Protect yourself from market losses with a Section 475 MTM election
By Robert A. Green CPA
Forbes blog version: Save On Taxes If You Make 1,000 Trades A Year.
As the dot-com bust and tech wreck unfolded in 2000, we preached the importance of Section 475 MTM elections to business traders for "tax-loss" insurance. We knew when the markets inevitably turned bearish, many traders would incur huge trading losses. This election means losses are considered business ordinary losses; without it, the losses are capital losses limited to $3,000 against ordinary income per year.
Business ordinary losses can be monetized into tax refunds quickly, whereas capital loss carryforwards often take a long time to monetize — sometimes a decade or more. Traders want immediate tax refunds to replenish their trading capital. Otherwise, they may have little capital left to generate capital gains.
Based on 30 years of experience working closely with traders, we know there are huge swings in bull and bear markets. We've seen clients make a lot of money in a few years and lose a lot in a subsequent year. Traders need to be able to carry back losses and that can't be done on securities unless Section 475 is used. Futures traders can carry back Section 1256 contract losses three years but only against Section 1256 contract gains.
A worst-case scenario in the 2000 tech wreck: Several securities traders made $500,000 in 1999 and lost it all in Q1 2000. They lost their 1999 taxes due in Q1 2000 and they missed the Section 475 MTM election by April 15, 2000. They couldn't pay the IRS for 1999 gains and they got stuck with a capital loss carryover for 2000, which they couldn't monetize since they had no capital left to trade. With a simple 2000 Section 475 election, they could have filed a net operating loss (NOL) carryback wiping out their 1999 tax debt. They would have been square with the IRS.
Why talk about 1999/2000? Because it feels like similar market conditions are developing now. 2013 was a big income year for traders and Q1 2014 started off rocky. Consider the rush of tech/mobile/gaming IPOs; CNBC's Jim Cramer says its Deja vu with the dot-com and tech wreck of 1999/2000. There could be a big correction or bear market later this year.
This past week I consulted with a client on a potential worst-case scenario for 2013/2014. He broke even for 2013 but said TradeLog shows over $1 million of wash sales deferred to 2014. That presents a huge 2013 tax liability on phantom income and he already lost all that tax money and more in Q1 2014.
Luckily, he came to us in time — he will file a Section 475 election by April 15, 2014. The required Section 481a adjustment turns deferred wash sales on year-end 2013 business positions into business ordinary losses on Jan. 1, 2014. The important challenge for him is to maintain his trader tax status in 2014 so he can use Section 475. We suggested filing a 2013 Form 9465 Installment Agreement Request including a note that taxpayer expects to file an NOL carryback wiping out his 2013 tax debt.
Section 475 is free to elect, which is why we call it free tax-loss insurance. While it costs money to switch back to the cash method, traders rarely do that — they just exit their trading activity, thereby suspending Section 475. We recommend section 475 on securities only; you want to retain the lower 60/40 tax rates on 1256 contracts.
Be careful to segregate your investments so 475 won't apply on those investments and you can hold them for lower long-term capital gains rates. Section 475 marks to market open business positions at year-end, but not investment positions.
Only business traders qualifying for trader tax status may use Section 475. The main requirement is 1,000 trade volume per year (annualized) and frequency over 75% of available trading days with trade executions.
Existing taxpayer individuals and partnerships file Section 475 elections by April 15, 2014. Attach the election statement to your 2013 tax return or extension. The second step is to perfect the election with a 2014 Form 3115 (change of accounting method) filed with your 2014 tax return. New taxpayers/new entities may adopt 475 within 75 days of inception by filing an internal resolution.
There are many nuances and misconceptions about section 475; read about them in Green's 2014 Trader Tax Guide.
It’s important to run Tradelog software to determine your trading gains and losses for 2013 and 2014 year to date. Turn on the Section 475 MTM election within Tradelog software for 2014, and the program will calculate the Section 481a adjustment for January 1, 2014.
