Bitcoin is a hot commodity, but is it taxed like commodities, assets, or currencies?
By Robert A. Green, CPA and Mark Feldman, tax attorney
Please promote this blog on bitcoin communities. Here's a tiny url for the blog http://tinyurl.com/mtezclw
Our Forbes blog: The Tricky Business Of Taxing Bitcoin. It's shorter than our blog version below.
Buttressed by an Internet craze, the price of bitcoin has skyrocketed this past year from $17 to over $1,200. Pundits expect significant price volatility in 2014 as well.
While the Federal Reserve gave tacit approval, stating “virtual currencies like bitcoin have legitimate uses and should not be banned,” the IRS has not yet issued tax guidance. Despite the lack of guidance, income from bitcoin transactions must be reported.
What's the bitcoin tax treatment for traders?
There are two possibilities how bitcoin should be treated for tax purposes: either it is an (1) intangible asset, or (2) a foreign currency. The problem with saying that it's a currency is that it is not issued by a government, and traditionally currencies are legal tender issued by governments. In California Bankers Assn v. Shultz, the Supreme Court stated (in a non-tax context): “‘Currency’ is defined in the Secretary’s regulations as the "coin and currency of the United States or of any other country, which circulate in and are customarily used and accepted as money in the country in which issued.” The IRS has not said its opinion, but both Canadian and Swedish tax authorities are treating bitcoins as an asset. Also, the German Finance Ministry says bitcoin is not classified as e-money or a foreign currency, but is rather a financial instrument under German banking rules. It is our sense that unless Congress enacts legislation to treat bitcoins as a foreign currency, the IRS will treat bitcoins as an asset.
If you buy bitcoin for purposes of appreciation and then sell it, then if (1) bitcoin is an asset, you will have capital gain and loss, and (2) if bitcoin is a foreign currency, then under Section 988 you will have ordinary income and loss.
Is bitcoin a commodity?
There is no definition in the Internal Revenue Code of “commodity.” Black's Law Dictionary 342 (4th ed. 1968) defines commodity: a movable article of value that can be bought or sold. A bitcoin is not movable property, so arguably it’s not a commodity. But at the Senate hearing, academics and financial industry players warned that bitcoin could be regulated as a commodity if market volatility continues. Such financial regulation may or may not impact the tax treatment.
Most bitcoin investors and traders will prefer capital gains tax treatment
After the astronomical rise in bitcoin this past year, most investors and traders may prefer capital gains and loss tax treatment. Consider this example: An American investor bought bitcoin at $17 just over 12 months ago and he sold it recently for $1,200. Is he entitled to significantly lower long-term capital gains tax rates of up to 20% in the top bracket and up to 15% in the second top bracket? That’s 20% lower than the top ordinary rates of 39.6% and 35%.
In this example of incredible appreciation, investors and traders will prefer that the IRS views their bitcoin transactions as trading in a commodity or other capital asset held for price appreciation. As long as the investor did not acquire the bitcoin as part of his business or for personal reasons this tax treatment seems safe to deploy on 2013 tax returns — until the IRS says otherwise.
It’s important to also consider tax treatment for commodities sold in a business vs. trading in commodity futures contracts. A farmer sells his wheat and reports ordinary gain or loss treatment in his trade or business. Conversely, a commodity futures trader holds “capital assets” subject to capital gain or loss treatment. Regulated futures contracts benefit from lower 60/40 capital gains tax rates (60% is a long-term capital gain — even on a day trade — and 40% is ordinary tax rates).
Say a trader’s regulated futures contract expires and he takes delivery of bushels of wheat. If he sells those bushels of wheat in less than 12 months, he receives short-term capital gains treatment, not ordinary gain or loss treatment or lower 60/40 tax rates since the bushel does not qualify as a Section 1256 contract.
Can bitcoin traders use ordinary loss tax treatment in Section 475?
What goes up fast and irrationally may also go down fast and irrationally. New investors may wind up with big trading losses and they may wish for ordinary loss treatment instead of $3,000 capital loss limitations and large capital loss carryovers.
As the bitcoin trading market expands, some bitcoin traders may be able to achieve trader tax status – business treatment – on trading that asset class. It is not clear whether they can make a Section 475 MTM election for trading bitcoin to have business ordinary gain or loss treatment. Section 475 allows “Traders in Securities and or Commodities” to make the election. The term “commodities” above really refers to trading Section 1256 contracts or regulated futures contracts; Section 475 does not seem to include bitcoin. However, if bitcoin becomes regulated as a commodity, it may qualify for Section 475 treatment.
