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Year-end tax planning, part 2

September 25, 2009

On Wednesday we discussed two potential ways to save money at year-end: cashing out long-term investments earlier than planned or converting to a Roth IRA. Here, we share more things to keep in mind as you begin to think about your 2009 tax return.

Use good software for your year-end tax planning.
Use a trade accounting program or reports from your broker to get a handle on your trading gains and losses well before you receive Form 1099-Bs in February. It’s always best to prepare a pro forma income tax return for the current tax year — which is fairly easy to do with tax software — to see exactly how all things work out tax-wise. Our software helps you view tax planning over several years.

Special 2009 tax breaks for homes and automobiles.
Take advantage of these special new tax breaks for 2009. Learn more specifics at www.irs.gov.

First-time home buyer credit. Stimulus legislation enacted earlier this year extended the 2008 first-time home buyer credit provision to cover qualified home purchases between Jan. 1, 2009 and Nov. 30, 2009. The maximum credit amounts are now $8,000, and it no longer has to be paid back over 15 years.

Vehicle sales tax deduction. Stimulus legislation passed earlier this year created a new federal income tax deduction for state and local sales and excise taxes paid on new vehicles purchased between Feb. 17, 2009 and Dec. 31, 2009.

Hybrid vehicle and lean-burn diesel vehicle credits. A federal income tax credit is allowed for buying a qualifying new hybrid vehicle or a qualifying new lean-burn diesel vehicle. The credit can be used to offset your 2009 federal income tax bill even if you owe the AMT, regardless of how high your income might be.

Do NOL planning before year-end.
Net operating loss (NOL) carry backs are a huge tax break for business taxpayers only. Business taxpayers are entitled to carry back NOL business losses two tax years to claim immediate tax refunds with interest. Unfortunately, the special five-year NOL carry back add-on rule only applied to tax-year 2008. NOL carry backs for business traders might be a risky proposition in 2009 and the years ahead since the IRS has recently turned up the heat on all taxpayers and traders in particular.

If a trader just barely qualifies for trader tax status in 2009, he or she should consider carrying the NOL forward instead. Another solution is to soak up the loss with a Roth IRA conversion; this could eliminate the NOL. Note that NOL carry backs were frozen in California and Hawaii; those states allow NOL carry forwards only.

Don’t be aggressive on trader tax status determinations, the IRS may disagree.
Every year, the rules for qualifying for trader tax status have tightened a little because the IRS seems to be challenging more traders on it. It’s difficult to qualify for trader tax status if you are a part-time trader. Trader tax breaks depend on qualifying for trader tax status — it opens the door to business expense treatment vs. the more restricted investment expense treatment. You need trader tax status in order to elect and use Section 475 MTM ordinary business loss treatment, which exempts traders from the puny $3,000 capital loss limitation.

If you’re a close call on trader tax status, see how your proforma tax return looks with investor tax status instead. Perhaps you don’t have business trading losses or material wash sale conditions, and therefore you may not really need to use Section 475 MTM, which is conditional on having trader tax status. Perhaps, you get a decent tax benefit from investment expense treatment on Schedule A miscellaneous itemized deductions (home office and education expenses are not allowed).

Futures and electing forex traders generally skip Section 475 MTM (ordinary gain or loss treatment) because they prefer retaining Section 1256 lower 60/40 capital gains tax rates (60 percent is a lower long-term capital gains rate). Forex traders who don’t opt out of Section 988 into Section 1256g benefit from ordinary loss treatment with or without trader tax status. If you are in this group, trader tax status may not be crucial to you in 2009.

If your pro forma tax return shows there’s not much benefit to investment expense treatment, consider classifying your 2009 trading expenses as “start-up” costs (under Section 195) to be amortized when you may qualify for trader tax status in 2010. Start-up costs have an expense election for the first $5,000 and the rest is amortized over 180-months. The same treatment applies to organization costs too, with a second $5,000 expense election.

If you used Section 475 MTM in prior years but don’t qualify for trader tax status in 2009, you must use the cash method instead for 2009. If you re-qualify for trader tax status in the future, the IRS compels you to use Section 475 MTM as soon as you re-qualify — but only on business positions, not segregated investment positions.

An entity is helpful for trader tax status and it can give you a clean start in 2010.
To deflect IRS scrutiny on trader tax status, I recommend that you house your trading business within an entity for 2010 and beyond. It’s easy to setup, and the costs are reasonable. Traders need an entity to financially engineer earned income that opens the door to a tax-deductible retirement plan or non-tax-deductible Roth retirement account. Only exchange-member futures and options traders can skip the entity as their trading gains are already subject to SE (earned income) tax (Section 1402i).

For married traders, a simple husband and wife general partnership is usually all that is needed. There are no state filing fees, annual fees, or state taxes, and it’s portable from state to state.

