Forex "self IBs" are a bad idea
We recently learned that certain forex brokerage firms have told traders they should form an introducing broker (IB) and/or management company primarily intended to earn fees related to their own trading accounts, including retirement accounts. These schemes are trouble on a number of fronts, including tax and regulatory.
Although these schemes may generate some savings on transaction costs, they often involve “tax inefficiency,” higher tax bills and some serious tax penalties and pitfalls.
For tax purposes, if your own retirement plan pays you a fee of any kind, it’s considered a “prohibited transaction” for “self-dealing.” There are significant IRS penalties and rules for prohibited transactions. We cover these problems on our retirement page (see the July 15, 2009 article). Your retirement plan can not invest in your own company, either.
In addition to the prohibited transaction penalties, the IRS will treat the IRA payments to the IRA owner as “early withdrawals” generally subject to ordinary income tax rates. Plus, if the IRA owner is under age 59 ½, he or she is subject to a 10 percent excise tax penalty reported on Form 5329.
Traders lacking traders tax status (business treatment) are stuck with restricted Section 212 investment expense treatment on the advisory fees paid to their own management company. In the case of IB transaction fees, if the trader elected capital gains treatment on forex — the opt-out election — he or she may face capital-loss limitations.
Often the fee payments aren't deductible — in a retirement plan or taxable account — whereas the fee income is subject to ordinary income tax rates plus SE tax costs. SE taxes are 15.3 percent of the SE base amount ($106,700 for 2009 and 2010) and 2.9 percent (Medicare portion) thereafter.
The fee income is often reported by the broker on Form 1099-Misc (non-employee compensation) and this net income is reportable on a Schedule C (Profit and Loss from Business) subject to ordinary income tax rates plus SE taxes. If you don’t have any other IB clients besides yourself (and your retirement plans), we believe it’s not appropriate to take business deductions for this activity on Schedule C.
Many forex traders don’t qualify for trader tax status (business treatment), and they must use the more restricted Section 212 investment expense treatment, which includes miscellaneous itemized deductions limited to 2 percent of adjusted gross income (AGI) and not deductible for the alternative minimum tax (AMT). Section 212 doesn't allow home-office expenses and travel education expenses.
The higher transaction payments channeled back to you as IB rebates may cause forex losses that are limited to the capital-loss limitation (with the capital gains election) or wasted forex losses if you have negative taxable income without trader tax status or forex losses inside a retirement plan.
Bottom line: These IB and management company schemes are very bad ideas for tax purposes and they can lead to some serious trouble with the IRS.
The Commodity Futures Trading Commission (CFTC) and National Futures Association (NFA) have new capital requirements for regulating forex IBs. We understand that some forex brokers are stopping this "self IB" scheme within a week or so. Hopefully, they won’t try to ship these schemes to their foreign-based platforms. December 22, 2009
Year-end tax planning, part 3 - compensation in entities
If you have a trading entity for 2009 and plan to use it for 2009 retirement plan and/or health insurance premium AGI-deduction strategies, you must take certain vital actions before year-end. You need to pay all earned income fees and officer salaries before year-end.
* If you have an S-Corp election, you should use formal payroll rather than administration fees. We can recommend a low-cost payroll tax compliance service provider. There is not much time left to arrange this before year-end. There are some benefits to payroll over fees, such as using year-end tax withholding through payroll to avoid under-estimated income tax penalties from earlier in the year. With payroll, you may qualify for unemployment insurance benefits too.
* If you have an LLC or general partnership filing a partnership tax return, you should use administrative fees rather than payroll. That skips payroll tax compliance and you can simply issue a check to the trading entity owner/workers who performed administration services (one or both spouses). We can prepare the 1099-Misc. in January. If you took distributions of sufficient cash from your entity during the year, after year-end we can reclassify some of those payments to administration fees. Just make sure you have taken out enough money to cover your AGI-deduction needs before year-end. Otherwise, you may wind up losing these deductions.
* Mini 401k plans (otherwise known as Individual or Solo 401k plans) must be established (opened) before year-end too. For S-Corps using payroll, the retirement plan should be in the name of the entity. For administration fees, the retirement plan should be in your individual names. You can fund these retirement plans after year-end, up until the due date of your 2009 tax return including extensions. If you are not sure which plan is right for you, just be sure to open one with a leading brokerage firm before year-end. It's free to do. You can roll it over to different plan in early 2010 after studying your options.
* Roth IRA conversions must be executed by year-end. Don't worry, you can recharachterize the conversion by Oct. 15, 2010. Learn more about these conversions in our articles below.
* Federal Q4 estimated taxes are due Jan. 15, but it's generally more favorable to pay the state Q4 vouchers by Dec. 31 for a year-end deduction (unless it triggers AMT).
