Depletion allowance on human labor to spur job growth

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



 (Human Jobs Under Attack By Tax Code Favoring Robots Over People)

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


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.

Eight Ways Profitable Traders Save Taxes

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

Traders thrive on market volatility, profiting from rapid changes in prices up or down as they take long and short positions. It’s different for investors: When market indexes drop into correction or bear market mode, they generally lose money or reduce gains.

There’s been significant market volatility in 2015 and many stocks are in correction or bear market mode. I’ve had tax consultations with many traders that are making a fortune from price volatility, catching the swings in price both up and down.

In my last blog post, I wrote about five ways traders should best deduct trading losses, figuring some traders may not have recognized a stealth correction in many stocks and commodities in enough time to profit from it. In this blog post, I address tax savings for profitable traders because there are many traders who have done very well.

Here are eight ways profitable traders save taxes.

1. Business expenses with qualification for trader tax status
Investment expense treatment is the default method for investors, but if you qualify for trader tax status, you can use the more favorable business expense treatment.

Business expense treatment under Section 162 gives full ordinary deductions, including home-office, education, Section 195 start-up expenses, margin interest, Section 179 (100%) depreciation, amortization on software, seminars, market data and much more. Conversely, investment expenses are only allowed in excess of 2% of adjusted gross income (AGI), and not deductible against the nasty alternative minimum tax (AMT). Investment expenses are further restricted with “Pease” itemized-deduction limitations for taxpayers with AGI over $300,000 (married) and $250,000 (single). Many states limit itemized deductions, too.

Highly profitable traders often have significant expenses including staff, an office outside the home, additional equipment and services and significant employee-benefit plan deductions for retirement and health insurance. Their 2% AGI threshold for deducting investment expenses is very high, so they really appreciate full business expense deductions from gross income.

Learn how to qualify for and claim trader tax status in our Trader Tax Center.

2. Home office expenses

Most traders work in their home with a trading workstation, multiple computers, monitors, mobile devices, TVs, office furniture and fixtures. They exclusively use one or more rooms, storage areas and a bathroom.

A typical allocation percentage might be 10% to 20% of the home. Include every expense of the home including mortgage interest, real estate taxes, utilities, repairs, maintenance, security and more. Also, take depreciation of the home and on improvements. Office equipment and furniture is depreciated directly in the business often with Section 179 (100%) depreciation.

The home office deduction requires income, which can include trading gains. You can have a home office and office outside the home, too. Don’t be shy with this deduction; it helps document your business activity. Investors may not take a home office deduction, trader tax status is required.

3. Business travel, education and seminars
Many traders travel around the country and world to trading conferences, seminars and for education courses. If you qualify for trader tax status, education, seminars, conferences and related travel costs qualify as a business expense. But investors may not deduct education, seminars, conferences and related travel expenses in accordance with Section 274(h)(7).

The IRS is a stickler for separating business versus personal travel, meals and entertainment (see Pub 463). If your spouse accompanies you on a trip and is not active in the trading business, the spouse’s share of expenses are deemed personal. If you spend another week on your trip for vacation reasons, that part of the trip is also personal.

If you entertain other traders and industry players, you may have business meals and entertainment expenses. Be careful with the rules for lavish expenditures.

4. Health insurance premium deductions
Obamacare is forcing many traders into buying health insurance or otherwise owe a shared responsibility payment if they don’t qualify for a hardship exemption. Highly profitable traders don’t qualify for exchange subsidies and they seek AGI deductions for high health insurance premiums. (Out-of-pocket health care expenses including deductibles and co-payments are not allowed as an AGI-deduction and the threshold for itemized deductions for medical expenses is high.)

Self-employed businesses and pass-through entities may take a 100% deduction of health insurance premiums from AGI on individual tax returns. The problem for traders is that trading gains are not self-employment income (SEI) and they can’t have an AGI deduction for health insurance premiums or retirement plans. There is a way to fix that.

Traders need to form a S-Corp trading company (or C-Corp management company) to pay officer’s compensation which allows an AGI deduction for health insurance premiums and retirement plan contributions. Execute payroll before year-end and add the health insurance premium to the officer’s W-2 wages. The officer then takes the AGI deduction on their individual tax return.

