Trader Tax Battle Of The States: Nevada Vs. New Hampshire

July 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.

Traders have unique tax issues on state and local income tax returns for business entities and individuals. Moreover, state and local tax regimes vary significantly. The preferred business entity for a trader is an S-Corp pass-through entity, which is free of entity-level federal taxation. Some states and cities subject S-Corps to taxation. (Read our recent blog post: A Few States Tax S-Corps: Traders Can Reduce It.)

In my five-part series “Trader Tax Battle Of The States,” I focus on state and local tax systems for S-Corps, LLCs, and partnerships. I mention basic information about individual income tax, estate and inheritance tax regimes. The numbers listed below are the states ranking by population.

35. Nevada:

NV enacted a Commerce Tax (CT), and the first fiscal year-end for this new tax regime is June 30, 2016. Per the CT sites below, “CT is imposed on businesses with a Nevada gross revenue (GR) exceeding $4,000,000 in the taxable year.” There are two exemptions applicable to a trading or investment company:

- “Passive entities are exempt if 90% of income is portfolio income, including capital gains from the sale of real property, gains from the sale of commodities traded on a commodities exchange and gains from the sale of securities.”

- Also exempt: “Intangible investments entity if it only owns and manages intangible investments, such as investments in other entities, bonds, patents, trademarks. Intangible investments include, without limitation, investments in stocks, bonds, notes and other debt obligations.”

COMMERCE TAX NEWS
COMMERCE TAX QUESTIONS AND ANSWERS
Exempt Status Entity Form for Exempt Entities registered with NV Secretary of State

NV does not have an individual income tax regime.

NV does not have an estate or inheritance tax system.

NV is one of the best states for traders.

42. New Hampshire:

NH has an 8.5% Business Profits Tax (BPT) “assessed on income from conducting a business activity within NH. Every business organization, organized for gain or profit carrying on business activity within the state is subject to this tax. However, organizations with $50,000 or less of gross receipts from all their activities are not required to file a return,” per Taxpayer Assistance – Overview of New Hampshire Taxes.

NH includes trading gains in gross receipts.

If you expect net trading gains of more than $50,000, forming an entity for your trading business in NH is unwise, since NH does not tax individuals on capital gains.

NH also has a 0.75% Business Enterprise Tax (BET) assessed on the Enterprise Value Tax Base (EVTB). The base is the “sum of all compensation paid or accrued, interest paid or accrued, and dividends paid by the business enterprise, after special adjustments and apportionment,” per above NH site.

NH has a limited individual income tax regime: A 5% tax on interest and dividend income, and no taxes on wages, capital gains, and other personal income.

NH does not have an estate tax or inheritance tax.

This blog post completes our five-part series “Trader Tax Battle Of The States.”

Attend our Webinar or watch the recording afterward: Trader Tax Battle Of The States.


Trader Tax Battle Of The States: New Jersey, Washington & Massachusetts

July 14, 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 have unique tax issues on state and local income tax returns for business entities and individuals. Moreover, state and local tax regimes vary significantly. The preferred business entity for a trader is an S-Corp pass-through entity, which is free of entity-level federal taxation. Some states and cities subject S-Corps to taxation. (Read our recent blog post: A Few States Tax S-Corps: Traders Can Reduce It.)

In my five-part series “Trader Tax Battle Of The States,” I focus on state and local tax systems for S-Corps, LLCs, and partnerships. I mention basic information about individual income tax, estate and inheritance tax regimes. The numbers listed below are the states ranking by population.

11. New Jersey:

NJ has an S-Corp Minimum Tax (MT) based on NJ gross receipts (GR), which includes net trading gains. It is $375 for less than $100,000 GR, $562.50 for less than $250,000 GR, $750 for less than $500,000 GR, $1,125 for less than $1M GR, and $1,500 if $1M GR or more. See S Corporation – MINIMUM TAX on Corporation Business Tax Overview.

NJ has a Partnership Filing Fee: “For New Jersey Gross Income Tax purposes, every partnership or limited liability company (LLC) that has income from sources in the State of New Jersey, or has a New Jersey resident partner, must file the New Jersey Partnership return, Form NJ-1065. The $150/partner fee is not to exceed $250,000 for each partnership with more than two partners. Assessed on partnerships with more than two partners AND having income or loss derived from New Jersey sources…,” per Partnership Filing Requirements.

NJ has a progressive individual income tax system, and the top rate is 8.97% on income over $500,000.

NJ individual income tax rates are lower than New York State/City rates, but many traders pay higher taxes in NJ because it does not allow deductions for losses. That includes business losses, caused by trading business expenses, net capital losses and net Section 475 ordinary trading losses. NJ only allows certain itemized deductions. NJ’s restrictions on deductions translate to higher effective tax rates. Many traders have net losses in some years, and they do not find tax relief in NJ.

NJ has an estate tax rate up to 16% and an exemption of $675,000, which is the lowest exemption in the country.

NJ has an inheritance tax rate up to 16%.

With high individual tax rates, disallowance of losses, high minimum tax on S-Corps, and the lowest estate exemption in the country, NJ is one of the worst tax states for traders.

13. Washington:

WA has a Business & Occupation Tax (B&O) assessed on gross receipts from business activities. See Business & Occupation tax. Tax rates vary by classification, with the highest rate 0.15% applying to a service business.

WA exempts a trading company from B&O tax, providing it does not have other types of income like management fees or profit allocation (carried interest) in a hedge fund.

WA does not have an individual income tax system.

WA has the highest estate tax rate (20%) in the country, and the estate exemption is 2.054M.

