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GreenTrader Weblog
GreenTraderTax & GreenTraderFunds
June 18, 2010
Is the tax extenders bill passable?
The tax extenders bill is struggling and the Senate voted 56-40 Thursday night to close debate on the bill. Some pundits argue this type of vote is a final “no.” But Sen. Harry Reid (D-Nev.) is trying to pass a revision of this bill by the July 4th recess.
Sen. Max Baucus (D-Mont.), chairman of the presiding Senate Committee on Finance, says, “The bottom line is, we're going to keep trying (on this bill).”
The latest round of voting included several important amendment modifications. (See the text of the last modified bill and a summary on the Senate Committee on Finance Web site.) The latest amendment took back some of the split between ordinary and carried interest — not good news for investment managers. The Senate removed the two-year phase-in period (with a 50/50 split), and the original 75/25 ordinary/carried-interest split in 2011 is back on the table after being lessened to 65/35 last week. (Perhaps this is to help lessen the harsh impact of a wider repeal of the S-Corp SE tax loophole.) The Senators listened to venture capitalists and shortened their holding period to five years (rather than seven) for the 50/50 ordinary/carried split.
The Senate also narrowed the S-corp SE tax repeal in its last modification; S-corps that have a material amount and number of non-owner professionals would be exempt from SE tax. I argue it’s unfair to charge an SE tax on the “return on human capital” element in S-corps, when owners have a material number of non-owner workers. This last modification says “only if 80 percent or more of the professional service income of the S-corporation is attributable to the services of three or fewer owners of the corporation.”
The good news is this bill is failing. Drama and brinksmanship continue in the Senate over trying to pass it. This fight seems to be the new battle line for the upcoming midterm elections, with campaigns well under way. Growing heat from the Tea Party over excessive spending and deficits is making it very difficult for Democrats to enact more Keynesian spending, including extending unemployment benefits and helping states, teachers, police and firefighters. Republicans also generally cry foul when Congress tries to raise taxes on job creators, especially during a jobless recovery and potential double-dip recession.
After harried attempts to make changes, which some liken to putting lipstick on a pig, Chairman Baucus seems to be throwing in the towel. But Leader Reid won’t have it; he vows further revision and voting before the July recess. Will this bill be out after three strikes?
Senator Olympia Snowe (R-Me.) — an important moderate who is courted by Democrats for key votes — was particularly interested in reducing the S-corp SE tax impact on small-business job creators. The Senator voted for closure along with all other Republicans and a few key Democrats.
It may be more prudent going into the midterm elections for the Senate to follow the successful lead of the “doc fix” arranged on Thursday. That vote succeeded because Senators on a bi-partisan basis narrowed the length and amount of this spending allotment and found savings and revenues, besides tax increases, to pay for this targeted bill. Maybe we have a new winning formula here.
Click here for more media coverage: WSJ, The Hill, Reuters, New York Times, and Courthouse News.
The Hill article on Saturday, June 19 explains the politics of this bill. The author doesn't agree with Leader Reid who blames Republicans again for failure to pass the bill, and not caring about the unemployed.
Key Democrats like Nelson (D-Neb.) and Lieberman (I-Conn.) also voted no both times on this bill, insisting it be fully paid for without adding to the deficit. They may like some Republicans' suggestions (Thune amendment elements) to use available stimulus funds rather than new deficit spending, but they don’t want to go as far as the Republicans in entirely dropping tax increases from the bill too.
Perhaps round three of this bill will include stimulus funds, reduce spending and still keep in the tax increases. That may win back the “say-no-to-deficit-spending” Democrats, but is it enough to also win over the "gettable" Republicans Snowe and Collins? Both groups are needed to gain 60 votes for passage.
Many economists, the Chairman of the Federal Reserve and the Secretary of Treasury are advocating more Keynesian spending and not withdrawing stimulus too early. What's anyone’s logic for not using available stimulus funds now, and in this bill? Perhaps some elements of this bill don't qualify for stimulus spending. Last year, Republicans and blue-dog Democrats were upset that TARP and other stimulus bills were not being used as intended. If those stimulus funds are adequate for pared-down stimulus needs in this bill, why also raise taxes now on small-business job creators? Stimulus only makes sense if it spurs growth and tax increases generally hurt growth.