5. Retirement plan contribution deductions
Generally, the best defined-contribution retirement plan for business traders is a Solo 401(k) 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 IRS limits). A SEP IRA only has a profit sharing plan.

Only traders with trader tax status on an S-Corp trading company (or with dual entity C-Corp management company) can satisfy the requirement for contributions to a retirement plan. That’s because trading gains are not considered SEI, which is required for retirement plan contributions. The trader needs wages from a S-Corp or C-Corp since a sole proprietor trader can’t pay themselves wages.

Retirement plan contributions are only allowed for traders who qualify for trader tax status and who use an S-Corp or C-Corp management company to create compensation as pointed out above.

High-income traders should consider a defined-benefit plan which allows much higher tax-deductible contributions. The maximum limit for 2015 is $210,000 and the actual amount is determined by an actuary.

Retirement plan contributions are made in connection with officer’s compensation, so trader tax status is imperative on these large combined amounts. Investment partnerships are not allowed to pay guaranteed payments to partners; only a trading business partnership may do so. Partnerships pass through losses reducing SEI, whereas S-Corps do not. We prefer the S-Corp for creating the wages needed for maximizing employee-benefit plan deductions.

6. Tax-advantaged growth in retirement plans
In traditional retirement plans, income growth is tax-deferred until taxable distributions are made in retirement subject to ordinary tax rates. Early withdrawals before age 59½ in IRAs and age 55 in qualified plans are also subject to a 10% excise tax penalty. Contributions to traditional retirement plans are tax deductible and hence there is tax-deferral only.

In Roth IRA and Roth 401(k) retirement plans, income growth is permanently tax-free because contributions to a Roth account are not tax deductible. When converting a traditional retirement account to a Roth account, taxes are due on the entire conversion amount. Afterward, the Roth is permanently tax-free. You can reverse the Roth conversion up to Oct. 15 of the following year if you are unhappy with it.

Highly profitable traders generally trade significant retirement assets alongside trading in taxable accounts. Taxable accounts qualify for trader tax status and retirement accounts do not. These traders seek to maximize deductions in connection with taxable accounts and minimize allocations if any to retirement accounts. Consult a CPA trader tax expert on this point.

7. Lower 60/40 capital gains tax rates on 1256 contracts
Profitable traders seek lower tax rates when possible. If you want to trade the Nasdaq 100 index you have two options: an ETF security (NASDAQ: QQQ) taxed at ordinary rates applicable on short-term capital gains, or an emini futures contract (CME: NQ), which is a Section 1256 contract taxed at lower 60/40 capital gains rates.

Section 1256 contracts bring meaningful tax savings throughout all tax brackets. These contracts have lower 60/40 tax rates, meaning 60% (including day trades) are taxed at the lower long-term capital gains rate and 40% are taxed at the short-term rate, which is the ordinary tax rate. At the maximum tax brackets for 2015, the top Section 1256 contract tax rate is 28%, 12% lower than the top ordinary rate of 39.6%. The long-term rate is 0% at the 10% and 15% ordinary tax brackets.

Section 1256 contracts are marked-to-market (MTM) on a daily basis. MTM means you report both realized and unrealized gains and losses at year-end. (Don’t confuse it with Section 475, which is also MTM but has different tax effects.) Many traders have small or no open positions on Section 1256 contracts at year-end. With MTM at year-end, a trader can’t hold a position for a long-term capital gain which requires a 12-month holding period, so Congress negotiated 60/40 capital gains rates. Active traders should take advantage of that tax break.

8. Long-term capital gains taxes
Long-term capital gains on sales of securities are subject to lower capital gains tax rates up to 20% which apply on securities held 12 months or more. Profitable traders often have segregated investment positions in securities — in addition to their trading activity — for which they seek deferral of taxes at year-end and eventually lower long term rates if held 12 months. (Caution: If you use Section 475 MTM, its imperative to properly segregate your investment positions.)

When market conditions change for their investments, rather than sell before 12 months or by year-end causing taxes on unrealized gains, they manage risk with option trades around the underlying position. For example, if they are long Apple stock and are concerned with its price dropping, they can purchase Apple put options for downside risk protection. They are still long Apple and they can continue to defer their unrealized gains in Apple at year-end.

