IRS plays havoc with traders misidentifying investments

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

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Click to read Green’s blog post

The IRS and some states have been playing havoc with traders in exams, claiming traders did not properly comply with Section 475 rules for segregation of investment positions from trading positions. Noncompliance gives the agent license to drag misidentified investment positions into Section 475 mark-to-market (MTM), or to boot misidentified trading losses out of Section 475 into capital loss treatment subject to the $3,000 capital loss limitation. Both of these types of exam changes cause huge tax bills, penalties and interest.

Traders don’t want to lose capital gains deferral and lower long-term capital gains rates on investment positions in securities. With misidentified investments the IRS has the power to drag those positions into Section 475 subjecting them to MTM and ordinary income tax rates.

Section 475 improper identification
Section 475 contains a clause to limit unrealized losses on investment positions dragged into Section 475. Under Section 475(d)(2) (which is applicable to traders pursuant to Section 475(f)(1)(D)), if a security was misidentified as an investment, then there is Section 475 MTM unrealized loss recognition only against other Section 475 gains, and any excess unrealized losses are deferred until the security is actually sold. Limiting MTM treatment on unrealized losses on investment positions is not much different from unrealized capital losses on those same positions.

Carefully identify investments
If you claim trader tax status and use Section 475 MTM, you can prevent this problem by carefully identifying each investment position on a contemporaneous basis. When you receive confirmation of the purchase of an investment position, email yourself to identify it as investment position as that constitutes a timestamp in your books and records. Don’t hold onto winning Section 475 trading positions and morph them into investment positions, as that does not comply with the rules. If identifying each separate investment is inconvenient, then ring-fence investments into identified investment accounts vs. active trading accounts. Use “Do Not Trade” lists for investing vs. trading accounts so you don’t trade the same symbol in both accounts.

But this compliance is not enough. If you hyperactively trade around your investments, the IRS can say you failed to segregate the investment in substance.

Section 475 clean up project
In 2015, the IRS acknowledged lingering problems with Section 475 and announced a Clean Up Project welcoming comments from tax professionals. I started a successful petition on Rally Congress to fix Section 475 and TTS rules and also sent a cover letter and comments to the IRS. The American Bar Association ABA Comments on Mark-to-Market Rules Under Section 475 are good. See my blog post in Aug. 2014 IRS warns Section 475 traders, which focuses on the segregation of investment issue.

Individuals have a problem
Section 475 misidentification of investments is a huge problem for individual sole proprietor traders who have both trading and investment positions. Section 475 is very valuable since it exempts trades from wash sale loss rules and the $3,000 capital loss limitation allowing full net operating loss (NOL) treatment for losses which generates huge tax refunds. A capital loss limitation is the biggest pitfall for traders.

Individuals often have a few trading accounts and also several investment accounts. Married couples may each have individual accounts, some joint accounts and IRA accounts. They may buy and hold popular equities in investment accounts and then hyperactively trade those same symbols in their designated trading accounts.

Entities navigate around the problem
The simple fix is to form an entity like a single-member or spousal-member LLC with an S-Corp election. Conduct all business trading with Section 475 on securities in those entity accounts. (The entity may elect Section 475 MTM internally within 75 days of inception of the entity.) Trader tax status, business expenses and Section 475 trading gains and losses are reported on the S-Corp tax return.

It’s wise to avoid investment positions in the entity accounts. But some traders want to use portfolio margining, and brokers don’t allow that between individual and entity accounts, so they want to transfer some large investment positions into the entity accounts. That can become a problem for Section 475 segregation of investment rules, especially if you trade the same symbols. Consult a trader tax expert.

Keep investments in your individual investment accounts. The individual and entity accounts are not connected for purposes of Section 475 rules since they’re separate taxpayer identification numbers.

The entity also looks much better in the eyes of the IRS claiming trader tax status and using Section 475 ordinary loss treatment. Plus, an S-Corp trading company can have employee-benefit plan deductions — health insurance and high-deductible Solo 401(k) retirement plan) — whereas a sole proprietor trader may not.

Tax court cases are for individual traders
A senior IRS official stated at an industry conference that the IRS is going after (auditing) “Chen cases,” referring to the landmark Chen tax court case. Chen was a part-time individual trader for just three months and he deducted TTS expenses and a huge Section 475 ordinary loss requesting a huge tax refund. The court denied TTS and use of Section 475.

Other recent trader tax court cases are individual traders claiming large TTS expenses and Section 475 losses. I covered these cases on my blog: see posts for Poppe, Assaderaghi, Nelson, Endicott, Holsinger and Chen (covered in my guides). Some of these traders may have been okay if they used an entity, however many did not qualify for trader tax status, and several botched or lied about electing Section 475.

In my blog post on the Poppe case, I point out that individuals face pitfalls in electing Section 475. The IRS granted Poppe TTS but denied Section 475 ordinary loss treatment because he botched or lied about the Section 475 election and he never filed a Form 3115. A new entity wouldn’t have that problem.

Wash sale losses are similar
Section 1091 wash sale rules are similar, yet different in one important aspect from Section 475 rules. While the entity is a different taxpayer from the individual for wash sale loss purposes, the IRS can apply Section 267 related party transaction rules to connect the entity and individual accounts if the trader purposely tries to avoid wash sale losses between the entity and individual accounts. I have not seen Section 267 mentioned in connection with Section 475 segregation rules.

Bottom line
Section 475 tax loss insurance is a huge tax break for traders who qualify for trader tax status but be careful with properly identifying investments. Be safe on using TTS and Section 475 by trading in an entity. Now is a good time to form one for 2016.

Defined-benefit plans offer huge tax breaks

| By: Robert A. Green, CPA

Consistently high-income business owners, including trading businesses with owner/employees close to age 50, should consider a defined-benefit retirement savings plan (DBP) for significantly higher income tax and payroll tax savings vs. a defined-contribution retirement savings plan (DCP) like a Solo 401(k).

DBP calculations are complex
DBP calculations are more complex than a DCP profit-sharing plan. With a DBP, an actuary is required to consider various factors in calculating retirement benefits and annual contributions to the DBP.

The first factor is three-year average annual compensation and the IRS limit is $265,000 (2015/2016 limits). W-2 compensation may be higher, but the actuary may only input the IRS limit. Compensation determines the accumulated retirement benefit and retirement plan distributions/income during retirement years. The IRS limits retirement benefits per year to $210,000 (2015/2016 limits). Based on the maximum factors possible, the accumulated retirement benefit would be approximately $2.6* million.

If the participant plans 10 years of service retiring at age 62, with a 5% growth rate the retirement plan contribution would be $207,000* for the initial years. If that same person has 15 years of participation the annual retirement contribution would be $120,500*. (*Calculations provided by PACE TPA.)

Meet with a DBP administrator/actuary
When you meet with a DBP administrator/actuary, look at some “what if” scenarios with different levels of compensation and years to retirement.

There’s plenty of room for different scenarios between a Solo 401(k) limit of $59,000 for age 50 or older vs. a DBP contribution, which can range between $60,000 and $300,000 per year in the initial years. Traders operating in an S-Corp have the option to use a lower officer compensation amount.

What’s the catch?
A DBP requires annual funding contributions, whereas a DCP does not. With a DBP, the owner/employer commits to saving the actuary-determined accumulated retirement savings amount.

Closing a DBP without a valid reason could lead the IRS to disqualify the plan, making the accumulated benefit taxable income in the year of disqualification. Closing a trading company due to significant trading losses should be a valid reason. On DBP termination, most plan documents allow a tax-free rollover to an IRA or other qualified plan or a lump-sum taxable distribution. The 10% early withdrawal tax rules apply on qualified plan distributions before age 55 (see below).

You should consult your DBP administrator on a timely basis — before June 30 or 1,000 hours of service — to modify the DBP when necessary. For example, if you’re making significantly less income in the first three years, the administrator may be able to lower required contributions. Some DBP administrators recommend maximum allowed funding in early years, which serves to reduce minimum funding requirements in later years. This makes sense as you may make less money as you approach retirement.

You can do direct-access investing or trading inside the DBP account. Leading brokers may allow trading in stocks, bonds, ETFs and restricted trading in options. Avoid margin interest, which triggers unrelated business income tax (UBIT). Caution: Investment losses in the DBP will require larger contributions to make up those losses. Conversely, stellar trading gains can serve to reduce contributions too.

