EDUCATION CENTER
GTT RESOURCES: STRATEGIES: YEAR-END TAX PLANNING

Each year, we update our year-end tax planning strategies and write new articles about it for the magazines and newsletters we contribute to. An edited version of the below article will be published in the November 2008 edition of Fidelity's Active Trader E-news (as it was for 2007). See lot's of other articles in prior years below this article and they are still helpful this year.

Read our blog for Green's articles on expected tax law changes coming in 2009 from our new President-elect Obama together with a Democratic-controlled Congress. Plus, about how the IRS is getting tougher on trader tax status and MTM ordinary loss treatment.

• If Obama and Congress agree on tax rate increases on upper-income taxpayers for 2009 and later years, it may be a wise 2008 year-end tax strategy to take more income into 2008, instead of 2009. Securities traders can sell short-term, and long-term profitable positions in 2008 (for a 15 percent long-term gains tax rate, versus a 20 percent rate maybe coming in 2009). Plus, give themselves a better chance to qualify for middle-class tax benefits coming in 2009.
  
  
• Try not to trigger AMT tax in 2008, because if AMT is repealed in 2009, you will lose a chance to get back an AMT credit (your AMT taxes back). If your income is high enough, you usually fall out of the AMT zone; since so much income is taxed at 35 percent versus the AMT rate of 28 percent.
  
  
• If you are a "close call" on trader tax status in 2008, and are counting on that business status to file for a large tax refund in 2008 - and possibly in the past two years too with a NOL carryback return - consider a change of course.
  
  For example, you can soak up your 2008 ordinary trading losses (from IRC 475 MTM on securities, or IRC 988 on forex) by converting from a traditional retirement plan to a Roth IRA. Rather than ask the IRS for a large tax refund, which can trigger an exam in this difficult environment, wind up being a small taxpayer for 2008. You can then trade your Roth IRA aggressively for permanent tax savings.
  
  Alternatively, plan to carry forward your NOL rather than carry it back. Fulltime traders with a strong case for trader tax status and use of ordinary loss treatment should file for their NOL carryback refunds and hopefully all states will honor them.
  
  
• Futures traders should think twice about joining a futures or options exchange, because their trading gains are subject to self-employment taxes (social security and Medicare) per Section 1402i. Obama campaigned on resubjecting earned incomes over $250,000 to 12.4 percent social security tax. The Medicare 2.9 percent tax already applies to all earned income without limits. We believe that Electronic Corporate Memberships on the CME are not full fledged memberships and they don't trigger the SE tax.
  
  
• Republicans proposed raising the capital loss limitation to $20,000 from the paltry $3,000 limit used for almost half a century; and it's never been indexed for inflation. Hopefully, Democrats will consider this tax change too, as it will help the entire investor-class.

Tools Section: See our third-party content provider for plain vanilla strategies. "Year End Tax Savings Ideas for Individuals" and "Year End Tax Savings Ideas for Businesses" (Nov. 2008 Newsletters). As pointed out above and below, some upper-income taxpayers may want to reverse normal year-end tax strategies; with a goal of accelerating income, deferring deductions and avoiding AMT more than ever before.

Update of annual year-end tax planning article geared to traders:

Year-end tax planning can be more challenging for traders than other taxpayers. Traders have widely fluctuating incomes and there are complex rules for wash sales, capital-loss restrictions, trader tax status and more. Plus, this year there are several proposed tax changes to consider, particularly the potential repeal of the Alternative Minimum Tax.

By Robert A. Green, CPA

Most year-end tax planning articles in the mainstream media focus on tried-and-true strategies – what I call “plain vanilla.”

This writer’s Web site also features plain vanilla year-end tax planning at http://www.greencompany.com/Tools/Newsletters.shtml (November, 2007 issue). An update of this article with appear in Fidelity's same newsletter for November 2008, along with another article from Green on Tips for Dealing with the IRS.

However, active traders should also focus on tax planning opportunities unique to their industry; this is especially true of traders rising to the level of business tax status.

Plain vanilla year-end tax planning strategies suggest that all taxpayers, including active traders, should generally defer income and accelerate expenses in order to reduce current-year taxable income and tax liabilities.

But the AMT (Alternative Minimum Tax) is becoming an increasingly big problem, turning most tax planning logic upside-down. AMT is a huge concern for 2008, since it is snagging more taxpayers this year and may be repealed in 2009. Taxpayers should therefore make AMT planning job No. 1 in their year-end tax planning.

Plain vanilla doesn’t cut it for active traders. Active traders need better and more customized tax planning suggestions.

Here are a few nifty 2008 year-end tax planning tips for active traders. First, though, a little more perspective on AMT.

AMT planning should dictate overall tax planning
If the Democratic-controlled Congress succeeds in repealing the AMT tax (in 2009), most taxpayers should avoid paying any AMT taxes in 2008. Congress is also proposing to raise tax rates on upper-income taxpayers by increasing their top marginal tax rate to 44 percent from 35 percent. Paying for AMT relief is the excuse for the tax hike.

See our blog for current articles on Obama's tax initiatives and the Democratic tax initiatives in 2008 tax bills (not passed), like HR 3970 (Jan. 2008 blog article)

By accelerating income into 2008 and deferring AMT tax deductions into 2009, a taxpayer can save taxes in two ways. First, they can reduce AMT taxes for 2008 (hopefully permanently), and second, they can subject more income to 35-percent tax rates in 2008 rather than (possibly) 44-percent tax rates in 2009.

For “married filing joint” incomes under $200,000, the regular tax rates are 28 percent, which matches the AMT tax rate.

That means these taxpayers will surely trigger AMT and be disenfranchised on many of their itemized deductions (state taxes, investment interest and expenses, miscellaneous deductions, portion of municipal bond interest and much more).

Futures and (electing) forex traders also trigger AMT way too easily. With 60/40 tax treatment on IRC 1256 contracts (60 percent of profits are taxed at the lower, long-term tax rate and 40 percent at the short-term rate, regardless of how long the position has been held), their maximum tax rate is 23 percent – far below the AMT rate.

Traders have unique opportunities and pitfalls
Again, the mainstream financial media often publicizes plain strategies for investors. However, business traders should sometimes follow the reverse strategies.

For the past decade or more, it’s generally not been possible to initiate offsetting positions to defer capital gains on one leg of a position and take capital losses before year-end on the other leg.

In the 1980s, Congress enacted IRC 1256 mark-to-market accounting for futures traders in order to prevent the above types of deferral abuse. Congress and the IRS have also prevented this type of deferral abuse for securities traders by enacting special rules for wash-sale loss deferrals, straddle losses, constructive receipts, and selling positions against the box.

Qualifying securities business traders often elect IRC 475 mark-to-market (MTM) accounting (for ordinary loss treatment rather than restricted capital losses), and this requires imputed sales for all open positions at year-end.

With MTM, a trader does not have to sell open positions for tax-loss selling at year-end. Rather, they can simply mark their open positions to market prices at year end.

Are wash sales always bad?
Wash-sale loss deferrals are generally a bad thing, since they increase your capital gains income in the current year. Sometimes, though, wash sales can be a good thing.

If a trader already has exceeded the $3,000 capital-loss limitation, it’s better to have wash sales rather than excess capital-loss carryovers.

The qualifying business trader will probably want to elect IRC 475 MTM in the following tax year, and their wash sales are converted to ordinary tax losses in that following year. They are part of the IRC 481(a) adjustment, which also includes year-end unrealized gains and losses (which are also preferable to carryover realized capital losses).

Conversely, capital-loss carryovers can never be converted into ordinary losses. A large capital-loss carryover may dissuade a trader from electing IRC 475 MTM, since capital-loss carryovers can’t be applied against MTM ordinary trading gains.

Business “trader tax status” unlocks significant savings
With trader tax status and MTM, a trader can unlock all sorts of tax breaks, including business expenses, ordinary trading losses, NOL carry-back refunds, and retirement-plan and health-insurance (AGI) deductions.

IRC 475 MTM exempts traders from the onerous wash-sale rules and capital-loss limitations.
Trader tax status converts restricted investment interest and expenses (not deductible for AMT) into unrestricted business expenses (all deductible for AMT).

If an active trader doesn’t qualify for trader tax status in 2008, but expects to in 2009, they should consider deferring trading expenses until 2009.

It's important to note that the IRS is beefing up it's attacks on business traders, so it's wise to be more conservative on trader tax status qualification determinations. Read our blog article "IRS denies trader tax status and MTM."

A conservative strategy may be to capitalize 2008“startup” expenses (IRC 195) and amortize those costs when they achieve trader tax status in 2009. The first $5,000 of startup costs may be expensed in the first business year, with the balance amortized on a straight-line basis over 15 years.

Retirement plans
Taxpayers need to establish a mini 401(k) plan (also called an individual or solo 401[k]) or defined-benefit (DB) plan before year-end; otherwise it’s too late to benefit. Full funding can wait until the extended tax return due date. Roth IRAs and Mini Roth IRAs are also attractive plans for traders.

Leading brokers (such as Fidelity) offer excellent retirement plan packages. Mini 401(k) plans are among the best retirement plan types for traders.

Taxpayers can contribute the elective deferral maximum ($15,500 for 2008), plus there is a 20-percent net profit-sharing plan included, too (for a maximum contribution of $46,000). For taxpayers age 50 or older, there is another $5,000 amount allowed under a "catch up" provision.