Tax extenders bill fails in Senate
Good news for traders — the Senate failed to gain enough votes to pass the “tax extenders” bill (H.R. 4123) in conference with the House, as some moderate Democrats joined all Republicans in voting against it today. The Senate fell short of the 60 votes needed for passage. See these stories in the WSJ, The Hill, CNBC and WebCPA for the latest.
But don’t get your hopes up just yet. I predict the Senate and House conference will pare down spending in this bill and raise more tax revenue in other ways, perhaps on oil companies (the latest villains). And, unfortunately, I don’t expect many Senators to hear the plight of hedge-fund managers when it comes to the repeal of carried-interest tax breaks. The Senate already threw investment managers a last-minute bone when it watered down the final split between ordinary vs. carried interest income (from 75/25 to 65/35), and reduced this split even more on venture capitalists holding underlying investments for seven years or more (55/45).
Pleas from small business owners and professionals using S-corps to reduce self-employment (SE) taxes probably won’t curry favor either, as Congress views this break as a “loophole” – in fact, it uses that label in the bill’s title.
Accounting groups have opposed this change; click here to see their efforts. I think the accountants raise good points, but they're facing a serious effort by Democrats, with the support of the labor movement, to swing the pendulum of taxation back from being labor-intensive to applying more to capital. Progressive taxation concepts, which are fundamental to our tax code, are supposed to mean that the wealthy pay higher tax rates. The labor sector feels too many rich people are getting away with paying lower taxes by pinning lots of income on capital rather than labor. Think hedge fund carried interest too.
This same concept applies in the carried-interest repeal debate. Democrats argued that investment managers are really receiving incentive fees (subject to ordinary rates and SE taxes) disguised as “profit allocation” capital gains.
The AICPA and other accounting groups pointed out to Congress that S-corps made up of professionals such as investment managers have owner and non-owner workers and generally a low amount of non-human capital (equipment and deposits). Like other businesses, they should be allowed a return on the capital that's not deemed to be service fees subject to SE taxes. The accountants argued that those non-owner professionals pay SE taxes on their compensation, and the owner's mark-up profits on their workforce should constitute a return on human capital rather than service fee revenue attributable to their own labor efforts. They're happy to pay SE taxes on their service fees. The accountants ask for a compromise split similar to the one given for carried interest. They also point out that current law is fair on these points, with S-corp owners taking 30 percent of profits as SE income subject to SE taxes. Perhaps they will be heard and Congress will offer some type of split.
Back to the tax extender bill in general. Republicans are proposing their own version that eliminates most of the debated tax increases (see the Thune amendment in the WebCPA article), but moderate Democrats aren’t expected to join forces with them. A Democratic-controlled Congress feels it must extend certain tax breaks, extend unemployment benefits and apply the Medicare doctor fix. This bill is very important to them. Politics is calling for a haircut on spending in the bill, so they may reduce some spending and find more taxes to increase too.
Financial regulation reform and tax change bills affecting traders, investment managers and professionals are picking up steam with lots of debate and changes in Congress this week. We'll be covering these issues in our weekly conference call tomorrow, June 17 at 4:15 - 5:30 pm ET. For more information, click here.
I added this comment earlier today on the media articles above. (This is an edited version.) Please add your comments as well to help sway Senators.