WA is a good tax state for traders to live in, but not a good place to pass away, if you exceed the estate exemption.

14. Massachusetts:

MA subjects S-Corps to a 0.26% Corporate Excise Tax (CET). It’s applied to MA tangible property or taxable net worth (TNW), which includes trading equity capital and undistributed trading income. The minimum CET is $456, which translates to $175,384 TNW. On $500,000 TNW, CET is $1,300. See MA Corporate Excise Tax.

S-Corps with high gross receipts, which includes net trading gains, may also be subject to an income tax measure of CET. “S-Corps with total receipts of $6 million or more are liable for the income measure of the corporate excise at the following rates: 1.83% on net income subject to tax if total receipts are $6 million or more, but less than $9 million; or 2.75% on net income subject to tax if total receipts are $9 million or more,” per MA tax site.

Most trading companies have trading gains under $6M, so they do not owe the income portion of CET. If you expect trading gains significantly over $6M, consider a dual entity structure: A trading general partnership, which is free of all CET, and an S-Corp management company paying the $456 minimum CET.

MA requires an LLC to file an annual report with a $500 fee. MA does not require an annual report from a general partnership.

MA has an individual income tax regime, with two flat tax rates for 2016. Per MA Personal Income Tax:

- 5.1% tax rate on earned income (salaries, wages, tips, commissions) and unearned income (interest, dividends, and certain capital gains);

- 5.1% tax rate on long-term capital gains (except collectibles);

- 12% tax rate on short-term capital gains, and Section 475 MTM ordinary income from trading gains earned by business traders who made a timely Section 475 election.

MA has an estate tax rate up to 16%. MA has an estate exemption of $1M, which is low among the fifteen states that have an estate tax regime.

Most MA residents pay individual income taxes at the 5.1% rate, which is competitive. But, traders owe the higher 12% rate on short-term capital gains and Section 475 ordinary income, which makes MA a bad tax state for traders.

Attend our Webinar or watch the recording afterward: Trader Tax Battle Of The States.


Trader Tax Battle Of The States: Midwest Vs. Southeast Top 10 States

| By: Robert A. Green, CPA

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

Traders have unique tax issues on state and local income tax returns for business entities and individuals. Moreover, state and local tax regimes vary significantly. The preferred business entity for a trader is an S-Corp pass-through entity, which is free of entity-level federal taxation. Some states and cities subject S-Corps to taxation. (Read our recent blog post: A Few States Tax S-Corps: Traders Can Reduce It.)

In my five-part series “Trader Tax Battle Of The States,” I focus on state and local tax systems for S-Corps, LLCs, and partnerships. I mention basic information about individual income tax, estate and inheritance tax regimes. The numbers listed below are the states ranking by population.

5. Illinois:

IL has a 1.5% Replacement Tax (RT) on partnerships, trusts, and S corps. There is an exemption for an “investment partnership” per Illinois Income Tax Act (IITA) Section 1501(a)(11.5). An LLC filing a partnership return qualifies for this exemption, but an S-Corp does not.

The 1.5% RT rate is meaningful, so it is important for traders to reduce it. There are two ways: Trade a smaller amount of funds in an S-Corp, so you do not owe significant RT.

Alternatively, if you have a larger amount of capital and expect high income, use a dual entity structure: A trading general partnership, which is exempt from RT, and an S-Corp management company, with reduced RT. The partnership pays the S-Corp a monthly administration fee and profit allocation defined in the partnership agreement. The S-Corp lowers it’s net income and RT, by deducting officer compensation and employee benefit plans, including health insurance premiums and retirement plan contributions. Most trading income remains in the general partnership, free of RT.

IL has an individual income tax system with a 3.7% flat rate.

IL has an estate tax rate up to 16% and an exemption of 4M.

IL reminds me of New York City, with lots of traders working for banks and trading firms nearby commodity and futures exchanges. While most people do not think of IL as a low tax state, its 3.7% flat tax rate on individual income is competitive, and traders can reduce RT on S-Corps.

6. Pennsylvania:

The PA legislature repealed the Capital Stock Tax on LLCs and S-Corps and completed the phase-out by December 31, 2015.

PA has an individual income tax system with a 3.07% flat rate.

PA has an inheritance tax rate up to 15%, but no estate tax.

7. Ohio:

OH has a 0.26% Commercial Activity Tax (CAT) based on taxable gross receipts (TGR). TGR do not include interest (other than from installment sales), dividends, and capital gains. See the CAT table at Important Changes to the Commercial Activity Tax in 2014.

A trading company should owe the minimum CAT of $150 since TGR excludes trading gains.

OH has a progressive individual income tax system, and the top rate is 4.997% on income over $208,500.

OH has no estate or inheritance tax.

8. Georgia:

GA has a net worth (NW) tax on S-Corps. The tax table has many brackets, and here are some examples: $100 for NW less than $100,000, $250 for NW less than $500,000, and $500 for NW less than $1M. See Net Worth Tax Table (pages 8-10) in GA’s 2015 S-Corp Income Tax instructions.

NW includes equity and undistributed income, which means it includes trading capital and undistributed trading gains.

S-Corps and partnerships do not pay an income tax, except they must withhold personal income tax on amounts paid to nonresident shareholders and partners.

GA has a progressive individual income tax system, and the top rate is 6% on income over $10,000 (married filing joint).

GA does not have an estate or inheritance tax.

9. Michigan:

MI does not subject S-Corps and partnerships to Corporate Income Tax (CIT) unless it is a financial institution or insurance company.

MI has an individual income tax system with a 4.25% flat rate.

MI does not have an estate or inheritance tax.