A potential case for using Section 988 ordinary gain or loss treatment
If you don’t qualify for trader tax status in bitcoin, perhaps you can convince the IRS to respect the Fed’s label of “virtual currency,” and argue your bitcoin trades qualify for application of Section 988 (foreign currency transaction) ordinary gain or loss treatment.
Section 988 is the default tax treatment for spot forex trades, which is a huge trading marketplace. Spot forex traders write off trading losses in full as ordinary losses on line 21 of Form 1040 (Other Income). If they have trader tax status, they use Form 4797 Part II business ordinary loss treatment, which feeds into Net Operating Loss (NOL) calculations.
Section 988 allows forex traders and investors, but not manufacturers and other operating businesses, to file a contemporaneous internal opt-out or capital gains election. Many forex traders file a capital gains election and navigate their way into lower Section 1256g lower 60/40 tax rates, too. Section 988 does not allow a capital gains election on holding physical currency and that would apply to holding bitcoin, too if Section 988 were to apply. Section 988 rules for forex traders are complex and beyond the scope of this article. (Learn more at http://www.greencompany.com/quick-links/forex.shtml.)
Bitcoin as a digital currency
In general, American vendors accepting bitcoin as a digital currency in their trade or business should report bitcoin transactions as they would with a foreign currency. Simply translate the foreign or digital currency back into U.S. dollars on the date of receipt. There are no grounds to defer recognition of these transactions simply because it’s in bitcoin.
Holding bitcoin in your business
What happens if a trade or business decides to hold bitcoin for appreciation after acquiring it in a regular business transaction? Is it ordinary gain or loss from holding a commodity in your trade or business, or a capital gain or loss from holding onto a commodity or capital asset for appreciation? Both can be the case and it depends on intention, facts and circumstances.
In the earlier example, the farmer stockpiles wheat in a grain elevator, perhaps waiting for higher prices. The farmer may also hedge wheat prices in the futures market. Under the “hedging rule,” the wheat farmer still has ordinary gain or loss on storing and hedging wheat.
Also, consider the example of a manufacturer who holds foreign currency reserves for later use in foreign markets or for appreciation. The manufacturer also may hedge his foreign currency in the futures market. Like the farmer, the manufacturer has ordinary gain or loss on all these transactions.
An Internet vendor is not a commodity farmer of bitcoin and it’s conceivable that he could segregate bitcoin as a commodity or capital asset held for investment.
Bitcoin is a hot asset for traders and investors and you should learn the tax rules before you plow your money in. If you acquired bitcoin in your business, make sure you reported your sale transactions correctly. November 15, 2013
Another non-business trader gets busted in tax court trying to cheat the IRS
By Robert A. Green, CPA
Our Forbes blog: Red Flags Make It Easy For IRS To Bust Traders.
Chalk up another win for the IRS on denying trader tax status. But it’s not a result of IRS excellence. Rather, it’s another case of a dumb taxpayer filing a huge red-flag tax return with crazy unsupportable positions. (Let’s face it, there’s no need to be polite.)
See the latest Tax Court case decision denying trader tax status: Nelson, TC Memo 2013-259. Here is an RIA summary with my highlights in yellow.
First off, the taxpayer seems to have been a tax cheat and that never bodes well in an exam. What trader in his or her right mind files a Schedule C for trader tax status deducting $800,000 of trading business expenses over two years? Nelson did, and when pressed, she conceded most of these expenses early on (see footnote 8 in the case). Most of those Schedule C expenses were probably unsubstantiated even as investment expenses on Schedule A. The IRS did not allow a Schedule C, since Nelson did not qualify for trader tax status.
Our firm has always pointed out that a sole proprietor trading business Schedule C is a red flag as it only shows expenses. We prefer a pass-through entity tax return for reporting a trading business. Traders generally have business expenses of $5,000 to $25,000. If the trader has trading gains, we use our income-transfer strategy to zero out Schedule C (read Green’s 2013 Trader Tax Guide).
In another recent IRS tax court win denying trader tax status, Endicott reported $300,000 of margin interest on his trading business Schedule C and that triggered his tax exam. The IRS was correct; it should have been reported as investment interest expense on Schedule A.
