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GreenTrader Weblog
GreenTraderTax & GreenTraderFunds
| For some prior posts, please click here to visit our prior blog. We are in the middle of transitioning to our new blog destination at greencompany. Thank you. |
May 29, 2009
GreenTrader self administered and self-directed retirement-plan strategies and services
GreenTraderTax offers lots of educational resources and services to traders on retirement plans. Whether you want to trade in your retirement plans (securities, futures and/or forex), build it up with annual tax-deductible contributions, borrow money from your retirement plan for personal or business reasons, convert to a Roth IRA for permanent tax-free build-up (special one-time opportunity in 2010 relaxes income thresholds), or take early withdrawals with fewer tax pitfalls, we can help you accomplish your goals.
There are many nuances, complexities and pitfalls with retirement plans, and it’s even more nuanced when you factor in special tax matters for business traders and investors. We have conceived many different strategies for utilizing retirement-plan assets and you will be pleased! Our good ideas and recommendations are included below.
As with our entity formation services, we add more value than those vendors who only offer online filing services; they lack the important integration to our trader tax strategies.
It’s important to note that you don’t need trader tax status to pursue these money-saving retirement plan trading and loan strategies. Several non-business traders also want a self-administered and self-directed retirement plan, so they can trade securities, futures and forex, and have plan loans. None of these value-added features are available in cookie-cutter retirement plans from brokers and banks.
You only need trader tax status if you want to make annual tax-deductible contributions to a retirement plan (or tax-free contributions to a Roth IRA). An entity with trader tax status can efficiently pay a tax-deductible (from gross income) administration fee, which creates the earned income needed for a retirement plan contribution. Without trader tax status, that administration fee is only deductible as a miscellaneous itemized deduction, which is significantly limited with the 2-percent AGI limitation and add-back for AMT purposes (the nasty second-tax regime).
Many investors (such as retiree traders) already have significant retirement assets, and they are more interested in using those assets in a more productive trading manner — without limitations on what and how they can trade. They want a self-administered and self-directed GreenTrader retirement plan to actively trade securities, futures and forex too. They also are interested in plan loans to retire other taxable debt with higher interest rates (mortgages and credit cards).
Business traders enjoy all these benefits and even more. They also benefit from the highest possible retirement contribution tax deductions, saving more income tax than they have to pay in self-employment (SE) tax on the administration fee component only (there is generally no SE tax on trading gains).
It’s wise to get a handle on your retirement-plan strategies in 2009, as a one-time only window of opportunity opens in 2010 with the last of the Bush tax cut breaks. All taxpayers can convert a Roth IRA in 2010, as the annual income threshold of $100,000 of modified adjusted gross income (MAGI) is waived in 2010 only. Normally, in all other years, only taxpayers with MAGI of $100,000 or less can convert a Roth IRA. Business traders with large Section 475 MTM ordinary losses and even NOLs (net operating losses caused by MTM losses) can choose to absorb those losses with a Roth IRA conversion (a great strategy for 2009 too). You can pay the conversion taxes in 2010 over two years too. We will have more content on this Roth IRA conversion strategy — check back soon.
It’s important to note that GreenTraderTax and the government — the Department of Labor under the Employee Retirement Income Security Act (ERISA) —also advocate long-term safety for retirement funds. Caution should be used to avoid “self dealing” and “prohibitive transactions” which are subject to onerous IRS tax penalties. We offer great ideas and ways to tap your retirement funds for active trading, but we also want you to be cautious and consider the down side. We don’t want to help enable individuals to lose their retirement funds in active trading activities.
We suggest starting with a half-hour consultation with our GreenTrader retirement-plan experts (Robert A. Green, CPA or Mark Durham, MBA). If we both agree that a GreenTrader self-administered and self-directed retirement plan is a wise strategy for you and your family, you can upgrade to our retirement-plan services retainer (click here).
Our GreenTrader retirement-plan services are structured and priced in the same manner as our entity-formation and tax-preparation services (which many of our clients are familiar with). We provide consultation, design, execution (formation) and annual compliance and support services. We ask you to pay for third-party providers (if required) directly, so there are no mark-ups and these third-parties owe you their direct care and support too. In some cases, we will negotiate special lower pricing and/or value-added services from our affiliates, so it pays to work through us. We make sure to use these providers in every way possible, so you don’t pay us to do what’s included in their fixed prices. If you don’t need the added features of a self-administrated retirement plan, we suggest a “cookie-cutter” self-directed retirement plan offered by leading brokers (which often costs much less).
As with our popular entity formation service, we don’t just form a retirement-plan strategy and walk away. Our clients count on us to provide ongoing support and annual service to help ensure the plan works as designed, reaping all possible benefits in a compliant manner. Just as with our entity-formation and tax-preparation services, the final tax saving comes at tax time (year-end planning and preparation), when we crunch the numbers to see the various savings from different strategies.
We also prepare your annual tax Form 5500 Annual Return/Report of Employee Benefit Plan (if required) and handle annual maintenance and upgrades for your plan. Congress and the IRS often update employee benefit laws, and it’s vital to keep your plans compliant with all changes in the law. Our third-party providers make sure the plan paperwork reflects any changes.
Our retirement team consists of a leading retirement plan-professional (who joined us after a 22-year career with Fidelity Investments), a retirement-plan/employee-benefits attorney, a tax attorney, a CPA from our trader tax practice area who also is an expert in preparing 5500s, all our CPAs, and Robert A. Green, CPA/CEO.
Our GreenTrader self-administered plans cover the gamut of your needs. From a simple plan only allowing plan loans at very low cost, to full-fledged value-added features offering trading securities, futures and forex. The annual costs are very reasonable — estimated at around $500 per year (more or less). The cost of forming a self-administered plan usually is our retainer amount of $750. There are complex situations where our time expended and billed will surpass the retainer amount. For example, defined benefit plans — allowing for much higher annual contributions — cost more, as you are required to use the services of an independent actuary too (which costs around $1,000 per year).
Details for our retirement-plan services, features and related costs are attached in this Power Point document prepared by our Mark Durham, MBA. Click here http://www.greencompany.com/Traders/GreenTrader%20Retirement%20Plan%20Services%202009.pdf .
Our retirement-plan content (including many magazine articles) below has grown over the years. It’s now better than ever with the 2009 roll out of our new GreenTrader self-administered and self-directed retirement-plan services and related strategies (see below).
Here is the evolution of our retirement plan services and content for traders.
In 2000, we pointed out the great tax pitfall of traders taking “early withdrawals” from their retirement plans to fund their trading accounts. Many of these traders got caught in a double-tax whammy when the tech bubble burst. They were forced to pay very high income taxes on their early withdrawals from retirement plans (at higher ordinary income tax rates), plus they had to pay the onerous 10-percent excise tax penalty (reported on IRS Form 5329). The painful lesson back then was that too many business traders neglected to also elect Section 475 MTM (to protect themselves with ordinary loss treatment), so they were stuck with restricted capital loss treatment and had to carry over large trading losses to subsequent tax years (and many never used them in later years). The sad result was that they paid taxes on just breaking even. Many of these traders wound up owing the IRS and their states more than they could pay. With Section 475, they could have offset their retirement-plan early withdrawal ordinary income with Section 475 MTM ordinary trading losses, thereby not owing any tax except the 10-percent excise tax. The remedy at that time was to trade within your retirement plans and if you took early withdrawals to make sure you also had Section 475 MTM. This same problem happened again in 2008 for many traders caught in the meltdown.
Now we are pleased to offer broader and better remedies to traders facing this conundrum and who need to access funds in their retirement plans for trading and other personal and business uses.
GreenTrader "Self-Administered" Retirement Plans:
We offer specially designed GreenTrader self-administered Mini 401k retirement plans (regular and Roth), as well as other types of retirement plans (including high-deductible “defined-benefit” retirement plans).
Our self-administered retirement plans contain value-added features such as plan loans (borrowing money from your retirement plans for whatever reason — business or personal), the ability to trade securities, futures and forex, as well as other types of investments (such as hedge funds). Most brokerage firms provide cookie-cutter prototype retirement plans that do not offer any of these value-added features.