10. North Carolina:

NC has a 0.15% Franchise Tax (FT) on S-Corps based on net worth (NW) or appraised value of NC tangible property. The minimum FT is $35. For example, FT is $150 on $100,000 NW. 2015 North Carolina S Corporation Tax Return Instructions on page 3.

Trading equity capital is part of NW, so if you have significant trading capital, consider a dual-entity trading structure: A trading partnership, which is free of FT, and an S-Corp management company with reduced FT, after paying officer compensation and employee benefit plans.

NC has an individual income tax system with a 5.75% flat rate.

NC does not have an estate or inheritance tax.

Attend our Webinar or watch the recording afterward: Trader Tax Battle Of The States.


Trader Tax Battle Of The States: New York Vs. Florida

| By: Robert A. Green, CPA

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

Traders have unique tax issues on state and local income tax returns for business entities and individuals. Moreover, state and local tax regimes vary significantly. The preferred business entity for a trader is an S-Corp pass-through entity, which is free of entity-level federal taxation. Some states and cities subject S-Corps to taxation. (Read our recent blog post: A Few States Tax S-Corps: Traders Can Reduce It.)

In my five-part series “Trader Tax Battle Of The States,” I focus on state and local tax systems for S-Corps, LLCs, and partnerships. I mention basic information about individual income tax, estate and inheritance tax regimes. The numbers listed below are the states ranking by population.

3. New York State/City:

You can have an S-Corp for federal and New York State tax purposes, but New York City will disregard your S-Corp tax status and treat it as a C-Corp, a regular corporation. That means your S-Corp owes NYC General Corporation Tax (GCT) of 8.85% on net income.

First, reduce net income with deductions for officer compensation and employee benefit plans. If your income is over $200,000, you may trigger “alternative tax,” which requires adding back officer compensation for an alternative GCT calculation. If you trade significant capital with great success, you may need higher officer compensation to get close to breaking even on the NYC corporation tax return. Higher compensation means higher payroll taxes, but it avoids NYC GCT.

- New York State/City Minimum Tax: There is an NYS S-Corp “fixed dollar minimum tax” based on NYS receipts, which includes trading gains. NYS lowered this minimum tax over the past few years. Currently, it is only $25 if receipts are not more than $100,000, $50 if not more than $250,000, $175 if not more than $500,000 and it rises from there. New York City has a similar fixed dollar minimum tax regime.

- New York City: 4% Unincorporated Business Tax (UBT) applies on unincorporated businesses including LLCs filing partnership returns, general partnerships, and sole proprietorships. NYC exempts a trading company from UBT, providing the company does not have any business income like brokerage commissions, or asset management fees. The company must solely derive its revenue from portfolio income, including capital gains.

Many investment managers and private equity managers use two management companies in NYC to reduce UBT. An LLC or S-Corp for receiving management fees, subject to UBT or GCT. And, an LLC filing a partnership return for receiving capital gains and portfolio income from the underlying hedge fund or private equity fund as profit allocation, otherwise referred to as “carried interest.”

On Feb. 4, 2016, NYC submitted a resolution to “eliminate the exemption of private investment fund carried interest from the New York City unincorporated business tax.” Minutes of the Stated Meeting Feb. 24, 2016, state: “Resolved, That the Council of the City of New York, calls upon the President of the United States to close the federal carried interest tax loophole using executive action.” In other words, NYC did not repeal carried interest. NYC proposed similar repeal in 2012 but did not enact repeal at that time, either.

NYS and NYC have progressive individual income tax systems. The top NYS rate is 8.82% on income over $2,125,450. The top NYC resident rate is 3.876% on income over $500,000. An NYC resident has a combined top rate of 12.7%.

NYS has an estate tax rate up to 16% and an exemption of 3.125M, which is below the federal exemption of $5.450M for 2016.

Many traders working for banks and hedge funds work and live in NYS/C, but online traders often move to a tax-free state like Florida to avoid high state/city taxes on S-Corps, individual income, and estates. It is not easy to change your tax residence away from NYS/C. Read my blog post: Bill de Blasio’s tax-the-rich plan.

4. Florida:

Florida does not tax S-Corps, or LLC’s filing as a partnership unless the LLC has a corporate owner. FL does tax corporations, see Florida’s Corporate Income Tax.

FL does not have an individual income tax system.

FL does not have an estate or inheritance tax regime.

With no state tax on S-Corps, individuals or estates, FL is one of the best tax states for online traders.

Learn the rules for establishing residency in Flordia. Read Florida Residency.

Attend our Webinar or watch the recording afterward: Trader Tax Battle Of The States.


Trader Tax Battle Of The States: California Vs. Texas

| By: Robert A. Green, CPA

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

Trading is a virtual business: All you need is money, a home office with computers, multiple monitors, high-speed Internet, market information and other trading services. Trading does not require an outside office or customers.

As a trader, you can move to a tax-friendly state. For example, if you retire from a job in high-tax California, New York State/City, Massachusetts, or New Jersey, you can move to tax-friendly Texas, Florida, or Washington.

Seven states do not have individual income tax regimes including Texas, Florida, Washington, Nevada, South Dakota, Alaska, and Wyoming. Tax Foundation publishes a handy state map: State Individual Income Tax Rates and Brackets for 2016.

“Currently, fifteen states and the District of Columbia have an estate tax, and six states have an inheritance tax. Maryland and New Jersey have both,” according to Tax Foundation’s Does Your State Have an Estate or Inheritance Tax? Many of the states with an estate or inheritance tax are in the northern part of the country.

