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Trader tax status review

GreenTraderTax | Thu, 08/06/2009 - 1:33pm |  Add a comment

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May 1, 2009

Part 4 and final blog article in this series on trader tax status.

Trader tax status is the lynchpin for many trader-tax breaks including business expense treatment vs. restricted investment expense treatment; Section 475 MTM ordinary loss treatment vs. restricted ($3,000) capital loss limitations; and AGI tax deductions, such as health insurance premiums and retirement plan deductions which are not available to investors.

However, there are many important tax breaks that don’t require qualification for trader tax status, such as lower 60/40 tax rates for futures and forex traders and exemption from the self-employment (SE) tax (with a few exceptions) on trading gains. With many tax changes looming, it’s important to note 60/40 tax breaks for traders and exemptions from the SE tax are unlikely to be repealed in the first round of tax change coming to Washington in 2009 and 2010.

Trader tax status is not for everyone
Trader tax status means a trader rises to the level of trading as a business. That unlocks business expense treatment, which is far superior in many cases (but not all) to investment expense treatment (used by investors or active traders who do not qualify for trader tax status).

Most business traders have a relatively low level of business expenses compared to other types of small businesses. Traders often work from an office within their home (saving on outside rent). They also rarely hire employees or independent contractors, thereby saving on labor costs. With these important overhead savings, trading business expenses usually range from $3,000 to $15,000; mostly for trading services, computers and other equipment. Education can be an additional expense of $5,000 to $25,000 or more. Special rules apply to deducting education expenses — see “Recession ushers in new traders” posted April 29 for details.

Only business traders can deduct home-office expenses and travel to trading seminars; investors may not. Margin interest is a fully deductible business expense with trader tax status, whereas it’s only deductible as investment interest under investor tax status. Excess investment interest expenses can be carried over to subsequent tax years.

The IRS is fighting more traders on trader tax status now, mostly when traders also elect Section 475f MTM accounting and use it to claim business ordinary loss treatment on securities trading losses (sometimes in the hundreds of thousands or dollars).

If you are a part-time trader and you don’t have many trading expenses, or you can deduct most of your general business expenses in another manner (as investment expenses without much of a haircut or in another business activity), then consider skipping trader tax status. Try to take advantage of other trading tax related benefits (such as lower 60/40 tax rates and exemption from SE taxes) instead.

In a tax-court case in the 1990s, the IRS attacked trader tax status because a taxpayer was claiming unlimited business interest expense treatment vs. what would otherwise be an interest-expense carryover. The big concern for the IRS is large reductions of taxable income, caused by Section 475 ordinary trading losses and large levels of business interest expense; both are predicated on trader tax status. Smaller levels of trading business expenses do not draw as much attention or concern.

Keep in mind excess investment interest expense and capital losses may both be carried over to subsequent tax years, so they are not officially lost. Practically speaking, they may not be very useful if the trader has little capital to risk in the markets to generate capital gains. At least interest income and dividends are investment income, which can provide the means for carryover investment interest expense deductions.

Lower 60/40 tax rates are a boon to traders
All traders and less-active investors may benefit from significantly lower income tax rates on trading Section 1256 contracts. Section 1256 contracts include regulated futures contracts, foreign currency contracts, nonequity options, dealer equity options, and dealer securities futures contracts. These contracts must generally be treated as if they are sold at fair market value on the last business day of the tax year.

Many tax professionals treat options on exchange-traded funds (ETFs) as Section 1256. ETFs are generally taxed as securities, but if they are based on commodities, they may have 1256 contract treatment too. Foreign futures may also qualify. Look for a Commodity Futures Trading Commission (CFTC) and/or IRS permission letter, which is usually published on the foreign exchange Web site.

“Substantial authority” (needed for a 2008 or 2009 tax position) exists for treating forex forwards or spot contracts (in major currencies for which the trader does not take or make delivery) as Section 1256g (60/40 treatment). A trader first needs to make a contemporaneous internal “capital gains election” to opt out of Section 988, the default ordinary gain or loss rules on forex. Forex over-the-counter (OTC) options are barred from 60/40 treatment per a 2007 IRS revenue ruling; they are reported directly on Schedule D with a capital gains election.

60/40 and tax-law changes
Currently, the highest tax rate on long-term capital gains is 15 percent, but it’s slated to rise to 20 percent in the 2010 Obama Administration budget (effective 2011). It had been scheduled to rise in this manner with the Bush tax cuts expiring at the end of 2010.

The highest tax rate on short-term capital gains — ordinary income tax rates — is 35 percent, and it’s scheduled to rise back to 39.6 percent when the Bush Administration tax cuts expire at the end of 2010.

