Attend our upcoming Webinar “Errors Traders Make On Tax Returns” and watch the recording afterwards.
Traders are more likely than other taxpayers to make errors on tax return filings because they face greater challenges than employees with simple W-2s or small businesses with revenue and expenses reported as ordinary income on one tax form. The IRS does not cater to traders’ needs, and tax reporting can be a frustrating maze.
Traders are forced to deal with complex tax treatment for a bevy of financial instruments, complicated accounting rules including wash sales and mark-to-market accounting, and many disparate tax forms.
Traders must deal with many different categories of income: ordinary, capital gains, 60/40 capital gains, portfolio, business and investment, plus several tax treatment elections for converting from one category to another.
Yet, many traders are do-it-yourself types, self-directing their investments and preparing their tax returns with programs like TurboTax. But these programs are not robust or sophisticated enough to handle complex tax treatment, wash-sale adjustments, trader tax status and several nuances in trader tax law.
Traders are better off working with experienced CPAs in trader tax. Many of the nuances involve thousands of dollars of tax breaks and pitfalls that can trigger IRS notices and exams. Here’s a list of 15 common errors made by traders and local accountants on tax returns.
1. Schedule C errors
Some accountants intuitively think traders qualifying for trader tax status (business treatment) should enter both trading income and expenses like other sole proprietors on Schedule C. That’s a big problem and we see this error often after a trader receives a tax exam notice from the IRS and comes to us for help.
Accountants often try to deduct a large trading loss on Schedule C after missing the election deadline for a Section 475 election so they can’t use Form 4797 ordinary loss treatment and are stuck with a capital loss limitation.
Only trading business expenses are reportable on Schedule C and that’s a red flag for IRS computers and agents. Home office expenses are carried over to subsequent years because they may only be deducted on a Schedule C with net income or against trading gains reported on other tax forms.
Tips: Green’s 2015 Trader Tax Guide suggests different ways to handle Schedule C and home office expenses including an explanation in a tax return footnote. Also explain trader tax status, elections and how disparate tax forms should be viewed as one to show a profitable trading business.
2. SEI and SE tax errors
Some traders and local accountants treat net trading business income as self-employment income (SEI) subject to self-employment (SE) tax. That’s incorrect unless the trader is a full member of an options or futures exchange and trading Section 1256 contracts on that exchange (Section 1402i).
Local accountants compound this error by having the trader contribute to a retirement plan based on net trading business income. Contributions may only be made on SEI and trading gains are not SEI. The trader is deemed to have an “excessive contribution” subject to tax penalties. Local accountants also mistakenly take an AGI deduction for self-employed health insurance premiums, which requires SEI.
Traders should consider a pass-through entity tax return, which looks considerably better than a Schedule C. An S-Corp can pay officer’s compensation to unlock employee benefit plan deductions for health insurance and retirement plan contributions, whereas a Schedule C cannot.
3. Form 8949 errors
Form 8949 requires trade-by-trade reporting of securities trades with wash-sale loss adjustments and special coding per IRS cost-basis regulations. The results move to Schedule D.
Traders often don’t make necessary wash-sale loss adjustments based on substantially identical positions across all accounts, including the various types of IRAs. They also don’t reconcile Form 8949 to 1099Bs which inevitably has unreconciled differences on wash sales because brokers only calculate them based on identical positions per account.
4. Form 4797 errors
Form 4797 is for Section 475 MTM trades, which is contingent on qualification for trader tax status. Trade-by-trade reporting is required, but no wash sales in Section 475 since it’s ordinary gain or loss treatment.
When an existing taxpayer files a Section 475 MTM election on time, they need to make a Section 481(a) adjustment to convert from the realization (cash) method to the MTM accounting method as of Jan. 1 of the election year. That adjustment is basically the unrealized gain or loss including wash-sale deferrals on the prior year-end open trading business positions, not including segregated investment positions. Negative Section 481(a) adjustments are reportable in full, but positive adjustments over $25,000 must be pro-rated over four years. Many local accountants skip or botch the adjustment and traders forget to report the deferral income.
