Certain retirement plans must file a 5500 information tax form by July 31

July 21, 2015 | By: Darren L. Neuschwander CPA

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As our firm has stated for years, the best retirement plan for a business trader is a defined-contribution employer 401(k), as this plan allows up to a maximum tax-deductible contribution of $53,000 ($59,000 if age 50 and over) based on 2015 IRS limits. As the majority of business-trading entities are owned 100% by the trader or jointly with his/her spouse, a Solo 401(k) plan is the preferred structure.

A Solo 401(k) plan, also referred to as an Individual 401(k), Mini 401(k) plan, Owner-only plan or One-participant plan (the legal name)is a “qualified” retirement plan that:

a) provides benefits to the 100% business owner only (or the 100% owner and his/her spouse); or

b) provides benefits to one or more partners in a business partnership only (or partner(s) and spouse(s) only in a partnership).

This applies to all business entities including: C or S Corporations, Sole Proprietorships, Partnerships, LLCs, or LLPs. (In our content, we also use the term “employer 401(k)” plans for S-Corp trading businesses and C-Corp management companies.)

Typically a Solo 401(k) plan does not have annual filing requirements unless the plan balance exceeds $250,000 in assets (including all liquid cash and non-liquid assets). If this is the case, an information return (Form 5500-EZ) is required to be filed with the Internal Revenue Service (IRS).

Form 5500-EZ must be filed on or before the last day of the seventh month after the end of the plan year. However, Form 5558 (Application for Extension of Time to File Certain Employee Plan Returns) can be filed with the IRS on or before the normal due date to receive an automatic two-and-a-half-month extension. For calendar-year plans, the due date is July 31. By filing a Form 5558, the due date is extended to Oct. 15.

The following significant penalties will be accessed for not timely filing a Form 5500:

·         Failure to timely file with the IRS — $25 per day

·         Failure to timely file the return with the Department of Labor (DOL) — $50 per day

·         Failure to timely file with the Pension Benefit Guaranty Corporation (PBGC) — $1,100 per day. Note that one-participant plans and plans “without employees” fall under the PBGC coverage exemption.

The IRS recently provided some penalty relief. Per http://www.irs.gov/uac/Newsroom/Small-Businesses-Can-Get-IRS-Penalty-Relief-for-Unfiled-Retirement-Plan-Returns, ‪”Small businesses that fail to file required annual retirement plan returns, usually Form 5500-EZ, can face stiff penalties — up to $15,000 per return. However, by filing late returns under this program, eligible filers can avoid these penalties by paying only $500 for each return submitted, up to a maximum of $1,500 per plan. For that reason, program applicants are encouraged to include multiple late returns in a single submission. Find the details on how to participate in Revenue Procedure 2015-32 on IRS.gov.” This is a good opportunity to catch up with 5500-EZ compliance for late years so speak with us about it soon.

Outside administrators often prepare 5500-EZ for clients but many traders act as their own administrator which means they need to deal with 5500-EZ on their own. Brokers often send annual guidance on filing 5500-EZ to their clients who have self-directed Solo 401(k) plans. Benefit plan information tax filings are not part of our firm’s income tax compliance engagement letters. IRAs are not qualified plans and therefore don’t have a 5500-EZ filing requirement.

If the Solo 401(k) plan balance is less than $250,000 by Dec. 31st, the IRS Form 5500-EZ normally does not have to be filed. However, we suggest considering the following:

·         Filing the Form 5500-EZ starts the statute of limitations regarding plan qualification (three-year vs. no statute regarding taxes and penalties due if the plan is disqualified). We recommend filing Form 5500-EZ regardless of this allowable exclusion; starting the statute of limitations running is a good idea.

·         Whether the plan has in excess of $250,000 or as little as $5,000, the owner-only business or self-employed individual plan sponsor is required to file a Form 5500-EZ for the year in which a plan is terminated. When a trader exits their trading business they need to deal with this filing requirement.

·         If the trust assets are not reconciled annually, how would the eventual preparer of the Form 5500-EZ timely determine if the owner-only business or self-employed individual “operated” the plan in accordance with the applicable rules under the law and permitted by the particular plan relative to the use of plans funds?  For example:

o   Were contributions made timely?

o   Were there any distributions during the plan year?  If yes, for what?  Does the plan permit loans? If yes, was it properly documented; repaid timely?

·         If the plan assets are held at multiple institutions, who monitors when the assets achieve the $250,000 threshold?

If you have a Solo 401(k) plan during 2014, even if assets are less than $250,000 within the plan, we strongly suggest you file Form 5500-EZ.

We can help:
We are happy to assist you with the preparation and filing of the 2014 Form 5500-EZ. Given that we are less than two weeks away from the filing deadline, we suggest that we file for an extension of your plan’s filing requirement for tax year 2014 from July 31st to Oct. 15, 2015.

To get started, please purchase our Form 5500 retirement plan tax compliance – advance payment. After your advance payment is made, our admin team will follow up with you with an engagement letter and information request for your Solo 401(k).

Robert A. Green, CPA contributed to this blog post.


15 errors traders make on tax returns

June 22, 2015 | By: Robert A. Green, CPA

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Attend our upcoming Webinar “Errors Traders Make On Tax Returns” and watch the recording afterwards.
Please answer our poll question
Do the majority of accountants make errors in preparing tax returns for active traders?

Traders are more likely than other taxpayers to make errors on tax return filings because they face greater challenges than employees with simple W-2s or small businesses with revenue and expenses reported as ordinary income on one tax form. The IRS does not cater to traders’ needs, and tax reporting can be a frustrating maze.

Traders are forced to deal with complex tax treatment for a bevy of financial instruments, complicated accounting rules including wash sales and mark-to-market accounting, and many disparate tax forms.

Traders must deal with many different categories of income: ordinary, capital gains, 60/40 capital gains, portfolio, business and investment, plus several tax treatment elections for converting from one category to another.

Yet, many traders are do-it-yourself types, self-directing their investments and preparing their tax returns with programs like TurboTax. But these programs are not robust or sophisticated enough to handle complex tax treatment, wash-sale adjustments, trader tax status and several nuances in trader tax law.

Traders are better off working with experienced CPAs in trader tax. Many of the nuances involve thousands of dollars of tax breaks and pitfalls that can trigger IRS notices and exams. Here’s a list of 15 common errors made by traders and local accountants on tax returns.

1. Schedule C errors

Some accountants intuitively think traders qualifying for trader tax status (business treatment) should enter both trading income and expenses like other sole proprietors on Schedule C. That’s a big problem and we see this error often after a trader receives a tax exam notice from the IRS and comes to us for help.

Accountants often try to deduct a large trading loss on Schedule C after missing the election deadline for a Section 475 election so they can’t use Form 4797 ordinary loss treatment and are stuck with a capital loss limitation.

Only trading business expenses are reportable on Schedule C and that’s a red flag for IRS computers and agents. Home office expenses are carried over to subsequent years because they may only be deducted on a Schedule C with net income or against trading gains reported on other tax forms.

Tips: Green’s 2015 Trader Tax Guide suggests different ways to handle Schedule C and home office expenses including an explanation in a tax return footnote. Also explain trader tax status, elections and how disparate tax forms should be viewed as one to show a profitable trading business.

2. SEI and SE tax errors

Some traders and local accountants treat net trading business income as self-employment income (SEI) subject to self-employment (SE) tax. That’s incorrect unless the trader is a full member of an options or futures exchange and trading Section 1256 contracts on that exchange (Section 1402i).

Local accountants compound this error by having the trader contribute to a retirement plan based on net trading business income. Contributions may only be made on SEI and trading gains are not SEI. The trader is deemed to have an “excessive contribution” subject to tax penalties. Local accountants also mistakenly take an AGI deduction for self-employed health insurance premiums, which requires SEI.

Traders should consider a pass-through entity tax return, which looks considerably better than a Schedule C. An S-Corp can pay officer’s compensation to unlock employee benefit plan deductions for health insurance and retirement plan contributions, whereas a Schedule C cannot.

3. Form 8949 errors

Form 8949 requires trade-by-trade reporting of securities trades with wash-sale loss adjustments and special coding per IRS cost-basis regulations. The results move to Schedule D.

Traders often don’t make necessary wash-sale loss adjustments based on substantially identical positions across all accounts, including the various types of IRAs. They also don’t reconcile Form 8949 to 1099Bs which inevitably has unreconciled differences on wash sales because brokers only calculate them based on identical positions per account.

4. Form 4797 errors

Form 4797 is for Section 475 MTM trades, which is contingent on qualification for trader tax status. Trade-by-trade reporting is required, but no wash sales in Section 475 since it’s ordinary gain or loss treatment.

When an existing taxpayer files a Section 475 MTM election on time, they need to make a Section 481(a) adjustment to convert from the realization (cash) method to the MTM accounting method as of Jan. 1 of the election year. That adjustment is basically the unrealized gain or loss including wash-sale deferrals on the prior year-end open trading business positions, not including segregated investment positions. Negative Section 481(a) adjustments are reportable in full, but positive adjustments over $25,000 must be pro-rated over four years. Many local accountants skip or botch the adjustment and traders forget to report the deferral income.

