirement benefits per year to $210,000 (2015/2016 limits). Based on the maximum factors possible, the accumulated retirement benefit would be approximately $2.6* million.

If the participant plans 10 years of service retiring at age 62, with a 5% growth rate the retirement plan contribution would be $207,000* for the initial years. If that same person has 15 years of participation the annual retirement contribution would be $120,500*. (*Calculations provided by PACE TPA.)

Meet with a DBP administrator/actuary
When you meet with a DBP administrator/actuary, look at some “what if” scenarios with different levels of compensation and years to retirement.

There’s plenty of room for different scenarios between a Solo 401(k) limit of $59,000 for age 50 or older vs. a DBP contribution, which can range between $60,000 and $300,000 per year in the initial years. Traders operating in an S-Corp have the option to use a lower officer compensation amount.

What’s the catch?
A DBP requires annual funding contributions, whereas a DCP does not. With a DBP, the owner/employer commits to saving the actuary-determined accumulated retirement savings amount.

Closing a DBP without a valid reason could lead the IRS to disqualify the plan, making the accumulated benefit taxable income in the year of disqualification. Closing a trading company due to significant trading losses should be a valid reason. On DBP termination, most plan documents allow a tax-free rollover to an IRA or other qualified plan or a lump-sum taxable distribution. The 10% early withdrawal tax rules apply on qualified plan distributions before age 55 (see below).

You should consult your DBP administrator on a timely basis — before June 30 or 1,000 hours of service — to modify the DBP when necessary. For example, if you’re making significantly less income in the first three years, the administrator may be able to lower required contributions. Some DBP administrators recommend maximum allowed funding in early years, which serves to reduce minimum funding requirements in later years. This makes sense as you may make less money as you approach retirement.

You can do direct-access investing or trading inside the DBP account. Leading brokers may allow trading in stocks, bonds, ETFs and restricted trading in options. Avoid margin interest, which triggers unrelated business income tax (UBIT). Caution: Investment losses in the DBP will require larger contributions to make up those losses. Conversely, stellar trading gains can serve to reduce contributions too.

Compensation defined
In an S-Corp, only wages are considered in compensation; pass-through Schedule K-1 income is not. Conversely, with an operating business partnership tax return, all self-employment income (SEI) including guaranteed payments and pass-through income for active partners is included in compensation. A trading partnership has underlying unearned income, which is not SEI.

Payroll tax savings
Under DBP rules, average compensation is determined over the initial three years of the plan and compensation amounts afterward don’t affect DBP contributions and benefits. After three years, a trader may significantly reduce officer compensation, which has the effect of reducing payroll taxes. Payroll taxes include FICA 12.4% up to the SSA wage base amount of $118,500 (2015 and 2016 limits) and unlimited 2.9% Medicare tax. Plus, upper income taxpayers have a 0.9% Medicare/Obamacare surtax on wages. That leaves traders enjoying the tremendous income tax savings with a much smaller offset of payroll taxes. This option to reduce payroll taxes is not available with a Solo 401(k).

An S-Corp trading company has underlying unearned income, which should be an acceptable reason to the IRS for why the S-Corp may not otherwise comply with IRS guidelines for reasonable officer compensation. Conversely, a regular S-Corp operating business like an investment manager receiving management fees or an IT consultant must adhere to IRS guidelines for reasonable compensation. Currently, the guidelines call for 25% to 50% of net income before wages to be officer compensation.

Establish a DBP and execute payroll before year-end
Speak to a DBP administrator well before year-end to establish the plan by Dec. 31. You can fund the plan up until Sept. 15 of the following year — the extended due date of the S-Corp tax return.

You also need to execute officer compensation payroll before year-end.

Although the DBP is based on a three-year average of compensation, you may open a DBP in the first year of S-Corp trading company. Without a three-year average in that first year, there’s a narrower range of minimum vs. maximum contributions each year. If your income drops considerably in the second year, contact the DBP administrator, who can probably modify the plan to lower compensation amounts. After the three-year average of compensation is set, the administrator can’t modify it lower. You also can’t unwind accumulated retirement benefits earned to date.

Types of DBP plans
For an S-Corp trading company with a single owner/employee or a spousal S-Corp with two employees and no outside employees, we recommend a traditional or personal DBP or a “cash balance” DBP with a separate DBP investment account established for each owner employee.