Many traders and accountants misunderstand, miscalculate and botch handling of Section 475 elections, accounting, Form 3115 change of accounting filings, use of Form 4797 and related NOL filings. Section 475 errors attract IRS attention because usually large tax refunds are involved.
5. Incorrect classification of financial instruments
There’s been a proliferation of new financial instruments for trading over the past two decades like ETFs, indexes, options, and forex. It’s not always clear which tax treatment category the instrument falls into. For example, commodity ETFs are taxed as securities and non-equity options are Section 1256 contracts. Broad-based indexes are Section 1256, but narrow-based indexes are securities.
Some brokers treat certain financial instruments one way and other brokers treat them another way. For example, options on commodity ETFs can be treated as Section 1256 contracts with up to 12% lower tax rates than securities. Other times, taxpayers claim Section 1256 treatment when they are not entitled to like on most foreign futures.
Tips: Use good tax accounting software or solutions for traders to properly categorize financial instruments. Visit the GreenTraderTax Center to learn more about tax treatment categories including securities, Section 1256 contracts, ETFs, options, foreign futures, forex, binary options, precious metals, bitcoin, swaps and more.
6. Incorrect wash-sale adjustments on securities
Taxpayers and brokers report trades in securities when realized (sold). Short-term capital gains are taxed at the higher ordinary rate (up to 39.6%) and long-term capital gains (held up to 12 months) are taxed at the lower capital gains rate (up to 20%).
One of the biggest problem areas for active securities traders is wash-sale losses. If you sell a security for a loss and buy a substantially identical position back within 30 days before or after, you have to make a wash-sale loss adjustment by adding the loss to the cost basis of the replacement position. If you trigger one in an IRA, you permanently lose the wash-sale loss.
While brokers report wash-sale loss adjustments on 1099Bs, they only do it on identical positions per account. Individual taxpayer rules are different: These adjustments have to be reported on substantially identical positions across all accounts, including IRAs. Substantially identical means Apple equity and Apple options, and at different strike dates. Identical means the exact same symbol.
Tips: Use good tax accounting software for securities to properly calculate wash sales. Set up “Do Not Trade” lists for your IRAs to avoid a permanent wash-sale loss with taxable accounts. Break the 30-day chain on wash sales in taxable accounts at year-end to avoid year-end wash sale loss deferrals. Visit the GreenTraderTax Center to learn more about wash sales.
7. Mis-categorizing Section 1256 contracts
Section 1256 contracts are MTM including realized and unrealized gains and losses. Holding period doesn’t matter as all contracts are 60% long-term and 40% short-term capital gains.
Section 1256 60/40 tax rates are 12% less than ordinary tax rates. There’s similar tax savings throughout the graduated tax rates as the 15% ordinary rate bracket comes with a zero long-term capital gains rate. By mis-categorizing an instrument as a security rather than Section 1256 contract, it costs the taxpayer significant tax liability if there are net capital gains. Don’t rely on brokers to categorize all Section 1256 contracts correctly, especially indexes and non-equity options.
8. Missing a Section 1256 loss carry back election
Many taxpayers and accountants don’t know about the Section 1256 loss carry back election on top of Form 6781. A current year loss can be carried back three tax years against Section 1256 gains. Many traders miss this election and wind up with unused capital loss carry forwards instead.
9. Missing a Section 475 election
Active traders qualifying for trader tax status may elect Section 475 MTM ordinary gain or loss treatment on securities only or futures, too. Section 475 is tax loss insurance: It exempts traders from wash-sale loss deferrals and the capital loss limitation ($3,000 per year against ordinary income). Section 475 ordinary losses add to net operating losses (NOLs), which can be carried back two years and/or forward 20 years against income of any kind.
Existing taxpayers must elect Section 475 by April 15 for partnerships and individuals and March 15 for S-Corps. New taxpayers may elect Section 475 within 75 days of inception. Far too many traders who should elect Section 475 miss the election deadline and get stuck with unused capital loss carryovers. The IRS recently loosened the rules to allow free and easy revocation of Section 475. Learn more about trader tax status and Section 475 in the GreenTraderTax Center.