In my five-part blog series “Trader Tax Battle Of The States,” I list states by population size. I cover the top eleven states, plus others, too. Over the past decade, some high-tax states lowered taxes to be more competitive and slow the exodus of residents to tax-free states. A few jurisdictions tax S-Corps, the preferred choice of entity for business traders, and I explain ways to reduce state or city S-Corp taxes.

1. California:

- S-Corps owe Franchise Tax (FT), which is the greater of 1.5% of net income or $800 minimum tax, even in a short year. There are two exceptions to minimum FT: For a first-year S-corp, or an S-Corp formed after Dec. 17, providing it did not conduct business until Jan. 1 of the following year. CA S-Corps.

The 1.5% FT rate is meaningful, so it is important for traders to reduce it. There are two ways: Trade a smaller amount of funds, so you do not owe FT above the $800 minimum. Alternatively, use a dual entity structure: A trading general partnership, which is exempt from FT, and an S-Corp management company for employee benefit plan deductions with lower income, and thereby lower FT.  Most trading income remains in the general partnership, free of FT.

The S-Corp’s income should be under $53,333, so you pay the $800 minimum tax only ($800 divided by 1.5% FT equals $53,333).  Calculate S-Corp net income after deducting officer compensation, health insurance, and retirement plan contributions. The partnership pays the S-Corp a monthly administration fee and profit allocation defined in the partnership agreement. The S-Corp needs this income to pay compensation and the employee benefits. In effect, the dual entity structure carves out net income to limit FT to the minimum, and the remainder of the income is exempt from FT. For a trader with consistent trading income over several hundred thousand, the dual entity structure delivers meaningful tax savings.

There are two routes to S-Corp tax treatment: Form an LLC or Corporation, and elect S-Corp treatment on Form 2553 within 75 days of inception.

- LLC tax: An LLC owes the $800 minimum FT, but not the 1.5% FT rate paid by S-Corps. The minimum FT applies to single-member LLC’s (SMLLC), LLC’s filing a partnership tax return, and limited partnerships (LP’s). General partnerships are exempt from the $800 minimum tax.

- LLC fee: There is a fee based on gross income: $0 if gross income is under $250,000, $900 if under $500,000, $2,500 if under $1M, $6,000 if under $5M, $11,790 if over $5M. Instructions (page 2 LLC Fee). Gross income includes net trading gains.

CA has a progressive individual income tax system, and the top rate is 13.3% on income over $1 million. Tax Table.

CA does not have an estate or inheritance tax.

2. Texas:

- Franchise Tax (FT) on limited liability entities and trusts. The FT rate is 0.75% for most entities times gross margin (defined below). The no tax due threshold is $1.11 million. TX exempts general partnerships from FT, providing they are owned entirely by natural persons.

“Exempt entities: Passive entities including partnerships (general, limited and limited liability) and trusts (other than business trusts) may qualify as a passive entity and not owe any franchise tax for a reporting period if at least 90% of the entity’s federal gross income is from net capital gains from the sale of real property, net gains from the sale of commodities traded on a commodities exchange and net gains from the sale of securities,” per 2016 Texas Franchise Tax Report Information and Instructions.

Unfortunately, an S-Corp does not qualify as an exempt entity.

Gross margin is total revenue times 70%, minus Cost of Goods Sold (COGS), minus allowed compensation, minus the no tax due threshold of $1.11 million. After this calculation, most traders will not have an amount subject to FT, and there is no minimum FT.

If you expect significant trading income, which subjects you to a material amount of FT, consider a dual entity solution: A trading general partnership or LLC, which is exempt as a passive entity, and an S-Corp management company, which won’t exceed the FT threshold.

Few TX traders pay FT.

TX does not have an individual income tax.

TX does not have an estate or inheritance tax.

TX is one of the best tax states for traders.

See the rest of my upcoming five-part blog series: Trader Tax Battle Of The States
New York Vs. Florida;
Midwest Vs. Southeast Top 10 States;
New Jersey, Washington & Massachusetts;
Nevada, New Hampshire & District Of Columbia

Attend our Webinar or watch the recording afterward: Trader Tax Battle Of The States.

 


A Few States Tax S-Corps: Traders Can Reduce It

July 6, 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 qualifying for trader tax status need an S-Corp structure if they want tax-advantaged employee benefit plans, including health insurance and retirement, saving thousands in taxes. Conversely, if they use a partnership or sole proprietor structure, traders cannot have employee benefit plan deductions.

An S-Corp is tax-free on the entity level for federal tax purposes, and most states have small minimum taxes on S-Corps. However, a few jurisdictions have higher taxes: On S-Corp net income, Illinois has a 1.5% Replacement Tax, California a 1.5% Franchise Tax, and New York City an 8.85% General Corporate Tax. In those jurisdictions, I recommend a dual entity structure for high-income traders: A trading general partnership, which is free of state or NYC taxes, and an S-Corp management company with a low income and little state or NYC taxes.

Illinois Replacement Tax
S-Corps and partnerships operating in Illinois are liable for IL replacement tax of 1.5% on net income. There’s an important exception applicable to traders:  an “investment partnership” is exempt from IL replacement tax. An investment partnership doesn’t have to file an IL Form 1065 partnership tax return. (See Illinois Income Tax Act Section 1501(a)(11.5)).

The investment partnership exception does not apply to an S-Corp. If the trading company files an S-Corp Form 1120-S federal tax return, it must also file an IL Form 1120-ST (Small Business Corporation Replacement Tax Return) and pay the replacement tax.