In the 2009 jobs recession and credit crisis, many people including traders are facing cash-flow shortages and the withdrawal of credit lines (on home equity loans) from their banks and credit card providers. Many traders are unable to finance their trading working capital and other living needs, especially after incurring large trading losses in 2008 and 2009 year-to-date. Finding a legal and tax-efficient way to tap into retirement funds to finance a trading business and/or living expenses can be a wise move (of last or first resort). Again, be cautious and think twice about using this type of financing to fund a losing business.
Even non-traders are interested in these retirement-plan strategies. As an example, if you are a conservative investor and have your retirement plan assets invested mostly in cash equivalents earning very low interest rates, consider borrowing from your retirement plans to pay down your mortgage and credit card debt, which probably has much higher interest rates (interest rates are sky rocketing on credit cards and remain high on jumbo mortgages too). Saving several basis points on interest rates is wise, even after forgoing some mortgage interest expense tax deductions. Credit card interest is not deductible.
We recommend the following strategy for business traders. Borrow some retirement-plan funds to sufficiently replenish your trading business accounts in order to maintain your trader tax status and Section 475 MTM treatment. Some traders have fallen below “pattern day trader” amounts of $25,000 for securities and their broker then restricts day trading, only allowing 2/1 margin (rather than 4/1 margin for pattern day traders). A retirement-plan loan can be the answer. But don’t borrow all the money you can from the plan (up to 50 percent) — borrow only enough to replenish what you need.
The maximum term for a participant loan generally is limited to five years (unless financing the purchase of a residence). The Code requires that participant loans be amortized substantially evenly over the loan term, with at least quarterly payments of both principal and interest .
The loan must bear a reasonable rate of interest. The interest is treated as investment return and not a contribution. Accordingly, there will not be a basis adjustment and will generate ordinary income upon distribution.
Even if otherwise deductible, the interest expense would not be deductible if the loan is a loan to a key employee or secured by amounts attributable to elective deferrals to a 401(k) plan.
Unfortunately, the interest part of this strategy is not very tax efficient, as the interest expenses (paid by the taxable account to the retirement plan) is not tax deductible. On the flip side, the interest income is ultimately taxed as part of later-year retirement-plan distributions. There is a benefit in that the interest income is not part of the annual retirement plan contribution limits — so you wind up with a higher payment into the retirement plan, which generates more tax-free build-up.
Why borrow the maximum amount allowed and then have to pay it back to the retirement plan over five years, after you pay annual taxes on the trading gains related to that plan loan funding? It may be wiser for you to leave as much of those retirement-plan assets as possible in the retirement plan itself and trade the plan as you like (securities, futures and forex in a self-administered plan trust account). That way, you build up the retirement assets without having to pay annual income taxes on the gains. If you have large losses with Section 475 in a taxable account (with full retirement-plan loan funding), you will enjoy NOL immediate tax refund treatment. However, the IRS is beefing up attacks on trader tax status and if yours is weak, it may be more prudent to trade in the retirement account instead. Avoiding taxes in a taxable account and trading more in your retirement account is better over time tax-wise. Growth from tax-free compounding is far better than paying taxes every year in a taxable account.
We suggest a consultation with Robert Green and/or our retirement-plan expert Mark Durham, MBA to determine the best strategy for your needs.
Green will consult with you on qualification for trader tax status and if you can benefit from an entity and a retirement plan contribution. He and/or Durham can advise you on using a retirement-plan strategy along with trader tax status and your entity, or using a self-administered retirement-plan strategy as a regular investor (to have plan loans and rights to trade securities, futures and forex).
We can fine tune the best overall retirement-plan strategy for you and work together with you and our affiliates to find the best cost versus benefits plan.
It’s important to note that trading securities on margin in your retirement plan (through an underlying hedge fund investment) leads to Unrelated Business Taxable Income (UBTI) and Unrelated Business Income Tax (UBIT). Current tax law dictates that margin interest paid on trading also means that the trading gains and income generated from that leverage (part only) is subject to annual income taxes — and is otherwise not protected by the tax-free status of the retirement plan.
Pension funds and college endowments invest in offshore hedge funds to avoid UBIT caused by using leverage in a domestic fund. Offshore hedge funds are known as “UBIT-blockers.” As part of Congress and the Obama administration’s agenda to reduce offshore tax breaks, Congress has proposed tax law-changes to encourage pensions and other tax-free institutional funds to invest in domestic funds rather than offshore funds. Congress proposes to eliminate the UBIT blocker tax loophole, not by causing offshore funds to generate UBIT on par with domestic funds, but rather in a more positive manner — by simply removing UBIT entirely in domestic funds.
These potential changes to UBIT rules could help traders using their own retirement plans too. Perhaps UBIT won’t apply in this instance either. It’s also important to note that trading futures and forex in a retirement plan does not generate UBTI as that type of leverage does not generate margin-interest expense.
Notes from our attorney on UBIT issues:
• Qualified plans are subject to the unrelated business income tax (UBIT) on its unrelated business taxable income (UBTI). While interest income and securities gains are generally considered exempt from UBIT, if an investment is "debt financed" then it is subject to tax in proportion to the financed amount. Accordingly, margin investments within a plan may be taxable. Also, revenue received from unexercised stock options (puts and calls) regularly issued on stocks held in the trust's portfolio may constitute UBTI and not "passive" investment income.
• Points for possible additional review:
A. Since there is no tracking of loan proceeds, there should be no prohibited transaction issue (not a plan investment); however, in the event that the business adopting the plan is premised on the use of a plan loan, query as to whether the validity of the business will be questioned.
B. Even though non-financed investment activities generally do not generate UBTI, will active trading ever rise to the level of an "unrelated business" if trust funds are utilized as a "trader" activity?
Comment from Green. We don’t want a taxable trading business (or hedge fund) to be solely funded from a retirement plan account. Rather, we prefer it to be less than 50 percent funded so the IRS can not take the position that the retirement plan is running a business.
Borrow what you need and leave as much of those assets as possible within your retirement plan, and trade them in the retirement plan as you like (securities, futures and forex). The funds traded within the retirement plan build up tax free until retirement (and they are permanently tax free in a Roth IRA). Trading losses incurred within the retirement plan reduce your tax basis, which reduces taxes to be paid on later year distributions from the plan. If you need to cover more living expenses later on, perhaps because you have trading losses in your taxable accounts, you can always borrow more retirement assets as you need them over time. We recommend this strategy rather than taking a larger loan to start.
Many traders have been asking us for these value-added retirement-plan features. They want the ability to borrow money from their own retirement plans to finance their trading business, especially during this recession. Their brokers have said no. Their only alternative has been taking an ill-advised early withdrawal from their retirement plans, subject to ordinary income taxes plus a nasty 10 percent excise tax penalty.
We can set up a GreenTrader self-administered retirement plan to meet your specific needs. Self-administered means you (and not our firm) are responsible for your investment decisions. (We don’t offer investment advice because GreenTrader is not an investment adviser.)
We provide support for compliance and administration, including 5500 tax filings, loan agreement setup and maintenance.
Many of our plans are fairly simple to set up and reasonably priced. The added-value features and tax benefits far exceed the set up and annual maintenance costs.
If you are interested in a GreenTrader self-administered and self-directed retirement plan, please email us at retirementplans@greencompany.com and tell us the features you are most interested in.
Our retirement-plan professional Mark Durham, MBA, recently joined us after a long and successful career at Fidelity. Mr. Durham is working on these plans along with Robert Green, CPA, and our outside employee-benefits attorney, Louis Barr, JD, and tax attorney, Mark Feldman, JD. We are using the leading non-prototype plan engines with opinion letters, too.
Ready for help? click here http://www.greencompany.com/Traders/TraderRetirement.shtml#retirementplanretainers . May 14, 2009
2010 Obama Budget Tax Proposals: Some Clarifications
Tax publisher RIA clarifies the point that important tax changes like the repeal of carried interest tax breaks for investment managers and the increase in long-term capital gains tax rates don't take effect until 2011. This is a relief, as some media had reported these two tax changes might take place in the later part of 2009.
