IRS Confirms Traders Are Eligible For QBI Deduction

January 21, 2019 | By: Robert A. Green, CPA | Read it on

Great news for traders: Section 199A final regs confirm QBI includes Section 475 ordinary income and loss.

On Jan. 18, 2019, the IRS issued final 199A regs for the 2017 Tax Cuts and Jobs Act (TCJA) 20% qualified business income (QBI) deduction. The final regs update the August 2018 proposed/reliance 199A regs and confirm that QBI includes Section 475 ordinary income/loss for “traders in securities and commodities,” who qualify for trader tax status (Section 162 business expense treatment).

Based on our interpretation of TCJA and the proposed/reliance regs, we figured QBI included Section 475 ordinary income/loss, but it was uncertain. Our previous content, including version one of Green’s 2019 Trader Tax Guide, stated that QBI “likely” included Section 475 ordinary income/loss. We are glad to remove the word “likely” from new versions and updates. What was uncertain before is now satisfied.

The final and proposed/reliance regs each state that QBI expressly excludes capital gains and losses, and also excludes Section 954 items of ordinary income, including forex Section 988 and notional principal contracts.

Making our case to the IRS
After noticing that the proposed/reliance regs were silent about Section 475 income/loss, I contacted one of the lawyers at the Office of Chief Counsel listed on the 199A proposed regs.

The attorney called me back after he saw my interview in Tax Notes, “Groups Urge IRS to Rethink 199A Business Income Rules.” I presented our firm’s rationale for including Section 475 ordinary income/loss in QBI and suggested he watch our Sept. 12, 2018, Webinar recording “How Traders, Hedge Funds, And Investment Managers Can Qualify For The New 20% QBI Deduction” (presentation slides) and read my Aug.15, 2018 blog post “How Traders Can Get 20% QBI Deduction Under IRS Proposed Regulations.” The IRS attorney said my rationale sounded “plausible” in his opinion.

Excerpts from final regs
Final 199A regs, p. 55-56:

“Given the specific reference to section 1231 gain in the proposed regulations, other commenters requested guidance with respect to whether gain or loss under other provisions of the Code would be included in QBI. One commenter asked for clarification about whether real estate gain, which is taxed at a preferential rate, is included in QBI. Additionally, other commenters requested clarification regarding whether items treated as ordinary income, such as gain under sections 475, 1245, and 1250, are included in QBI.

To avoid any unintended inferences, the final regulations remove the specific reference to section 1231 and provide that any item of short-term capital gain, short-term capital loss, long-term capital gain, or long-term capital loss, including any item treated as one of such items under any other provision of the Code, is not taken into account as a qualified item of income, gain, deduction, or loss. To the extent an item is not treated as an item of capital gain or capital loss under any other provision of the Code, it is taken into account as a qualified item of income, gain, deduction, or loss unless otherwise excluded by section 199A or these regulations.

Similarly, another commenter requested clarification regarding whether income from foreign currencies and notional principal contracts are excluded from QBI if they are ordinary income. Section 199A(c)(3)(B)(iv) and §1.199A-3(b)(3)(D) provide that any item of gain or loss described in section 954(c)(1)(C) (transactions in commodities) or section 954(c)(1)(D) (excess foreign currency gains) is not included as a qualified item of income, gain, deduction, or loss. Section 199A(c)(3)(B)(v) and §1.199A-3(b)(3)(E) provide any item of income, gain, deduction, or loss described in section 954(c)(1)(F) (income from notional principal contracts) determined without regard to section 954(c)(1)(F)(ii) and other than items attributable to notional principal contracts entered into in transactions qualifying under section 1221(a)(7) is not included as a qualified item of income, gain, deduction, or loss. The statutory language does not provide for the ability to permit an exception to these rules based on the character of the income. Accordingly, income from foreign currencies and notional principal contracts described in the listed sections is excluded from QBI, regardless of whether it is ordinary income.”

Parsing the language in the final 199A regs
In the proposed 199A regs, QBI excluded all capital gains and losses, and ordinary income/loss items expressly listed in Section 954. Section 954 does not include Section 475 ordinary income/loss. In the proposed regs, QBI expressly included Section 1231 losses from the sale of business property, whereas, QBI excluded Section 1231 capital gains. Section 475 ordinary income/loss is similar to Section 1231 ordinary losses, and it’s not in Section 954, so we determined that QBI likely included Section 475 ordinary income/loss.

The final 199A regs acknowledge the uncertainty and tax writers fixed it in the above language. They opened the door for Section 1231 losses to include more items like Section 475 ordinary income/loss, reiterating that it must not be on the Section 954 list, which Section 475 is not.

How QBI works for a trading business
The proposed and final 199A regs state that traders eligible for trader tax status are a “specified service activity” (SSA), so the SSA taxable income (TI) cap applies. Taxpayers who make one dollar over the TI cap will not be allowed a QBI deduction on SSA QBI. On the other hand, non-SSA activity is not restricted to the TI cap, although the W-2 wage and property limitations apply over the TI threshold.

For 2018, the SSA TI cap is $415,000/$207,500 (married/other taxpayers). The phase-out range below the cap is $100,000/$50,000 (married/other taxpayers), in which the QBI deduction phases out for an SSA. The 50% W-2 wage and property basis limitations also apply within the phase-out range. For 2018, the TI threshold is $315,000/$157,500 (married/other taxpayers): If a taxpayer is below the TI threshold, there are no phase-out, wage or property limitations for SSA and non-SSA.

For 2019, the SSA TI cap increases to $421,400/$210,700 (married/other taxpayers) based on the inflation adjustment. The phase-out range remains the same, so for 2019, the TI threshold is $321,400/$160,700 (married/other taxpayers).

Hedge funds with TTS and Section 475 ordinary income/loss should report QBI, too. Investors in these hedge funds are eligible for a QBI deduction if they are under the TI cap.

Investment managers are also SSA, and they have QBI from advisory fees. Carried interest as a profit allocation of Section 475 ordinary income/loss is QBI, too. Carried interest in capital gains is not.

It’s more crucial to qualify for TTS than ever before
TTS allows business expense treatment, whereas, TCJA suspended “certain miscellaneous itemized deductions subject to the 2% floor,” which includes investment fees and investment expenses. TCJA still allows investors itemized deductions for investment-interest expenses limited to investment income, and stock borrow fees as other itemized deductions. TTS business expenses allow a long list of deductions from gross income, including home office, and that’s far better!