California Franchise Tax
S-Corps operating in California are liable for CA franchise tax of 1.5% on net income. The minimum franchise tax is $800 per year, even in a short year. $800 divided by 1.5% equals $53,333. That means an S-Corp owes franchise tax above the $800 minimum tax after net income exceeds $53,333. Deduct officer compensation and employee benefit plans in calculating net income. General partnerships are not liable for an $800 minimum tax, but LLCs are. Only the S-Corp owes 1.5% franchise tax.

New York City General Corporation Tax
You can have an S-Corp for federal and New York State tax purposes, but New York City will disregard your S-Corp tax status and treat it as a C-Corp, a regular corporation. That means New York City will expect your S-Corp to pay General Corporation Tax (GCT) of 8.85% on net income. Reduce net income with deductions for officer compensation and employee benefit plans. If your income is high, you may trigger some “alternative tax,” which requires adding back officer compensation with an alternative tax calculation.

Strategies to limit state taxation
If you have trading gains not exceeding $200,000 per year in Illinois, California, or New York City, it’s okay to use an S-Corp, providing you plan to maximize retirement plan contributions using a Solo 401(k). From the $200,000 trading gains in the S-Corp, deduct the maximum $140,000 of officer compensation needed to unlock the maximum Solo 401(k) plan contribution limit of $53,000, or $59,000 with the over-age 50 catch-up provision. Net income will be low, thereby limiting state or NYC taxes.

If you consistently have trading gains over $300,000 per year in Illinois, California, and New York City, consider a dual entity structure: A trading general partnership, which is free of state or NYC taxes, and an S-Corp management company with a low income and little state or NYC taxes.

The trading company pays the management company monthly administration fees, and a “profit allocation,” which is a share of trading gains. With this income, the management company pays officer compensation and employee benefit plans. The goal is for the management company to have a minor net income to reduce state or NYC taxes. With proper tax planning, tax savings from the dual-entity solution should well exceed tax compliance costs for the two entities.

State and city taxation varies, so consult with a trader tax advisor.

Read my upcoming five-part blog series and attend our Webinar: Tax Battle Of The States.

Darren Neuschwander CPA contributed to this blog post.


Tax Treatment For Volatility Products Including ETNs

June 27, 2016 | By: Robert A. Green, CPA

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

After the Brexit referendum vote on June 24, 2016, volatility-based financial products skyrocketed in price, and by Monday, June 27, prices had subsided. That’s volatility!

There are many different types of volatility-based financial products to trade, and tax treatment varies. For example, CBOE Volatility Index (VIX) futures are taxed as Section 1256 contracts with lower 60/40 MTM tax rates. The NYSE-traded SVXY is an exchange-traded fund (ETF) taxed as a security. The iPath S&P 500 VIX Short-Term Futures (VXX) is an exchange-traded note (ETN), and while tax treatment is similar to an ETF, there is uncertain tax treatment on ETNs. I focus this blog post on tax treatment for ETNs.

How ETN’s work
Per TAX STRATEGIES FOR LONG-SHORT EQUITY, Practical Tax Strategies, Sep 2014: “An exchange traded note (ETN) can be linked directly to an active index. An ETN is similar to a bond except the interest rate is replaced with the return of an index.” “ETNs include significant creditor risks because they are not backed by underlying assets, but only by the issuer’s ability to pay at maturity (which may be 30 years in the future).” This creditor risk probably increased after the Brexit vote, as many of these banks operate in the U.K. and European Union. Day traders are not as concerned with creditor risks.

VXX prospectus discusses tax treatment
In the prospectus for iPath® S&P 500 VIX Short-Term Futures ETN, tax attorneys write “by purchasing the ETNs you agree to treat the ETNs for all U.S. federal income tax purposes as a pre-paid executory contract with respect to the applicable Index. If the ETNs are so treated, you should generally recognize capital gain or loss upon the sale, early redemption or maturity of your ETNs in an amount equal to the difference between the amount you receive at such time and your tax basis in the ETNs. The U.S. federal income tax consequences of your investment in the ETNs are uncertain.”

Tax publishers use a similar term: “prepaid forward contracts” and tax treatment calls for deferral of taxes until sale and long-term capital gains rates if held 12 months. Constructive receipt of income rules prevents tax avoidance with offsetting positions.

Traditionally, ETN’s are tax advantaged because they allow deferral until realization (sale) and lower long-term capital gains rates if held 12-months. That’s good for investors. But, day and swing traders don’t benefit from deferral and long-term rates; they incur short-term capital gains taxes throughout the year taxed at ordinary rates.

Traders would rather have the option of using Section 1256 tax treatment on volatility ETNs including lower 60/40 capital gains rates. That’s how the IndexCBOE: VIX is taxed. (60% is lower long-term capital gains rates up to 20%, even on day trades, and the other 40% are short-term capital gains at ordinary rates.) Section 1256 also requires mark-to-market (MTM) accounting, imputing sales on open positions at year-end and that’s not a problem for day traders.

IRS ruling
The IRS caused questions when it issued Rev. Rul 2008-1 about foreign currency linked ETN’s. The IRS also issued Rev. Ruling 2008-2 asking for comments on prepaid forward contracts and similar arrangements. The IRS has not yet issued final guidance on ETN’s.

In Rev. Ruling 2008-1, the IRS “looked through” the currency ETN to the underlying market bet on the Euro and market interest rates. The IRS objected to the ETN benefiting from tax deferral and long-term capital gains rates when the underlying foreign currency transactions (Section 988) would require ordinary gain or loss treatment. Plus, debt instruments require accrual of annual interest income. The IRS knows that traditional ETN tax treatment prejudices Treasury, and it would prefer to accrue income and use ordinary rather than capital gains tax rates.