From RIA: "On May 11, the Treasury Department released the 'General Explanations of the Administration's Fiscal Year 2010 Revenue Proposals,' known as the Green Book for the color of its cover. This 130-page document carries a fairly comprehensive blueprint of the tax proposals the Administration hopes to shepherd through Congress to make its FY 2010 budget plans a reality."
Other key excepts:
"For tax years beginning after 2010, carried interests would be taxed as ordinary income."
"For tax years beginning after 2010, a 20% tax rate on long-term capital gains and qualified dividends would apply for married taxpayers filing jointly with income over $250,000..."
RIA did not recap the potential repeal of 60/40 for futures dealers.
RIA observation: "The Green Book's revenue raising tax proposals would pose significant tax planning challenges for higher-income individuals, higher taxes for many businesses, and higher compliance costs for business of all sizes."
May 12, 2009
New potential attack on 60/40 treatment for dealers
Congress and/or the Administration have started an attack to repeal 60/40 tax breaks, a topic I have been worrying and writing about for well over a year now.
The first blow is only against futures and options dealers, not traders (futures and forex using 1256g).
Included (and buried) in the fine print of “General Explanations of the Administration’s Fiscal Year 2010 Revenue Proposals” (otherwise known as the “Green Book”), is a section titled “Require Ordinary Treatment for Certain Dealers of Equity Options and Commodities” (page 110). See the Green Book at http://www.ustreas.gov/offices/tax-policy/library/grnbk09.pdf .
In layman’s terms, this section points out that some dealers have ordinary gain or loss treatment, whereas futures and options dealers (unfairly) benefit from special lower 60/40 income tax breaks (in Section 1256).
It’s argued that all dealers should have ordinary gain or loss treatment in their business; therefore futures and options traders should lose that tax break.
The fine print indicates futures and options dealers will no longer be allowed to report capital gains income (let alone futures 60/40 capital gains income) -- they will be required to report their earnings as ordinary income. This would lead to more SE taxes too, as ordinary income is generally SE taxable income.
Don’t panic yet: It’s a proposal and not yet finalized. But it's pretty clear to everyone that the Administration and Congress are hunting for revenues (i.e., taxes), targeting groups such as the "money classes" (traders, investors, bond holders, Wall Street firms and more). They advocate “pay go,” which means raising new taxes to pay for their social agenda, such as universal health care.
As we pointed out on our April 28, 2009 blog (and warned for more than a year) http://www.greencompany.com/blog/index.php?postid=19 , Congress and the Administration just agreed to repeal carried interest tax breaks for investment managers in the not yet signed 2010 Obama Budget. This provision is also in the Green Book and the effective date for the repeal of carried interest is 2011. House and Senate conferees signed off on this repeal of carried interest tax breaks and it's awaiting final bill (detail) language and enactment by the President (which is expected).
Also in the 2010 Obama Budget and Green Book: Long-term capital gains rates are scheduled to rise to 20 percent (from 15 percent) in 2011, as scheduled with the Bush tax cuts expiring at the end of 2010.
An earlier edit of this blog indicated both of the above provisions might take effect in late 2009 -- that scare is abated. We have until 2011 to plan for these tax changes and also enjoy these benefits a little longer.
The big question: Will 60/40 be repealed for traders too? Look at the dangerous reasoning in the above referenced 2010 Green Book. That same logic can easily be applied to traders, although it’s a little more of a stretch.
For traders, the government doesn’t need to call for business ordinary income treatment; rather consistent capital gains treatment. The government can argue in the same manner as above that securities traders pay ordinary income tax rates on short-term capital gains and it’s unfair for futures traders to receive lower 60/40 tax rates (60 percent long term capital gains rate treatment).
We covered this topic in detail on my blog entry of May 1, 2009 (and on many earlier blog posts and articles too) http://www.greencompany.com/blog/index.php?postid=22 . Professional traders who are members of futures exchanges pay SE tax and with 60/40, the total tax rates approximate ordinary tax rates. But most futures traders now are not members of exchanges and they are not subject to SE taxes.
It's also important to remember the Senate tried to repeal 60/40 during Senate/House conference negotiations for passage of the 2003 Bush Administration tax-cut act. Luckily, the House prevailed after futures exchanges defended it.
Before becoming President, Obama was a Democratic senator from Illinois, home of the futures exchanges. But with the state's politics currently in disarray caused by former Illinois Governor Blagojevich's alleged "pay to play" scandal, and with the new environment stacked against lobbyists and special interests, can the CBOE and other futures exchanges defend 60/40, as the CBOE is attempting to do? (See recap below.) Will President Obama weigh in to give special treatment to his home state?
The government’s first step could be to repeal 60/40 for everyone (dealers, traders and investors). Next, they could argue that day traders have earned income on their trading gains too, thereby subjecting them to SE taxes (which are also headed up in the Obama initiatives).
Will the government seek to apply MTM treatment for all professional traders, as is the case in Section 1256? Will it do away with Section 475 MTM ordinary loss treatment too? Who knows -- the sky is the limit by this group in DC when it comes to the money class.
No need to speculate too much yet. But this revenue proposal attack on dealers currently enjoying 60/40 is certainly a warning shot for traders.
We were sent a May 12 CBOE circular -- IC09-043 Potential Change to 60/40 Tax Rule. I don't see a link for this circular on the CBOE site.
In this circular, the CBOE states its opposition to this potential tax change (as expected). The CBOE argues that this tax hike will likely increase the cost of doing business for futures dealers, who may feel inclined to pass on these higher (tax) costs to customers, which may undermine the markets. They further point out that 60/40 is a long-standing tax rule intended to compensate dealers for mark-to-market treatment in Section 1256. Helpful arguments in my view, but not compelling and that's a concern. May 1, 2009
Trader tax status review
Part 4 and final blog article in this series on trader tax status.
Trader tax status is the lynchpin for many trader-tax breaks including business expense treatment vs. restricted investment expense treatment; Section 475 MTM ordinary loss treatment vs. restricted ($3,000) capital loss limitations; and AGI tax deductions, such as health insurance premiums and retirement plan deductions which are not available to investors.
However, there are many important tax breaks that don’t require qualification for trader tax status, such as lower 60/40 tax rates for futures and forex traders and exemption from the self-employment (SE) tax (with a few exceptions) on trading gains. With many tax changes looming, it’s important to note 60/40 tax breaks for traders and exemptions from the SE tax are unlikely to be repealed in the first round of tax change coming to Washington in 2009 and 2010.
Trader tax status is not for everyone
Trader tax status means a trader rises to the level of trading as a business. That unlocks business expense treatment, which is far superior in many cases (but not all) to investment expense treatment (used by investors or active traders who do not qualify for trader tax status).
Most business traders have a relatively low level of business expenses compared to other types of small businesses. Traders often work from an office within their home (saving on outside rent). They also rarely hire employees or independent contractors, thereby saving on labor costs. With these important overhead savings, trading business expenses usually range from $3,000 to $15,000; mostly for trading services, computers and other equipment. Education can be an additional expense of $5,000 to $25,000 or more. Special rules apply to deducting education expenses — see “Recession ushers in new traders” posted April 29 for details.
Only business traders can deduct home-office expenses and travel to trading seminars; investors may not. Margin interest is a fully deductible business expense with trader tax status, whereas it’s only deductible as investment interest under investor tax status. Excess investment interest expenses can be carried over to subsequent tax years.
The IRS is fighting more traders on trader tax status now, mostly when traders also elect Section 475f MTM accounting and use it to claim business ordinary loss treatment on securities trading losses (sometimes in the hundreds of thousands or dollars).
If you are a part-time trader and you don’t have many trading expenses, or you can deduct most of your general business expenses in another manner (as investment expenses without much of a haircut or in another business activity), then consider skipping trader tax status. Try to take advantage of other trading tax related benefits (such as lower 60/40 tax rates and exemption from SE taxes) instead.
In a tax-court case in the 1990s, the IRS attacked trader tax status because a taxpayer was claiming unlimited business interest expense treatment vs. what would otherwise be an interest-expense carryover. The big concern for the IRS is large reductions of taxable income, caused by Section 475 ordinary trading losses and large levels of business interest expense; both are predicated on trader tax status. Smaller levels of trading business expenses do not draw as much attention or concern.