As with Endicott, we agree with the Tax Court and IRS that Nelson did not qualify for trader tax status in 2005 and 2006. First, it sounds like Nelson’s live-in boyfriend, perhaps a trader himself, made many of the trades on her trading account. Nelson seemed focused on her active and successful mortgage business. We’ve always pointed out that trades made by an outside manager do not qualify for trader tax status. This can be a problem even with married couples, when one spouse trades the other spouse’s individual account. This is why we recommend a general partnership or LLC filing a partnership tax return for married couples — or significant others — so the trader/partner can bring trader tax status to the entity level for the benefit of all partners, even passive owners.
The tax court is right to point out that even if Nelson was credited with making all the trades – which clearly she did not – the activity did not rise to the level of trader tax status. The account failed our golden rules for trader tax status. Our rules call for 1,000 total trades and the Nelson account had half that in one year and one-quarter of that in the other year. Even considering a partial year, it was too few trades. Our golden rules call for executions on 75% of available trading days, and the Nelson account had executions of less than 50% one year and less than 30% the other year. The IRS was not clear about the average holding periods; they may have been under 31 days, which could be okay. But there were far too many sporadic lapses in trading, which is against the tax law requiring “regular, frequent and continuous” trading.
“I appreciate the break down of trading within this case,” says Green NFH co-managing member Darren Neuschwander, CPA. “This will be good to show clients how the IRS is clearly reviewing trader tax status.”
Notice Nelson couldn’t get relief from significant accuracy-related penalties. According to the RIA summary, “Nelson's claim that she spoke with a friend who is an accountant was insufficient to show what advice the accountant provided and whether her reliance on same was reasonable.” If you are a close call on trader tax status, we suggest you consider our Trader Tax Status Opinion Service.
Get educated on trader tax status before you claim it. Conservatively assess it at year-end before deploying it on your annual tax returns. Consider an entity going forward. If you’re examined by the IRS, consult with a trader tax status expert and consider their representation. Don’t bring a losing case to tax court and argue it on your own. November 6, 2013
Investors in hedge funds depend on “assurance” from quality independent CPA firms
By Robert A. Green, CPA of Green NFH in cooperation with Kristine Pistininzi, CPA of Warren Averett, LLC
Get to know Warren Averett CPAs and partners in our Webinar with them to discuss this blog and more. Watch the recording. Click here.
An annual audit of a hedge fund is not just a “rubber stamp” from a licensed certified public accounting (CPA) firm. CPAs refer to an audit practice as an assurance service. Assurance is what hedge fund investors are looking for but an audit certainly doesn't assure everything.
Investors fear fraud
Investors have a reason to fear fraud: There’s been plenty of it in the investment management industry including insider trading at SAC Capital Advisors, Ponzi schemes like that of Bernie Madoff, fake financial statements and deception in Bayou Hedge Fund Group, and smaller schemes, as well. In 2002, the AICPA’s Auditing Standards Board raised the bar on the auditor’s responsibility with SAS No. 99: Consideration of Fraud in a Financial Statement Audit.
It's important to understand what an audit is, its limitations and what the audit report speaks to. The audit certainly does not guarantee to catch all or any fraud and the auditor is not the one making representations and disclosures — management is. The auditor’s job is to express an opinion on the financial statements based on the audit.
During the past decade, hedge funds grew exponentially in number, and the media expects them to grow dramatically more over the next five years. Service providers have made it fairly easy and low in cost to start a hedge fund. Investors hunt for returns well above historically low interest rates fueling the trend. Has it also gotten easier to fool investors? In the recent PFGBest fraud, it was easy for the owner to pull another Madoff in doctoring up monthly bank statements and paper audit confirmations with fool’s gold. (Audit confirmations are now often processed electronically, fixing that glaring problem in the PFGBest audit.)
Advertising requires audited performance records
President Obama’s Jumpstart Our Business Startups Act (JOBS) lifts the advertising restrictions on certain private companies, including private hedge funds and private equity funds. The SEC adopted changes to Rule 506 of Regulation D in July 2013. The new rule, 506(c) became effective Sept. 23, 2013 and permits general advertising or general solicitation by issuers of private funds, such as hedge funds, with certain restrictions. You can imagine the floodgates opening over the Internet for investment managers advertising their audited performance records. For the first time, private hedge funds are able to advertise like mutual funds, opening up the marketplace to new investors. With advertising of performance records, audit reports from quality CPA firms become even more important than ever before. While investors may not be knowledgeable about the investment manager, they may know and trust the audit firm, as well as the fund’s other service providers.