With a mini 401(k) plan, a taxpayer can enjoy maximum income tax savings in exchange for self-employment (SE) tax costs. Structured in the right manner, the active trader usually saves more in income taxes than they pay in SE taxes.

A mini 401(k) plan requires an annual 5500 or 5500-EZ filing.

With a DB plan, higher income traders can contribute much higher amounts than the limit on defined contribution or profit-sharing plans (including the Mini 401[k] plan).

Note that trading gains are not earned income, unless a trader is a member of an options or futures exchange. So, non-exchange traders often need to form entities to create (financially engineer) earned income for retirement-plan deductions, unless they have another source of earned income.

See 2008 contribution limits for various types of retirement plans on our tools' tax rates page, towards the bottom of the page.

Consult us on these strategies.

A Roth IRA conversion may be a good strategy
Because traders have fluctuating income from year-to-year, they may fall under the Roth IRA income threshold in 2008 ($100,000 specially calculated AGI limit). That can be a good time to do a Roth IRA conversion.

Pay taxes at 2008 tax rates on the conversion amounts, before tax rates possibly go up in 2009 (for the two most upper-income marginal tax brackets), and then trade the account (permanently) tax-free through retirement.

Permanently tax free means a taxpayer can take distributions in retirement tax-free, too.

If you exceed the income thresholds, build up a regular retirement plan and consider a special break currently on the books for 2010 only. The Bush Tax Cuts relaxed the income threshold for all taxpayers in 2010 only in connection with Roth IRA conversions.

Try to qualify for “middle-class tax breaks”
Almost every middle-class tax break including deductions and credits (such as retirement, education, and child care) have preset phase ins-and phase-outs based on varying levels of Adjusted Gross Income (AGI).

Democrats plan even more tax breaks for the middle class along these lines for 2009; see the Obama middle-class tax benefits mentioned on our blog and his own Web site.

Active traders can qualify for these breaks in some years and not in other years (when they make their bigger gains). Only good tax planning and preparation software can figure it all out in your favor and on time before year-end.

Our progressive tax code was historically based on progressive income tax rates (graduated marginal tax rates), and now tax writers are using complex specialized income formulas to control access to other tax breaks, too.

Bottom line
Prepare a proforma year-end tax return using 2008 tax software. If you trigger AMT, try to figure a way to prevent it. Assess your trader tax status and capital gains and losses year-to-date along with all unrealized gains and losses on open positions. Develop the right strategy to reduce capital gains and maximize the $3,000 capital-loss limitation, but don’t exceed that limitation if possible. Develop the right tax strategy for 2009 to complement your 2008 tax planning and save even more in 2009. It’s probably best to engage a trader tax expert for more help.

"Year-end tax planning may be important for all taxpayers, but it's paramount for traders. Jobs with steady income lead to steady tax planning, as only a few tax strategies may apply each year. However, trading for a living is anything but steady, and valuable tax planning is almost impossible to achieve without “crunching the numbers” before year-end to evaluate every available tax break and pitfall." Read this article by Robert A. Green, CPA, on year-end tax planning for traders. It was written for the 2005 year-end, but it still applies for the 2006 year-end, as the tax code is basically the same this year-end.

The tax code is generally indexed for inflation and threshold amounts change each tax year. For a full run down on all the changes for the 2006 and 2007 tax years, click here for a Client Letter from a leading tax publisher.

Hedge funds should also do year-end tax planning in order to maximize tax benefits for their investors and themselves. Click here to learn more about special GreenTrader hedge fund tax strategies.

Click here for other good year end tax planning articles by Robert A. Green, CPA. "Here are some nifty tax tips to put in your holiday basket. Some require action before year-end, such as tax-loss selling, converting capital losses into ordinary losses, establishing mini 401(k) retirement plans and paying some of your taxes on time. Otherwise, start in January to enjoy tax savings for all of next year."

We also have some excellent newsletters on general year-end tax planning for all taxpayers (not just traders) in our Tools section. Click here for our newsletter archive. See November and December.

Retirement plan strategies:
Establish a mini 401(k) plan or defined benefit (DB) plan before year-end; otherwise it’s too late to benefit. You just need to form the plan with a few dollars and you can do the contribution up until the due date of your tax return including the extension.

Mini 401k plans are among the best retirement plan types for traders. For lower contribution amounts, nothing beats a mini 401(k) plan. You can contribute the elective deferral maximum ($15,000 for 2006). Enjoy maximum income tax savings for very low self-employment (SE) tax cost with a net savings of thousands of dollars.

With a DB plan, higher income traders can contribute much higher amounts than the limit on defined contribution or profit sharing plans (including the Mini 401(k) plan).

Click here to learn more about the best retirement plans for traders and our related services. You need to jump through some hoops, including the formation of an entity. We can do it all fast and at a low cost before year-end. Just don’t come calling on us just before the year end holidays – there won’t be sufficient time.

Feel free to post questions on our message board, attend our conference calls, e-mail us at info@greencompany.com or call us.

We are standing by ready to help you plan and save before year-end. Please sign up for a consultation with Robert A. Green, CPA/CEO or another CPA with GreenTraderTax. CPA. Customer service will schedule you right away.

You also may want to sign up for annual tax preparation and planning before year-end. If you have trader tax status in the current year, our retainer is another year-end tax deduction. Otherwise, you are welcome to sign up whenever you like.

One important year-end tax strategy is to pay 100% of your state income taxes owed by December 31st, rather than Q4 estimated tax due date of January 15th of the following year. If you satisfy the "safe harbor" exception on estimated taxes, you can defer the balance of your taxes owed until April 15th.

But watch out for the nasty AMT tax - that second tax regime that is catching many middle class taxpayers this year. State income taxes are an AMT tax preference; meaning they are not deductible for AMT. For clients who ask for our help, we plan this all correctly before year-end.

Ready for a consultation

Year-end tax planning may be important for all taxpayers, but it's paramount for traders. Jobs with a steady income can count on steady tax planning, as only a few tax strategies may apply each year. However, trading for a living is anything but steady, and valuable tax planning is almost impossible to achieve without “crunching the numbers” before year-end to evaluate every available tax break and pitfall.

An article by Robert A. Green, CPA
(Written for Active Trader magazine in 2005. The tax code is generally indexed for inflation and threshold amounts change each tax year. For a full run down on all the changes for the 2006 and 2007 tax years, click here for a Client Letter from a leading tax publisher.)

U.S. and state income tax codes are much too complicated. For almost 100 years, dueling politicians have used a weapon of fiscal (tax) policy to reward their constituents, encourage or discourage certain behaviors (tax incentives and penalties), and spread the wealth (progressive rates and now many formulas, too).

Many in Congress and the White House are pushing for significant tax reform. For our take on tax reform, visit our GTT Alliance for Traders and Tax Reform section, specifically Tax Reform and Fair Tax. The best laid tax plans need to be flexible, reactive, and visionary, and we cover all these needs.

Back in the "old" days (the early 1990s), before powerful, easy-to-use computers, most taxpayers and professionals prepared income tax returns by hand, so the tax code writers were forced to keep things fairly simple (relatively speaking, compared to today).

Now with the proliferation of computerized tax return preparation (e.g., TurboTax and others), tax code makers and writers have enjoyed unlimited ability to monkey around with the tax code. Call it pork barrel politics on steroids. Almost every new tax break is written with all sorts of income phase-outs, which only a computer could figure out. In the past decade, many taxpayers used computers for preparation and consultations only. Now you need computer number crunching for year-end planning too!

Here are some examples:

AMT: There are now two tax calculations that apply to many millions of taxpayers. The second tax calculation is the nasty and now infamous Alternative Minimum Tax (AMT). AMT was conceived for a small group of millionaires who abused tax-shelter schemes, but now AMT is sneaking up on many unsuspecting taxpayers. It's a real shame to be surprised by AMT with your tax return bill after year-end, when you can do several things to avoid AMT before year-end. You can't blame your accountant (the messenger) about AMT anymore; we are trying to educate you. Congress is promising to fix AMT, but it might take several more years. Yes, tax reform may repeal AMT, but when you look closely, it's AMT that is the one tax scheme that is surviving. After all, repealing all itemized deductions is just like AMT in the first place. Learn more about AMT tax planning in this article from BNA. Our tax professionals can crunch your numbers, see if you get snagged by AMT and try to figure out a way to limit the damage (there are lots of options to consider).

Middle-class tax breaks: As another example, almost every middle-class tax break including retirement savings, education-related payments and savings, child care payments and savings, and more are phased in-and-out based on varying levels of Adjusted Gross Income (AGI). Read the rules in the BNA article above and your head will spin. Only good tax planning and preparation software can figure it all out in your favor and on time before year-end. Our progressive tax code was historically based on progressive income tax rates (graduated marginal tax rates), and now tax writers are using complex specialized income formulas to control access to other tax breaks, too. Fine tune your year-end tax planning to get into the right tax bracket with the right formula for maximum savings.

Here are some tax saving tips:

Upper-income: If you are an upper-income taxpayer on a steady basis, you can safely assume that most middle class AGI-dependent tax breaks won't apply to you. That's too bad, but there are some other powerful savings opportunities. Focus on high-end tax planning strategies for wealthy individuals such as using trusts, family planning, charitable contribution plans, and defined benefit retirement plans.