Keep in mind excess investment interest expense and capital losses may both be carried over to subsequent tax years, so they are not officially lost. Practically speaking, they may not be very useful if the trader has little capital to risk in the markets to generate capital gains. At least interest income and dividends are investment income, which can provide the means for carryover investment interest expense deductions.
Lower 60/40 tax rates are a boon to traders
All traders and less-active investors may benefit from significantly lower income tax rates on trading Section 1256 contracts. Section 1256 contracts include regulated futures contracts, foreign currency contracts, nonequity options, dealer equity options, and dealer securities futures contracts. These contracts must generally be treated as if they are sold at fair market value on the last business day of the tax year.
Many tax professionals treat options on exchange-traded funds (ETFs) as Section 1256. ETFs are generally taxed as securities, but if they are based on commodities, they may have 1256 contract treatment too. Foreign futures may also qualify. Look for a Commodity Futures Trading Commission (CFTC) and/or IRS permission letter, which is usually published on the foreign exchange Web site.
“Substantial authority” (needed for a 2008 or 2009 tax position) exists for treating forex forwards or spot contracts (in major currencies for which the trader does not take or make delivery) as Section 1256g (60/40 treatment). A trader first needs to make a contemporaneous internal “capital gains election” to opt out of Section 988, the default ordinary gain or loss rules on forex. Forex over-the-counter (OTC) options are barred from 60/40 treatment per a 2007 IRS revenue ruling; they are reported directly on Schedule D with a capital gains election.
60/40 and tax-law changes
Currently, the highest tax rate on long-term capital gains is 15 percent, but it’s slated to rise to 20 percent in the 2010 Obama Administration budget (effective 2011). It had been scheduled to rise in this manner with the Bush tax cuts expiring at the end of 2010.
The highest tax rate on short-term capital gains — ordinary income tax rates — is 35 percent, and it’s scheduled to rise back to 39.6 percent when the Bush Administration tax cuts expire at the end of 2010.
The current highest blended rate of 60/40 is 23 percent, 12 percent less than the highest current ordinary rate. With the changes, the new highest blended rate for 60/40 will be 28 percent, still around 12 percent less than the new highest ordinary rate.
Is 60/40 safe from more changes? The 2010 Obama Budget includes a proposal to repeal 60/40 tax breaks for futures dealers (not traders). The Senate tried to repeal 60/40 in a silent last-minute attack during Senate/House conference negotiations for passage of the 2003 Bush Administration tax cut act. Luckily, the House prevailed after futures exchanges defended 60/40.
The question remains: Can President Obama justify 60/40 tax breaks, while raising taxes on many traders, the upper-income, and corporations?
Traders and the SE tax
With a few exceptions, traders are generally exempt from SE tax because trading gains are not earned income. How did this come about?
In the mid-1980s, when Congress enacted Section 1256 along with lower 60/40 tax rates, it may have acted to make up for this significant overall reduction in tax rates vs. other traders by forcing professional futures traders (most of which were on the exchange at that time) to also pay SE tax. Now, most futures traders are not members of exchanges, yet they still receive 60/40 tax breaks without having to also pay SE tax. Some futures traders join the CME as Electronic Corporate Members (ECMs). Some tax attorneys believe that this less-than-full membership does not trigger Section 1402i self-employment income.
There are a few exceptions: If you trade futures as a member of a futures or options exchange, those trading gains (net of business expenses) are deemed self-employment income (Section 1402i). Also, trading advisors who receive fees as payment rather than a share of trading profits are subject to SE taxes. This applies to investment managers in hedge funds and proprietary traders receiving a 1099-Misc. for non-employee compensation. If your trading income is subject to SE taxes, you should take advantage of adjusted gross income (AGI) deductions, in order to save on income tax (thereby offsetting some or all of the SE tax cost).
Proprietary traders who receive a Form 1099-Misc. for “non-employee compensation” also owe SE tax. Don’t feel sorry for them, though: In the proprietary trading firm model, they are allowed to use much higher leverage (which for some is very dangerous) of around 10 to 1 rather than the 4-to-1 limitation for pattern (retail) day traders.
Most legitimate proprietary trading firms are restructuring to the LLC K-1 model, where proprietary traders receive a K-1 with trading gains (not subject to SE tax) rather than reporting those gains as earned income on the 1099-Misc. I wonder if Congress will consider this K-1 income to be a form of carried interest and deny this tax break treatment. Read about the repeal of carried interest tax breaks in “Trader Tax and Carried Interest Updates” posted on April 28, 2009.
When to skip trader tax status
There are other options if you think you might not win an IRS exam of trader tax status.
If you don’t have many trading expenses and/or can deduct your general business expenses in another manner (as investment expenses or another business activity), then you probably don’t need to elect trader tax status.
Part-time traders face high IRS-scrutiny. Most have an after-tax retirement plan and health insurance benefits with their companies. So, unlike a full time trader, they don’t need trader tax status to create AGI deductions. Retirees also face higher IRS scrutiny, but many have Medicare insurance coverage and have already met their retirement plan savings needs. One strategy for this group is to trade their retirement plan actively and convert a Roth IRA in 2010, when the no-income threshold applies as the last of the Bush tax breaks. They can then trade a Roth IRA tax-free for the rest of their life.
Soon-to-be retiring or downsized business executives
Many baby-boomers are getting ready to retire or are being forced out of jobs due to their high salaries. Many have started trading stock and index options, which is ideal for their current and future needs. They can study trading at nights and on weekends, set up trades in the morning before work, and monitor and tweak positions from work. Many of these executives have won the right to use flexible time and work from home too, allowing even more freedom to build their trading business.
But these traders are facing stiff challenges from the IRS on trader tax status. The biggest problem for qualifying for trader tax status appears to be in trading options (part time or as a retiree), and executing trades on under 60 percent of available trading days.
The problem with trading options in qualifying for trader tax status is that option trading programs often do not advocate day trading. Instead, they suggest making trades with 30-day average holding periods. Options trading programs also do not advocate execution of trades on a daily basis. Many full-time options traders make a good living and they qualify for trader tax status. But the IRS feels strongly about attacking part-time traders on the qualification issue, focusing on fewer trades and fewer days with trades. See the IRS attacks on a retiree and options trader (Holsinger) and a part-time executive and options trader in our post “Recent IRS techniques against traders” on April 30.
Forex and futures traders
Forex traders face difficulties in qualifying for trader tax status too — they usually don’t trade the required amount of days and leave positions open for weeks at a time, thereby not generating enough transactions.
However, both forex and futures traders can enjoy some tax breaks without trader tax status. Forex and futures traders usually don’t have many trading expenses, as there is no investment interest expense on forex and futures. With fewer expenses and a preference to skip Section 475 MTM (which requires trader tax status), forex and futures traders should not push the envelope on trader tax status.
By default, forex is given Section 988 ordinary gain or loss treatment. Lose $25,000 trading forex and you can offset you and your spouse’s wages and any other income with the ordinary forex loss in full. As a forex trader, you are also permitted to elect capital gains and loss treatment instead of ordinary gain or loss treatment. The real reason to make the capital gains election is to achieve lower 60/40 futures tax treatment on some forex contracts. With the capital gains election, forex forward contracts and forex spot contracts in major currencies (for which you don’t take or make delivery) can be treated as Section 1256g (foreign currency contracts fall under 1256); thereby being treated like futures on Form 6781 with lower 60/40 tax rates.
Futures losses (including forex treated as 1256g) can be carried-back three tax years, but only against futures gains in those years. With this loss carry back feature, futures and forex (1256g) traders don’t need to depend on trader tax status with a Section 475f MTM election generating net operating loss (NOL) treatment. Generally speaking, a NOL carry back is better than a futures loss carry back, because it can offset income of any kind (not just futures gains). For the 2008 tax year only, the NOL two-year carry back rule may be expanded to up to five years — for more information, see “Changes for NOL reporting” in the April 28 blog entry.
The perennial money-losing trader
Amateur, start up and on-again, off-again money-losing traders may be pushing the envelope on trader tax status, considering the escalating IRS challenges to trader tax status. These traders should calculate their tax scenarios with and without trader tax status. If it’s not costly to skip trader tax status, and you want piece of mind, then skip trader tax status.
