Foreign partners in a U.S. trading partnership can be tax free

August 19, 2014 | By: Robert A. Green, CPA

Non-resident alien traders often ask us these two tax questions:

• “If I open an individual brokerage account in the U.S. to trade securities, futures and forex, will I be liable for U.S. taxes on my trading gains?”

• “If I become a partner in a U.S. proprietary trading firm filing a partnership tax return, do I owe U.S. taxes on my Schedule K-1 income?”

The answer to the first question is no. Trading gains are considered portfolio income which is not effectively connected income (ECI) in the U.S. Generally, non-resident aliens are liable for U.S. tax on income from business and real property in the U.S. There is tax withholding on dividend payments and sales of master limited partnerships (MLPs). There is no withholding in connection with futures or forex trading.

The answer to the second question is more complex. Typically, foreign partners in U.S. partnerships are considered to have U.S. ECI on their Schedule K-1 income. But if the partnership is a trading company — in financial markets, not goods — the income is considered portfolio income, including the partner’s share. Typically, U.S. partnerships withhold taxes on foreign partners, but that is not required if the foreign partner only has portfolio income not subject to U.S. tax. It gets more complicated with dividends in the partnership, since there was no withholding of dividends tax for the share owned by the foreign partner.

864(b) Trading Safe Harbor
According to research by tax attorney Mark Feldman, if the partnership is doing just forex trading (or other types of trading in stock, securities or futures), then it is probable that a foreign partner will not be subject to U.S. tax based on the following:

Generally, under Section 875(1), if a partnership is engaged in a trade or business in the U.S. (“ETB”), a nonresident alien partner of the partnership is automatically ETB. However, Section 864(b)(2)(A)(ii)&(B)(ii), provides an exception to ETB if a nonresident alien trades for his own account—even if through a principal office located in the US. It seems that this exception overrides the general rule of Section 875(1); after all, a deemed presence under 875(1) should be no worse than an actual presence in a principal office.

See FSA 199909004: Section 1.864-2(c)(2)(iii) provides rules for determining whether the taxpayer’s principal office is in the United States. . . . However, we note that the Taxpayer Relief Act of 1997, P.L. 105-34, section 1162(a), removed the requirement that the partnership have its principal office outside the United States. Therefore, for taxable years beginning after December 31, 1997, even if it was determined that USP [US partnership, with its principal office in the US] was a trader rather than investor in stocks and securities, FC [foreign corp, which was a partner in USP] nevertheless would not be subject to tax on its distributive share of USP’s capital gains due to the section 864(b)(2)(A)(ii) safe harbor. After December 31, 1997, FC would fail the trading safe harbor in section 864(b)(2)(A)(ii) only if either FC or USP was also a dealer in stocks or securities.

The FSA is presumably basing itself on this language in Treas. Reg. 1.864-2(c)(2)(ii) (which was not yet amended to reflect the repeal of the principal office requirement, otherwise known as the Ten Commandments, in 1997):

Partnerships. A nonresident alien individual, foreign partnership, foreign estate, foreign trust, or foreign corporation shall not be considered to be engaged in trade or business within the United States solely because such person is a member of a partnership (whether domestic or foreign) which, pursuant to discretionary authority granted to such partnership by such person, effects transactions in the United States in stocks or securities for the partnership’s own account or solely because an employee of such partnership, or a broker, commission agent, custodian, or other agent, pursuant to discretionary authority granted by such partnership, effects transactions in the United States in stocks or securities for the account of such partnership. This subdivision shall not apply, however, to any member of (a) a partnership which is a dealer in stocks or securities or (b) a partnership (other than a partnership in which, at any time during the last half of its taxable year, more than 50 percent of either the capital interest or the profits interest is owned, directly or indirectly, by five or fewer partners who are individuals) the principal business of which is trading in stocks or securities for its own account, if the principal office of such partnership is in the United States at any time during the taxable year.

Presumably, after the regulation is amended, part (b) of the last quoted sentence will be removed. Also, PLR 8850041 (not reliable for precedent) says that Section 864(b)(2)(B) “commodities” include forex.

Bottom line
“It’s my understanding that a non-U.S. person that is a member of a prop trading firm is subject to the exemption in 864 for trading for your own account provided that the prop trading firm is not a dealer,” tax attorney Roger Lorence says. “In some cases, a prop trading firm is a member of a commodities exchange or a securities exchange, but this is as a customer member. The prop trader receives better fees and commissions, but is not actually making a market or otherwise trading. So long as the prop trading firm is a customer member, then there’s no ETB issue. However, there can be state issues where the state diverges from the federal rules of 864.”


IRS warns Section 475 traders

August 13, 2014 | By: Robert A. Green, CPA

The IRS Chief Counsel (ICC) recently gave auditors advice on challenging Section 475 mark-to-market (MTM) traders trying to game the system with segregated investment positions. Section 475 MTM means ordinary gain or business loss treatment, whereas investment positions are capital gain or loss treatment. It’s important not to mix up the two on tax return filings. If you are unclear on your situation, check with one of our CPAs.

In new IRS Chief Counsel Advice 201432016, the IRS focuses on options created on “basket transactions,” which I feel are rarely used tax avoidance schemes. During the past decade, some very large hedge funds parked their trading activity inside of banks and arranged option transactions with the banks to reclaim their trading profits after year-end. These hedge funds avoided application of Section 475 MTM income on their trading gains during the tax year, and replaced it with an option allowing them tax deferral and long-term capital gains tax rates in the following year(s). They converted 40% ordinary tax rates to 20% capital gains rates and received a tax deferral to boot. Their tax savings from these transactions was in the billions of dollars and it attracted the attention of Congress and the IRS. The hedge funds’ arguments about “economic substance” sound pretty hollow to me in relation to tax savings from this tax avoidance scheme. The IRS wants to treat these segregated option transactions as part of the trader’s Section 475 MTM ordinary income trading activities, since they see a connection to those activities (see rules below). To learn more about these schemes, read Hedge Fund Chief Testifies at Senate Tax-Avoidance Hearing (New York Times, July 22, 2014).

There’s a lesson for retail traders using Section 475
We haven’t seen retail traders attempt these complex schemes with bank counterparties. Yet it’s a good time to revisit the segregation rules in Section 475 MTM. It’s a nuanced area of the law and it can have significant consequences on tax returns for business traders who have investments.

All business traders using or considering Section 475 MTM should learn its segregation of investment rules. (One way to prevent this problem is to conduct your business trading activity in an entity separate from individual and IRA investment accounts. The entity has a different taxpayer identification number, so there is no connection in the activity.)

We’ve recommended Section 475 MTM since 1997 when Congress expanded it for traders. The biggest tax benefit is unrestricted business ordinary loss treatment, with taxpayers escaping the onerous rules for wash-sale loss deferrals and the capital loss limitation ($3,000 against ordinary income per year on individual tax returns). Section 475 MTM can be the ticket to receiving huge tax refunds, often on NOL carryback returns.