Middle-class income: If your income is between $50,000 and $160,000, you should consider every possible (AGI-dependent) tax break. Tax writers want the middle class to save for retirement, education, children and more, and know they need some help – hence these breaks.

AMT taxes rarely snag very high income taxpayers (isn't that ironic)? Note that commodities/futures traders have lower "60/40 split" income tax rates (maximum blended rate is 23 percent), which is less than the AMT tax rates (maximum rate of 28 percent), so they may be snagged with AMT even with higher income.

If your income is between $160,000 and $600,000, and you live in a high-taxing state, it's very likely AMT will snag you. So plan ahead! Why pay state taxes in December in order to increase your regular income tax deductions if you get snagged by AMT, which does not allow state tax deductions?

Lower income: If you have little to no income, tax planning and savings may not be your main focus anyway and it's unlikely you need to do year-end tax planning – except if you are a trader! Then you need to consider lots of tax-savings strategies including trader tax status, wash sales, mark-to-market accounting (MTM), start-up expenses, net operating losses, and more.

There are all sorts of special tax strategies for traders across the income spectrum (high, middle, and low).

Defined benefit plans: If in 2005 you had another stellar year and you are confident about the future being the same, consider a defined benefit retirement plan for huge tax savings. An actuary may calculate that you must contribute very large amounts to the plan over the next several years, but this can save you a fortune in taxes. Plus, you can trade the account for further tax deferral savings. DB plans must be established before year-end and there is much customized paperwork. We need to start by Thanksgiving.

Trading: Perhaps you can buy or sell certain trading and/or investment positions before year-end to fall into the middle class tax savings zone and unlock plenty of breaks. You need to know how close you are to know what is possible. The educated tax consumer gets the most breaks! We suggest you get GTT TradeLog now to figure your gains and losses so we don't build a plan on incorrect information. Click here to read the other year-end tax planning articles by Robert Green.

Roth IRA conversions: If you are having a bad year in the markets, consider the following special strategy: If your AGI is less than $100,000, it might be an excellent time to convert your retirement savings accounts (with tax deferral only) into a Roth IRA (for permanent tax deferral). Also consider that traders can actively trade their Roth IRAs. Click here to learn more about retirement plans and strategies for trading the funds in those plans.

Business trader tax status: With trader tax status and mark-to-market accounting, you unlock all sorts of business tax breaks. You escape the onerous wash sale rules, capital loss limitations, and phased out itemized and miscellaneous deductions. You also don't have to worry about AMT preferences.

Both winning and losing traders benefit. Winning traders get many ordinary business deductions, and AGI deductions (also ordinary and above the line) for retirement-plan contributions and health-insurance premiums. Losing traders generate net operating losses (NOLs) that generate immediate tax refunds from two-year carrybacks. It's win-win on all levels!

However, it's paramount to review trader tax status in advance of year-end. See Robert Green's year-end tax planning articles for traders below. There are several clever strategies on converting capital losses into ordinary losses and much more. You won't find that content anywhere else.

Why be surprised next April 15 to learn you don't have trader tax status? It's wiser to assess your situation now (with Green's help in a consultation if you like) and help yourself gain trader tax status before year-end. If necessary, you can make a few changes, such as trading more frequently.

Finally, like other small businesses taxpayers, business traders have opportunities to manage their income and expenses. If you don't have MTM, you can do tax-loss selling before year-end, and create or prevent wash sales depending on your needs. It cuts both way, so read those trader articles below from Green. The same applies to expenses; in some cases you should accelerate them and in others defer them.

But again, there are so many scenarios that may apply, what seems to be prudent may not be. You may be better off accelerating income and expenses or deferring them, bunching deductions or not. Let us help you figure it all out to your greatest tax advantage.

The moral of this story is that tax breaks are highly complex and vary significantly by income level. The only way to tell for sure if you can claim a tax break is with good tax software and actual numbers (or good estimates). Almost all taxpayers prepare their tax returns with tax software after year-end and good programs point out tax savings ideas for the future. Why not cash in on good program tools for savings before year-end – when it counts the most?

Our firm uses the best tax software programs on the market (Lacerte and BNA). Our CPA professionals can automatically input your 2004 tax information (from your 2004 tax return files which we prepared already), then update the information with 2005 actual numbers and/or estimates and then crunch your numbers. Our software and professionals spot every possible savings strategy.

Here's the bottom line: There is no way you can get every tax benefit you are entitled to without crunching the actual or estimated numbers in an excellent year-end tax planning program. And with our top-flight trader tax CPAs and attorneys, we can deliver the trader and general tax savings you deserve. Yes, it would be fairer for tax savings to flow from the spigot and for money to grow on trees, but it doesn't. You need to engage an expert using the right tools to mine our current income tax code. Vote for tax change tomorrow, but keep playing today's tax game right today.

Remember, there are lots of good general tax content sites, publishers, and services around and they are very helpful. But traders are a special breed of taxpayer and we have built our practice researching, conceiving, writing, and delivering on traders’ special tax needs. For almost every tax break, there is a special twist or spin for traders. We bring it all to the table.

Here is how we suggest you proceed before year-end:

Read all the tax planning content and articles on this page. .

Next, consider signing up for tax planning and preparation or just a one-hour consultation. We get you started with specific steps immediately by e-mail.

We aim to please!

Year-End Tax Planning Strategies for Traders

Active Trader magazine. Click here.
SFO magazine. Click here.

Robert A. Green, CPA, wrote the below article for the December 2003 issue of Active Trader magazine.

(Written for Active Trader magazine in a prior year. The tax code is generally indexed for inflation and threshold amounts change each tax year. For a full run down on all the changes for the 2006 and 2007 tax years, click here for a Client Letter from a leading tax publisher.)

Year-End Tax Planning Tips: Although the tax year isn't over yet, it's never too early to begin your tax planning. Tax-loss selling, converting capital losses into ordinary losses and establishing a mini 401(k) retirement plan are just some of the things you can do to ease your tax burden before the calendar turns.

Here is the original article submitted, before editing by the magazine.

Here are some nifty tax tips to put in your holiday basket. Some require action before year-end, such as tax-loss selling, converting capital losses into ordinary losses, establishing mini 401(k) retirement plans and paying some of your taxes on time. Otherwise, start in January to enjoy tax savings for all of next year.

By Robert A. Green, CPA

Investors and active traders have tax-savings opportunities at year-end. Many investors sell losing positions towards the end of the year to lower their capital gains income and capital gains taxes (known as “tax loss selling”).

Business traders with mark-to-market accounting (MTM) report unrealized gains and losses at year-end, so it's not necessary for them to exit their positions to gain tax savings. There are plenty of things you can do just before year-end to improve your tax situation, but it all depends on your tax status.

Investors and active traders use the default “cash method” of accounting, which means they report realized gains and losses, and not open positions (unrealized gains and losses), at year-end. Cash method accounting also includes the dreaded wash-sale and straddle-loss deferral rules. This means certain realized losses are not allowed to be deducted on your current year’s tax return; instead, they are carried over (deferred) to the following tax year, potentially raising your tax bill for the current year.

The most dreaded part of cash method accounting is the onerous excess capital-loss limitation rules. Congress allows taxpayers to deduct a maximum loss of $3,000 per year, and the balance may be carried forward to future tax years (commodities losses may also be carried back three tax years, although they can only be applied against commodities gains).

Many business traders elected MTM (Internal Revenue Code 475) for securities only (because MTM is not beneficial for commodities) and thereby get around the dreaded aspects of “cash method” accounting. MTM business traders are exempt from the onerous wash-sale and straddle-loss deferral rules, and all losses are deductible as ordinary losses without any capital-loss limitations.

Many traders use the cash method for the current year and want to elect MTM in the following year. This raises further complications and requires other strategies.

Find your tax status and act accordingly
Your first order of business in late November or early December is to determine what your tax status is for the current tax year. Did you rise to the level of business status (trader tax status) for the entire year, or a portion of the year? Will that portion of the year include the year-end?

Did you elect MTM IRC 475 on time in the current tax year, or carry over that election from the prior tax year? Existing taxpayers must elect MTM by April 15 of the current tax year by attaching an election statement to their prior year tax return or extension. New taxpayers don’t have a prior tax return, so they can elect “internally” (in their own books and records).

Some taxpayers miss the MTM election filing and later realize they qualify as a “defacto” husband/wife general partnership because they have joint trading accounts and both worked as traders. Perhaps their defacto partnership made the necessary “new taxpayer” internal election with a verbal resolution. If you think you may qualify for a defacto partnership and need to use MTM accounting to deduct large losses in the current year, consult with a proven trader tax expert. For more information, see "I promise to love, honor and save you tax money" in the July 2003 issue of Active Trader. The article explains how husband-wife partnerships require no formal agreement or paperwork, and they can save you a bundle on your tax returns. You can also click here to learn more.

If you elected MTM but don’t qualify for trader tax status at year-end, you must use the cash method at year-end (and for any other portion of the year you did not qualify for trader tax status). If you are a business trader without MTM, you must use the cash method like any other investor. You can still take advantage of many business tax breaks, some of which require action before year-end.

”Cash method” accounting trading strategies to lower your taxes at year-end
If you are an active trader but don’t qualify for business treatment (trader tax status) – or, if you do qualify but did not elect MTM IRC 475 – you must use the default “cash method” of accounting. Here are some tips for lowering your taxes at year-end:

Manage your portfolio at year-end to defer unrealized capital gains and realize capital losses, which lowers your capital gains and capital gains taxes.