Compensation defined
In an S-Corp, only wages are considered in compensation; pass-through Schedule K-1 income is not. Conversely, with an operating business partnership tax return, all self-employment income (SEI) including guaranteed payments and pass-through income for active partners is included in compensation. A trading partnership has underlying unearned income, which is not SEI.

Payroll tax savings
Under DBP rules, average compensation is determined over the initial three years of the plan and compensation amounts afterward don’t affect DBP contributions and benefits. After three years, a trader may significantly reduce officer compensation, which has the effect of reducing payroll taxes. Payroll taxes include FICA 12.4% up to the SSA wage base amount of $118,500 (2015 and 2016 limits) and unlimited 2.9% Medicare tax. Plus, upper income taxpayers have a 0.9% Medicare/Obamacare surtax on wages. That leaves traders enjoying the tremendous income tax savings with a much smaller offset of payroll taxes. This option to reduce payroll taxes is not available with a Solo 401(k).

An S-Corp trading company has underlying unearned income, which should be an acceptable reason to the IRS for why the S-Corp may not otherwise comply with IRS guidelines for reasonable officer compensation. Conversely, a regular S-Corp operating business like an investment manager receiving management fees or an IT consultant must adhere to IRS guidelines for reasonable compensation. Currently, the guidelines call for 25% to 50% of net income before wages to be officer compensation.

Establish a DBP and execute payroll before year-end
Speak to a DBP administrator well before year-end to establish the plan by Dec. 31. You can fund the plan up until Sept. 15 of the following year — the extended due date of the S-Corp tax return.

You also need to execute officer compensation payroll before year-end.

Although the DBP is based on a three-year average of compensation, you may open a DBP in the first year of S-Corp trading company. Without a three-year average in that first year, there’s a narrower range of minimum vs. maximum contributions each year. If your income drops considerably in the second year, contact the DBP administrator, who can probably modify the plan to lower compensation amounts. After the three-year average of compensation is set, the administrator can’t modify it lower. You also can’t unwind accumulated retirement benefits earned to date.

Types of DBP plans
For an S-Corp trading company with a single owner/employee or a spousal S-Corp with two employees and no outside employees, we recommend a traditional or personal DBP or a “cash balance” DBP with a separate DBP investment account established for each owner employee.

Two spouses working in an S-Corp trading company can take advantage of the hybrid plan: A DBP integrated with partial Solo 401(k) (elective deferral and 6% profit-sharing rather than the normal 25% profit-sharing). If there’s only one employee, the traditional DBP or cash balance DBP is used.

Anti-discrimination rules
There are many anti-discrimination rules and requirements for high-deductible qualified plans intended to prevent the owner/employee from enjoying huge benefits with “top-heavy plans” while omitting or short-changing non-owner employees. Plan designers offer options like vesting over several years for complying with these rules but still favoring owners where possible.

Affiliated service group (ASG) rules apply in a similar context. If you own a business with many employees, you can’t exclude those employees by owning a separate (affiliated) S-Corp trading company with a high-deductible qualified plan for you alone. Consult an employee-benefit plan attorney.

Consult your tax advisor
After you speak with a DBP administrator, actuary, and perhaps an employee-benefit plan attorney, consult your tax advisor on choosing the compensation amount, which drives the related targeted retirement savings goal under the DBP. For S-Corp operating businesses, officer compensation must adhere to IRS guidelines for reasonable compensation, too.

Make sure you are comfortable committing to the annual minimum funding amounts of the DBP. If you want a lower commitment, choose a lower compensation amount. If the DBP calculation shows an annual contribution under $60,000, you are probably better off choosing a Solo 401(k) as it does not require annual funding and its limit is $53,000 for under age 50 and $59,000 for age 50 and older (2015 and 2016 limits).

With Solo 401(k) retirement plans, our CPA firm doesn’t want to see a S-Corp loss after deducting compensation and the retirement plan contribution. We apply this same rationale to the first year of a DBP plan. It’s wise to have sufficient S-Corp year-to-date trading income and expect similar trading gains in subsequent years so there won’t be an S-Corp loss from these large deductions. Once you start the DBP, mandatory contributions may generate a net loss in the S-Corp and that is acceptable. Explain the net loss and DBP funding commitment in a tax return footnote.

Your S-Corp trading company must qualify for trader tax status (business expense treatment), otherwise you can’t have officer compensation and retirement plan contributions in an investment company.

Costs and tax filings
DBP administrators charge $1,200 to $2,000 to design and establish a DBP. DBP administrators also charge around $1,200 to $2,000 per year for plan administration to keep the plan up to date along with modifications based on your evolving needs and changes in the law. Employee-benefit attorneys charge closer to $3,000 to $5,000 or more for DBP design and an attorney is not required. Net tax savings far exceeds these reasonable fees. In many cases, the DB administrator covers the cost of an independent actuary.

Charles Schwab offers a Personal Defined Benefit Plan and they have good resources on their site.

The IRS and The Employee Retirement Income Security Act of 1974 (ERISA) have many stringent rules and requirements for DBPs and it’s imperative to stay in proper compliance. Keep your DBP administrator aware of changes so they can make necessary modifications to the plan on time. There are many pitfalls to avoid with DBP and it’s not as simple as a Solo 401(k) or IRA.

As with all qualified plans, the sponsor of a DBP most likely must file an annual IRS Form 5500 tax return due July 31 of the following year for calendar year entities and plans. A 2½-month extension to Oct. 15 is allowed on Form 5558. Several administrators help with this tax form.

Tax-free growth and retirement distributions
Unless you are making non-tax-deductible contributions to a Roth IRA or Roth Solo 401(k) plan, with traditional retirement plans including qualified plans and IRAs, you get an income tax deduction from gross income for the contribution amount.

With a Roth plan, tax savings are permanent. Conversely, with a traditional qualified plan like a DBP or DCP, there is only tax deferral. Enjoy tax-free growth in the plan until taking taxable retirement plan distributions in retirement years. For traders who do more short-term investing, this annual tax savings is huge. Use a retirement plan calculator and you’ll see the power of tax-free compounded growth. Consider the time-value of money with tax deferral as well.

Under current tax law, retirement-plan distributions are ordinary taxable income. “Early withdrawals”(before retirement years age 59½ in an IRA or age 55 in qualified plans) are also subject to a 10% excise tax penalty on IRS Form 5329. Qualified plans including Solo 401(k) and DBP can offer qualified plan loans, which avoid early withdrawals. Qualified plans are a form of deferred compensation, but there are no payroll taxes on retirement plan distributions or contributions.

In qualified plans, there are required minimum distributions (RMD) by a participant’s required beginning date (RBD). The RBD rule is similar to the RMD rule for IRAs with distributions required no later than by age 70½.

Bottom line
If you are close to age 50, have consistently high annual income, can afford to commit to large tax-deductible contributions and want to smooth your taxable income in retirement taxed at lower tax brackets, then a DBP may be for you. The tax savings is enormous and with tax-free compounded growth it’s an incredible retirement savings tool.



Traders: Good and Troubling News in Poppe Ruling

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

Click to read Green's blog post

Click to read Green’s post on Forbes

In light of the William F. Poppe vs. Commissioner court case, there’s good news for retail traders on the volume of trades needed to qualify for trader tax status.

There’s also troubling news. The IRS denied Poppe his Section 475 election because he could not prove compliance with the two-step election process. Traders should be more diligent in documenting their election. The consequence was that instead of deducting his $1 million trading loss as an ordinary loss, Poppe was stuck with a $3,000 capital loss limitation and a capital loss carryover.

The court construed Poppe’s proprietary trading firm arrangement to be a disguised retail customer account. This ruling should be a huge concern for the proprietary trading firm industry, especially since regulators warned clearing firms about disguised customer accounts in the past. By agreement, prop traders do not trade their own capital in a retail customer account. They trade a firm sub-account with firm capital and far higher inter-firm leverage than is available with a retail customer account.

Qualification for trader tax status
The Poppe court awarded trader tax status (TTS) with 720 trades (60 trades per month). That’s less than our 2015 golden rule calling for 1,000 trades per annum on an annualized basis. Poppe seems to have satisfied our other golden rules on frequency, holding period, intention to run a business, serious account size, serious equipment, business expenses, and more. Plus, Poppe had a good background as a stockbroker.