• For more information from us about the JOBS Act’s implications for hedge funds, watch our GreenTraderTax Webinar dated Aug. 27, 2013, Investment management: Key updates on regulation, tax, compliance and business. Host Robert A. Green, CPA & CEO of GreenTraderTax and guest Brent Gillett of InvestmentLawGroup.com. Description: Panelists discuss current hedge fund news and developments for investment management, including the JOBS Act, federal and state regulatory changes for securities, NFA changes for futures and forex and more. Click here to download or stream (105 MB, time 1:20) the recording in our Amazon Cloud. See the agenda in the first few power point slides presented. It’s also helpful to Google “JOBS Act implications for hedge funds.”
Smaller funds should choose audit firms that best suit their needs
When it comes to choosing an audit firm, bigger doesn’t necessarily mean better. Small- and medium-sized hedge funds can be better served by small- or medium-sized audit firms that provide more individualized service and charge lower fees. Many of the well-publicized undetected frauds of the last decade were perpetrated by large hedge funds audited by big-four audit firms. Conversely, it was ridiculous that big funds and broker dealers operated by Bernie Madoff and Russell Wassendorf of PFG and Peregrine could use a one-partner shop audit provider for a very long time. That didn’t make sense.
• Assurance (Audit & Attest): GreenTraderTax.com and Green NFH, LLC have partnered with Warren Averett, LLC (WA) – a highly regarded mid-sized CPA firm with a financial services audit practice – to offer WA's assurance services to investment managers, traders and broker dealers. These services include startup and annual audits, reviews, compilations, performance records, and performance of agreed-upon procedures (which are sometimes required by prime brokers, other financial counterparties or regulators). Clients and GreenTraderTax.com site users can now directly engage WA for those services. GNFH partners will help out as needed. WA is registered with the Public Company Accounting Oversight Board (PCAOB) permitting them to audit SEC-registered investment advisers and their related hedge funds. WA also audits offshore funds in Cayman Islands, BVI, Bermuda and other jurisdictions.
Incubator funds need an audit, too
Since 2000, GreenTraderTax, GreenTraderLaw (now discontinued) and GreenTraderFunds played an integral part in the launch of hundreds of new small hedge funds. Many of them started out as incubator funds, a concept and term we created in the industry. Don’t confuse our incubator fund strategy –forming an investment vehicle that holds only proprietary (the owner’s) capital and does not offer interests to investors – with others who refer to incubator funds housed inside a successful hedge fund group or offices and infrastructure. The purpose of our incubator fund strategy is to generate an historical performance record for the Investment Manager. We use the term “incubator fund” to refer to a start-up hedge fund. An incubator fund is generally structured as a limited partnership (LP) or limited liability company (LLC). Since interests in the fund are not offered to outside investors, the Investment Manager does not charge management or performance fees. Accordingly, the LP agreement or LLC operating agreement excludes compensation and related clauses generally found in the operating agreements of hedge funds. For about one-half the initial legal fees to establish a hedge fund, with an outside law firm like Investment Law Group, an incubator fund can put its trading program into operation to generate an auditable performance record, using the managers’ own funds and in some cases funds from close family and friends too. (Consult with outside legal counsel about that first.)
An audit of an incubator fund without compensation to the manager and without outside investors generally requires less audit testing, which means it also costs less than an audit of a fund that charges fees and has outside investors.
Choose your auditor early on
Sometimes an investment manager needs to list the fund’s auditor in a private placement memorandum or in registration forms; therefore you may want to choose your auditor early on.
Your auditor will perform substantial “client acceptance procedures” in accordance with Generally Accepted Auditing Standards (GAAS). These include background checks, assessments of client integrity and character, contacting key service providers like attorneys and prime brokers, reviewing interim and prior year financial statements and reviewing financial reporting and accounting systems.
Consider including the stub-period in the first audit period
Many funds commence operations on a date other than the first day of the fiscal year. For example, if the year-end date is December 31, for a fund that started on October 1, 2012, it may be too costly to have an audit for the three-month period (the stub period) ending December 31, 2012. The investment manager may consider a 15-month audit for the period ending December 31, 2013. Factors to consider when making this decision include the provisions of the partnership agreement (or other fund governing documents if applicable) related to annual audits, SEC requirements if the fund advisor is registered with the SEC and state requirements if the advisor is registered with a state. (Consult with Warren Averett about the appropriate length of a stub period. While three months is generally appropriate, six months may be too long.)
