IRS Considering “Freeze and Mark” for Section 475 Election

May 10, 2016 | By: Robert A. Green, CPA

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

According to Tax Notes article “IRS Considering ‘Freeze and Mark’ for Trader Election” dated Jan. 20, 2016, Robert Williams, branch 3 senior counsel, IRS Office of Associate Chief Counsel (Financial Institutions and Products), said he was optimistic, though cautious, that updated Section 475 regulations will come out by June 30, 2016.

The Tax Notes article mentioned a few significant potential changes that would affect traders in making a new Section 475 election. If codified by the IRS, I expect these changes won’t apply retroactively, so traders who made a 2016 Section 475 election by April 18 should not be affected.

Clarification of the character of income or loss of a Section 481(a) adjustment: The IRS may clarify that it’s a capital gain or loss, rather than an ordinary income or loss, which is the current interpretation. Many traders have benefited from ordinary loss treatment, especially when a Section 481(a) adjustment included wash sale loss deferrals on open trading business positions.

No election deadline: The changes may allow existing taxpayers to make a new Section 475 election throughout the tax year. Currently,  the election deadline is April 15 for existing partnerships and individuals and March 15 for S-Corps. Many existing taxpayers will appreciate doing away with the deadline.

No retroactive application: Williams discussed applying ordinary income or loss treatment on the election date and going forward, and doing away with retroactive application of ordinary income or loss to Jan. 1.

Under current law, when a trader elected Section 475 by April 18, 2016 for 2016 (normally April 15), the election was retroactive to Jan. 1, 2016, so all 2016 trading gains and losses are ordinary income and loss. If a trader qualified for trader tax status (TTS) at year-end 2015, he also makes a Section 481(a) adjustment on Jan. 1, 2016 for unrealized gains or losses on open trading positions on Dec. 31, 2015.

Traders have been able to use hindsight between Jan. 1 and April 15 to make a last-minute decision about electing Section 475. For example, if they have a large trading loss in Q1, they may elect Section 475 to lock in ordinary loss treatment for that loss, and plan to revoke Section 475 in the subsequent year to get back to capital gains treatment to use up capital loss carryovers. That type of hindsight may be lost with these potential updates in the law.

 

 


Safeguard Use Of Section 475 By Trading In An Entity

| By: Robert A. Green, CPA

Section 475 “tax loss insurance” is a fantastic tax benefit for active securities traders qualifying for trader tax status (TTS). Many individual taxpayers have been using it successfully for years. I’ve exhorted the benefits since 1997, when Congress enacted Section 475 tax law for traders.

Some Section 475 provisions are vague
Increasingly, my firm’s tax compliance CPAs have noticed problems with the nuances of Section 475, including some of the rule sections, which are too vague. The IRS acknowledged this with its “Section 475 Clean Up Project” and read our comment letter to the IRS. The IRS said the project is being completed and to expect updated Section 475 regulations in the summer of 2016. (I cover the changes being discussed at tax attorney conferences in my next blog post IRS Considering “Freeze and Mark” for Section 475 Election.)

One of the problems with Section 475 regulations has to do with segregation of investments. Segregation should be done in form and substance and that can be confusing. A prior IRS proposed regulation called for designation of investment accounts, but that was not sufficient as traders could use substance to trump form.

This problem arises when a trader uses Section 475 and also holds investment positions in substantially identical positions. Traders can’t elect Section 475 by account. The law makes the election by taxpayer identification number, which means the election applies to all active trading accounts and investment accounts containing active trading.

Traders can solve this problem by housing the trading business using Section 475 in a separate legal entity and holding investments in individual accounts. This is the only way to fully segregate investments from trading. (Read my recent blog post Active Traders Should Consider An Entity For Tax Savings for other reasons to form an entity.)

Misidentified investment positions
Many individuals trade substantially identical positions between Section 475 active trading accounts and taxable investment accounts, including joint and spousal accounts. For example, they trade Apple options in a Section 475 account and also hold Apple equity in segregated investment accounts.

The IRS can view this trading as gaming the system, with the trader deducting ordinary losses on Apple options but deferring taxes on unrealized long-term capital gains in Apple equity held as an investment. Because Apple options and Apple equity are substantially identical positions, the IRS has the power in Section 475 regulations to treat either the Apple options or the Apple equity as “misidentified investment positions,” which means it can apply Section 475(d)(2). (Learn more about that Section 475 penalty in my blog post IRS Plays Havoc with Traders Misidentifying Investments.)