In some years, Poppe was a teacher and part-time trader, fitting trading into his schedule. It helped that Poppe made a lot of money trading in a few years in comparison to his teacher’s salary.

Botched Section 475 election
Poppe had large trading losses ($1 million in 2007) for which he claimed Section 475 ordinary business loss treatment rather than a puny $3,000 capital loss imitation against other income. But like other recent tax court cases (Assaderaghi, Nelson, Endicott, Holsinger and Chen), the court busted Poppe for either lying to the IRS about making a timely Section 475 election or making a valid election but not being able to prove it to the IRS. Poppe never filed a required Form 3115 to perfect the Section 475 election, which begs the question: Did he ever file an election statement on time?

The case opinion states that Poppe intended to elect Section 475 for 2003 and he filed his 2003 tax return late in 2005 omitting a required 2003 Form 3115. Poppe’s tax preparer reported 2003 Section 475 trading gains on Schedule C. That’s incorrect: Section 475 trading gains are reported on Form 4797 Part II ordinary gain or loss. This botched reporting indicates to me that Poppe’s tax preparer did not understand Section 475 tax law and it probably buttressed the IRS win.

Many traders are in the same predicament as Poppe and should do their best to document the election filing in case the IRS challenges it later on. We document the process for our clients and ask them to document their filings, too. Send yourself an email with the relevant facts as email has a timestamp. Safeguard a copy of the election and Form 3115 in your permanent files.

One learning moment in the Poppe case is how to properly make a timely Section 475 election and to avoid pitfalls in botching the election process.

Section 475 tax loss insurance
By default, investors and traders in securities and Section 1256 contracts have capital gain and loss treatment, as opposed to ordinary gain or loss treatment. Capital losses offset capital gains without limitation, but a net capital loss is limited to $3,000 per year against other income with the remainder of capital losses carried over to the subsequent tax year(s).

Traders qualifying for TTS may file a timely election for Section 475 ordinary gain or loss treatment (on securities only or Section 1256 contracts, too). Generally, traders prefer to retain Section 1256 treatment with lower 60/40 capital gains rates. Section 475 exempts traders from wash-sale loss treatment on securities and capital loss limitations. It’s known as “tax loss insurance” since it allows full business ordinary loss treatment comprising NOLs generating NOL tax refunds.

A sole proprietor (unincorporated) trader makes an individual-level Section 475 election. A proprietary trading firm or hedge fund makes an entity-level Section 475 election. A partner in a proprietary trading firm or hedge fund cannot override the firm’s Section 475 election or lack of an election made on the entity-level.

Warning: Don’t botch the election
Botching the election empowers the IRS to deny use of Section 475 serving up a simple win for the IRS in tax court. Even when a taxpayer properly makes a Section 475 election, an IRS agent may challenge his or her qualification for TTS, which pulls the rug out from under using Section 475. (Each tax year TTS must be assessed as a prerequisite to using Section 475.)

Section 475 election two-step process
The first step is for the trader to file a timely election statement early in the current tax year to prevent the trader from using hindsight about the election later.

An “existing taxpayer” (who filed a tax return before) must file an election statement with the IRS (that means “external”) by the due date of the prior year tax return not including extensions: April 15 for individuals and partnerships and March 15 for S-Corps. (Note that in 2017, the partnership due date changes to March 15.) Attach the Section 475 election statement to the tax return or extension filing. I suggest documenting this first step in your books and records including emailing a copy to yourself and your accountant. Don’t count on the IRS for keeping a copy of the election statement.

An existing taxpayer’s second step is to file a Form 3115 (Change Of Accounting Method) with appropriate Section 481(a) adjustment by the due date of the election-year tax return including extensions. The complex Form 3115 must be filed in duplicate: one copy with the timely filed tax return and a second copy to the IRS national office.

Example of existing taxpayer: A sole proprietor trader files a 2015 Section 475 election by April 15, 2015, attaching the election statement to his 2014 federal tax extension filed on time by mail. (You can’t attach an election to an e-filed extension.) Second step: The accountant prepares a 2015 Form 3115 to accompany the 2015 Form 1040 filed by Oct. 15, 2016 with a valid extension filed by April 15, 2016.

Why the two steps? So taxpayers can make a very simple election filing with little hindsight but to allow sufficient time to prepare a complex Form 3115 with the tax return filing after year-end.

Common errors with Section 475 elections
Many local accountants are confused about the two-step process. Some think only one step is required: either filing the Form 3115 in lieu of the election statement, or the election statement as part of a Form 3115 filing with the tax return. They don’t comply with both required steps and that botches the election.

Section 475 “new taxpayer” exception
There is an important exception to the election process for “new taxpayers” such as a new entity. A new taxpayer may file the Section 475 election statement within its own books and records (internally) within 75 days of inception of the new entity.

Existing taxpayers who miss the external 475 election by April 15 should consider forming a new entity to make an internal Section 475 election within 75 days of inception, which is later in the year. A new taxpayer “adopts” Section 475 from inception as opposed to changing its accounting method so they don’t have the second step of filing a Form 3115 with Section 481(a) adjustment (converting realization/cash method to MTM on Jan. 1).

The entity provides better flexibility in making, revoking, and ending Section 475 elections with closure of the entity. With fewer steps to follow, the internal election for new taxpayers is a better choice for prevailing with the IRS.

Poppe’s errors on Section 475
Poppe was not able to verify the external 475 election statement (step one) or a Form 3115 filing (step two). It wasn’t just a question of being late on a Form 3115 filing, Poppe never filed a Form 3115 and he was an existing taxpayer individual.

Traders should file the external Section 475 election statement with certified return receipt. But that may not be enough because it only verifies a mailing, which also contains the tax return or extension. The IRS recognized this problem and suggests that taxpayers include a perjury statement on Form 3115 stating they filed the 475 election statement on time.

Is there any relief from the IRS?
My partner Darren Neuschwander, CPA spoke with an IRS official in the Form 3115 area a few years ago who said the IRS had granted some relief to a few traders providing they were only a little late with their Form 3115 filing and they filed the election statement on time. The IRS official pointed out there is no relief for filing the initial election statement late.

But Poppe was not a little late — he never filed a Form 3115, even with the case being heard years later. It’s wise to file Form 3115 on time per the written rules and not rely on hearsay about possible relief from IRS officials, which may no longer be granted after the Poppe decision. Consult your trader tax advisor.

Poppe’s mental incapacity argument didn’t work
The Poppe case shows that it doesn’t work to claim reasonable cause on noncompliance due to mental incapacity if the taxpayer can’t demonstrate the same mental incapacity in a job, business, or trading. Poppe tried to raise this issue for special relief and the IRS said no because he wasn’t mentally impaired as a teacher and as an active trader.

Per Thomson Reuters, “Poppe argued that his actions met the requirements of the ‘substantial compliance’ doctrine, under which perfect compliance with a tax provision isn’t required. But the Court said that the substantial compliance doctrine does not apply to the Code Sec. 475(f) election and that, even if it did, Poppe failed to meet many of Rev Proc 99-17 ‘s requirements and thus hadn’t substantially complied.”

Proprietary trading account or disguised customer account?
In 2007 (the IRS exam year), Poppe lost $1 million trading with a proprietary trading firm that cleared through Goldman Sachs Execution & Clearing (GSEC). This is the tax loss at the center of this case.

On his original tax return filing, Poppe reported this loss (assumed) on Schedule E page 2, as an ordinary loss flowing through to him as a partner in a partnership. If the proprietary trading firm qualified for TTS and filed a timely Section 475 election on the firm level, then trading losses allocated to partners would have ordinary loss treatment.

Poppe attached a partner Schedule K-1 to his tax return even though it is not required. But during the exam, the IRS was unable to find Poppe’s K-1 in the partnership tax return filings where it is required to be attached. This begs the question: Did Poppe fabricate his own Schedule K-1? That would be illegal. Or did the firm present Poppe with a Schedule K-1 only to retract it in their partnership tax filing later on? (IRS computers match K-1s reported on partner’s individual tax returns with partnership tax filings looking for incorrect reporting.)

