Short Selling: How To Deduct Stock Borrow Fees

September 19, 2016 | By: Robert A. Green, CPA

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How To Deduct Borrowing Fees When Selling Stocks Short

Traders like to go long and short to play both sides of the market. The IRS has special tax rules for short sellers, and in this blog post, I focus on how to deduct stock borrow fees vs. interest expenses.

Stock borrow fees and loan premiums
Short selling is not free; a trader needs the broker to arrange a loan of stock from another account holder. Brokers charge short sellers “stock borrow fees” or “loan premiums.” Tax research indicates these payments are “fees for the temporary use of property.” Watch out: Many brokers refer to stock borrow fees as “interest expense,” which confuses short sellers.

For tax purposes, stock borrow fees are Section 212 “investment expenses” for investors and Section 162 business expenses for traders qualifying for trader tax status (TTS). Stock borrow fees are not “interest expense” so investors can’t include them in Section 212 “investment interest expense” deductions. It’s a significant distinction that has a profound impact on tax returns because investment expenses face greater limitations vs. investment interest expenses.

Support for this tax position
According to New York City tax attorney Roger D. Lorence: “Short sale expenses (stock borrow fees) are not investment interest expense. To support any interest deduction, there must be a valid interest-bearing obligation under state or federal law. (See Stroud v. U.S.) The IRS has ruled that short sales do not give rise to an interest-bearing indebtedness (Revenue Ruling 95-8, 1995-1 CB 107). Rather, the short sale borrower has a liability under state law to return the borrowed stock and pay fees, but this is not interest expense. This is why short sales do not give rise to Section 514 UBIT (no debt-financed property), which is the specific code section in issue in the ruling. The revenue ruling is based on Deputy v. du Pont. The du Pont case applies by analogy here because there can be no interest expense generated in a short sale.”

Investors face limitations on tax deductions
Investors are entitled to deduct Section 212 investment expenses including “investment interest expenses” and “investment expenses” reported on Schedule A (itemized deductions).

It’s important to differentiate between investment interest expenses vs. investment expenses because they have different tax treatments. Taxpayers carry over unused investment interest expense to the subsequent tax year(s), whereas they may not carry over unused investment expenses, which means they may entirely lose some of those. Calculate investment interest expense on Form 4952 where it’s limited to net investment income, with the balance carried over. Net investment income is portfolio income minus investment expenses. (Read Form 4952 instructions for further details.)

Investment expenses are “miscellaneous itemized deductions” in excess of 2% of adjusted gross income (AGI), and they are not deductible for the alternative minimum tax (AMT). Most itemized deductions are subject to a phase-out for the upper-income brackets (known as the Pease limitation, indexed for inflation); some taxpayers are better off using the standard deduction than the itemized deduction.

MORE: Tax treatment for selling short

Easy vs. hard to borrow fees
Very liquid securities are “easy to borrow,” and many brokers charge small fees to short sellers for lending out those shares. Non-liquid securities are “hard-to-borrow” and brokers update their “hard to borrow lists.” Brokers charge higher “hard to borrow fees,” and most publish those rates with sample calculations on their websites. Hard to borrow fee rates rise as demand for shorting increases. A few brokers specialize in finding very hard to borrow stocks, and they charge “up front borrow fees” in addition to hard to borrow fees.

Brokers conflate stock borrow fees with interest expenses
There is a lack of clarity in separating stock borrow fees from interest expenses. The distinction matters since fees are investment expenses, whereas interest is an investment interest expense.

I wonder if some brokers prefer using the term interest expense since customers may find that more logical with borrowing shares under securities lending agreements, and because it leads to better tax treatment. Customers may also object to paying significant fees.

For example, one leading online broker calls the “interest rate charged on borrowed shares” a “fee rate” and also “net short stock interest.” This broker does not report the fees on Form 1099.

A few other online brokers mention interest on shorted shares as a “fee rate.” They report “miscellaneous non-reportable deductions” on Form 1099; not interest expense.

One of the largest online brokers states on its website: “When you borrow the shares, you pay interest to the brokerage house for this loan, and the harder the shares are to find, the higher the interest rate.” I called customer support, and a support person admitted it’s a stock borrowing fee and not interest expense.