Experienced trader tax preparers and IRS agents may seek other ways to address this problem, including reclassifying Section 475 ordinary losses on Apple options as investment capital losses, which then triggers capital loss limitations and wash sale loss adjustments on substantially identical positions across all accounts. Or if it’s better for the IRS position, reclassifying Apple equity investments as Section 475 trades, triggering Section 475 MTM ordinary income treatment, thereby losing tax deferral and missing out on lower long-term capital gains rates on realization.

An entity solves the problem
Traders can avoid this problem by ring-fencing Section 475 trades in separate entity accounts and holding investments in individual accounts. A separate legal entity has a different taxpayer identification number vs. an individual taxpayer social security number.

Don’t transfer investment positions into the entity, as that brings the same problem to the entity-level: having trading and investment accounts and or positions on the same taxpayer identification number.

I suggest that traders using portfolio margining on investment positions make the following decision. Either bring investments into the trading entity for portfolio margining and don’t elect Section 475 in the entity or leave the investments out of the entity and elect Section 475.

A newly formed entity may elect Section 475 by placing a resolution in its own books and records within 75 days of inception. Existing taxpayers must elect Section 475 by making an election statement with the IRS by the due date of the prior year tax return, and later file a timely Form 3115 for the year of the election. (Read my blog post Traders: Consider Ordinary Loss Election By Tax Deadline for more details on making the election.)

IRS scrutinizes individuals with large Section 475-related NOL tax refunds
It’s been over a decade since Chen vs. Commission (2004), but an IRS official recently reiterated the importance of that landmark tax court case, deeming similar cases “Chen cases.”

The IRS official was referring to sole proprietor (individual) traders reporting large Schedule C and Form 4797 (Section 475) ordinary losses on individual tax returns and filing for large NOL carryback refunds claims with the IRS. All the cases in my Green’s 2016 Trader Tax Guide, including Assaderaghi, Nelson, Endicott and Holsinger are similar: individuals with Schedule C and Form 4797 losses.

It’s much better to file as an entity trader with Section 475 ordinary loss treatment. The tax refund is the same, but you substantially reduce your chances of IRS exam and denial of TTS, which is required for use of Section 475.

Section 475 tax benefits
Securities traders qualifying for TTS benefit from a Section 475 election. Section 475 securities trades are exempt from wash sale loss adjustments and a capital loss limitation. Section 475 has business ordinary loss treatment, which offsets income of any kind and contributes to net operating losses (NOLs), which may be carried back two years and/or forward 20 years. Short-term capital gains and Section 475 MTM gains are taxed at the ordinary tax rate, so Section 475 is recommended for securities traders.

Conversely, Section 1256 contract traders (futures and more) generally don’t want Section 475 since they would lose lower 60/40 capital gains tax rates in Section 1256 (60% is a long-term capital gain taxed at lower rates and 40% is a short-term capital gain).

Traders can elect Section 475 on securities only, retaining Section 1256 treatment on futures. Section 475 does not apply to segregated investments. Traders value ordinary loss treatment: It’s free tax loss insurance for securities traders.

I’ve been advising traders on tax matters for over 30 years and I’ve seen many ups and downs in the financial markets. I’ve seen professional traders with wide fluctuations of income and loss, too. It’s important to avoid the dreaded $3,000 capital loss limitation against other income and benefit from Section 475 ordinary business loss treatment to generate immediate tax refund relief.

 

 


Active Traders Should Consider An Entity For Tax Savings

May 3, 2016 | By: Robert A. Green, CPA

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

Forming an entity can save active investors and business traders significant taxes. Active investors can limit wash sale losses calculated between their individual taxable investment accounts and IRAs with an entity account. Business traders solidify trader tax status (TTS), unlock employee-benefit deductions, gain flexibility with a Section 475 election and revocation and limit wash-sale losses with individual and IRA accounts. For many active traders, an entity solution generates tax savings in excess of entity formation and compliance costs.

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. It’s important to segregate investments from business trading when claiming TTS, and an entity is most useful in that regard. It’s simple and inexpensive to set up and operate.