· Skip this job-killing bill entirely. Even if spending is reduced, the bill still contains nasty tax increases placed on job creators such as small business professionals operating in S-corp structures. That nasty Medicare tax will heap 3 percent more taxes on those small businesses now and 4 percent in 2013 with the health care tax increase. This bill also takes revenge on hedge-fund managers, venture capitalists and real-estate managers with a repeal of carried-interest tax breaks. These managers have skin (capital) in the game and many are being sued for losses in their funds during the recession (coughing up their own capital to cover it). Capital deserves capital gains. All these types of funds are under distress now with lower returns, losses and problems due to Meltdown 2.0 contagion in Europe and a potential double-dip recession in Europe and the U.S. Now is not the time to take tax retribution/redistribution. Why redistribute taxes from job creators (professionals and investment managers) to people who won't pick themselves off the dole-out unemployment lines already. Extending unemployment insurance forever is not fair to taxpayers who work hard every day to pay taxes and keep smaller and smaller net amounts.
One reason Congress will redo this bill is to beef up their attack (in the form of tax increases) on oil companies to pay for more of this runaway spending. They will block drilling in the Gulf too and get more people fired, bringing another great U.S. and global industry to its knees. Good luck collecting taxes with declining growth. This bill will be known as a "kiss campaign contributions goodbye" bill, as professionals, small businesses and investment managers will no longer support the enactors. Any tax bill will face a rocky road before the midterms and voters will carve these mistakes in stone in their minds. You don't have to be a tea party supporter to kick the incumbents out. Just kill this bill entirely! October 16, 2008
Market Turmoil Effect on Hedge Funds & Traders, and Tax Losses
The IRS appears to be beefing up attacks on trader tax status (for traders and hedge funds); perhaps to protect the US Treasury during these difficult economic times (read about the Holsinger tax court case on our blog). Will the federal and state governments continue to honor Net Operating Loss (NOL) tax refund claims going forward; especially NOLs based on trading business losses (using trader tax status with IRC 475(f) MTM ordinary loss treatment)? Consider that the State of California froze NOL refund claims during the last recession in early 2000s.
The US Treasury and Federal Reserve Bank are being called on, in unprecedented ways, to bailout financial institutions, home-mortgage-owners, state and local governments and others (more to come). During these difficult financial times, it's hard for me to imagine that the governments will continue to allow - without a fight in exams or even change of tax law - trader tax status with IRC 475 MTM ordinary tax loss treatment. After all, can the government afford to pay perhaps a trillion dollar's (or more) of tax refunds to traders, hedge fund investors, and financial institutions?
Yes, financial institutions will be allowed NOL tax treatment. In fact, NOL rules for banks were just enhanced as part of the government bailout package; because banks are part of systemic risk. Unfortunately in this current crisis, traders and hedge funds are not perceived as being part of systemic risk. The bailed out hedge fund Long-Term Capital was considered too big to fail in the late 1990s; but this time around it seems like hedge funds will be the odd-man out.
The media, politicians, regulators and public are casting black marks against hedge funds and traders and I don’t expect much tax support from the cavalry. As always, traders and hedge funds are on their own, so it’s more important than ever to learn how to protect your clients and yourselves – and sometimes there are conflicts of interest; which this time may wind up in a court of law.
Claw-backs based on fraudulent conveyance laws are a hot topic in the news. New York State Attorney General Cuomo just attacked AIG on this issue. If your hedge fund goes bankrupt, can investors’ seek to claw-back (a return of) profit allocations or incentive fees paid in the past 3-months or even a longer period? Brent Gillett, JD will discuss these and many other challenging legal issues for investment managers to consider during these difficult times.
2008 has been a very difficult year for many traders and hedge funds and many of them have incurred very significant trading losses. We will discuss ways to protect your money (and your clients if you have any) and ways to protect your trader tax status, MTM accounting and filing strategies to receive timely tax refunds. Get the tax-money you are entitled to, while it’s hot, and without triggering an IRS or state challenge.
September 18, 2008
Protect your client's and your own money in the financial crisis.