It would be helpful if brokers cleaned up their language to be clear about stock borrow fees vs. interest expense.

poll

Do you do short selling?

Active traders using Section 475 have it easy
Active traders qualifying for trader tax status (TTS) with a Section 475 election have an easy time reporting short-sale trades and related expenses, and they maximize tax advantages. They are unaffected by special rules for short sales for constructive sales on appreciated positions and holding period rules. (Section 475 is tax beneficial because it exempts traders from the $3,000 capital loss limitation against other income, wash-sale losses, and short sale adjustments.)

With Section 475 mark-to-market accounting, traders impute sales at year-end on open positions. That negates the need to make “constructive sales on appreciated positions” from selling short against the box. Short-term vs. long-term holding periods are not an issue with Section 475. TTS unlocks Section 162 business expense treatment, so expenses related to selling short (including stock borrow fees and interest expense) are deductible as business expenses from gross income. Sole proprietors use Schedule C for reporting business expenses.

Example of a trader with TTS
I recently worked with a client who had a $800,000 net short-term capital gain from selling short during 2015 and $500,000 of stock borrow fees (probably high for a short seller). He hoped the effect on his taxable income would be $300,000 ($800,000 less $500,000) as that was his economic gain. But, his accountant told him taxable income was considerably higher after applying itemized deduction limitations and the AMT preference for investment expenses. The client qualified for TTS, and therefore could report his stock borrow fees along with other trading business expenses on Schedule C. His taxable income effect was under $300,000.

But, his Schedule C would look like an enormous red flag since it reported trading business expenses only, and that amount was a loss over $500,000. He entered capital gains and losses on Form 8949, transferred to Schedule D. In Green’s 2016 Trader Tax Guide, I suggest moving a portion of business trading capital gains to Schedule C to zero it out. We also recommend a footnote explaining that the taxpayer is profitable and the transfer of income to Schedule C. Additionally, the note explains what trader tax status is by law, how the client qualified for TTS, and how to treat selling-short expenses.

Example of an investor
Another client has a net capital loss of $100,000. After the $3,000 capital loss limitation against other income, he has negative taxable income, which means he will not get any tax benefit from his investment expenses, which include stock borrow fees.

Webinar/Recording: Short Sellers: IRS Tax Rules Are Unique

Short Selling: IRS Tax Rules Are Unique

| By: Robert A. Green, CPA

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IRS Short Selling Rules Can Be A Taxing Matter

The essence of trading is buying and selling financial products for income. If you think the asset will rise in value, buy first and sell afterward — this is what’s known as a “long position.” If you want to speculate on the asset declining in value, borrow the security to sell it first, and buy it back later to close the short position — this is “selling short.” (There are other ways to speculate on market drops like buying put options or inverse ETFs, both of which are long positions.)

In this blog post, I cover the tax treatment for selling short. There are two types of short sales: (1) a short sale and (2) a short sale against the box. Both involve borrowing securities from another account holder, arranged by a broker.

Constructive sales on appreciated positions
In the old days, owners stored stock certificates in safe deposit boxes. They could borrow and sell securities, but not the ones stored in their box — hence the moniker, “short sale against the box.” It became a popular tax shelter to defer capital gains taxes.

The Taxpayer Relief Act of 1997 mostly closed the deferral loophole by adding new Section 1259 Constructive Sales Treatment For Appreciated Financial Positions. Before these changes, a trader could own security A with a large unrealized capital gain and short it against the box before year-end to economically freeze the capital gain, but defer realization of the capital gain until the following year. Exception: A trader can still achieve tax deferral on an open short against the box position at year-end if he buys to cover the open short position by Jan. 30 and leaves the long position open throughout the 60-day period beginning on the date he closes the transaction — so there is an economic risk.

An example from Pub. 550 Investment Income and Expenses, Short Sales:
“On May 7, 2015, you bought 100 shares of Baker Corporation stock for $1,000. On September 10, 2015, you sold short 100 shares of similar Baker stock for $1,600. You made no other transactions involving Baker stock for the rest of 2015 and the first 30 days of 2016. Your short sale is treated as a constructive sale of an appreciated financial position because a sale of your Baker stock on the date of the short sale would have resulted in a gain. You recognize a $600 short-term capital gain from the constructive sale and your new holding period in the Baker stock begins on September 10.”