If you can’t get much benefit from your trading expenses as either investment expenses or in another business activity, then you may be able to defer those deductions to a subsequent year where you qualify for trader tax status. For a reasonable period of time, you may be able to look back and capitalize your prior trading costs and expenses as Section 195 start-up costs. You may then have the opportunity to amortize start up and organization costs and depreciate equipment once you qualify for trader tax status.
If you are not trading a large amount of capital in securities, you probably won’t lose too much money without “tax loss” insurance in Section 475 MTM ordinary loss treatment. You can probably use up your capital loss carryovers in subsequent tax years.
Wash sales are better than excess capital-loss carryovers, as wash sales can become part of a Section 475 MTM ordinary trading loss in the following tax year (in the Section 481a adjustment).
So, who needs it?
Serious full-time traders can more safely depend on using trader tax status. The IRS’s “material participation” standard calls for 500 hours of work spent before a taxpayer can rise above passive activity loss rules and claim business loss treatment. If you put on a minimum of 500 round-trip trades per year, trade more than 75 percent of available trading days for more than four hours per day, and have average holding periods under a week, you should qualify for trader tax status. You also need to have the intention to run a business activity to make a living, serious tools & business expenses, and a material account size.
If you feel you qualify (and its best to consult a trader tax expert), then a separate trading entity (used only for trading) is a solid way to claim trader tax status. (See “Forming an entity” in the April 29 blog entry.) The IRS won’t see your W-2 or other business activity when it looks at the separately filed trading entity tax return.
Historically, the IRS has frequently examined Schedule C (sole proprietor) small businesses. Small-business traders invite even more scrutiny because a trader’s Schedule C only shows business expenses; trading gains and losses are reported on other tax forms. We advocate an income transfer strategy to Schedule C (other income) to mitigate this problem.
Ex-Wall Street trader turns small-business trader
Many people are losing their jobs in this recession, and some have turned to a trading business as their perceived best hope. One distinct group of new traders includes ex-financial service executives and professional traders at hedge funds, private equity firms, banks, brokerage firms and other institutions. These traders often (mistakenly) immediately commit hundreds of thousands of dollars of capital to their new trading businesses. They correctly understand that they can’t make their prior salaries on a small trading account.
These ex-trading professionals also have the necessary training, skills, experience and discipline to be successful over the long-term. The good news is they qualify in the eyes of the IRS more easily over traders without this background because the IRS considers them to be long-term trading professionals. The bad news is many traded as they did for a hedge fund and lost a large amount of capital quickly — and many did not bother to contact us to learn about a Section 475 MTM election. They were stuck with huge capital-loss carryovers.
Bottom line
Trader tax status is great for deducting legitimate trading business expenses, including the very powerful home-office deduction, start-up costs, education and margin interest expenses. Trader tax status also provides the opportunity to elect the powerful Section 475 MTM ordinary tax loss treatment, which is highly recommended for securities traders (but not futures and forex traders who would rather retain lower 60/40 treatment).
The IRS is increasingly challenging trader tax status. For this reason, traders should carefully assess the benefits strictly related to trader tax status; after examination, many traders may decide trader tax status is more trouble than it’s worth. If you are in this group, there are still plenty of tax benefits for you.
April 30, 2009
Recent IRS techniques against traders
Part 3 in our series of new blog articles continues with a look at a specific exam we encountered — a 55-year-old business executive turned part-time stock-option trader. This person was denied trader tax status at the exam level. We’re expecting to overturn this decision at the appeals level.
We have noticed the IRS giving part-time business executive traders a hard time in tax exams, especially if large Section 475 MTM ordinary business losses are at stake. The IRS doesn’t necessarily consider this type of activity to be a true business activity. Often, the account size is under $50,000 and the executive is losing money.
Number of round trip trades, frequency of trades, average holding period, and number of days on which trades were executed vs. total available trading days are the biggest bones the IRS picks. These qualifications are easy to analyze and verify. Conversely, number of hours per day and intention are subjective and impossible to prove by the IRS.
The numbers of days on which trades are executed vs. total available trading days seems to be the new Achilles heel for option traders. Option trading programs involve putting on complex positions and spreads (with multiple legs), which is set up to keep positions open for several weeks or longer.
In the recent landmark Holsinger vs. IRS tax court case, the IRS denied trader tax status because Holsinger only executed trades on 45 percent of available trading days, holding options trades open for 30 to 45 days. Being a retiree put Holsinger at a disadvantage vs. a younger person trading full time in the eyes of the IRS. It’s hard for a retiree to raise the full-time argument, as they are out of the fulltime workforce already. See our blog article on the Holsinger case here http://www.greencompany.com/blog/index.php?postid=7 .
We are handling an IRS exam for a business executive facing downsizing and retirement at age 55. The IRS raised these same types of issues in seeking to deny trader tax status and large Section 475 ordinary loss treatment.
Trading days and hotel stays
I have a huge bone to pick with the IRS over the number of executed trading days argument, which is unfortunately approaching a new “case law” standard (Holsinger and others). In my recent tax exam for this part-time stock option trader (a California-based 55-year-old executive facing downsizing), I raised this “hotel analogy” argument and the agent did not fully listen to it or agree to it. But he seemed curious on the logic and it could have an impact in the next step of appeals. Sometimes you need to agree to disagree with an agent on the exam level and pursue the case in the appeals process. I recently wrote an article for Fidelity’s Active Trader e-Newsletter, “IRS Strategy for Active Traders” at http://personal.fidelity.com/misc/framesets/iwarticle.shtml?pagename=AT0902IRS_Strategies .
My analogy: A hotel guest checks into a hotel on a Monday and checks out on a Saturday. Monday and Saturday are two executed transaction days of a seven-day week — 29 percent of the week, which is well under the 60 percent standard amount (which is a working guess at the IRS’s current standard amount). My argument is that the hotel guest needed hotel services (towels, room service, etc.) on the part of hotel management and workers Monday through Saturday, five of seven days of the week (70 percent).
This is comparable to trading — traders monitor trades daily, every day of the week, even on weekends. They often also initiate unexecuted trades and stop-loss and limit orders. In my opinion, the IRS should count daily activity in addition to executed trades.
I told the last IRS agent I spoke to that tax code and case law does not mention the concept of “executed” trades vs. “unexecuted trades” anywhere. It’s not clear in case law that executed trades set the standard for material participation of business activity. Business hours spent has always set that standard. In this exam, the agent started off by raising the passive loss activity “material participation” standards.
Material participation calls for 500 hours of work spent per year before a taxpayer can rise above passive activity loss rules and claim business loss treatment. Otherwise, passive losses are offset only against passive activity income and if not, they are carried over to the subsequent tax year(s). (There are other standards that call for only 100 hours.)
Over the years, we made the point that a trading business may not be subject to “passive activity loss” rules (Section 469 and IRS publication 925) because a trading business falls under the “trading rule” exception. The trading rule exception in Section 469 was enacted to prevent a taxpayer otherwise stuck with passive activity loss deferrals from using a hedge fund or investment company to generate passive activity income, thereby unlocking the passive-activity loss deduction. That would make it too easy to navigate around Section 469 intentions. The trading rule is part of Section 469, and maybe a trader should be able to still use material participation standards to claim trader tax status. Most traders would easily qualify under these standards because they trade well more than the 500 hours the rule requires.
Material participation standards would certainly help trump the IRS’s standard on number of days for executed trades vs. total available trading days. Our golden rules for trader tax status call for more than four hours trading every day of the week (approximately 25 hours a week). If a trader works 48 weeks per year (not including vacation weeks), it totals 1,200 hours per year, well over the 500 hours required in the material participation standards.
The above California-based trader spent over 1,200 hours per year, consistently throughout the year. The IRS agent agreed to this fact, which was first supported by extensive business plans and archived work product.
Your personal life, examined. Another interesting aspect of this exam is that the IRS agent asked the trader about his personal life. Questions included whether or not he spent time on a daily basis with his children coaching sports teams or otherwise. The agent tried to add up the hours reported to make sure they made sense. They did.