By Robert A. Green, CPA and CEO
Over the past year, we have continually warned conference call participants to carefully monitor the financial health of their brokerage firms and prime brokers. We warned that developing market crisis events could lead to lost access to trading accounts and perhaps even asset loss caused by brokerage firm failure; without full protection. This problem became evident this week with the AIG’s bankruptcy-avoiding government bailout. AIG is very big in forex prime brokerage and some large forex funds scrambled to withdraw their client funds this past Monday and Tuesday. Losing access to forex markets during major market moves in currencies can be crushing to performance. Plus, forex accounts don’t have quasi-government protection like FDIC, SIPC or state insurance guarantees. Unfortunately, in this day and Internet-age, it can take just days to go from market rumor, to loss of confidence, to a run on a bank, to an institution’s loss of counterparties and agency ratings, to failure, merger or bailout. It’s cruel and wrong, but it’s reality.
The media has done a good job reporting on “how to protect your money” in financial institutions: from FDIC at banks ( http://www.myfdicinsurance.gov/ ); to SPIC protection at brokerage firms http://www.sipc.org/; to state regulators who are guarantors of many insurance products; to the full-faith of the US government on Treasuries, and states/cities on municipal bonds; to private insurers for some financial institutions holding accounts over quasi-government protector amounts; to non-quasi-government insured accounts like futures, forex and more. This last point can be very scary for futures and forex managers, if their brokerage firm does not have adequate and safe private insurance coverage (many do).
Hopefully, all these protections will work when push comes to shove. Yet, gold bugs argue that many of these protections are in precarious financial situations themselves. Gold is a renewed safe haven today, yet it was selling off aggressively over the past few weeks and it can be very volatile going forward too.
Millions of Americans and people around the world are rushing to transfer funds to (perceived) safer investments; with as much FDIC and SPIC coverage as possible, breaking down amounts by bank and broker etc. For a retail trader without millions of dollars, it’s prudent and achievable to break down assets by bank and broker and type to maximize quasi-government protection. For example, break down bank accounts to under $100,000 each per person in your family. Break down IRA accounts to $250,000 per institution and maybe rollover parts of IRAs into Mini 401(k) plans, as employee benefit plans have a separate $250,000 of coverage from IRAs. Today’s New York Times (see below link) had a good article on money market accounts at banks versus funds and the differences in protection and risk for “breaking the buck” (having a market loss).
When it comes to your own money, you can take action based on your risk profile. But, what are your responsibilities as an investment manager to your clients; managed accounts versus hedge fund or commodity or forex pools? For managed accounts, you primarily initiate trades under power of attorney, and the responsibility for protection of client funds rests with that client in choosing their broker or FCM. Related risks for hedge fund managers appear far greater, as they are responsible for the investment pool and choosing and monitoring the broker.
Brent Gillett, JD will explain these differences and risks associated with prime broker failures; which accounts are insured, and which are not, for how much, etc.
Doug Nelson, CEO of Northpoint Trading, an introducing broker to Goldman Sachs prime brokerage, will report from the trenches on what’s been happening this week, and what managers can do to protect their clients and themselves going forward.
Remember the Refco bankruptcy and how managers had funds frozen for months. Suppose you have significant long and short positions and you lose access to your trading account for some time. How can you liquidate those positions and protect these assets from volatile market events?
Finally, if you are not satisfied with your risk situation (AND RISK COUNTS!), and don’t feel that you can sufficiently protect your clients (and your own funds), maybe it’s wise to redeem investment funds to your clients – to protect themselves - and tell them you want to wait for the dust to settle in this market crisis before asking for their money back; to resume your normal investment program. After all, is your investment program set up to work in a financial crisis anyway? The risk is that redeemed money will never return, but neither will money lost in the market (or unprotected brokerage failure) either. Do the right thing!
Can managers get insurance for themselves to protect themselves from these risks?
Let’s discuss this all on our conference calls (9/18/08 at 4:15 pm ET, see www.greencompany.com/EducationCenter/InteractiveOnlineMeetings.shtml ) and bring your stories to share with us too.
Links:
Visit your brokerage firm's Website and there should be information about asset protection; mostly likely on their home page now. For example, see http://www.schwab.com/public/schwab/nn/legal_compliance/asset_protection.html?cmsid=P-2466992&lvl1=nn&lvl2=legal_compliance&refid=P-2778796&refpid=P-997178 .
Wall Street Journal, 9/18/08: Your Cash: How Safe Is Safe?