Prop trading firm arrangements, agreements, tax treatment and regulatory issues are murky. Perhaps Poppe never formally signed the prop trading firm’s LLC Operating Agreement. The case states Poppe couldn’t satisfy the IRS that he was a partner in the firm. If not an LLC member, perhaps he was an independent contractor, which is the second business model for proprietary trading firms.

Poppe claimed he was a Class B member of the firm. Generally, the main owners (Class A members) are allocated firm-wide trading losses on their K-1s since they own the firm’s capital in their capital accounts, which provide tax basis for deducting trading losses. Generally, Class B members don’t have capital accounts so they aren’t allocated losses since they wouldn’t have tax basis to deduct losses, which would then be suspended to subsequent years when they might have capital.

Instead of paying into firm capital, Class B members pay “deposits” to the firm. This is where the confusion mainly lies. The firm applies these deposits to cover the prop trader’s trading losses incurred in a firm sub-account. Prop traders are entitled to deduct lost deposits as business bad debts, which are ordinary business losses. Perhaps Poppe should have considered lost deposit bad debt tax treatment instead of using an incorrect K-1 and later relying on an alleged Section 475 election as a retail individual trader.

I’ve been covering the proprietary trading industry since the late 1990s. Around 2000, some people questioned whether proprietary trading firm arrangements were really “disguised” retail customer accounts. Reg T margin rules allow 4:1 margin on pattern day trader (PDT) customer accounts requiring a $25,000 minimum account size. Otherwise, retail investors are limited to 2:1 margin on securities. The big attraction of proprietary trading firms is they offer proprietary traders (LLC members or independent contractors) far greater leverage (greater than 10:1 in some cases) on their deposits made with the firm. Some proprietary trading firms have minimum deposit amounts as low as $2,000.

If the firm’s profit sharing arrangement is more than 80% sharing to the prop trader, FINRA’s Regulatory Notice 10-18 issued to clearing firms stated it’s one of several signs it may be a disguised retail customer account. Read my June 2010 blog post FINRA’s notice to prop traders. Poppe had 90% profit sharing and perhaps that led the IRS to conclude it was a disguised retail customer account. GSEC is a popular clearing firm for proprietary trading firms and I don’t believe it services individual retail customers. Goldman Sachs brokerage firm has high standards for opening individual retail customer accounts.

The Poppe opinion states: “The parties stipulated that all transactions and capital in the GSEC account belonged to petitioner (Poppe).” Perhaps the parties preferred this tact so they could ague the case over Poppe’s alleged Section 475 election as a retail trader. In my view, the word “stipulate” means the parties agreed on facts as a pre-condition to negotiating a settlement. But it’s not necessarily the true facts.

Should prop traders file Section 475 elections as a backup position in case the IRS later considers them a disguised retail customer account? I imagine plenty proprietary trading firms and prop traders are in tax controversy (exams, appeals or tax court) now and I suggest they consider contacting our CPA firm for help soon.

Bottom line
I’m happy to see a new trader tax court case moving the goal posts back to 720 trades from 1,000. That opens the door for more traders. I am not surprised that another trader (and his accountant) botched the complex Section 475 election process and later tried to bamboozle the IRS about it in order to get a huge tax benefit. Proprietary trading firm arrangements with prop traders are murky and the IRS may turn up the heat on them both soon.

For more information, check out T.C. Memo. 2015-205.

Darren Neuschwander CPA contributed to this blog post.

Common Tax-Planning Questions

October 30, 2015 | By: Robert A. Green, CPA

Here are the top questions we often ask our clients. Consider your answers and contact us to find out if there are specific tax moves you should make before year-end. Read our year-end tax planning series: Smart Tax Saving Moves For 2015Retirement Plan Strategies for 2015 and Tax Moves for Business Owners in 2015.

  1. Should you sell some losing investment positions to offset capital gains (tax loss selling) before year-end?
  2. Do you have a wash sale loss problem and can you fix all or part of it for 2015?
  3. Have you done whatever you can to use up capital loss carryovers?
  4. Have you maximized long-term capital gains rate benefits?
  5. Should you form a trading business entity to unlock employee-benefit plan deductions including health insurance premiums and a retirement plan?
  6. When is it too late to form an entity in 2015 and consider one instead for Jan. 1, 2016?
  7. How can you maximize employee-benefit plan deductions by year-end?
  8. If you have high income, is a defined benefit plan better than a defined contribution plan?
  9. Will you get good bang for the tax buck on purchasing new equipment before year-end?
  10. Do you qualify for trader tax status (business expense) in 2015 or will you qualify in 2016?
  11. Should you elect Section 475 MTM in your new entity within 75 days of inception?
  12. Is Section 988 ordinary treatment or Section 1256(g) capital gains treatment better for your forex trading through year-end?
  13. Is a Roth IRA conversion a good idea for you before year-end?
  14. Is an NOL carry back or carry forward better or should you soak up the NOL with a Roth IRA conversion in the current year?
  15. What tax brackets are in you in for 2015 and should you defer or accelerate income at year-end?
  16. Do you face an underestimated tax payment penalty and what can you do to avoid it?
  17. Are you avoiding tax hikes on upper-income taxpayers including Obamacare Net Investment Tax as best you can?


Tax Moves for Business Owners in 2015

October 28, 2015 | By: Robert A. Green, CPA

A cash method business can often accelerate or defer sales, billing and collection of revenue around year-end. If they sell their business or assets they can either use the installment method to defer capital gains, or elect out of that method to report the entire capital gain in the current tax year.

Businesses can accelerate or defer purchases of fixed assets and expenses around year-end as well. And, they have many options for how to depreciate and amortize fixed and intangible assets, respectively.

Accrual-method businesses can delay providing goods or services to customers until after Jan. 1. There are also special rules allowing accrual method taxpayers to deferring revenue received in advance of shipment of goods or services. Read about other smart moves for operating businesses on The Tax Advisor.

Keep an eye out on “tax extenders”on depreciation discussed in our blog post Smart Tax Savings Moves For 2015. Traders don’t often exceed old rules (which currently apply for 2015) allowing up to $25,000 of purchases for Section 179 (100%) depreciation whereas other types of businesses certainly do. The 50% bonus first-year depreciation deduction also lapsed but businesses can use the half-year conversion to similar effect.

If you expect debt cancelation and expect related debt-cancelation taxable income, it may pay to defer that taxable event to 2016.

Payroll and self-employment taxes
An operating business can use the S-Corp structure to reduce payroll taxes by 50% or more (subject to new guidance pending from the IRS). S-Corps don’t pass through self-employment income (SEI) triggering self-employment (SE) tax as partnerships and sole proprietorships do. Consider the SE tax reduction loophole for management companies and other types of business.

Traders use a S-Corp trading company (or C-Corp or S-Corp management company along with a trading partnership) to unlock employee-benefit plans including retirement and health insurance premium deductions. Sole proprietor traders can’t have these tax breaks. It’s hard to arrange them on trading partnership returns.

Both payroll and Solo 401(k) retirement plans must be executed or established before year-end. A SEP IRA can be established up until the due date of the tax return including extensions, although a Solo 401(k) is a much better plan for traders. Learn more in our blog post Retirement Plan Strategies For 2015.

Retirement Plan Strategies for 2015

| By: Robert A. Green, CPA


Click to read Green’s post on Forbes

There’s still ample time in 2015 to rearrange the timing of your investments, trading, retirement and business affairs to improve your overall taxes for 2015 and surrounding years.  In this second blog post of our year-end tax planning series I focus on retirement plans.

Retirement plans for traders can be used several ways. You can trade in the retirement plan, build it up with annual tax-deductible contributions, borrow money from it to start a trading business and convert it to a Roth IRA for permanent tax-free build-up. Whatever the use, traders often need help through these important planning opportunities. There are plenty of pitfalls to avoid like early withdrawals subject to ordinary income tax rates and 10% excise tax penalties, and penalties on prohibited transactions.

Tax-advantaged growth
Many Americans invest in the stock market through their 401(k), IRA or other types of traditional retirement plan. Capital gains and losses are absorbed within the traditional retirement plans with zero tax effect on current year tax returns. Only withdrawals (or distributions) generate taxable income at ordinary tax rates. The retirement plan does not benefit from lower long-term capital gains rates. Traditional retirement plans aren’t disenfranchised from deducting capital losses, since a reduction of retirement plan amounts due to losses will eventually reduce taxable distributions accordingly.