Many traders and accountants misunderstand, miscalculate and botch handling of Section 475 elections, accounting, Form 3115 change of accounting filings, use of Form 4797 and related NOL filings. Section 475 errors attract IRS attention because usually large tax refunds are involved.

5. Incorrect classification of financial instruments

There’s been a proliferation of new financial instruments for trading over the past two decades like ETFs, indexes, options, and forex. It’s not always clear which tax treatment category the instrument falls into. For example, commodity ETFs are taxed as securities and non-equity options are Section 1256 contracts. Broad-based indexes are Section 1256, but narrow-based indexes are securities.

Some brokers treat certain financial instruments one way and other brokers treat them another way. For example, options on commodity ETFs can be treated as Section 1256 contracts with up to 12% lower tax rates than securities. Other times, taxpayers claim Section 1256 treatment when they are not entitled to like on most foreign futures.

Tips: Use good tax accounting software or solutions for traders to properly categorize financial instruments. Visit the GreenTraderTax Center to learn more about tax treatment categories including securities, Section 1256 contracts, ETFs, options, foreign futures, forex, binary options, precious metals, bitcoin, swaps and more.

6. Incorrect wash-sale adjustments on securities

Taxpayers and brokers report trades in securities when realized (sold). Short-term capital gains are taxed at the higher ordinary rate (up to 39.6%) and long-term capital gains (held up to 12 months) are taxed at the lower capital gains rate (up to 20%).

One of the biggest problem areas for active securities traders is wash-sale losses. If you sell a security for a loss and buy a substantially identical position back within 30 days before or after, you have to make a wash-sale loss adjustment by adding the loss to the cost basis of the replacement position. If you trigger one in an IRA, you permanently lose the wash-sale loss.

While brokers report wash-sale loss adjustments on 1099Bs, they only do it on identical positions per account. Individual taxpayer rules are different: These adjustments have to be reported on substantially identical positions across all accounts, including IRAs. Substantially identical means Apple equity and Apple options, and at different strike dates. Identical means the exact same symbol.

Tips: Use good tax accounting software for securities to properly calculate wash sales. Set up “Do Not Trade” lists for your IRAs to avoid a permanent wash-sale loss with taxable accounts. Break the 30-day chain on wash sales in taxable accounts at year-end to avoid year-end wash sale loss deferrals. Visit the GreenTraderTax Center to learn more about wash sales.

7. Mis-categorizing Section 1256 contracts

Section 1256 contracts are MTM including realized and unrealized gains and losses. Holding period doesn’t matter as all contracts are 60% long-term and 40% short-term capital gains.

Section 1256 60/40 tax rates are 12% less than ordinary tax rates. There’s similar tax savings throughout the graduated tax rates as the 15% ordinary rate bracket comes with a zero long-term capital gains rate. By mis-categorizing an instrument as a security rather than Section 1256 contract, it costs the taxpayer significant tax liability if there are net capital gains. Don’t rely on brokers to categorize all Section 1256 contracts correctly, especially indexes and non-equity options.

8. Missing a Section 1256 loss carry back election

Many taxpayers and accountants don’t know about the Section 1256 loss carry back election on top of Form 6781. A current year loss can be carried back three tax years against Section 1256 gains. Many traders miss this election and wind up with unused capital loss carry forwards instead.

9. Missing a Section 475 election

Active traders qualifying for trader tax status may elect Section 475 MTM ordinary gain or loss treatment on securities only or futures, too. Section 475 is tax loss insurance: It exempts traders from wash-sale loss deferrals and the capital loss limitation ($3,000 per year against ordinary income). Section 475 ordinary losses add to net operating losses (NOLs), which can be carried back two years and/or forward 20 years against income of any kind.

Existing taxpayers must elect Section 475 by April 15 for partnerships and individuals and March 15 for S-Corps. New taxpayers may elect Section 475 within 75 days of inception. Far too many traders who should elect Section 475 miss the election deadline and get stuck with unused capital loss carryovers. The IRS recently loosened the rules to allow free and easy revocation of Section 475. Learn more about trader tax status and Section 475 in the GreenTraderTax Center.

10. Missed Section 1256 60/40 rates on certain foreign futures

U.S.-based regulated futures contracts (RFCs) are Section 1256 contracts, but that’s not the default case for futures traded on foreign exchanges. The IRS has granted Section 1256 lower 60/40 rates to certain foreign exchanges. Look for the required IRS revenue ruling which is available in the GreenTraderTax Center.

11. Reporting options incorrectly

Options are derivatives and there are options on securities, Section 1256 contracts, forex and other types of financial instruments. Options are generally taxed in the same manner as the underlying instrument. For example, equity options are taxed like equities and both are securities. Non-equity options are Section 1256 contracts.

With phase-in of cost-basis regulations, brokers reported options starting on 2014 Form 1099Bs. Three events may happen when trading options: you can trade it (the only event that counts toward trader tax status), let it expire worthless or exercise it. Trading and expiration are realization transactions. Conversely, exercise is not a realization; it’s a stepping-stone to owning the stock which holding period starts fresh. Traders also enter complex offsetting position trades, which can trigger straddle-loss rules.

Caution: some brokers adjust proceeds for option exercise when they should adjust cost basis. This can throw off reconciliations between correct Form 8949 based on good software. Learn more about tax treatment for option traders in the GreenTraderTax Center.

12. ETFs mis-categorized as commodities

All ETFs are securities with the exception of precious-metal backed ETFs structured as grantor trusts which are disregarded entities owning collectibles. Options on ETFs structured as registered investment companies (RICs) are securities with the exception of options on commodity ETFs structured as publicly traded partnerships (PTP) — these are Section 1256 contracts.

Some taxpayers and accountants confuse broad-based ETFs (securities) with broad-based indexes (Section 1256 contracts). Google the symbol and notice it says ETF, it trades on a securities exchange and if it’s a RIC. There are lists of commodity ETFs structured as PTPs.

13. Double counting income on commodity ETFs

In some cases, commodity ETFs structured as PTPs issue Schedule K-1s passing through income including Section 1256 income. It’s a common error for traders to omit this income reporting. The second error is overlooking adjustments to cost basis for that pass-through income. Brokers don’t make that cost basis adjustment on 1099Bs, so without adding pass-through income to cost basis, taxpayers will double count that income.

14. Omitting forex transactions from tax returns

Spot forex isn’t a covered security for broker issuance of 1099Bs. Many taxpayers and accountants omit spot forex transactions from tax returns. That’s wrong: It’s reportable whether on U.S. or offshore forex accounts. Taxpayers must report underlying income or loss on their brokerage and bank accounts worldwide.

Foreign bank and brokerage accounts are subject to FBAR reporting requirements due by June 30 of the subsequent year. Learn more and file online at http://www.fincen.gov/forms/bsa_forms/fbar.html.

15. Botched forex reporting and missed capital gains elections

Spot forex is covered in Section 988 (foreign currency transactions) and is considered an ordinary gain or loss. In the case of negative taxable income, the negative amount is wasted as it’s not a capital loss carryover or NOL. With trader tax status, it is a NOL.

Use Form 1040 line 21 Other Income for reporting Section 988 forex trades in summary form. With trader tax status, use Form 4797 instead.

Few accountants inform their clients about filing a contemporaneous internal election to opt out of Section 988 for capital gain and loss treatment.  Our firm makes a case for treating spot forex like forex forwards and allowing use of Section 1256g (foreign currency contracts) on major currencies for which currency RFCs trade on futures exchanges.

Many taxpayers and accountants treat rollover interest expense as true interest expense when it’s really part of trading gain or loss. They also don’t pick up the other side of open rollover trades and many brokers skip that, too.

Ordinary forex losses over $50,000 must be reported on Form 8886 Reportable Transaction Disclosure Statement; omitting that form can lead to large penalties.

Bottom line

Consider Green NFH’s Tax Return Checkup: 30-Minute Consultation. Upload your tax return in a secure manner and one of our CPAs will look it over and email you comments. It’s an excellent value which should either generate tax savings in excess of cost and/or help you sleep better at night. It will also help fix things early in 2015 before it’s too late for the current year.


IRS data hacking prompts new refund advice

June 2, 2015 | By: Darren L. Neuschwander CPA

As was widely reported over the last week, over 100,000 taxpayers’ personal information — including Social Security information, date of birth and street address — was hacked from the IRS Website. We have experienced identity theft for income tax purposes with several clients over the last couple of years, and it’s a very painful process. Usually, someone files a fraudulent return, trying to get a refund. The victim receives an IRS letter asking about a refund, when he has not filed a tax return yet.

The taxpayer has to fill out a new form with the IRS, file a paper tax return and likely wait up to six months (if he is lucky) to get the refund back.

Many taxpayers like to bank on a refund for vacations or other large anticipated expenses. Rising tax fraud is another reason why I would suggest never getting a refund; instead, set aside extra money from your paycheck each pay period.

Many of our trading clients have outside jobs and will get a decent refund due to trader status and MTM accounting. I suggest these clients change their withholding to get less of a refund and more cash throughout the year.

If you’re counting on that large tax refund, this latest case of stolen identity goes to show that it may happen much later than you would like, or not at all.