Another option is to start your audit period later
In the previous example, instead of including the 2012 stub period, the auditor can discuss the option of starting the audit period on January 1, 2013. In this case, the auditor will audit the balance sheet as of December 31, 2012 and use this as the starting point. If you formed a hedge fund in late 2011, this approach may make more sense.
Tax compliance services can’t be deferred
Many startup hedge funds may defer audits until managers feel they can raise meaningful money from investors, providing their LLC or LP agreement allows for that. While audits may be deferred, tax compliance may not be — the tax man is not patient. (Green NFH, LLC offers federal and state tax compliance services and is executing engagement letters now for tax compliance services for 2013. For offshore hedge fund tax compliance services, we recommend Warren Averett.)
Performance record examinations are different from audits of financial statements
Hedge fund private placement memorandums (PPM) and LLC Operating Agreements often call for annual audited financial statements. But, managers also often want to distribute and advertise performance records which have been examined by a CPA firm. These are different from annual audited financial statements.
While CPAs adhere to GAAS in the U.S. for audits of financial statements, examinations of performance records are based on different attestation standards. Warren Averett performs both types of services.
When are audited financial statements required by regulators vs. self-imposed?
SEC-registered (larger) investment advisers operating private investment funds and NFA-registered Commodity Pool Operations (CPOs) are required to have annual audits.
State-registered or exempt-from-registration advisers operating smaller hedge funds may not be required to have an annual audit, but most choose to do so to satisfy investor needs. Note that if the advisor discloses the fund will have an annual audit in the private placement memorandum and/or other investor documents, then it’s a self-imposed requirement.
PCAOB-registered audit firms
An SEC-registered investment adviser’s hedge funds need to be audited by Public Company Accounting Oversight Board (PCAOB)-registered auditors. Dodd-Frank financial regulation raised the threshold of funds under management for SEC investment adviser registration. Most smaller hedge funds fall under this threshold – they have less than $1 million to less than $100 million under management, and in many states, they may use audit firms that are not registered with PCAOB. Warren Averett is a PCAOB-registered auditor.
Audits are formal, technical and industry-specific
Investors are looking for assurance from a respected and independent CPA firm with significant experience, qualifications and a good brand name in performing audit engagements of alternative investment funds and managers. Audit work is dictated by GAAS and industry guides like the AICPA Audit Guide of Investment Companies.
Financial statements for hedge funds have different disclosure requirements from those prepared for service companies or manufacturers. Experience in the investment management industry is needed in order to prepare or review the financial statements. Warren Averett personnel have the experience and training to perform audits of alternative investment funds.
The makings of a successful audit
An audit should be conducted in an efficient and effective manner keeping an eye on cost, but not to the point that it undermines quality. Hedge fund audits are often due within 120 days of year-end and auditors are on a strict time schedule. Investors want IRS Schedule K-1s well before April 15th so they can prepare their individual tax returns. Hedge fund income passes through to them whether they get distributions or not. Tax service providers don’t want to complete their work until the audit is completed. (WA performs audit services and Green NFH, LLC performs tax compliance services seamlessly.)
To best meet this timetable, auditors should perform interim procedures during the year. Tax planning is good to do before year-end and during the development process. (Get started with WA and Green NFH in November or December if you haven’t yet. January may be too late.) Just email us at email@example.com to get started with any of these services. We will follow up immediately as time is of the essence.
Use a qualified accounting firm for monthly accounting
Many small hedge funds use an outside independent accountant for monthly net asset value (NAV) reports to investors, and some owners try to cut corners and do the accounting work themselves. While managers may feel that keeps their costs lower, this can render their financial statements and accounting un-auditable, or it can significantly increase audit testing, which can raise overall costs and problems in the audit. Don’t save a quarter to cost a dollar. Increasingly, investors want independent accounting — not accounting done by the investment manager. Internal controls are key, but if the manager does everything including the accounting, that’s not proper internal controls.
The auditor can’t perform accounting work
An auditor must be independent. Auditor independence rules bar auditors from taking responsibility for the preparation of accounting entries or financial statements. During the course of the audit, an auditor may propose adjusting entries or prepare the financial statements; the client must acknowledge his or her responsibility for the entries and the financial statements in the management representation letter. A client’s books and records must be substantially complete and current prior to the commencement of the audit. If an auditor performed and took responsibility for the client’s accounting, how could he or she possibly audit his or her own work and also remain independent? That’s the reason for these rules.