An example of investments vs. business trades
Many traders want to make long-term investments as well in order to benefit from deferral on taxable income (until sale) and to hold investment securities 12 months for lower long-term capital gains tax rates (currently up to 20% vs. 39.6% the ordinary tax rate on short-term capital gains).

Each year we run into a handful of confusing situations on what’s considered a trading position vs. an investment position. Here’s a common example: A trader may want to house his investment portfolio inside a business trading account for portfolio margining purposes and hyperactively trade stock options around his core investment stock positions.

Suppose a trader holds Apple stock as an investment and trades Apple options for business around it to manage risk. Apple stock and Apple stock options are substantially identical positions for purposes of wash sales and Section 475 MTM. By doing this type of commingling activity, the trader may inadvertently subject his Apple stock investment to Section 475 MTM treatment at year-end, thereby losing deferral on the stock and subjecting his gains to ordinary rates rather than lower long-term capital gains rates.

There are all sorts of scenarios that can come up and in some cases it appears to benefit the taxpayer. It’s important to keep in mind that the IRS is entitled to apply the rules in a way that does not prejudice the government’s position. In the previous example, if the trader had a material loss in the Apple stock held for investment, the IRS is entitled to bar the application of Section 475 on that losing investment position. The IRS can have its cake and can eat it too.

Segregation of investment position rules
Per Thomson Reuters/Tax & Accounting, “Any securities held by the trader are subject to marking unless they fall within the exception to marking under Code Sec. 475(f)(1)(B). In the case of traders, there is only one exception to marking. Under that exception, two requirements must be met. First, it must be established to IRS’s satisfaction that the security has no connection to the activities of such person as a trader. (Code Sec. 475(f)(1)(B)(i)) Second, any such security must be clearly identified in such person’s records as being described in Code Sec. 475(f)(1)(B)(i) before the close of the day on which it was acquired, originated or entered into (or such other time as IRS may by regs prescribe). (Code Sec. 475(f)(1)(B)(ii)) An identification that a security is held for investment for financial reporting purposes is not sufficient for Code Sec. 475 purposes. (Rev Rul 97-39, 1997-2 CB 62).

Generally, gains and losses recognized under Code Sec. 475 are ordinary income or loss to a trader that has made an election under Code Sec. 475(f). (Code Sec. 475(d)(3)(A)(i) and Code Sec. 475(f)(1)(D)) However, Code Sec. 475(d)(3)(B) provides exceptions to the automatically ordinary rule under Code Sec. 475(d)(3)(A). If a taxpayer can establish that it held securities as hedges, or that the securities were not held in connection with its trading business, or that a security is improperly identified (see Code Sec. 475(d)(2) ), then gains and losses are not automatically ordinary. (Code Sec. 475(d)(3)(B)(i), Code Sec. 475(d)(3)(B)(ii) and Code Sec. 475(d)(3)(B)(iii)) Character must then be determined by other relevant Code sections.”

Many hedge funds and some traders skip a Section 475 election because they don’t want to be burdened with identifying investments on the time and date of purchase. They establish a trade and may let their profits run and morph the position into an investment position for long-term capital gain and deferral.

How Section 475 MTM and the segregation rules work
A business trader using Section 475 MTM has ordinary gain or loss treatment, plus open business positions are marked-to-market as imputed sales at year-end. On the first day of the subsequent year, the trader imputes a purchase of that same position at the same year-end price.

Duly segregated investment positions are not subject to Section 475 MTM. For example, a business trader organized as a sole proprietor may have a business trading account at Interactive Brokers and a segregated investment account held jointly with his spouse at Fidelity for making long-term investments. Like all professionals, it’s expected that a business trader would have investments, too.

It’s important for the business trader to contemporaneously segregate investment positions from business positions in “form and substance.” Form means a separate account and substance means don’t trade substantially identical positions with business trading positions. While proposed IRS regulations required a separate account, that rule never became final law, so a trader can have investment positions within a business trading account. Just make sure to email yourself contemporaneously when purchasing an investment position. Don’t trade around investment positions with your business positions, as that runs afoul of the substance rule. The lines of distinction can be blurred in some cases and you should consult a trader tax expert about it.

Read Green’s 2014 Trader Tax Guide Chapter 2 on Section 475 MTM to learn more.

Recent trader tax court cases
In recent trader tax court cases covered on our blog, Assaderaghi, Nelson and Endicott, the IRS won denial of trader tax status partially because these option traders did not segregate active option trading from investing in stocks (similar to the example above). However, even if these traders did follow segregation rules and our above guidance, I still don’t think they traded options enough to qualify for trader tax status. They also sought Section 475 MTM ordinary loss treatment on stock investments, which is not possible.

Bottom line
Section 475 MTM is fantastic for most business traders — we call it “tax loss insurance.” But the fine print requires discipline on dealing with investments. It’s best to trade in a separate entity to skip these handcuffs.

 


IRS issues final regs on straddle-by-straddle identification

July 25, 2014 | By: Robert A. Green, CPA

Per TaxAnalysts on July 17, 3014, “The IRS has issued final regulations relating to section 1092 identified mixed straddles established after Aug. 18, 2014, explaining how to account for unrealized gain or loss on a position held by a taxpayer before the time the taxpayer establishes a mixed straddle using straddle-by-straddle identification. (T.D. 9678).”

Straddle rules are very complex. We suggest a consultation with our tax attorney.


Tax treatment for Nadex binary options

June 20, 2014 | By: Robert A. Green, CPA

There’s a bevy of financial instruments to trade on securities and futures exchanges around the world, and derivatives and swaps exchanges offering binary options and swap contracts are increasingly becoming part of the mix. How are these unique instruments treated come tax-time? Can they be considered Section 1256? Let’s delve into binary options and swaps in more detail. (For more background on Section 1256 and its qualified board or exchange requirement, see Tax treatment for foreign futures.”)

Dodd-Frank changed the law
A principal focus of the Dodd-Frank Wall Street Reform and Consumer Protection Act law enacted in July 2010 is better regulation and control of the several-hundred-trillion-dollar derivatives and swaps marketplace. Dodd-Frank requires many privately negotiated derivatives and swaps contracts to clear on derivatives and swaps exchanges to insure collection of margin and to prevent another financial crisis. Remember, AGI wrote too many derivatives and swaps contracts, which it did not have sufficient capital or margin to pay out when markets melted down and counterparties demanded payment in 2008.

Dodd-Frank synchronized regulation and tax law, requiring the IRS to exclude swap contracts from Section 1256. Although Congress required private derivative contracts to clear on Section 1256 exchanges, it didn’t want to reward derivatives contracts with Section 1256 tax advantages.

Before Dodd-Frank, the CFTC had more leeway in designating instruments as “options.” According to a CFTC lawsuit, the CFTC used a limited definition of what constituted an option; e.g. it trades like an option (more on this lawsuit later). According to a CFTC official, “After Dodd-Frank, unless the option expires into a futures contract, the CFTC categorizes it as a swap contract. If the contract expires into cash, it’s a swap contract.”