TTS traders may elect Section 475 mark-to-market (MTM) accounting on securities and or commodities (Section 1256 contracts). Securities traders appreciate that Section 475 trades are exempt from dreaded wash-sale loss adjustments and the $3,000 capital loss limitation. I call it “tax loss insurance,” because 475 ordinary losses lead to much faster tax refunds. (TCJA did repeal NOL carrybacks, forcing NOL carryforwards, instead.) TTS traders are entitled to segregate investment positions to achieve lower tax rates on long-term capital gains. TTS traders prefer to skip Section 475 on commodities to retain lower 60/40 capital gains rates on Section 1256 contracts.

Now with final 199A regs, there’s a certainty for another benefit of Section 475. Profitable TTS traders may consider a Section 475 election to be eligible for a potential QBI deduction. In some years, the trader might be under the TI cap, allowing a QBI deduction, and in other years, he might have a (good) problem of exceeding the cap for no QBI deduction.

Married taxpayers should consider filing separately, as that might unlock a QBI deduction for one spouse since the other spouse might have income exceeding the SSA income cap. TCJA equalized the tax rates for filing jointly vs. separately.

TTS traders with Section 475 ordinary losses might be unhappy. For example, assume a trader has $100,000 of QBI from a consulting business. She also has TTS/Section 475 ordinary losses of $40,000, so her aggregate QBI is $60,000, which reduces the QBI deduction.

The Section 199A regs are complicated
There are complex issues over what constitutes an SSA vs. non-SSA, how to calculate the W-2 wage and property limitations, definitions of QBI, and more.

Taxpayers have to calculate the QBI deduction on whichever is lower: aggregate QBI or taxable income minus net capital gains/losses.

If you expect to receive a 2018 Schedule K-1 containing QBI tax information, then consider filing an automatic extension by April 15. I assume that many pass-through entities won’t issue final 2018 Schedule K-1s until after that date. It’s great that the IRS issued the final 199A regs now, so it doesn’t cause further delay in tax season. Look for QBI items on Schedule K-1 line 20 “Other Information” marked with various codes for 199A items of income, wages, property and more. See the K-1 instructions for line 20.

Elect Section 475 on time to be eligible for the QBI deduction
Individual TTS traders need to file a 2019 Section 475 election statement with the IRS by April 15, 2019, as sole proprietor traders are eligible for the QBI deduction. Existing partnerships and S-Corps need to file a 2019 Section 475 election statement with the IRS by March 15, 2019. New taxpayers (i.e., new entities) may elect Section 475 within 75 days of inception by internal election. Existing taxpayers have a second step to file a Form 3115 with their 2019 tax return.

Learn more about TTS, Section 475, QBI and entity solutions in Green’s 2019 Trader Tax Guide.

Darren L. Neuschwander, CPA contributed to this blog post.


Highlights From Green’s 2019 Trader Tax Guide

January 15, 2019 | By: Robert A. Green, CPA | Read it on

Use Green’s 2019 Trader Tax Guide to receive every trader tax break you’re entitled to on your 2018 tax returns. Our 2019 guide covers the 2017 Tax Cuts and Jobs Act’s impact on investors, traders, and investment managers. Learn various smart moves to make in 2019.

Whether you prepare your 2018 tax returns as a trader or investor, this guide can help. Even though it may be too late for some tax breaks on 2018 tax returns, you can still use this guide to execute these tax strategies and elections for tax-year 2019.

Tax Cuts and Jobs Act

Tax Cuts and Jobs Act (TCJA) was enacted on Dec. 22, 2017, and the law changes take effect in the 2018 tax year.

Like many small business owners, traders eligible for trader tax status (TTS) restructured their business for 2018 and 2019 to take advantage of TCJA. Two tax benefits caught their eye: The 20% deduction on qualified business income (QBI) in pass-through entities, and the C-Corp 21% flat tax rate. TCJA suspended investment fees and expenses, which makes TTS even more crucial. (TCJA continues to allow itemized deductions for investment-interest expenses and stock borrow fees.)

TCJA didn’t change trader tax matters, including business expense treatment, Section 475 MTM ordinary gain or loss treatment, wash-sale loss adjustments on securities, Solo 401(k) retirement contributions, and health insurance deductions for S-Corp TTS traders. TCJA also retains the lower Section 1256 60/40 capital gains tax rates; the Section 1256 loss carryback election; Section 988 forex ordinary gain or loss; and tax treatment on financial products including options, ETFs, ETNs, swaps, precious metals, and more.

Tax forms changed with TCJA for 2018

TCJA required significant revisions to 2018 income tax forms. The redesigned two-page 2018 Form 1040 resembles a postcard because the IRS moved many sections to six new 2018 Schedules (Form 1040). It’s a block-building approach with the elimination of Form 1040-EZ and 1040-A.

See the new 2018 Schedule 1 (Form 1040) for reporting “Additional Income” including state tax refunds, Schedule C, D, E, Form 4797 (Section 475), and Other Income/Loss (Section 988 forex) on line 21. Schedule 1 (Form 1040) is also for reporting “Adjustments To Income,” previously called items of “adjusted gross income” (AGI).

The IRS significantly changed Schedule A (Itemized Deductions). TCJA suspended “certain miscellaneous itemized deductions subject to the 2% floor.” These deductions were included in “Job Expenses and Certain Miscellaneous Deductions” on the 2017 Schedule A, lines 21 through 24. The revised 2018 Schedule A deletes these deductions, including job expenses, investment fees and expenses, and tax compliance fees and expenses.

The 2017 Schedule A also had “Other Miscellaneous Deductions,” not subject to the 2% floor, on line 28. That’s where investors reported stock-borrow fees, which are not investment fees and expenses. The 2018 Schedule A changed the name to “Other Itemized Deductions” on line 16.

TCJA introduced a new 20% deduction on qualified business income, but the IRS did not draft a tax form for it. A taxpayer must use a worksheet for the calculation and report a “qualified business income deduction” on the 2018 Form 1040, page 2, line 9.