Defined contribution plan vs. defined benefit plan
Most private companies switched to defined contribution plans, whereas public-sector unions still use richer defined benefit plans. In a defined contribution plan, the contribution is defined as a percentage of compensation, whereas in a defined benefit plan, the retirement benefit itself is defined.

If you own and operate a small business, consider a Solo 401(k) defined contribution plan. It combines a 100% deductible “elective deferral” contribution ($18,000 for 2015) with a 25% deductible profit-sharing plan contribution on an employer-level plan. There is also a “catch up provision” ($6,000 for 2015) for taxpayers age 50 and over. Together, the maximum tax-deductible contribution is $53,000 per year and $59,000 including the catch up provision (based on 2015 and 2016 IRS limits).

Consistently high-income business owners, including trading businesses with owner/employees close to age 50, should consider a defined-benefit retirement savings plan (DBP) for significantly higher income tax and payroll tax savings vs. a defined-contribution retirement savings plan (DCP) like a Solo 401(k). Read our blog post Defined-benefit plans offer huge tax breaks.

Get started before year-end
Contact your tax advisor in early November as these plans take time to consider, establish and fund. Several large online brokers offer Solo 401(k) plans, otherwise known as Individual 401(k)s. Paychex, our recommended service provider for payroll tax compliance, also offers the Solo 401(k) product and integrates it with payroll tax compliance. The Paychex Solo 401(k) product contains the plan loan feature, whereas I only know of one large broker that also offers a plan loan feature (TD Ameritrade). Direct-access trading is allowed with all these options. (Paychex has a team dedicated to GreenTraderTax clients – brochure.)

Only a few top brokers offer a defined benefit plan product.

Solo 401(k) defined contribution plans and defined benefit plans must be established before year-end, so get started by early December. IRAs can be established and funded after year-end by April 15. A SEP IRA can be established and funded by the due date of the tax return including extensions, so if you miss the Solo 401(k) deadline, that could be a last resort option.

A Solo 401(k) is better for most traders in most situations than a SEP IRA, because it has a 100% deductible elective deferral in addition to profit sharing plan and the SEP IRA only has the profit sharing plan. In a Solo 401(k), it takes a lower amount of wages to maximize the higher contribution amount versus a SEP IRA. Because traders are in control of the compensation amount they can achieve a higher income tax benefit versus a lower payroll tax cost with a Solo 401(k).

Contributions to IRAs
Traditional and Roth IRAs allow a small annual contribution if you have earned income: $5,500 per person if under age 50 and $6,500 if 50 and older (2015 and 2016 limits). If you (and your spouse) are not active in an employer-sponsored retirement plan, or if either of you are active but your modified adjusted gross income (AGI) doesn’t exceed certain income limits, you may contribute to a traditional tax-deductible IRA.

Non-deductible IRA. If you have earned income, you should also consider making a non-deductible IRA contribution, which doesn’t have income limits. The growth is still tax deferred and you are not taxed on the return of the non-deductible contributions in retirement distributions. The general rule applies: If you deduct the contribution, the return of it is taxable, but if you don’t deduct the contribution, the return of it is non-taxable. Income growth within the plan is always taxed unless it’s inside a Roth IRA.

Contributions require SEI or wages
Many traders are interested in making tax-deductible contributions to retirement plans for immediate income tax savings in excess of payroll tax costs and to actively trade those accounts with tax deferral and growth until retirement. But, there is an obstacle: Trading gains and portfolio income are not self-employment income (SEI) or compensation, either of which is required for making contributions to a traditional or Roth retirement plan. (The exception to this is futures traders who are full-fledged dealer/members of options or futures exchanges; their individual futures gains are considered SEI.) You can overcome this obstacle with a trading business entity — S-Corp trading company or C-Corp management company — paying compensation to the owner/trader. This strategy does not work for investment companies, though.

Early withdrawals vs. a qualified plan loan
If you need to withdraw money from a traditional retirement plan before retirement age 59 ½ for IRAs and age 55 for a 401(k), in addition to the distribution being taxable income, you’ll probably owe a 10% excise tax penalty subject to a few limited exceptions (Form 5329). In lieu of an early withdrawal, consider a loan from a qualified plan like a Solo 401(k). IRAs are not qualified plans and loans would be a prohibited transaction blowing up the IRA, making it all taxable income. You can borrow up to the lower of $50,000 or 50% of plan assets, and you must repay the loan with market interest over no longer than five years and a quarterly basis.

Required minimum distributions
Per Thomson Reuters, “Take required minimum distributions (RMDs) from your IRA or 401(k) plan (or other employer-sponsored retired plan) if you have reached age 70½. Failure to take a required withdrawal can result in a penalty of 50% of the amount of the RMD not withdrawn. If you turned age 70½ in 2015, you can delay the first required distribution to 2016, but if you do, you will have to take a double distribution in 2016 — the amount required for 2015 plus the amount required for 2016. Think twice before delaying 2015 distributions to 2016 — bunching income into 2016 might push you into a higher tax bracket or have a detrimental impact on various income tax deductions that are reduced at higher income levels. However, it could be beneficial to take both distributions in 2016 if you will be in a substantially lower bracket that year.”

Roth retirement plans and conversions
A Roth retirement plan is different from a traditional retirement plan. The Roth plan has permanent tax savings on growth, whereas the traditional retirement plan only has deferral with taxes owed on distributions in retirement. Distributions from a Roth plan are tax-free unless you take an early withdrawal that exceeds your non-deductible contributions to the plan over the years (keep track well).

Consider annual contributions to a Roth IRA. The rules are similar to traditional IRA contributions. Also, consider a Roth IRA conversion before year-end 2015 to maximize use of lower tax brackets, offset business losses and fully utilize itemized deductions.

Here’s an example: Assume a trader left his job at the end of 2014 and incurred trading losses in 2015 with trader tax status and Section 475 MTM ordinary loss treatment as a sole proprietor. Rather than carry back an NOL that could draw IRS attention, or carry forward the NOL to subsequent years when income isn’t projected, this trader rolls over $300,000 from his prior employer 401(k) to a Rollover IRA and enacts a Roth IRA conversion for $300,000 before year-end. He winds up paying some taxes within the 15% ordinary tax-rate bracket. If the trader skipped a Roth conversion, he would lose tax benefits on his itemized deductions including real estate taxes, mortgage interest, charity, and miscellaneous itemized deductions. This trader’s Roth account grows in 2016 and he chooses to skip a recharacterization. (If a recently converted Roth account drops significantly in value in the following year, a taxpayer may reverse the Roth conversion with a “recharacterization” by the due date of the tax return including extensions (Oct. 15).

Also, after recent market corrections in indexes and many individual stocks, consider a Roth conversion at lower amounts to benefit from a potential recovery in markets inside the Roth IRA where that new growth is permanently tax-free. Converting at market bottoms is better than market tops.

DOs and DON’Ts of using IRAs and other plans
Learn the DOs and DON’Ts of using IRAs and other retirement plans in trading activities and alternative investments (read our blog post). Many traders may be triggering IRS excise-tax penalties for prohibited transactions including self-dealing and/or UBIT (unrelated business income tax) by using their IRAs and other retirement funds to finance their trading activities and alternative investments. Spot these problematic schemes early, like the IRA-owned LLC. Avoid “blowing up” your IRA, which means it becomes taxable income; plus there are severe penalties.

When it comes to retirement plans and tax savings, it’s wise to do tax planning well before year-end to maximize your available options. The door closes on many at year-end.

Smart Tax Saving Moves For 2015

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


Click for Green’s post on Forbes

There’s still ample time in 2015 to rearrange the timing of your investments, trading, retirement and business affairs to improve your overall taxes for 2015 and surrounding years.

Tax planning may be challenging, but it pays off
With plenty of moving parts, graduated tax rates and a long list of loopholes, tax breaks and penalties, you’ll need extra diligence for tax planning this year. Upper-income individuals must contend with AMT, Obamacare NIT and AGI-based phase-outs of tax breaks on itemized deductions, personal exemptions and credits.