Regulators don’t drive tax treatment
The Securities and Exchange Commission (SEC) regulates securities and the IRS treats sales of securities with short-term and long-term capital gain/loss tax treatment based on realized gains subject to wash sale loss deferral rules. The Commodity Futures Trading Commission (CFTC) regulates commodities, futures, forex and derivatives and the IRS has varying tax treatment for these different types of financial instruments.

Regulated futures contracts and nonequity options are Section 1256 contracts afforded lower 60/40 capital gains tax rates with MTM accounting reporting realized and unrealized gains and losses at year-end (reported on Form 6781).

If an investor sells physical commodities, capital gain/loss treatment applies and there is no MTM. Conversely, if a farmer sells physical commodities, ordinary treatment applies, but again, there is no MTM.

Forex (interbank spot and forward contracts) falls under Section 988 ordinary gain and loss on realized transactions. Traders may file a contemporaneous “capital gains election” to opt out of Section 988, whereas manufacturers may not.

Notional principal contracts defined as two or more periodic payments — commonly called swaps — receive ordinary gain or loss treatment and MTM accounting applies.

IRS proposed regulations on swaps 
In connection with Dodd-Frank, the IRS issued proposed regulations “Notice of Proposed Rulemaking and Notice of Public Hearing Swap Exclusion for Section 1256 Contracts” (REG-111283-11) on Oct. 17, 2011. Excerpts are provided below, with our notes in italics:

• Summary: .. describe swaps and similar agreements that fall within the meaning of section 1256(b)(2)(B). This document also contains proposed regulations that revise the definition of a notional principal contract under §1.446-3 (Note that swaps generally fall within the definition of “Notional Principal Contracts”.)

• Dodd-Frank Act added section 1256(b)(2)(B), which excludes swaps and similar agreements from the definition of a section 1256 contract. Section 1256(b)(2)(B) provides that the term “section 1256 contract” shall not include— any interest rate swap, currency swap, basis swap, interest rate cap, interest rate floor, commodity swap, equity swap, equity index swap, credit default swap, or similar agreement. (All swaps are effectively excluded.)

• Congress enacted section 1256(b)(2)(B) to resolve uncertainty under section 1256 for swap contracts that are traded on regulated exchanges. .. increased exchange-trading of derivatives contracts by clarifying that section 1256 of the Internal Revenue Code does not apply to certain derivatives contracts transacted on exchanges. (Nadex binary options trade on a regulated exchange.)

• Option on a notional principal contract
Section 1256(b)(2)(B) raises questions as to whether an option on a notional principal contract that is traded on a qualified board or exchange would constitute a “similar agreement” or would instead be treated as a nonequity option under section 1256(g)(3). Since an option on a notional principal contract is closely connected with the underlying contract, the Treasury Department and the IRS believe that such an option should be treated as a similar agreement within the meaning of section 1256(b)(2)(B). (If a Nadex binary option were deemed an option on a NPC, it would be excluded as a NPC per this rule.)

• Ordering rule
The proposed regulations provide an ordering rule for a contract that trades as a futures contract regulated by the Commodity Futures Trading Commission (CFTC), but that also meets the definition of a notional principal contract. The Treasury Department and the IRS believe that such a contract is not a commodity futures contract of the kind envisioned by Congress when it enacted section 1256. (We don’t think the IRS will view Nadex binary options as a futures contract; therefore, will view it as a NPC.)

• Definition of Regulated Futures Contract (RFC)
Section 1256(g)(1) defines a regulated futures contract as “a contract (A) with respect to which the amount required to be deposited and the amount which may be withdrawn depends on a system of marking to market, and (B) which is traded on or subject to the rules of a qualified board or exchange.” The apparent breadth of section 1256(g)(1) has raised questions in the past as to whether a contract other than a futures contract can be a regulated futures contract. (The IRS is trying to clean up some loose definitions in the past.)

Trading binary options on Nadex
The derivatives exchange based in the U.S. is the North American Derivatives Exchange (Nadex) which offers retail traders an online trading platform for limited-risk “binary options and spread contracts” based on stock indices, commodities, forex and financial events. Make a speculation and hold it through expiration for an “all or nothing” pay off, which some pundits say is akin to making a bet. Or trade the contract before expiration to cash it in at the current market price fluctuating on Nadex. Most Nadex contracts settle in one hour or one day, and the rest settle in a week or longer.

There is active trading on the Nadex platform/exchange similar to trading platforms on securities and futures exchanges. A trader may not notice much difference, but there are important differences in regulation and tax treatment.

Nadex issued 1099Bs using Section 1256 treatment
For tax years 2004 through 2013, Nadex issued direct members a Form 1099-B reporting Section 1256 tax treatment.

As pointed out in our first blog in this series, Nadex is a domestic board of trade — a category 2 qualified board or exchange (QBE) since it’s a CFTC-regulated “Designated Contract Market”. But that alone is not enough; Nadex binary options still must meet the definition of Section 1256 contracts. In February 2014, Nadex emailed us the following statement: “Nadex has recently been advised by staff of the Commodity Futures Trading Commission that its instruments are considered ‘commodity options’ categorized as ‘swaps.’”

We feel that Nadex binary options probably don’t qualify for Section 1256 
Nadex binary options don’t seem to meet the definition of inclusion in Section 1256 as either a regulated futures contract or a nonequity option, and they seem to meet the definition of exclusion from Section 1256 as a swap contract.

Nadex binary options don’t meet the definition of Section 1256 for “regulated futures contract” (RFC). A Nadex binary option requires full payment in advance — it’s not collateral — and there is no withdrawals based on MTM. Nadex binary options are prepaid bets. There seems to be consensus on this point.

Nadex binary options probably do not meet the definition of Section 1256 for “nonequity options” as they don’t seem to meet the definition of “options” in the tax code (Section 1234a) (see further discussion below). We haven’t seen a private letter ruling, tax opinion letter or tax research supporting a nonequity option argument for Nadex binary options.

Nadex binary options probably are excluded from Section 1256 as swap contracts. The CFTC said they are “commodity options” categorized as swaps. Dodd Frank law enacted Section 1256(b)(2)(B) into law effective July 2011. Section 1256(b)(2)(B) excludes swap contracts from Section 1256 tax breaks. Proposed regs for Section 1256(b)(2)(B) are not yet effective and they define swaps based on the IRS definition of “notional principal contracts” (NPC). NPC normally require two payments whereas Nadex binary options have one payment. The difference between one versus two payments does not seem material to us.

The IRS proposed regulation excludes all notional principal contracts (swaps) from Section 1256. But, the IRS received many comments arguing that exchange-traded swap contracts, as opposed to off-exchange OTC swaps, should not be excluded since the commenters believed they had Section 1256 tax treatment before Dodd-Frank. Until the final regulation 1256(b)(2)(B) is issued, we won’t know the final outcome. Nadex binary options are exchange-traded swaps, not OTC. Even if in final IRS regulations Nadex binary options are not excluded as exchange-traded swaps, they still must qualify as a non-equity option and we don’t think they do.