ETFs based on volatility
The IRS can’t apply this same look through logic to ETF’s because as a “registered investment company” (RIC), security ETF’s are taxed as securities.  A commodity ETF can’t use the RIC structure; it’s a publically traded partnership also taxed as securities. A commodity ETF issues a Schedule K-1 passing through Section 1256 contract income or loss.

ProShares has three volatility ETF’s: ULTRA VIX SHORT-TERM FUTURES ETF (NYSEArca: UVXY), SHORT VIX SHORT-TERM FUTURES ETF (NYSEArca: SVXY), and VIX SHORT-TERM FUTURES ETF (NYSEArca: VIXY).  These ProShares ETF’s are taxed as securities: Unlike ETN’s, ETF RIC’s make annual distributions of income and capital gains to shareholders. ETF’s don’t provide as much deferral as ETN’s.

Possible alternative tax treatments for ETN’s
In the VXX prospectus, tax attorneys suggest that Section 1256 is a “possible alternative” tax treatment. “Moreover, it is possible that the IRS could seek to tax your ETNs by reference to your deemed ownership of the Index components. In such a case, it is possible that Section 1256 of the Internal Revenue Code could apply to your ETNs, in which case any gain or loss that you recognize with respect to the ETNs that is attributable to the regulated futures contracts represented in the applicable Index could be treated as 60% long-term capital gain or loss and 40% short-term capital gain or loss, without regard to your holding period in the ETNs… And, currently accrue ordinary interest income in respect of the notional interest component of the applicable Index.”

When traders talk about volatility products, they often conflate tax treatments. Until we get further formal guidance from the IRS, the tax treatment on volatility and other ETN’s is uncertain. Consult with a trader tax expert.

Darren Neuschwander, CPA contributed to this blog post.


Some Proprietary Traders Under-Report Income

June 6, 2016 | By: Robert A. Green, CPA

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

Proprietary traders are significantly different from retail traders. Proprietary traders don’t trade their capital. They trade the firm’s capital, usually accessed from a sub-trading account. A prop trader becomes associated with a prop-trading firm either as an independent contractor (1099-Misc), an employee (W-2) or an LLC member (Schedule K-1).

Independent contractors
Profitable independent contractor (IC) proprietary traders receive a 1099-Misc for “non-employee compensation.” Sole proprietors use a Schedule C to report revenue and deduct business expenses. Schedule C net income is subject to federal and state income taxes, and self-employment (SE) taxes.

Reinvesting earnings are taxable income
Prop traders generate trading gains on their sub-trading account. At the end of a defined period, usually monthly, the firm presents them with a choice: Request a fee payment (distribution of earnings) or reinvest income in their sub-trading account. 

Some prop firms only include fee payments on annual tax form 1099-Misc. They don’t include reinvested earnings. That’s a problem: In the above scenario, reinvested earnings constitute “constructive receipt of income,” which should be reportable income. 

This firm’s prop traders are likely under-reporting income since many will inadvertently or purposely overlook reporting reinvested earnings on Schedule C. Taxpayers are responsible for reporting their correct income, even income that should be included on 1099s but is not.

Constructive receipt of income
In the June 2004 issue of Strategic Finance Magazine: “Constructive Receipt and the Substantial Restrictions Limitation,” Charles E. Price, Ph.D., “Treas. Regs. Sec. 1.451-2 explains that a taxpayer need not have physical possession for an amount to be included in gross income. Income that is set aside for the taxpayer, credited to an account, or otherwise made available is constructively received by the taxpayer. If the taxpayer’s control is subject to “substantial limitations or restrictions,” however, the income isn’t considered to be received.”

“Constructive receipt requires an unqualified vested right to receive income – there can be no condition, limitation, or restriction that prevents the taxpayer from having unrestricted access to his or her money without penalty. The taxpayer, however, can’t waive a present right to receive income— in other words, the taxpayer may not “turn his back” on income that is already earned. But if the taxpayer requests deferral of payment prior to receiving an unqualified vested right to income, constructive receipt doesn’t occur.”

“The key to recognition or deferral is an unrestricted present right of the taxpayer to control the disposition of the income. If substantial limitations or restrictions hinder the taxpayer’s right of access to income, then recognition can be deferred. Taxpayers who seek to defer income recognition must avoid an unqualified right to control that income.”

The trader’s income is set aside and credited to his sub-trading account for his benefit.

 The trader receives an unrestricted, present right to control the disposition of the income, so income deferral is inappropriate.

Example:
A prop trader pays $5,000 as a deposit or expense to a prop trading firm, and the firm gives them a limited power of attorney to trade a sub-trading account containing $25,000.

In month 1, the trader earns $1,000. (Generally, a prop trader receives around 70% of trading gains in the form of non-employee compensation.) The sub-trading account balance is now $26,000. 

The firm offers the trader a distribution (fee payment) of $1,000, but the IC may decline (turn his back on income) and reinvest the $1,000 in the sub-trading account.

After a few additional months with trading gains, the sub-trading account balance is $30,000 containing: reinvested earnings of $5,000, $25,000 of firm capital, and no fee payments to the trader. The firm decides to allocate another $25,000, so the trader is now trading a sub-account with $55,000.

 At the end of the calendar year, the account balance is $65,000 containing trader earnings of $15,000, $50,000 of the firm’s capital, and no fee payments to the trader. 

In the above example, the firm we spoke with would not issue a 1099-Misc because they did not pay fees during the year. The trader’s $15,000 of reinvested earnings meets the IRS definition of a constructive receipt of income, so the firm should report it on a 1099-Misc.