Business traders fare better

By default, the IRS lumps all traders into “investor tax status,” and investors get penalized in the tax code — more so with TCJA. Investors have restricted investment interest expense deductions, and investment fees and expenses are suspended. Investors have capital-loss limitations ($3,000 per year), and wash-sale loss deferrals; they do not have the Section 475 MTM election option or health insurance and retirement plan deduction strategies. Investors benefit from lower long-term capital gains rates (0%, 15%, and 20%) on positions held 12 months or more before sale. If active traders have segregated long-term investment positions, this is available to them as well.

Business traders eligible for TTS are entitled to many tax breaks. A sole proprietor (individual) TTS trader deducts business expenses and is entitled to elect Section 475 MTM ordinary gain or loss treatment. However, to deduct health insurance and retirement plan contributions, a TTS trader needs an S-Corp to create earned income with officer compensation.

Don’t confuse TTS with the related tax-treatment election of Section 475 MTM accounting.  The election converts new capital gains and losses into business ordinary gains and losses, avoiding the $3,000 capital loss limitation. Only qualified business traders may use Section 475 MTM; investors may not. Section 475 trades are also exempt from wash-sale loss adjustments. TCJA has a new 20% deduction on qualified business income, which includes Section 475 ordinary income but excludes capital gains.

A business trader can assess and claim TTS after year-end and even going back three open tax years. But business traders may only use Section 475 MTM if they filed an election on time, either by April 15 of the current year (i.e., April 17, 2018, for 2018) or within 75 days of inception of a new taxpayer (i.e., a new entity).

Can traders deduct trading losses?

Deducting trading losses depends on the instrument traded, the trader’s tax status, and various elections.

Many traders are hoping to find a way to deduct their 2018 trading losses. Maybe they qualify for TTS, but that only gives them the right to deduct trading business expenses.

Securities, Section 1256 contracts, ETN prepaid forward contracts, and cryptocurrency trading receive capital gain/loss treatment by default. If a TTS trader did not file a Section 475 election on securities and/or commodities on time (i.e., by April 17, 2018), or have Section 475 from a prior year, they are stuck with capital loss treatment on securities and Section 1256 contracts. Section 475 does not apply to ETN prepaid forward contracts, which are not securities, or cryptocurrencies, which are intangible property.

Capital losses offset capital gains without limitation, whether short-term or long-term, but a net capital loss on Schedule D is limited to $3,000 per year against other income. Excess capital losses are carried over to the subsequent tax year(s).

Once taxpayers get in the capital loss carryover trap, a problem they often face is how to use up the carryover in the following year(s). If a taxpayer elects Section 475 by April 15, 2019, the 2019 business trading gains will be ordinary rather than capital. Remember, only capital gains can offset capital loss carryovers. Once a trader has a capital loss carryover hole, he or she needs a capital gains ladder to climb out of it and a Section 475 election to prevent digging an even bigger one. The IRS allows revocation of Section 475 elections if a Section 475 trader later decides he or she wants capital gain/loss treatment again. Even so, an entity is still better for electing and revoking Section 475 as needed.

Traders with capital losses from trading Section 1256 contracts (such as futures) might be in luck if they had gains in Section 1256 contracts in the prior three tax years. On the top of Form 6781, traders can file a Section 1256 loss carryback election.  This allows taxpayers to offset their current-year losses against prior-year 1256 gains to receive a refund of taxes paid in prior years.  Business traders may elect Section 475 MTM on Section 1256 contracts, but most elect it on securities only so they can retain the lower 60/40 capital gains tax rates on Section 1256 gains, where 60% is considered a long-term capital gain, even on day trades.

Taxpayers with losses trading forex contracts in the off-exchange Interbank market may be in luck. By default, Section 988 for forex transactions receives ordinary gain or loss treatment, which means the capital loss limitation doesn’t apply. However, without TTS, the forex loss isn’t a business loss and therefore can’t be included in a net operating loss (NOL) calculation — potentially making it a wasted loss since it also can’t be added to the capital loss carryover. If taxpayer has another source of taxable income, the forex ordinary loss offsets it; the concern is when there is negative taxable income. Forex traders can file a contemporaneous “capital gains and losses” election in their books and records to opt out of Section 988, which is wise when capital loss carryovers exist. Contemporaneous means in advance — not after the fact using hindsight. In some cases, this election qualifies for Section 1256(g) lower 60/40 capital gains tax rates on major pairs, not minors.

A TTS trader using Section 475 on securities has ordinary loss treatment, which avoids wash-sale loss adjustments and the $3,000 capital loss limitation. Section 475 ordinary losses offset income of any kind, and a net operating loss carries forward to subsequent tax year(s). TCJA’s “excess business loss” (EBL) limitation of $500,000 married and $250,000 other taxpayers applies to Section 475 ordinary losses and trading expenses. Add an EBL to an NOL carryforward.

Tax treatment on financial products

There are complexities in sorting through different tax-treatment rules and tax rates. It’s often hard to tell what falls into each category.

Securities have realized gain and loss treatment and are subject to wash-sale rules and the $3,000 per year capital loss limitation on individual tax returns.

Section 1256 contracts — including regulated futures contracts on U.S. commodities exchanges — are marked to market by default, so there are no wash-sale adjustments, and they receive lower 60/40 capital gains tax rates.

Options have a wide range of tax treatment. An option is a derivative of an underlying financial instrument, and the tax treatment is generally the same. Equity options are taxed the same as equities, which are securities. Index options are derivatives of indexes, and broad-based indexes are Section 1256 contracts. Simple and complex equity option trades have special tax rules on holding period, adjustments, and more.

Forex receives an ordinary gain or loss treatment on realized trades (including rollovers), unless a contemporaneous capital gains election is filed. In some cases, lower 60/40 capital gains tax rates on majors may apply.

Physical precious metals are collectibles and, if these capital assets are held over one year, sales are subject to the taxpayer’s ordinary rate capped at 28% (the collectibles rate).

Cryptocurrencies are intangible property taxed like securities on Form 8949, but wash-sale loss and Section 475 rules do not apply because they are not securities.

Foreign futures are taxed like securities unless the IRS issues a revenue ruling allowing Section 1256 tax benefits.

Several brokerage firms classify options on volatility exchange-traded notes (ETNs) and options on volatility exchange-traded funds (ETFs) structured as publicly traded partnerships as “equity options” taxed as securities. There is substantial authority to treat these CBOE-listed options as “non-equity options” eligible for Section 1256 contract treatment. Volatility ETNs have special tax treatment: ETNs structured as prepaid forward contracts are not securities, whereas, ETNs structured as debt instruments are.