If you have a large trading loss for Q1 2014, and also a large capital loss carryover, it’s probably wise to make the Section 475 MTM election to lock in the 2014 loss as ordinary. Resume trading in a new entity with capital gains treatment so you can use up the capital loss carryovers.
Not sure what to do? Consider a 30-minute consultation with Robert A. Green, CPA.
If the music stops in the markets, don't be caught without a chair to sit on — Section 475 may be just the chair for you. February 27, 2014
Another trader tax court loss (Assaderaghi)
By Robert A. Green, CPA
Forbes blog (same article, but different heading): Knowing The Rules Keeps Traders Out Of Tax Trouble
The IRS is piling up victories in tax court against individual traders who inappropriately use Section 475 MTM business ordinary loss treatment for deducting large trading losses. Fariborz Assaderaghi & Miao-Fen Lin v. Commissioner is yet another IRS win that can be added to the list. According to Tax Analysts, “The Tax Court held that a husband's trading activity in securities didn't constitute a trade or business and, thus, he wasn't eligible for a mark-to-market accounting method election under section 475(f) and the couple was limited to a $3,000 deduction of losses from the purchase and sale of securities under section 1211(b) for each year at issue.”
Only traders who qualify for trader tax status (Schedule C business expenses) may elect and use Section 475. Lots is at stake since without trader tax status or a timely Section 475 MTM election, traders are forced to use a puny $3,000 capital loss limitation against other income.
We agree with the IRS that Assaderaghi did not qualify for trader tax status in any of the years examined. Assaderaghi had many day trades, and he used professional trading equipment and charts. But he had a demanding full-time career as an engineer/executive and the IRS is more skeptical toward part-time traders claiming trader tax status. Assaderaghi was unable to prove his hours spent in trading and his evidence lacked credibility in the eyes of the IRS and tax court.
Most importantly, Assaderaghi came up short on meeting our golden rules for 2008, the one year he had a chance to qualify for trader tax status. He had 535 trades and our golden rules call for 1,000 total trades. He traded just over 60% of available trading days and our golden rules call for trade executions on 75% of available trading days. In the other years examined, he came up far short of trader tax status and when you view the years together it’s especially weak.
Perhaps Assaderaghi could have fought harder to win trader tax status in 2008, and concede the other years, but that is generally not the main issue. A bigger issue is filing a timely Section 475 MTM election and Assaderaghi and his accountant did not do that. It’s significant since Assaderaghi’s CPA deducted $374,000 in trading losses for his 2008 Schedule C, but the IRS forced them to use a puny $3,000 capital loss limitation instead. Once again, a trader and professional go to tax court with a clear losing case on technical grounds, missing or botching a Section 475 MTM election, and there is nothing that can be done about it. They wasted their money and effort in tax court.
Assaderaghi made some tragic rookie tax mistakes which sealed his fate as a loser with the IRS. He made the common mistake of asking his local CPA tax preparer to elect trader tax status and Section 475 MTM, but after not getting an answer from his CPA, he didn’t do anything about it. His accountant was clueless about trader tax benefits and rules — which is sadly still often the case. When it comes to timely Section 475 elections, there is no excuse allowed for relying on an accountant, and there is no IRS relief. The IRS is lenient on many things, but not Section 475.
His accountant grasped the idea of trading as a business — filing a Schedule C — but he jumped to the tragic conclusion that he could simply report trading gains and losses on schedule C like other types of businesses. He should have filed a timely election for Section 475 and reported trading gains and losses on Form 4797 Part II with ordinary gain and loss treatment. It’s clear the accountant did not know that Section 475 MTM had to be elected by April 15, 2008 for 2008 or perfected with a 2008 Form 3115 change of accounting filed in 2009 with the 2008 tax returns. Had Assaderaghi known the golden rules, perhaps he would have traded more to meet them.