We suggested to Nadex that they file for a private letter ruling to support using Section 1256 on 1099Bs for Nadex binary option transactions.

CFTC definition of “option”
The Nadex email says the CFTC referred to their binary options as “commodity options.” They are bets that rise or fall based on an underlying market or financial event, they are based on option pricing models and they trade like options. Before Dodd-Frank, the CFTC could use this narrow definition. The issue of whether binary options are “options” in accordance with CFTC regulation came up in court in 2013. As reported on Goodwingaming, “The binary option trading platform Banc de Binary currently faces a civil lawsuit in the District of Nevada brought by the CFTC for allegedly violating ‘the Commission’s ban on trading options off-exchange.’ The regulatory authority of the CFTC covers ‘options’ which are adroitly defined as ‘transaction(s) .. . held out to be of the character of, or . . commonly known to the trade as option(s).’” The defendant argued their binary options are not options per the CFTC’s full regulatory definition. The CFTC argued that only the first part of the definition counts: “What makes an option an option is the first of these three components — price speculation.” This sounds similar to Nadex’s options pricing.

“In a parallel lawsuit brought by the Securities and Exchange Commission, Judge Robert Jones (District of Nevada) agreed, explaining: With a binary option, . . . the purchaser receives neither the stock itself nor the right to purchase the stock in the future. Binary options are in substance pure gambling bets. . . . Binary option givers and buyers do not purport to trade interests in securities any more than tellers and gamblers at a racetrack purport to trade interests in horses. . . . The Court simply cannot agree that a contract under which the purchaser has no putative right to obtain the security is an ‘option.’”

IRS definitions of “option” is different
The tax code definition of an option sounds like the SEC argument rather than the CFTC argument in the above court cases. The main problem with saying that a Nadex binary option is a nonequity option for Section 1256 is that there is no right to receive property, or alternatively to receive cash equal to the right to receive property (in the case of a cash settled option).

Tax court cases and very limited IRS guidance
Industry professionals equate binary options with “digital options” and “paired options.” These terms came up in just a few tax court cases, which are about tax avoidance, not options. We don’t see any statements in these cases that indicate the court viewed binary options as true options. Section 1256 tax treatment is not used on binary options in any of these tax court cases. These cases do not connect the dots for supporting a Section 1256 position.

In The Markell Company, Inc. v. Commissioner, TC Memo 2014-86, “taxpayer/partner wasn’t entitled to multimillion dollar loss on complicated basis-inflating paired options/Son of BOSS (tax shelter) transaction using newly formed LLC/partnership.”..”Paired Options. The paired options in this case consisted of short and long European digital call options. These cash-or-nothing options can be valued by multiplying the present value of the cash payoff amount by the probability calculated from the Black-Scholes-Merton (BSM) model that the digital option will be in the money at the expiration date.” While Markell used paired options, the case is about tax avoidance transactions based on purposely mispricing paired options. (This case does provide tax guidance for treating binary options based on currencies as Section 988 ordinary gain or loss. There is a connection between the binary option and the underlying instrument it’s meant to mimic in price.)

In Douglas R. Griffin, (TC Memo 2011-61), “HydroTemp timely filed a return for the tax year ending June 30, 2003, reporting a $7,524,153 long-term capital gain from the asset sale to Pentair and a $7 million short-term capital loss from the sale of binary options (i.e., options in which the payoff is structured to be either a fixed amount of compensation if the option expires in the money or nothing at all if the option expires out of the money). .. IRS’s position. IRS disallowed HydroTemp’s losses from its claimed binary options sale.” In this case, the court accepted the binary option transactions as legitimate and the taxpayer won the case. (This case may provide tax guidance for treating the sale of binary options before they expire as being capital gain or loss on realized transactions; however, the IRS attorneys did not seem to have focused on the tax treatment of the options, but simply questioned the legitimacy of the transaction . When terminating a binary option short of expiration, perhaps capital gains and loss treatment is applicable, as discussed below.)

In an IRS Coordinated Issue Paper explaining IRS Notice 2003-81 (Tax Shelters), ,the IRS discusses “option premium” on binary options. “Gain and loss on options is accounted for on an open transaction basis. As explained in Notice 2003-81, the justification for open transaction treatment is that the gain or loss on an option cannot be finally accounted for until such time as the option is terminated. Thus, premium income is not recognized until an option is sold or terminated. Rev. Rul. 58-234.… explains that this is the treatment for the option writer because the option writer assumes a burdensome and continuing obligation, and the transaction therefore stays open without any ascertainable income or gain until the writer’s obligation is finally terminated. When the option writer’s obligation terminates, the transaction closes, and the option writer must recognize any income or gain attributable to the prior receipt of the option premium.” This should be the rule for the receipt of option premium whether the instrument is truly an option or not. This IRS guidance seems weak for building a case that a binary option is treated as a true option and therefore a nonequity option in Section 1256. (In Notice 2003-81, the binary options discussed were based on foreign currency transactions and Section 988 ordinary gain or loss on realized transactions applied by default on the binary options, not Section 1256.)

Tax compliance and planning
In general, we think binary options start off with ordinary gain or loss treatment. In Highwood Partners v. Commissioner (133 TC 1, 2009), digital options based on currency transactions were Section 988 ordinary gain or loss treatment. If you have a Nadex 1099B reporting Section 1256 treatment from binary options based on currencies, you should use Section 988 ordinary gain or loss treatment and not Section 1256, thereby overriding the 1099B.

Swap tax treatment calls for ordinary gain or loss tax treatment, too. Ordinary losses can generate large tax refunds since traders are not subject to the $3,000 capital loss limitation. Caution, large ordinary losses without qualification for trader tax status (business treatment) can lead to some wasted losses and wasted itemized deductions; as those ordinary losses are not a capital loss carryover or a net operating loss carryback or forward.

When a trader sells a Nadex binary option (not based on currency) before expiration, the IRS may view the proceeds as a “termination payment” on the sale of a capital asset, rather than a “period payment” on a swap contract. Normally, termination payments on capital assets are capital gains.

Tax attorneys Mark Feldman and Roger Lorence, and Darren Neuschwander, CPA contributed to this blog. 


IRS softens its stance for some taxpayers with undeclared offshore accounts

June 19, 2014 | By: Robert A. Green, CPA

IRS pressure and new Foreign Account Tax Compliance Act (FATCA) rules taking effect July 1, 2014 are intimidating Swiss banks into breaking their sworn legal promise of bank secrecy. Foreign banks are forcing American clients to turn themselves in to the IRS before the bank does so. Turning yourself in on time can lead to lower (but still very significant) penalties and no jail time.

After too many horror stories (see “Expatriate Americans Break Up With Uncle Sam to Escape Tax Rules”) about normal middle-class Americans getting caught up in this tax dragnet, the IRS changed its rules to catch and release the smaller fish. See the IRS news release “IRS Changing Offshore Programs to Ease Burdens, Increase Compliance” (IR-2014-73). Here’s the new IRS program.