Hold securities positions for 12 months to avoid short-term capital gains (which are taxed at ordinary tax rates up to 35 percent) using hedges in order to benefit from long-term capital gains (which are capped at a 15-percent tax rate). The 2003 tax act lowered both rates, but it also widened the difference, making this strategy more beneficial than in prior years.

Avoid wash-sale and straddle-loss deferrals by re-entering similar, rather than identical, positions within 30 days.

Avoid purchasing mutual funds just after dividend declaration dates, which usually occur around the end of the year. Price often drops after dividends.

Avoid capital-loss carryovers. Don’t exceed the $3,000 capital-loss carryover. This creates “tax baggage” for business traders (see below).

When planning for capital-loss limitations and estimated taxes, anticipate mutual fund capital-gain distributions.

Avoid investment-interest carryovers and investment-expense limitations. Both require investment income for these deductions. Figure out your investment income (portfolio income and capital gains).

Find out if your hedge fund or investment company Form K-1s will report trading gains and losses using the cash or MTM methods of accounting (trader tax status and this accounting election is on the entity level).

Consider allocating some of your “taxable portfolio” to tax-free investments and tax-free retirement accounts (with tax-deductible or non-deductible contributions).

Consider shifting income to other family members. Children younger than 14 are subject to the “kiddie tax” rules, which allow lower tax rates on the first $1,500 of “unearned” income (the excess is taxed at the parents’ tax rates). Children 14 or older are not eligible for the “kiddie tax” rules. Consider paying your children wages to help in your trading business; you both are exempt from payroll taxes and can benefit from the child’s lower tax bracket rates.

Contribute appreciated securities to charity. You get a tax-deductible contribution at the higher fair market value (FMV). You are exempt from capital-gains taxes on the increase of FMV over purchase price. This is wiser then paying capital-gains taxes and then contributing cash to the charity.

Commodities and futures traders (with or without trader tax status) are automatically subject to another type of mark-to-market accounting, IRC Section 1256. They report “economic” gains and losses and can’t manage their income with the above strategies. Commodities losses can be carried back three tax years against commodities gains, so plan accordingly.

If you are in low tax brackets in 2003 and expect to be in high tax brackets for 2004, you may want to reverse some of these strategies.

There are lower 2003 Act tax rates on qualifying dividends and long-term capital gains.
Arrange your investments to take advantage of the new lower tax rates on “qualifying” dividends, paid by domestic and qualifying foreign corporations. Pay careful attention to the detailed rules; most traders won’t get these benefits, except on their “segregated” investment accounts.

“Dividends” from money market funds, life insurance policies, real estate investment trusts (REITS – 90-percent portion) and some mutual funds do not qualify. Many mutual funds invest in bonds, currencies and other instruments that do not have qualifying corporate earnings and profit taxes.

The “holding period” for qualifying dividends is 60 of 120 days before the ex-dividend date, which will ruin this benefit for many traders (those that don't hold positions that long).

The “effective date” for lower long-term capital-gains rates is May 5, 2003.

Carefully plan to offset capital gains and losses to maximize post-May 5, 2003 long-term capital gains.

Shift investment income to children (with annual gift limits) to take advantage of the two lowest tax brackets (5 percent) on long-term capital gains.

Click here for more information on the 2003 Tax Act changes.

MTM traders can’t manage income, but they have many other tax-saving opportunities, including net operating losses (NOL).
Unlike traders who use the default cash method of accounting, MTM business traders (and all commodities and futures traders) report both realized and “unrealized” gains and losses at year-end.

MTM business traders may not defer capital gains on trading positions, but can on “segregated” investment positions.

MTM business traders are not penalized with the onerous wash-sale and straddle-loss deferral rules and capital-loss limitations; all realized and unrealized trading losses are deducible in the current tax year in full as ordinary losses (not capital losses).

MTM business traders can have negative taxable income and carry back “net operating losses” (the business portion of trading expenses and trading losses) two tax years (or five years for 2001 and 2002 only).

Carefully plan your NOLs in advance in order to receive immediate tax refund relief for prior years in which you have taxable income taxed at higher marginal rates. For example, if you have significant taxable income in 2001 but losses in 2002, try to increase your 2003 NOL so you can carry the NOL back to 2001. You won’t be able to carry back a 2004 NOL for any benefit in 2002 and 2003, two losing years (since you have losses in those carryback years). Instead, you can carry forward your 2004 NOL to 2005 and beyond (up to 15 years).

Traders without MTM can still generate a NOL with their trading-business expenses.

MTM traders don’t need to worry about tax-loss selling. They can take profits early and not worry about trying to defer capital gains. They also don't have to worry about rushing to sell a losing position to lock in the tax loss; it is already locked in with MTM.

Switching to MTM from cash method accounting is difficult if you have tax baggage.
Business traders face complex issues when they consider switching to MTM from the default cash method (capital gains and losses). The most important issue concerns capital loss carryovers.

Capital loss carryovers are the main culprit for putting traders out of business.
Not being able to deduct your trading losses because of capital-loss limitation and wash-sale rules is sort of like paying full-service brokerage commissions. It can accelerate your exit from a trading business.

It’s foolish to pay full-service brokerage commissions if you trade on your own with an online or direct-access brokerage firm. It’s also foolish to not get exempt from the capital-loss limitation rules on securities if you are a business trader. All that is necessary is a little free education about how and when to elect MTM. You can’t tell a full service broker to give you a refund because you later learned about better offerings, and you also can’t tell the IRS later on to allow you to use MTM. The IRS is very strict about denying late MTM elections.

Many traders skip the MTM election when they start their trading business because they don’t know about it, get the wrong advice and/or make the wrong decision about it. The latter is certainly the case if they get stuck with capital loss carryovers.

You can carry back MTM losses for immediate tax refunds to replenish your trading accounts rather than having carried-over "capital losses" suspended to future years. Many traders never cash in on those capital-loss carryovers after having to exit a trading business. They simply have no or little money left to invest for capital gains.

These non-MTM traders fall into the following tax trap, because you can’t have it both ways. If you have trading gains in the following year, you want to keep the cash method to offset new trading capital gains with capital loss carryovers. If you have trading losses, you want to have MTM for ordinary loss treatment, as it's adding fuel to your fire to add to your capital-loss carryovers.

If you have large trading losses by April 15, it’s probably safer to elect MTM to insure ordinary loss treatment. Conversely, if you have large trading gains, it may be OK to skip the MTM election and gamble on having net trading gains for the year (and using your capital-loss carryovers). If you have small gains or losses, your MTM election decision is a gamble.

Consider electing MTM on securities only (not commodities) and utilizing other ways to generate capital gains to use up your capital-loss carryovers.

Start trading commodities such as the E-Minis, which may be similar to securities products you trade. E-Minis and other commodities will not be subject to MTM treatment (unless you also elect MTM on commodities) and will instead generate capital gains and losses. Your first set of commodities gains will be tax-free because you will offset them with your capital loss carryovers. Afterwards, you will benefit from the lower tax rates on commodities. 60 percent is long-term capital gains (capped at a 15-percent tax rates) and 40 percent is short-term capital gains (which are taxed at up to 35 percent). That translates to a maximum blended rate of 23 percent on commodities vs. a maximum rate of 35 percent on short-term securities trading. Instead of trading the QQQQ, an exchange traded fund (ETF) taxed as a “security,” trade the E-Mini, a similar market risk instrument taxed as a “commodity.”

Traders have a large variety of new financial products to trade: ETFs, E-Minis, single-stock futures, plenty of new indices, and options and futures on almost everything. Learn how all these new products are taxed – as securities or commodities – and consider that commodities have lower tax rates. Click here.

Another way to use up capital-loss carryovers is to “segregate” some securities as “investment positions,” not subject to MTM. For starters, their capital gains are tax-free. And, if you hold them for 12 months, the capital gains are taxed at the lower long-term capital gains rates. If you believe the markets have turned the corner from bear to bull, this may be a timely strategy.

Limit capital losses and then covert some into wash sales for ordinary loss treatment next year.
The higher your capital-loss carryovers; the harder it is for you to make the switch to MTM.
First, try to limit the amount of your capital-loss carryovers.

If you already reached the capital-loss limitation, sell profitable positions and keep open losing positions. Hedge accordingly. Don’t sell any additional losing positions. More losses won’t benefit your current year’s taxes, and they will make your MTM election in the following year a tougher decision to make.

If you do sell losing positions that generate a capital-loss carryover, consider re-entering the position within 30 days to create a beneficial wash-sale condition (in all other cases, wash sales are not beneficial). If you elect MTM in the following year, wash-sale loss deferrals are better than capital-loss carryovers because wash sales can be converted into ordinary losses, whereas capital-loss carryovers may never be converted into ordinary losses (and remain as your tax baggage).

Pay your bills early for additional tax savings, providing you don’t trigger AMT taxes and AGI limitations.
All taxpayers should consider paying more bills early before year-end to maximize current year tax deductions.

Taxpayers and most sole proprietor business traders use the cash method of accounting rather than the accrual method of accounting. This is different from the cash vs. MTM methods of accounting as they apply to trading gains and losses. Cash accounting is when bills are paid; accrual accounting is when expenses are incurred. Credit card purchases are cash items on the date purchased, not when the credit card bill is paid.