Assaderaghi’s tax return screamed for an IRS beat down. The IRS computers see trades on Schedule C and issue a tax notice because trades don’t belong on Schedule C. The IRS tries to match broker 1099-Bs to Schedule D (in 2008 and Form 8949 after 2010), Form 4797 Part II (section 475 MTM) and Form 6781 (Section 1256). The IRS agent asked the CPA preparer about his filing of a Section 475 MTM election and the CPA did not even know what the agent was talking about. Case closed — it’s a loser! You can never file a Section 475 MTM election late (or with hindsight).
Lessons learned: Learn trader tax benefits and rules with our content and hire a proven trader tax CPA like our firm Green NFH, LLC to assist you with the election, Form 3115, Form 4797 and tax return footnotes.
It’s important to note that 2014 Section 475 MTM elections are due by April 15, 2014 for individuals and existing partnerships, and March 15, 2014 for existing S-Corps. “New taxpayers” (new entities) file a Section 475 MTM election in their own books and records (internally) within 75 days of inception of the new entity formation. We recommend Section 475 MTM on securities only, so you retain lower 60/40 capital gains rates on Section 1256 contracts like futures. Section 475 MTM does not apply to segregated investment positions. If you have capital loss carryovers, you may want to wait until you generate more capital gains to use them up first. Section 475 is complex and nuanced, so read Green’s 2014 Trader Tax Guide Chapter 2 on Section 475 and Chapter 1 on trader tax status.
Make sure you meet our golden rules for trader tax status based on tax court cases. The Assaderaghi case does not change our golden rules. The Assaderaghi court reinforced the notion that business traders must be consistent in trading volume and frequency and avoid sporadic lapses in active trading. The tax law requires “regular, frequent and continuous trading based on daily market movements and not long-term appreciation.”
It’s wise to stop trading as an individual and form an entity that qualifies for trader tax status and files an entity business tax return that resembles many active trading hedge funds. As pointed out in Green’s 2014 Trader Tax Guide, a high ranking IRS person in the trader tax status and Section 475 area recently warned at a tax conference that the IRS is going after individual traders inappropriately using trader tax status and Section 475 MTM ordinary loss treatment. Get the help you need to be a winner.
See the Tax Analysts PDF file on this case with our yellow highlights. February 1, 2014
Net investment tax
The Patient Protection and Affordable Care Act (also known as “ObamaCare”) has many new and different types of taxes to finance the law, starting on different dates.
One of these new tax regimes — the “ObamaCare 3.8% Medicare surtax on unearned income” — affects upper-income traders and investment managers as of Jan. 1, 2013. It only applies to individuals with modified adjusted gross income (AGI) exceeding $200,000 (single), $250,000 (married filing jointly) or $125,000 (married filing separately). (Modified AGI means U.S. residents abroad must add back any foreign earned income exclusion reported on Form 2555.)
Final IRS regulations and tax form 8960 instructions were late
The IRS released its final regulations for “net investment income” (NII) and “net investment tax” (NIT) in December 2013, and draft instructions for Form 8960 (Net Investment Income Tax) in January 2014. The IRS was late because the proposed IRS regulations were highly problematic for many CPAs and industry groups who submitted comments asking the IRS for many changes. The proposed regulations disenfranchised taxpayers from deducting their losses against NII which was unfair and against the spirit of the tax code.
Thankfully, the final regulations are better. We are pleased with the results for business traders, who went from being the most disenfranchised to the most enfranchised. Unlike most taxpayers with NII, business traders may deduct trading business net losses and expenses against NII.
What’s included and excluded from NII?
Notice the term “investment income” is used in lieu of “unearned income.” People who receive “earned income” from a job pay FICA (on the social security base amount) and Medicare on their wages or self-employment income. In general, unearned income includes interest, dividends, rents, royalties, capital gains and distributions from companies in which you are passive. Now, this type of income is subject to Medicare taxes, too — albeit at upper-income brackets only.