10. Missed Section 1256 60/40 rates on certain foreign futures
U.S.-based regulated futures contracts (RFCs) are Section 1256 contracts, but that’s not the default case for futures traded on foreign exchanges. The IRS has granted Section 1256 lower 60/40 rates to certain foreign exchanges. Look for the required IRS revenue ruling which is available in the GreenTraderTax Center.
11. Reporting options incorrectly
Options are derivatives and there are options on securities, Section 1256 contracts, forex and other types of financial instruments. Options are generally taxed in the same manner as the underlying instrument. For example, equity options are taxed like equities and both are securities. Non-equity options are Section 1256 contracts.
With phase-in of cost-basis regulations, brokers reported options starting on 2014 Form 1099Bs. Three events may happen when trading options: you can trade it (the only event that counts toward trader tax status), let it expire worthless or exercise it. Trading and expiration are realization transactions. Conversely, exercise is not a realization; it’s a stepping-stone to owning the stock which holding period starts fresh. Traders also enter complex offsetting position trades, which can trigger straddle-loss rules.
Caution: some brokers adjust proceeds for option exercise when they should adjust cost basis. This can throw off reconciliations between correct Form 8949 based on good software. Learn more about tax treatment for option traders in the GreenTraderTax Center.
12. ETFs mis-categorized as commodities
All ETFs are securities with the exception of precious-metal backed ETFs structured as grantor trusts which are disregarded entities owning collectibles. Options on ETFs structured as registered investment companies (RICs) are securities with the exception of options on commodity ETFs structured as publicly traded partnerships (PTP) — these are Section 1256 contracts.
Some taxpayers and accountants confuse broad-based ETFs (securities) with broad-based indexes (Section 1256 contracts). Google the symbol and notice it says ETF, it trades on a securities exchange and if it’s a RIC. There are lists of commodity ETFs structured as PTPs.
13. Double counting income on commodity ETFs
In some cases, commodity ETFs structured as PTPs issue Schedule K-1s passing through income including Section 1256 income. It’s a common error for traders to omit this income reporting. The second error is overlooking adjustments to cost basis for that pass-through income. Brokers don’t make that cost basis adjustment on 1099Bs, so without adding pass-through income to cost basis, taxpayers will double count that income.
14. Omitting forex transactions from tax returns
Spot forex isn’t a covered security for broker issuance of 1099Bs. Many taxpayers and accountants omit spot forex transactions from tax returns. That’s wrong: It’s reportable whether on U.S. or offshore forex accounts. Taxpayers must report underlying income or loss on their brokerage and bank accounts worldwide.
Foreign bank and brokerage accounts are subject to FBAR reporting requirements due by June 30 of the subsequent year. Learn more and file online at http://www.fincen.gov/forms/bsa_forms/fbar.html.
15. Botched forex reporting and missed capital gains elections
Spot forex is covered in Section 988 (foreign currency transactions) and is considered an ordinary gain or loss. In the case of negative taxable income, the negative amount is wasted as it’s not a capital loss carryover or NOL. With trader tax status, it is a NOL.
Use Form 1040 line 21 Other Income for reporting Section 988 forex trades in summary form. With trader tax status, use Form 4797 instead.
Few accountants inform their clients about filing a contemporaneous internal election to opt out of Section 988 for capital gain and loss treatment. Our firm makes a case for treating spot forex like forex forwards and allowing use of Section 1256g (foreign currency contracts) on major currencies for which currency RFCs trade on futures exchanges.
Many taxpayers and accountants treat rollover interest expense as true interest expense when it’s really part of trading gain or loss. They also don’t pick up the other side of open rollover trades and many brokers skip that, too.
Ordinary forex losses over $50,000 must be reported on Form 8886 Reportable Transaction Disclosure Statement; omitting that form can lead to large penalties.
Consider Green NFH’s Tax Return Checkup: 30-Minute Consultation. Upload your tax return in a secure manner and one of our CPAs will look it over and email you comments. It’s an excellent value which should either generate tax savings in excess of cost and/or help you sleep better at night. It will also help fix things early in 2015 before it’s too late for the current year.