Additionally, entities help traders elect Section 475 MTM (ordinary-loss treatment) later in the tax year — within 75 days of inception — if they missed the individual MTM election deadline on April 15. And it’s easier for an entity to exit TTS and revoke Section 475 MTM than it is for a sole proprietor. It’s more convenient for a new entity to adopt Section 475 MTM internally from inception, as opposed to an existing taxpayer whom must file a Form 3115 after filing an external election with the IRS.

Don’t worry, prior capital loss carryovers on the individual level are not lost; they still carry over on your individual Schedule D. The new entity can pass through capital gains if you skip the Section 475 MTM election to use up those capital loss carryovers. After using up capital loss carryovers, your entity can elect Section 475 MTM in a subsequent tax year.

Business traders often use an S-Corp trading company or an S-Corp or C-Corp management company to pay salary to the owner in connection with a retirement plan contribution, which otherwise isn’t possible in a partnership trading company (unless a trader has other sources of earned income or is a dealer member of a futures or options exchange).

Trading in an entity can help constitute a performance record for traders looking to launch an investment-management business. Finally, many types of entities are useful for asset protection and business continuity. A separate legal entity gives the presumption of business purpose, but a trader entity still must achieve TTS.

Avoid wash sales with an entity
Active investors in securities are significantly impacted by permanent and deferred wash sale losses between IRA and individual taxable accounts.

Trading in an entity helps avoid these problems. The entity is separate from your individual and IRA accounts for purposes of wash sales since the entity is a different taxpayer. An individual calculates wash sales among all their accounts. Ring fencing active trading into an entity account separates those trades from the individual wash sale loss calculations. The IRS is entitled to apply related party transaction rules (Section 267) if the entity purposely tries to avoid wash sales with the owner’s individual accounts. In that case, the entity will not avoid wash sale loss treatment.

If you don’t purposely avoid wash sales, you can break the chain on year-to-date wash sales in taxable individual accounts by switching over to an entity account mid-year or at year-end, and prevent further permanent wash-sale losses with IRAs. If the entity qualifies for TTS, it can consider a Section 475 MTM election exempting it from wash sales (on business positions, not investment positions); that also negates related party rules.

Play it safe on related party transaction rules by avoiding the repurchase of substantially identical positions in the new entity after taking a loss in the individual accounts.

Business traders: consider an entity
Many active traders ramp up into qualification for TTS. They wind up filing an individual Schedule C (Profit or Loss from Business) as a sole proprietor business trader the first year. That’s fine. They deduct trading business expenses on Schedule C and report trading gains and losses on other tax forms. They can even elect Section 475 MTM by April 15 of a given tax year to use ordinary gain or loss treatment (recommended on securities only). But a Schedule C owner may not pay himself compensation and the Schedule C does not generate self-employment income, either of which is required to deduct health insurance premiums and retirement plan contributions from gross income. (The exception is a full-fledged dealer/member of an options or futures exchange trading Section 1256 contracts on that exchange; they have SEI per Section 1402i.) The business trader needs an entity for those employee-benefit plan deductions.

Safeguard use of Section 475

Pass-through entities
We recommend pass-through entities for traders. A pass-through entity means the entity is a tax filer, but it’s not a taxpayer. The owners are the taxpayers, most often on their individual tax returns. Consider marriage, state residence and state tax rules including minimum taxes, franchise taxes and more when setting up your entity. Report all entity trading gains, losses and expenses on the entity tax return and issue a Schedule K-1 to each owner for their respective share — on which income retains its character. For example, the entity can pass through capital gains to utilize individual capital loss carryovers. Or the entity can pass through Section 475 MTM ordinary losses to comprise an individual net operating loss (NOL) carryback for immediate refund.

The best types of entities
We like the S-Corp because it pays compensation (officer’s salary) to the owner, which efficiently unlocks health insurance premium and retirement plan contribution deductions. You can form a single-member LLC or multi-member (spousal) LLC and the LLC can elect S-Corp tax treatment within 75 days of inception or by March 15 of the following tax year. (Another option is to form a corporation and it can elect S-Corp tax treatment, too.) A general partnership can also elect S-Corp status in every state except Connecticut, the District of Columbia, Michigan, New Hampshire, New Jersey and Tennessee.