IRS Eases Up on Accidental Tax Cheats” says “The Internal Revenue Service is sharply increasing the penalties on U.S. taxpayers who hide assets abroad, while lowering or eliminating fines on taxpayers if their failure to disclose offshore accounts was unintentional, the agency said Wednesday.”

If you want to learn more about these IRS programs, consider a consultation with our tax attorney who is an expert in this area and has handled many cases successfully. Attorney-client privilege will apply.

Update about OVDI: Under transition rules, a taxpayer who entered OVDP before July 1 is entitled to use Streamlined even without opting out of OVDP. On or after July 1, a taxpayer must choose between Streamlined and OVDP and cannot opt out of one into the other. Therefore, a taxpayer who is unsure whether he would be considered negligent or willful should weigh entering OVDP before July 1. Non-willful conduct is conduct that is due to negligence, inadvertence, or mistake or conduct that is the result of a good faith misunderstanding of the requirements of the law.


IRA rollover rule changes

June 12, 2014 | By: Robert A. Green, CPA

By Darren L. Neuschwander, CPA

There’s an important change in the rules for both traditional and Roth IRA rollovers, which are transactions that let you withdraw funds from one IRA and redeposit them in another IRA without paying income tax on the transaction.

Rollovers are a popular way of moving IRA money around from one investment to another. They are also a way to get a short-term tax-free loan from your IRA as long as you redeposit the funds to the same or another IRA no later than 60 days from the date you made the withdrawal.

One tax-free rollover from an IRA is allowed per year. The one-year waiting period begins on the date you received the IRA distribution, not on the date you roll the funds back into an IRA.

For about 30 years, IRS publications and proposed regulations have supported the general understanding among tax professionals that the one-year waiting period applies separately to each IRA an individual owns. Now, following a recent tax court case (Bobrow, T.C. Memo 2014-21), the IRS stated via Announcement 2014-15 that it will treat all of your IRAs as one IRA for purposes of the one-year waiting period. This more restrictive interpretation to IRA rollovers applies to transactions starting with tax-year 2015 and forward.

Pre-2015 IRA distribution example: Suppose you have four IRAs: A, B, C and D. In March of 2014, you withdrew the balance from A and rolled it over into C within 60 days. In August of 2014, you withdraw the balance from IRA B and roll it over into IRA D within 60 days. Assuming you haven’t previously made any rollovers, neither withdrawal will be taxed because both IRAs A and B are treated separately for purposes of the one-year waiting period.

Post-2014 IRA distribution example: Assume the same facts as in previous example, except the year of the transactions has changed from 2014 to 2015. In this case, the withdrawal from B will be a taxable distribution and also could be hit with a 10% early distribution penalty if you are under the age of 59 ½ . Only the withdrawal from A would be a tax-free rollover. To make matters worse, if the funding of D from the B withdrawal exceeded any allowable regular IRA contribution for 2015, it would be treated as an excess contribution subject to an additional 6% tax unless you withdraw the excess amount by 2015.


Bitcoin is not reported on 2013 FBARs

June 6, 2014 | By: Robert A. Green, CPA

Bitcoin investors store bitcoin on foreign exchanges in countries like Estonia, Russia and elsewhere. Do they have to file bitcoin holdings outside the U.S. on 2013 FBARs due June 30? The IRS just said no.

The following are excerpts from Thomson Reuters/Tax & Accounting’s “IRS official: taxpayers don’t have to report virtual currency on 2013 FBARs”:

“During a recent webinar, an IRS official stated that for purposes of the current filing season, taxpayers aren’t required to report virtual currencies on a Report of Foreign Bank and Financial Accounts (FBAR) with the U.S. Treasury. However, although this previously disputed matter is settled for the present, he stated that this position may well be subject to change.”

“Virtual currency isn’t subject to FBAR reporting … for now. During a recent IRS webinar titled “Reporting of Foreign Financial Accounts on the Electronic FBAR,” Rod Lundquist, Senior Program Analyst in IRS’s Small Business/Self Employed (SB/SE) division, stated that for purposes of the current filing season (i.e., for 2013 FBARs due later this month), taxpayers aren’t required to report Bitcoin on an FBAR. However, he cautioned that IRS is continuing to analyze virtual currency and that this policy could very well change going forward.

The issue of whether Bitcoin is subject to FBAR reporting has been widely debated among the financial and tax online community. One view is that, unless a taxpayer can prove that their bitcoins are within the U.S. (a potentially tricky proposition), then their owner would be required to file an FBAR if his holdings exceed $10,000. However, others question whether a Bitcoin account is truly a “financial account” with a “financial institution” for purposes of the FBAR rules-and, despite the IRS official’s recent pronouncement, these questions are still unanswered.”


Tax treatment for foreign futures

June 2, 2014 | By: Robert A. Green, CPA

A leading global broker Newedge promised Section 1256 treatment for foreign futures traded on Euronext Paris and Euronext Amsterdam exchanges. Our blog helped them retract that promise and agree those exchanges don’t have Section 1256 treatment.

Section 1256 offers up to 12% lower capital gains tax rates on short-term trading with its attractive 60/40 tax rates. It includes regulated futures contracts (RFCs), broad-based stock indices, options on those indices, options on futures, nonequity options, certain off-exchange foreign currency contracts and a few other items. But it can be a hard club to get into. Among Section 1256 contracts, regulated futures contracts, nonequity options and securities futures contracts must be traded on or subject to the rules of a “qualified board or exchange” (QBE). U.S. exchanges make the list pretty easily, but foreign exchanges don’t. Let’s look at the QBE requirement in more detail.

QBE
Section 1256 includes a list of those exchanges that are considered QBEs. Imagine Section 1256 being a popular club with a bouncer at the door holding a VIP guest list. If the exchange or board of trade you trade on is not on the QBE list, then the contracts you trade are excluded from Section 1256 tax treatment — even if they are regulated futures contracts.

QBEs include national securities exchanges registered with the SEC (category 1), domestic boards of trade designated as a “contract market” by the CFTC (category 2) or any other exchange or board of trade or other market (worldwide) that the CFTC and Treasury determines has rules adequate to carry out the purposes of Section 1256 (category 3).

According to Section 1256, contracts on category 1 and 2 exchanges are deemed RFCs if the contract “(A) with respect to which the amount required to be deposited and the amount which may be withdrawn depends on a system of marking to market, and (B) is traded on or subject to the rules of a qualified board or exchange.” (This doesn’t include securities futures contracts.)

The first step in finding out if a product qualifies for Section 1256 is to see if its exchange is on the QBE list. Don’t jump to that conclusion just because you received a 1099B reporting Section 1256 treatment. E&Y’s “Updated 2013 US IRC Section 1256 qualified board or exchange list” is a handy reference.

Notice the North American Derivatives Exchange (Nadex) — a domestic board of trade — is a category 2 because it’s a CFTC-regulated “Designated Contract Market” (DCM). In part two of this blog series, I discuss whether Nadex binary and variable payout options meet the definition of Section 1256 contracts, as either a regulated futures contract, or nonequity option.

