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Trader tax & carried interest updates

GreenTraderTax | Thu, 08/06/2009 - 1:29pm | Trader tax & carried interest |  Add a comment

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April 28, 2009

First article of a multi-article series.

The IRS is turning up the heat on traders, small business taxpayers, the upper-income class, pass-through entities, Nevada C-Corps, offshore entities, and more. Trader tax status is under attack and I’m guessing Congress may even rethink opening Section 475 to traders (for huge ordinary loss treatment — it only applied to dealers before 1997). The U.S. Treasury simply can’t afford to pay all qualifying traders refunds for their losses and expenses. The easiest out is to raise the qualification. Hopefully, Congress won’t repeal Section 475 MTM for traders and pass the dreaded financial-transaction tax (see several links in archives and the first here http://www.greencompany.com/blog/index.php?postid=12) .

All in all, traders should fare better than other types of business and non-business taxpayers. Don’t skip trader tax status when you safely qualify for it. Also, don’t miss out on important Section 475 MTM and Section 988 to Section 1256g forex elections. Play it smart with your carry back and carry forward strategies.

With tax rates headed higher, not claiming and electing your rightful trader tax breaks can cost you an even higher fortune (maybe up to half your trading losses). Today, I take a look at new issues on the horizon for traders.

Carried interest being repealed
Senate and House conferees have agreed upon the 2010 Obama Budget. But the President hasn't signed it yet and much of the legislation (detail) language is not yet done. Sometimes, the devil is in the details. See the Green Book discussion in later blog posts in mid May.

The carried interest tax break was repealed in the 2010 Obama Budget, and its detailed language is not yet formalized. Our below content is based on the proposed language and we expect it to happen as planned. We also expect that there will be a fight behind the scenes from the hedge fund and private equity industries.

For the past several decades, hedge-fund managers structured their incentive fees as “carried interest” (otherwise known as “profit allocation”) in their managed funds.

The purpose was to recharacterize their incentive fees as a share of trading gains on Schedule K-1s, rather than as additional advisory fees which are treated as earned income subject to ordinary income tax rates and self-employment (SE) tax. A long-standing IRS audit manual said to challenge this treatment, but it was rarely challenged.

Passage of the new 2010 budget law is expected to repeal carried interest tax breaks for investment managers. Final reconciliation steps are underway as of this writing and both the Senate and House have already agreed-upon this repeal. The Green Book released on May 11, 2009 indicates the effective date is 2011.

Investment managers with profit allocation in a commodity pool or forex fund will face steep tax increases with the repeal of carried interest tax breaks. Currently, they enjoy lower 60/40 tax rates with a blended maximum rate of 23 percent, and they are exempt from SE tax.

The change will bring a rise in income tax rates (12 percent) and investment managers are subject to SE taxes of 15.3 percent on the base amount ($106,800) and 2.9 percent over the base amount. If the base amount is re-established over $250,000, the tax is much more.

Because of this repeal, it may be less costly overall to operate a managed account business and pay the added compliance costs of operating an investment pool.

It’s important to note that carried interest treatment remains for the investor, which in some cases is still preferable. Having a lower capital gain after the profit allocation is better than a higher gain and non-deductible investment expenses for incentive fees (not deducted due to AMT or otherwise).

Per RIA on April 9, 2009, ..."Bill to tax “carried interest” as ordinary income introduced in House. On Apr. 3, House Ways and Means Committee member Rep. Sander Levine (D-MI) introduced a bill to tax at ordinary income rates income received by partners for performing investment management services for a partnership. The provision is aimed at “carried interest,” or a share in the fund's profits—an important part of the incentive package of partner-managers of investment funds structured as partnerships. In exchange for providing the service of managing their investors' assets, fund managers often receive a portion (usually 20%) of the fund's profits (carried interest). Under current law, partner-managers treat their carried interest as low-taxed long-term capital gain. However, under the bill, the capital gains rate would continue to apply to the extent that managers' income represents a reasonable return on capital they have invested in the partnership."