Two spouses working in an S-Corp trading company can take advantage of the hybrid plan: A DBP integrated with partial Solo 401(k) (elective deferral and 6% profit-sharing rather than the normal 25% profit-sharing). If there’s only one employee, the traditional DBP or cash balance DBP is used.

Anti-discrimination rules
There are many anti-discrimination rules and requirements for high-deductible qualified plans intended to prevent the owner/employee from enjoying huge benefits with “top-heavy plans” while omitting or short-changing non-owner employees. Plan designers offer options like vesting over several years for complying with these rules but still favoring owners where possible.

Affiliated service group (ASG) rules apply in a similar context. If you own a business with many employees, you can’t exclude those employees by owning a separate (affiliated) S-Corp trading company with a high-deductible qualified plan for you alone. Consult an employee-benefit plan attorney.

Consult your tax advisor
After you speak with a DBP administrator, actuary, and perhaps an employee-benefit plan attorney, consult your tax advisor on choosing the compensation amount, which drives the related targeted retirement savings goal under the DBP. For S-Corp operating businesses, officer compensation must adhere to IRS guidelines for reasonable compensation, too.

Make sure you are comfortable committing to the annual minimum funding amounts of the DBP. If you want a lower commitment, choose a lower compensation amount. If the DBP calculation shows an annual contribution under $60,000, you are probably better off choosing a Solo 401(k) as it does not require annual funding and its limit is $53,000 for under age 50 and $59,000 for age 50 and older (2015 and 2016 limits).

With Solo 401(k) retirement plans, our CPA firm doesn’t want to see a S-Corp loss after deducting compensation and the retirement plan contribution. We apply this same rationale to the first year of a DBP plan. It’s wise to have sufficient S-Corp year-to-date trading income and expect similar trading gains in subsequent years so there won’t be an S-Corp loss from these large deductions. Once you start the DBP, mandatory contributions may generate a net loss in the S-Corp and that is acceptable. Explain the net loss and DBP funding commitment in a tax return footnote.

Your S-Corp trading company must qualify for trader tax status (business expense treatment), otherwise you can’t have officer compensation and retirement plan contributions in an investment company.

Costs and tax filings
DBP administrators charge $1,200 to $2,000 to design and establish a DBP. DBP administrators also charge around $1,200 to $2,000 per year for plan administration to keep the plan up to date along with modifications based on your evolving needs and changes in the law. Employee-benefit attorneys charge closer to $3,000 to $5,000 or more for DBP design and an attorney is not required. Net tax savings far exceeds these reasonable fees. In many cases, the DB administrator covers the cost of an independent actuary.

Charles Schwab offers a Personal Defined Benefit Plan and they have good resources on their site.

The IRS and The Employee Retirement Income Security Act of 1974 (ERISA) have many stringent rules and requirements for DBPs and it’s imperative to stay in proper compliance. Keep your DBP administrator aware of changes so they can make necessary modifications to the plan on time. There are many pitfalls to avoid with DBP and it’s not as simple as a Solo 401(k) or IRA.

As with all qualified plans, the sponsor of a DBP most likely must file an annual IRS Form 5500 tax return due July 31 of the following year for calendar year entities and plans. A 2½-month extension to Oct. 15 is allowed on Form 5558. Several administrators help with this tax form.

Tax-free growth and retirement distributions
Unless you are making non-tax-deductible contributions to a Roth IRA or Roth Solo 401(k) plan, with traditional retirement plans including qualified plans and IRAs, you get an income tax deduction from gross income for the contribution amount.

With a Roth plan, tax savings are permanent. Conversely, with a traditional qualified plan like a DBP or DCP, there is only tax deferral. Enjoy tax-free growth in the plan until taking taxable retirement plan distributions in retirement years. For traders who do more short-term investing, this annual tax savings is huge. Use a retirement plan calculator and you’ll see the power of tax-free compounded growth. Consider the time-value of money with tax deferral as well.

Under current tax law, retirement-plan distributions are ordinary taxable income. “Early withdrawals”(before retirement years age 59½ in an IRA or age 55 in qualified plans) are also subject to a 10% excise tax penalty on IRS Form 5329. Qualified plans including Solo 401(k) and DBP can offer qualified plan loans, which avoid early withdrawals. Qualified plans are a form of deferred compensation, but there are no payroll taxes on retirement plan distributions or contributions.

In qualified plans, there are required minimum distributions (RMD) by a participant’s required beginning date (RBD). The RBD rule is similar to the RMD rule for IRAs with distributions required no later than by age 70½.