Profitable traders can do these eight things to lower their tax bill by a significant amount. Why over pay Uncle Sam?


Five Ways To Deduct Losses In Financial Markets

| By: Robert A. Green, CPA

forbes_logo_main          Accountants World

Investors often asked J.P. Morgan his stock market predictions, and his retort was: “There are only two good predictions — the market will go up or down.” Because it’s impossible to predict the stock market, it’s essential to learn the best way to write off losses.

The deck is stacked against you
The tax code disenfranchises investors and traders from deducting losses. The capital-loss limitation, wash-sale loss deferrals, passive-loss activity limitations and carryovers, investment interest expense carryovers, wasted personal investment losses, at-risk limitations and more are used to pay for or offset lower long-term capital gains rates (up to 20%) on positions held over 12 months and on qualifying dividends. Ordinary tax rates rise to 39.6%, almost twice as high as long-term capital gains rates.

Buy and hold investments
If you buy and hold securities, you may wind up selling and holding capital loss carryovers. If you have unrealized capital gain positions and are close to the 12-month holding period for lower long-term capital gains rates, consider buying protection on the long equity position in the options market (e.g., buying a put option).

Capital-loss carryovers can take decades to use up
Many investors still haven’t used up their capital-loss carryovers realized in the crash in 2000. While capital losses are deductible in full against capital gains, individuals may only deduct $3,000 of capital losses per tax year against non-capital gains income like wages. Plus, that $3,000 limitation isn’t indexed for inflation. I’ve seen it take decades to use up capital-loss carryovers in the hundreds of thousands of dollars for many clients.

Pundits suggest planning for losses at this time
Since the Great Recession and market meltdown of 2007, the financial markets recovered to new highs riding the coattails of Fed monetary easing and government stimulus which appear to be ending soon. The world’s locomotive economy China is apparently slowing and its financial markets are exhibiting some signs of boom/bust conditions. That seems to be causing contagion in emerging and even developed markets.

While some investors see buying opportunities, others feel it’s different this time around and they don’t want to catch a falling knife. Remember J.P. Morgan’s words about making predictions.

Five ways to maximize losses on tax returns

1. Elect Section 475 for unlimited ordinary losses
If you trade as a business activity and qualify for trader tax status (TTS), you’re entitled to make a timely Section 475 MTM election. Section 475 trades are reported on Form 4797 (Sale or Business Property) Part II ordinary gain or loss tax treatment. Ordinary losses are exempt from capital-loss limitations and wash-sale loss deferral rules.

Unfortunately, too many traders and tax advisors aren’t experienced with Section 475 and TTS and they missed filing a 2015 election by April 15, 2015 for existing individuals and partnerships and March 15 for existing S-Corps.

“New taxpayers” (new entities) can elect Section 475 within 75 days of inception, so consider a new entity later in the year. Caution: pre-entity losses remain capital losses, so wait the 75 days to decide whether to elect 475 internally or not. If the entity has capital gains, it can pass through capital gains to soak up individual-level capital losses, so you can skip the entity 475 election that first year. Conversely, if the entity has significant losses, you should elect Section 475 for ordinary loss treatment. You can revoke Section 475 the following year to get back to generating capital gains to soak up capital-loss carryovers. If you dig a big hole of capital-loss carryovers, it’s important to climb out of that hole with a capital gains ladder and not dig a bigger hole with a Section 475 floor.

2. Net operating losses generate tax refunds
Section 475 ordinary losses reduce gross income without any limitation. If you have negative taxable income, Section 475 losses are includible in a net operating loss (NOL) tax computation. NOLs are carried back two tax years and or forward 20 years. You can file a timely election to forgo the NOL carry back and only carry it forward. NOLs offset all types of income.

3. Wash sale losses require careful management
If you take a loss on a security in a taxable account and buy a substantially identical position back 30 days before or afterward in any of your individual accounts including IRAs, it’s considered a wash-sale loss. On taxable accounts, it’s a deferral with adding the wash-sale loss adjustment to the replacement position’s cost-basis.