We focus on traders, investors and investment managers and with volatile financial markets in 2015, many experienced wide swings in income and losses. Several face an unfamiliar tax landscape, such as much higher income and not realizing or setting aside higher taxes with surprises like Obamacare NIT; or huge losses, missing a timely Section 475 election for business ordinary loss treatment and getting stuck with significant capital loss carryovers.

Traders have special issues to contend with
Wash sales: Securities traders must comply with onerous wash sale loss rules (Section 1091) and brokers make it more difficult for them by applying different rules from taxpayers on tax reports and Form 1099-Bs. Taxpayers must report wash sales on substantially identical positions across all accounts, whereas brokers report only identical positions per account. Use TradeLog to identify potential wash-sale loss problems. Break the chain by selling the position before year-end and not buying a substantially identical position back 30 days before or after in any of your individual taxable or IRA accounts. (Starting a new entity effective Jan. 1, 2016 can break the chain on individual account wash sales at year-end 2015 providing you don’t purposely avoid wash sales with the related party entity.)

Section 475 elections: Business traders qualifying for trader tax status like Section 475 on securities for exemption from wash-sale rules and capital loss limitations. Section 475 ordinary losses contribute to NOL refunds. Individuals and existing partnerships can elect Section 475 by April 15, 2016 for 2016 (March 15 for S-Corps).

Trading entities: A “new taxpayer” entity can elect Section 475 within 75 days of inception. Consider that for 2015, especially later in the year. But it’s too late to form a new trading entity by late November and still qualify for trader tax status in that short period before year-end. Unlock employee benefit plan deductions for traders with an S-Corp trading company or C-Corp management company with a trading partnership. Sole proprietor traders can’t have employee-benefit plan deductions since trading income is not self-employment income (SEI). An entity formed late in the year can unlock employee-benefit plan deductions for an entire year by paying officer wages in December.

Trader tax status (TTS): If you qualify for TTS (business expense treatment — no election needed) in 2015, accelerate trading expenses into that qualification period as a sole proprietor or entity. If you won’t qualify until 2016, defer trading expenses until then. You may also capitalize and amortize Section 195 startup costs in the new business, going back six months before commencement. Business expense treatment is far better than investment expense treatment. Investment expenses are part of miscellaneous itemized deductions which are only deductible in excess 2% of adjusted gross income (AGI) and are non-deductible for AMT. If you are stuck with investment expense treatment, try to bunch expenses into one useful year rather than two. The bunching strategy may also be effective for medical expenses and other itemized deductions.

Fill the gaps in tax brackets
If you own an investment portfolio, you have the opportunity to do tax loss selling or the reverse by selling winning positions for capital gains.

Traders like to study investment charts, and they should also study the IRS charts for tax rates with graduated tax brackets, Social Security and retirement contribution limits, standard deductions, exemptions and more. See Tax Rates and other tax charts in our Tax Center. There are significant differences in the charts for filing status: single, married filing joint, married filing separate and head of household. Did you change your filing status in 2015?

Focus on the ordinary income and long-term capital gains brackets. Consider accelerating income and deferring expenses to fill a gap in a bracket before entering the next higher tax bracket. Or, defer income and accelerate expenses to drop down a marginal tax bracket. Just keep an eye out for triggering AMT, a minimum tax rate.

Miscellaneous considerations for individuals

  1. Note inflation adjustment increases to rate brackets and more.
  2. Consider your time-value of money when considering acceleration or deferral of tax payments.
  3. Consider estimated tax payment rules including the safe-harbor exceptions. If you accelerate income, you may need to pay Q4 2015 estimated taxes by Jan. 15, 2015.
  4. Alternatively, increase tax withholding on wages to avoid estimated tax underpayment penalties.
  5. If you still need to avoid estimated tax underpayment penalties, arrange a rollover distribution from a qualified retirement plan with significant tax withholding before year-end. Next, rollover the gross amount into a Rollover IRA. The result is zero income and avoidance of an estimated tax penalty.
  6. Consider year-end gifts of appreciated property to family members within the annual gift exclusions ($14,000 for 2015) to shift income. Consider the “kiddie tax” rules.
  7. Sell off passive loss activities to unlock and utilize suspended passive-activity losses.
  8. Maximize contributions to retirement plans.
  9. The IRS has many obstacles to deferring income including passive-activity loss rules, a requirement that certain taxpayers use the accrual method of accounting, and limitations on certain itemized deductions like investment interest expense and charitable contributions.
  10. Individuals on the cash method get credit for purchases charged to their credit card by Dec. 31.

Long-term capital gains rates are lower than most people think
If you are married filing joint and your taxable income is under the 2015 15% ordinary bracket $74,900 maximum, you have zero federal taxes on long-term capital gains income. For example, if your taxable income is $60,000, you can sell a security held over 12 months for a $14,900 long-term capital gain and not pay any additional federal tax on that capital gain. (For a single filer, the corresponding 2015 15% ordinary bracket maximum is $37,450 of taxable income.)

Long-term capital gain graduated rate brackets:
Zero for the 10% and 15% ordinary rates,
15% above the 15% ordinary rate, except,
20% in the 39.6% top ordinary rate.

Match short-term vs. long-term capital gains and losses
It’s not tax efficient to do “tax-loss selling” on short-term positions while eating into lower long-term capital gain rate benefits — in other words, to offset short-term capital losses against long-term capital gains. The IRS rules for accounting for the two separate buckets can be confusing. Read last year’s tax planning blog 2014 year-end tax planning for traders point #10.

Qualified dividends are taxed at long-term capital gains rates
Another beauty left over from the Bush-era tax cuts is the rule for qualified dividends taxed at lower long-term capital gains rates: A fiscal incentive was given to long-term investors who hold dividend-paying stocks. As pointed out above, the long-term capital gains rate tax break transcends all tax brackets; it’s not just for the upper-income.

How to qualify: To be a qualified dividend, the dividend must be paid from a domestic corporation or certain (“qualified”) foreign corporation. The taxpayer must hold common stock for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date. For preferred stock, the holding period is 90 days during the 180-day period beginning 90 days before the stock’s ex-dividend date.

The long-term capital gains rate affects futures trading, too
Section 1256 contracts (including futures, broad-based indexes and non-equity options) are subject to 60/40 capital gains tax rates and mark-to-market accounting: 60% is long-term even on day trades and 40% is short-term taxed at ordinary rates. The blended 60/40 rate in the top bracket is 28%. That’s 12% less than the top ordinary rate of 39.6%.

With zero long-term rates in the 10% and 15% ordinary brackets, there is meaningful tax rate reduction throughout the brackets. In the 15% ordinary tax bracket, the blended 60/40 rate is 6%. (Here’s the math: 60% LT x 0% LT rate = 0%. Plus, 40% ST x 15% ST rate = 6%.) In the 10% ordinary tax bracket, the blended 60/40 rate is 4%. States don’t apply a long-term rate, so regular state tax rates apply. Tax Foundation has a useful chart on top federal and state capital gains tax rates.

Instead of day or swing trading the Nasdaq 100 ETF (Nasdaq: QQQ) taxed as a security at ordinary rates, consider trading the Nasdaq 100 emini index (CME: NQ), a Section 1256 contract taxed at lower 60/40 tax rates. There’s also a Section 1256 loss carry back election allowed to apply the loss in the prior three tax years against Section 1256 gains only.

AGI-based phase-outs and tax rates
It’s not always evident whether it’s better to defer or accelerate income, loss and expenses. Consider AGI-based phaseouts of various tax breaks and effective use of marginal tax brackets in the current and surrounding years.

AGI-based phaseouts include the 2% AGI threshold for miscellaneous itemized deductions, which includes investment expenses, the Pease itemized deduction limitation on upper-income taxpayers, child and dependent care tax credits, higher education tax credits, deductions for student loan interest and allowed deductible IRA contribution limits.

Alternative tax regimes NIT and AMT
The Patient Protection and Affordable Care Act has many new and different types of taxes to finance the law, starting on different dates. One of these new tax regimes — the “Net Investment Income Tax” (NIT) originally referred to as “ObamaCare 3.8% Medicare surtax on unearned income” — affects upper-income taxpayers as of Jan. 1, 2013. It only applies to individuals with net investment income (NII) and modified AGI exceeding $200,000 (single), $250,000 (married filing jointly) or $125,000 (married filing separately). (Modified AGI means U.S. residents abroad must add back any foreign earned income exclusion reported on Form 2555.) The tax also applies to irrevocable trusts (and estates) on the undistributed NII in excess of the dollar amount at which the highest tax bracket for trusts begins (this amount is $12,300 in 2015).