For other useful year-end tax planning strategies, read Green's article in Fidelity Investor's Publication, "Tax Tips for Traders," http://personal.fidelity.com/misc/framesets/iwarticle.shtml?pagename=AT0911_tax Active Trader magazine (Dec. issue), and on our site http://www.greencompany.com/EducationCenter/GTTRecStratYearEndPlanning.shtml .
Special note on using a new entity set up in Q4 2009, or Q1 2010.
A year-end strategy with entities - using new taxpayer MTM elections and AGI deductions such as retirement plans - can only work if we form the entity and you open the entity trading accounts within the week. That was last week when we wrote it and it's now too late to deploy this new strategy for Q4 2009. It's now wise to consider an entity formation for 2010, with an early January start date. That's usually better than operating as a sole proprietor for part of 2010 and with an entity for the balance of the 2010. Click here http://www.greencompany.com/Traders/TraderEntities.shtml to learn more and get started. September 23, 2009
Year-end tax planning, part 1
Most years, taxpayers take every opportunity to kick the tax-can down the road, by deferring and accelerating income. This year and next should be different, because tax rates are likely heading higher for the upper and middle class starting in 2011.
You have two choices this year-end. Minimize 2009 taxes as best you can to safeguard cash flow — paying as little taxes as possible and maximizing your refund. Or, view your tax situation over the next several years and minimize taxes over the long term. That second choice may mean accelerating income into 2010 to pay more taxes at lower tax rates vs. higher tax rates later on.
There are few ways that investors can follow this cash out strategy — by cashing out long-term investments earlier than planned or with a Roth IRA conversion.
Tax rates are on the rise.
The Bush tax cuts are set to expire in 2011. President Obama promised no tax rate increases on the middle-class, so only the upper two marginal income tax brackets are scheduled (in the Obama 2010 budget) to increase to 39.6 percent from 35 percent and 36 percent from 33 percent. The highest long-term capital gains tax rate will rise 5 percent to 20 percent. The House proposed a further increase to 24 percent to help finance health care reform.
Democrats currently have the power to enact their vision of fiscal (tax) policy. A common Democratic belief is supply-side economics only benefit the upper class and don’t trickle down to the middle-class and poor.
Conversely, Republicans tend to believe supply-side economics lifts all boats, and lower tax rates spur entrepreneurial-led growth, which creates jobs and raises absolute tax revenues. It’s always been difficult to prove who is right on these points.
Congressional leaders and President Obama are under pressure to lessen the escalating budget deficit. At the same time, leaders are proposing new spending programs — stimulus for the recession, health-care reform, and financial reform regulation. In the Democrats view, raising taxes on the rich is required to “pay go” for this new spending.
Many pundits have said President Obama may need to break his promise on raising taxes on the middle class too. Presidential surrogates have not denied this when asked about it on Sunday talk shows.
For a good short history of income tax in the US, see http://www.infoplease.com/ipa/A0005921.html .
With taxes headed higher, consider cashing-out your taxable portfolio now.
With the long-term capital gains rate scheduled to rise to 20 percent in 2011 (from 15 percent), consider selling long-term capital gains positions before year-end 2009 if the markets are at high levels. Holding short-term positions into 2010 to gain long-term status is another potentially worthwhile strategy; you can sell these positions before year-end 2010 and avoid the tax increase in 2011. The goal is to pay more taxes at lower tax rates vs. higher tax rates later on.
Cash out your retirement funds with a Roth retirement account conversion.
This same concept can be applied to your traditional retirement plan accounts in connection with a year-end Roth IRA conversion.
Traditional retirement plans have different tax benefits from Roth IRA plans. Traditional retirement plans offer tax deductions on annual contributions and temporary tax-free income build-up in the retirement account until you take ordinary income taxable distributions at retirement age (as early as age 59 ½ and no later than age 70 ½ ). Roth IRAs and Roth Mini 401ks have a different tax bargain. Rather than getting tax deductions up front for contributions, the Roth accounts are tax free for life.
The key difference is the permanent tax-free status on the contributions. In the traditional plans, the funds are ultimately taxed in retirement, and tax rates are forecasted to be higher when you retire. Conversely, with the Roth plans, the funds are never taxed at retirement age. We advocate a simple strategy: make annual tax deductions to a traditional retirement plan during high-income years (when you pay taxes at higher tax rates) and in years when you have losses, convert to a Roth IRA, paying taxes at lower rates. The goal is to get more assets into the Roth accounts.
Roth retirement accounts are attractive to traders because their “stock-in-trade” (business) is managing a portfolio for (active trading) growth and unlike all other types of taxpayers, they can escape taxes on their stock-in-trade.