Don’t solely rely on broker 1099-Bs: There are opportunities to switch to lower 60/40 tax capital gains rates in Section 1256, use Section 475 ordinary loss treatment if elected on time, and report wash-sale losses differently. Vital 2019 tax elections need to be made on time.

Entities for traders

Entities can solidify TTS, unlock health insurance and retirement plan deductions, gain flexibility with a Section 475 election or revocation, and prevent wash-sale losses with individual and IRA accounts. An entity return consolidates trading activity on a pass-through tax return, making life easier for traders, accountants, and the IRS. Trading in an entity allows individually held investments to be separate from business trading. It operates as a separate taxpayer yet is inexpensive and straightforward to set up and manage.

An LLC with S-Corp election is generally the best choice for a single or married couple seeking health insurance and retirement plan deductions.

Retirement plans for traders

Annual tax-deductible contributions up to $62,000 for 2019 to a TTS S-Corp Solo 401(k) retirement plan generally saves traders significantly more in income taxes than it costs in payroll taxes (FICA and Medicare). Trading gains aren’t earned income, so traders use an S-Corp to pay officer compensation.

There’s also an option for a Solo 401(k) Roth: If you are willing to forgo the tax deduction, you’ll enjoy permanent tax-free status on contributions and growth within the plan.

20% deduction on qualified business income

The IRS issued proposed reliance regulations (Proposed §1.199A) for TCJA’s 20% deduction on qualified business income (QBI). The regs confirm that TTS traders are a “specified service activity,” which means if their taxable income is above an income cap, they won’t get any QBI deduction. The 2018 taxable income (TI) cap is $415,000/$207,500 (married/other taxpayers). The phase-out range below the cap is $100,000/$50,000 (married/other taxpayers), in which the QBI deduction phases out for specified service activities. The W-2 wage and property basis limitations also apply within the phase-out range. TTS hedge funds and investment managers are specified service activities, too. QBI includes Section 475 ordinary income, whereas, TCJA expressly excluded capital gains and losses from it.

Affordable Care Act

TCJA did not change the Affordable Care Act’s (ACA) 3.8% Medicare tax on unearned income. The net investment tax (NIT) applies on net investment income (NII) for individual taxpayers with modified AGI over $250,000 (married) and $200,000 (single). The threshold is not indexed for inflation. Traders can reduce NIT by deducting TTS trading expenses, including salaries paid to them and their spouses. Traders may also reduce NII with investment expenses that are allowed on Schedule A, such as investment-interest expense and stock borrow fees. Investment fees and other investment expenses are not deductible for NII.

ACA’s individual health insurance mandate and shared responsibility fee for non-compliance, exchange subsidies, and premium tax credits continue to apply for 2018 and 2019. However, TCJA reduced the shared responsibility fee to $0 starting in 2019.

Investment management carried interest

TCJA modified the carried interest tax break for investment managers in investment partnerships, lengthening their holding period on profit allocation of long-term capital gains (LTCG) from one year to three years. If the manager also invests capital in the partnership, he or she has LTCG after one year on that interest. The three-year rule only applies to the investment manager’s profit allocation — carried interest. Investors still have LTCG based on one year.

Investment partnerships include hedge funds, commodity pools, private equity funds, and real estate partnerships. Many hedge funds don’t hold securities more than three years, whereas, private equity, real estate partnerships, and venture capital funds do.

Investors also benefit from carried interest in investment partnerships. TCJA suspended “certain miscellaneous itemized deductions subject to the 2% floor,” which includes investment fees and expenses. Separately managed account investors are out of luck, but hedge fund investors can limit the negative impact by using carried-interest tax breaks. Carried interest reduces a hedge fund investor’s capital gains instead of having a suspended investment fee deduction.

Family office

Restructuring investment fees and expenses into a management company might achieve business expense treatment providing it’s a genuine family office with substantial staff rendering financial services to extended family members and outside clients.

The IRS might assert the family office is managing “one’s own investments,” not for outside clients, so the management company is also an investment company with non-deductible investment expenses.

Learn more about and purchase Green’s 2019 Trader Tax Guide and see the Table of Contents.

Watch our webinar recording: Tips For Traders On Preparing 2018 Tax Returns


To Save Taxes, Traders Need To Deal With Unique Issues Before Year-End

October 31, 2018 | By: Robert A. Green, CPA | Read it on

While the 2017 Tax Cuts and Jobs Act did not change trader tax status, Section 475 MTM, wash-sale loss rules on securities, and more, there is still plenty to consider.

To Get The Most Out Of Tax Reform, Traders Need To Act Fast covered critical moves to make before the calendar year expires. But that’s just the tip of the hat. Read on for more action items to initiate sooner, rather than later.

Wash sales: Securities traders must comply with wash-sale loss rules, but the IRS makes it difficult by applying different standards for taxpayers vs. brokers on tax reports and Form 1099-Bs. Taxpayers must report wash sales on substantially identical positions across all accounts, whereas brokers report only identical positions per account. Active securities traders should use a trade accounting program or service to identify potential wash sale loss problems going into year-end. In taxable accounts, break the chain by selling the position before year-end and not repurchasing a substantially identical position 30 days before or after in any of your taxable or IRA accounts. Avoid wash sales between taxable and IRA accounts throughout the year, as that is otherwise a permanent wash sale loss. (Starting a new entity effective Jan. 1, 2019, can break the chain on individual account wash sales at year-end 2018 provided you don’t purposely avoid wash sales with the related party entity.) Read strategies to avoid wash sale losses. Wash sales only apply to securities; not Section 1256 contracts, cryptocurrencies as intangible property, and volatility ETNs structured as prepaid forward contracts.

Wash sale losses might be preferable to capital loss carryovers at year-end 2018 for TTS traders. A Section 475 election in 2019 converts year-end 2018 wash sale losses on TTS positions (not investment positions) into ordinary losses in 2019. That’s better than a capital loss carryover into 2019, which might then give you pause to making a Section 475 election. You want a clean slate with no remaining capital losses before electing Section 475 ordinary income and loss. (Learn more about wash sales and capital loss limitations in a video on our Website and consider our trade accounting service.)