Tax treatment for trading options

May 27, 2015 | By: Robert A. Green, CPA

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Options trading is proliferating with the advent and innovation of retail option trading platforms, brokerage firms and trading schools. A trader can open an options trading account with just a few thousand dollars vs. $25,000 required for “pattern day trading” equities (Reg T margin rules).

Options trading provides the opportunity to make big profits on little capital using “risk it all” strategies. Options are a “tradable” financial instrument and a way to reduce risk with hedging strategies. When it comes to option taxation, complex trades with offsetting positions raise complex tax treatment issues like wash sale and straddle loss deferral rules.

Investors also trade options to manage risk in their investment portfolios. For example, if an investor owns significant equity in Apple and Exxon, he or she may want to trade options to manage risk or enhance income on long equity positions. He or she can collect premium by selling or “writing” an options contract or buy a “married put” for portfolio insurance. Traders also use ETFs and indexes for portfolio-wide insurance. (Investopedia has explanations for different option trading strategies.)

Simple vs. complex option trades
There are simple option trading strategies like buying and selling call and put options known as “outrights.” And there are complex option trades known as “option spreads”which include multi-legged offsetting positions like iron condorsbutterfly spreads; vertical, horizontal and diagonal spreads; and debit and credit spreads.

Tax treatment for outright option trades is fairly straightforward and covered below. Tax treatment for complex trades triggers a bevy of complex IRS rules geared toward preventing taxpayers from tax avoidance schemes: deducting losses and expenses from the losing side of a complex trade in the current tax year while deferring income on the offsetting winning position until a subsequent tax year.

Look to the underlying financial instrument tax treatment
Options are “derivatives” of underlying financial instruments including equities, ETFs, futures, indexes, forex, and more. The first key to determining an option’s tax treatment is to look at the tax treatment for its underlying financial instrument. The option is to buy or sell that financial instrument and it’s tied at the hip.

For example, an equity option looks to the tax treatment of equities, which are considered “securities.” Conversely, options on Section 1256 contracts are deemed “non-equity options.”

ETFs are taxed as securities, so options on securities ETFs are taxed as securities. Options on commodity ETFs (structured as publicly traded partnerships) are non-equity options taxed as Section 1256 contracts. Options on futures are taxed as futures, which are Section 1256 contracts.

Capital gains and losses for securities are reported when realized (sold or closed). Conversely, Section 1256 contracts are marked-to-market (MTM) at year-end and they benefit from lower 60/40 capital gains tax rates: 60% long-term and 40% short-term. MTM imputes sales on open positions at market prices so there is no chance to defer an offsetting position at year-end. Generally, that means wash sale and straddle loss deferral rules don’t apply to Section 1256 options.

There are three things that can happen with outright option trades:

  • Trade option (closing transaction)
    Trading call and put equity options held as a capital asset are taxed the same as trading underlying equities. Report proceeds, cost basis, net capital gain or loss and holding period (short-term vs. long-term held over 12 months) from realized transactions only on Form 8949 (Capital Gains & Losses).
  • Option expires (lapses)
    There’s a minor twist on the above scenario. Rather than realizing a dollar amount on the closing out of the option trade, the closeout price is zero since the option expires worthless.Use zero for the realized proceeds or cost basis, depending on whether you’re the “writer”or “holder” of the option and if it’s a call or put. Use common sense — collecting premium on the option trade is proceeds and therefore the corresponding worthless exercise represents zero cost basis in this realized transaction. For guidance on entering option transactions as “expired”on Form 8949, read IRS Pub. 550 – Capital Gains And Losses: Options.
  • Exercise the option
    This is where tax treatment gets more complicated. Exercising an option is not a realized gain or loss transaction; it’s a stepping-stone to a subsequent realized gain or loss transaction on the underlying financial instrument acquired. The original option transaction amount is absorbed (adjusted) into the subsequent financial instrument cost basis or net proceed amount.Per IRS Pub. 550 Capital Gains & Losses: Options: “If you exercise a call, add its cost to the basis of the stock you bought. If you exercise a put, reduce your amount realized on the sale of the underlying stock by the cost of the put when figuring your gain or loss. Any gain or loss on the sale of the underlying stock is long term or short term depending on your holding period for the underlying stock…If a put you write is exercised and you buy the underlying stock, decrease your basis in the stock by the amount you received for the put…If a call you write is exercised and you sell the underlying stock, increase your amount realized on the sale of the stock by the amount you received for the call when figuring your gain or loss.” Some brokers interpret IRS rules differently, which can lead to confusion in attempting to reconcile broker-issued Form 1099Bs to trade accounting software. A few brokers may reduce proceeds when they should add the amount to cost basis. Equity options are reportable for the first time on 2014 Form 1099Bs.Exercising an option gets to the basics of what an option is all about: it’s the right, but not the obligation, to purchase or sell a financial instrument at a fixed “strike price” by an expiration date. Exercise may happen at any time until the option lapses. An investor can have an in the money option before expiration date and choose not to execute it, but rather hold or sell it before expiration.
  • Holding period for long-term capital gains
    When an equity option is exercised, the option holding period becomes irrelevant and the holding period for the equity begins anew. The holding period of the option doesn’t help achieve a long-term capital gain 12-month holding period on the subsequent sale of the equity. When an option is closed or lapsed, the option holding period does dictate short- or long-term capital gains treatment on the capital gain or loss.With exceptions recapped in IRS Pub. 550: “Put option as short sale.  Buying a put option is generally treated as a short sale, and the exercise, sale, or expiration of the put is a closing of the short sale. If you have held the underlying stock for one year or less at the time you buy the put, any gain on the exercise, sale, or expiration of the put is a short-term capital gain. The same is true if you buy the underlying stock after you buy the put but before its exercise, sale, or expiration.”

Complex trades lead to complex tax treatment issues
In general, if an investor has an offsetting position he or she should look into more complex tax treatment issues.

Offsetting Positions
IRS Pub. 550: Capital Gains & Losses: Straddles defines an “offsetting position” as “a position that substantially reduces any risk of loss you may have from holding another position.”

In the old days, shrewd professional options traders would enter offsetting positions and close out the losing side before year-end for a significant tax loss and let the winning side remain open until the subsequent year. They used this strategy to avoid paying taxes. The IRS goes through (and causes) great pains to prevent this type of tax avoidance. Offsetting position rules included “related persons” including a spouse and your flow-through entities.

“Loss Deferral Rules”in IRS Pub. 550 state “Generally, you can deduct a loss on the disposition of one or more positions only to the extent the loss is more than any unrecognized gain you have on offsetting positions. Unused losses are treated as sustained in the next tax year.”

IRS enforcement of offsetting position rules
Frankly, the offsetting position rules are complex, nuanced and inconsistently applied. There are insufficient tools and programs for complying with straddle loss deferral rules. Brokers don’t comply with taxpayer wash sale rules or straddle loss deferral rules on Form 1099Bs or profit and loss reports. Few local tax preparers and CPAs understand these rules, let alone know how to spot them on client trading records.

The IRS probably enforces wash sale and straddle loss deferral rules during audits of large taxpayers who are obviously avoiding taxes with offsetting positions. They make a lot of money, but it’s always deferred to the next tax year. The IRS doesn’t seem to be questioning wash sales and straddles during exams for the average Joe Trader.

I expect the IRS will launch a tax exam initiative for measuring taxpayer compliance with new cost-basis reporting law and regulations. I see a big problem brewing with unreconciled differences between taxpayer and broker rules on wash sales.

Wash sales
As we stress in our extensive content on wash sale loss deferral rules, Section 1091 rules for taxpayers require wash sale loss treatment on substantially identical positions across all accounts including IRAs. Substantially identical positions include Apple equity, Apply options and Apple options at different expiration dates on both puts and calls.

If a taxpayer re-enters a substantially identical position within 30 days before or after existing a position, the IRS defers the tax loss by adding it to the cost basis of the replacement position. When a taxable account has a wash sale caused by a replacement position purchased in an IRA, the wash sale loss is permanently lost.

Cost-basis regulations phased-in options as “covered securities” starting with 2014 Form 1099Bs. Brokers report wash sales based on identical positions, not substantially identical positions. Investors who trade equities and equity options cannot solely rely on Form 1099Bs and they should use their own trade accounting software to generate Form 8949. Learn more about wash sales in our Trader Tax Center.

Straddle loss deferral rules
Options traders use option spreads containing offsetting positions to limit risk and provide a reasonable opportunity to make a net profit on the trade. That’s very different from an unscrupulous trader entering a complex trade with offsetting positions set up for no overall risk (the rule is substantially reduced risk) or reward. Why would an options trader do that? For tax avoidance reasons only.

The IRS straddle loss deferral rules are set up to catch this trader and prevent this type of tax avoidance. The straddle loss deferral rule defers a loss to the subsequent tax year when the winning side of the position is closed, thereby reversing what the unscrupulous trader was trying to achieve. The IRS also suspends holding period so it’s impossible to qualify for long-term capital gains rates in the following year, too. Transaction-related expenses (carrying costs) and margin interest (certain interest) are also deferred by adding them to the cost-basis of the offsetting winning position.