"The bill would clarify that any income received from a partnership, capital or otherwise, in compensation for services provided by the employee is subject to ordinary tax rates. Managers of investment partnerships who receive a carried interest as compensation would have to pay regular income tax rates rather than capital gains rates on that compensation."

"Levin had previously introduced similar legislation in the 110th Congress, which was later included in several tax packages approved by the Ways & Means Committee and the House of Representatives. A similar proposal was also included in President Obama's FY 2010 budget request."

Click http://www.govtrack.us/congress/bill.xpd?bill=h111-1935 for the text of H.R. 1935, a bill to provide for the treatment of partnership interests held by partners providing services, introduced by Rep. Levin.

Click http://www.house.gov/apps/list/press/mi12_levin/PR040309.shtml for the text of a press release with background information on the carried interest bill introduced by Rep. Levin.

Other changes

We don't see the SE tax break in S-Corps repealed in the 2010 Obama Budget. This repeal was proposed in H.R. 3970 in early 2008. See http://www.greencompany.com/blog/index.php?postid=6 . This omission may provide some relief to investment managers to deflect some SE tax caused by the repeal of carried interest tax breaks. LLCs can elect S-Corp status; which can be filed late with relief.

Long-term capital gains tax rates are scheduled to rise to 20 percent from 15 percent, on the upper income tax brackets, as the Bush tax cuts expire at the end of 2010.

Close the gap
In other news, the Treasury is trying to close the gap on tax cheating and other forms of inadvertent non-compliance, caused by convoluted IRS laws, 1099 reporting oversights, and a litany of complex tax loopholes. Trade accounting is complex with wash sales, straddles, LIFO vs. specific identification, securities vs. futures, and much more.

Brokers only issue Form 1099s to the IRS (and taxpayers) for “covered securities” which leaves out a large portion of trading transactions (options, single-stock futures and more). Covered securities currently only include reporting proceeds on securities — not trading gains or losses on securities.

Form 1099 futures reporting is much clearer, partially because mark-to-market (MTM) accounting (imputed gains and losses at year end on open positions) is built into Section 1256. A futures 1099 reports one net gain or loss number. But some brokers leave out commissions and options on futures too, as well as other types of instruments that can use futures tax treatment. It becomes a huge mess without proper software (such as TradeLog from Armen Computing http://www.greencompany.com/Traders/Software.shtml ). Forex trading is also not covered on 1099-B reporting. Only a few brokers issue a 1099 for forex and they should not.

The first close-the-gap initiative passed includes new “cost basis” 1099-B reporting rules. Unfortunately, the new rules only add holding period and average cost basis, and they still leave a large number of instruments out of covered securities. Accounting messes continue. (Software such as TradeLog remains the only viable solution for securities.)

Traders also botch or cheat on key tax elections
Another concern is that key elections for trader tax treatment — including Section 475 MTM ordinary loss treatment on securities and futures, and the Section 988 capital gains election for forex — are confusing and not monitored properly by the IRS. The IRS wants to flush this out with more exams too.

Section 475 MTM elections are required to be filed externally for existing taxpayers. Recent reports from Washington DC indicate the IRS seems to have botched its archive system for proving MTM elections. You may be able to show you filed an extension on time, but the IRS seems to have a hard time proving the Section 475 MTM election was attached to the extension. To rectify this, the IRS asks for a signed perjury statement indicating you filed it on time. This statement should be included with the Form 3115 filing mailed in the next tax year.

Far too many tax-court cases that have denied trader tax status were focused on improper Section 475 MTM elections (such as the Holsigner and Chen cases).

Once a trader loses MTM ordinary loss treatment (which is easy for the IRS to prove when botched), the trader often caves on trader tax status, because it usually involves a much smaller tax consequence.

Forex traders also abuse the tax system with ordinary loss treatment in 988 and futures 1256g treatment for lower 60/40 rates on gains.

We expect more changes from the IRS on elections. The IRS was supposed to provide a tax form for electing Section 475 MTM and they may require external elections for forex capital gains too.