Normal taxpayers and investors may want to consider “bunching” their itemized deductions into the current year and then taking a standard deduction in the following year. There is no sense coming up short on the standard deduction every year and wasting some itemized deductions such as charitable contributions.

Again, watch out for that dreaded Alternative Minimum Tax, because many itemized deductions are not deductible for AMT (including investment interest, all taxes and miscellaneous itemized deductions).

Calculate if your Adjusted Gross Income (AGI) will be significantly lower in the following tax year. Many itemized deductions and other tax breaks (see below) are limited by AGI levels. Medical expenses are deductible in excess of 7.5 percent of your AGI. Miscellaneous itemized deductions, including non-reimbursed employee business expenses, job-hunting expenses, education expenses (except for business traders) and investment expenses are only deductible in excess of 2 percent of AGI. You also need to beware of casualty losses.

Business expenses are not added back for AMT tax calculations.

Business traders should lower their AGI to unlock “middle-class” tax breaks.
Business traders should accelerate expenses for two good reasons:

First, additional business expenses lower your taxable income, which lowers your tax bill. If you have a net operating loss, additional expenses increase your NOL and related NOL tax refunds. The sooner the better when it comes to NOLs, as you can only go back two tax years.

Secondly, a business trader should know about many special tax breaks which are based on AGI levels. These breaks are “phased out” at different levels of AGI, hence their common name: “middle-class tax breaks.”

Business traders often go from rags to riches and vice versa in any given year. One year their AGI may be very high and most tax breaks are phased out. In other years, they have low AGI and their window opens to put in place many of these middle-class tax breaks.

For example, if your AGI is less than $100,000, you can convert a taxable retirement plan into a Roth IRA, which can convert “timing” tax-free build up into “permanent” tax-free build up (every trader's dream scenario). See more details on this strategy below.

Here are some other tax breaks limited to certain AGI levels: IRA contributions, Roth IRA conversions, education credits, Coverdell education savings accounts, interest on student loans, exemptions for children, earned income credit, real estate passive activity losses and social security income exclusions, to name a few.

Read about them and the phase out amounts at www.irs.gov.

Business traders should buy more equipment before year-end for their home office
If you have trading gains in excess of your trading-business expenses, accelerate fixed asset purchases before year-end to maximize section 179 (100 percent) depreciation and home-office deductions. Both deductions require income; otherwise you must carry them over to the following year.

Section 179 depreciation limits were raised to $100,000 for 2003 from $24,000 in 2002. If you don’t have income, opt for accelerated “bonus” depreciation instead.

Don’t shy away from home-office deductions. They are no longer a red flag and they won’t interfere with your home-sale gain exclusion.

Deduct health-insurance premiums and retirement plans to lower your AGI
AGI deductions for sole proprietor businesses (Schedule C) include, but are not limited to, retirement-plan deductions, health-insurance premiums and 50 percent of self-employment taxes.
The problem for traders is that, unlike other sole proprietor businesses, they may not take these AGI deductions unless they create some “earned income.” Trading gains with or without MTM are not earned income.

Traders can form an entity for their trading business and have their entity pay them, as owner/manager, a fee. This management fee is reported on a second Schedule C, which is earned income subject to self-employment taxes and which can drive a health-insurance premium deduction and contribution to a tax-deductible retirement plan.

Alternatively, a trader can pay their spouse a fee for helping them manage their trading business, with the requirement that the spouse not be an owner of the trading business. A Schedule C owner may not pay his or herself a fee or salary. If the husband and wife are both owners, then they cannot file a Schedule C. Instead, they are a “defacto” general partnership and must file a partnership tax return. A guaranteed payment can then be declared in lieu of a fee to accomplish the same earned income result.

If you paid your spouse money during the year and he or she did help you in your trading business, you may be able to structure this all at year-end or early in the following year. Consult with a trader tax expert if you have further questions. It can be well worth it. Click here for more information on husband/wife general partnerships.

Paying fees to your children older than 14 also lowers your AGI.

Favorable Mini 401(k) retirement plans must be established before year-end
Establish a Mini 401(k) retirement plan for you and/or your spouse before year-end with nominal funds. The balance of your tax-deductible contribution can be calculated and paid after year-end.

All “qualified” retirement plans must be established before year-end, including 401(k) plans, Mini 401(k) plans, profit-sharing plans and defined benefit plans.

Qualified plans must be fully funded for annual contributions by the due date of your tax return, including extensions (up to Oct. 15 of the following year).

IRA and Roth IRA plans must be established and contributions must be made by April 15 of the following year. SEP IRA plans, another type of profit-sharing plan for business owners, may be both established and funded up until the due date of your tax return, including extensions. If you miss the Mini 401(k) plan setup before year end, use a SEP IRA instead.

Otherwise, Mini 401(k) plans are the most attractive for traders. You need fee income rather than trading income to fund a retirement plan. Therefore, owners/managers need a trading or investment entity such as a general partnership, LLC or S-Corp to pay them a fee before year-end.

Recent tax law changes increased the annual profit-sharing contribution limit from $25,000 in 2002 to $40,000 for 2003 and $41,000 for 2004.

Click here to learn more about retirement plans.

Roth IRAs are also attractive for traders.
Roth IRAs are especially attractive for traders. Their main tax features are “permanent” tax-free savings on portfolio income, and traders know how to maximize portfolio savings.

Roth IRA contributions (limited to $3,000 per year) are not tax deductible, but the corresponding good news is that distributions in retirement are not taxable.

Traditional IRA contributions (limited to $3,000 per year) are tax deductible (up to certain AGI levels), but the corresponding bad news is that distributions in retirement are taxable at the higher ordinary income tax rates (up to 35 percent).

Roth IRAs provide for “permanent” tax savings on the portfolio income buildup, whereas traditional IRAs (and qualified retirement plans) only provide “temporary” tax savings. Traditional IRAs are not attractive for traders. It might be a better idea to “buy and hold” securities for the long term – no tax is due until sale of the securities and lower long-term capital gains tax rates (up to 15 percent) apply.

A note of caution: If you operate a business (trading or otherwise) in a retirement account, the IRS may classify it as a “prohibited transaction” which makes you subject to penalties. Play it safe and only trade 25 percent actively.

Note: All retirement plan contributions require “earned income.”

Get more bang for your buck with a Roth IRA conversion
Roth IRAs are great for traders, but many traders can’t get much bang for their buck out of that puny $3,000 non-deductible contribution per year (which you can make even if you have other retirement plans).

There is a better solution. You may “convert” an existing retirement plan into a Roth IRA. The one caveat is that you must pay all income taxes on the ordinary income portion of the conversion in the year of conversion. The requirement is that your “modified AGI” is less than $100,000 in the year of conversion, before the converted income is added in.

The conversion rules are complex, so visit www.irs.gov to learn more. You may only convert from an IRA to a Roth IRA, so if you have a qualified retirement plan, do a Rollover IRA direct transfer first.

The IRS treats the Roth converted amount as ordinary income (an “early withdrawal”), but you are exempt from the additional normal “early withdrawal” excise tax penalties of 10 percent.

Not included in ordinary income are non-deductible contributions (and certain employer matched contributions in 401(k) plans).

If your existing retirement plans have been battered by the recent bear markets, it’s an ideal time to consider this conversion. You will have lower conversion income taxed at ordinary rates and the recovery of these assets will be tax-free.

So if you had a bad year in 2003, it can be worth your while to do this conversion. Rather than carry back a NOL, which can cause an IRS exam (which you don't want if you are a close call on trader tax status), do a Roth conversion to use up your losses. Don’t just stop at zero taxable income – consider taking advantage of the lower tax brackets with some positive taxable income.

You can stop wherever you like by only converting a portion of your retirement plans to the Roth IRA.

Fringe Benefits Plans and Flexible Spending Accounts
If you are interested in opportunities to convert more of your non-deductible family expenses into deductible business expenses, you should learn about “fringe benefit" plans.

Most small businesses, including trading businesses, overlook fringe benefit plans; many larger companies rely on fringe benefit plans to attract and retain employees.

Fringe benefits, commonly known as “perks,” include: retirement plans; health, life and disability insurance; education, dependent care and adoption assistance; meals, lodging and parking; and many other types of plans.

Self-employed individuals (and pass-through entity owner/employees) who want to benefit from fringe benefit plans can do so if their spouses work for the business. By covering employees and spouses, they become entitled to benefits by virtue of being the spouse of an employee.

Click here to learn more about fringe benefit plans.

Choose the right entity early.
You still may have time before year-end to choose the right entity for your trading business to provide the tax benefits you need (retirement plans, health insurance premiums and fringe benefit plans among them).

If you want to use your entity for the following year, it’s beneficial to form the entity just before year-end and to commence its operations on Jan. 1 of the following year. It may take a few weeks to form the entity and open the trading accounts. Starting in November or early December is prudent.

If you commence your business operations after the start of the tax year, you will have a more complex tax filing for the following year; with sole proprietor operations for the first part of the year and the entity operations for the balance of the tax year.

Traders prefer “pass-through” entities to avoid double taxation in a C-Corp, on both the entity level (up to a 34-percent tax rate) and again on the individual level (up to 15 percent, if there are qualifying dividends). Pass-through entities have single taxation on only the individual level (rates up to 35 percent).