The current highest blended rate of 60/40 is 23 percent, 12 percent less than the highest current ordinary rate. With the changes, the new highest blended rate for 60/40 will be 28 percent, still around 12 percent less than the new highest ordinary rate.

Is 60/40 safe from more changes? The 2010 Obama Budget includes a proposal to repeal 60/40 tax breaks for futures dealers (not traders). The Senate tried to repeal 60/40 in a silent last-minute attack during Senate/House conference negotiations for passage of the 2003 Bush Administration tax cut act. Luckily, the House prevailed after futures exchanges defended 60/40.

The question remains: Can President Obama justify 60/40 tax breaks, while raising taxes on many traders, the upper-income, and corporations?

Traders and the SE tax
With a few exceptions, traders are generally exempt from SE tax because trading gains are not earned income. How did this come about?

In the mid-1980s, when Congress enacted Section 1256 along with lower 60/40 tax rates, it may have acted to make up for this significant overall reduction in tax rates vs. other traders by forcing professional futures traders (most of which were on the exchange at that time) to also pay SE tax. Now, most futures traders are not members of exchanges, yet they still receive 60/40 tax breaks without having to also pay SE tax. Some futures traders join the CME as Electronic Corporate Members (ECMs). Some tax attorneys believe that this less-than-full membership does not trigger Section 1402i self-employment income.

There are a few exceptions: If you trade futures as a member of a futures or options exchange, those trading gains (net of business expenses) are deemed self-employment income (Section 1402i). Also, trading advisors who receive fees as payment rather than a share of trading profits are subject to SE taxes. This applies to investment managers in hedge funds and proprietary traders receiving a 1099-Misc. for non-employee compensation. If your trading income is subject to SE taxes, you should take advantage of adjusted gross income (AGI) deductions, in order to save on income tax (thereby offsetting some or all of the SE tax cost).

Proprietary traders who receive a Form 1099-Misc. for “non-employee compensation” also owe SE tax. Don’t feel sorry for them, though: In the proprietary trading firm model, they are allowed to use much higher leverage (which for some is very dangerous) of around 10 to 1 rather than the 4-to-1 limitation for pattern (retail) day traders.

Most legitimate proprietary trading firms are restructuring to the LLC K-1 model, where proprietary traders receive a K-1 with trading gains (not subject to SE tax) rather than reporting those gains as earned income on the 1099-Misc. I wonder if Congress will consider this K-1 income to be a form of carried interest and deny this tax break treatment. Read about the repeal of carried interest tax breaks in “Trader Tax and Carried Interest Updates” posted on April 28, 2009.

When to skip trader tax status
There are other options if you think you might not win an IRS exam of trader tax status.
If you don’t have many trading expenses and/or can deduct your general business expenses in another manner (as investment expenses or another business activity), then you probably don’t need to elect trader tax status.

Part-time traders face high IRS-scrutiny. Most have an after-tax retirement plan and health insurance benefits with their companies. So, unlike a full time trader, they don’t need trader tax status to create AGI deductions. Retirees also face higher IRS scrutiny, but many have Medicare insurance coverage and have already met their retirement plan savings needs. One strategy for this group is to trade their retirement plan actively and convert a Roth IRA in 2010, when the no-income threshold applies as the last of the Bush tax breaks. They can then trade a Roth IRA tax-free for the rest of their life.

Soon-to-be retiring or downsized business executives
Many baby-boomers are getting ready to retire or are being forced out of jobs due to their high salaries. Many have started trading stock and index options, which is ideal for their current and future needs. They can study trading at nights and on weekends, set up trades in the morning before work, and monitor and tweak positions from work. Many of these executives have won the right to use flexible time and work from home too, allowing even more freedom to build their trading business.

But these traders are facing stiff challenges from the IRS on trader tax status. The biggest problem for qualifying for trader tax status appears to be in trading options (part time or as a retiree), and executing trades on under 60 percent of available trading days.

The problem with trading options in qualifying for trader tax status is that option trading programs often do not advocate day trading. Instead, they suggest making trades with 30-day average holding periods. Options trading programs also do not advocate execution of trades on a daily basis. Many full-time options traders make a good living and they qualify for trader tax status. But the IRS feels strongly about attacking part-time traders on the qualification issue, focusing on fewer trades and fewer days with trades. See the IRS attacks on a retiree and options trader (Holsinger) and a part-time executive and options trader in our post “Recent IRS techniques against traders” on April 30.

Forex and futures traders
Forex traders face difficulties in qualifying for trader tax status too — they usually don’t trade the required amount of days and leave positions open for weeks at a time, thereby not generating enough transactions.

However, both forex and futures traders can enjoy some tax breaks without trader tax status. Forex and futures traders usually don’t have many trading expenses, as there is no investment interest expense on forex and futures. With fewer expenses and a preference to skip Section 475 MTM (which requires trader tax status), forex and futures traders should not push the envelope on trader tax status.