The constructive sale rules apply on substantially identical properties, which includes equities, equity options (including put options), futures and other contracts. For example, Apple equity is substantially identical with Apple call and put equity options. Traders use a bevy of financial products, and they may inadvertently trigger Section 1259 constructive sales. Report gains on constructive sales, not losses.

Brokers do not report constructive sales on appreciated positions on Form 1099-Bs. Traders need to make manual adjustments on Form 8949. I recommend using tax-compliant software or a service provider that uses a tax-compliant software.

poll

Do you do short selling?

Special rules for short-term vs. long-term capital gains and losses
Most traders understand capital gains rules for long positions. For securities using the realization method, a position held for 12 months or less is a short-term capital gain or loss subject to marginal ordinary tax rates (up to 39.6% for 2015 and 2016). A position held for more than 12 months is a long-term capital gain with lower capital gains tax rates (up to 20% for 2015 and 2016).

According to Pub. 550, “As a general rule, you determine whether you have short-term or long-term capital gain or loss on a short sale by the amount of time you actually hold the property eventually delivered to the lender to close the short sale.”

If you sell short without owning substantially identical property (stock or option) in your account, the holding period starts when you later buy the position to close the short sale. The holding period is one day, so it’s a short-term capital gain or loss. Most investors think selling short is the reverse of going long and the holding period should start on the date you short the security — but that is not the case.

Holding period rules are more complicated when you short against the box. Special anti-abuse rules contained in Section 1233 prevent traders from converting short-term capital gains into long-term capital gains and long-term capital losses into short-term capital losses. Read the “Special Rules” in IRS Pub. 550.

Dividends and “payments in lieu” of dividends
When traders borrow shares to sell short, they receive dividends that belong to the lender, the rightful owner of the shares. After the short seller receives these dividends, the broker uses collateral in the short seller’s account to remit a “payment in lieu of dividend” to the rightful owner to make the lender square in an economic sense. But there are complications which may lead to higher taxes.

Dividend issues for the short seller
If a short seller holds the short position open for 45 days or less, add the payment in lieu of dividend to cost basis of the short sale transaction reported on Form 8949 (realization method) or Form 4797 (Section 475 MTM method). Watch out for a capital loss limitation. (Traders with trader tax status using Section 475 are not concerned as they have ordinary loss treatment.)

If a short seller holds the short sale open for more than 45 days, payments in lieu of dividends are deductible as investment interest expense. Report investment interest expense on Form 4952. Watch out, because the current year tax deduction is limited to net investment income, which includes portfolio income, minus investment expenses. (See Form 4952 instructions.) Carry over disallowed investment interest expense to the subsequent tax year(s). With itemized deduction limitations, some short sellers come up short on investment interest expense deductions. (If a short seller holds the short sale open for more than 45 days, in connection with a trading business with TTS, payments in lieu of dividends are deductible as business expenses.)

Dividend issues for the lender
When investors sign margin account agreements, few realize they are authorizing their broker to lend their shares to short sellers. Instead of issuing the account owner (lender) a Form 1099-DIV, which may include ordinary and qualified dividends, the broker issues a Form 1099-Misc or similar statement for “Other Income.” The lender forgoes the qualified dividends tax break on common stock held at least 60 days. Lower capital gains rates apply on qualified dividends.

Lenders report this substitute dividend payment as “Other Income” on line 21 of Form 1040. Don’t overlook including substitute dividends in investment income entered on Form 4952 used to limit investment interest expense. Some brokers offer to compensate lenders for losing the qualified dividend rate. Institutional or large stock lenders may earn credit interest on lending out their shares.

In my next blog post, I cover how to deduct stock borrow fees.

Webinar/Recording: Short Sellers: IRS Tax Rules Are Unique.

MORE: IRS Pub. 550 Short Sales

MORE: Section 1.1233-1 – Gains and losses from short sales

MORE: 1259 – Constructive sales treatment for appreciated financial positions


These Tax Errors Will Cost Professional Traders Dearly

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

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Read my blog post in Forbes.