Savers Find Ways to Boost Their Deposit Insurance;
PODs, CDARS and CDs
http://online.wsj.com/article/SB122169783324750379.html
Excerpts:
"One product that has been attracting attention lately is an informal trust account known as a "payable on death," or POD, account. To set up a POD account, depositors must name a beneficiary or beneficiaries who will receive money if the primary account holder dies. For each qualified beneficiary, the FDIC will boost insurance coverage by up to $100,000."
"Brokered CDs. Buying multiple certificates of deposit at once through a brokerage firm provides a fast way to spread out money across different institutions, capturing the full FDIC protection."
"CDARS. This deposit-placement service, short for Certificate of Deposit Account Registry Service, disperses deposits into different individual CDs of up to $100,000 each, up to a maximum covered amount of $50 million."
"Joint accounts. Deposit accounts owned by two or more people are insured up to $100,000 for each account holder listed."
"Credit unions. Deposit insurance for credit unions works in much the same way as FDIC insurance does for banks and thrifts, except that the funds are insured by the National Credit Union Share Insurance Fund."
FDIC Edie the Estimator
http://www2.fdic.gov/EDIE/
NY Times 9/18/08: Money Market Funds Enter a World of Risk
http://www.nytimes.com/2008/09/18/business/yourmoney/18money.html?_r=1&hp&oref=slogin
CNBC On The Money 9/17/08: Q&A: Keeping Your Money Safe Right Now
http://www.cnbc.com/id/26762171/site/14081545/
January 10, 2008
“Tax Reduction and Reform Act of 2007” (H.R. 3970)
The “Tax Reduction and Reform Act of 2007” (H.R. 3970) is still on the table. If enacted, it could have profound tax consequences for traders.
By Robert A. Green, CPA
You all know the popular line, “There are two things that are certain in life: death and taxes.”
There is another certainty this coming year and that is that Democrats and Republicans will wage a tax war and make it a key element in defining their differences in connection with the hotly contest 2008 Presidential election.
President Bush and the Republicans have enjoyed eight years of free reign to adopt their tax cuts, including lowering (and hopefully repealing) taxes on savings and investment income (dividends and long-term capital gains).
In November 2006, during the mid-term elections, the Democrats finally won control of both houses of Congress and they took over the bully pulpit.
Newly elected Chairman of the House Ways and Means Committee Charlie Rangel (D.-NY) crafted H.R. 3970, the “Tax Reduction and Reform Act of 2007” (introduced on Oct. 25, 2007).
In H.R. 3970, Chairman Rangel was able to showcase many of the fiscal (tax) values currently advocated by the Democrats.
Political tax maneuvering
First and foremost, Democrats want to cast off their prior image of tax raisers and spenders to become the better party of fiscal conservatism.
Democrats have cried foul about huge increases in the budget deficit since President Bush inherited surpluses from former President Bill Clinton.
The first tax mantra from controlling Democrats after November 2006 was their new creed of “pay go” – paying for tax cuts with tax increases and spending cuts.
Next up were Democratic suggestions for middle-class tax cuts, paid for by tax increases on the rich, with a combination of repeals, expiration of Bush tax cuts and more. Democrats also want some spending cuts, such as in defense and ending the costly Iraq War.
The poster boy for tax change is the Alternative Minimum Tax (AMT) and it’s the cornerstone of the “Tax Reduction and Reform Act of 2007.”
AMT is certainly broken, and taxpayers resent this nasty stealth tax. H.R. 3970 purports to repeal AMT.
Chairman Rangel crafted H.R. 3970 in a clever but antagonizing way to Republican leadership. The bill repeals AMT, but replaces it with new taxes on the rich and many other important repeals and changes.
H.R. 3970 probably has no chance of passage until 2009
President Bush has stated on multiple occasions that he will veto any new tax increases on the rich, specifically the ones in H.R. 3970.
This gives good reason to believe that H.R. 3970 will be effectively “dead on arrival” until there is a new President in the White House in January 2009, assuming Democrats keep control of both the Senate and House.