Foreign exchanges with QBE status
These category 3 foreign QBEs received a CFTC exemption (“no action letter”) and Treasury/IRS determination granting them QBE status published in a required revenue ruling:

• International Futures Exchanges (Bermuda) Ltd.(inactive)
• Mercantile Division of the Montreal Exchange (inactive)
• Mutual Offset System (Rev. Rul. 87-43). A partnership between Chicago Mercantile Exchange and Singapore International Monetary Exchange Limited
ICE Futures Rev Rul 2007-26

o Per RIA, “a United Kingdom Recognized Investment Exchange that was (1) a wholly-owned subsidiary of a U.S. parent corporation, and (2) overseen by the U.K.’s Financial Services Authority, provided that the exchange continued to comply with all CFTC conditions necessary to retain its no-action relief permitting it to make its electronic trading and matching system available in the U.S.”

Dubai Mercantile Rev. Rul. 2009-4
ICE Futures Canada Rev. Rul. 2009-24
London International Financial Futures and Options Exchange (LIFFE) Rev. Rul. 2010-3

o Per RIA, “Is a regulated exchange of the United Kingdom … Exchange offered electronic trading of commodity futures contracts and other futures and options contracts. Contracts were cleared and settled by Clearing House, a CFTC-regulated Derivatives Clearing Organization. The CFTC had granted Exchange no-action relief permitting it to make its electronic trading and matching system available in the U.S.”

Eurex Deutschland Rev. Rul. 2013-5

o Per RIA, “Is a regulated exchange of Germany, as long as: either CFTC continues to allow Eurex to provide direct access to its electronic trading and order matching system from U.S. under existing no action letter, pending CFTC approval of Order of Registration, or Eurex holds valid Order of Registration as foreign boards of trade (FBOT). IRS grants consent to taxpayers to change to Section 1256 mark to market method for 1st taxable year during which taxpayer holds Eurex Deutschland Contract that was entered on or after 3/1/2013.”

CFTC looks abroad
The CFTC’s reach is global — protecting customers located in the U.S. trading on foreign exchanges.

The CFTC website (international foreign products) says “These regulations are designed to carry out Congress’s intent that foreign futures and foreign options products offered or sold in the U.S. be subject to regulatory safeguards comparable to those applicable to domestic transactions. As set forth in CFTC Regulation 30.4, any domestic or foreign person engaged in activities like those of a futures commission merchant (FCM), introducing broker (IB), commodity pool operator (CPO), or commodity trading advisor (CTA) must register in the appropriate capacity or seek an exemption from registration under CFTC Regulation 30.5 or CFTC Regulation 30.10.”

The first step in finding out if Section 1256 applies is to look up the CFTC no action letter with 30.5 or 30.10 exemption. The CFTC publishes current and pending no action letters at “Foreign Government Agencies and SROs that have Received CFTC Orders under CFTC Regulation 30.10” and “Pending Requests for CFTC Regulation 30.10 Exemption.”

Treasury’s determination is published
The second step is to look up the IRS revenue ruling. The IRS has a two-step process for these determinations.

1. The foreign exchange must submit a private letter ruling requesting QBE status. If the IRS is satisfied that the exchange has sufficient rules for application of Section 1256, it publishes a revenue ruling. The revenue ruling applies to the commodity futures contracts and futures contract options only entered on the named exchange, and not any affiliated exchanges (Note 1). For example, Section 1256 applies for futures traded on Eurex Deutschland, but not for futures traded on an affiliate of Eurex Deutschland.

2. The IRS looks to see if the exchange obtained a CFTC exemption (no action letter). Section 738 of the Dodd-Frank Act gives the CFTC authority to adopt rules and regulations that require registration of a foreign board of trade that provides U.S. participants direct access to the board of trade’s electronic trading system. This proposed registration system is supposed to replace the no-action letter process.

Mergers, partnerships and cooperation lead to questions about QBE status
There have been several cross-border mergers and acquisitions, partnerships and other cooperation agreements between U.S., EU and Asian exchanges and foreign boards of trade. These mergers and affiliations are confusing brokers, who are then confusing their clients. Keep things simple and clear: make sure you see an IRS revenue ruling in the exact name of the exchange you trade on.

When a U.S. QBE has a “mutual offset agreement” with a non-QBE foreign exchange, the IRS treats trades executed on the foreign exchange that are assumed by the U.S. QBE as Section 1256. But trades executed on the U.S. QBE that are assumed by the foreign exchange are not considered Section 1256. This was the case with the CME/SIMEX Mutual Offset System (Rev. Rul. 87-43).

If a U.S. QBE acquires a foreign non-QBE, generally the foreign regulator oversees the foreign non-QBE. The foreign non-QBE does not inherit the U.S. exchange’s QBE status. The foreign exchange must have it’s own CFTC exemption (no-action letter) and request a formal determination by Treasury for foreign QBE status. The ICE Futures 2009 revenue ruling listed above is a similar case. (Note 2 confirmation from IRS)

Dodd Frank rules for swaps
As of 2011, the Dodd-Frank Act requires privately negotiated derivatives contracts to clear on derivatives exchanges or boards of trade. The CFTC is trying to coordinate these rules with similar ones enacted in the EU. Among other things, the CFTC wants EU swaps exchanges to report on trading activities by Americans. Dodd-Frank law and IRS proposed regulations exclude swap contracts from Section 1256.

Many foreign exchanges don’t want U.S. filings
NYC tax attorney Roger Lorence heard from Treasury and IRS officials that several foreign exchanges and boards of trade fear getting involved with the U.S. Treasury and IRS — perhaps due to controversial U.S. FATCA and FBAR reporting — so they don’t want a CFTC exemption and Treasury determination granting them QBE status. But perhaps they will change their minds if Americans demanding QBE status become a major part of their business activity.

Note 1: Preamble to Proposed Regulation § 1.1256(g)-1 

(Part D, 9/16/2011)
D. Qualified Board or Exchange
Section 1256(g)(7)(C) provides that a qualified board or exchange includes any other exchange, board of trade, or other market which the Secretary determines has rules adequate to carry out the purposes of section 1256. Section 1.1256(g)-1(a) of the proposed regulations specifies that such determinations are only made through published guidance in the Federal Register or in the Internal Revenue Bulletin. 

Robert Green observation: The proposed reg requires publishing in the Federal Register or Internal Revenue Bulletin, whereas the current 1.1256 regulation requires publishing in an IRS Revenue Ruling. Either way, qualification for Section 1256 requires Treasury/IRS to make a formal determination and publish it for public consumption. Notice the IRS published some of the above Revenue Rulings in the IR Bulletin, whereas others we published as pdf files only. More consistency in publishing would be better.