Speak with your audit firm early to make sure your financial reporting and accounting systems are auditable in an efficient and effective manner. That involves implementing proper internal controls and systems. Plan to use a respected outside accounting firm that specializes in hedge fund accounting and a separate CPA firm to conduct the fund’s annual audit. The fund will also need a tax-compliance service provider (like Green NFH, LLC).
An auditor can’t set up internal controls for a client; the client needs to do this himself with the help of accounting and other service providers.
Investor-level accounting is complex
Hedge fund accounting can be complex and requires more than preparing general ledger accounting entries. Partnership accounting requires that partnership gains and losses are allocated to the partners in each accounting period, usually based on each partner’s beginning of period capital balance as a percentage of total partners’ capital.
Get used to planning for success
Here are some planning items:
1. Advance planning:
a. Meet with auditor to discuss:
i. New developments in the funds being audited (and any related entities)
ii. Changes in management or structure of organization
iii. New relationships (prime broker, attorney, administrator, etc.)
iv. Performance and change in net assets during the year
v. Significant or unusual transactions during the year
vi. Securities that may be difficult to price
vii. New Generally Accepted Accounting Principles (GAAP) requirements
viii. Investment advisor registration status and regulatory examinations during the year
ix. Filing deadlines and other client deadlines, such as K-1s and tax return
x. Services to be performed by CPA firm (auditor)
xi. Fees for audit
xiii. Timeline for completion of work and having the information available and organized for the audit
xiv. Administrator responsibilities with regard to audit, if applicable
b. Auditor should also conduct planning meeting with fund administrator, if applicable, to discuss timing (i.e. schedule the audit, availability of report on internal controls, etc., and have all client-created work papers completed before the audit begins)
2. Auditor should perform the following as early as possible (ideally before year-end):
a. Risk assessment
i. Obtain or update understanding of the entity and its environment, including internal controls
ii. Obtain or update understanding of significant transaction cycles, including processes and controls
iib Perform walk-throughs iii. Fraud risk assessment
iv. Preliminary analytics and interim testing
b. Review fund documents (e.g., Limited Partnership Agreement, Offering Memorandum)
3. Interim procedures that can be done in advance:
a. Testing economic allocations
b. Review interim financial statements and portfolio
c. Journal entry testing
d. Broker statement testing
4. Prepare pro forma draft of financials, including footnotes
5. Timely response to auditor’s request for information for the audit
6. Audit confirmations prepared and ready to send out before year-end in electronic format.
1. Lack of a competent internal accountant and/or administrator.
2. Poor internal controls.
3. Not understanding the role of the auditor vs. the administrator vs. the client.
4. Insufficient advance planning.
5. Interim work not performed in advance.
6. Audit surprises cause delays. Examples are:
a. Client not informing the auditor in advance of significant issues that may affect the nature and timing of audit procedures (e.g., pending litigation).
b. Difficult to price securities or securities not custodied with broker that auditor was not informed of.
c. Fee waivers, side letters and related party transactions not previously discussed.
7. Delays in receiving items on the PBC (prepared by client) list. This entire list should be provided before audit field work begins.
8. Draft financial statements not prepared until end of audit.
If you launched and operate a small- or medium-size hedge fund in 2013 for trading of marketable securities, futures or forex, consider Warren Averett for assurance services and our CPA firm Green NFH, LLC for tax compliance services. Warren Averett can handle both assurance and tax compliance services for offshore funds, too.
GreenTraderFunds.com and GreenTraderTax.com have been respected brand names in the active trading and hedge fund entrepreneur marketplace since 1997. Robert A. Green, CPA has worked with hedge fund clients on tax compliance since founding Green & Company CPAs in 1983.
Give your investors the confidence and assurance they seek by choosing Warren Averett for your audit report and Green NFH for your signed income tax returns.
Before we take on new clients, we make sure to get to know them. Many of our clients have used our tax compliance services before they launch their hedge fund using an outside attorney.
Trust, hard work, dedication, experience, ideas, passion for success and knowledge are the hallmarks of our company and CPA and tax attorney professionals.
Get to know Warren Averett CPAs and partners in our upcoming Webinar with them to discuss this blog and more. Monday, Nov. 18, 2013, 4:15 - 5:30 pm ET. Click here to register. October 31, 2013
Year-end tax planning for 2013
By Robert A. Green, CPA
While traders should consider general year-end planning strategies like deferring income and accelerating expenses, they should also be aware of special year-end strategies.