Trader tax status: If you qualify for TTS (business expense treatment — no election needed) in 2018, accelerate trading expenses into that qualification period as a sole proprietor or entity. If you don’t qualify until 2019, try to defer trading expenses until then. You may also capitalize and amortize (expense) Section 195 startup costs and Section 248 organization costs in the new TTS business, going back six months before commencement. TTS is a prerequisite for electing and using Section 475 MTM. (Learn more about trader tax status in a video on our Website.)

Section 475 MTM: TTS traders choose Section 475 on securities for exemption from wash-sale rules and the $3,000 capital loss limitation — and to receive the new 20% QBI deduction. Existing individual taxpayers had to elect Section 475 by April 17, 2018, for 2018 (March 15 for existing S-Corps and partnerships). They need to complete the election process by filing a 2018 Form 3115 with their 2018 tax return. If you missed the 2018 election deadline, then consider the election for 2019. Capital loss carryovers are a concern.

Trading entities: A “new taxpayer” entity can elect Section 475 within 75 days of inception. But it’s getting late to form a new trading entity by the middle of November, and still qualify for TTS in that short period before year-end. Elect 475 once, and it applies in subsequent years in which you are eligible for TTS unless you revoke the election. (Learn more about Section 475 in a video on our Website.)

Net operating losses: Section 475 ordinary losses and TTS business expenses contribute to net operating loss (NOL) carryforwards, which are limited to 80% of taxable income in the subsequent year(s). TCJA repealed two-year NOL carrybacks, except for farmers. For some traders, this is the worst change in TCJA as traders have counted on quick NOL carryback refunds to replenish their trading accounts and remain in business. Get immediate use of NOLs with a Roth IRA conversion before year-end and other income acceleration strategies.

Excess business losses: TCJA introduced an “excess business loss” (EBL) limitation of $500,000/$250,000 (married/other taxpayers), per tax year. Aggregate EBL from all pass-through businesses: A profitable company can offset another business with losses to remain under the limit. EBL is an NOL carryforward. For example, if a single TTS/475 trader has an ordinary loss of $300,000, his EBL is $50,000, and it’s an NOL carryforward.

2018 S-Corp: TTS traders use an S-Corp trading company to arrange health insurance and retirement plan deductions. The S-Corp must execute officer compensation, in conjunction with these employee benefit deductions, through formal payroll tax compliance before year-end. Otherwise, you will miss the boat. TTS is an absolute must since an S-Corp investment company cannot have tax-deductible wages, health insurance, and retirement plan deductions. This S-Corp is not required to have “reasonable compensation” as other types of businesses are, so a TTS trader may determine officer compensation based on how much to reimburse for health insurance, and how much they want to contribute to a retirement plan. Some use a dual-entity solution: An LLC/partnership trading company, and a management company, organized as a C-Corp, or S-Corp. In that case, the management company executes year-end payroll and these employee benefits. (C-Corps can have other types of employee benefits, too.)

TTS traders organized as a sole proprietorship (an unincorporated business), cannot have health insurance and retirement plan deductions because they don’t have self-employment income (SEI) from trading income. A TTS Schedule C does not have a net income, and the IRS does not permit a TTS sole proprietor to pay officer compensation (wages) to themselves as owners. A TTS partnership faces obstacles in attempting to arrange health insurance and retirement plan deductions because the partnership passes through expenses for reducing SEI, whereas, an S-Corp does not pass through expenses or losses for SEI — that’s why the S-Corp works for traders.

An S-Corp formed later in the year can unlock a retirement plan deduction for an entire year by paying sufficient officer compensation in December when results for the year are evident. The S-Corp may only deduct health insurance for the months the entity was operational and qualified for TTS.

Another reason to create officer compensation is to increase the 20% QBI deduction if you are in the phase-out range subject to the 50% wage limitation. (See my other blog posts and Webinars on year-end planning for TTS S-Corps to execute health insurance, make retirement plan contributions, and generate a QBI deduction.)

2019 S-Corp: If you missed out on employee benefits in 2018, then consider an LLC/S-Corp for 2019. Starting 2019 with trading in the new S-Corp is beneficial. That breaks the chain on wash sales with your individual account at year-end 2018. If you start later, you will have tax compliance for your individual return and S-Corp return in dealing with broker 1099Bs and more.

If you wait to start your entity formation process on Jan. 1, 2019, you won’t be ready to trade in an entity account on Jan. 2, 2019. Instead, you can form a single-member LLC by mid-December 2018, obtain the employee identification number (EIN) at irs.gov, and open the entity brokerage account before year-end. If desired, add your spouse as a member of the LLC on Jan. 1, 2019, which means the LLC will file a partnership return. If you want health insurance and retirement plan deductions, then your LLC should submit an S-Corp election for 2019 by March 15. The S-Corp should also consider making a Section 475 MTM election on securities only for 2019 by March 15. (Consider our entity formation service.)

Solo 401(k): A Solo 401(k) retirement plan for a TTS S-Corp must be established (opened) with a financial intermediary before year-end. Plan to pay (or fund) the 2018 elective deferral amount up to a maximum $18,500 (or $24,500 if age 50 or older) executed with December payroll by Jan. 31, 2019. Plan to pay (fund) the 25% profit-sharing plan (PSP) portion of the S-Corp Solo 401(k) up to a maximum of $36,500, by the due date of the 2018 S-Corp tax return, including extensions, which means Sept. 15, 2019. The maximum PSP contribution requires wages of $146,000 ($36,500 divided by 25% defined contribution rate.) A SEP IRA is less attractive; it doesn’t have a 100%-deductible elective deferral, which means a similar contribution requires more compensation that is subject to Medicare taxes.

Cryptocurrencies: Report realized capital gains and losses for all sales of cryptocurrencies. The IRS classifies cryptocurrencies as intangible property. Include crypto-to-altcoin sales, crypto-to-currency sales, hard forks if you have control and there is a fair market value and purchases of items using crypto. Many crypto traders inappropriately deferred 2017 income on crypto-to-altcoin sales claiming Section 1031 like-kind deferral treatment. TCJA restricted Section 1031 usage to real property only starting in 2018. Bitcoin, Ethereum and other crypto are not securities so wash sale loss rules, and Section 475 MTM elections do not apply. The SEC recently stated that some ICOs and tokens are securities, but not Bitcoin and Ethereum. The IRS has not changed its designation as intangible property, and I expect updated crypto tax guidance from the IRS soon. (See the cryptocurrencies section of our Website.)