Since section 1256(g)(7) was adopted, the Treasury Department and the IRS have issued determinations for six* entities, all of them foreign futures exchanges. See Rev. Rul. 2010-3 (2010-1 CB 272 (London International Financial Futures and Options Exchange)), Rev. Rul. 2009-24 (2009-2 CB 306 (ICE Futures Canada)), Rev. Rul. 2009-4 (2009-1 CB 408 (Dubai Mercantile Exchange)), Rev. Rul. 2007-26 (2007-1 CB 970 (ICE Futures)), Rev. Rul. 86-7 (1986-1 CB 295 (The Mercantile Division of the Montreal Exchange)), and Rev. Rul. 85-72 (1985-1 CB 286 (International Futures Exchange (Bermuda))). The IRS has followed a two step process for making each of the six qualified board or exchange determinations under section 1256(g)(7). See § 601.601(d)(2)(ii)(b).

*Robert Green observation: Eurex Deutschland (Rev. Rul. 2013-5) was published after this preamble date of 9/16/2011.

In the first step, the exchange submitted a private letter ruling to the IRS requesting a determination that the exchange is a qualified board or exchange within the meaning of section 1256(g)(7)(C). Once the IRS determined that the exchange had rules sufficient to carry out the purposes of section 1256, the Treasury Department and the IRS published a revenue ruling announcing that the named exchange was a qualified board or exchange. The revenue rulings apply to commodity futures contracts and futures contract options of the type described under the CEA that are entered into on the named exchange. The revenue ruling does not apply to contracts that are entered into on another exchange that is affiliated with the named exchange.

Robert Green observation: The above important sentences in bold are current law, they are not something new in Proposed Regulation § 1.1256(g)-1.

In determining whether a foreign exchange is a qualified board or exchange under section 1256(g)(7)(C), the Treasury Department and the IRS have looked to whether the exchange received a CFTC “direct access” no-action relief letter permitting the exchange to make its electronic trading and matching system available in the United States, notwithstanding that the exchange was not designated as a contract market pursuant to section 5 of the CEA. Section 738 of the Dodd-Frank Act, however, provides the CFTC with authority to adopt rules and regulations that require registration of a foreign board of trade that provides United States participants direct access to the foreign board of trade’s electronic trading system. In formulating these rules and regulations, the CFTC is directed to consider whether comparable supervision and regulation exists in the foreign board of trade’s home country. Pursuant to section 738, the CFTC has proposed a registration system to replace the direct access no-action letter process. Under the proposed registration system, a foreign board of trade operating pursuant to an existing direct access no-action relief letter must apply through a limited application process for an “Order of Registration” which will replace the foreign board of trade’s existing direct access no-action letter. Many of the proposed requirements for and conditions applied to a foreign board of trade’s registration will be based upon those applicable to the foreign board of trade’s currently granted direct access no-action relief letter.

The IRS has conditioned a foreign exchange’s qualified board or exchange status under section 1256(g)(7)(C) on the exchange continuing to satisfy all CFTC conditions necessary to retain its direct access no-action relief letter. Consequently, if the CFTC adopts the proposed registration system, an exchange that has previously received a qualified board or exchange determination under section 1256(g)(7)(C) must obtain a CFTC Order of Registration in order to maintain its qualified board or exchange status. The IRS will continue to evaluate the CFTC’s rules in this regard to determine if any changes to the IRS’s section 1256(g)(7)(C) guidance process are warranted.

Note 2: Confirmation with IRS
Our tax attorney Roger Lorence spoke with an IRS official responsible for Section 1256 issues, and he confirmed that: “A foreign board or exchange must get a revenue ruling if they have a CFTC 30.10 ruling to receive 1256 treatment for their qualifying contracts. A foreign board that receives a revenue ruling is covered on 1256 but related foreign exchanges are not covered – the revenue ruling only applies to the exchange covered in that ruling. Affiliated foreign exchanges must get their own revenue ruling to qualify under 1256.”

Thank you to our tax attorneys Mark Feldman and Roger Lorence and my co-managing member Darren Neuschwander, CPA for their help with this blog.


Can business traders apply Section 475 elections to bitcoin trades?

May 21, 2014 | By: Robert A. Green, CPA

At the May 9 American Bar Association (ABA) meeting, tax attorneys asked the IRS about bitcoin. According to Tax Analysts coverage of the meeting, Jo Lynn Ricks of Deloitte Tax LLP said the IRS guidance didn’t answer the question of whether a virtual currency could be a commodity, adding that if it is a commodity, dealers and traders could elect mark-to-market treatment under section 475(e) and (f).

“If you have something that trades through a futures contract, then it could be a commodity through the [Commodity Exchange Act],” she said. Bitcoin futures are traded on an exchange called ICBIT, creating the potential for virtual currencies to meet that broader definition of commodity, according to Ricks.

In its guidance, the IRS labels bitcoin an “intangible asset,” but it doesn’t go as far as labeling bitcoin a commodity. The sale of an intangible asset, commodity or security brings capital gains or loss treatment. The sale of a commodity futures contract traded on a U.S. commodities or futures exchange means lower 60/40 tax rates under Section 1256.

Business traders electing Section 475 have ordinary gain or business loss treatment on Form 4797 Part II. We generally recommend business traders elect Section 475 on securities only, so they can retain lower 60/40 tax capital gains tax rates on futures (considered “commodities” in Section 475). Our tax attorney Mark Feldman suggests that to deal with bitcoins, the election language be changed so that it applies “for securities and for those commodities which are not eligible for Section 1256 treatment.”


Puerto Rico’s tax haven status is made for traders

May 13, 2014 | By: Robert A. Green, CPA

Puerto Rico’s new tax incentive acts are tailor made for traders/investors, investment managers and financial institutions. In the past, Puerto Rico offered tax incentives to manufacturers. Puerto Rican officials now believe investors, investment managers and financial institutions can more easily move virtual businesses there. The officials figure these groups will bring an influx of new money and key investments to the island to help it rise above its current state of financial distress.

“Puerto Rico is one of only a few places in the world where a U.S. citizen or permanent resident can live, without giving up their U.S. citizenship and passport, while legitimately avoiding payment of tax to the IRS on PR source income,” NYC tax attorney William Blum says. “Those who would like to legally reduce their tax burden, and who are ready for an exciting lifestyle change, should seriously consider it.”

Act 22 for traders and investors
Enacted in 2012, PR Act 22 allows investors and traders with bona fide residence in Puerto Rico to exclude 100% of all short-term and long-term capital gains from the sale of personal property accrued after moving to PR. Act 22 does not require investment in Puerto Rican stocks and bonds; trades can be made with a U.S. broker or on any exchange around the world. This applies to day traders. While trader tax status and Section 475 MTM elections are important tax strategies for residents of the U.S., they are irrelevant when applying PR Act 22 exclusions.

U.S. tax law Section 933 “Income from sources within Puerto Rico” is synchronized with PR tax law, including Acts 22 and 20. Americans with residence in PR split their income, reporting “non-PR source” income (income in the U.S. and elsewhere other than in PR) on U.S. Form 1040, and PR-source income on a PR income tax return filed with Hacienda (PR’s tax authority).