But the S-Corp is not feasible alone in some states or cities, including California and New York City. In those places, we suggest a trading company partnership return — either a general partnership or LLC — and a management company S-Corp or C-Corp. You can convey interests in the pass-through entity to family revocable trusts or even irrevocable trusts. (See our blog post Business Traders Maximize Tax benefits with an S-Corp.)

Year-end Entity planning
There are important tax matters to execute with entities before year-end. For example, S-corps and C-corps should execute payroll before year-end. A Solo 401(k) defined contribution plan or defined benefit retirement plan must be established before year-end. (Watch our Webinar recording: Year-End Planning For Entities: Payroll, Retirement and Health Insurance.)

This is an excerpt from Green’s 2016 Trader Tax Guide.

Webinar 5/17:  Entity & Benefit Plan Tax-Advantaged Solutions 2016. We plan to offer a recording afterwards. 

 

 


Traders: Consider Ordinary Loss Election By Tax Deadline

March 22, 2016 | By: Robert A. Green, CPA

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

Traders who qualify for trader tax status (TTS) and have a large trading loss in 2016 should consider filing a 2016 Section 475 MTM (ordinary loss treatment) election statement with their extension or return by the April 18, 2016 due date. Section 475 exempts traders from the capital loss limitation and wash sale loss rules. It’s too late to elect Section 475 for 2015: that election was due last April 15, 2015.

Section 475 allows a choice: an election on securities only, Section 1256 contracts only, or both. Specify such in the election statement. Only traders who qualify for trader tax status may use Section 475 and it applies to active trading in that business activity as a sole proprietor individual or on the entity level. Section 475 doesn’t apply to segregated investment positions, so traders may use long-term capital gains benefits on investments.

The biggest problem for investors and traders occurs when they’re unable to deduct trading losses on tax returns, significantly increasing tax bills or missing opportunities for tax refunds. Investors are stuck with this problem, but business traders with TTS can avoid it by filing timely elections for business ordinary tax-loss treatment: Section 475 mark-to-market (MTM) for securities and/or Section 1256 contracts if elected. (Section 1256 contracts include futures, broad-based indexes, options on futures, options on broad-based indexes and several other instruments.)

By default, securities and Section 1256 investors are stuck with capital-loss treatment, meaning they’re limited to a $3,000 net capital loss against ordinary income. The problem is that their trading losses may be much higher and not useful as a tax deduction in the current tax year. Capital losses first offset capital gains in full without restriction. After the $3,000 loss limitation against other income is applied, the rest is carried over to the following tax years. Many traders wind up with little money to trade and unused capital losses. It can take a lifetime to use up their capital loss carryovers. What an unfortunate waste! Why not get a tax refund from using Section 475 MTM right away?

Business traders qualifying for TTS have the option to elect Section 475 MTM accounting with ordinary gain or loss treatment in a timely fashion. When traders have negative taxable income generated from business losses, Section 475 accounting classifies them as net operating losses (NOLs). Caution: Individual business traders who miss the Section 475 MTM election date (April 18 for 2016) can’t claim business ordinary-loss treatment on trading losses for the current tax year. They will be stuck with capital-loss carryovers.

A new entity set up after April 18, 2016 can deliver Section 475 MTM for the rest of 2016 on trading losses generated in the entity account if the entity files an internal Section 475 MTM election within 75 days of inception. The new entity using Section 475 does not change the character of capital loss treatment on the individual accounts before or after entity inception. The entity is meant to be a fix for going forward; it’s not a means to clean up the past problems of capital loss treatment.

Ordinary trading losses can offset all types of income (wages, portfolio income, and capital gains) for you and your spouse on a joint filing, whereas capital losses only offset capital gains. Plus, business expenses and business ordinary trading losses comprise a NOL, which can be carried back two tax years and/or forward 20 tax years. It doesn’t matter if you are a trader or not in a carryback or carryforward year. Business ordinary trading loss treatment is the biggest contributor to federal and state tax refunds for traders.

