The MF Global Tax Trap & How to Handle 2011 Tax Extensions
April 4, 2012
By Robert A. Green, CPA
Update: See our April 12th blog IRS issues tax guidance on MF Global missing customer funds where the IRS matches our below suggested tax treatment.
Forbes blog version: Caught Between MF Global And The Tax Man.
There is still significant money missing from MF Global customers’ futures accounts. The bankruptcy trustee sent MF Global customers 2011 Form 1099-Bs showing their realized and unrealized trading gains and losses from Section 1256 contracts. (Note: The cost-basis reporting crisis does not extend to futures. Taxpayers and tax preparers can rely on Form 1099-Bs for futures, whereas they cannot for securities 1099-Bs.)
MF Global’s bankruptcy trustee James W. Giddens added this note to the Form 1099-Bs: “Although you may not have recovered the entire value of your MFGI account in the SIPA Proceeding (bankruptcy process), your Form 1099 reflects all transactions credited to your MFGI account during 2011. You should consult your tax advisor to determine whether you may claim a deduction or loss for income tax purposes as a result of your not having recovered the full amount of your account.”
Giddens doesn’t say which year the loss may be taken. It’s the consensus of our CPAs and tax attorneys — and the consensus of others we have seen on the Internet — that a MF Global deposit loss recognition event most likely occurs after 2011.
Tax law for writing off deposit losses
The loss is not determined and the trustee still hopes to recover the entire amount (or much more) of missing customer monies. Certainly, they should, as these monies were taken inappropriately and as I pointed out in my Dec. 9 Forbes blog “How To Pay Back MF Global Customers 100%,” why can’t those last-minute transactions to pay counterparties with customer funds be reversed, and the monies recovered? I still believe that not doing this recovery is illegal and wrong. But, this has no affect on my discusson of tax posture.
The loss is not yet realized. Tax law for deposit impairment, casualty or theft loss or capital losses all require a known loss and a realization event of that loss. Again, the missing MF Global monies are being recovered slowly and some hold out hope for full or significant recovery. Although the bankruptcy and liquidation happened Oct. 31, 2011 and some courts ruled in early December 2011 on certain matters, the “missing money” file remains open and that is telling for tax purposes.
The tax code isn’t always logical or fair
It doesn’t matter if taxpayers took withdrawals of their trading gains during the year at MF Global or not — it has no effect on reporting their underlying trading gains and losses. If you made $200,000 trading futures in 2011 and $90,000 went missing — at no fault of your own — shouldn’t you be able to report $110,000 of net income on your 2011 tax returns? Then, if monies are recovered later, you would report that amount paid during the year it was received. This seems logical but currently it’s not an option.
The tax code works in strange ways that seem logical to accountants, but not so much to taxpayers. Accounting and tax principles always call for reporting transactions on a gross basis, without netting and offsetting transactions to change the character of income or loss. Taxpayers need to report their trading gains and losses separate from any loss on their deposits, just as Giddens said in his note.
An example of the tax trap
It’s tax time and we need to make decisions in spite of any uncertainty for a client with missing monies at MF Global. Mr. Giddens sent our client a 2011 Form 1099-B showing $1.7 million of Section 1256 trading gains. Our worksheet shows our client has still not recovered $1 million of his funds as of this date.
We’ve waited as long as we can for news, and now we must finalize his 2011 tax extensions due April 17, 2012. We’ve already entered his $1.7 million of Section 1256 contract trading gains on Form 6781. The good news is the lower 60/40 tax rates apply, so 60 percent is considered a long-term capital gain. But we don’t see a way to deduct all or a portion of his $1 million of unrecovered customer funds in 2011. Our client shows a significant tax liability and balance due with the extension filing. We have some ideas for clients who need to pay less below.
Business traders fare better in the tax trap
Let’s assume the worst — that our client never recovers the missing $1 million. If the trustee gives up and the money is declared fully lost in 2012, what happens next? Our client is luckier than many others since he qualifies for trader tax status (business treatment on trading futures) in 2012, and therefore his realized deposit-impairment loss will be a business bad debt. This means he’s entitled to Section 162 ordinary gain or loss treatment on a bad-debt loss, so it’s a full ordinary business loss. If there’s negative taxable income after this loss offsets any type of income, the client will have a net operating loss (NOL) carryback and/or carryforward.
MF Global customers can’t accrue a reserve or provision for 2011 taxes
Could a business trader on the accrual method of accounting accrue a reserve or provision before year-end 2011? Our tax attorney Mark Feldman said “no” and provided us with this tax research from RIA: “Reserves are generally not accruable. Although it is sound accounting and good business practice to deduct from current income estimated amounts to cover a variety of contingencies, these reserves (except for those few expressly authorized by the Code) are not deductible for tax purposes.” We reviewed the list of expressly authorized “reserves” or “provisions” which are allowed as tax deductions, and a deposit loss is not on that list.
RIA observation: “The underlying principle is that the income tax law is concerned only with realized losses and expenses. Furthermore, since the amount of a contingent liability ordinarily cannot be ascertained with any definite degree of accuracy, the underlying reserve is not susceptible of computation within a reasonably narrow limit, there is no assurance that the amount of the reserve will accurately reflect the actual future liability.”
