Protect yourself from market losses with a Section 475 MTM election
By Robert A. Green CPA
As the dot-com bust and tech wreck unfolded in 2000, we preached the importance of Section 475 MTM elections to business traders for "tax-loss" insurance. We knew when the markets inevitably turned bearish, many traders would incur huge trading losses. This election means losses are considered business ordinary losses; without it, the losses are capital losses limited to $3,000 against ordinary income per year.
Business ordinary losses can be monetized into tax refunds quickly, whereas capital loss carryforwards often take a long time to monetize — sometimes a decade or more. Traders want immediate tax refunds to replenish their trading capital. Otherwise, they may have little capital left to generate capital gains.
Based on 30 years of experience working closely with traders, we know there are huge swings in bull and bear markets. We've seen clients make a lot of money in a few years and lose a lot in a subsequent year. Traders need to be able to carry back losses and that can't be done on securities unless Section 475 is used. Futures traders can carry back Section 1256 contract losses three years but only against Section 1256 contract gains.
A worst-case scenario in the 2000 tech wreck: Several securities traders made $500,000 in 1999 and lost it all in Q1 2000. They lost their 1999 taxes due in Q1 2000 and they missed the Section 475 MTM election by April 15, 2000. They couldn't pay the IRS for 1999 gains and they got stuck with a capital loss carryover for 2000, which they couldn't monetize since they had no capital left to trade. With a simple 2000 Section 475 election, they could have filed a net operating loss (NOL) carryback wiping out their 1999 tax debt. They would have been square with the IRS.
Why talk about 1999/2000? Because it feels like similar market conditions are developing now. 2013 was a big income year for traders and Q1 2014 started off rocky. Consider the rush of tech/mobile/gaming IPOs; CNBC's Jim Cramer says its Deja vu with the dot-com and tech wreck of 1999/2000. There could be a big correction or bear market later this year.
This past week I consulted with a client on a potential worst-case scenario for 2013/2014. He broke even for 2013 but said TradeLog shows over $1 million of wash sales deferred to 2014. That presents a huge 2013 tax liability on phantom income and he already lost all that tax money and more in Q1 2014.
Luckily, he came to us in time — he will file a Section 475 election by April 15, 2014. The required Section 481a adjustment turns deferred wash sales on year-end 2013 business positions into business ordinary losses on Jan. 1, 2014. The important challenge for him is to maintain his trader tax status in 2014 so he can use Section 475. We suggested filing a 2013 Form 9465 Installment Agreement Request including a note that taxpayer expects to file an NOL carryback wiping out his 2013 tax debt.
Section 475 is free to elect, which is why we call it free tax-loss insurance. While it costs money to switch back to the cash method, traders rarely do that — they just exit their trading activity, thereby suspending Section 475. We recommend section 475 on securities only; you want to retain the lower 60/40 tax rates on 1256 contracts.
Be careful to segregate your investments so 475 won't apply on those investments and you can hold them for lower long-term capital gains rates. Section 475 marks to market open business positions at year-end, but not investment positions.
Only business traders qualifying for trader tax status may use Section 475. The main requirement is 1,000 trade volume per year (annualized) and frequency over 75% of available trading days with trade executions.
Existing taxpayer individuals and partnerships file Section 475 elections by April 15, 2014. Attach the election statement to your 2013 tax return or extension. The second step is to perfect the election with a 2014 Form 3115 (change of accounting method) filed with your 2014 tax return. New taxpayers/new entities may adopt 475 within 75 days of inception by filing an internal resolution.
There are many nuances and misconceptions about section 475; read about them in Green's 2014 Trader Tax Guide.
It’s important to run Tradelog software to determine your trading gains and losses for 2013 and 2014 year to date. Turn on the Section 475 MTM election within Tradelog software for 2014, and the program will calculate the Section 481a adjustment for January 1, 2014.
If you have a large trading loss for Q1 2014, and also a large capital loss carryover, it’s probably wise to make the Section 475 MTM election to lock in the 2014 loss as ordinary. Resume trading in a new entity with capital gains treatment so you can use up the capital loss carryovers.
Not sure what to do? Consider a 30-minute consultation with Robert A. Green, CPA.
If the music stops in the markets, don't be caught without a chair to sit on — Section 475 may be just the chair for you. March 25, 2014
IRS guidance on bitcoin transactions will chill its use
By Robert A. Green, CPA
The IRS just issued guidance on bitcoin in time for the April 15th tax-filing deadline. Our Dec. 3, 2013 blog "Bitcoin is a hot commodity, but is it taxed like commodities, assets, or currencies?" was correct: bitcoin is considered property, not a currency.
That's good news for taxpayers with huge gains on using, investing or trading bitcoin, since it receives capital gains treatment and if they held it over one year, the lower long-term capital gains tax rate applies.
Conversely, it's bad news for those with large losses, with the recent price of bitcoin dropping significantly. According to the IRS guidance, bitcoin does not receive Section 988 ordinary loss treatment, which is unlimited; instead, its capital-loss treatment is limited to $3,000 per year.
The IRS guidance stresses a point — widely overlooked by many taxpayers — that using bitcoin to purchase an item or service triggers capital gain or loss recognition reflecting appreciation or depreciation of bitcoin. Compare the market price on the date bitcoin is used to make a purchase vs. the market price on the date you acquired that bitcoin, and the difference is a capital gain or loss on property. Few people or companies have filed Form 1099s on these transactions, as may be required, and taxpayers will have to scurry around to figure their cost basis and sales proceeds on each purchase where they used bitcoin as a digital currency. See the example of buying a cup of coffee with bitcoin in the Bloomberg article Bitcoin Is Property Not Currency in Tax System, IRS Says. The WSJ articles IRS Says Bitcoin Is Property, Not Currency and Q&A: The New IRS Rules on Bitcoin are good too.