Most active traders make serious errors on income tax returns, whether they self-prepare or engage a local accountant. Many miss out on trader tax benefits and overpay on their taxes. The cost ranges from $5,000 to hundreds of thousands of dollars.

When you shop for a tax preparer, ask about trader tax status, Section 475 elections, wash sale loss rules, and tax treatment for forex, options, Section 1256 contracts, ETFs, and ETNs. If they look like a deer caught in headlights, you’ll realize that your tax professional is not proficient enough for your needs. CPAs have a code of ethics requiring them to decline an engagement if they are not proficient, but local tax storefronts do not.

Here’s my 2016 list of tax reporting errors made by traders and accountants.

1. Mistakenly believing you can rely on securities Form 1099-B:

Most preparers rely on broker Form 1099-B for tax reporting. There’s a problem with wash sales. A wash sale loss is tax-deferred when you buy back a security position 30 days before or after making a sale at a loss.

Here’s the problem with wash sales reported on the 1099-B: IRS rules for brokers are simple, and most people do not realize that IRS rules for taxpayers are different and more complex. Tax preparers choose to play ignorant and import 1099-B, so it’s easy to reconcile Form 8949 with 1099-B. That means they are using broker rules and willfully disregarding Section 1091 rules for taxpayers. They should use trade accounting software that is compliant with taxpayer rules.

Broker rules base wash sales on identical positions, per account. Taxpayer rules base wash sales on substantially identical positions, across all accounts, including IRAs. A broker does not calculate a wash sale on Apple equity vs. Apple options because they are not identical symbols, but taxpayers must do so because they are substantially identical positions.

With education, traders can avoid wash sale losses. That is better than ignoring taxpayer rules and playing the audit lottery with the IRS.

2. Messing up Form 8949 cost-basis reporting:

The IRS requires reporting each securities trade on Form 8949 with the description, dates acquired and sold, proceeds, cost basis, code, adjustments, and gain or loss.

The primary adjustment is for wash sales. Other cost-basis adjustments include corporate actions (stock splits and reinvested dividends), inherited positions, gifts, and transfers from other accounts. Taxpayers often use incorrect amounts for these items.

There is one scenario where a taxpayer can solely rely on a 1099-B and skip filing Form 8949 by entering 1099-B amounts on Schedule D: when the taxpayer has only one brokerage account and trades equities only with no trading in equity options, which are substantially identical positions. Plus, the taxpayer must not have any wash sale loss or other adjustments.

However, if you trade options and equities, which are substantially identical positions, and/or you have multiple brokerage accounts, including IRAs, then you need trade accounting software that’s compliant with Section 1091 to generate Form 8949. Most software available through brokerage websites are not compliant with taxpayer rules in Section 1091. Download the original trade history from your broker’s website into a compliant program to generate Form 8949 or Form 4797 with Section 475.

3. Overlooking trader tax status or messing it up on Schedule C:

Most tax preparers and tax software do not offer resources about trader tax status (TTS) and related tax benefits. Other CPAs tell me they didn’t even realize their long-term clients had started a trading business. They thought trading was an investing activity using Section 212′s investment expense and the capital gains and loss treatment.

Overlooking qualifications for TTS can cost a trader $5,000 to $15,000 or more in tax benefits due to the preference of Section 162′s business expense treatment on Schedule C vs. Section 212′s restricted expense treatment on Schedule A.

Some accountants err in reporting trading income and losses on Schedule C. They should list trading business expenses only on Schedule C. Traders report trading gains and losses on different tax forms, including Form 8949 for securities, Form 6781 for Section 1256 contracts, and Form 4797 for Section 475 trades.

Traders should include well-written statements with their tax returns explaining TTS, how they qualify, tax treatments, and elections made. They should ask the IRS to view their trading business as a collection of tax forms. Otherwise, the IRS may see Schedule C as a losing business without any revenue. Most preparers do not include footnotes, and if they do, they tell the wrong story.

Don’t fall into the hobby loss or passive activity loss trap: Do not let a preparer or IRS agent subject your trading business to Section 183 hobby loss disallowance rules because it’s not recreational or personal in nature. A trading company is also exempt from Section 469′s passive activity loss rules by the Section 469 “trading rule.”