The last minute AMT patch for 2007 was passed without “pay go”
While H.R. 3970 caused great rancor between the parties, AMT was slated to snag 21 million Americans in 2007, drastically up from only 4 million Americans in 2006.
The structural and simple problem is that AMT is not indexed for inflation, whereas regular taxes are, so AMT bracket creep grabs more middle-class Americans each year.
The perverse problem is that AMT was targeted against the rich, but the rich for the most part no longer pay AMT. That’s because the rich pay so many taxes at the highest tax rates (up to 35 percent in 2007) and the highest AMT rate is far less (up to 28 percent in 2007).
Within just five days of introducing H.R. 3970, Chairman Rangel introduced H.R. 3996, the “Temporary Tax Relief Act of 2007.”
Chairman Rangel included “pay go” in H.R. 3996 (just as he had in H.R. 3970), calling for a repeal of “carried interest” tax breaks for investment managers.
After much fanfare, the Senate sided with the Republicans and President Bush to insist on another annual AMT patch (for 2007), without any new tax increases.
So where do we stand now?
The tax debate was punted down the road and it’s still contained in H.R. 3970, which remains on the table.
So it’s important to focus on the tax changes contained in H.R. 3970.
Current political pundits are forecasting good odds for a Democrat to win the Presidency; probably Senator Obama or Senator Hillary Clinton.
This writer believes that H.R. 3970 was crafted by Chairman Rangel while he was in communication with Senator Hillary Clinton (they both serve in NY and are long-time friends).
If Senator Obama wins the presidency, H.R. 3970 also nicely dovetails with his big tax initiative to expand the payroll tax base significantly or to an unlimited amount. See the S-Corp tax break repeal for owner compensation below.
Higher social security taxes
Senator Obama’s main tax proposal is to significantly expand the social security tax (of 12.4 percent) applied against the base amount ($102,000 in 2008) to a much higher base amount or even unlimited.
This is very similar to changes made in the 1990s, created by then-first lady Hillary Clinton.
In the 1990s, the Medicare tax portion (2.9 percent) of the payroll tax of 15.3 percent was decoupled from the payroll tax base, meaning it applies to an unlimited amount of earned income and wages.
Senator Obama proposes to do a similar change with the social security portion (12.4 percent) – to either raise the base amount significantly or to make it apply to an unlimited amount (phased-in over several years). Expect a firestorm here as well. Raising the base amount only (to a reasonable amount) is more palatable.
Good news for traders: Their trading gains are exempt from these payroll or self-employment (SE) taxes, unless they trade IRC 1256 contracts as a member of an options or futures exchange (in which case it is earned income IRC 1402i).
H.R. 3970 summary of tax law changes
See a summary of H.R. 3970 on the Internet by searching for “HR 3970.”
Repealing AMT entirely is the poster boy for H.R. 3970.
In my view, this is not really a true repeal of AMT.
Rather, it extricates the middle-class from AMT and pays for it with a new “surcharge” and itemized deduction phase-outs on upper-income taxpayers.
Again, upper-income taxpayers were not paying AMT with their higher taxes paid vs. the 28-percent AMT rate and H.R. 3970 cleverly passes the AMT load from middle-income to upper-income taxpayers.
This is a little sneaky. AMT should be repealed for all taxpayers up and down the class-warfare ranks.
AMT was never indexed for inflation, whereas regular taxes are, and this is the fundamental problem with this tax. AMT was passed in the late 1960s to tax the rich who avoided tax with tax shelters, which were subsequently shut down anyway.
AMT is most harshly falling on taxpayers in the $200,000 to $500,000 income range.
Chairman Rangel was very clever in H.R. 3970.
The bill showcases a complete repeal of AMT (what all Americans want), yet the bill subjects upper-income people (10 percent of the highest income taxpayers and/or those earning more than $500,000 in some provisions) to a new tax “surcharge” of 4 percent to 4.6 percent.