Most business traders can impress an IRS agent on the complex nature of a highly technical trading business. Charts, computers, software, systems, research, analysis and much more is very impressive. Along with material participation rules (if they can be deployed for business traders), this type of support can lead to a winning argument on qualifying for trader tax status.
The risk factor. In this exam, the IRS agent figured total proceeds per trade (total trading proceeds divided by total trades). He argued the risk was not material enough vs. the trader’s overall net worth. This trader had much more capital committed in prior years when he had high profits; recent losses caused his account size reduction. This tentative argument never made it the agent’s conclusions.
In terms of risk per trade, it raises another interesting concern. When we tell some clients they may have trouble with the IRS on the number of executed trading days, many ask if they can just execute smaller day trades with less risk to overcome this concern. It is not clear if the IRS will raise the risk-per-trade argument more going forward.
The IRS code talks about risk, but it doesn’t do much to quantify risk per net worth or otherwise. I think this IRS agent’s argument about risk is flawed. Putting on trades with no risk (offsetting positions) would clearly not help.
A bright-line test? The IRS appears to be allowing the courts to help define a rule or standard, composed of objective factors, which leaves little or no room for varying interpretation. The purpose of a bright-line rule is to produce predictable and consistent results in its application.
The agent on this exam argues that days with just one trade should not be counted — only days with more than one trade should be counted. That argument is very unfair and is not supported by any case law precedent. It's self-serving because it stacks the deck for the IRS on counting days traded — the entire basis for the IRS's argument against this trader qualifying for trader tax status. This is the problem with bright-line tests: One can argue over how the lines of demarcation are drawn, and then traders have a shooting target to surpass for qualification.
The bottom line
We weren’t successful during the exam process, but we expect to win at the IRS appeal stage of the game. If you are facing an IRS exam on trader tax status, be prepared for many questions about your daily activities and for your trading activity to be scrutinized. Always consult a trader tax professional for guidance on this topic.
Check back soon. Our next article will go into further detail on trader tax status, describing the groups of traders who easily qualify, and those who don’t. If you’re in the latter group, learn about significant tax savings as well. April 29, 2009
Recession ushers in new traders
Second article of a multi-article series which started on April 28, 2009 (see below post).
The recession has brought a record number of job losses, but it also means a rise in the number of individuals launching a trading business for the first time. The active retail trading industry is growing more than ever, just as it did in the early-2000s recession. Many people who have lost their job have turned to trading as a new source of income. These newbie traders often enroll in trading schools or seminars. It’s a great idea to do this before launching a full-fledged trading career — there is much to learn. However, be wary of some of the tax information given out in these schools and seminars.
Aspiring traders often pay $5,000 to $25,000 or more to attend trading academies and schools, and many never successfully establish a trading business that qualifies for trader tax status. Perhaps to help sell tuition to these aspiring traders, many school curriculums tie in with some trader-tax service providers (not GreenTraderTax) who promise “get-(tax)-rich-quick” schemes.
Some may suggest setting up two entities — an LLC and C-Corp. They say the C-Corp opens the door to deducting tuition as a business expense, no matter what happens with trader tax status. This scheme doesn’t work without trader tax status because the LLC pays the C-Corp a fee and then the LLC doesn’t qualify for business expense treatment.
In addition, tax law states traders are only entitled to deduct education and travel-related costs after they have commenced their trading business operations and qualify for trader tax status. The problem is that most traders incur these education and seminar expenses before they qualify for trader tax status. Some education-related expenses may be squeezed into Section 195 start-up expenses.
Patience is a virtue
The best advice: Wait to determine if your trading plan qualifies for trader tax status. Many plans do not. Next, give yourself some time trading to see if you can successfully launch an active trading business. If you qualify and have a successful business launch, then — and only then — you should consider a new trading business entity. At that time, all you need is one entity and it should be as simple as possible.
Many education firms also partner with brokerage firms, where graduates are given incentives to open trading accounts. The broker offers reduced commissions offsetting tuition costs over time. This raises an interesting tax accounting question. If tuition is not otherwise deductible as a business expense, can the trader recharacterize the tuition cost as commissions and thereby get a deduction through reduction of trading gains? Questions like these are best left to trader tax experts.
Forming an entity
We recommend a simple pass-through entity, such as a husband-wife general partnership, or a single-member LLC in your home state electing S-Corp. tax status. The entity will help you to claim trader tax status, elect Section 475f MTM later in the year, and have the key AGI deductions for health insurance premiums and retirement plans.
The entity pays an administration fee; turning non-SE trading income into SE earned income. An administration fee is not subject to payroll tax compliance, unemployment insurance, and workmen compensation payments. There are some risks here, so consult a tax advisor.
You could add a C-Corp to the plan as a second entity if you need a medical reimbursement plan to receive the administration fee. Otherwise, the administration fee goes to your Schedule C.
Once you have a trading entity, or a rock-solid unincorporated Schedule C for your trading business, you can consider deducting your Section 195 start up costs, including some or all of your trading school and seminar costs. These costs can be amortized over 180 months and there is a $5,000 first-year expense election too.
If you don’t qualify for trader tax status, be realistic and don’t count on papering it over with a two-entity scheme. Qualification for trader tax status is not easy for many; the rules are very vague and the IRS is attacking trader tax status in more exams. However, many graduates of day trading schools go on to easily qualify and recover tuition and travel related costs. Consult a tax advisor on these more nuanced deduction and capitalization strategies.
More entity benefits
Unless they have another source of earned income, profitable business traders should set up their own trading entity to have the opportunity to financially engineer some earned income. But only enough earned income to deploy a retirement-plan strategy; when done correctly, traders can save more in income taxes than they cause themselves (fully at their own option) to pay in SE taxes.
We don’t advocate guaranteed payments, because the IRS audit manual challenges that practice in investment companies. It’s different as a trading-business company. The Armstrong vs. IRS tax court case also provides support on this front.
With a Mini 401(k) retirement plan, the trade off on an elective deferral retirement plan contribution is a net tax saving proposition; with income tax savings exceeding SE tax costs. Plus, you replace bad income taxes with good SE taxes (which provide social security and Medicare benefits in retirement).
Bottom line
If are looking to start a trading business during this recession, you are probably inundated with the army of trading schools, courses, and seminars out there. Many promise riches and pass along bad tax advice. You should consider setting up an entity only after you’ve become a proven, successful trader. You can deduct your reasonable start-up costs at that time as well. Always consult a trader tax expert for guidance.
Check back soon: Our next entry provides helpful information from a trader-tax examination we recently encountered. Our California-based trader was denied trader tax status. We’ll go over the IRS agent’s questions and why this particular trader was unsuccessful on the exam-level. We expect to win that exam on the IRS appeals-level. April 28, 2009
Trader tax & carried interest updates
First article of a multi-article series.
The IRS is turning up the heat on traders, small business taxpayers, the upper-income class, pass-through entities, Nevada C-Corps, offshore entities, and more. Trader tax status is under attack and I’m guessing Congress may even rethink opening Section 475 to traders (for huge ordinary loss treatment — it only applied to dealers before 1997). The U.S. Treasury simply can’t afford to pay all qualifying traders refunds for their losses and expenses. The easiest out is to raise the qualification. Hopefully, Congress won’t repeal Section 475 MTM for traders and pass the dreaded financial-transaction tax (see several links in archives and the first here http://www.greencompany.com/blog/index.php?postid=12) .
All in all, traders should fare better than other types of business and non-business taxpayers. Don’t skip trader tax status when you safely qualify for it. Also, don’t miss out on important Section 475 MTM and Section 988 to Section 1256g forex elections. Play it smart with your carry back and carry forward strategies.
With tax rates headed higher, not claiming and electing your rightful trader tax breaks can cost you an even higher fortune (maybe up to half your trading losses). Today, I take a look at new issues on the horizon for traders.
Carried interest being repealed
Senate and House conferees have agreed upon the 2010 Obama Budget. But the President hasn't signed it yet and much of the legislation (detail) language is not yet done. Sometimes, the devil is in the details. See the Green Book discussion in later blog posts in mid May.
The carried interest tax break was repealed in the 2010 Obama Budget, and its detailed language is not yet formalized. Our below content is based on the proposed language and we expect it to happen as planned. We also expect that there will be a fight behind the scenes from the hedge fund and private equity industries.