There are many nuances and misconceptions about Section 475 MTM, and it’s important to learn the rules. For example, you’re entitled to contemporaneously segregate investment positions that aren’t subject to Section 475 MTM treatment, meaning at year-end you can defer unrealized gains on properly segregated investments. You can have the best of both worlds — ordinary tax losses on business trading and deferral with lower long-term capital gains tax rates on segregated investment positions. We generally recommend electing Section 475 on securities only, so you retain lower 60/40 capital gains rates on Section 1256 contracts. Far too many accountants and traders confuse TTS and Section 475; they are two different things, yet very connected.

Section 475 Election Procedures
Section 475 MTM is optional with TTS. Existing taxpayer individuals and partnerships that qualify for TTS and want Section 475 must file a 2016 Section 475 election statement with their 2015 tax return or extension by April 18, 2016 (April 19, 2016 if you live in Maine or Massachusetts). Existing S-Corps file in the same manner by March 15, 2016.

Election statement. The MTM election statement is one simple paragraph; unfortunately the IRS hasn’t created a tax form for it. It’s a version of the following: “Pursuant to Section 475(f), the Taxpayer hereby elects to adopt the mark-to-market method of accounting for the tax year ended Dec. 31, 2016 and subsequent tax years. The election applies to the following trade or business: Trader in Securities as a sole proprietor (for securities only and not Section 1256 contracts).” If you expect to have a loss in trading Section 1256 contracts, you can modify the parenthetical reference to say “for securities and Section 1256 contracts.” But remember, you’ll give up the lower 60/40 tax rates on Section 1256 contracts. If you trade in an entity, delete “as a sole proprietor” in the statement.

Form 3115 filing. Don’t forget an important second step: Existing taxpayers complete the election process by filing a Form 3115 (change of accounting method) with the election-year tax return. A 2016 MTM election filed by April 18, 2016 is reported and perfected on a 2016 Form 3115 filed with your 2016 tax returns in 2017 – by the due date of the return including extensions. Many accountants and taxpayers confuse this two-step procedure and they file the Form 3115 as step one on the election statement date. The IRS usually sends back the Form 3115, which can jeopardize ordinary-loss treatment.

Key strategy
If you have an individual $50,000 capital-loss carryover going into 2016, and you lose $50,000 in Q1 2016, it’s probably wise to elect Section 475 MTM as a sole proprietor for business ordinary loss treatment — and related tax relief — rather than digging a bigger hole of unutilized capital losses.

You can form a new entity for a “do over” to get back to capital gains treatment, so you can use up your capital loss carryovers. You have 75 days of additional hindsight once the entity commences business to file an internal Section 475 MTM election resolution for the entity trading. You’re hoping to generate capital gains in the entity to use up your remaining capital-loss carryovers and put off the Section 475 MTM election to the following entity year.

For more information on Section 475 and trader tax status, read Green’s 2016 Trader Tax Guide.

 


Don’t Sweat The Tax Deadline, Just Get An Extension

| By: Robert A. Green, CPA

It’s that time of year again: when birds chirp, buds grow on trees and you lose sleep over the April 15th tax deadline. It doesn’t have to be that way: You should have peace of mind to enjoy springtime. This year, the individual 2015 tax return deadline is April 18, 2016 (April 19, 2016 if you live in Maine or Massachusetts), and a six-month extension is available until Oct. 17, 2016.

Six-month extension of time to file
Take charge of your relationship with the IRS: Request an automatic six-month extension of time to file your federal and state income tax returns. Form 4868 instructions point out how easy it is to get this automatic extension — no reason is required.

It’s an extension of time to file a complete tax return, not an extension of time to pay taxes owed. In good faith, estimate and report on the extension form what you think you owe for tax year 2015 based on your tax information received.

Avoid penalties
Try to pay at least 90% of your actual tax return liability with the extension filing to avoid a late-payment penalty of 0.5% per month, up to a maximum of 25%. Filing a timely extension avoids the more onerous late-filing penalty of 5% per month, up to a maximum of 25%. Refer to Form 4868 for further details.

Here’s an example. Assume your 2015 tax liability is $50,000. You file an extension by April 18 but don’t pay any of your tax liability. You file your actual tax return on the extended due date of Oct. 15, 2016 with full payment. A late-payment penalty applies because you did not pay 90% of your tax liability on April 18. The late-payment penalty is $1,500 (6 months late x 0.5% per month x $50,000). Some traders view a late-payment penalty like a 6% margin loan. I’ve seen traders skip an extension payment to trade the tax money longer, only to lose it and cause bigger tax penalties. That’s risky.