Recent trader tax court cases served up significant losses to traders. The IRS caught traders trying to deduct capital losses as ordinary losses. Net capital losses are limited to $3,000 per year on Schedule D, and excess capital losses should be carried over to subsequent tax year(s) on Schedule D. Ordinary loss treatment for trading losses is possible if a trader with TTS timely elects Section 475. In that case, report Section 475 trading losses on Form 4797 Part II, not on Schedule C.

A trader can claim TTS business expense treatment after-the-fact, and the IRS does not require an election. Preparers often conflate TTS with Section 475, but that’s a mistake. A trader with TTS has the option to elect Section 475, but many choose not to do so.

4. Overlooking or messing up a Section 475 election:

A trader qualifying for TTS may elect Section 475 MTM with ordinary gain or loss treatment. Report Section 475 trades on Form 4797 Part II, rather than on Form 8949.

The main tax benefits of Section 475 are an exemption from wash sale loss adjustments and capital loss limitations. Ordinary business losses offset income of any kind, and they are part of net operating loss (NOL) carrybacks and or carryforwards.

One of the biggest pitfalls for traders is messing up the decision-making with a Section 475 election. If you have existing capital losses from a capital loss carryover, year-to-date realized capital losses, and unrealized capital losses, you may want to retain capital gains treatment. That’s because Section 475 is ordinary income, which can’t absorb capital loss carryovers. On the other hand, you don’t want additional capital losses that are unutilized.

Preparers err in making a decision too early, not waiting until the election deadline, which offers some hindsight. They do not understand they can make alternative plans: You can revoke Section 475 in a subsequent tax year or form a new entity for a “do over” on electing Section 475, within 75 days of inception. You can choose Section 475 on securities only and retain lower 60/40 capital gains tax rates on Section 1256 contracts.

Many preparers miss the deadline for filing a Section 475 election statement and Form 3115 (Change in Accounting Method). Any misstep invites the IRS to disallow Section 475. Read recent trader tax court cases on my blog, including on Poppe, Assaderaghi, Nelson, and Endicott.

5. Messing up Form 4797 and overlooking a Section 481(a) adjustment:

Report each Section 475 transaction on Form 4797. Mark-to-market reporting means you must impute sales of open securities positions at year-end based on market prices.

The Section 475 election process includes 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 the unrealized gain or loss on the prior year-end open trading business positions. Negative Section 481(a) adjustments are reportable in full, but positive ones over $50,000 must be pro-rated over four years. Many preparers overlook or err in making this adjustment, and others forget about reporting the deferral income in subsequent years. If you don’t qualify for TTS in the prior year, there is no Section 481(a) adjustment.

6. Commingling Section 475 trades with investment positions:

If you use Section 475 on your trading account and also make investments in a segregated investment account, be sure not to trade the same symbols between the two accounts, as that gives the IRS an opening to reject some Section 475 losses, or to disallow some long-term capital gains. Both will raise your tax bill. Section 475 regulations require careful segregation of investments from Section 475 trades in form and substance. Most preparers are unaware of these nuances in Section 475, and they misadvise clients about how to stay clear of this trouble.

7. Overlooking or messing up capital loss carryovers:

Some self-preparers mistakenly think they should only report a 3k capital loss carryover each year since they figure that is all they can use against other income. That is wrong: Report the entire capital loss carryover on Schedule D, short term vs. long term. It is okay to have a capital loss that carries over again to the next tax year.

Others overlook entering a capital loss carryover. Some figure not reporting them until they have capital gains to use them up. However, it can become too late, since the capital loss carryover year closes after three years. The IRS does not allow a capital loss carryover unless you report it on your prior year’s tax return, so don’t let a capital loss carryover lapse. Capital loss carryovers do not expire.

Capital losses are unlimited against capital gains. Deduct up to $3,000 of net capital losses against other income. It’s automatic, and not optional. For example, carry over $50,000 of capital losses and use it against $30,000 of current year capital gains, leaving a $20,000 net capital loss. Use the $3,000 capital loss limitation against other income and carry over $17,000 of the remaining capital loss to the subsequent tax year.