For the past several decades, hedge-fund managers structured their incentive fees as “carried interest” (otherwise known as “profit allocation”) in their managed funds.
The purpose was to recharacterize their incentive fees as a share of trading gains on Schedule K-1s, rather than as additional advisory fees which are treated as earned income subject to ordinary income tax rates and self-employment (SE) tax. A long-standing IRS audit manual said to challenge this treatment, but it was rarely challenged.
Passage of the new 2010 budget law is expected to repeal carried interest tax breaks for investment managers. Final reconciliation steps are underway as of this writing and both the Senate and House have already agreed-upon this repeal. The Green Book released on May 11, 2009 indicates the effective date is 2011.
Investment managers with profit allocation in a commodity pool or forex fund will face steep tax increases with the repeal of carried interest tax breaks. Currently, they enjoy lower 60/40 tax rates with a blended maximum rate of 23 percent, and they are exempt from SE tax.
The change will bring a rise in income tax rates (12 percent) and investment managers are subject to SE taxes of 15.3 percent on the base amount ($106,800) and 2.9 percent over the base amount. If the base amount is re-established over $250,000, the tax is much more.
Because of this repeal, it may be less costly overall to operate a managed account business and pay the added compliance costs of operating an investment pool.
It’s important to note that carried interest treatment remains for the investor, which in some cases is still preferable. Having a lower capital gain after the profit allocation is better than a higher gain and non-deductible investment expenses for incentive fees (not deducted due to AMT or otherwise).
Per RIA on April 9, 2009, ..."Bill to tax “carried interest” as ordinary income introduced in House. On Apr. 3, House Ways and Means Committee member Rep. Sander Levine (D-MI) introduced a bill to tax at ordinary income rates income received by partners for performing investment management services for a partnership. The provision is aimed at “carried interest,” or a share in the fund's profits—an important part of the incentive package of partner-managers of investment funds structured as partnerships. In exchange for providing the service of managing their investors' assets, fund managers often receive a portion (usually 20%) of the fund's profits (carried interest). Under current law, partner-managers treat their carried interest as low-taxed long-term capital gain. However, under the bill, the capital gains rate would continue to apply to the extent that managers' income represents a reasonable return on capital they have invested in the partnership."
"The bill would clarify that any income received from a partnership, capital or otherwise, in compensation for services provided by the employee is subject to ordinary tax rates. Managers of investment partnerships who receive a carried interest as compensation would have to pay regular income tax rates rather than capital gains rates on that compensation."
"Levin had previously introduced similar legislation in the 110th Congress, which was later included in several tax packages approved by the Ways & Means Committee and the House of Representatives. A similar proposal was also included in President Obama's FY 2010 budget request."
Click http://www.govtrack.us/congress/bill.xpd?bill=h111-1935 for the text of H.R. 1935, a bill to provide for the treatment of partnership interests held by partners providing services, introduced by Rep. Levin.
Click http://www.house.gov/apps/list/press/mi12_levin/PR040309.shtml for the text of a press release with background information on the carried interest bill introduced by Rep. Levin.
Other changes
We don't see the SE tax break in S-Corps repealed in the 2010 Obama Budget. This repeal was proposed in H.R. 3970 in early 2008. See http://www.greencompany.com/blog/index.php?postid=6 . This omission may provide some relief to investment managers to deflect some SE tax caused by the repeal of carried interest tax breaks. LLCs can elect S-Corp status; which can be filed late with relief.
Long-term capital gains tax rates are scheduled to rise to 20 percent from 15 percent, on the upper income tax brackets, as the Bush tax cuts expire at the end of 2010.
Close the gap
In other news, the Treasury is trying to close the gap on tax cheating and other forms of inadvertent non-compliance, caused by convoluted IRS laws, 1099 reporting oversights, and a litany of complex tax loopholes. Trade accounting is complex with wash sales, straddles, LIFO vs. specific identification, securities vs. futures, and much more.
Brokers only issue Form 1099s to the IRS (and taxpayers) for “covered securities” which leaves out a large portion of trading transactions (options, single-stock futures and more). Covered securities currently only include reporting proceeds on securities — not trading gains or losses on securities.
Form 1099 futures reporting is much clearer, partially because mark-to-market (MTM) accounting (imputed gains and losses at year end on open positions) is built into Section 1256. A futures 1099 reports one net gain or loss number. But some brokers leave out commissions and options on futures too, as well as other types of instruments that can use futures tax treatment. It becomes a huge mess without proper software (such as TradeLog from Armen Computing http://www.greencompany.com/Traders/Software.shtml ). Forex trading is also not covered on 1099-B reporting. Only a few brokers issue a 1099 for forex and they should not.
The first close-the-gap initiative passed includes new “cost basis” 1099-B reporting rules. Unfortunately, the new rules only add holding period and average cost basis, and they still leave a large number of instruments out of covered securities. Accounting messes continue. (Software such as TradeLog remains the only viable solution for securities.)
Traders also botch or cheat on key tax elections
Another concern is that key elections for trader tax treatment — including Section 475 MTM ordinary loss treatment on securities and futures, and the Section 988 capital gains election for forex — are confusing and not monitored properly by the IRS. The IRS wants to flush this out with more exams too.
Section 475 MTM elections are required to be filed externally for existing taxpayers. Recent reports from Washington DC indicate the IRS seems to have botched its archive system for proving MTM elections. You may be able to show you filed an extension on time, but the IRS seems to have a hard time proving the Section 475 MTM election was attached to the extension. To rectify this, the IRS asks for a signed perjury statement indicating you filed it on time. This statement should be included with the Form 3115 filing mailed in the next tax year.
Far too many tax-court cases that have denied trader tax status were focused on improper Section 475 MTM elections (such as the Holsigner and Chen cases).
Once a trader loses MTM ordinary loss treatment (which is easy for the IRS to prove when botched), the trader often caves on trader tax status, because it usually involves a much smaller tax consequence.
Forex traders also abuse the tax system with ordinary loss treatment in 988 and futures 1256g treatment for lower 60/40 rates on gains.
We expect more changes from the IRS on elections. The IRS was supposed to provide a tax form for electing Section 475 MTM and they may require external elections for forex capital gains too.
Tax rates are headed up
The new Democratic Obama Administration in lock step with a Democratic-controlled Congress should be successful in raising all sorts of tax rates and base amounts (income, payroll, estate, and carbon) — especially on the upper-income, global corporations, and the trader/investor-class.
Blue dog democrats and a professed fiscally responsible administration want the taxpayer to pay for (i.e., “pay go”) its (tremendous) increases in health care, education and the environmental spending. The rally cry: “It’s time for the rich who made out like bandits in the Bush years to pay their fair share.”
It’s an admirable social/green agenda, but it’s going to be costly. The U.S. is coordinating with the EU and others to raise taxes, close loopholes, and increase regulation.
The UK continues to use its financial-transaction tax; I hope U.S. congressmen don’t seek to copy them. An increasing number of left-leaning congressmen from non-financial market states are advocating the 0.25 percent financial-transaction tax (see blog archive) on most financial transactions (buy and sell) to pay for the Wall Street bailout and the ravages of “casino capitalism” in general.
The UK just passed a 10-percent tax increase, raising its highest bracket to 50 percent.
Traders can’t use their rallying cry that financial service jobs will move to London and London traders can’t say the same thing about New York. Tax policy coordination is becoming like currency coordination.
Everywhere you look you see higher federal and state taxes coming down the pike and it’s important for traders to navigate this minefield as best they can.
Yes, you can move to a lower-taxing or no-individual income tax state (Texas, Florida and Nevada), but it may not help much to move abroad (especially if you retain citizenship or a greencard — which may be a good idea to surrender if you don’t need it anymore).
U.S. tax rates: Low or high?
Current tax rates may seem fairly low. After all, federal income tax rates in the highest bracket are only 35 percent. But this is deceptive. It’s different than in the EU, where higher rates are what they appear. In the EU, tax rates may be 50 percent, but that can be the most taxes a citizen pays at the highest bracket. In the EU, the price on a restaurant’s menu is the total price. In America, you need to add tax and tip.