By simply filing the extension on time in the above example, you avoided a late-filing penalty of $11,250 (6 months late x 5% per month (25% max), less late-payment penalty factor of 2.5% max, equals a net late-filing penalty of 22.5% x $50,000). Interest is also charged on taxes paid after April 18.

Pay extra with your tax extension
Profitable traders should consider making quarterly estimated tax payments due during the year to avoid underestimated tax penalties. I recommend the following strategy for traders and business owners: Overpay your tax extension on April 15 and apply an overpayment credit toward Q1 current-year estimated taxes. Most traders don’t make estimated tax payments until Q3 and or Q4, when they have more visibility on trading results. Why pay estimated taxes for Q1 and Q2 if you incur large trading losses later in the year?

It’s a better idea to add a cushion to your 2015 tax liability and payment with the extension filing. That gives you three good choices: You’ll have a cushion on 2015 if your estimates of tax liability are low, you can apply an overpayment credit toward 2016 taxes or you may request a tax refund for 2015 if no estimated taxes are due.

Benefits from filing extensions
Sophisticated and wealthy taxpayers know the real tax deadline is Oct. 17, 2016 for individuals and Sept. 15, 2016 for pass-through entities, including partnership and S-Corp tax returns.

You don’t have to wait until the last few days of the extension period like most wealthy taxpayers. Try to file your tax return in the summer months, when IRS and state auditor’s are on vacation. I think audit percentages drop after April 18.

I’ve always advised clients to be aggressive but legal with tax-return filings and look conservative with cash (tax money). Impress the IRS with your patience on overpayment credits and demonstrate you’re not hungry and perhaps overly aggressive to generate tax refunds. It’s a wise strategy for traders to apply overpayment credits toward estimated taxes owed on current-year trading income. You want to look like you’re going to be successful in the current tax year.

The additional time helps build tax positions like qualification for trader tax status in 2015 and 2016. It may open opportunities for new ideas on tax savings. A rushed return does not.  For example, a large trading gain or loss during the summer of 2016 could affect some decision-making about your 2015 tax return. It’s like having the stock market results of April 18 a day early on April 17.

The extension also pushes back the deadline for paying money into qualified retirement plans including a Solo 401(k), SEP IRA and defined benefit plan. If you did a Roth IRA conversion in 2015, you’ll have six months of additional time to recharacterize (unwind) the conversion. That may come in handy, if the stock market drops in Q2 and Q3 2016.

Working with accountants
Your accountant can prepare extension forms quickly for a nominal additional cost related to that job. There are no fees from the IRS or state for filing extensions.

Your accountant begins your tax compliance (preparation) engagement and he or she cuts it off when seeing a reliable draft to use for extension filing purposes. Your accountant will wait for final tax information to arrive after April 18 to complete your tax return. Think of the extension as a half-time break. It’s not procrastination; accountants want tax returns finished.

Please don’t overwhelm your accountants the last few weeks and days before April 18 with minor details on your tax return in a rush to file a complete tax return. Accounting firms with high standards of quality have internal deadlines for receiving tax information for completing tax returns. It’s unwise to pressure your accountant, which could lead to mistakes or oversights in a rush to file a complete return the last-minute. That doesn’t serve anyone well.

Broker 1099-Bs often come late
It’s difficult for securities traders to file a complete tax return by April 18 considering that many brokers send original and corrected Form 1099-Bs late. In some cases, this occurs just days before April 18, or even after.

In a blog post earlier this tax season, I pointed out how securities Form 1099-Bs are apples vs. oranges when it comes to applying Section 1091 wash sale loss rules for taxpayers. It’s a challenge to reconcile your own trade accounting with 1099-Bs so why stress over this reconciliation before the tax deadline? (Read my blog post Securities Brokers Don’t Tell The Full Story About Wash Sale Losses.)

It’s unwise to rush to file a complete tax return based on a 1099-B that could be corrected after filing. Corrected 1099-Bs based on complex cost-basis regulations have been par for the course the last few years. Why incur the cost and risk of filing an amended tax return? If you don’t reconcile your Form 8949 with the 1099-B, IRS computers will likely send you a tax notice, spotting differences under their matching program. (Read my blog post Traders: Don’t Talk To An IRS Agent Until You Read This.)