Many situations call for taking advantage of the tax deduction on a traditional retirement plan contribution too. Traders need to financially engineer earned income with a fee or payroll in their own trading entity, as trading gains are not earned income. That earned income triggers self-employment (SE) taxes. Generally, a traditional retirement plan deduction saves more in income taxes than the trader must pay in SE taxes.
In years with large trading losses, which lead to material business net operating losses (NOLs), it may also be prudent to soak up the NOL with a Roth conversion, instead of filing a NOL carry-back refund claim return. Full-time and very active business traders don’t need to worry about the IRS as much and NOL carry back returns are generally better for them.
Roth IRA distributions can also prevent Social Security benefits from being subject to income tax. If combined AGI is more than $44,000 (2009 threshold), up to 85 percent of Social Security benefits are subject to income tax. If under the threshold, social security benefits are tax-free. Roth IRA distributions can help taxpayers qualify for other middle-class tax breaks too (also dependent on AGI).
Can the Roth tax pledge be trusted?
Some traders tell me they worry about the government will eventually decide to tax the income build-up in a Roth IRA. It can’t tax the original contributions, as they were not tax-deductions and paid for with after-tax dollars.
I highly doubt this will happen. The government wants to provide incentives for saving for retirement. Curiously, to save on cash flow, the government recently announced a new program offering taxpayers an option to divert a portion of their tax refund to their retirement savings account, instead of getting a tax refund. It reminds me of states such as California issuing IOUs for tax refunds in 2009.
Everyone can convert to a Roth in 2010.
The last scheduled juicy tax break from the Bush administration is the Roth IRA conversion loophole in 2010, waiving the normal “income threshold” for 2010 only and making it possible for any taxpayer (even otherwise barred married filing separate taxpayers) to convert to a Roth IRA. For any other year, the income threshold rule only allows the Roth conversion option if the taxpayer has a modified adjusted gross income (MAGI) of $100,000 or less for both joint and single filings.
The biggest drawback to the Roth conversion is you need sufficient cash flow to pay the conversion income taxes; you can’t use the converted amounts to pay those taxes, either. But the 2010 tax break also allows you to pay the conversion taxes over two years; half of the income resulting from the conversion will be includible in gross income in 2011 and the other half in 2012. Taxpayer's in the upper-two brackets (being raised in 2011) can opt out of the two year tax deferral, so they don't pay taxes at higher rates.
Qualified plans (like a Mini 401k), a SEP-IRA, or SIMPLE IRA may be converted to a Roth plan too.
A conversion from a regular IRA to a Roth IRA is subject to tax as if it were distributed from the traditional IRA, but at least it isn't subject to the 10% premature distribution tax (which otherwise would not apply if the taxpayer was over age 59 1/2).
Suppose you convert to a Roth IRA before year-end, pay taxes on the converted amounts, and then face a large loss on the Roth trading account. It could be from actual active trading losses or the market dropping in value. This unfortunate loss on permanently tax-free money can’t be deducted on your taxes.
Not to worry, there’s a fix: The IRS allows taxpayers to change their minds. The process is known as a Roth IRA recharacterization. Learn more at www.irs.gov and search Roth IRAs.
Generally, a taxpayer has until Oct. 15 of the following tax year to undo a Roth conversion. For example, a Roth conversion completed in December 2009 may be recharacterized by Oct. 15, 2010. If a taxpayer already filed his or her 2009 tax return before Oct. 15, 2010, the return can be amended, but it’s better to wait with an extension.
Just ask your administrator to do a "recharacterization."
Bottom line on the Roth conversion strategies.
If you qualify for a conversion, try it in 2009. Maybe the converted assets will rise in value. If they drop in value, consider a recharacterization for 2009 and possibly converting again in 2010 with the lower asset values.
If you skip the Roth conversion strategy, you may wind up taking traditional retirement plan distributions subject to much higher tax rates. Also note that lower 60/40 tax rates on futures and electing forex traders are not available on retirement plan distributions.
Here’s another good article: http://www.nytimes.com/2009/07/18/your-money/individual-retirement-account-iras/18money.html?_r=2&nl=your-money&emc=your-moneyema2 .
Check back later this week for more year-end tax planning tips. July 15, 2009
Retirement-plan strategies - Important Update
Important Update on July 15, 2009.
Click here http://www.greencompany.com/Traders/TraderRetirement.shtml for Robert A. Green, CPA's 10-page blog article (in pdf format) on retirement-plan strategies for traders. This same article is being edited into a shorter version for Green's Business of Trading column in Active Trader magazine (October 2009 issue).
Traders Have Retirement Choices
..Short video produced by MoneyShow.com featuring Robert A. Green, CPA. "Author and trader tax expert Robert Green reviews some of the retirement account options available to today's traders and how some may allow traders to write off expenses and trading costs." Released: 7/16/2009.