Learn more about straddle loss deferral rules in connection with options in IRS Pub. 550: Capital Gains & Losses: Straddles. “A straddle is any set of offsetting positions on personal property. For example, a straddle may consist of a purchased option to buy and a purchased option to sell on the same number of shares of the security, with the same exercise price and period. Personal property. This is any actively traded property. It includes stock options and contracts to buy stock but generally does not include stock. Straddle rules for stock. Although stock is generally excluded from the definition of personal property when applying the straddle rules, it is included in the following two situations. 1) The stock is of a type which is actively traded, and at least one of the offsetting positions is a position on that stock or substantially similar or related property. 2) The stock is in a corporation formed or availed of to take positions in personal property that offset positions taken by any shareholder.”

Straddle loss rules are complex and beyond the scope of this blog post. Consult a tax adviser who understands the rules well.

Caution to unsuspecting option traders
Active traders in equities and equity options entering complex trades with multi-legged offsetting positions may unwittingly trigger straddle loss deferral rules if they calculate risk and reward wrong and there is substantially no risk.

Section 475 MTM
Traders who qualify for trader tax status may elect Section 475(f) MTM accounting, provided they do so by the deadline. MTM means the trader reports unrealized gains and losses on trading positions at year-end by imputing sales at year-end prices. Segregated investment positions are excluded from MTM. The character of the income changes from capital gain and loss to ordinary gain or loss. Section 475 trades are exempt from Section 1091 wash sale rules and straddle loss deferral rules since no open positions are deferred at year-end.

Employee stock options
Don’t confuse tradable options with employee stock options. When an employee acquires non-qualified options on his employer’s stock (equity), the later exercise of those options triggers ordinary income reported on the employee W-2 because the appreciated value is considered a form of wage compensation.

Other resources
Ernst & Young prepared a useful guide with a good section on options taxation. It was requested by The Options Industry Council and is available on the CBOE website at https://www.cboe.com/LearnCenter/pdf/TaxesandInvesting.pdf.


Dear IRS & Congress: Please fix tax rules for active traders

May 14, 2015 | By: Robert A. Green, CPA

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We mailed the IRS Commissioner this cover letter and comments for the IRS Section 475 “Clean Up Project.” This blog post is comprised of those comments. 

Please take action: sign our Petition to CongressWithout your participation traders are too small a voice. 

The IRS recognizes problems with tax rules for active traders including Section 475 marked-to-market (MTM) reporting, Section 1091 wash sale loss rules and trader tax status (business treatment).

These problems are connected. Only a trader who qualifies for trader tax status may elect and use Section 475(f) MTM ordinary gain or loss treatment. Otherwise with the default “realization method” (cash method), securities trades are subject to Section 1091 wash sale loss rules and capital gain and loss treatment. Wash sale rules are a huge problem for active securities traders; non-compliance is widespread and the IRS is not enforcing the rules. That is unsustainable.

Trader tax status is a requirement for Section 475(f)
Traders, tax professionals, IRS and state tax agents don’t fully understand trader tax status (TTS), and the result is botched tax compliance causing significant losses from higher taxes, penalties, interest and professional fees.

Hundreds of thousands of active traders qualify for TTS, trading their own funds as a business activity. Most of them don’t know they are entitled to file a timely election for Section 475(f) MTM ordinary gain or loss treatment and exemption from Section 1091 wash sale loss treatment. They also don’t realize they can use Section 162 business expense treatment as a sole proprietor or in a pass-through trading company without an election required for Section 162.

Since enactment in 1997, Section 475 and TTS rules remain too confusing to tax professionals and traders. Many local tax preparers conflate the two code sections, not realizing a qualifying trader may use Section 162 but not elect Section 475(f). The IRS needs to do a better job with its guidance.

Better define trader tax status
There is no “statutory law” defining qualification for TTS. There is only “case law” and “trader tax” cases have a broad range of criteria without giving a bright-line test, except the Endicott court stated average holding period must be 31 days or less. Traders need similar standards for volume and frequency of trades and hours per day.

Case law rewards losing day traders with TTS and 475(f) elections, but denies both to profitable options traders who may make a consistent living but have less volume and frequency of trades. The average trader with TTS has business expenses of approximately $15,000 and that does not stress the Treasury in terms of tax benefits.

The IRS has a history of misquoting TTS case law to traders in tax exams. On several occasions, IRS agents told traders they needed to make their “primary or sole living” from trading, whereas tax law requires “an intention to make a living.” Hobby loss rules do not apply to trading because trading is “not recreational or personal in nature.”

Section 475(f) MTM
Section 475 was drafted for dealers in securities and or commodities. In 1997, Congress expanded Section 475 to include traders who qualify for trader tax status adding Section 475(f). The IRS added the terms “trader in securities” and “trader in commodities.” Traders must qualify for TTS to elect and use Section 475(f).

Securities traders consider a Section 475(f) election for two reasons: exemption from wash sale loss deferral rules and the $3,000 capital loss limitation. Section 475 MTM is ordinary gain or loss treatment. Section 475 trading losses contribute to NOL carry backs and forwards which generate tax refunds faster than carrying forward capital loss carryovers, which otherwise are the biggest pitfall for traders. Section 475 MTM ordinary income is taxed at the same ordinary tax rate as short-term capital gains.

Better define commodities
The IRS needs to better define the term “commodities” in Section 475 (and throughout the tax code). The definition needs to clearly state that traders may elect Section 475(f) on “securities only” and retain lower 60/40 tax rates on Section 1256 contracts (futures and broad based indexes). While dealers sell bushels of wheat (commodities), traders do not.

I appreciate the ABA’s comments to the IRS. Their comments on the definition of commodities are confusing. The ABA addresses dealers and traders, whereas we focus on traders only.

Suspending Section 475 treatment
One of the challenges in administrating Section 475 is in the determination of qualification for TTS. Falling short of TTS means the trader must suspend use of Section 475 and use the realization (cash) method until he or she re-qualifies in a subsequent tax year. Suspension treatment is not included in Section 475 rules, yet it should be. The concept is that without TTS, all open positions automatically become investment positions.

The IRS recently fixed Section 475 revocation rules
There’s good news for traders about Section 475 MTM buried in the IRS annual update on procedures for changes of accounting method. It has always been free and easy to elect Section 475 MTM, yet difficult and costly to revoke that election. With this rule change, the IRS makes revocation a free and easy process. (Read my blog post New IRS rules allow free and easy Section 475 revocation.)

Section 475(f) election and Form 3115
Current rules for making a Section 475(f) election are too narrow and complex. In other words, there is a very small window of opportunity to consider and make a 475(f) election and most traders don’t speak with their tax advisor on time. Far too many qualified traders who would benefit from Section 475(f) miss the boat and that’s unfair.

“Existing taxpayers” must elect Section 475(f) by the original due date of the prior year tax return (not including extensions). That provides about three months of hindsight from Jan. 1 until April 15 for individuals and partnerships and March 15 for S-Corps. It’s an election statement as there isn’t a tax form.

The second step — to perfect the election — is to file a Form 3115 with the current year tax return. Many accountants think it’s a one-step procedure and they botch the election by missing either the election statement or the Form 3115 filing (required in duplicate).

A taxpayer must attach the election statement to their extension or tax return and a certified return receipt only proves a tax filing not the election statement. The IRS admits they don’t have a system to record the 475(f) election, so they ask a taxpayer for a perjury statement on the Form 3115 representing they filed the election statement on time. The IRS provides relief for late Form 3115s but not late election statements.

Provide late relief for Section 475 elections
Tax law (Regulation Section 301.9100-3 relief) allows six months to file a private letter ruling to get late relief on certain elections including Section 475(f). But to date it has been almost impossible to get this type of relief for a late Section 475(f) election. The process requires a private letter ruling and the IRS denied all of them to date with the exception of Larry Vines who had a perfect fact pattern. The IRS refuses late relief for Section 475(f) by claiming prejudice to Treasury and hindsight. It takes almost a perfect set of factors to get by this stringent posture. An open portfolio of unrealized capital losses is currently considered enough of a reason for the IRS to deny late relief for a Section 475(f) election.

Rather than loosen up here, I prefer the IRS just allow a Section 475(f) election with more time. Focusing too much on hindsight disenfranchises traders.

Expand Section 475(f)new taxpayerexception
Under current law, there is an exception for “new taxpayers” like a new entity. A new taxpayer may elect Section 475(f) by internal resolution within 75 days of inception. If you start trading after April 15, you can’t make a 475(f) election as an individual; but you can form a new entity to make the election within 75 days of inception.

The new taxpayer exception isn’t clear or broad enough. The IRS should broaden it to accommodate “new traders” qualifying for TTS, not just a new entity. Individual traders or entities qualifying for TTS after April 15 should be able to elect Section 475(f) within 75 days of qualification.

I think the IRS should go even further by allowing the election on the tax return filing after year-end. Traders using Section 162 business expense treatment simply claim that treatment on their tax return (Schedule C) where they also choose the cash method or accrual method of accounting for expenses. Why not enact the same procedure for a Section 475(f) election? Why make Section 475 confusing and different from Section 162 since they are so tied together already?

Most tax professionals don’t know their client qualified for TTS until tax time and often that’s after the April 15 deadline for filing extensions. Their clients often miss the 475(f) election for the past year, as well as the current year, too.