Count up all the taxes in America and you will most likely surpass the highest taxes paid in the EU. Published federal tax rates can be a mirage after you add phased out deductions, restrictions on losses and expenses, AMT taxes and more.
Plus, throw in payroll and/or SE taxes, state and local income taxes, sales taxes and property taxes. All of these things considered could put the U.S. equal to or higher than the EU’s tax rates.
Taxes are especially high in New York City or California. NYC also has a 4-percent unincorporated business tax (luckily traders can be exempt from that in the right structure).
Despite the evidence, politicians argue income tax rates are at historically low levels and its okay to raise them in all sorts of ways. After the Bush tax cuts expire at the end of 2010, the highest tax rate will rise 4.6 percent to 39.6 percent. In 2008, Democrats proposed a 5-percent surcharge (on the highest bracket of income tax rates) to pay for the repeal of AMT. Perhaps a surcharge will be called upon to pay for health care. I would not be surprised to see the highest federal bracket at 45 percent.
President Obama campaigned for raising the payroll tax base on all earned income over $250,000 for an additional 12.4 percent tax increase on the upper income. That group’s total tax could approach 58 percent.
State and local income tax rates are also skyrocketing as a last resort to avoid crushing state budget deficits and even insolvency in California, New York, and other states too.
Changes for NOL reporting
It’s wise to elect Section 475f MTM accounting in years you may experience large trading losses in order to carry back a net operating loss (NOL) for immediate tax refunds. That’s what NOL law is intended to do for businesses.
For the 2008 tax year only, the NOL two-year carry back rule may be expanded to up to five years. There is a 15-million dollar revenues test to go beyond two years, up to five years, in order to limit this tax benefit to small businesses. But this revenues test is not a problem for traders, as trading proceeds are not revenue — net gains or losses are the revenue number for this test and therefore all business traders should qualify for the longer NOL carry back period. This is a welcomed tax change for traders.
Bottom line
There are plenty of tax changes on the horizon. We’ll be sure to keep you up-to-date on the latest proposed legislation and what it could mean for you. Check back soon for commentary on a new group of traders: those born from the recession. We’ll provide tips for this group on forming an entity and deducting start-up costs.
March 5, 2009
SEC raising fees
http://www.sec.gov/news/press/2009/2009-41.htm
Fee Rate Advisory #3 for Fiscal Year 2009
FOR IMMEDIATE RELEASE
2009-41
Washington, D.C., March 4, 2009 — Effective on April 1, 2009, or 30 days after the date of enactment of the Commission's regular appropriation for fiscal year 2009, whichever is later, the Section 31 fee rate applicable to securities transactions on the exchanges and over-the-counter markets will increase to $25.70 per million dollars. Until that date, the current rate of $5.60 per million dollars will remain in effect. The Section 31 assessment on security futures transactions will remain unchanged at $0.0042 per round turn transaction. Click the link above for the rest of this notice.
Green comment:
We said all along that the SEC already has a fee on transactions, which resembles a transaction tax. We expected an SEC fee increase as another way to pay for beefed up regulations and enforcement proceedings. The big question remains: Will this increase be in lieu of a transaction tax, or just another cost? March 4, 2009
Rep. Peter DeFazio defends financial-transaction tax on CNBC
http://www.cnbc.com/id/15840232?video=1051076486&play=1
CNBC Airtime: Tues. Mar. 3 2009 | 4:14 PM ET
Debating whether a small trading tax would be worth the bigger consequences, with Rep. Peter DeFazio, D-Oregon, and CNBC's Rebecca Jarvis.
In my view, DeFazio is pretty worked up and defensive in this CNBC interview. (Overall, CNBC has been against this tax.) DeFazio implies that day traders are gamblers, and they need to absorb this new tax if they want to continue doing business. (Traders will need a bigger spread for profits with this tax on both sides of the transaction.) He implies day traders should do something productive for the long-term economy and give up day trading.
DeFazio is not alone among Democrats in this line of thinking. The Obama administration, in lock step with a Democratic super majority in Congress, seems to be telling Americans what's right and wrong in terms of business decisions going forward. For example, old energy is out; new alternative energy is in. Governments use fiscal tax incentives and penalties and regulations to dictate business behavior. It’s your choice: Take the green energy tax benefits, or leave it.
Is the Democratic government really ready and willing to put the majority of day traders out of business over night? Are they going to force them onto bread lines or chain-gang road crews (to build roads in far off cities)? What other white-collar jobs are available now? Aren’t we hemorrhaging jobs now in this economy?
The administration may finally be listening to the (declining) stock market — which is down almost 50 percent since the Obama machine came to power and more if you look back to his rise to expected win on the campaign trail — and also listening to the now less-adoring financial media, but they seem to be reacting in a combative approach. The President’s press secretary and even the President himself are dismissing the stock market decline as just another fickle “trailing poll” and they are trying to discredit proven financial media journalists (i.e., Jim Cramer, Rick Santelli and others). Is that playing fair? Didn't President Obama say during the campaign he’s a “uniter” rather than a “divider”?
President Clinton swept into office with an “it’s the economy, stupid” mantra and blamed an ordinary business-cycle recession (and recovery was already under way) on the first President Bush. Rather than pursue left-leaning big-ticket spending plans pent up during the Reagan years, President Clinton and his guru James Carville listened to the bond market and Federal Reserve Chairman Alan Greenspan to reverse course towards fiscal conservatism. Carville is famous for saying “Why did they work so hard and then wake up to realize the bond market ran things?” It seems the Obama administration thinks President Clinton made a mistake, so President Obama is going a different course. If the economy is broken and getting worse, are they deciding to swing for the fences in a whole new long-term ball game? Please don’t trash day traders; give them a chance to continue making a living. Be a gambler in other places and let traders, who are not gamblers, make a living. President Clinton generated a surplus and a good economy and many think he did a good job by being a good listener.
By the way, is President Obama going to visit New York City, the home of his evil empire Wall Street any time soon? President Obama has many important places to visit such as Denver, Phoenix, Canada and Europe of course, and I'm wondering if he thinks NYC – the biggest city in America – is of any interest on his itinerary too. New Yorkers will line the streets waving victory flags for Obama and the general media will continue their adoring ways. But is the President afraid to look Wall Streeters in the eye as he tars and feathers them? February 27, 2009
Did Chairman Frank say the financial-transaction tax is on hold pending Wall Street payback of TARP funds?
Someone sent me this article today, from Alphatrends’ blog (by Brian Shannon): http://alphatrends.blogspot.com/2009/02/traders-tax-update.html
According to this blog, a board member with the Boston Securities Traders Association met with Congressman Barney Frank last Thursday to discuss the financial-transaction tax proposal. Frank assured him it was off the table for this presidential cycle (the next 4 years or so). Frank said the only way it would be enacted is if Wall Street doesn't pay back its share of tarp funds.
The good news: This is one leading Democratic Congressional leader who will not support and pass the financial-transaction tax during the Obama administration, and he probably speaks for other leaders too (Sen. Charles Schumer, NY and Sen. Dick Durbin, IL). A GOP Congress or administration would probably never support this ill-conceived tax.
Frank’s hearsay statement “The only way it would be enacted is if Wall Street doesn't pay back its share of TARP funds” still troubles me. It’s the same rationale used in the financial-transaction tax proposals: That Wall Street should pay for the TARP bailout.
Blue-dog Democrats advocate “pay go” to raise targeted taxes and user fees to pay for targeted government spending. The Democrats blame the toxic asset mess on Wall Street (and traders), and they want Wall Street to pay for the clean up.
What’s new with this Frank hearsay statement? Only that Congress needs to hold off on the financial-transaction tax until it determines if Wall Street has paid back the TARP bailout funds. If not, then it may charge the financial-transaction tax to “pay go” the TARP bailout.
Chances are Wall Street will not fully pay back TARP loans, and TARP capital may fall in value or go to zero with nationalizations. Does this mean the financial-transaction tax is hovering over traders’ heads?
We need to get traders exempted from this carrot-and-stick approach. Traders haven’t received bailout loans or capital and again, traders are not responsible for the toxic asset mess. Rather, home owners, mortgage brokers, mortgage securities packagers, rating agencies, appraisers, sellers and investors are responsible.