It would be fairer to call this an “AMT pass the buck” tax, since this bill clearly passes the current AMT burden on the middle-class to upper-income taxpayers.
Phase-out itemized deductions and exemptions
H.R. 3970 also phases out itemized deductions and personal exemptions for upper-income taxpayers.
Current AMT tax law requires the add-back of several types of itemized deductions to AMT taxable income (like investment interest expense, state taxes and miscellaneous itemized deductions).
The combination of the surcharge tax on upper-income taxpayers above along with this phase-out of itemized deductions again points out how this is truly a passing of the AMT tax buck to upper-income taxpayers.
But there’s good news for business traders: Most of their trading-related expenses are deducted as business expenses and not itemized deductions.
Repeal of the carried interest and deferred compensation tax breaks
Current tax law allows investment managers to receive a “profit allocation” of capital gains rather than investment fees.
Profit allocation or carried-interest gains (depending on the underlying income) can be taxed at lower long-term capital gains tax rates, or with 60/40 futures tax rates, and they are also not subject to payroll/SE taxes.
H.R. 3970 re-characterizes these carried interests as ordinary fee income, which subjects this income to ordinary income tax rates and payroll/SE tax.
The bill also repeals deferred compensation tax breaks for managers of offshore funds and corporations.
Along the same lines, this bill takes away the incentive for U.S. tax-free institutions (such as pension funds, universities and charities) to invest in offshore funds instead of domestic funds. Current tax law subjects them to UBIT taxes on domestic funds only and that will no longer apply with H.R. 3970.
S-Corps can’t reduce SE tax
S-Corps will no longer have an edge in reducing SE tax vs. LLCs, partnerships and sole proprietorships (where SE tax is unavoidable for service companies).
In current law, an owner/manager of an S-Corp in a service business passes through income that is not subject to SE tax. Conversely, with LLCs, partnerships and sole-proprietorships, this earned income passes through to the owner for purposes of SE tax.
S-Corps can’t avoid SE tax entirely. The IRS requires S-Corps to pay reasonable compensation to its owner/managers, which is subject to SE tax.
H.R. 3970 puts S-Corps on a level playing field with LLCs, partnerships and sole proprietorships. All S-Corp earned income will pass through as earned income to owners, whether or not they have a salary or a fee.
This is not very bad news for traders. Their trading gains are not earned income, unless they are a IRC 1256 trader/member of an options or futures exchange. So their S-Corp income can still pass through to their individual tax returns without triggering SE tax.
Business traders can use strategies to create earned income with an entity to have the opportunity to contribute funds to a tax-deductible retirement plan. This is usually done in a way that saves more in income taxes than it costs in payroll/SE taxes.
Money managers face stiff tax increases in H.R. 3970
Under current tax law, many money managers receive profit allocation (carried interest) from their hedge funds, which may be long-term capital gains or 60/40 tax treatment. Plus they don’t currently owe SE tax on the profit allocation income.
H.R. 3970 would repeal carried interest; subjecting this income to higher ordinary income tax rates plus SE tax.
It’s a huge difference.
Currently, a money manager for a commodity fund owes federal taxes at 23 percent (2007 rates) using 60/40.
But with HR 3970, and other expected tax law changes like non-extension of Bush tax rate cuts, the managers taxes may rise by 258 percent to 59.3 percent (44 percent ordinary income tax rates plus 15.3% SE tax, which may be unlimited over time).
Basis reporting by brokers on sales of stock
A very important tax law change for traders in H.R. 3970 are the new rules for significantly expanding the reporting by brokers on securities traders Form 1099-Bs.
This is not an issue for futures traders; their net “Aggregate Profit and Loss” is reported on a one-page Form 1099-B.
But for securities traders the IRS has a huge problem with the lack of current reporting. That’s because current rules only require that brokers report proceeds on the sale of stock. Brokers don’t have to currently report option sales and purchases, securities purchases or gain or loss on securities transactions.
As part of the IRS’s “close the tax gap” initiative, the IRS wants to significantly improve tax information reporting on securities trading activities from brokerage firms by requiring most of the above missing items.