Bottom line
If you are close to age 50, have consistently high annual income, can afford to commit to large tax-deductible contributions and want to smooth your taxable income in retirement taxed at lower tax brackets, then a DBP may be for you. The tax savings is enormous and with tax-free compounded growth it’s an incredible retirement savings tool.

 

 


Traders: Good and Troubling News in Poppe Ruling

November 6, 2015 | By: Robert A. Green, CPA

Click to read Green's blog post

Click to read Green’s post on Forbes

In light of the William F. Poppe vs. Commissioner court case, there’s good news for retail traders on the volume of trades needed to qualify for trader tax status.

There’s also troubling news. The IRS denied Poppe his Section 475 election because he could not prove compliance with the two-step election process. Traders should be more diligent in documenting their election. The consequence was that instead of deducting his $1 million trading loss as an ordinary loss, Poppe was stuck with a $3,000 capital loss limitation and a capital loss carryover.

The court construed Poppe’s proprietary trading firm arrangement to be a disguised retail customer account. This ruling should be a huge concern for the proprietary trading firm industry, especially since regulators warned clearing firms about disguised customer accounts in the past. By agreement, prop traders do not trade their own capital in a retail customer account. They trade a firm sub-account with firm capital and far higher inter-firm leverage than is available with a retail customer account.

Qualification for trader tax status
The Poppe court awarded trader tax status (TTS) with 720 trades (60 trades per month). That’s less than our 2015 golden rule calling for 1,000 trades per annum on an annualized basis. Poppe seems to have satisfied our other golden rules on frequency, holding period, intention to run a business, serious account size, serious equipment, business expenses, and more. Plus, Poppe had a good background as a stockbroker.

In some years, Poppe was a teacher and part-time trader, fitting trading into his schedule. It helped that Poppe made a lot of money trading in a few years in comparison to his teacher’s salary.

Botched Section 475 election
Poppe had large trading losses ($1 million in 2007) for which he claimed Section 475 ordinary business loss treatment rather than a puny $3,000 capital loss imitation against other income. But like other recent tax court cases (Assaderaghi, Nelson, Endicott, Holsinger and Chen), the court busted Poppe for either lying to the IRS about making a timely Section 475 election or making a valid election but not being able to prove it to the IRS. Poppe never filed a required Form 3115 to perfect the Section 475 election, which begs the question: Did he ever file an election statement on time?

The case opinion states that Poppe intended to elect Section 475 for 2003 and he filed his 2003 tax return late in 2005 omitting a required 2003 Form 3115. Poppe’s tax preparer reported 2003 Section 475 trading gains on Schedule C. That’s incorrect: Section 475 trading gains are reported on Form 4797 Part II ordinary gain or loss. This botched reporting indicates to me that Poppe’s tax preparer did not understand Section 475 tax law and it probably buttressed the IRS win.

Many traders are in the same predicament as Poppe and should do their best to document the election filing in case the IRS challenges it later on. We document the process for our clients and ask them to document their filings, too. Send yourself an email with the relevant facts as email has a timestamp. Safeguard a copy of the election and Form 3115 in your permanent files.

One learning moment in the Poppe case is how to properly make a timely Section 475 election and to avoid pitfalls in botching the election process.

Section 475 tax loss insurance
By default, investors and traders in securities and Section 1256 contracts have capital gain and loss treatment, as opposed to ordinary gain or loss treatment. Capital losses offset capital gains without limitation, but a net capital loss is limited to $3,000 per year against other income with the remainder of capital losses carried over to the subsequent tax year(s).

Traders qualifying for TTS may file a timely election for Section 475 ordinary gain or loss treatment (on securities only or Section 1256 contracts, too). Generally, traders prefer to retain Section 1256 treatment with lower 60/40 capital gains rates. Section 475 exempts traders from wash-sale loss treatment on securities and capital loss limitations. It’s known as “tax loss insurance” since it allows full business ordinary loss treatment comprising NOLs generating NOL tax refunds.

A sole proprietor (unincorporated) trader makes an individual-level Section 475 election. A proprietary trading firm or hedge fund makes an entity-level Section 475 election. A partner in a proprietary trading firm or hedge fund cannot override the firm’s Section 475 election or lack of an election made on the entity-level.

Warning: Don’t botch the election
Botching the election empowers the IRS to deny use of Section 475 serving up a simple win for the IRS in tax court. Even when a taxpayer properly makes a Section 475 election, an IRS agent may challenge his or her qualification for TTS, which pulls the rug out from under using Section 475. (Each tax year TTS must be assessed as a prerequisite to using Section 475.)