IRS Pub 1321 “Special Instructions For Bona Fide Residents Of Puerto Rico Who Must File A U.S. Individual Income Tax Return (Form 1040 or 1040A)” shows how to treat different types of income (see page 2, “Source of Income Rules”). Other than the “sale of personal property” which is sourced in the “seller’s tax home” (presumably in Puerto Rico), other types of income are sourced from: the location of payer for interest and dividend income; where the service is performed for wages and compensation; where services were performed that earned the pension income; where the property is used for royalties paid on patents, copyrights and IP; and the location of property for the sale or real property like residential, rental and commercial real estate.

Can you see the tax loophole? Worldwide capital gains (other than gains on real property) are sourced in PR and they are 100% excluded from both U.S. and PR tax, resulting in a trader’s tax nirvana. There’s one exception: trades made from an office outside of PR do not qualify as PR source capital gains subject to the exclusion.

Pub 1321 includes these instructions: “Caution: There are special rules for gains from dispositions of certain investment property (for example, stocks, bonds, debt instruments, diamonds, and gold) owned by a U.S. citizen or resident alien prior to becoming a bona fide resident of a possession. You are subject to these special rules if you meet both of the following conditions: For the tax year for which the source of gain must be determined, you are a bona fide resident of Puerto Rico; for any of the 10 years preceding that year, you were a citizen or resident alien of the United States (other than a bona fide resident of Puerto Rico); if you meet these conditions, gains from the disposition of this property will not be treated as income from sources within the relevant possession for purposes of the Internal Revenue Code. Accordingly, bona fide residents of American Samoa and Puerto Rico, for example, may not exclude the gain on their U.S. tax return. However, there is a special election that you can make to allocate gain/losses between the U.S. and Puerto Rico from disposition of certain property. For additional details see Publication 570.”

It’s a bit deceptive in marketing materials from PR sites for Act 22. Many promise 100% exclusion on all interest and dividend income, but the U.S. will keep taxing non-PR source interest and dividend income, even if PR does not. Act 22 also provides a 10% PR tax rate on the sale of real property located in PR if held under 10 years since establishing PR residence, and a 5% tax rate if held more than 10 years.

Act 20 for investment managers
Investment managers charge advisory fees, which are service business revenues. They export their services to investors outside of Puerto Rico and hence they can qualify for Act 20 tax incentives for “export service businesses.”

To receive these incentives, they need to move their operations to PR and they should have a minimum of three employees there who are paid reasonable wages. The employees are bona fide residents and they pay PR taxes on their individual tax returns on this compensation. PR is part of FICA and Medicare, so the employer needs to charge payroll taxes in a similar manner to the U.S.

The Act 20 tax incentive is a 4% flat tax rate on net business income. The owner receives Act 22 100% exclusion on dividends received from the PR business entity. PR-sourced dividends are excluded from U.S. taxes under Section 933.

Companies retaining some operations in the U.S. will have “effectively connected” trade or business income subject to U.S. tax.

Many owners and employees of investment management operations have significant capital gains income generated from their own investment portfolios, including investments in their own funds and profit allocations of capital gains in their managed hedge funds. These capital gains can be excluded under Act 22, except for the trades that originate from an office outside of PR. A CEO of an investment management firm can not be the only one that moves to PR, he also needs to bring along much of his investment management operations and employees, too.

Bona fide residence has stringent tests
You must pass all three different tests — the presence test, tax home test and closer connection test – for individual bona fide residence and all three are not easy to pass. Many taxpayers and advisors are aggressive about state residency tests for domicile and they lose when audited by tough tax examiners. PR’s Act 22 and 20 are new and only 2012 and 2013 tax returns have been filed, not giving state and PR auditors much time to check yet.

It’s difficult to move an investment management business to PR. You have to change documents with investors, hedge funds and counterparties to reflect the PR company name and address and carry on your business from Puerto Rico.

Everyone There Will Have Moved Here! An Overview of the US Federal and Puerto Rican Tax Incentives for Bona Fide Residents of Puerto Rico” is an excellent article by NYC tax attorney Mark Leeds and PR tax accountant Gabriel Hernandez. (The article includes in-depth information about the three residency tests and an example of an investment manager.)

When someone calls with questions about Puerto Rican tax benefits, Leeds says offspring are an important factor. “The first thing I ask is do you have kids and what are their ages? The sweet spot of the PR tax strategy is for people in their 20s without kids and older people whose children have moved on,” he says. “If children are embedded in communities, it’s hard to make the change of residence work because it’s hard to meet the bona fide residence tests. If kids and spouses will stay in the U.S., it’s unlikely that the trader will satisfy the closer connection test. The strategy works well for young traders and older guys in private equity and hedge funds.”

The article says “(Act 22) has a 100% tax exemption from Puerto Rico income taxes on all long-term capital gains accrued after the individual becomes a bona fide resident of Puerto Rico.” I asked Mr. Hernandez if this should say all capital gains (including short term). Hernandez confirmed all capital gains now receive the exemption.

“Originally, PR Act 22 had only the long-term capital gains exclusion and after a short while they corrected it to include all capital gains (on the sale of personal property),” he says. Afterwards, I asked Mr. Hernandez for a legal citation on this correction and he emailed me Law 138 in Spanish and wrote “Article 3 of Law 138 amends Article 5 of Act 22 to provide exemption to the “totalidad” (which means 100%) of the capital gains.”

Some tax professionals feel the Hacienda might consider a day trader, scalper or high-frequency trading market-maker to be a business, and disqualify their trading gains from Act 22 exclusions. But Hernandez and Leeds disagree.

“Puerto Rico follows federal precedents on trade or business, and trading is a capital gains activity in the U.S.,” Hernandez says.

Moving to a foreign country instead
If an American citizen or legal resident (greencard holder) becomes a bona fide resident of a foreign country, as opposed to a U.S. territory or possession like Puerto Rico, their taxes are handled as follows: If they retain U.S. citizenship or legal residence status, they may use Section 911’s Foreign Earned Income Exclusion ($99,200 for 2014). If they surrender U.S. citizenship or legal residence status, they are subject to Section 877’s Expatriation Tax rules. (Both are beyond the scope of this article.)

Bottom line
For traders and investment managers who are ready, willing and able to meet the stringent bona fide residency tests, PR Act 22 and Act 20 tax incentives are probably a great deal.

For such a drastic move and change of lifestyle, you will want to be conservative in assessing your passing of the residency tests. It’s wise to discuss the ins and outs of these tax programs with experts in these matters, and run pro-forma U.S. and PR tax returns based on your facts and circumstances over a few years of projected stay. Carefully assess the pros and cons. One con is there’s no Section 475 NOL tax loss insurance for business traders.

If you’re young and single or an empty nester, this type of move may work well for you. Saving up to 50% or more on federal and state income tax rates on your trading gains can beef up your retirement income in a significant way. Plus, in PR you already found your retirement home in the sun!

For more information
Moving to Puerto Rico

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