8. Overlooking the election to carry back a Section 1256 loss:

Many preparers do not know they can elect to carry back a Section 1256 loss. Check that box on top of Form 6781 to report current year net losses on Form 1040X amended tax returns for the prior three tax years, in order of oldest year first. The loss can only offset Form 6781 gains, not other income.

9. Using the wrong tax treatment on various financial instruments:

Many preparers do not realize that some financial instruments require ordinary gain or loss treatment or qualify for lower 60/40 capital gains tax rates in Section 1256. Many preparers incorrectly think that all trading instruments use the realization method with short-term and long-term capital gains rates.

It’s wise to double-check your broker’s 1099-B reporting. For example, a few foreign futures received Section 1256 treatment in IRS revenue rulings. Otherwise, without that ruling, they are treated as securities.

Forex trading is an ordinary gain or loss by default, but traders may elect to opt out of Section 988 into Section 1256(g) on “major currencies” only, which means the U.S. future exchanges list the same pairs. The U.S. brokers do not issue a 1099-B for spot forex transactions. A trader must file a Section 988 opt-out election on a contemporaneous basis in a taxpayer’s books and records. That means internally as opposed to filing it with the IRS. You can file the election for the whole year or part of the year. Many preparers mess up forex tax treatment, and IRS and state agents are confused over the reporting, too.

Securities ETFs are usually registered investment companies (RICs). Selling a Securities ETF is deemed a sale of security. Many preparers make errors with commodities/futures ETFs, which are publicly-traded partnerships (PTPs). PTPs issue annual Schedule K-1s passing through Section 1256 tax treatment on Section 1256 transactions to investors, as well as other taxable items. Selling a commodities ETF is deemed a sale of security, calling for short-term and long-term capital gains tax treatment. Taxpayers invested in commodities/futures ETFs should make adjustments to cost basis on Form 8949 to capital gains and losses, ensuring they don’t double count Schedule K-1 pass through income or loss. The broker 1099-B will not make this adjustment for you. Options on ETFs are securities whereas options on commodity ETFs can be Section 1256 contracts.

Gold ETFs use the publicly traded trust (PTT) structure, which the IRS considers a disregarded entity. In effect, it’s like directly owning gold bullion. Precious metals are “collectibles” with higher long-term capital gain rates up to 28%. Collectibles held one year, and less are short-term capital gains. Many preparers make errors reporting transactions in precious metals.

Exchange-traded notes (ETNs) are prepaid forward contracts, and tax treatment calls for the deferral of taxes until sale. Alternative tax treatment is unclear on ETNs.

10. Mishandling foreign transactions:

Many Americans trade financial products on global exchanges. Some trade through a U.S. broker who reports all sales globally on Form 1099-B. Most U.S. brokers keep accounts for foreign transactions in U.S. dollars.

It is complicated when traders open an offshore brokerage account held in a foreign currency. Counterparties outside the U.S. do not issue Form 1099-B, and accounting is a challenge. Separate capital gains and losses with embedded currency fluctuation from currency fluctuation on cash balances. Many preparers make mistakes double counting some currency appreciation or depreciation.

Some brokers outside the U.S. encourage Americans to form a foreign entity to set up an offshore brokerage account. Look before you leap: Tax compliance for foreign entities is significant, and there are few to no tax advantages for traders. International tax compliance is very complex and often nuanced, and it’s risky if you mess up tax reporting. Most preparers are not proficient in international tax compliance for U.S. residents.

For U.S. residents, foreign bank, brokerage, investment and other types of accounts — including retirement and insurance in some cases — must be e-filed on FinCEN Form 114, Report of Foreign Bank and Financial Account. If your foreign bank and financial institution accounts combined are under $10,000 for the entire tax year, you fall under the threshold for filing. If you do need to e-file FinCEN Form 114, the deadline is June 30 of the following year. Many preparers overlook FinCEN Form 114, and the penalties can be very high for willful non-compliance.

11. Overlooking or double counting home office deductions:

Most traders with TTS have a room in their home used for business, but they omit home office deductions since they think it’s a red flag with the IRS. The reverse it true: Without a home office or outside office, it does not look like you operate a business.

Some self-preparers double count real estate taxes and mortgage interest deductions on Schedule A. They do not realize Form 8829 allocates the non-business portion of those deductions to Schedule A.