The IRS holds the trader responsible for reporting $15,000 of revenue on Schedule C whether or not the prop trading firm issues a correct 1099-Misc. 
The IRS may also assess a tax penalty to the firm for under-reporting on a 1099-Misc.

Losses of reinvested earnings
Assume the same facts as in the above example; only the trader has $6,000 in trading losses in December. That leaves an account balance of $59,000, containing trader earnings of $9,000, $50,000 of the firm’s capital, and no fee payments.

It may be acceptable to net the losses against the income by issuing a 1099-Misc for $9,000. Otherwise without netting, the 1099-Misc should be for $15,000, and the prop trader can report a $6,000 business bad-debt deduction on Schedule C. Firms should provide traders’ with accounting for reinvested earnings.

Initial deposits
Aspiring traders have two choices: Open a retail trading account or join a prop trading firm.

Retail traders place a deposit with a broker-dealer. If they want to day trade securities, four or more times in five business days, they need “pattern day trading” (PDT) privileges allowing a 4:1 margin and the minimum account size is $25,000. Otherwise, a retail trader is limited by Reg T margin rules to a 2:1 margin.

Many securities traders can’t afford $25,000, and they are drawn to prop trading firms offering higher leverage with less money required upfront. Some prop trading firms ask prop traders for a deposit or another type of payment. Some firms use murky accounting and tax classifications to avoid calling it a “deposit” because they are non-customer broker-dealers who may not accept deposits. Only customer broker-dealers accept deposits. Non-customer broker-dealers also have lower capital requirements and less regulatory scrutiny versus customer broker-dealers.

Some prop trading firms classify initial deposits and reinvested earnings as education expenses or other service expenses, reporting revenue for these payments in the firm’s books and records. But, there are conflicts with sales materials and other paperwork referring to the payments as a deposit or a share of capital.

If a prop trader loses an initial deposit, he can report a business bad-debt deduction on Schedule C, provided they have entered into an independent contractor agreement for rendering trading services.

For other tax tips for prop traders, read Green’s 2016 Trader Tax Guide, Chapter 12 Proprietary Trading.

 Darren Neuschwander, CPA, contributed to this article.

Webinar June 21 & Recording: Proprietary Trader Tax Treatment & Recent Developments

 


Top 10 Tax Deductions For Active Traders

May 31, 2016 | By: Robert A. Green, CPA

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

Active traders qualifying for trader tax status (TTS) maximize these deductions in the following ways:

1. Home-office (HO) deductions 
Use the square footage or rooms method to allocate every expense of your home including mortgage interest, real estate taxes, rent, utilities, repairs and maintenance, insurance and depreciation. The IRS limits use of HO expenses by requiring business income to offset the deduction, except for the mortgage interest and real estate tax portion. Link the HO Form 8829 to TTS trading gains or transfer some to Schedule C to unlock the HO deduction. If you have trading losses, carry over unallowed HO deductions to subsequent tax year(s). Converting personal home expenses to business use is great.

2. Additions and improvements to office
Consider an addition or improvements to your home office like building more space, replacing windows, walls, and flooring. Depreciate residential real property over 39 years on a straight-line basis. If you rent or own an outside office, depreciation rules are more attractive. The Protecting Americans From Tax Hikes (PATH) Act of 2015 created “qualified improvement property.” It’s a new class of nonresidential real property, excluding additions like increasing square footage. Use 50% bonus depreciation on qualified improvement property placed in service in 2016. PATH extended bonus depreciation through 2019.

3. Tangible property expensing
Expense new tangible property items up to $2,500 per item. Before 2015, the IRS threshold for capitalization with depreciation vs. full expensing was $500. When you purchase a new trading computer system its best to arrange separate invoices for each item not exceeding $2,500.

4. Section 179 (100%) depreciation
For equipment, furniture and fixtures above the tangible property threshold ($2,500), use Section 179 depreciation allowing 100% depreciation expense in the first year. PATH made permanent generous Section 179 limits. The 2016 limit is $500,000 on new and used equipment including off-the-shelf computer software. The IRS limits the use of Section 179 depreciation by requiring income to offset the deduction. Look to business trading gains, other business income or wages, from either spouse, if filing joint.

5. Automated trading systems
Increasingly, traders are writing computer code for developing automated trading systems. The IRS allows a few different choices for expensing “internal-use software.” If you qualify for TTS before incurring software development costs, deduct them like other research expenses in Section 174(a) in the year paid. If you don’t qualify for TTS before incurring software development costs, capitalize them under Section 174(b). Two choices: When you complete the software and qualify for TTS, amortize (expense) the intangible asset over 60 months. Or, wait until you place the software in service with qualification for TTS to amortize (expense) the intangible asset over 36 months. Traders may qualify for TTS using automated trading systems providing they write the code or have other significant involvement with creation and modification of the automated trading systems. Conversely, if a trader purchases an off-the-shelf automated trading system providing entry and exit signals and trade execution, the trader probably doesn’t get credit for the volume and frequency of trades made by the automated trading system.

6. Education, mentoring and seminars
All three are considered education expenses and tax deductibility hinges on qualification for TTS. Education business expenses paid after the start of your business are allowed for maintaining and improving your business. Learning a new business before starting that business is not allowed as a business expense. If you are learning about investing while carrying on an investment activity, that education expense is not allowed as a Section 212 investment expense by Section 274(h)(7). Tip: If you pay for trading education services before qualifying for TTS, consider using Section 195 start-up expenditures treatment below.