Traders also prefer pass-through entities to utilize ordinary losses on their individual tax returns. This allows them to offset other types of income and get NOL carrybacks. Losses are often trapped in C-Corps for many years to come.

Click here to learn more about entities for traders.

Plan your business start-up, suspension and exit well.
There are many important tax-planning issues to consider when you start up your trading business, when you suspend it and when you exit it.

The key in all cases is to maximize your business expenses and to use MTM accounting during the period of business activity (not before or after it).

Business expenses paid outside the period of business activity may be “start-up expenses,”“investment expenses” (restricted and limited) or non-deductible expenses.

Trading losses outside the period of business activity may not utilize MTM accounting, meaning those capital losses will be subject to the capital-loss limitation. If the business activity stops before year-end, the trader must deal with the onerous wash-sale and straddle-loss deferral rules at year-end. Before year-end, if you believe you are falling short of qualification, try to increase your trading activity by trading tiny amounts or taking very small risks. Commissions are low enough these days to make this strategy worthwhile.

If you know you are exiting your trading business, make sure to pay all your business expenses before you close your trading accounts (or slow the activity to a point you no longer qualify).

If you use MTM, you can mark all open positions to market on the date of exit and start with that market value for cash accounting going forward. Play it safer and sell all open positions before you exit the trading business. However, most traders don’t know they exited until after the fact.

If you exit your trading business and have an open section 481 adjustment, you will have to report the remaining deferred income in the year of exit (and it may trigger estimated taxes in the quarter you exit). It may pay to try to continue to qualify through year-end to defer a 481 adjustment one more year.

Click here to learn more about Section 481 adjustments.

If you stop trading for a while but plan to resume soon, you are in a complex situation without much guidance from the IRS. It’s wise to re-elect MTM in the following year in case the IRS considers you to have exited and then re-entered a trading business. You should consult with a proven trader tax expert.

Start-up expenses.
In general, your costs for acquiring a capital asset, including the start of a business, are added to the cost basis of your asset and not deducted until the business is sold or closed.

There is a special rule for “start-up” expenses (IRC Section 195). Start-up expenses may be amortized (expensed) over not less than 60 months on a straight-line basis. Start-up expenses must meet three requirements: expenses must be paid in connection with “investigating” the creation of your trading business (easy for traders); they must be a normal expense of the business (also easy for traders); and they must not be interest, taxes, or research and development, each of which has its own tax treatment.

Many traders spend considerable funds before entering a trading business. They attend seminars, educational programs, buy computers and start using trading tools for mock trading. Later, when they see success from simulated trading, they open a brokerage account and start their actual trading activity.

It’s wise to open your trading account early and trade very small sums with very small risk before you pay for many business expenses.

Pay education expenses after you start trading
Education expenses are only deductible after you start your trading business, with one exception. If you are already in a trading-related profession or business, such as a stock broker, then it's deductible for "maintaining and improving your job or business skills."

Education expenses may not be lumped in with start-up expenses. Investors can't deduct education expenses, even after trading (because they don’t have business status).

Education expenses for qualifying institutions (undergraduate or post-graduate school) can be utilized for education credits. Trading schools are not qualifying institutions.

There may be room for interpretation. Aggressively considering trading schools as a way to “investigate” a trading business and then including these expenses as amortizable start-up expenses is a possible idea.

Learn more about education expense benefits in our article on fringe benefit plans. Click here.

Trading gains require timely tax payments to avoid penalties and interest.
Trading and investment income is subject to the estimated tax payment rules.

This income is not part of an employee W-2; therefore there is no employer to withhold your taxes. If you are late with estimated tax payments, consider asking your employer to withhold additional amounts from your paycheck at year-end. A tax loophole treats all W-2 tax withholding as being ratably done throughout the tax year.

Estimated tax payment rules call for paying your tax obligations on a quarterly basis. Read about these rules at www.irs.gov. Read about the “safe harbor” rules, which provide for paying a lower amount based on your prior year’s taxes.

Estimated tax payment rules are not a good match for trading businesses and provide headaches for many traders who face the following problem: They may make a fortune in the first quarter only to lose it all in the later quarters. They then must wait until the following tax year to file their tax returns and get these refunds back. One could argue, though, that if you lost money in the later quarters, it was safer to leave some capital with Uncle Sam rather than in your trading account.

Some traders consider the underestimated non-deductible tax penalty of 4 percent per annum an attractive “margin loan” rate. The IRS changes the rate often, and the current rate is fairly low.

Even if you want to borrow from Uncle Sam as long as possible (until April 15, when you have to pay 90 percent of your taxes for the prior year or be subject to additional penalties and interest), it’s a good idea to pay some or all of your state taxes before year-end to maximize your itemized deductions for additional tax savings.

Note: State taxes are not deductible for alternative minimum tax (AMT), so there's no sense paying early if you don’t get a tax benefit. Learn more about AMT taxes at www.irs.gov.

Click here to learn more about this tax payment strategy below.

Bottom line
The tax code is very complex for all taxpayers. For traders it’s even more complex, with myriad investment rules and complexities of trader tax status. To make things even more difficult, the tax code has different breaks for different income levels, and traders move quickly between these levels. How can a trader keep one eye on the markets and another on mastering the tax code? The answer is they can't, so they need a trader tax expert to help. This once a year “general checkup” is most effective just before the end of the year. We suggest you consider a consultation with our firm or sign up for 2003 tax preparation and planning soon.

This article by Robert A. Green, CPA, appeared in the February 2004 issue of SFO magazine: What tax rate does your future hold? Securities and futures exchanges are competing for your business with many new products. When choosing which ones look most attractive, add taxation to the mix; it could help reduce your tax rate by 12 percent.

Here is the original article submitted, before editing by the magazine.
(Written for the magazine in a prior year. The tax code is generally indexed for inflation and threshold amounts change each tax year. For a full run down on all the changes for the 2006 and 2007 tax years, click here for a Client Letter from a leading tax publisher.)

Wise taxpayers should do their tax planning before year-end. Traders have special circumstances that make year-end tax planning even more paramount. Certain moves can save you a fortune come April 15.

By Robert A. Green, CPA

Self-employed business traders have more tax responsibilities than employees (who have their taxes withheld and paid by their employers). For example, self-employed persons must pay their own estimated income taxes (on a quarterly basis) and they must file business tax returns (Schedule C for individuals). These responsibilities can be burdensome.

The good news for self-employed persons is that with added responsibilities come many opportunities for tax benefits. Self-employed persons also have many options for different accounting treatment, and they control their own tax destiny. However, much of that tax destiny expires at year-end, meaning you must make certain moves before year-end to improve your tax results.

Traders are a special breed of self-employed persons. They have all the same rules and opportunities that regular self-employed businesses have, plus additional headaches or opportunities when it comes to dealing with trader tax status, wash sales, straddle rules, constructive receipts, mark-to-market (MTM) accounting and Section 481(a) adjustments.

For all these reasons, it is paramount that business traders deal with these tax issues before year-end, come up with a good year-end tax planning strategy and execute that strategy on time.
“Cash method” business traders (such as investors) in securities are stuck with the onerous application of various tax-loss deferral rules including: wash-sale and loss-deferral rules; year-end tax straddles and constructive receipt transactions; and annual net capital-loss limitation ($3,000 per year for individuals, zero for C-corporations).

It is important to see ahead of time how these “capital-loss treatment” limitation rules might affect your trading around the year-end period. Many traders find it advantageous to make minor changes to their trading programs to result in better results tax-wise.

MTM business traders are able to avoid the above “capital-loss treatment” headaches. MTM traders report their “economic” trading gains and losses (realized and unrealized gains and losses). MTM traders do not have to sell securities at year-end for “tax selling,” which can save them commissions. Wash sales and straddles rules are both irrelevant, as MTM traders are specifically exempt from them.

MTM traders have ordinary gain or loss treatment on their trading positions and cash method treatment on their “segregated” investment positions. It is important to seek all this out before year-end to see where you stand.

By planning ahead, a cash method securities trader planning to elect MTM for the following tax year may convert unutilized “unrealized” capital losses into ordinary tax losses for the following tax year (see example below).

Like other self-employed taxpayers, business traders may accelerate business deductions and estimated state income tax payments into the current tax year. That can save you significant income taxes, even though it’s just a “timing” benefit.

First, figure out your general gameplan before year-end.
A first step in year-end tax planning for a trader is to assess whether or not the trader qualifies for trader tax status for all or part of the current tax year.

If you do not qualify for trader tax status as of year-end, you may not use mark-to-market accounting, even if you elected it on time or carried over that accounting method from the prior tax year. In this case, though, you may qualify for trader tax status for the earlier part of the tax year and use MTM accounting (ordinary loss treatment) for that period only. You will be stuck with the onerous “capital-loss treatment” limitations at year-end.

Don’t wait until tax time in the following year to make this determination of “trader tax status;” it may be too late if you want to take advantage of year-end tax strategies.

If you don’t qualify for trader tax status at year-end, but plan to qualify starting in January of the following year, don’t accelerate your business expenses per the above tax strategy. You will be accelerating “investment expenses,” which may not generate tax benefits. It would be better to defer investment expenses and turn them into business expenses in the following tax year.