Single traders can have a general partnership too. Single people need a second entity, like a C-corp or S-Corp, to own 1 percent of the general partnership. This is a good idea in states such as California and New York City. One client said the second entity is a less expensive option than getting married in order to have a general partnership alone. In most states, only an S-corp is needed without any other partnership.

There is still time in 2009 to form an entity (preferably before December), to set up these year-end tax planning strategies for AGI deductions such as retirement plan and health insurance premium deductions. You also need to act before year-end to pay yourself a fee or salary, and establish a Mini 401k plan (if desired).

With ordinary income tax rates headed higher, retirement plans and their related deductions will become even more valuable for tax savings. Trader tax status business expenses and Section 475f MTM ordinary trading losses will also be more valuable too.

Don’t give up on trader tax status. Improve it with an entity in the year ahead and get a clean start on Jan. 1. This is a better strategy than filing a Schedule C as a sole proprietor trader (a red flag for the IRS) for part of the year and an entity for the balance of the year.

Either avoid AMT, or embrace its historically low rate.
Earlier this year Congress enacted its annual “AMT patch,” saving millions of taxpayers from “bracket creep” (which means AMT rates are not indexed for inflation, unlike regular tax rates). The patch raises the exemption level for the AMT. The AMT patch was included in the first round of tax-change legislation and winded up in “The American Recovery and Reinvestment Act 2009.”

In 2008, the House proposed repealing the AMT entirely and replacing it with a 5-percent surcharge on upper-income taxpayers. But this repeal has dropped off the radar screen and the House has steered the 5-percent surcharge toward its health-care bill instead. Therefore, you can probably count on using an AMT tax credit over the next few years as well. That credit is not widely known or understood (IRS Form 8801).

Your pro forma return will indicate if the AMT is triggered. For regular income tax purposes, it’s smart to prepay all state income taxes before year-end for an ad¬ditional tax deduction. But if you trigger AMT, prepaying some or all of your state income taxes is a big mistake because state taxes are not deductible for AMT. Instead, you can pay just enough fourth-quarter estimated state income taxes before year-end to equal the AMT threshold and pay the balance when due the follow¬ing year. That’s either Jan. 15 (for the esti¬mated income tax safe harbor exception) or by the April 15 tax return or extension due date. Some tax writers argue that state taxes attributed to business income are not subject to AMT preference and itemized deduction treatment. Consult us about that.
If you can’t avoid AMT, consider embracing its historic and relatively low rate, versus the higher regular tax rates. The highest AMT rate is only 28 percent vs. 35 percent ordinary rates, which rise to 39.6 percent in 2011 (and maybe more with a surcharge).

AMT preferences include the following types of itemized deductions: state taxes (income, real estate and property), investment interest expense, and miscellaneous itemized deductions including investment expenses (if you don’t qualify for trader tax status) and Form 2106 unreimbursed employee business expenses. See Form 6251 at www.irs.gov for more on AMT.

Some states have not only raised tax rates on the wealthy, but they have also significantly reduced their itemized deductions — for example, in New York it has been reduced to 50 percent.

You can’t fool the IRS with offsetting positions.
Before the IRS closed tax loopholes, professional traders used strategies to defer investment income and accelerate trading losses. For the most part, these loopholes have been closed with tax rules for wash sales, straddles, offsetting positions, constructive receipt, and shorting against the box. You are entitled to reduce market risk on individual stocks with offsetting positions in futures and indexes. Bottom line, you need to show a distinct economic risk to avoid offsetting position rules in general. Don’t try to be too cute with the IRS on this front; it’s just going to get you into trouble.

Wash sales can be a royal pain.
A wash sale occurs when you trade securities at a loss, and within 30 days before or after, you trade substantially identical securities (which include options on that security). Rules require wash sales to be computed across all accounts, including IRA accounts and entity accounts. Year-end trading gains often absorb wash sales from earlier in the tax year. Remaining year-end wash sale losses must be deferred to the following tax year.

It’s almost impossible for active traders and tax professionals to figure wash sales by hand. The only software program we know about that currently calculates wash sales correctly for active traders is TradeLog from Armen Computing (sold on our Web site at http://www.greencompany.com/Traders/Software.shtml ). TradeLog is the only program that calculates wash sales between multiple trading accounts and your retirement accounts, as required by the IRS. When wash sales are triggered in a taxable account as a result of buying back the position in an IRA account, that wash sale loss is wasted tax-wise, and this should be avoided if possible.