Taxpayers often don’t discuss election opportunities with their accountants until after year-end, not when they launch a new activity. Traders don’t even realize that trading can be a business; otherwise they might call their accountant early on. It’s unreasonable for the IRS to assume traders can digest the complications of Section 475(f) and TTS on their own.

First year hindsight is reasonable
While extending the 475(f) election until tax filing time gives traders more hindsight during the first calendar year (and into the next tax year) and new IRS rules for revocation allow reversal in a subsequent year, once revoked, Section 475 can’t be re-elected for five years.

Most tax elections are made on a tax return filing, and they are not required earlier in the year – hindsight is allowed. With so many traders missing the boat on Section 475 — and then building up a capital loss carryover hole committing them to the realization method — it’s reasonable for traders to conclude the onerous 475(f) election rules are intended to disenfranchise traders from using ordinary loss treatment.

The original tax law on Section 475(f) mentioned the IRS would issue a tax form for the election. But, to date the IRS has not issued a form. Even with the S-Corp election Form 2553 due within 75 days of inception, the IRS grants relief for late-filed elections. I don’t see precedent for stringent hindsight rules against traders. Missing the Section 475(f) election requirement is the biggest problem in Section 475 and it causes the most inequity for traders contrary to the intention of Congress in expanding Section 475 to traders.

Section 475 segregation of investmentrules are vague
I disagree with IRS proposed regulations for segregation of investments from Section 475 calling for a separate investment account.

Segregation should be done in “form and substance.” It’s not enough to designate an account as an investment account (in form) because traders often actively trade around core investment positions in an active trading account (in substance). Segregation must be assessed in overall actions by traders. (Read my blog post IRS warns traders on Section 475.)

I agree with Chief Counsel Advice (“CCA”) 201432016 stating “the 475 election is made on an entity-by-entity basis, not a separate trade or business basis, and only in the case of separate commodities and securities businesses can a taxpayer make separate elections.” I also agree the proposed regulation stating “a trader may identify an investment with ‘clear and convincing evidence that a security has no connection to its trading activities.’”

As tax preparers for traders, real world fact patterns can be confusing and it would be good if the IRS issued more guidance on segregation of investments. If a client trades the same symbol for which he invests and uses Section 475(f) for active trading but not investing, should all the symbols traded and invested be consolidated into Section 475(f) or into investment treatment, or otherwise? The proposed regulations offer some solutions but they need more work. Tax preparers need support for taking positions that don’t prejudice Treasury. In general, I agree with many of ABA’s comments on May 7, 2015 in this regard.

Wash sale rules are a problem
A Section 475(f) election is an escape hatch for a qualifying trader from wash sale loss treatment (Section 1091). When the IRS considers changes to Section 475, they should also address significant problems with Section 1091 as these code sections are joined at the hip for active traders.

IRS rules for broker 1099Bs differ from rules for taxpayer reporting of wash sale adjustments on Form 8949 (Capital Gains & Losses). The IRS requires brokers to calculate wash sales based on identical positions (same symbol) per account. Conversely, the IRS requires taxpayers to report wash sales based on substantially identical positions (stocks and options) across all accounts including IRAs. With apples and oranges structurally in the rules, there are obviously large, unreconciled differences between broker 1099Bs and taxpayer Form 8949, especially for active traders with multiple accounts and those who trade stocks and options. These 1099B matching problems will overwhelm the IRS in coming years.

The IRS doesn
t enforce wash sales
Too often taxpayers and tax professionals cut corners choosing to solely rely on broker-issued 1099Bs. They don’t comply with different IRS wash sale rules for taxpayers (see above).

Brokers aren’t helping with taxpayer compliance; they are encouraging clients to download 1099-B data into TurboTax and they don’t sufficiently mention Section 1091 compliance issues. The IRS needs to either enforce or change the wash sale rules to better coordinate broker and taxpayer reporting.

Cost-basis reporting also has problems
In 2008, Congress enacted cost-basis reporting to close the “tax gap” on investors. Prior to cost basis rules, Form 1099Bs only reported proceeds on securities, and cost-basis information wasn’t included. Starting in 2011, the IRS phased in the cost-basis reporting rules.

While cost-basis reporting requires wash-sale adjustments, it falls short of the needs of active traders with multiple accounts and those who trade substantially identical positions (stocks and options).

Starting in 2014, 1099Bs reported equity options for the first time. But brokers don’t calculate wash sales between stocks and options and options at different expiration dates whereas taxpayers must do so. This will generate many unreconciled differences or non-compliance with Section 1091 rules.

While cost-basis rules help the IRS with millions of investors, they are not working well enough for active traders who are stuck with huge unreconciled differences. The choice is either reconciliation and non-compliance or huge differences and compliance.

Cost basis problems are another great reason to open the door wider to 475 elections. It’s easier to explain why a Form 4797 (where 475 is reported) is different from a 1099B prepared for the realization method.

Improve sole proprietor tax return reporting
A sole proprietor trader tax return is a red flag in the eyes of IRS agents and IRS computer algorithms because Section 162 trading expenses are reported on Schedule C but trading gains and losses are reported on other tax forms. That looks like a losing business without revenue.

There should be a formal way to transfer some trading gains to Schedule C to show a profitable activity or zero it out. Trading gains are not self-employment income (SEI) and they are exempt from SE tax, with the exception of members of a futures exchange (Section 1402i).

Traders work hard every day and they deserve a tax code that respects their unique tax needs. Since the Great Recession of 2008, the markets have experienced tremendous growth and capital gains taxes have skyrocketed.

Darren Neuschwander CPA and co-managing member of Green NFH contributed to this blog post.


New IRS rules allow free and easy Section 475 revocation

May 1, 2015 | By: Robert A. Green, CPA

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There’s good news for traders about Section 475 MTM buried in the IRS annual update on procedures for changes of accounting method. It has always been free and easy to elect Section 475 MTM, yet difficult and costly to revoke that election. With this rule change, the IRS makes revocation a free and easy process, mirroring the Section 475 election and automatic change of accounting procedure for existing taxpayers.

Before this rule change, the Section 475 revocation procedure cost several thousand dollars in filing fees (close to $7,000 for hedge funds) and the outcome was uncertain since it required advanced consent from the IRS, which could be denied. Few traders opted for revocation; most used other options like suspension or exit (see below).

New revocation procedure is similar to the election procedure
To elect Section 475, “existing taxpayers” must file an election statement with the IRS attached to their prior year tax return or extension by April 15 of the current tax year for individuals and partnerships and March 15 for S-Corps. The second step requires filing a Form 3115 with the tax return for year of the election. For example, a 2015 Section 475 election statement must be filed by April 15, 2015 and the 2015 Form 3115 must be filed (in duplicate) with the 2015 tax return in 2016.

There’s an exception for “new taxpayers” (new entities) who file the election statement in their own books and records within 75 days of inception, since there is no prior tax return to attach the election to. New taxpayers don’t file a Form 3115 because they adopt Section 475 from inception rather than change an accounting method.

The new revocation procedure is similar to the election procedure. An existing individual or partnership must file a 2016 notification statement of revocation (see details below) with the IRS by April 15, 2016 (March 15, 2016 for S-Corps). The second step is to file 2016 Form 3115 for revocation of Section 475 with the 2016 tax return in 2017.

Suspension of Section 475
Historically, our trader clients navigated around the costly and uncertain revocation procedure by “suspending” their Section 475 election.

By disqualifying themselves for trader tax status, they became investors who could not use Section 475 as of the disqualification date. In that case, the Section 475 election was suspended until the trader re-qualified (if ever) for trader tax status. While the IRS may have preferred that the trader follow the costly revocation procedure, we suggested suspension as another option free of cost.

Taxpayers will appreciate having this new choice to revoke Section 475 instead of leaving it suspended on their individual returns if they elected it as a sole proprietor trader.

Other options besides revocation
Prior to this rule change, our trader clients avoided the costly and uncertain revocation procedure in two ways: by trading less and falling short of qualification for TTS, thereby “suspending”the Section 475 election; or by closing a trading business entity which used Section 475, thereby terminating Section 475. These traders could form a new “do over”entity to get back to the cash method, otherwise called the “realization” method.

When to revoke Section 475
A trader may want to elect Section 475 MTM on securities and also Section 1256 contracts to benefit from large ordinary business loss treatment year-to-date as of the April 15 election deadline of the current tax year. In the subsequent tax year, the trader may want to return to lower Section 1256 60/40 capital gains tax rates and retain Section 475 on securities only. With this rule change, the trader can revoke Section 475 on commodities (Section 1256 contracts) only and not securities.

Unlike with retail traders, it’s not convenient for an investment manager to close a hedge fund or trade less to revoke Section 475. Hedge funds will really appreciate the new automatic and free revocation procedure. Hedge funds often have trouble following Section 475 segregation of investment rules. They enter a trading position and sometimes “let profits run” by having it morph into an investment position. That doesn’t adhere to stringent Section 475 segregation of investment position rules. Plus, the manager prefers deferral at year-end so investors don’t request redemptions in order to pay taxes on unrealized gains if using Section 475 MTM. Segregation requires contemporaneous (same day) identification of investment positions and segregation must be done in form and substance. (Read IRS warns Section 475 traders.)