Section 475 election two-step process
The first step is for the trader to file a timely election statement early in the current tax year to prevent the trader from using hindsight about the election later.

An “existing taxpayer” (who filed a tax return before) must file an election statement with the IRS (that means “external”) by the due date of the prior year tax return not including extensions: April 15 for individuals and partnerships and March 15 for S-Corps. (Note that in 2017, the partnership due date changes to March 15.) Attach the Section 475 election statement to the tax return or extension filing. I suggest documenting this first step in your books and records including emailing a copy to yourself and your accountant. Don’t count on the IRS for keeping a copy of the election statement.

An existing taxpayer’s second step is to file a Form 3115 (Change Of Accounting Method) with appropriate Section 481(a) adjustment by the due date of the election-year tax return including extensions. The complex Form 3115 must be filed in duplicate: one copy with the timely filed tax return and a second copy to the IRS national office.

Example of existing taxpayer: A sole proprietor trader files a 2015 Section 475 election by April 15, 2015, attaching the election statement to his 2014 federal tax extension filed on time by mail. (You can’t attach an election to an e-filed extension.) Second step: The accountant prepares a 2015 Form 3115 to accompany the 2015 Form 1040 filed by Oct. 15, 2016 with a valid extension filed by April 15, 2016.

Why the two steps? So taxpayers can make a very simple election filing with little hindsight but to allow sufficient time to prepare a complex Form 3115 with the tax return filing after year-end.

Common errors with Section 475 elections
Many local accountants are confused about the two-step process. Some think only one step is required: either filing the Form 3115 in lieu of the election statement, or the election statement as part of a Form 3115 filing with the tax return. They don’t comply with both required steps and that botches the election.

Section 475 “new taxpayer” exception
There is an important exception to the election process for “new taxpayers” such as a new entity. A new taxpayer may file the Section 475 election statement within its own books and records (internally) within 75 days of inception of the new entity.

Existing taxpayers who miss the external 475 election by April 15 should consider forming a new entity to make an internal Section 475 election within 75 days of inception, which is later in the year. A new taxpayer “adopts” Section 475 from inception as opposed to changing its accounting method so they don’t have the second step of filing a Form 3115 with Section 481(a) adjustment (converting realization/cash method to MTM on Jan. 1).

The entity provides better flexibility in making, revoking, and ending Section 475 elections with closure of the entity. With fewer steps to follow, the internal election for new taxpayers is a better choice for prevailing with the IRS.

Poppe’s errors on Section 475
Poppe was not able to verify the external 475 election statement (step one) or a Form 3115 filing (step two). It wasn’t just a question of being late on a Form 3115 filing, Poppe never filed a Form 3115 and he was an existing taxpayer individual.

Traders should file the external Section 475 election statement with certified return receipt. But that may not be enough because it only verifies a mailing, which also contains the tax return or extension. The IRS recognized this problem and suggests that taxpayers include a perjury statement on Form 3115 stating they filed the 475 election statement on time.

Is there any relief from the IRS?
My partner Darren Neuschwander, CPA spoke with an IRS official in the Form 3115 area a few years ago who said the IRS had granted some relief to a few traders providing they were only a little late with their Form 3115 filing and they filed the election statement on time. The IRS official pointed out there is no relief for filing the initial election statement late.

But Poppe was not a little late — he never filed a Form 3115, even with the case being heard years later. It’s wise to file Form 3115 on time per the written rules and not rely on hearsay about possible relief from IRS officials, which may no longer be granted after the Poppe decision. Consult your trader tax advisor.

Poppe’s mental incapacity argument didn’t work
The Poppe case shows that it doesn’t work to claim reasonable cause on noncompliance due to mental incapacity if the taxpayer can’t demonstrate the same mental incapacity in a job, business, or trading. Poppe tried to raise this issue for special relief and the IRS said no because he wasn’t mentally impaired as a teacher and as an active trader.

Per Thomson Reuters, “Poppe argued that his actions met the requirements of the ‘substantial compliance’ doctrine, under which perfect compliance with a tax provision isn’t required. But the Court said that the substantial compliance doctrine does not apply to the Code Sec. 475(f) election and that, even if it did, Poppe failed to meet many of Rev Proc 99-17 ‘s requirements and thus hadn’t substantially complied.”