A Section 475 MTM election exempts you from wash sale reporting on your business trading accounts. If you elect Section 475 MTM in 2010, 2009 wash sales become part of your 2010 Section 481a ordinary loss adjustment, which converts wash sales into ordinary losses — a good thing. The 2010 Section 481a adjustment is the 2009 year-end unrealized gain or loss. In this example, wash sales are better than capital loss carryovers, as the later can never be converted into ordinary loss treatment.
Wash sales are highly complex and beyond the scope of this article.

Futures tax rates are headed higher too.
Higher long-term capital gains rates plus higher ordinary tax rates translate to higher tax rates on futures traders.

Here’s the new futures tax rate (60/40) math for 2011. The 60 percent long-term capital gains portion times 20 percent (raised 2011 long-term rate) equals 12 percent. The 40 percent short-term ordinary rate component times 39.6 percent (raised 2011 ordinary rate) equals 16 percent. The 2011 highest blended futures tax rate is 28 percent, a 5 percent increase over the current 23 percent blended rate.

A potential 5-percent surcharge on the upper class and a further increase in the long-term capital gains rate to 24 percent means the futures tax rate may rise to 32 percent.

Investment managers could lose carried interest tax breaks in 2011
Starting in 2011, investment managers could lose “carried interest” tax breaks, meaning their compensation will be deemed investment-management fee income, subject to ordinary income tax rates, as well as self-employment taxes.

If a repeal occurs, for example, futures fund managers' federal tax rates will rise from 23 percent to 54 percent: 39.6 ordinary rates plus 15.3 percent self employment tax rates — which only apply in full to the social security base amount and with 2.9 percent unlimited. (Note: While a repeal has been proposed in President Obama's 2010 and 2011 budgets and passed by the House, it hasn't been approved in the Senate yet. Please listen to our 2/4/10 podcast for very important updates.)

A current tax loophole allows a manager to reduce self-employment tax using an S-corp structure. The House proposed closing that loophole in 2008, but it never made it to the first round of tax changes in the Obama 2010 budget.

More investment managers may consider managed accounts as an alternative, with repeal of carried interest tax breaks. Now managed accounts and hedge funds are on the same footing tax-wise for the manager. Carried interest can still be helpful to hedge-fund investors over managed account structures.

With potentially more regulation and compliance costs coming to hedge funds too, managed accounts may be a good option.

Year-end tax-loss selling is good for investors, but not needed for MTM traders.
“Tax-loss selling” is a major factor in the markets each year. The media recommends that taxpayers consider it as a simple year-end tax strategy to reduce capital gains taxes.

If many taxpayers already exceeded their $3,000 capital loss limitations earlier in the year, tax-loss selling may not be a huge factor this year-end.

Business traders with Section 475 mark-to-market accounting (MTM, ordinary gain or loss treatment), and all futures traders and forex traders (electing Section 1256g) don’t need year-end tax-loss selling to take losses. MTM accounting imputes their losses and gains at year-end.

Be careful when buying a mutual fund at year-end, as you may fall into a tax trap. You may qualify for a taxable capital gains distribution, offset by a capital loss you can’t deduct; because you may be over the $3,000 capital loss limitation or you haven’t sold that position by year-end.

The estate tax is coming back on radar screens again too.
There is one silver lining on lower home values — it lowers your taxable estate too. However, not too many taxpayers have the estate tax on their radar now, because the federal estate tax was mostly focused on the wealthy under the Bush Administration tax cuts. This was accomplished by raising the estate tax exemption each year. The federal estate tax exemption is at its highest rate in 2009 — $3.5 million, up from $2 million in 2008.

But most people don’t realize that many states decoupled from Bush estate tax cuts, and kept their lower exemption amounts in place. Check in your state.

During the Bush tax cuts, there was great fanfare and debate about the estate tax being repealed in 2010. Lots of people changed their living wills to pull the plug on grandma in 2010 rather than 2009. It’s still unclear whether the estate tax will be repealed for good or not (probably not). We expect discussion on the estate tax in Congress in 2009 and 2010.

Many tax experts and I believe that a Democratic-controlled Congress may temporarily act to extend the (higher) 2009 estate tax exemption to 2011, and later try to reinstate estate tax exemption levels to pre-Bush years. That would open the door to lots of estate tax planning again.

Reducing your taxable estate with annual gifts continues to be a good idea. The current year annual gift limit per person is $13,000.

Using family limited partnerships for family businesses is a valid estate planning strategy. But it doesn’t work well for a family trading business, because you can’t justify a minority discount on an investment portfolio, whereas you can for a regular business.

Bottom line
The financial mainstream media has good year-end tax planning articles for investors and regular taxpayers. I tried to focus on active traders, particularly the wonderful Roth conversion strategy (see Part. 1 from Sept. 23) and unique aspects to trader tax status, Section 475 MTM and more. Just make sure you run your numbers and consult your tax advisor. It’s much harder to save money after year-end then before.

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