7. Section 195 start-up expenditures
Go back a reasonable period (six months) before qualifying for TTS to capitalize a reasonable amount ($15,000) of start-up costs. Start-up expenses include costs to investigate and inquire about a new business. Costs capitalized in Section 195 would have to qualify as a business expense if paid after business commencement. Section 195 allows an expense allowance in the first year up to $5,000. Start a calendar year business late in the year and still get the full $5,000 expense allowance. Amortize the remainder of the costs over 180 months on a straight-line basis. If you exit the trading business, you may write off the unamortized balance.

8. Organization costs
Under Section 248 for corporations and Section 709 for partnerships, treat expenses to organize or form an entity in a similar manner as Section 195 start-up expenditures. There is a separate first-year expense allowance up to $5,000, and the balance is amortizable over 180 months on a straight-line basis.

9. Health insurance premiums
Deduct health insurance premiums from individual AGI if you have an S-Corp trading company paying you W-2 wages which include your premiums. The plan must be in association with your small business and not a third-party employer plan for you or your spouse. Deduct health insurance premiums during the entity period, not before. This S-Corp wage component for health insurance premiums is not subject to social security and Medicare taxes, so enjoy the income tax savings with no offsetting payroll tax costs. A C-Corp management company deducts health insurance premiums on the corporate tax return.

10. Retirement plans
Most traders with TTS should consider a Solo 401(k) retirement plan. Consistently high-income traders with TTS should consider a defined benefit plan if they are close to age 50. Retail traders need an entity like an S-Corp trading company or C-Corp management company to arrange retirement plan deductions since sole proprietor traders don’t have earned income required for employee benefit plan deductions. With one exception: Futures traders using full exchange membership have self-employment income (Section 1402i).

Solo 410(k) plan: S-Corp officer wages of $140,000 unlock the maximum $53,000 contribution/deduction or $59,000 if age 50 or older with the $6,000 catch-up provision. The 100%-deductible elective deferral up to $18,000, or $24,000 with the catch-up provision, provides the greatest income tax savings vs. payroll tax costs. The 25%-deductible profit-sharing plan up to $35,000 is good if you have sufficient cash flow to invest in tax-free compounded growth within the plan.

Defined-benefit plan (DBP): With consistent high trading income, arrange a $100,000 plus contribution/deduction with a defined-benefit plan. Work with an actuary on complex DBP calculations.

Business traders have a wide variety of other expenses including independent contractors and employees for trade assistance and IT, market data providers, charting software, chat rooms and trading groups, subscriptions, books, periodicals, attorneys, accountants, tax advisors and more.

Commissions are not expenses; they are part of the trading capital gain or loss.

Business expenses are deductible “above the line” from gross income, whereas investment expenses face significant limitations “below the line.” Section 212 investment expenses exclude home office, start-up expenditures, employee benefits and education. They are part of miscellaneous itemized deductions, which must first exceed a 2% of AGI threshold. Upper-income taxpayers face additional limitations: a Pease itemized deduction phase-out and AMT taxes since investment expenses are an AMT preference item.

Learn how to qualify for TTS on GreenTraderTax.com.

Related Webinar & Recording: Top 10 Tax Deductions For Active Traders


Section 481(a) Positive Adjustment Spread Period Changes

May 26, 2016 | By: Robert A. Green, CPA

According to tax research service Thomson Reuters CheckPoint, “Under the new procedures for filing a Form 3115 for tax year 2015 and forward, the four-year spread period generally applicable to a positive Section 481(a) adjustment has been modified as De minimis § 481(a) adjustment amount increased. Under a de minimis provision, positive adjustment may be spread over one year (versus four years) at the taxpayer’s election. The new procedures increases the de minimis threshold to $50,000 from $25,000. The election is made on the new Form 3115 (Rev 12-2015), Part IV, Line 27.”

This means that a trader with a Section 481(a) income adjustment up to $50,000 can elect to report the entire amount of income in the current tax year rather than spread the income over four years. The IRS is probably hoping fewer taxpayers defer income and some may forget to report that income in subsequent tax years. 

According to Green’s 2016 Trader Tax Guide, “Form 3115 (Change in Accounting Method) includes a section for reporting a Section 481(a) adjustment, which is required when a change of accounting is made. The rest of the multi-page Form 3115 relates to tax law and code sections, etc. In the case of changing to Section 475 MTM, a trader’s section 481(a) adjustment is his unrealized business trading gain or loss as of Dec. 31 of the prior tax year. A section 481(a) loss is deductible in full; whereas a gain of more than $25,000 must be prorated over four tax years.” Effective for 2015 tax filings, the $25,000 is changed to $50,000. 

For example: If a trader’s 2015 Section 481(a) adjustment is $40,000, on their 2015 Form 3115 they may elect to report the full income. Conversely, if the income adjustment is $60,000 they would have to spread it over four years reporting $15,000 each year.

Section 475 and Section 481(a) adjustments
When a trader with trader tax status (TTS) elects Section 475 mark-to-market (MTM) ordinary gain or loss treatment, the IRS requires a Section 481(a) adjustment on income tax Form 3115 (Application for Change in Accounting Method) and Form 4797 (Sales of Business Property).

The trader is changing accounting method from the cash method on Dec. 31 to the Section 475 MTM method on Jan. 1. If the trader has open TTS securities positions on Dec. 31 the Section 481(a) adjustment is the unrealized gain or loss on TTS positions on Dec. 31. Gain is a positive adjustment and loss is a negative adjustment. Segregated investment positions in securities are not included in the Section 481(a) adjustment. Section 1256 contracts like futures are already subject to MTM so they also are not included in the 481(a) adjustment.

 


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