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New potential attack on 60/40 treatment for dealers

May 12, 2009

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.

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