Calculate your trading and investment gains and losses before year end.
Traders need to have a good handle on their trade accounting well before year-end if they want the opportunity to plan around wash sales, straddles, constructive receipts and conversion to MTM in the following year.

It is also important to have separate accountings for trading gains and losses vs. “segregated” investment gains and losses. MTM traders use MTM for trading gains and losses, but they still must use cash method accounting for “segregated” investment positions.

Segregation is supposed to be done “contemporaneously” on the date you acquire a position. All positions in a trading account are by default a trading position unless you label it an investment position and then hold it accordingly for a certain period of time. The segregation rules are complex and beyond the scope of this discussion.

Traders should have all these accounting components in place before they embark on year-end tax planning.

Many brokerage firms have profit and loss reports available online. Take caution that many of them have “unmatched trades” and/or they do not account for wash sales, straddles, constructive receipts or MTM if you are a MTM trader.

You can use a good trade accounting software program such as our “GTT TradeLog” to import all your trades for the entire year. For cash method traders, the program calculates wash sales, and makes the Section 481 adjustment for the following tax year. For MTM traders, the program calculates year-end MTM imputed sales using year-end prices downloaded off the Internet.

Cash method traders have many tax opportunities and pitfalls at year-end. Without proper tax planning, profitable and losing traders may be stuck with “capital-loss treatment” limitations including wash sales, straddle rules and constructive receipts. Losing traders are also limited by the capital-loss limitation each year.

Wash-sale conditions exist when a trader re-enters a losing trade within 30 days or exiting the losing trade (i.e., closing the position). Straddle rules and constructive receipt rules apply when a trader has an “offsetting position” – he or she takes a loss on one part of the position but holds the offsetting gain position open at year-end. The IRS seeks to prevent cash method traders from playing games by taking losses in one year and deferring offsetting positions with gains into the next tax year. This makes sense by design, but it is a nightmare for most traders and they are not trying to play games with the IRS.

Wash sales, straddle rules and constructive receipts are beyond the scope of this article. Click here for more information on wash sales.

MTM method traders are exempt from “capital-loss limitation” rules.
MTM business traders have it much easier at year-end than cash method traders. MTM traders don’t have to worry about year-end “tax selling” of trading positions. They are exempt from wash sales, straddles and constructive receipt rules on their trading positions. They are subject to these rules on their “segregated” investment positions.

Cash method traders electing MTM for the next tax year have excellent opportunities for tax benefits. The flip side is tax pitfalls.

Cash method traders first have a headache in dealing with the “capital-loss limitation” rules at year end (discussed above).

If that cash method trader also wants to elect mark-to-market accounting for the following tax year, their level of tax planning complexity raises a notch. When a cash basis trader elects MTM for the following tax year there are many new tax planning opportunities as well as pitfalls. All of these must be factored into the general tax planning for capital-loss limitations.

When a cash method trader makes a change in accounting method to MTM, they are required to make a Section 481(a) adjustment on the first date of the year of change. With MTM, the trader starts the year with all prior-year open positions valued on opening prices the first trading day of the year. The trader ended the prior year without having to report “unrealized” gains and losses on open positions at year-end. Therefore, the Section 481(a) adjustment is meant to account for this disconnect. The Section 481(a) adjustment equals the prior year-end “unrealized” gains or losses on trading positions only (not segregated investment positions).

The gold in this article is a strategy to convert unutilized capital losses into ordinary losses.
A cash method trader who already exceeds the capital-loss limitation should not sell additional losing positions before year-end (in December); instead, that trader should try to hold those losing positions open until January (using indices to hedge risk if necessary).

The idea is that a carryover capital loss is not useful in the current tax year and it may not be useful in the following tax year. By holding the position open at year-end, the loss becomes a Section 481(a) adjustment, which is a full ordinary loss deduction in the following tax year.

Negative Section 481(a) adjustments are reported in full in the year of change. Positive Section 481(a) adjustments greater than $25,000 are prorated over four years.

It may even make sense to convert large unrealized gain positions to MTM trading positions in the next tax year (with a MTM election) and then prorate those gains over four tax years.

Caution – You are stuck with "built-in" capital loss
Please note that when a partner contributes an asset to a partnership where the asset has a "built-in" capital loss in the hands of the partner (i.e., the cost basis of the asset is more than the fair market value at the date of the contribution to the partnership), the loss from sale of the asset is still treated as a capital loss by the partnership if the asset is sold within five years of the date it was contributed to the partnership. This is true even if the partnership has trader status and has properly elected MTM. Internal Revenue Code Section 724(c) specifically prevents the conversion of “built-in” capital losses on security transactions to ordinary losses by contributions from a cash basis trader/investor to a trading entity that has properly elected MTM. This applies also to a limited liability corporation (LLC), including a single-member LLC. However, it does not apply to S-corporations

Joe Trader converts “unutilized” unrealized capital losses from the current year into fully deductible ordinary losses in the following year.
Joe Trader is a cash method (non-MTM) securities trader. On Dec. 1 of the current tax year, Joe calculates current year-to-date net capital losses in the amount of $25,000. On the same day, Joe also calculates net “unrealized” trading losses on his open trading positions in the amount of $50,000. As a cash method trader, he is limited to a net capital loss deduction of $3,000 for the current tax year.

Joe plans to elect MTM for the following year, by April 15, so his following year trading gains and losses will be “ordinary” and not “capital.” Joe is happy to avoid the prospect of increasing his already unutilized capital loss carryovers.

Joe does not have GTT TradeLog and he is not certain of his wash sales and straddles. He figures he can skip this headache since he can’t imagine that his deductible capital loss would end up being less than his capital-loss limitation of $3,000.

Joe should know that a wash-sale or straddle-loss deferral may be better tax-wise than a capital-loss carryover, because he is electing MTM for the following year. In most cases, wash-sale and straddle-loss deferrals become part of a Section 481(a) ordinary loss adjustment. However, a capital-loss carryover can never be recovered as an ordinary loss. Joe should calculate his proper wash-sale and straddle-loss deferrals to take advantage of this tax benefit.

When thinking about his open positions in December, Joe figures his current year-to-date capital losses already far surpass the $3,000 capital-loss limitation, so why take more capital losses before year-end? They won’t help lower his current year tax liability.

Joe further figures that capital-loss carryovers are harder to utilize in the following year because he will be generating ordinary rather than capital gains from trading, and he will have few segregated investment positions to generate capital gains.

The smart move for Joe in December is to not sell his open positions and instead try to hold them through year-end. If the market risk is too great, Joe can hedge the open positions with indices.
By doing this, Joe will convert unutilized current year “unrealized” capital-loss carryovers into a negative Section 481(a) adjustment that is an ordinary loss in the following year.

Joe killed two birds with one stone. He lowered his capital-loss carryover and he also increased his ordinary tax loss in the following year.

Joe can be even more clever by tax-loss selling before year-end on his open unrealized gain positions. That will reduce his capital-loss carryover and increase his Section 481(a) adjustments, respectively.

Note: If Joe had the reverse fact pattern and had unrealized capital gains instead of unrealized capital losses, it would be imperative for Joe to sell all those unrealized capital gains before year-end to offset his $25,000 of realized capital losses to date.

Business traders accelerate following-year expenses to lower current-year tax liabilities
The cardinal rule of year-end tax planning is to accelerate business deductions and losses into the current tax year and defer income and gains into the following tax year.

The idea is to defer income taxes until the following tax years, thereby benefiting from the use of this tax money during the current and following tax year. These are referred to as “timing” rather than “permanent” tax benefits.

As a default method of accounting, business traders use the “cash method” of accounting for both business expenses and trading gains and losses. This means that business expenses are deductible when “paid”, as opposed to when “incurred.”

Note: When a business trader elects MTM, it only changes how gains and losses are treated, not how “cash basis” expenses are treated.

For example, if a cash method business trader attends a seminar at year-end, but pays the bill in January, it is a business expense for the following year.

A business trader may also elect to use the “accrual method” of accounting, which means that expenses are deductible when incurred, not when paid.

A business trader may also elect to use MTM accounting for their trading gains and losses. This MTM election must be filed with the IRS by April 15 of the current tax year; otherwise the cash method of “capital gains and losses” applies for the entire tax year. See below for tax planning moves related to trading gains and losses.

Since trading gains and losses are treated separately from expenses and business traders don’t have other forms of income, for most business traders it may be better tax-wise to use the accrual method of accounting for business expenses. This also may be more trouble accounting-wise.

For cash method business traders, the easiest way to accelerate deductions is to pay all bills before year-end. Note, however, that a prepayment of following-year expenses will not give rise to a current-year tax deduction.

Credit card charges are treated like payments of cash or check. It does not matter when you pay the credit card bill. For example, if you charge your credit card for a new computer on Dec. 31, that is a current-year tax deduction under the cash method. It does not matter that the computer is listed on your January credit card statement.

Maximize your 100-percent depreciation for the current tax year.
If you plan to upgrade your computers, equipment and/or furniture/fixtures soon, why not do it before year-end rather than in early 2003?

Each tax year, a taxpayer is allowed IRC Section 179 depreciation (100 percent) up to the first $100,000 (increased from $24,000 for 2002) of depreciable assets. Excess amounts are subject to the normal rules of depreciation and amortization (over the useful life of the asset).