Rev. Proc. 2015-14
Click on Rev. Proc. 2015-14 and scroll down to pages 349 through 355. It starts at SECTION 23. MARK-TO-MARKET ACCOUNTING METHOD (§475). This explains the election procedure for Section 475. Scroll further to page 351: 23.02 Taxpayers requesting to change their method of accounting from the mark-to-market method of accounting described in §475 to a realization method.

  • “(2) Exclusive procedure. The procedure set forth in this section 23.02 is the exclusive procedure for changing a taxpayer’s method of accounting from the mark-to-market method described in §475 to a realization method. Thus, filing the Notification Statement described in section 23.02(6) of this revenue procedure is the exclusive manner of revoking a §475(e), (f)(1), or (f)(2) election. Moreover, any taxpayer requesting permission to change to a realization method must follow the procedures described in this section 23.02 and other applicable provisions of Rev. Proc. 2015-13, 2015-5 I.R.B. XX, to request consent to change its method of accounting for securities described in §475(c)(2) (Section 475 Securities), commodities described in §475(e)(2) (Section 475 Commodities), or both.”
  • “(5) Manner of making change. This change is made using a cut-off basis and applies only to Section 475 Securities, Section 475 Commodities, or both, that are accounted for using the mark-to-market method of accounting described in §475 and for which a change in method is requested under this section 23.02. Accordingly, a §481(a) adjustment is neither permitted nor required…Under the cut-off basis, a taxpayer must make a final mark of all Section 475 Securities, Section 475 Commodities, or both, that are being marked to market and that are the subject of the accounting method change being requested, on the last business day of the year preceding the year of change…”

I see some issues here. This assumes the taxpayer qualifies for trader tax status on the last day of the year for the final mark. If the taxpayer disqualifies for trader tax status before year-end, then Section 475 MTM is used only to the date of qualification ending. See suspension treatment above.

One catch
Darren Neuschwander, CPA, my co-managing member and our head of tax compliance, pointed out one catch.

“If a trader uses the automatic election to revoke Section 475(f), then the trader can’t use the automatic election to get 475(f) again for five years without going through the non-automatic procedures with the IRS, which includes a fee,” he said. “Now we have an opportunity for successful traders to remove Section 475 MTM, if needed, to use against capital loss carryovers without having to use a new entity. Also, we can help people remove MTM if they are concerned that they don’t want it in place in the future as an individual, without having to petition the commission of the IRS or pay the user fee. Basically, notification statement and another Form 3115 filing. Much simpler!”

For more information on the benefits of Section 475, click here.


April 15 tax extensions and Section 475 election

March 15, 2015 | By: Robert A. Green, CPA

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Securities brokers issue corrected 1099Bs close to and sometimes even after the April 15 tax deadline due to complications over cost basis reporting. Schedule K-1s often come late, too.

When tax information is incomplete near the deadline, it’s wise to file an automatic six-month extension. Caution: It’s not a payment extension; so try to pay at least 90% of your tax liability to avoid late-filing and late-payment penalties. If you don’t pay 90%, hopefully the IRS will accept your “reasonable cause” spelled out in a letter seeking penalty abatement. Retaining tax funds as working capital for trading is not reasonable cause in my view.

April 15 is also the important deadline for individual and partnership traders qualifying for trader tax status to file a Section 475 MTM election statement with the IRS for 2015 and subsequent years. The election statement is attached to the federal extension.

There are many advantages to filing extensions. One negative is waiting longer for a tax refund, but traders often apply overpayment credits to estimated taxes due on trading income instead of claiming a refund.

Extensions for individuals
If you don’t owe taxes, the extensions are easy. Enter taxes paid (including credits) with the same amount for tax liability reflecting a zero balance due. Perhaps your spouse has a W-2 with ample tax withholding and you have trading business losses, itemized deductions and nominal other income. You don’t need to prepare detailed draft tax returns before April 15.

If you think you may owe taxes, then continue working on your tax filings. Prepare draft tax returns based on tax information in hand, accounting and estimates of missing information to generate the extensions from tax software. If you have year-to-date trading gains in 2015, it’s wise to be conservative with extension payments figuring you can apply overpayment credits toward 2015 estimated income taxes.

Extensions for entities
Tax extensions for pass-through entities are March 16, 2015 for S-Corps (since 15th is a Sunday) and April 15, 2015 for partnerships with an extension due date of Sept. 15. 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 twelve months.

Some states have nominal franchise taxes or minimum taxes so check with your state or tax advisor. The state taxes are generally due with the extension filing. March 16 is also the deadline for an existing entity – LLC, C-Corp or general partnership (in most states) to elect S-Corp tax status (see our recent blog on S-Corps).

Section 475 MTM election
Active securities traders qualifying for trader tax status should consider a Section 475 MTM election for ordinary business loss treatment (tax loss insurance). Generally, you should elect Section 475 on securities only, not Section 1256 contracts so you retain lower 60/40 tax rates on those. Section 475 converts capital losses — otherwise subject to a $3,000 capital loss limitation and wash sales — into unlimited business ordinary losses. If you have large trading losses in 2015, you should consider a Section 475 election to lock in those losses as business ordinary losses. Ordinary losses are far better than capital losses.

If you have material capital loss carryovers, you can form a new trading entity to pass-through capital gains to your individual tax return, thereby using up capital loss carryovers. In the last-minute rush of tax season, many taxpayers and tax preparers make the wrong decision on Section 475 and it costs them thousands of dollars in tax savings.

Existing partnerships and individuals elect Section 475 for 2015 by attaching an election statement to their 2014 federal extension filed by April 15, 2015. For existing S-Corps, the election date is March 16, 2015. The second step is to file a Form 3115 (Change of Accounting Method) with your 2015 tax return filed in 2016. Learn more about Section 475 and see the election statement in Green’s 2015 Trader Tax Guide. Consult a trader tax expert before the election deadline.

Broker 1099Bs and confusion over wash sales
Many securities brokers are issuing corrected 1099Bs — it’s the new normal. Brokers continue to face many challenges with new IRS cost-basis reporting rules, including wash sale loss adjustments.Options and simple debt instruments purchased on or after Jan. 1, 2014 are considered “covered securities” and are included on 2014 Form 1099Bs for the first time.

Broker and taxpayer rules differ on calculations for wash sales. Brokers calculate wash sales based on the same equity or symbol (identical position) per account. Conversely, taxpayers must calculate wash sales based on substantially identical positions — i.e., between stocks and stock options and options at different expiration dates — across all individual accounts including all IRAs, even Roth IRAs.

Taxpayers can’t rely on 1099Bs and profit and loss reports from brokers if they trade securities and options or have multiple accounts. In these cases, taxpayers should use securities trade accounting software, which calculates wash sales correctly based on substantially identical positions across all accounts. It’s important to reconcile your own software results to 1099Bs, so taxpayers need to account for corrected 1099Bs on tax filings.  Software publishers release program updates late in tax season or after April 15, too.

Traders are not simple like employees
Employees have taxes withheld on each paycheck and many wind up over-withheld generating material tax refunds, which they are anxious to collect. Many employees have simple tax filings and they can file early. Don’t wait for tax refunds every year — update your W-4 for more allowances and less tax withholding. Traders don’t have tax withholding on trading income. They generally owe taxes on trading income on April 15 because many prefer to underpay estimated taxes.

Traders with large Section 475 ordinary losses may be due large tax refunds. These traders have a lot riding on trade accounting and trader tax status; they should not rush their tax filings, especially if corrected 1099Bs are expected. Rushing may lead to errors, delays in tax refunds and potential tax exams, which can hold up refunds.

Futures and forex traders
If you trade Section 1256 contracts (futures), your broker issues a simple one-page 1099-B listing “aggregate profit and loss” based on marked-to-market accounting (realized and unrealized gains and losses). Correct 1099-Bs are rare for Section 1256 contracts. Likewise, forex brokers provide an online tax report that is reliable.

Extensions provide benefits for retirement plans
2014 contributions to Individual 401(k), SEP IRA and employer 401(k) profit-sharing plans must be funded by the due date of your tax return — Oct. 15 if you filed for an extension. That helps your cash flow. But IRAs must be funded by the original due date of April 15.

If your 2014 Roth IRA conversion didn’t work out well — perhaps the securities dropped significantly in value and you paid conversion taxes on the higher value — you’re entitled to “re-characterize” (reverse) the Roth IRA conversion up until the extended due date of Oct. 15. If you already filed your 2014 tax return, you’ll have to amend it to reflect the re-characterization.

Pressuring your tax preparer may lead to errors
If you engage a quality CPA firm for tax compliance, you should not expect them to focus on completing your tax returns during the last few weeks of tax season when filing an extension is a better option. Quality firms have internal deadlines and they avoid error-prone working conditions. I’ve seen countless cases of clients coming to us with botched prior year tax returns where they also missed vital tax elections like Section 475 because they focused on filing a complete return rather than filing an extension and making this election.

Early filers may get audited more
“The early bird gets the worm.” But in this case, the IRS is the bird and your tax return may be the worm selected for audit. I’ve always believed that audit quotas are met based on early filers. The IRS also wants to get started early with exams, and not wait until Oct. 15.

At the start of tax season, the IRS commissioner said there would be delays due to complications over Obamacare taxes, late renewal of “tax extenders” and the IRS being short of resources and staff.