With the 2018 crash in cryptocurrency prices, now before year-end 2018 is an excellent time to sell losing crypto positions to realize capital losses which offset capital gains on securities (“tax loss selling”). The wash sale loss rules on securities don’t apply on crypto because it is intangible property, not a security. You can repurchase the crypto positions within hours after booking the tax loss.

Fill in the gaps in tax brackets

If you own an investment portfolio, you have the opportunity to reduce capital gains taxes via “tax loss selling.” You may wish to sell winning positions to accelerate income, perhaps to use up a capital loss carryover or an NOL. TTS traders want a “clean slate” — meaning no capital loss carryovers — so they can make a Section 475 election in the subsequent tax year.

If you are in the lowest two “ordinary” tax brackets for 2018 (10% or 12%), try to take advantage of the 0% long-term capital gains rate. The 12% ordinary income bracket applies on taxable income up to $37,800/$77,400 (single/married). For example, if your single taxable income is $30,000, you can realize $7,500 of long-term capital gains with zero federal tax.

If you realized significant short-term capital gains year-to-date in 2018 and had open positions with substantial unrealized capital losses, you should consider selling (realizing) some of those losses to reduce 2018 capital gains taxes. Don’t repurchase the losing position 30 days before or after, as that would negate the tax loss with wash-sale-loss rules.

The IRS has rules to prevent deferral of income and acceleration of losses in offsetting positions that lack sufficient economic risk. These rules include straddles, the constructive sale rule, and shorting against the box. Also, be aware of “constructive receipt of income” — you cannot receive payment for services, turn your back on that income, and defer it to the next tax year. (See Some Proprietary Traders Under-Report Income.)

Tax-loss selling is inefficient for short-term positions that reduce long-term capital gains. It’s also a moot point with Section 1256 and Section 475 positions since they are mark-to-market (MTM) positions reporting realized and unrealized gains and losses.

Taxpayers should review tax brackets, Social Security and retirement contribution limits, standard deductions, and more. See Tax Rates, other tax charts, and analysis of TCJA at Tax Foundation. There are differences in filing status.

We recommend discussing year-end planning with your tax adviser by early December. Don’t wait until the last minute! If our firm prepared your 2017 tax return, your Client Copy includes a “Tax Reform Impact Summary,” which shows the impact of TCJA on your 2017 file. Our CPAs and I hope to hear from you soon.

Darren L. Neuschwander CPA contributed to this blog post. 

Webinar: Traders Have Unique Issues For Year-End Planning. Come to the Dec. 5, 2018 event or watch the recording after.


To Get The Most Out Of Tax Reform, Traders Need To Act Fast

October 30, 2018 | By: Robert A. Green, CPA | Read it on

Actions are required before year-end to cash in on some of the tax benefits of the 2017 Tax Cuts and Jobs Act (TCJA).

Defer income and accelerate tax deductions
Consider the time-honored strategy of deferring income and accelerating tax deductions if you don’t expect your taxable income to decline in 2019. Tax rates are the same for 2019, although the IRS adjusts tax brackets for inflation each year. Enjoy the time-value of money with income deferral.

Year-end tax planning is a challenge for traders because they have wide fluctuations in trading results, making it difficult to forecast their income. Those expecting to be in a lower tax bracket in 2019 should consider income deferral strategies. Conversely, a 2018 TTS trader with ordinary losses, hoping to be in a higher tax bracket in 2019 should consider income acceleration strategies.

If you have trader tax status in 2018, consider accelerating trading business expenses, such as purchasing business equipment with full expensing.

Don’t assume that accelerating itemized deductions is also a smart move; there may be two problems. TCJA suspended and curtailed various itemized deductions, so there is no sense in expediting a non-deductible item. Even with the acceleration of deductible expenses, many taxpayers will be better off using the standard deduction of $24,000 married, $12,000 single, and $18,000 other taxpayers — these are roughly doubled by TCJA. There is an additional standard deduction of $1,300 for the aged or the blind. If itemized deductions are below the standard deduction, consider a strategy to “bunch” itemized deductions into one year and take the standard deduction in other years.

Accelerate income and defer certain deductions
A TTS trader with substantial losses that are not subject to the capital loss limitation should consider accelerating income to soak up the business loss, instead of having an NOL carryover. TCJA repealed the two-year NOL carryback rule starting in 2018. Try to advance enough income to fully utilize the standard deduction and take advantage of lower tax brackets. Be sure to stay below the thresholds for unlocking various types of AGI-dependent deductions and credits.

Roth IRA conversion: Convert a traditional IRA into a Roth IRA before year-end to accelerate income. The conversion income is taxable in 2018, but you avoid the 10% excise tax on early withdrawals. One concern is that TCJA repealed the recharacterization (reversal) option. There isn’t an income limit for making Roth IRA conversions, whereas, there is for making contributions.

Sell winning positions: Another way traders can accelerate income is to sell open winning positions to realize short-term capital gains. Consider selling long-term capital gain positions, too. In the bottom two ordinary tax rates of 10% and 12%, the long-term capital gains tax rate is zero.

Business expenses, and itemized deduction vs. standard deduction

Business expenses: TTS traders are entitled to deduct business expenses and home-office deductions from gross income. The home office deduction requires income, except for the mortgage interest and real estate portion. The SALT cap on state and local taxes does not apply to the home office deduction. TCJA expanded full expensing of business property; traders can deduct 100% of these costs in the year of acquisition, providing they place the item into service before year-end. If you have TTS in 2018, considering going on a shopping spree before Jan. 1. No sense deferring TTS expenses, because you cannot be sure you will qualify for TTS in 2019.

Itemized deductions: TCJA suspended all “miscellaneous itemized deductions subject to the 2% floor” including investment fees and expenses, unreimbursed employee business expenses, and tax compliance fees. (See Investment Fees Are Not Deductible But Borrow Fees Are.)

Net investment tax: Investment fees and expenses remain deductible for calculating net investment income for the 3.8% net investment tax (NIT) on unearned income. NIT only applies to individuals with net investment income (NII) and modified adjusted gross income (AGI) exceeding $200,000 (single), $250,000 (married filing jointly), or $125,000 (married filing separately). The IRS does not index these thresholds for inflation. (Learn more on my website.)