Try to defer income and accelerate expenses to reduce MAGI under the NIT threshold above. In calculating NII, deduct properly allocated expenses including but not limited to trading and investment expenses. If you are stuck over the MAGI threshold, try to reduce NII to reduce NIT. There’s also a 0.9% Medicare tax that applies to individuals receiving wages in excess of $200,000 ($250,000 for married couples filing jointly and $125,000 for married couples filing separately).

If you are in a lower income situation and purchase health insurance on an Obamacare exchange, consider how deferral or acceleration of income might affect your current and subsequent year exchange subsidies on Form 8962 (Premium Tax Credit). You don’t want to owe expensive subsidies back to Treasury.

The Alternative Minimum Tax (AMT) was enacted in 1982. Originally intended as a second tax regime to prevent the rich from avoiding most income tax, with lack of indexing for inflation, AMT has exploded on the upper middle-class, too. The AMT rates are 26% and 28%, which are not bad compared to the top regular income tax rate of 39.6%. Many tax advisors suggest that upper income individuals enjoy the AMT rate and accelerate income to pay 28% rates when they can, rather than higher ordinary tax rates. Just don’t bother accelerating deductions that are non-deductible for AMT (as preferences). AMT preferences include real estate and property taxes, state income taxes, miscellaneous itemized deductions and personal exemption deductions. Medical expenses are calculated in a more restrictive way for AMT for taxpayers over age 65. Congress passed the AMT patch (inflation adjustment) for 2015 earlier in the year, rather than wait until year-end as is par for their course.

Will Congress renew lapsed tax extenders?
There’s a long list of temporary tax breaks that Congress can’t afford to write into permanent tax law, even with a sunset provision since it would bust the budget. Each year, Congress has dealt with this mini-fiscal cliff to renew these so-called “tax extenders.”

Per Thomson Reuters, “These tax breaks include, for individuals: the option to deduct state and local sales and use taxes instead of state and local income taxes; the above-the-line-deduction for qualified higher education expenses; tax-free IRA distributions for charitable purposes by those age 70-1/2 or older; and the exclusion for up-to-$2 million of mortgage debt forgiveness on a principal residence. For businesses, tax breaks that expired at the end of last year and may be retroactively reinstated and extended include: 50% bonus first year depreciation for most new machinery, equipment and software; the $500,000 annual expensing limitation; the research tax credit; and the 15-year write off for qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property.”

They lapsed at year-end 2014 and I suspect Congress will renew them again around year-end 2015. Perhaps a GOP-led Congress won’t want to affect the 2016 presidential and Congressional elections by upsetting so many taxpayers without a renewal. Neither will President Obama and Democrats. Tax reform is more important and a bigger issue which can include tax extenders but it’s doubtful Congress can address tax reform until 2017 when the next Congress and President take office

Consult your tax advisor
If your tax planning is complex, consider having your CPA prepare a draft tax return to weigh the different “what if” scenarios and options. Many CPAs like our firm use professional tax planning software making the process easier and more effective. If you are a securities trader, run TradeLog accounting software year to date and use its Potential Wash Sale Loss report to avoid wash-sale loss conditions at year-end. Give your CPA a chance to save you some big bucks!

Stay tuned in the next couple days for more blog posts with helpful advice for 2015!


Depletion allowance on human labor to spur job growth

October 4, 2015 | By: Robert A. Green, CPA


Click for Green’s post on Forbes

Hopefully, a presidential candidate or Congress will consider my tax idea to spur jobs with a new depletion allowance on human labor. Similar in concept to the depletion allowance on oil and gas, it would be an annual tax deduction for a portion of the value of the underlying energy resource. Per Mineral Web, it’s “the using up of a natural resource.” I’m sure many human workers feel used up after a lifetime of hard work, too.

Rise of Robots
In his breathtaking new book on modern economics, “Rise of the Robots: Technology and the Threat of a Jobless Future,” author Martin Ford explains how robots and IT replace human white-collar and blue-collar jobs. This trend is a major contributor to the “new normal,” a frightening low labor participation rate (62%), and a higher U.S. (broad U6) unemployment rate (10%).

Ford points out that robots work faster and longer and more intelligently with fewer errors and with fewer collateral issues than humans. Robots — with artificial intelligence (AI), algorithms and access to big data — are replacing white-collar jobs in law (data mining), finance (high-frequency trading), health care (Dr. Watson IBM), education, science and business. While you may not yet shake hands with a robot that looks like a human, robot systems are working broadly behind the scenes in almost everything we do today.

Ford points out it’s no longer a competitive playing field with robots either winning new jobs or making it possible for virtual immigration of foreign workers, both of which replace U.S.-based jobs.

While the rise of robots is generally a good thing, Ford points out that as a society we should value sustainable jobs for the middle-class, not to slow down advances and adoption of robotics, but to incentivize businesses to hire humans to work side-by-side with robots. Ford argues that income inequality is accelerating with robots since productivity-induced profits go to business owners and investors. Robots don’t buy cars; they are self-driving cars. Robots don’t consume food, medicine and consumer products, and they don’t sustain a consumption-driven economy.

Tax policy favors robots over people
U.S. tax policy favors capital spending on robots, technology and energy over human resources. Businesses benefit from generous Section 179 (100%) depreciation (cash expensing) and bonus depreciation on purchases of technology and tax credits on R&D (research and development) in biotech, software development and more. These tax breaks are among the largest “tax extenders” expected to be renewed again by Congress later this year.

Current fiscal policy for U.S.-based human resources is unattractive. Employers must contribute to Social Security, Medicare, federal and state unemployment insurance, state workers’ compensation, Obamacare health insurance, retirement plans and other employee benefit plans.

In 2011, many people called for a payroll tax holiday and Congress enacted a partial reduction on the employee portion of Social Security contributions. I suggested a full payroll tax holiday on the employer portion, too. But Social Security and Medicare are facing insolvency and a tax holiday accelerates the problem. Consider my idea for a human depletion allowance, instead.

Depletion allowance on human resources
Jobs for Americans are worth more than energy, which is currently in abundance. American workers feel used up just like oil resources. Big oil and gas won and continues to defend its depletion allowance; it’s time to spur American jobs by leveling the fiscal policy playing field back in favor of the American worker.

Energy companies acquire resources and depletion is a mechanism to write off those resources in production. In technology spending, a company writes off the purchase with depreciation. With human resources, companies also write off salaries, payroll taxes and employee benefits. Therefore, depletion on human resources could be construed as double dipping. I argue there is a human resource value above the salary amount and that human resource can have a depletion allowance similar to oil and gas depletion allowances.

The mechanics: Figure the added value of a human resource job over a reasonable period of time and allow the employer to take an annual tax depletion deduction for the annual reduction of that human resource value. I am not suggesting that employers capitalize that value on balance sheets even though intellectual capital becomes structural capital (human capital), which does help businesses win. Google and Facebook have very few human jobs per revenues due to this added human resource value.

Further details can be worked out after Congress accepts the concept.

Robots can also contribute to Social Security and Medicare
Also, consider robots having to pay Social Security, Medicare, workers’ compensation and unemployment insurance. Consider this policy for virtual jobs, too. When a worker in India replaces a U.S.-based white-collar job for a U.S. employer, it would be helpful for the employer to continue paying payroll taxes.

Carried interest is fair tax law for all investors

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


Click for Green’s post on Forbes

Carried interest is long-standing tax law that benefits investment managers and investors alike. Historically, carried interest contributed to the growth of the investment management, private equity, real estate and energy industries, and it’s had a positive effect on the overall economy and increasing tax revenues. Carried interest treats all partners the same. It is fair and not withstanding populist politics, the established partnership tax law should be maintained.

If Congress repeals carried interest provisions in investment partnerships, investors will be stuck with large investment expense itemized deductions that generate few tax deductions. There’s the 2% AGI threshold, Pease itemized deduction limitation and non-deductibility for AMT, the nasty second tax regime. Currently, investors have a reduction of capital gains as a share (carried interest) is allocated to the investment manager, which translates to full tax deductibility for investors.