NII’s proposed regulations interpreted the tax code to require segregation of different types of unearned income into three different buckets, for the main purpose of disenfranchising taxpayers from using losses from any given bucket. The final regs make some serious amends here and the Section 475 MTM trader fares very well...
The NII buckets include the following:
Bucket 1: Portfolio income (includes interest, dividends and annuity distributions), royalties (net of oil and gas depletion expenses) and rents (net of depreciation);
Bucket 2: Passive activity income and loss from pass-through entities;
Bucket 3: Capital gains and losses from the sale of property not used in an active business. In the final regs, the IRS moved trading businesses into bucket 3, so trading business capital gains and losses are counted with investment capital gains and losses. Smart move!.....
THERE MAY BE EVEN BETTER NEWS, TOO
The regulations state: “To minimize the inconsistencies between chapter 1 and section 1411 for traders, the final regulations assign all trading gains and trading losses to section 1411(c)(1)(A)(iii). The final regulations also permit a taxpayer to deduct excess losses from the trading business of a section 475 trader from other categories of income. Part 5.C of this preamble describes the treatment of those excess losses.”
Consider the example of a Section 475 MTM trader who arbitrages securities trades against interest income......
This is an excerpt from Chapter 15 of Green's 2014 Trader Tax Guide). Read the full chapter for further details on what's included and excluded from NII, an NIT calculation example and more. January 14, 2014
New IRS guidance on SE tax deductions affects partnership AGI-deduction strategies
By Robert A. Green, CPA & Darren Neuschwander, CPA
Update on Mar. 4: Potential solution for 50/50 HW partnership returns. In general, we recommend 50/50 as that is how married couples generally share property. Pay administration fees during the year and if you need more cash flow, the husband and wife can reinvest capital to finance ongoing fee payments. Consult with us about your administration fee agreements and payment schedules.
Update on Feb. 21: With a two-spouse partnership return, you can maximize AGI-deductions (health insurance and retirement plans) with the active-trader spouse owning just 1% (or a minority) of capital, rather than 99% (or a majority) of capital. However, that may not be feasible or wise considering joint property issues. In these cases, it’s better to consider an S-Corp election, or add a C-Corp, so the partnership can remain 50/50. Active traders owning 99% (or a majority) should consider changes soon. 2014 S-Corp elections are due by March 15, 2014. Consult with us about these changes.
Update on Jan. 24: We published Green's 2014 Trader Tax Guide). See Chapter 7 Entities & Chapter 8 Retirement Plans for our updated strategies on entities and retirement plans.
(Watch our Webinar recording on this content from Fri. Jan. 17 Click here).
Business traders reporting an administration fee on an individual tax return Schedule C paid from their trading business partnership in order to unlock AGI deductions for health insurance and retirement plan contributions need to consider some changes as a result of new IRS guidance. The IRS released draft instructions to Form 8960 (Net Investment Income Tax) in January 2014. The instructions state that trading business expenses should be deducted against self-employment income (SEI), and any excess amount generating negative SEI may be deducted against Net Investment Income (NII). These draft instructions are based on the IRS’s final NII regulations released in December 2013.
Business traders using an S-Corp or C-Corp with payroll rather than a partnership administration fee are mostly unaffected by this new IRS guidance. But partnerships need to consider these suggested solutions. We’re adopting this new guidance for 2013 tax returns and subsequent years.
The partnership fee/AGI-deduction strategy can still work on some partnership tax returns.
Prior to 2013, the simplest entity for a husband and wife was a general partnership filing a partnership tax return. To unlock AGI deductions for health insurance and retirement plans, the partnership paid an administration fee to the trading owner’s individual Schedule C, creating the earned income needed for the AGI deductions. But the trading business expenses passed through from the partnership — including the fee payment — were not included in SEI. With new IRS guidance requiring an SEI deduction for partnership expenses, it’s harder to achieve the SEI that is necessary for purposes of maximizing these AGI deductions.