The IRS is rightfully concerned that many securities traders are botching their Schedule D reporting, and usually in their own favor.
In 2005, the IRS made a big stink of clarifying their Schedule D and D-1 instructions that require line-by-line reporting of securities transactions. Far too many traders were reporting one-line item summaries per broker and stating “see details on request.”
The IRS doesn’t trust taxpayers to deal with the tremendous complexities of reporting securities transactions and millions of Americans are trading hyperactively.
H.R. 3970 reinforces several earlier 2007 tax bill initiatives (H.R. 878 and S. 601, and even President Bush’s 2008 Budget) to create mandatory cost basis reporting by brokers for transactions involving publicly traded securities.
The bill also requires brokers to report “adjusted cost basis with FIFO (first in first out) method unless the customer makes an adequate identification to the broker of the shares he sold.”
The bill also requires brokers to report “…whether any gain or loss as a result of the transaction is short- or long term.”
At committee hearings in May, there was much industry criticism about the new reporting burdens this will place on brokerage firms.
Placing undue added burdens on smaller brokerage firms during a possible slow down or recession may be a tough provision to pass. The largest full service brokerage firms already provide their customers with realized gain or loss reports and they will have a much easier time here with enhanced 1099-B reporting.
I believe the new rules will significantly expand what’s reportable to the IRS, but it will fall far short of 100-percent reporting. That means that Form 1099-Bs for securities traders will not provide an adequate report for attaching to a Schedule D.
Securities traders will mostly likely still need good industry third-party software for securities trading gains and losses. Wash-sale reporting must be done across brokerage accounts and brokers can’t do this.
These changes are not scheduled to begin (with phased deployment) until 2009.
One-year extenders & miscellaneous other provisions
As has generally been the case for the past few years, with great gridlock in Congress, H.R. 3970 includes many “One-Year Extenders.”
The tax game seems to be to pass major new legislation when one party dominates all branches of government and to just punt short-term changes down the road until you can hit a home run.
We need more baseball-type singles and lasting legislation that one can count and plan on.
There are some “General Tax Reductions” in HR 3970 too.
The bill has an increase in the standard deduction. This does not help people who itemize their deductions, including mortgage interest, real estate taxes, state income taxes, charitable contributions and miscellaneous deductions (investment expenses). Rather, it mostly helps lower middle-class people.
The bill expands the earned income credit and refundable child credit. This also only helps lower middle-class and the poor.
Lower corporate tax rates
Reducing top corporate tax rates to 30.5 percent from 35 percent was a welcomed surprise from the Democrats in H.R. 3970.
But to pay for it, the bill also captures more taxation on foreign earnings in several ways. That may be a good thing, considering that America’s corporations may be making more profits abroad, with our current slowdown in America underway.
With the growing divergence in individual versus corporate tax rates, many taxpayers may want to reconsider C-Corporations to park more profits in C-Corps taxed at lower tax rates.
Traders usually avoid C-Corps because of double taxation, no 60/40 treatment and other limitations. Adding a C-Corp to the mix, along with an LLC, partnership or S-Corp, may be useful and requires further study.
But is H.R. 3970 going to be a Trojan horse tax trap?
Individual tax rates go up to approximately 44 percent in H.R. 3970, after you count in the 4-percent “surcharge” and denying extensions to the Bush tax cuts (regular increase in rates).
Plus you need to consider Senator Obama’s 15.3-percent SE tax proposal possibly applying to unlimited earned income.
That means federal tax rates can approach 59 percent. By the way, add state tax rates, sales taxes, and real estate taxes, and you are well over 70 percent.
If you earn money in a C-Corp, your top tax rate is 30.5 percent and you are often free of the SE tax, too.
But is it going to be 30.5 percent vs. 59 percent?
The Trojan horse is not extending the Bush tax cuts on “qualifying dividends” (currently taxed at 15 percent) and forcing taxpayers into double taxation. That’s 30.5 percent plus 59 percent.
Stay tuned!