Traders should focus on trade accounting
If you know you’ll have a capital loss limitation of $3,000, it doesn’t matter if your capital loss is $50,000 or $75,000 at extension time. Either way, you’ll be reporting a capital loss limitation of $3,000 against other income. In this case, don’t get bogged down with trade accounting and reconciliation with Form 1099-Bs until after April 18.

Consider wash sale loss rules. If you know wash sale loss adjustments won’t change your $3,000 capital loss limitation, you can proceed with your extension filing. But if you suspect wash sale loss adjustments could lead to reporting capital gains rather than losses, or if you aren’t sure of your capital gains amount, focus your efforts on trade accounting well before April 18.  Trade accounting software downloads original transactions, not 1099-B information, so you won’t be held up waiting for 1099-Bs.

For Section 1256 contracts, you can rely on the one-page 1099-B showing aggregate profit or loss. For forex, you can rely on the broker’s online tax reports. Wash sales don’t apply to Section 1256 contracts and forex.

State extensions
Some states don’t require an automatic extension if you’re overpaid; they accept the federal extension. Generally in all states, if you owe taxes, you need to file a state extension with payment. States tend to be less accommodating than the IRS in waiving penalties, so it’s usually wise to cover your state first if you’re short on cash. Check the extension rules in your state.

U.S. citizens and resident aliens abroad
Excerpt from the IRS website: “If you are a U.S. citizen or resident alien residing overseas, or are in the military on duty outside the U.S., on the regular due date of your return, you are allowed an automatic two-month extension to file your return and pay any amount due without requesting an extension. For a calendar year return, the automatic two-month extension is to June 15. If you qualify for this two-month extension, penalties for paying any tax late are assessed from the two-month extended due date of the payment (June 15 for calendar year taxpayers). However, even if you are allowed an extension, you will have to pay interest on any tax not paid by the regular due date of your return (April 15 for calendar year taxpayers).”

Extensions for entities
Tax extensions for pass-through entities are March 15, 2016 for S-Corps and April 18, 2016 for partnerships with an extension due date of Sept. 15, 2016. (Note that the IRS recently changed the rule for next year: 2016 partnership tax returns will be due March 15, 2017 to synchronize with S-Corps.)

Pass-through entities are tax filers, not taxpayers, so the federal extension is simple to prepare without any tax liability. Be sure to file it on time because the late-filing penalty for missing the election is $195 per month per partner or shareholder up to a maximum of 12 months.

Some states have nominal franchise taxes, minimum taxes or excise taxes so check with your state or tax advisor. The state taxes are generally due with the extension filing. March 15 is also the deadline for an existing entity — LLC, C-Corp or general partnership (in most states) to elect S-Corp tax status. And March 15 is the date for existing S-Corps to elect Section 475 MTM treatment.

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes. It’s a prior and different version.




Tax Tips For Sole Proprietor Traders Preparing 2015 Tax Returns

February 15, 2016 | By: Robert A. Green, CPA

Click to read Green's blog post in Forbes

Click to read Green’s blog post in Forbes

The IRS hasn’t created specialized tax forms for individual trading businesses. Traders enter gains and losses, portfolio income, business expenses and investment expenses on various forms. It’s often confusing. Which form should you use if you’re a forex trader? Which form is best for securities traders using the Section 475 MTM method? The different reporting strategies for the various types of traders make tax time not so cut-and-dried.

Sole proprietor trading business
Other sole-proprietorship businesses report revenue, cost of goods sold and expenses on Schedule C. But business traders qualifying for trader tax status (TTS) report only expenses on Schedule C. Trading gains and losses are reported on various forms, depending on the situation. In an entity, all trading gains, losses and expenses are consolidated on the entity tax return — a partnership Form 1065 or S-Corp Form 1120-S. That’s one reason why I recommend entities for TTS traders.

Sales of securities must be first reported on Form 8949, which then feeds into Schedule D (cash method) with capital losses limited to $3,000 per year against ordinary income (the rest is a capital loss carryover). Capital losses are unlimited against capital gains.