Consider this example of a husband and wife 50/50 general partnership or LLC filing a partnership tax return for 2013. The partnership has trading business expenses of $20,000 before paying an administration fee to the husband, who is the active trader (assume the wife is non-active). Before the new IRS guidance, the partnership could pay an administration fee of $30,000 to the husband to cover AGI deductions for health insurance (close to $12,000) and Individual 401(k) elective deferral ($17,500). Now, the partnership needs to gross up the fee to cover the husband's 50% share of partnership Schedule E SEI deductions. Therefore, the partnership needs to pay a fee of $80,000 to have a net SEI of $30,000. Fifty percent of the trading partnership’s loss (equal to $50,000 in this example) from trading business expenses ($100,000) is allocated to the husband. (The $100,000 is comprised of the $20,000 expenses and $80,000 fee.) The wife's 50% allocation with negative SEI has no effect, as SEI and SE tax is calculated separately.
This change is not as simple as it may sound. The partnership needs to generate more income to justify a higher fee — an increase of $50,000 — and it needs the cash flow to execute it. If the husband owned a lower percentage of the partnership, the fee increase can be lower. But, in many HWGP entities, the non-active owner holds 1% of profit and loss, and that is a problem for this potential solution. They should consider changing to 50/50 or even 20/80.
If you want net SEI of $30,000, calculate the fee payment as follows. Trading expenses x allocation percentage = a negative SEI. You want to add an amount to get to $30,000 positive SEI and divide it by the other spouse's allocation percentage to get the administration fee amount. For example, with 20/80, the negative SEI is: $20,000 x 20% = ($4,000). To get to the target $30,000 SEI, pay $34,000. Next, gross up $34,000 by dividing it by 80% which equals the administration fee of $42,500 (and is only $12,500 more than the $30,000 target). Total expenses are $62,500 ($20,000 expenses + $42,500 fee). Total expenses x the 20% allocation = a negative SEI of ($12,500) + the administration fee of $42,500 = target SEI of $30,000.
If the above partnership approach doesn’t work for you, arrange salary not administration fees
The key issue for claiming health insurance and retirement plan deductions is to arrange these employee benefits in connection with a salary. The IRS does not allow partnership tax returns to pay a salary (payroll) to owners; it requires guaranteed payments or administration fees. The solution is to convert an LLC or a general partnership to an S-Corp, or add a C-Corp as a 1% partner, because an S-Corp or C-Corp pay salary to owner/employees.
An existing general partnership or multi-member LLC filing a partnership return can elect to be taxed as an S-Corp for 2014, by filing a federal Form 2553 S-Corp election by March 15, 2014. Some states rely on the federal form and other states have their own election form. Very few states don’t conform to federal “check the box regulations” allowing general partnerships or LLCs to elect S-Corp tax treatment. Consult with us about whether an S-Corp election is beneficial for you, and allowed in your state.
These solutions are less disruptive and lower in cost than opening, and closing entities. You can keep your existing trading business, including its trading accounts and bank accounts, in place.
S-Corp tax treatment is inappropriate for a hedge fund or trading company with special allocations like “carried-interest” to owners as that is considered a second class of equity and is not allowed. These types of partnerships should consider adding a C-Corp as a 1% owner.
A general partnership or multi-member LLC filing a partnership tax return can add a new C-Corp as a 1% owner of the partnership. There are few changes for the partnership: It keeps filing a partnership tax return and pays the C-Corp an administration fee and 1% or more allocation of profits. The C-Corp then has sufficient income to pay the owner a salary to unlock C-Corp-level employee benefits for health insurance and retirement plan contributions.
C-Corp owners have added benefits that are not available with partnership and S-Corp returns. The owner can have a medical reimbursement plan, which increasingly is an attractive idea considering higher deductibles and out-of-network health costs under ObamaCare plans. You can also shift individual income to lower C-Corp tax rates or operate the C-Corp close to break even if state corporate taxation is a concern.