Tax rates are headed up
The new Democratic Obama Administration in lock step with a Democratic-controlled Congress should be successful in raising all sorts of tax rates and base amounts (income, payroll, estate, and carbon) — especially on the upper-income, global corporations, and the trader/investor-class.

Blue dog democrats and a professed fiscally responsible administration want the taxpayer to pay for (i.e., “pay go”) its (tremendous) increases in health care, education and the environmental spending. The rally cry: “It’s time for the rich who made out like bandits in the Bush years to pay their fair share.”

It’s an admirable social/green agenda, but it’s going to be costly. The U.S. is coordinating with the EU and others to raise taxes, close loopholes, and increase regulation.

The UK continues to use its financial-transaction tax; I hope U.S. congressmen don’t seek to copy them. An increasing number of left-leaning congressmen from non-financial market states are advocating the 0.25 percent financial-transaction tax (see blog archive) on most financial transactions (buy and sell) to pay for the Wall Street bailout and the ravages of “casino capitalism” in general.

The UK just passed a 10-percent tax increase, raising its highest bracket to 50 percent.

Traders can’t use their rallying cry that financial service jobs will move to London and London traders can’t say the same thing about New York. Tax policy coordination is becoming like currency coordination.

Everywhere you look you see higher federal and state taxes coming down the pike and it’s important for traders to navigate this minefield as best they can.

Yes, you can move to a lower-taxing or no-individual income tax state (Texas, Florida and Nevada), but it may not help much to move abroad (especially if you retain citizenship or a greencard — which may be a good idea to surrender if you don’t need it anymore).

U.S. tax rates: Low or high?
Current tax rates may seem fairly low. After all, federal income tax rates in the highest bracket are only 35 percent. But this is deceptive. It’s different than in the EU, where higher rates are what they appear. In the EU, tax rates may be 50 percent, but that can be the most taxes a citizen pays at the highest bracket. In the EU, the price on a restaurant’s menu is the total price. In America, you need to add tax and tip.

Count up all the taxes in America and you will most likely surpass the highest taxes paid in the EU. Published federal tax rates can be a mirage after you add phased out deductions, restrictions on losses and expenses, AMT taxes and more.

Plus, throw in payroll and/or SE taxes, state and local income taxes, sales taxes and property taxes. All of these things considered could put the U.S. equal to or higher than the EU’s tax rates.

Taxes are especially high in New York City or California. NYC also has a 4-percent unincorporated business tax (luckily traders can be exempt from that in the right structure).

Despite the evidence, politicians argue income tax rates are at historically low levels and its okay to raise them in all sorts of ways. After the Bush tax cuts expire at the end of 2010, the highest tax rate will rise 4.6 percent to 39.6 percent. In 2008, Democrats proposed a 5-percent surcharge (on the highest bracket of income tax rates) to pay for the repeal of AMT. Perhaps a surcharge will be called upon to pay for health care. I would not be surprised to see the highest federal bracket at 45 percent.

President Obama campaigned for raising the payroll tax base on all earned income over $250,000 for an additional 12.4 percent tax increase on the upper income. That group’s total tax could approach 58 percent.

State and local income tax rates are also skyrocketing as a last resort to avoid crushing state budget deficits and even insolvency in California, New York, and other states too.

Changes for NOL reporting
It’s wise to elect Section 475f MTM accounting in years you may experience large trading losses in order to carry back a net operating loss (NOL) for immediate tax refunds. That’s what NOL law is intended to do for businesses.

For the 2008 tax year only, the NOL two-year carry back rule may be expanded to up to five years. There is a 15-million dollar revenues test to go beyond two years, up to five years, in order to limit this tax benefit to small businesses. But this revenues test is not a problem for traders, as trading proceeds are not revenue — net gains or losses are the revenue number for this test and therefore all business traders should qualify for the longer NOL carry back period. This is a welcomed tax change for traders.

Bottom line
There are plenty of tax changes on the horizon. We’ll be sure to keep you up-to-date on the latest proposed legislation and what it could mean for you. Check back soon for commentary on a new group of traders: those born from the recession. We’ll provide tips for this group on forming an entity and deducting start-up costs.

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