Caution: The wash-sale loss is permanently lost on an IRA account. That rule does not apply to qualified retirement plans like a Solo 401(k). Lesson: don’t trade substantially identical positions between taxable and IRA accounts. Also, consider active trading in an entity account — this account is considered a different taxpayer, although related party rules can apply if you purposely try to avoid wash sales with the related accounts.

Monitor wash-sale loss conditions using software like Tradelog and “break the chain” on wash sales at year-end. (Don’t worry too much about wash sale losses on taxable accounts during the year as they may melt away by year-end and that’s when it counts most.) Break the chain means realize the loss and don’t buy back a substantially identical position 30 days before or afterward. “Substantially identical position” means between Apple stock and Apple options and Apple options at different expiration dates. Apple stock and Google stock are not substantially identical positions.

Note that broker-issued 1099Bs calculate wash-sale loss adjustments on a per account basis and based on identical positions. Broker rules differ from taxpayer rules who calculate wash sales based on all their accounts including IRAs based on substantially identical positions. This causes non-compliance and significant confusion.

4. Section 1256 loss carry back election
In general, capital losses may never be carried back like NOLs. There is one exception: Section 1256 contract losses may be carried back three tax years but applied only against Section 1256 gains in those prior years.

Section 1256 contracts include regulated futures contracts (RFCs), broad-based indexes like e-minis, options on futures, options on indexes and non-equity options. A broad-based index has 10 or more underlining securities in the index (e.g. S&P 500). Exchange-traded funds (ETFs) are securities and they aren’t Section 1256 contracts.

Section 1256 contracts have other tax breaks. Section 1256 contracts are marked-to-market (MTM) which means wash-sale loss rules are a moot point and don’t apply. MTM also means a long-term holding period of 12 months is impossible to achieve so Congress negotiated a blended long-term and short-term capital gains rate: 60% and 40%, respectively. In the highest tax bracket, the blended 60/40 rate is 28%, almost 12% less than the highest ordinary rate (39.6%). There are meaningful differences in the rates throughout the tax brackets since the lowest long-term rate is 0% for the 10% and 15% ordinary tax brackets.

Unlike a Section 475 election required during the tax year, a Section 1256 loss carry back election can be made after year-end. Simply check the box on top of Form 6781 for the Section 1256 loss carry back election. Omit the losses from the current year tax return and include them on amended tax returns for one or more of the prior three tax years (in order of oldest year first).

5. Forex losses are ordinary by default
Spot forex trading losses in the Interbank market are Section 988 ordinary gain or loss treatment, meaning they aren’t subject to the capital-loss limitation or wash-sale loss treatment.

Unlike manufacturers, investors and traders holding forex as a capital asset may file a contemporaneous and internal capital gains election to opt out of Section 988 into capital gain or loss treatment. If you have large capital-loss carryovers, that election can help soak up losses with capital gains on forex trading.

Caution: If you have negative taxable income caused by forex trading losses, you need trader tax status to have NOL treatment. Otherwise, you’ll waste part or all of your forex loss since it’s not a capital loss carryover.

If you trade the major currencies, with the capital gains election you can navigate into lower Section 1256(g) 60/40 tax rates and use the Section 1256 loss carry back election. Section 988 losses over $50,000 require a Form 8886 filing.

Losses in retirement plans
In traditional retirements plans, taxes are deferred on trading gains until taxable distributions are withdrawn in retirement. Losses are deferred deductions because they reduce retirement distributions accordingly.

It’s different with Roth IRA and Roth Solo 401(k) plans. There are no taxes owed on normal retirement distributions with permanent deferral. That means losses are not deductible and they are wasted. If you lose a lot in a Roth conversion executed for 2014 or 2015, you may be able to reverse the Roth conversion in order to benefit from the losses.

Bottom line
Losses can paralyze investors. Some exit the markets entirely, figuring they can’t afford more non-deductible capital losses. Traders need refunds from losses to replenish their trading capital. Understand what you are trading and how losses work and maximize your tax affairs accordingly. Consult with a trader tax expert.

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

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


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, ‪”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” 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


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

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


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

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

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


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.

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