A repeal of carried interest for investment managers will likely lead to the disuse of it in investment operating agreements for investors, which will put a chill on growth in the investment management, private equity and other investment-related industries. That will slow down the economy, choke finance of start-up companies and impair restructuring transactions. In other words, it’s the classic tax-hike/choke-growth policy which reduces tax revenues.

Investment managers are partners too, and they should be treated equally with other partners, the investors. Equal treatment ensures common goals and outcomes. This is, in fact, what happens with carried interest provisions. If investors receive a long-term capital gain, so does the investment manager who’s taking a risk in the transaction. Many pundits and Democratic presidential contender Hillary Clinton are calling for more long-term investment goals with related fiscal incentives. Clinton proposed stretching out long-term capital gain holding periods with graduated long-term capital gain tax rates. Why repeal carried interest, which is this fiscal incentive for investment managers to make more longer-term investments? Investment managers control the underlying transactions; not the investors.

Playing politics
President Obama and Congressional Democrats are campaigning to repeal carried interest; they claim it only benefits rich hedge fund managers and private equity executives, arguing they don’t pay their fair share.

Republican presidential candidate Donald Trump got on the populist bandwagon, riding shotgun probably so he isn’t pigeonholed by voters into the same corner as private-equity-rich-guy Mitt Romney who lost the last presidential election partially due to class warfare issues. It’s funny that Trump probably built a portion of his fortune from receiving carried-interest tax breaks in his real-estate syndication partnerships years ago.

When President Obama called for repeal of carried interest for investment managers in his two presidential campaigns and annual budget proposals, Senator Chuck Schumer (D-NY) objected, saying it singled out the finance industry (hedge funds and private equity) which obviously were concentrated in his state and New York City. Senator Schumer argued that carried-interest tax breaks were used in other industries — including oil and gas and real estate — all around the country, and if repealed, it should be repealed everywhere in all industries.

There are similar tax breaks throughout American industry in areas such as start-ups and tech companies. Companies grant stock options to executives and many executives benefit from lower long-term capital gains after exercising the options (the gain on option exercise is ordinary income). Companies use restricted stock units (RSUs) as another form of executive compensation, and they grant shares for sweat equity, too. How are these pervasive practices much different from carried-interest provisions in the investment management and private equity industries? As Senator Schumer argued, why single out and penalize investment managers and (I argue) investors, too?

The energy industry receives many special tax breaks including master limited partnerships (MLPs) and overly generous depletion allowances which some argue are phantom tax deductions. The real estate industry gets many special tax breaks with REITS and real estate partnerships with carried-interest provisions.

A call for the repeal of carried-interest on investment managers and private equity reminds me of another progressive-Democrat tax proposal for a financial-transaction tax (FTT) — a “small tax” on each purchase or sale transaction in financial markets. (Eleven EU countries are trying to adopt a version of FTT in the EU.) The FTT proposal is another populist attack to win over voters and while the intended targets are rich Wall Street institutions, FTT falls mostly on investors and retirees all around the country. FTT will also put out of business market makers and traders, which will significantly decrease liquidity and cause flash crashes more often. Even President Obama recognized that and it’s the reason why he prefers a tax on financial institution liabilities over a FTT on investors.

Politically motivated populist attacks are a dangerous game. Often a populist attempts to stab his target with a pitchfork, only to miss and stab his constituents in the foot.

Defer Capital Gains On Real Estate Using Like-Kind Exchanges

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

(From our Feb. 2015 Monthly Newsletter written by cpasitesolutions)

If you’re a savvy investor, you probably know that you must generally report as income any mutual fund distributions whether you reinvest them or exchange shares in one fund for shares of another. In other words, you must report and pay any capital gains tax owed.

But if real estate’s your game, did you know that it’s possible to defer capital gains by taking advantage of a tax break that allows you to swap investment property on a tax-deferred basis?

Named after Section 1031 of the tax code, a like-kind exchange generally applies to real estate and were designed for people who wanted to exchange properties of equal value. If you own land in Oregon and trade it for a shopping center in Rhode Island, as long as the values of the two properties are equal, nobody pays capital gains tax even if both properties may have appreciated since they were originally purchased.

Section 1031 transactions don’t have to involve identical types of investment properties. You can swap an apartment building for a shopping center, or a piece of undeveloped, raw land for an office or building. You can even swap a second home that you rent out for a parking lot.

There’s also no limit as to how many times you can use a Section 1031 exchange. It’s entirely possible to roll over the gain from your investment swaps for many years and avoid paying capital gains tax until a property is finally sold. Keep in mind, however, that gain is deferred, but not forgiven, in a like-kind exchange and you must calculate and keep track of your basis in the new property you acquired in the exchange.

Section 1031 is not for personal use. For example, you can’t use it for stocks, bonds and other securities, or personal property (with limited exceptions such as artwork).

Properties of unequal value

Let’s say you have a small piece of property, and you want to trade up for a bigger one by exchanging it with another party. You can make the transaction without having to pay capital gains tax on the difference between the smaller property’s current market value and your lower original cost.

That’s good for you, but the other property owner doesn’t make out so well. Presumably, you will have to pay cash or assume a mortgage on the bigger property to make up the difference in value. This is referred to as “boot” in the tax trade, and your partner must pay capital gains tax on that part of the transaction.

To avoid that you could work through an intermediary who is often known as an escrow agent. Instead of a two-way deal involving a one-for-one swap, your transaction becomes a three-way deal.

Your replacement property may come from a third party through the escrow agent. Juggling numerous properties in various combinations, the escrow agent may arrange evenly valued swaps.

Under the right circumstances, you don’t even need to do an equal exchange. You can sell a property at a profit, buy a more expensive one, and defer the tax indefinitely.

You sell a property and have the cash put into an escrow account. Then the escrow agent buys another property that you want. He or she gets the title to the deed and transfers the property to you.

Mortgage and other debt

When considering a Section 1031 exchange, it’s important to take into account mortgage loans and other debt on the property you are planning to swap. Let’s say you hold a $200,000 mortgage on your existing property but your “new” property only holds a mortgage of $150,000. Even if you’re not receiving cash from the trade, your mortgage liability has decreased by $50,000. In the eyes of the IRS, this is classified as “boot” and you will still be liable for capital gains tax because it is still treated as “gain.”

Advance planning required

A Section 1031 transaction takes advance planning. You must identify your replacement property within 45 days of selling your estate. Then you must close on that within 180 days. There is no grace period. If your closing gets delayed by a storm or by other unforeseen circumstances, and you cannot close in time, you’re back to a taxable sale.

Find an escrow agent that specializes in these types of transactions and contact your accountant to set up the IRS form ahead of time. Some people just sell their property, take cash and put it in their bank account. They figure that all they have to do is find a new property within 45 days and close within 180 days. But that’s not the case. As soon as “sellers” have cash in their hands, or the paperwork isn’t done right, they’ve lost their opportunity to use this provision of the code.

Personal residences and vacation homes

Section 1031 doesn’t apply to personal residences, but the IRS lets you sell your principal residence tax-free as long as the gain is under $250,000 for individuals ($500,000 if you’re married).

Section 1031 exchanges may be used for swapping vacation homes, but present a trickier situation. Here’s an example of how this might work. Let’s say you stop going to your condo at the ski resort and instead rent it out to a bona fide tenant for 12 months. In doing so, you’ve effectively converted the condo to an investment property, which you can then swap for another property under the Section 1031 exchange.

However, if you want to use your new property as a vacation home, there’s a catch. You’ll need to comply with a 2008 IRS safe harbor rule that states in each of the 12-month periods following the 1031 exchange you must rent the dwelling to someone for 14 days (or more) consecutively. In addition, you cannot use the dwelling more than the greater of 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented out for at fair rental price.

You must report a section 1031 exchange to the IRS on Form 8824, Like-Kind Exchanges and file it with your tax return for the year in which the exchange occurred. If you do not specifically follow the rules for like-kind exchanges, you may be held liable for taxes, penalties, and interest on your transactions.

While they may seem straightforward, like-kind exchanges can be complicated. There are all kinds of restrictions and pitfalls that you need to be careful of. If you’re considering a Section 1031 exchange or have any questions, don’t hesitate to contact us.

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