Join CPA Robert A. Green, Managing Member of Green NFH, LLC for a special Webinar on Tuesday Nov. 12 at 4:15 to 5:30 pm ET.
For each of the past few years, Congress passed “tax extenders” and the AMT patch for another year. While Congress patched AMT in January 2013 with the fiscal cliff deal, they haven’t dealt with “tax extenders” yet. The debt ceiling and CR fiscal mess was punted to year-end, so perhaps there’s a window of opportunity to pin more tax extenders on that donkey. Make sure to get your tax extender break while it’s still hot. Here’s the list of tax extenders expiring in 2013.
Currently, 2014 tax rates match 2013 rates. Generally, that means it’s a good idea to defer income and accelerate business expenses and itemized deductions. There are some situations where it’s better to accelerate income and defer expenses, such as if you happen to be in a very low tax bracket in 2013 due to trading losses and loss of other types of income. Why not take advantage of tax rates up to 28%?
One good way to generate income is with a Roth IRA conversion. You can break up an IRA into pieces in order to convert the amount you like. You can always re-characterize the conversion in 2014 if it doesn’t work well — for example, if you lose the money in the Roth account and prefer a do over.
Smart investors, business traders and investment managers spend December identifying and avoiding potential wash sale losses on “substantially identical positions” (i.e., between Apple stock and Apple options at different strike prices). Don’t wait until you receive broker-issued Form 1099-Bs in February to find out you have a huge tax problem with wash sale loss deferrals which might increase your 2013 tax bill significantly.
Run TradeLog software before year-end to calculate and avoid wash sales, handle cost-basis reporting correctly and generate Form 8949 for tax filings. Keep running it through the end of January for wash sale loss calculations. The latest version of TradeLog has a Potential Wash report, which you should use for year-end planning to avoid wash-sale loss surprises.
Don’t forget to run TradeLog on your individual IRA accounts, too as that is the IRS rule. Avoid permanent wash sale losses between individual taxable accounts and IRAs. Don’t trade substantially identical positions between taxable and IRA accounts. Once you spot a potential wash sale, sell all open positions before year-end and don’t buy it back for 31 days. Or, start trading in a separate entity on Jan. 1 to disconnect your trades under a different taxpayer ID number. A SMLLC disregarded entity doesn’t work here; you need a partnership or S-Corp return.
“Tax loss selling” is a popular phrase in the financial media at year-end. If you have capital gains for the year, why not sell a few more open positions, ones showing unrealized losses in order to reduce your capital gains and related tax bill? But don’t rush to buy back the positions with a January rally as that can cause a wash sale loss deferral at year-end 2013, thereby defeating the purpose of tax loss selling.
Investors, business traders and hedge fund managers seek holding open securities positions with unrealized gains at year-end in order to defer taxes and perhaps achieve lower long-term capital gains rates up to 20%. Hedge fund managers using carried-interest tax breaks to get their allocation of long-term capital gains, too.
Business traders should learn about Section 475 MTM business ordinary gain or loss treatment. If they don’t have Section 475 in 2013, they can elect it for 2014 by April 15, 2014. That 2014 election converts unrealized business trading gains and losses at the end of 2013 into ordinary gains or losses on Jan. 1, 2014 – that’s the required Section 481(a) adjustment. A negative Section 481(a) adjustment on Jan. 1 is far better than a capital loss carried over from 2013 to 2014. In some cases, wash sales are good because they are part of a Section 481(a) adjustment, rather than being a capital loss carryover. Traders generally have a hard time using up large capital loss carryovers.
Hedge fund managers often skip making Section 475 MTM elections because they have a hard time following the rules for “contemporaneous” segregation of investments vs. business trading positions. They also don’t want investors paying taxes on open positions, as investors often request redemptions to pay the tax bill while managers have cash funds tied up in those open positions.
Active retail traders and hedge fund managers should assess qualification for trader tax status before year-end. Sole proprietors and hedge funds can claim TTS after they assess the facts and circumstances of meeting our golden rules. Section 475 MTM is not allowed after the fact; it had to be elected with the IRS by April 15, 2013 for 2013, or within 75 days of a “new taxpayer” new entity filed in the entity books and records (an internal election).
Forex Section 988 opt-out “capital gains” internal elections on major forex going into Section 1256g lower 60/40 tax rates had to be filed “contemporaneously” during the year on a “good to cancel basis.” Otherwise, Section 988 is ordinary gain or loss treatment.