Retirement plans: If you engage outside investment advisors for managing your retirement accounts, try to pay the advisors from traditional retirement plans, but not Roth IRAs. An expense in a traditional tax-deferred retirement plan is equivalent to a tax-deferred deduction. (Roth IRAs are permanently tax-free, so you don’t need deferred deductions in Roth plans.) A postponed deduction is better than a suspended itemized deduction, which is not deductible. Some brokerage firms might not cooperate unless you engage the firm’s wealth management service. Consider a retirement plan custodian or intermediary who is more accommodating on these expense payments. Don’t allow your retirement plan to pay investment fees to you, or close family members: It’s self-dealing, a prohibited transaction, which might blow up your retirement plan. If you don’t have TTS, consider trading in your retirement plan, instead of taxable accounts.

Employee business expenses: Ask your employer if they have an “accountable plan” for reimbursing employee-business expenses. You must “use it or lose it” before year-end. TTS traders allocate a portion of tax compliance fees to TTS business expense.

Short-selling stock borrow fees, remain deductible under TCJA as “other miscellaneous deductions” on Schedule A (Itemized Deductions) line 28. If you qualify for TTS, short-selling expenses are business expenses. (See Investment Fees Are Not Deductible But Borrow Fees Are.)

Investment interest expense: TCJA did not change investment-interest expense rules: This itemized deduction is limited to investment income, and the excess is carried over to the subsequent tax year(s). TTS traders deduct margin interest expenses on trading positions as a business expense. TCJA curtailed business interest expenses for larger companies only.

SALT: TCJA’s most contentious provision was capping state and local income, sales and property taxes (SALT) at $10,000 per year ($5,000 for married filing separately). Many high-tax states continue to contest the SALT cap, but they haven’t prevailed in court. The IRS reinforced the new law by blocking various states’ attempts to recast SALT payments as charitable contributions, or payroll tax as a business expense.

Estimated income taxes: If you already reached the SALT cap, you don’t need to prepay 2018 state estimated income taxes by Dec. 31, 2018. Pay federal and state estimated taxes owed by Jan. 15, 2019, with the balance of your tax liabilities payable by April 15, 2019. (You can gain six months of additional time by filing an automatic extension on time, but late-payment penalties will apply.)

AMT: In prior years, taxpayers had to figure out how much they could prepay their state without triggering alternative minimum tax (AMT) since state taxes are not deductible for AMT taxable income. It’s easier for 2018 with SALT capped at $10,000 and because TCJA raised the AMT exemption. If you are subject to AMT for 2018, then don’t accelerate AMT preference items.

Standard deduction: TCJA roughly doubled the standard deduction and suspended and curtailed several itemized deductions. Many more taxpayers will use the standard deduction for 2018, which might simplify their tax compliance work. For convenience sake, some taxpayers may feel inclined to stop tracking itemized deductions because they figure they will use the standard deduction. Don’t overlook the impact of these deductions on state tax return where you might get some tax relief for itemizing deductions. Plus, certain repeals and curtailed itemized deductions might be deductible on other parts of your tax return.

20% deduction on qualified business income
This deduction might be one of the most crucial TCJA changes to consider for 2018, and you should take action before year-end.

The IRS recently issued proposed reliance regulations (Proposed §1.199A) for the TCJA’s 20% deduction on qualified business income (QBI) in pass-through entities. The proposed regulations confirm that traders eligible for TTS are a “specified service activity,” which means if their taxable income is above an income cap, they won’t get a QBI deduction. The taxable income (TI) cap is $415,000/$207,500 (married/other taxpayers). The phase-out range below the cap is $100,000/$50,000 (married/other taxpayers), in which the QBI deduction phases out for specified service activities. The W-2 wage and property basis limitations also apply within the phase-out range. Hedge funds eligible for TTS and investment managers are specified service activities.

QBI likely includes Section 475 ordinary income, whereas, TCJA expressly excluded capital gains and losses from it. (See How Traders Can Get 20% QBI Deduction Under IRS Proposed Regulations.)

TCJA favors non-service businesses, which are not subject to an income cap. The W-2 wage and property basis limitations apply above the TI threshold of $315,000/$157,500 (married/other taxpayers). The IRS will adjust TI income cap, phase-out range, and the threshold for inflation in each subsequent year. Calculate QBI on an aggregate basis.

You might be able to increase the QBI deduction with smart year-end planning. If your taxable income falls within the phase-out range for a specified service activity, you might need wages, including officer compensation, to avoid a 50% wage limitation on the QBI deduction. Try to defer income to get under the TI threshold and use up less of the phase-out range.

Consult your tax advisor well before year-end. The QBI deduction is complicated, and questions are pending with the IRS. Accountants are going to be very busy in December, so get on their schedule early.

Married couples should compare filing joint vs. separate
Each year, married couples choose between “married filing joint” (MFJ) vs. “married filing separate” (MFS). TCJA fixed several inequities in filing status, including the tax brackets by making single, MFJ, and MFS brackets equivalent, except for divergence at the top rate of 37%. See the ordinary tax brackets: MFJ/MFS enter the top 37% rate at $600,000/$300,000 vs. $500,000 for single. TCJA retains the marriage penalty at the top rate only.

Married couples may be able to improve QBI deductions, AGI and other income-threshold dependent deductions, and credits with MFS in 2018. It’s wise to enter each spouse’s income, gain, loss and expense separately and have the tax software compare MFJ vs. MFS. In a community property state, there are special rules for allocating income between spouses.