Late-filing and late-payment penalties
Read federal automatic extension Form 4868 with instructions, especially the Page 2 sections on late-filing and late-payment penalties and how to avoid them.

State extensions
Some states don’t require an automatic extension if you’re overpaid and 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 are 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 2-month extension to file your return and pay any amount due without requesting an extension. For a calendar year return, the automatic 2-month extension is to June 15. If you qualify for this 2-month extension, penalties for paying any tax late are assessed from the 2-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).” 

 

 


Business traders maximize tax benefits with an S-Corp

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

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S-Corp elections are due by March 15, 2015 for existing entities.

Forming an entity taxed as an S-Corp can save active business traders significant taxes. With an S-Corp, business traders solidify trader tax status, maximize employee-benefit deductions (such as health insurance and retirement plan deductions) and gain flexibility with a Section 475 election.

Tax returns are simple
An S-Corp tax return consolidates your trading activity on a pass-through tax return making life easier for you, your accountant and the IRS. Pass-through means there’s no federal tax on the entity level, which avoids double taxation in C-Corps. (Read our recent blog on corporations.) The S-Corp Form 1120-S reports trading gains, losses and expenses, including officer compensation and profit-sharing plan contributions.

Better than a sole proprietorship
The first tax benefit is business expense treatment (Section 162) rather than restricted investment expense treatment (Section 212). If the S-Corp qualifies for trader tax status, it has business expense treatment; otherwise it’s an investment company with investor tax status. The S-Corp tax return looks better than a sole proprietorship trading business Schedule C. The S-Corp shows all activity, whereas a Schedule C only shows business expenses — with trading gains reported on other tax forms — and that looks like a losing business to the IRS. Business expense treatment saves traders more than $5,000 per year in taxes vs. investment expense treatment.

Sole proprietor business traders cannot have employee-benefit deductions in connection with trading gains. Plus, a sole proprietor cannot pay himself a salary or fee to generate self-employment income (SEI) or earned income, which is required for AGI deductions including health insurance and retirement plans. Those employee-benefit plans can save business traders between $3,000 to $17,000 or more per year if properly arranged with an S-Corp structure.

Better than a partnership tax return
Traders need an entity to financially engineer earned income for health and retirement plan deductions. The S-Corp is better than a partnership tax return for this.

Partnership tax returns are inefficient for employee-benefit plan deductions. Partnership tax returns pass through expenses and net losses for income tax and self-employment income tax — the latter being a problem. The partnership pays a guaranteed payment or administration fee to the owner/trader to create SEI. But after the partnership passes through SEI losses, the net result is a low amount of SEI, which constricts a retirement plan contribution.

It works differently with an S-Corp. The S-Corp pays the owner/trader compensation reported on a W-2. The S-Corp passes through expenses and losses for income tax purposes, but not for SEI tax purposes. Employee-benefit plan deductions are entirely based on the amount of W-2 wages and there’s no reduction of earned income from S-Corp expenses and losses. That key difference unlocks the ability to maximize retirement plan contributions.

Tax planning
The owner/officer can have a base salary for covering the health insurance premium deduction, which is allowed even if the S-Corp has trading losses. If the S-Corp has sufficient trading profits by Q4, establish a retirement plan before year-end. Start with the 100% deductible employer 401(k) elective deferral ($17,500 for 2014 and $18,000 for 2015) and pay it before year-end through payroll since it’s reported on the annual W-2.

If you have large trading gains, increase payroll in December for a performance-based bonus to unlock a 25% employer 401(k) profit-sharing retirement plan contribution. You don’t have to contribute into the plan until the due date of the tax return (including extensions). The maximum defined-contribution profit-sharing plan amount is $52,000 plus $5,500 catch-up for 2014, and $53,000 plus $6,000 catch-up for 2015. (For details about retirement plan choices, limits and savings, see Green’s 2015 Trader Tax Guide Chapter 8.)

S-Corp elections
Existing LLCs, C-Corps and general partnerships may elect S-Corp treatment in every state except general partnerships in Connecticut, the District of Columbia, Michigan, New Hampshire, New Jersey and Tennessee. File a S-Corp election on IRS Form 2553 by March 15, 2015. The effective date of the election is January 1, 2015. Most states accept the federal election; if not, file an election in your home state, too. If you miss the S-Corp election deadline, there is IRS and in some cases also state relief for late filings. You’ll need a perjury statement stating you intended to file the election on time. Existing corporations cause taxation on converting accumulated retained earnings.

A new entity may elect S-Corp treatment within 75 days of inception.

Other rules
If you use an S-Corp, read Green’s 2015 Trader Tax Guide Chapter 7 on important issues including officer’s reasonable compensation, stock and debt basis, accounting allocations and more. Underlying income from a trading business is not earned income, so IRS reasonable compensation rules do not apply.

Bottom line
If you’re interested in making an S-Corp election, contact your tax advisor well before the March 15 deadline. There’s still plenty of time to set up a new S-Corp after March 15 to generate employee benefit plan deductions before year-end.

 


C-Corps have limited use for tax savings

February 26, 2015 | By: Robert A. Green, CPA

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A C-Corp can help upper-income taxpayers in business save taxes, but it’s not useful to investors.

Increasingly, upper-income folks and their tax professionals are considering a corporate structure in tax planning in order to avoid Obama-era tax hikes. Starting in 2013, Congress raised the top tax bracket for individuals to 39.6% — effectively 41% after factoring in the Pease itemized-deduction limitation. When the 3.8% Net Investment Tax on unearned income is factored in, the combined individual top rate is a hefty 45%. Upper-income taxpayers are rewarded with an 11% or more tax savings when they can shift income from their individual to corporate tax returns. Plus, Congress is discussing corporate tax reform and they may reduce corporate rates widening the gap with individual rates.

Active traders who don’t qualify for trader tax status (business treatment) wonder if a corporate structure allows trading expense deductions considering that Section 212 investment expenses are restricted on individual tax returns. Corporations cannot deduct Section 212 investment expenses; therefore they don’t provide tax relief when a trader does not qualify for trader tax status.

Businesses can efficiently shift income to a corporation
A pass-through-entity trading business – like an LLC or S-Corp – qualifying for trader tax status has business expense treatment. Administration fees paid to a management company organized as a corporation are a business deduction on the pass-through entity. The receiving corporation has business income and expense treatment.

Business treatment on both the pass-through entity and corporation translates to tax efficiency.

Investors cannot efficiently shift income to a corporation
A pass-through-entity investment company has Section 212 investment expense treatment on the individual owner’s level for administration fees paid to a management company organized as a corporation.

That’s not tax efficient since investment expenses face significant limitations on individual tax returns, including the 2% AGI threshold for miscellaneous itemized deductions and the Pease itemized deduction limitation. Miscellaneous itemized deductions are not deductible for AMT tax.

If the investment company allocates a share of trading gains to the management company corporation in lieu of paying fees, the corporation doesn’t have business purpose. Plus, the corporation could be deemed a personal holding company (PHC) subject to a PHC surtax of 20% on undistributed PHC income. A corporation may not deduct non-business expenses including Section 212 investment expenses, which only individuals may deduct.

Corporations deduct business expenses, not investment expenses
Corporations with business activities may deduct Section 162 trade or business expenses. Corporations aren’t permitted to deduct non-business expenses including Section 212 investment expenses for individuals. When a corporation with established trade or business has ancillary investment expenses related to their business activities — like investing working capital — those expenses are deemed Section 162 business expenses and not Section 212 investment expense. Pure investment companies structured as a corporation may not deduct investment expenses. Pass-through entities with investor tax status report investment expenses on Schedule K-1 issued to individual owners.

Tax law is clear
Our CPA firm researched this tax law: It’s clear Section 212 is for individuals only, and corporations need business purpose to deduct Section 162 business expenses. Corporations cannot deduct non-business expenses. I spoke with an IRS official on this matter and his informal advice was to agree with the position stated in this blog.

Here are some excerpts from highly respected tax publication Bittker and Eustice on “Corporate Deductions.”

  • “The Code allows individuals to take a number of deductions that are not allowed to corporations, including the standard deduction, (investment expenses)…. (the code) prevent restrictions aimed primarily at individuals from being sidestepped by a transfer of the restricted activities to a closely held corporation…Section 212 is restricted to individuals, however, presumably on the theory that § 162(a) covers the same ground for corporations that § 162(a) and 212 in combination cover for other taxpayers. Thus, if a corporation engaged in manufacturing holds some securities as an incidental investment, the cost of a safe-deposit box, investment advice, bookkeeping, and so forth incurred with respect to the securities would be deductible under § 162(a) as trade or business expenses, even though an individual proprietor holding such securities would have to resort to § 212 as authority for deducting such expenses.”

Warning to traders not qualifying for trader tax status
Traders not qualifying for trader tax status should not use a corporation since they don’t have business purpose and corporations can’t deduct non-business expenses. While a corporation starts off with presumption of business purpose, that alone doesn’t achieve business purpose. The corporation must qualify for a trade or business. For a trader that means qualification for trader tax status. A corporation is not a remedy for not qualifying for trader tax status.