Having to report a capital gain or loss on each purchase using bitcoin will have a chilling effect on bitcoin reaching its goal to be a widely used digital currency. Who wants to spend 30 minutes or more figuring out their capital gain or loss for a simple $3 cup of coffee? And who wants to risk getting audited by the IRS over bitcoin tax reporting to boot?
See the IRS Notice 201421 which includes many good FAQs that may strike a cord with taxpayers. March 24, 2014
SEC Large Trader Reporting Rule
By Robert A. Green, CPA
Some high-frequency-trader (HFT) clients are receiving email notices from their brokerage firms advising them to file SEC Registration Form 13H to obtain a SEC Large Trader ID number (LTID). The broker needs that LTID in order to comply with the SEC Large Trader Reporting Rule, a rule that has been in place since 2011. (Broker-dealers were required to comply with the rules by April 30, 2012.)
In my view, regulators are keen on tackling — but not necessarily blocking — HFT. They need a better handle on HFT for their own reporting and accountability to Congress. Regulators are still concerned about the flash crash from May 2010, which, along with Congress, they blame on HFT. The first step in regulation is often registration light. It’s not public so your friends won’t see what you are up to. But, it will give the SEC a means to analyze what you are doing in the markets and it may react accordingly. Perhaps the SEC can request a broker to analyze all activity for a given LTID. Bottom line, this is more government oversight for HFT, but it’s not a burden of compliance or cost. (I don’t see any fee required with Form 13H.) It would be worse to have financial-transaction taxes – something we continue to fight against – and HFT trading restrictions. (New York’s Attorney General just blocked a data provider from giving an edge to HFT customers.)
Interactive Brokers includes a helpful summary of these SEC rules at http://ibkb.interactivebrokers.com/article/1842. The summary describes what the SEC is after:
"Large Trader" is defined as a person or entity who, directly or indirectly, through the exercise of "Investment Discretion," effects transactions in exchange-listed equities and options that equal or exceed 2 million shares or $20 million during any calendar day, or 20 million shares or $200 million over the course of any calendar month … Calculating Options Traded. The Rule requires the calculation of shares and dollars of options traded as follows: Shares traded = option contracts traded * option multiplier (typically 100)… (similar option multiplier for ETFs and index options)…
… Initial Filing: A person must "promptly" file an initial Form 13H after its transactions reach the identifying activity level. The SEC states that under normal circumstances, "promptly" means 10 days.
The filing threshold is high and the filing requirement seems simple enough to do on your own. Of course, it’s always wise to consult a securities attorney with any questions. We recommend Brent Gillett JD of www.investmentlawgroup.com.
Take a look at a manual SEC Form 13H with instructions, but note you must file it electronically with the SEC EDGAR system. It asks for basic information and not much else.
If you or your broker determines you should file SEC Form 13H, don’t miss the very short 10-day deadline. Not acting can cause you a bunch of trouble. I wonder if all brokers are set up properly to make this filing analysis. March 3, 2014
Entities & Retirement Plans for Traders
Join noted CPA trader tax experts Robert A. Green & Darren Neuschwander, managing members of Green NFH, LLC, a leading tax compliance firm for traders and investors, as they explain all the details traders need to know about entity formation and retirement plans. (Webinar registration link at the bottom)
This Webinar will cover these important points:
* If you qualify for trader tax status (business treatment), we recommend an entity. Investors only need an entity to avoid wash sales in their IRA accounts.
* Trading gains are not earned income, so traders need to form an entity to create compensation required for health insurance and retirement plan deductions. (One exception: members of futures exchanges have earned income.)
* Choose an entity structure favorable to your family situation and resident state. Register out-of-state entities in your home state. Offshore entities don’t provide tax relief.
* S-Corp tax returns maximize health insurance and retirement plan contribution deductions versus underlying compensation — income tax savings versus payroll tax cost.
* Partnership tax returns with 50/50 spousal ownership require a higher administration fee* paid to the trader spouse to achieve target health insurance and retirement plan deductions. (Read our Jan. 14 blog.) While 1/99 trader/non-trader ownership may be attractive tax wise, it’s generally unfeasible. *Potential solution for 50/50 HW partnership returns. Pay administration fees during the year and if you need more cash flow, the husband and wife can reinvest capital to finance ongoing fee payments. Consult with us about your administration fee agreements and payment schedules.
* General partnerships and LLCs should consider S-Corp elections by March 15, 2014.
* An individual 401(k) retirement plan is generally the best plan for small-business traders. It has an elective deferral of $17,500, which is 100% deductible and a 20% deductible profit sharing plan. Plus, it has a $5,500 100% deductible catch-up provision for those over age 50.
* High deductible defined-benefit plans are an excellent choice for business traders generating high income consistently. They can deduct up to $210,000 per year.
* S-Corps require formal payroll tax compliance, but there are low-cost and easy options like paychex.com.
* Partnership tax returns use administration fees reported on 1099-Misc. While tax compliance is easier and more flexible, achieving target self-employment income (SEI) often requires greater cash-flow payments for compensation and that may be a burden.
* S-Corps should have entity-level retirement plans and partnerships should have individual-level plans.
* Health insurance plans can be individual policies whether using an S-Corp or partnership tax return structure. In both cases, health insurance premiums are an AGI deduction on the individual return. Entity group policies are possible, too.
* Rather than elect S-Corp status, entities filing partnership tax returns may consider adding a C-Corp as an owner to handle the health insurance and retirement plan deductions, and also avoid higher individual tax rates.
Questions & answers. What entity and retirement plan is right for you?
Webinar Thursday March 6 at 4:15 - 5:15 pm ET. Click here to register.