Proprietary trading account or disguised customer account?
In 2007 (the IRS exam year), Poppe lost $1 million trading with a proprietary trading firm that cleared through Goldman Sachs Execution & Clearing (GSEC). This is the tax loss at the center of this case.

On his original tax return filing, Poppe reported this loss (assumed) on Schedule E page 2, as an ordinary loss flowing through to him as a partner in a partnership. If the proprietary trading firm qualified for TTS and filed a timely Section 475 election on the firm level, then trading losses allocated to partners would have ordinary loss treatment.

Poppe attached a partner Schedule K-1 to his tax return even though it is not required. But during the exam, the IRS was unable to find Poppe’s K-1 in the partnership tax return filings where it is required to be attached. This begs the question: Did Poppe fabricate his own Schedule K-1? That would be illegal. Or did the firm present Poppe with a Schedule K-1 only to retract it in their partnership tax filing later on? (IRS computers match K-1s reported on partner’s individual tax returns with partnership tax filings looking for incorrect reporting.)

Prop trading firm arrangements, agreements, tax treatment and regulatory issues are murky. Perhaps Poppe never formally signed the prop trading firm’s LLC Operating Agreement. The case states Poppe couldn’t satisfy the IRS that he was a partner in the firm. If not an LLC member, perhaps he was an independent contractor, which is the second business model for proprietary trading firms.

Poppe claimed he was a Class B member of the firm. Generally, the main owners (Class A members) are allocated firm-wide trading losses on their K-1s since they own the firm’s capital in their capital accounts, which provide tax basis for deducting trading losses. Generally, Class B members don’t have capital accounts so they aren’t allocated losses since they wouldn’t have tax basis to deduct losses, which would then be suspended to subsequent years when they might have capital.

Instead of paying into firm capital, Class B members pay “deposits” to the firm. This is where the confusion mainly lies. The firm applies these deposits to cover the prop trader’s trading losses incurred in a firm sub-account. Prop traders are entitled to deduct lost deposits as business bad debts, which are ordinary business losses. Perhaps Poppe should have considered lost deposit bad debt tax treatment instead of using an incorrect K-1 and later relying on an alleged Section 475 election as a retail individual trader.

I’ve been covering the proprietary trading industry since the late 1990s. Around 2000, some people questioned whether proprietary trading firm arrangements were really “disguised” retail customer accounts. Reg T margin rules allow 4:1 margin on pattern day trader (PDT) customer accounts requiring a $25,000 minimum account size. Otherwise, retail investors are limited to 2:1 margin on securities. The big attraction of proprietary trading firms is they offer proprietary traders (LLC members or independent contractors) far greater leverage (greater than 10:1 in some cases) on their deposits made with the firm. Some proprietary trading firms have minimum deposit amounts as low as $2,000.

If the firm’s profit sharing arrangement is more than 80% sharing to the prop trader, FINRA’s Regulatory Notice 10-18 issued to clearing firms stated it’s one of several signs it may be a disguised retail customer account. Read my June 2010 blog post FINRA’s notice to prop traders. Poppe had 90% profit sharing and perhaps that led the IRS to conclude it was a disguised retail customer account. GSEC is a popular clearing firm for proprietary trading firms and I don’t believe it services individual retail customers. Goldman Sachs brokerage firm has high standards for opening individual retail customer accounts.

The Poppe opinion states: “The parties stipulated that all transactions and capital in the GSEC account belonged to petitioner (Poppe).” Perhaps the parties preferred this tact so they could ague the case over Poppe’s alleged Section 475 election as a retail trader. In my view, the word “stipulate” means the parties agreed on facts as a pre-condition to negotiating a settlement. But it’s not necessarily the true facts.

Should prop traders file Section 475 elections as a backup position in case the IRS later considers them a disguised retail customer account? I imagine plenty proprietary trading firms and prop traders are in tax controversy (exams, appeals or tax court) now and I suggest they consider contacting our CPA firm for help soon.

Bottom line
I’m happy to see a new trader tax court case moving the goal posts back to 720 trades from 1,000. That opens the door for more traders. I am not surprised that another trader (and his accountant) botched the complex Section 475 election process and later tried to bamboozle the IRS about it in order to get a huge tax benefit. Proprietary trading firm arrangements with prop traders are murky and the IRS may turn up the heat on them both soon.

For more information, check out T.C. Memo. 2015-205.

Darren Neuschwander CPA contributed to this blog post.