By default, forex is given Section 988 ordinary gain or loss treatment. Lose $25,000 trading forex and you can offset you and your spouse’s wages and any other income with the ordinary forex loss in full. As a forex trader, you are also permitted to elect capital gains and loss treatment instead of ordinary gain or loss treatment. The real reason to make the capital gains election is to achieve lower 60/40 futures tax treatment on some forex contracts. With the capital gains election, forex forward contracts and forex spot contracts in major currencies (for which you don’t take or make delivery) can be treated as Section 1256g (foreign currency contracts fall under 1256); thereby being treated like futures on Form 6781 with lower 60/40 tax rates.

Futures losses (including forex treated as 1256g) can be carried-back three tax years, but only against futures gains in those years. With this loss carry back feature, futures and forex (1256g) traders don’t need to depend on trader tax status with a Section 475f MTM election generating net operating loss (NOL) treatment. Generally speaking, a NOL carry back is better than a futures loss carry back, because it can offset income of any kind (not just futures gains). For the 2008 tax year only, the NOL two-year carry back rule may be expanded to up to five years — for more information, see “Changes for NOL reporting” in the April 28 blog entry.

The perennial money-losing trader
Amateur, start up and on-again, off-again money-losing traders may be pushing the envelope on trader tax status, considering the escalating IRS challenges to trader tax status. These traders should calculate their tax scenarios with and without trader tax status. If it’s not costly to skip trader tax status, and you want piece of mind, then skip trader tax status.

If you can’t get much benefit from your trading expenses as either investment expenses or in another business activity, then you may be able to defer those deductions to a subsequent year where you qualify for trader tax status. For a reasonable period of time, you may be able to look back and capitalize your prior trading costs and expenses as Section 195 start-up costs. You may then have the opportunity to amortize start up and organization costs and depreciate equipment once you qualify for trader tax status.

If you are not trading a large amount of capital in securities, you probably won’t lose too much money without “tax loss” insurance in Section 475 MTM ordinary loss treatment. You can probably use up your capital loss carryovers in subsequent tax years.

Wash sales are better than excess capital-loss carryovers, as wash sales can become part of a Section 475 MTM ordinary trading loss in the following tax year (in the Section 481a adjustment).

So, who needs it?
Serious full-time traders can more safely depend on using trader tax status. The IRS’s “material participation” standard calls for 500 hours of work spent before a taxpayer can rise above passive activity loss rules and claim business loss treatment. If you put on a minimum of 500 round-trip trades per year, trade more than 75 percent of available trading days for more than four hours per day, and have average holding periods under a week, you should qualify for trader tax status. You also need to have the intention to run a business activity to make a living, serious tools & business expenses, and a material account size.

If you feel you qualify (and its best to consult a trader tax expert), then a separate trading entity (used only for trading) is a solid way to claim trader tax status. (See “Forming an entity” in the April 29 blog entry.) The IRS won’t see your W-2 or other business activity when it looks at the separately filed trading entity tax return.

Historically, the IRS has frequently examined Schedule C (sole proprietor) small businesses. Small-business traders invite even more scrutiny because a trader’s Schedule C only shows business expenses; trading gains and losses are reported on other tax forms. We advocate an income transfer strategy to Schedule C (other income) to mitigate this problem.

Ex-Wall Street trader turns small-business trader
Many people are losing their jobs in this recession, and some have turned to a trading business as their perceived best hope. One distinct group of new traders includes ex-financial service executives and professional traders at hedge funds, private equity firms, banks, brokerage firms and other institutions. These traders often (mistakenly) immediately commit hundreds of thousands of dollars of capital to their new trading businesses. They correctly understand that they can’t make their prior salaries on a small trading account.

These ex-trading professionals also have the necessary training, skills, experience and discipline to be successful over the long-term. The good news is they qualify in the eyes of the IRS more easily over traders without this background because the IRS considers them to be long-term trading professionals. The bad news is many traded as they did for a hedge fund and lost a large amount of capital quickly — and many did not bother to contact us to learn about a Section 475 MTM election. They were stuck with huge capital-loss carryovers.

Bottom line
Trader tax status is great for deducting legitimate trading business expenses, including the very powerful home-office deduction, start-up costs, education and margin interest expenses. Trader tax status also provides the opportunity to elect the powerful Section 475 MTM ordinary tax loss treatment, which is highly recommended for securities traders (but not futures and forex traders who would rather retain lower 60/40 treatment).

The IRS is increasingly challenging trader tax status. For this reason, traders should carefully assess the benefits strictly related to trader tax status; after examination, many traders may decide trader tax status is more trouble than it’s worth. If you are in this group, there are still plenty of tax benefits for you.

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