Figure out whether to pay the minimum or maximum state estimated income taxes before year-end for a tax-savings deduction.
Self-employed taxpayers, like business traders, are responsible for paying their own estimated income taxes during the current tax year. This is more complex than it is for employees who have their federal and state income tax withheld by their employers and reported on their W-2s.

For most traders, if they wait until April 15 of the following year (the tax deadline) to pay their current year federal and state income taxes, they will be subject to federal and state “underestimated tax penalties.” The current federal rate is 4 percent.

In general, these rules work as follows: You may owe this penalty for the current year if the total of your withholding and estimated tax payments did not equal at least the smaller of 90 percent of your current year tax liability, or 100 percent of your prior year tax liability (the “safe harbor rule”). If your adjusted gross income (AGI) for the prior year was more than $150,000 ($75,000 if your filing status is married filing a separate return), substitute 110 percent for 100 percent above.

Some traders make a business decision to not pay estimated income tax payments for their first three quarters in order to use that tax money for additional trading capital. In the event they lose money in Q4 and end the year with loses or lower gains, they can catch up with a Q4 estimated tax payment.

If they have trading gains in Q4, they are willing to pay the underestimated tax penalties for Q1, Q2 and Q3, charged on a quarterly basis. They consider this another form of a margin loan at 4-percent rates.

The important tax planning question is whether to pay the minimum or maximum state income tax payment by Dec. 31, or on the due date of Jan. 15 the following year.

Assume a trader’s current-year taxable income is significantly higher than their prior year's taxable income. Using the safe harbor rule, this trader can pay a good portion of their current-year income taxes by April 15 of the following year, thereby paying less with Q4 estimated income tax payments.

In many cases, it is tax beneficial for the above trader to pay their entire current-year state tax due by Dec. 31 rather than the required amount on Jan. 15 and the balance on April 15. A current-year itemized deduction for state taxes will reduce the trader’s federal tax liability at their highest federal marginal rates, up to 35 percent.

A note of caution about alternative minimum tax (AMT): Make sure the Q4 estimated income tax payment does not give rise to an AMT, since state income taxes are not a deduction for AMT taxable income. Only pay enough state taxes before year-end until AMT is triggered. Pay the rest in the following year (some may be owed by Q4 Jan. 15 and the rest by April 15).

Another note of caution about forgoing estimated tax payments to increase trading capital as long as possible: Many traders played this game for tax year 1999 and lost what they owed by April 15, 2000. Many of them are still in hot water with the IRS and state tax authorities. Every year just before April 15, many traders must liquidate positions to raise capital to pay taxes. Watch out for this annual musical chairs.

Client Letter from a leading tax publisher:
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2006 Year-End Tax Planning for Individuals

Dear Client:

As 2006 draws to a close, there is still time to reduce your 2006 tax bill and plan ahead for 2007. This letter highlights several potential tax-saving opportunities for you to consider. I would be happy to meet with you to discuss specific strategies.

Basic Numbers You Need To Know

Because many tax benefits are tied to or limited by adjusted gross income (AGI)—IRA deductions, for example—a key aspect of tax planning is to estimate both your 2006 and 2007 AGI. Also, when considering whether to accelerate or defer income or deductions, you should be aware of the impact this action may have on your AGI and your ability to maximize itemized deductions that are tied to AGI. Your 2005 tax return and your 2006 pay stubs and other income- and deduction-related materials are a good starting point for estimating your AGI.

Another important number is your "tax bracket," i.e., the rate at which your last dollar of income is taxed. The tax rates for 2006 are 10%, 15%, 25%, 28%, 33%, and 35%. Although tax brackets are indexed for inflation, if your income increases faster than the inflation adjustment, you may be pushed into a higher bracket. If so, your potential benefit from any tax-saving opportunity is increased (as is the cost of overlooking that opportunity).

IRA, Retirement Savings Rules for 2006

More tax-saving opportunities continue for retirement planning in 2006 than in previous years due to the availability of Roth IRAs, changes that make regular IRAs more attractive, and other retirement savings incentives. As discussed herein, even more changes will begin in 2007.

Traditional IRAs: Individuals who are not active participants in an employer pension plan may make deductible contributions to an IRA. The annual deductible contribution limit for an IRA for 2006 is $4,000. Individuals who are active participants in a plan may also make deductible contributions to an IRA, but limited in amount depending on their AGI. For 2006, the AGI phase-out range for deductibility of IRA contributions is between $50,000 and $60,000 of modified AGI for single persons (including heads of households), and between $75,000 and $85,000 of modified AGI for married filing jointly. Above these ranges, no deduction is allowed.

For 2006, a $1,000 "catch-up" contribution deduction is allowed for taxpayers age 50 or older by the close of the taxable year who meet the other qualifications for IRA deductions. Thus, the total deductible limit for these individuals may be as high as $5,000.

In addition, an individual will not be considered an "active participant" in an employer plan simply because the individual's spouse is an active participant for part of a plan year. Thus, you may be able to take the full deduction for an IRA contribution regardless of whether your spouse is covered by a plan at work, subject to a phase-out if your joint modified AGI is $150,000 to $160,000. Above this range, no deduction is allowed.

Roth IRA: This type of IRA permits nondeductible contributions of up to $4,000 a year. Earnings grow tax-free, and distributions are tax-free provided no distributions are made until more than five years after the first contribution and the individual has reached age 591/2. Distributions may be made earlier on account of the individual's disability or death. The maximum contribution is phased out for persons with AGI above certain amounts: $150,000 to $160,000 for joint filers, and $95,000 to $110,000 for single filers (including heads of households). For 2006, a $1,000 "catch-up" contribution is allowed for taxpayers age 50 or older by the close of the taxable year, making the total limit $5,000 for these individuals.

Roth IRA Conversion Rule: Funds in a traditional IRA may be rolled over into a Roth IRA. Such a rollover, however, is treated as a taxable event, and you will pay tax on the amount converted. No penalties will apply if all the requirements for such a transfer are satisfied.

A taxpayer's AGI (whether married filing jointly or single) is limited to $100,000 to make such a conversion and the taxpayer must not be a married individual filing a separate return.

401(k) Contribution: The 401(k) elective deferral limit is $15,000 for 2006, up from $14,000 in 2005. If your 401(k) plan has been amended to allow for catch-up contributions for 2006 and you will be 50 years old by December 31, 2006, you may contribute an additional $5,000 to your 401(k) account, for a total maximum contribution of $20,000 ($15,000 in regular contributions plus $5,000 in catch-up contributions).

SIMPLE Plan Contribution: The SIMPLE plan deferral limit is $10,000 for 2006, the same as in 2005. If your SIMPLE plan has been amended to allow for catch-up contributions for 2006 and you will be 50 years old by December 31, 2006, you may contribute an additional $2,500.

Catch-Up Contributions for Other Plans: If you will be 50 years old by December 31, 2006, you may also contribute an additional $5,000 to your 403(b) plan or SEP.

Saver's Credit: A nonrefundable tax credit is available based on the qualified retirement savings contributions to an employer plan made by an eligible individual. Only taxpayers filing joint returns with AGI of $50,000 or less, head of household returns with AGI of $37,500 or less, or single returns (or separate returns filed by married taxpayers) with AGI of $25,000 or less, are eligible for the credit. The amount of the credit is equal to the applicable percentage (10% to 50%, based on filing status and AGI) of qualified retirement savings contributions up to $2,000.

Maximize Retirement Savings: In many cases, employers will require you to set your 2007 retirement contribution levels before January 2007. You may want to increase your contribution to lower your AGI in order to take advantage of some of the tax breaks described above. In addition, maximizing your contribution is generally a good tax-saving move.

Hurricane Relief: The 10% penalty on early distributions from qualified retirement plans does not apply to qualified hurricane distributions of up to $100,000 from a qualified retirement plan, a §403(b) annuity, or an IRA. A qualified hurricane distribution covers distributions taken after Hurricanes Katrina, Rita and Wilma. A qualified Hurricane Katrina distribution is any distribution from an eligible retirement plan made on or after August 25, 2005, and before January 1, 2007, to an individual whose principal place of abode on August 28, 2005, is located in the Hurricane Katrina disaster area and who has sustained an economic loss by reason of Hurricane Katrina. A qualified Hurricane Rita distribution is any distribution from an eligible retirement plan made on or after September 23, 2005, and before January 1, 2007, to an individual whose principal place of abode on September 23, 2005, is located in the Hurricane Rita disaster area and who has sustained an economic loss by reason of Hurricane Rita. A qualified Hurricane Wilma distribution is any distribution from an eligible retirement plan made on or after October 23, 2005, and before January 1, 2007, to an individual whose principal place of abode on October 23, 2005, is located in the Hurricane Wilma disaster area and who has sustained an economic loss by reason of Hurricane Wilma. Distributions from someone affected by multiple hurricanes cannot overlap. Withdrawals are ratably included in income over a three-year period, unless the taxpayer elects to include the amount in the current year. Withdrawals can be recontributed to a qualified plan during such three-year period to avoid the withdrawal being included in income. Any tax paid prior to the recontribution can be recovered through refund procedures.

Pension Act Relief: Effective for distributions made after 2006, nonspouse beneficiaries may roll over to an IRA or other plan structured for that purpose amounts inherited as a designated beneficiary. The inherited amounts are subject to the annual minimum distribution rules requiring distributions over the person's life expectancy (recalculated annually). Also, for taxable years beginning after 2006, the IRS must make available a form for a taxpay