Common Tax-Planning Questions

October 30, 2015 | By: Robert A. Green, CPA

Here are the top questions we often ask our clients. Consider your answers and contact us to find out if there are specific tax moves you should make before year-end. Read our year-end tax planning series: Smart Tax Saving Moves For 2015Retirement Plan Strategies for 2015 and Tax Moves for Business Owners in 2015.

  1. Should you sell some losing investment positions to offset capital gains (tax loss selling) before year-end?
  2. Do you have a wash sale loss problem and can you fix all or part of it for 2015?
  3. Have you done whatever you can to use up capital loss carryovers?
  4. Have you maximized long-term capital gains rate benefits?
  5. Should you form a trading business entity to unlock employee-benefit plan deductions including health insurance premiums and a retirement plan?
  6. When is it too late to form an entity in 2015 and consider one instead for Jan. 1, 2016?
  7. How can you maximize employee-benefit plan deductions by year-end?
  8. If you have high income, is a defined benefit plan better than a defined contribution plan?
  9. Will you get good bang for the tax buck on purchasing new equipment before year-end?
  10. Do you qualify for trader tax status (business expense) in 2015 or will you qualify in 2016?
  11. Should you elect Section 475 MTM in your new entity within 75 days of inception?
  12. Is Section 988 ordinary treatment or Section 1256(g) capital gains treatment better for your forex trading through year-end?
  13. Is a Roth IRA conversion a good idea for you before year-end?
  14. Is an NOL carry back or carry forward better or should you soak up the NOL with a Roth IRA conversion in the current year?
  15. What tax brackets are in you in for 2015 and should you defer or accelerate income at year-end?
  16. Do you face an underestimated tax payment penalty and what can you do to avoid it?
  17. Are you avoiding tax hikes on upper-income taxpayers including Obamacare Net Investment Tax as best you can?

 


Tax Moves for Business Owners in 2015

October 28, 2015 | By: Robert A. Green, CPA

A cash method business can often accelerate or defer sales, billing and collection of revenue around year-end. If they sell their business or assets they can either use the installment method to defer capital gains, or elect out of that method to report the entire capital gain in the current tax year.

Businesses can accelerate or defer purchases of fixed assets and expenses around year-end as well. And, they have many options for how to depreciate and amortize fixed and intangible assets, respectively.

Accrual-method businesses can delay providing goods or services to customers until after Jan. 1. There are also special rules allowing accrual method taxpayers to deferring revenue received in advance of shipment of goods or services. Read about other smart moves for operating businesses on The Tax Advisor.

Keep an eye out on “tax extenders”on depreciation discussed in our blog post Smart Tax Savings Moves For 2015. Traders don’t often exceed old rules (which currently apply for 2015) allowing up to $25,000 of purchases for Section 179 (100%) depreciation whereas other types of businesses certainly do. The 50% bonus first-year depreciation deduction also lapsed but businesses can use the half-year conversion to similar effect.

If you expect debt cancelation and expect related debt-cancelation taxable income, it may pay to defer that taxable event to 2016.

Payroll and self-employment taxes
An operating business can use the S-Corp structure to reduce payroll taxes by 50% or more (subject to new guidance pending from the IRS). S-Corps don’t pass through self-employment income (SEI) triggering self-employment (SE) tax as partnerships and sole proprietorships do. Consider the SE tax reduction loophole for management companies and other types of business.

Traders use a S-Corp trading company (or C-Corp or S-Corp management company along with a trading partnership) to unlock employee-benefit plans including retirement and health insurance premium deductions. Sole proprietor traders can’t have these tax breaks. It’s hard to arrange them on trading partnership returns.

Both payroll and Solo 401(k) retirement plans must be executed or established before year-end. A SEP IRA can be established up until the due date of the tax return including extensions, although a Solo 401(k) is a much better plan for traders. Learn more in our blog post Retirement Plan Strategies For 2015.


Securities Brokers Don’t Tell The Full Story About Wash Sale Losses More By: Robert A. Green, CPA On: 01/20/16
Don’t Solely Rely On 1099-Bs For Wash Sale Loss Adjustments More By: Robert A. Green, CPA On: 01/05/16
Green’s 2016 Trader Tax Guide More By: Robert A. Green, CPA On: 12/24/15
S-Corps: Use Accountable Plan Before Year-End More By: Robert A. Green, CPA On: 12/16/15
IRS Increases “Expensing” Amount to $2,500 More By: Robert A. Green, CPA On: 12/03/15