Investors get a shorter end of the tax stick
Many MF Global futures trading customers won’t qualify for trader tax status (business treatment) in 2012. Some lost their trading capital and had to exit their trading businesses. Others never traded enough to qualify anyway. See how to qualify for trader tax status in our Trader Tax Center.
Investors have two tax treatments available to them, and they should run proforma tax returns to see which one is best for their facts and circumstances. A personal or investment bad debt is a capital loss. Alternatively, the loss can be declared a casualty or theft loss, which is an itemized deduction on individual tax returns (Schedule A).
If an investor has a large short-term capital gain in 2012, then offsetting capital gains by reporting a large MF Global deposit loss as a capital loss may be the best choice. The loss isn’t wasted in this case. Conversely, if a client has a capital loss limitation, he or she may prefer to consider a casualty or theft loss, which is widely covered for MF Global on the Internet. Caution: A casualty or theft loss is an itemized deduction and the taxpayer must first clear a 10-percent AGI threshold amount, meaning 10 percent of AGI will be a wasted loss. Also, take into account additional wasted losses due to itemized deduction phase-outs on federal and state tax returns. Thankfully, casualty and theft losses are not AMT tax preferences. Learn more about casualty and theft losses on irs.gov — see IRS topic 515.
Any hope for a Private Letter Ruling?
Our firm considered and then dismissed the idea of filing a private letter ruling (PLR) for the client mentioned previously. We see no legal tax grounds to ask the IRS to allow our clients to deduct a reasonable estimate of a MF Global deposit loss in 2011 to avoid the MF Global tax trap. PLRs are a long shot, so don’t hold up hope for this requested relief. It would be good if the IRS granted relief from its own initiative, but it probably won’t.
How to handle MF Global matters on extensions
With minor uncertainty over the deposit-loss recognition, it’s prudent for some MF Global traders to file extensions for 2011. For some, a million-dollar question is whether or not to pay their tax bill in full with the extension filing. Some may decide to pay less, assuming they may ultimately be entitled to report some of the deposit loss in 2011; but this is a long shot at best.
Other clients simply cannot pay what is due with the extension, but extension rules may provide relief from IRS penalties. Will the IRS assess MF Global customers’ late-filing and late-payment penalties if taxpayers file a Form 4868 automatic extension with less than 90 percent of their tax liability due? Paying less could be a risky gamble on penalties.
The managing members of our CPA firm Green NFH, LLC, Darren Neuschwander CPA and I decided to prepare our MF Global clients’ 2011 tax extensions relying on their Form 1099-Bs and without taking into account any missing monies (deposit losses) in 2011. But, we don’t take the choice of paying less away from our clients; we provide them with the following ideas for further consideration.
Can clients pay less with their extensions?
In our article “Extensions: Some traders may qualify for IRS penalty relief,” we explained cases where clients may qualify for special penalty relief on new extension form 1127-A (for hardship). If you qualify to use Form 1127-A, then you can skip tax payments on April 17, and the IRS will waive late-filing and late-payment penalties. (Check with your state, too.) As stated in our article, the penalties are steep. Taxpayers with big tax bills based on MF Global trading gains or otherwise won’t qualify for this hardship relief; Form 1127-A states “you must owe less than $50,000 with the extension to qualify for this relief.”
In our article, we pointed out that some taxpayers can’t pay what they owe but if they follow the rules carefully, have “reasonable cause,” and show good faith, they may succeed in requesting the IRS to abate late-filing and late-payment penalties. In my view, the IRS would be doubly cruel to not provide relief to MF Global traders and then slap them with late-filing and late-payment penalties. They certainly have a good reason why they can’t pay by April 17.
Tax preparers have to follow the letter of the law
Based on information available to us at this time — just two weeks before April 17 — tax extensions need to be prepared based on the 1099-B and without taking into account the deposit loss in 2011.
For informational purposes only, we plan to show our clients how their tax bill for 2011 might be lowered if they were able to take into account a deposit loss for 2011. We will make those calculations based on their facts and circumstances. It would be so much better for most to deduct a capital loss against capital gains in 2011, and avoid the tax trap in 2012.
Caution tax preparers: Preparing extensions taking the deposit losses into account for 2011 might open the door to claims by clients for reimbursement for their tax penalties. The IRS could deny penalty abatement letter requests, making this approach risky. Or, the IRS could abate penalties, but your state may not. The choices are not great here, and the more conservative approach is suggested.
The MF Global saga is painful to those who have missing monies. They were locked out of trading for a while, they lost a material part of their trading capital, and they got the short end of the stick in bankruptcy so far. It’s wrong for the IRS to hit them a second time when they are down. Hopefully, the IRS will provide some relief. With the bankruptcy filing so close to year-end, the tax trap was certain to happen. While Rome still burns on the missing money, taxpayers must file their 2011 tax extensions and it’s very hard for many of them to pay their tax bills due. The tax monies they saved up are still missing.
Posted 1 year, 3 months ago on April 4, 2012
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