Retirement plan changes
The other change you need to make is converting an individual-level retirement plan to the entity level. Salary-based retirement plans require entity-level retirement plans. This is fairly easy to accomplish, however some brokers may be confused about a general partnership electing S-Corp treatment, so consult with us.
For 2013, if you used a partnership and you reclassified distributions to administration fees, you may want to reclassify them back to distributions so you don’t need to file a 2013 Form 1099-Misc. by the end of February. But if you do file the 1099-Misc., it may not unlock many AGI deductions per the new guidance: The fee payments included in the partnership loss offset the fee income for both gross income and self-employment income purposes. It depends on the fee recipients share of the partnership loss.
If there is insufficient 2013 net self-employment income, you can’t fund retirement plans, so make sure there is no excess retirement plan funding for 2013 subject to IRS penalties. If you already excess funded a plan for 2013, withdraw those excessive funds as soon as possible to avoid penalties.
There’s time to fix 2014, but no time to fully fix 2013
Traders using partnerships can rearrange their tax affairs to get all the tax breaks for 2014 and subsequent years, but 2013 is a transition year so they get left holding the bag on fewer tax breaks such as no or limited AGI deductions based on their trading businesses. They do keep their business expense treatment, Section 475 and other trader tax benefits.
Unfortunately, you can’t reclassify administration fees to payroll, as payroll is a formal contemporaneous filing. It’s not a big deal to handle payroll with an outside firm like paychex.com. We have more information on these new entity strategies and how to handle payroll in Green’s 2014 Trader Tax Guide. In Chapter 7, see “New 2014 pathway towards trader tax success, including entities.”
Good news/bad news
This seems like positive news for business traders and other taxpayers, since SEI deductions are more valuable than NII deductions. SE taxes include FICA and Medicare tax, whereas Net Investment Tax (NIT) only includes the 3.8% Medicare tax. Deducting trading business expenses against self-employment income first is generally a good thing and we are not against this new guidance.
Sole proprietor traders with other earned income activities will generally be happy with this new IRS guidance. They can now deduct their trading business expenses from SEI and pay less SE tax. But they also have less earned income for retirement plan calculations.
The bad news is the new guidance causes issues for business traders using AGI-deduction strategies for health insurance and retirement plan contributions arranged through trading business partnership tax returns. Those strategies were constructed based on trading business expenses not being deductible against SEI. With the new IRS guidance, the partnership loss on Schedule E — increased by the administration fee payment — is also deductible against SEI, so the administration fee on Schedule C cannot generate positive SEI needed for the AGI deduction for a 99/1 HWGP.
Our prior position excluding trading business expenses from SEI
To date, we’ve taken the position that trading business expenses — like related trading business gains and losses — should be excluded from SEI.
While Section 1402 (SE tax rules) first state that Section 162 “trade or business” expenses for individuals and partnerships are deductible against SEI, they go on to exclude trading capital gains. IRS publications, trader tax court cases and Website statements all clearly state that business trading gains and losses are excluded from SEI. Unfortunately, we don’t see trading business expenses discussed specifically anywhere. Leading tax publishers have also said this matter was unclear in the law.
We’ve taken a conservative position: Since trading gains and losses are excluded from SEI, so should their related trading business expenses. When tax law is unclear, it’s often appropriate to turn to general tax concepts and theory, which includes a matching concept. If the income is non-taxable, generally the expenses to generate that income are also non-deductible. That’s how it works with tax-exempt income — the investment fees and margin interest to generate that income are non-deductible.
To clarify this matter, we asked an IRS official involved with the new NII regulations about these questions. The IRS person unofficially said the IRS thinks trading business expenses offset SEI first, and then NII. He pointed to example 4 in “Reg §1.1411-9. Exception for self-employment income,” which was released in December. We conclude it’s prudent to adopt this new guidance on 2013 tax filings. We believe our tax filings for 2012 and prior years are correct based on existing tax law at that time.