Other preparers wind up with a carryover of home office expenses, with no current year deduction, because they did not point Form 8829 to trading gains or transfer some trading gains to Schedule C as explained in Green’s 2016 Trader Tax Guide. Form 8829 deductions require income; that’s how the IRS keeps a lid on this deduction. Traders without TTS may not deduct home office expenses.

12. Deducting education expenses when not allowed:

New traders often incur significant education costs before they begin trading in live accounts and qualify for TTS. Many preparers incorrectly deduct education as a Section 212 investment expense on Schedule A. However, pre-business education is not deductible in Section 212 by Section 274(h)(7).

Education incurred after business commencement is a business expense. Try to capitalize pre-business education as part of Section 195 startup costs, which can be expensed $5,000 when business commences, with the rest amortized over 15 years. Include a reasonable amount going back six months.

13. Paying self-employment tax when not owed:

Some preparers 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).

The full SE tax (15.3%) applies to the social security base ($118,500 for 2016). The Medicare portion (2.9%) is unlimited.

14. Deducting employee benefit plans when not allowed:

Preparers compound the above error by having the trader contribute to a retirement plan based on net trading business income. A taxpayer may contribute to a retirement plan if he or she has SEI or wages, but trading gains are not SEI. In this case, the trader is deemed to have an “excessive contribution” subject to tax penalties.

Preparers also mistakenly take an AGI deduction for self-employed health insurance premiums, which requires SEI.

If a trader wants employee benefit plan deductions, including health insurance and a retirement plan, he or she should consider an S-Corp pass-through entity tax return. The S-Corp pays officer compensation to unlock these deductions. Many preparers overlook year-end tax planning, which includes payroll and Solo 401(k) plan execution.

Some preparers err in deducting employer-provided health insurance like COBRA. For health insurance to be AGI-deductible, the medical insurance must be an individual or group plan associated with the business. Many preparers err in not adding the health insurance premiums to the S-Corp officer compensation Form W-2, and it’s not subject to payroll tax.

Watch our video: These Tax Errors Will Cost Professional Traders Dearly.


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

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

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

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

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

35. Nevada:

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

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

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

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

NV does not have an individual income tax regime.

NV does not have an estate or inheritance tax system.

NV is one of the best states for traders.

42. New Hampshire:

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

NH includes trading gains in gross receipts.

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

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

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

NH does not have an estate tax or inheritance tax.

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

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


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

July 14, 2016 | By: Robert A. Green, CPA

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

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

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

11. New Jersey:

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

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

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

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

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

NJ has an inheritance tax rate up to 16%.

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

13. Washington:

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

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

WA does not have an individual income tax system.

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

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

14. Massachusetts:

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

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

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

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

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

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

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

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

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

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

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


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

| By: Robert A. Green, CPA

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

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

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

5. Illinois:

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

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

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

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

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

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

6. Pennsylvania:

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

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

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

7. Ohio:

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

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

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

OH has no estate or inheritance tax.

8. Georgia:

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

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

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

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

GA does not have an estate or inheritance tax.

9. Michigan:

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

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

MI does not have an estate or inheritance tax.

10. North Carolina:

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

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

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

NC does not have an estate or inheritance tax.

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


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

| By: Robert A. Green, CPA

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

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

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

3. New York State/City:

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

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

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

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

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

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

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

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

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

4. Florida:

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

FL does not have an individual income tax system.

FL does not have an estate or inheritance tax regime.

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

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

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


Trader Tax Battle Of The States: California Vs. Texas

| By: Robert A. Green, CPA

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

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

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

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

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

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

1. California:

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

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

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

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

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

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

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

CA does not have an estate or inheritance tax.

2. Texas:

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

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

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

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

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

Few TX traders pay FT.

TX does not have an individual income tax.

TX does not have an estate or inheritance tax.

TX is one of the best tax states for traders.

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

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

 


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

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

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

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

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

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

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

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

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

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

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

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

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

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

Darren Neuschwander CPA contributed to this blog post.


Tax Treatment For Volatility Products Including ETNs

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

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

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

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

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

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

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

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

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

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

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

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

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

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

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

Darren Neuschwander, CPA contributed to this blog post.


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