Corporate tax rates are materially lower than individual rates
The corporate tax rate starts at 15% on the first $50,000 of income, 25% on the next $25,000 and it settles in at 34% thereafter. Personal service companies don’t qualify for the lower rates under 34%. Taxpayers generally try to take advantage of the lower bracket rates so if the corporation pays them qualified dividends years later there’s still meaningful cumulative tax savings.

Unlike pass-through entities including S-corps, LLCs and partnerships, a corporation (C-Corp) pays entity-level taxes. (Note: LLCs can also elect C-Corp tax-filing status.) An individual owner pays taxes on qualified dividends paid by the corporation up to a 20% (long-term capital gains) rate. Plus a 3.8% NIT is applied on unearned income if you’re over the AGI threshold. Paying taxes on the entity and individual levels is commonly referred to as “double taxation.” Corporations avoid double taxation by paying compensation to owner/officers. Most states also tax corporations, so double taxation can defeat the purpose of using a corporation in high tax states. (State taxation for corporations is beyond the scope of this blog post; see more information in Green’s 2015 Trader Tax Guide.)

A corporation needs business purpose
Before you jump into reorganization as a corporation, it’s important to understand the pros, cons and potential pitfalls. My bailiwick is investors, traders and investment managers. In a nutshell, adding a corporation as a second entity makes sense for a business trader or investment manager to reduce Obama-era tax hikes on individuals. But using a C-Corp structure for an investment company does not work. Corporations need a business purpose; therefore, investors won’t find salvation using a corporate structure.

A successful strategy for a trading business
Suppose you have a successful trading company LLC that qualifies for trader tax status and files as either a S-Corp or partnership. Consider adding a corporation as a second entity to provide administration services or to hold intellectual property and charge royalties to the trading company LLC. That has the effect of shifting income from your individual tax return to a corporate tax return. Either the S-Corp trading company or C-Corp management company can unlock employee-benefit plan deductions including health insurance and retirement plans. (Investment companies can’t generate compensation or earned income by arranging employee-benefit plan deductions.)

A failed strategy for an investor
Suppose you have an investment activity that doesn’t qualify for trader tax status (business treatment). (Read How to Qualify.) You also don’t offer investment management services to clients, so you don’t have any business purpose.

A tax salesman approaches you and promises tax deductions using a corporation. These promoters find their prey on the trading education and seminar circuit. The promoter says you can dump your education expenses and other startup expenses into a corporation going 18 months back and generate a net operating loss (NOL) in the corporation to carryover to subsequent tax years. The promoter also suggests a second LLC entity for trading.

If that LLC doesn’t qualify for trader tax status and pays the corporation management or administration fees, it will have investment expense treatment. That defeats the purpose and you’re right back at the beginning of the problem with investment expense limitations on your individual tax return. Seminars and pre-business education are generally not deductible as investment expenses pursuant to Section 274(h)(7).

Conversely, the LLC can wait to achieve trader tax status at a later date and pay the corporation fees then, which will be business deductions for the LLC trading business. The promoters argue the corporation can utilize its NOL to offset the income from the trading business LLC. But, that doesn’t work in my view, as the corporation can’t deduct those expenses in the first place without business purpose from its inception. Dumping expenses that lack deductibility into a corporation for later use does not have legal authority.

At best, the corporation is entitled to capitalize Section 195 startup business expenses for a reasonable amount over a reasonable period if it has business purpose in the works. It’s simple for an IRS agent to determine whether a corporation has trader tax status or business revenue and, therefore, to determine whether any expenses are legitimate Section 162 corporate deductions.

Personal holding company taxes
Corporate structures are intended for trade or business, not investment companies. Personal holding company (PHC) law charges additional taxes on corporations straying into non-business activities. There are exceptions from PHC rules for financial institutions including banks and insurance companies, but that list doesn’t include trading companies.

The PHC tax is 20% of undistributed personal holding company income. PHC income (Section 543) includes dividends, interest, royalties (with exceptions), annuities, rents, personal service contracts (with exceptions) and more. Exceptions from PHC income include active business computer software royalties, active business copyright royalties in many fact patterns and personal service contracts when a specific person (talent) isn’t named in the contract (consult a tax expert). PHC income also does not include capital gains on trading, which is the main source of income in a trading company. PHCs are corporations with five or fewer owners and more than 60% of their income is from PHC income. The definition of PHC Section 542 discusses business deductions and it clearly leaves out Section 212 investment expenses (which are for individuals not corporations).

Bottom line
The tax code is written to prevent individuals from skirting the narrow Section 212 investment expense deduction rules. Schemes to dump these expenses into corporations are poorly conceived and will lead to tax trouble.

Business traders and investment managers paying top Obama-era tax rates should consider adding a corporation to the mix for legitimate tax savings.

Green NFH CPA Darren Neuschwander and tax attorney Roger Lorence contributed to this blog.

 


9 good reasons to engage Green NFH for tax preparation

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

Traders have unique tax needs requiring a specialist. Here are nine good reasons to engage our firm for your 2014 federal and state income tax return preparation. Tax compliance including preparation and planning is our core business and we have excellent long-term relationships with our valued clients.

  1. Large trading losses

Filing a tax return with large trading losses reported as ordinary losses causes IRS concern about paying large refunds. The IRS is accustomed to capital loss imitations. Forex traders with the default Section 988 treatment have ordinary losses. Active securities traders qualifying for trader tax status (TTS) and using a timely filed Section 475 election also generate business ordinary losses and net operating loss carryback refund claims. If you’re counting on a large refund or tax benefit from deducting ordinary trading losses, you should have our firm prepare and sign your tax return.

  1. Trader tax status and related tax benefits

The IRS doesn’t fully understand TTS and it’s important to file your tax return without red flags and include good written explanations in tax return footnotes. Many self-preparers and local accountants botch TTS reporting strategies, missing tax benefits and reporting items incorrectly. Taxpayers must properly elect Section 475 on time and perfect the election with a correctly filed Form 3115. The linchpin to trader tax benefits — business expenses, Section 475, and employee-benefit plans with entities — is qualification for TTS and our CPAs are highly trained in analyzing your qualification.

  1. Entities and retirement plans

Traders need to create compensation correctly to unlock and maximize employee-benefit plans including health insurance and retirement plans. Home office and other unreimbursed expenses need to be reported properly on individual returns in relation to entity income passed through on Schedule K-1. Pitfalls need to be avoided with C-Corps.

  1. Wash sales and Form 8949

Active securities traders generate many wash sale loss adjustments and brokers don’t report wash sales according to IRS rules for taxpayers. Taxpayers must make many changes on Form 8949 and they also must reconcile Form 1099Bs and explain differences in footnotes.

  1. Forex traders using lower 60/40 tax rates

We make a case for filing a capital gains election on spot forex to get lower Section 1256(g) 60/40 tax treatment. But those rules are vague and uncertain. If you’re reporting large forex trading gains with lower 60/40 tax rates, it’s wise to have our firm prepare and sign your tax return.

  1. Trading many different financial instruments

Tax treatment varies significantly among different types of financial instruments including securities, options, 1256 contracts, ETFs, indexes, forex, Nadex binary options, swaps, precious metals, bitcoin, and other financial products. It’s not always clear how a financial instrument is taxed and some brokers don’t get it right. Our CPAs look over your financial instruments to identify errors in tax treatment.

  1. Maximize expense deductions

Our CPAs are focused on maximizing deductions for investors, business traders, and investment managers. Where, how, and what expenses to deduct depend on your tax status. We handle thousands of traders and see every type of deduction possible — we won’t miss any for you.

  1. Obamacare net investment tax (NIT)

If you’re over the AGI thresholds for NIT — $250,000 married and $200,000 single — it’s important to reduce 3.8% NIT as much as possible. Many accountants don’t understand the nuances of NIT for traders. For example, unlike other taxpayers, Section 475 traders may offset trading losses against other bucket income getting a better result. Traders can also reduce NII by trading and investment expenses.

  1. Convenience and excellent service

Investor, trader, investment management, and small business tax compliance is complex and nuanced. Self-preparers will spend countless hours trying to get it right and they will probably get it wrong. Local CPAs, accountants and tax storefronts are known to botch tax return planning and preparation for investors, traders, and investment managers. We have endless stories of traders missing vital tax elections like the contemporaneous forex capital gains election or the Section 475 MTM election due by April 15, 2015. Our virtual service is very convenient and we maximize every legal tax benefit while avoiding tax trouble and pitfalls. We utilize best practices and technologies with our highly trained CPAs for excellent communication, work product, and client satisfaction. We have the best client testimonials and media and trading industry endorsements by far. Or tax preparation prices are very competitive and they represent a great value when you factor in tax savings and avoidance of tax trouble. Plus our fees are tax deductible, often as a business expense. We guarantee that you will be pleased with our service!
Tax return or extension due dates are coming up: March 15 for S-Corps and April 15 for individuals and partnerships. Visit our tax compliance section to get started.

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We recommend our trade accounting service for active securities traders with wash sales.

We hope to hear from you soon. Don’t wait until the last minute, as we likely won’t be able to accommodate you then. Thanks for considering our services.

Sincerely,
Robert A. Green, CPA
Darren L. Neuschwander, CPA
Managing Members of Green NFH LLC

 

 


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