Business traders who elect and use Section 475 MTM on securities report their business trades (line by line) on Form 4797 Part II. MTM means open business trades are marked-to-market at year-end based on year-end prices. Business traders still report sales of segregated investments in securities (without MTM) on Form 8949. Form 4797 Part II (ordinary gain or loss) has unlimited business ordinary loss treatment and avoids capital loss limitations and wash sale loss treatment. Form 4797 losses are counted in net operating loss (NOL) calculations.

Section 1256 contract traders (i.e., futures) should use Form 6781 (unless they elected Section 475 for commodities/futures; in that case, Form 4797 is used). Section 1256 traders don’t use Form 8949 — they rely on a one-page Form 1099-B showing their net trading gain or loss (“aggregate profit or loss”). Simply enter that amount in summary form on Form 6781 Part I. If you have a large Section 1256 loss, consider a Section 1256 loss carryback election to carryback those losses three tax years, but only applied against Section 1256 gains in those years. If you want this election, check box D labeled “Net section 1256 contracts loss election ” on the top of Form 6781.

Forex traders with Section 988 ordinary gains or losses who don’t qualify for TTS should use line 21 (other gross income or loss) on Form 1040. Traders who qualify for TTS should use Form 4797, Part II ordinary gain or loss. What’s the difference? Form 4797 Part II losses contribute to NOL carrybacks against any type of income, whereas Form 1040’s “other losses” do not. The latter can be wasted if the taxpayer has negative income. In that case, a contemporaneous capital gains election is better on the Section 988 trades. If you filed the contemporaneous Section 988 opt-out (capital gains) election, use Form 8949 for minor currencies and Form 6781 for major currencies. Forex uses summary reporting.

Schedule C issues
Sole-proprietor business traders report business expenses on Schedule C and trading income/loss and portfolio-related income on other tax forms, which may confuse the IRS. It may automatically view a trading business’s Schedule C as unprofitable even if it has large net trading gains on other forms. This is one reason why I recommend an entity. To mitigate this red flag, I advocate a special strategy to transfer a portion of business trading gains to Schedule C to “zero it out” if possible.

Transfer trading gains to Schedule C
In some cases, a good strategy for sole proprietorship business traders is to transfer some business trading gains to Schedule C to zero the income out, but not show a net profit. Showing a profit could cause the IRS to inquire about a self-employment (SE) tax, which otherwise trading gains are exempt from. (Traders who are full members of a futures or options exchange are an exception here; they have self-employment income under Section 1402(i) on their exchange-generated trading gains reported on Form 6781.)

This special income-transfer strategy also unlocks the home-office deduction and Section 179 (100%) depreciation deduction, both of which require income. While Section 179 depreciation can look to wage income outside the business, the bulk of home-office deductions can only look to business income. This transfer strategy isn’t included on tax forms or form instructions. It’s my suggested industry-accepted practice to date designed to deal with insufficient tax forms for sole-proprietorship trading businesses, and it must be carefully explained in footnotes — another important strategy for business traders. It also has the effect of allowing Schedule C losses in states like New Jersey that don’t allow them.

There is an alternative to the income-transfer strategy: Report gains from trading (from Form 4797, Form 8949, and Form 6781) on Line 8 of the home-office Form 8829. This is an alternative way to provide the necessary income required to generate a home office deduction. While this alternative method leaves Schedule C with larger losses – which is a red flag — it has the added benefit of reducing self-employment income (SEI) and/or net investment income (NII), thereby lowering SE tax and/or NIT. Consider this method if you have SEI from another Schedule C or K-1 business, or if you owe NIT under Obamacare thresholds. Perhaps you want higher SEI to unlock higher AGI deductions.

Include footnotes
I strongly recommend that business traders always include well-written tax-return footnotes, explaining trader tax law and benefits, why and how you qualify for TTS (business treatment), whether you elected Section 475 MTM or opted out of Section 988, and other tax treatment, such as the income-transfer strategy. If you’re a part-time trader, use the footnotes to explain how you allocate your time between other activities and trading. Including footnotes with your return takes a step to address any questions the IRS may have about your qualification for TTS and the various aspects of its reporting on your return before it has a chance to ask you.

This blog post is an excerpt from Green’s 2016 Trader Tax Guide (Chapter 6).


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.


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