Cash-basis business traders should accelerate business expenses in 2013, and using credit cards on the last days of the year counts. They may not qualify for TTS in 2014, triggering far less beneficial investment expense treatment. Get business deductions while you still can, including our firm’s advance payments for tax compliance services made with credit cards. Investment expenses exclude home office, education and startup costs. (Business expenses allow them.)
A trading entity provides more tax breaks for business traders. Set up a trading entity in early November 2013 to enjoy many trader tax breaks through year-end. Break the chain on wash sales in your individual and IRA accounts, by continuing trading in an entity which has a different taxpayer ID number – thereby disconnecting the trading for wash sales with your individual accounts. In the entity, capitalize a reasonable amount of Section 195 startup costs going six months back before the entity commencement date. Generate trading gains in the entity and pay yourself an administration fee to unlock 100% AGI deductions for health insurance premiums and retirement plans. Don’t wait until December, it’s too narrow a window of opportunity in the eyes of the IRS. If you miss the boat on forming the entity now, try to start your entity on Jan. 1, 2014 for a clean year of trading in 2014, without the added complication of trading individually as well.
Business traders should open an Individual 401(k) plan before year-end — otherwise, you will miss the boat on the best retirement plan choice for most traders. The 401(k) elective deferral of $17,500 is 100% deductible, plus it’s paired with a 20% profit-sharing plan allowing a total contribution up to $51,000. There’s also a catch-up contribution for taxpayers aged 50 and over of $5,500. Make sure to pay administration fees or salaries before year-end – or reclassify other payments to administration fees – to execute these AGI deduction strategies. High income traders still have time to consider a defined benefit plan where you can contribute much higher amounts per year. Consider different options for your retirement plan contributions, and whether you have sufficient cash flow to maximize this tax deduction. Can you afford a Roth contribution too? See retirement plan limits for 2013 on the IRS site here.
Focus on accounting before year-end to get a proper handle on tax planning. New entities need an accounting solution like excel worksheets, or QuickBooks - if set up properly - to set up a proper balance sheet and profit & loss statement, and to track capital, fixed assets, intangible assets like software, startup costs, organization costs and more. Additions and withdrawals to capital (basis) need to be tracked as well. This will make tax compliance (preparation) much easier, more effective and less costly. In many cases, we've seen clients use QuickBooks, but botch the accounting.
Execute expense reimbursements before year-end – a requirement in S-Corps and suggested in partnerships.
Learn how to handle the health insurance premium AGI deduction, which is tricky with S-Corps. AGI deductions determine the amount of administration fees or officer’s salaries needed to unlock those deductions. S-Corps should consider using salaries in December and engaging a payroll processing firm – we recommend paychex.com.
Try to manage your income thresholds for the Obama-era tax hikes on modified AGI of $250k married/$200k single, household income for ACA health insurance mandate tax credit subsidies, navigating between the marginal tax brackets, other types of tax credits and more.
Consider the GreenTraderTax strategies to avoid Obama-era tax hikes on the upper income. Use a C-Corp to house intellectual property, charging your trading entity royalties for usage. Or, the C-Corp can charge the trading entity for administration fees. This takes advantage of lower C-Corp tax rates on the first $50,000 of net income. A medical reimbursement plan (MRP) is a good way to pay for high deductible ACA-compliant health insurance plans. You can use a middleman S-Corp for receiving the administration fee first. S-Corps help reduce both self-employment (SE) taxes and ObamaCare Medicare taxes on unearned income. Read about these strategies in Green’s 2013 Trader Tax Guide, which is on promotion now.
Don’t forget to get caught up with your 2013 estimated income taxes. Many traders underpay during the year, considering the underestimated tax penalty like a low-cost margin loan. The Q4 estimate is due Jan. 15, 2014, so you can see where you stand at year-end first. Consider paying the state(s) before year end for another 2013 tax deduction, unless you trigger AMT and don’t get that benefit.
Be careful not to risk your tax money up until April 15. We see that with a few clients every year. They make a fortune in 2013, had few gains in 2012 and therefore don’t owe most 2013 taxes until April 15, 2014. Meanwhile, they lose the 2013 tax money in Q1 2014 and then face late-payment penalties.
If you want a tax reduction, then you must attend to year-end planning. There is only so much you can do after the year closes.
Other resources: Here's an excellent "Year-end tax planning client letter" from our tax research service RIA. Click here.