Miscellaneous considerations for individuals
• Becoming familiar with all of the changes in TCJA is crucial. TaxFoundation.Org is an excellent resource.
• Note inflation adjustment increases to rate brackets and more.
• Consider estimated tax payment rules including the safe-harbor exceptions. If you accelerate income, you may need to pay Q4 2018 estimated taxes by Jan. 15, 2019.
• Alternatively, increase tax withholding on wages to avoid estimated tax underpayment penalties.
• If you still need to avoid estimated tax underpayment penalties, arrange a rollover distribution from a qualified retirement plan with significant tax withholding before year-end. Next, roll over the gross amount into a rollover IRA. The result is zero income and avoidance of an estimated tax penalty.
• Sell off passive-loss activities to unlock and utilize suspended passive-activity losses.
• Maximize contributions to retirement plans. That lowers AGI, which can unlock more of a QBI deduction, reduce net investment tax, and unlock AGI dependent benefits.
• The IRS has many obstacles to deferring income including passive-activity loss rules, a requirement that certain taxpayers use the accrual method of accounting and limitations on charitable contributions. TCJA allows more businesses to use the cash method.
• Consider a charitable remainder trust to bunch charitable contributions for itemizing deductions. (Ask Fidelity or Schwab about it.)
• Donate appreciated securities to charity: You get a charitable deduction at the FMV and avoid capital gains taxes. (This is a favorite strategy by billionaires, and you can use it, too.)
• Retirees must take required minimum distributions by age 70½. Per TCJA, consider directing your retirement plan to make “qualified charitable distributions” (QCD). That satisfies the RMD rule with the equivalent of an offsetting charitable deduction, allowing you to take the standard deduction rather than itemize.
• TCJA improves family tax planning: Consider “kiddie tax” rules with increased gift exclusions. Section 529 qualified tuition plans now can be used to pay for tuition at an elementary or secondary public, private or religious school, up to $10,000 per year; the annual gift exclusion is $15,000; the unified credit for estate tax is significantly higher at $11.18 million per person, and “step-up in basis” rules still avoid capital gains taxes on inherited appreciated property. TTS traders should also consider hiring adult children as employees.
• Make sure to fund FSAs and HSAs before year-end fully.

See my next blog post for more info: To Save Taxes, Traders Need To Deal With Unique Issues Before Year-End.

Darren L. Neuschwander, CPA contributed to this blog post. 

Webinar: How Traders Can Save Taxes Before Year-End. Come to the Nov. 7, 2018 event or watch the recording after.


Congress & IRS Offer Help to Hurricane & Wildfire Victims

October 12, 2018 | By: Robert A. Green, CPA

Follow latest IRS updates on hurricanes and wildfire tax relief:

– Disaster victims in Florida, Georgia, Virginia, North Carolina, and South Carolina qualify for tax relief from Hurrican Michael.

“IRS has announced on its website that victims of Hurricane Michael in counties of Georgia and victims of Hurricane Florence in Virginia that are designated as federal disaster areas qualifying for individual assistance, as well as additional victims of Hurricane Florence in counties of South Carolina and North Carolina and additional victims of Hurricane Michael in counties of Florida, that have been similarly designated, have more time to make tax payments and file returns. Certain other time-sensitive acts also are postponed. This article summarizes the relief that’s available and includes up-to-date disaster area designations and extended filing and deposit dates for all areas affected by storms, floods and other disasters in 2018.” (Thomson Reuters/Tax & Accounting). See additional information on Hurricane Michael disaster tax relief here.

– IRS extends Oct. 15 and other upcoming deadlines provides expanded tax relief for victims of Hurricane Michael. Click here.

– IRS extends upcoming deadlines, provides tax relief for victims of Hurricane Florence

Sept. 15, 2018: WASHINGTON — Hurricane Florence victims in parts of North Carolina and elsewhere have until Jan. 31, 2019, to file certain individual and business tax returns and make certain tax payments, the Internal Revenue Service announced today. (See IR-2018-187.)

This relief applies to 2017 partnership and S-Corp tax returns, and 2018 third-quarter estimated taxes due September 17, 2018.

– Retirement plans can make loans, hardship distributions to wildfire, Hurricane Maria victims.

Nov. 1, 2017, Thomson Reuters Checkpoint: “In an Announcement, IRS has announced that employer-sponsored retirement plans can make loans and hardship distributions to victims of Hurricane Maria and the California wildfires and members of their families. And, while IRA participants are barred from taking out loans, they may be eligible to receive distributions under liberalized procedures. But, IRS is not waiving the 10% penalty that applies to early withdrawals. Ann. 2017-15, 2017-47 IRB.”

– Tax Relief for Victims of California Wildfires: Extension Filers Have Until Jan. 31 to File

Oct. 17, 2017, Thomson Reuters Checkpoint: “The IRS has provided tax relief for the victims of wildfires affecting parts of California. Currently, the IRS is providing relief to seven California counties: Butte, Lake, Mendocino, Napa, Nevada, Sonoma, and Yuba. The tax relief postpones various tax filing and payment deadlines that occur starting on 10/8/17. Affected individuals and businesses now have until 1/31/18 to file returns and pay any taxes that are originally due during the relief period. This includes quarterly estimated tax payments, extended 2016 income tax returns, and quarterly payroll and excise tax returns. The IRS noted that tax payments related to 2016 individual tax returns were originally due on 4/18/17, and therefore, not eligible for this relief. The relief is automatically available to any taxpayer with an IRS address of record located in the disaster area. Therefore, the taxpayer does not need to contact the IRS to get this relief. Firefighters and aid workers assisting in the relief efforts that are affiliated with a recognized organization and live outside the disaster area also may qualify for the relief by contacting the IRS. News Release IR 2017-172.”

Oct. 13, 2017: Per IRS.gov, “Victims of wildfires ravaging parts of California now have until Jan. 31, 2018, to file certain individual and business tax returns and make certain tax payments. This includes an additional filing extension for taxpayers with valid extensions that run out this coming Monday, Oct. 16.”

– Tax Provisions in the 2017 Disaster Tax Relief Bill

Per Thomson Reuters CheckPoint: On September 29, President Trump signed into law P.L. 115-63, the “Disaster Tax Relief and Airport and Airway Extension Act of 2017.” The Act, which had been passed by Congress the day before, provides temporary tax relief to victims of Hurricanes Harvey, Irma, and Maria. Businesses that qualify for relief may claim a new “employee retention tax credit” of up to $2,400 for qualified wages paid to eligible employees. Relief for individuals includes, among other things, loosened restrictions for claiming personal casualty losses, tax-favored withdrawals from retirement plans, and the option of using current or prior year’s income for purposes of claiming the earned income and child tax credits. H.R. 3823, the “Disaster Tax Relief and Airport and Airway Extension Act of 2017.”

Relief for casualty losses
The Act exempts qualified disaster-related personal casualty losses from the 10% AGI threshold. Victims don’t have to itemize; they can add this casualty loss to their standard deduction, and that part is deductible for AMT. The Act increases the $100 per-casualty floor to $500. Congress doesn’t want to disenfranchise victims from taking these important tax deductions.

Eased access to retirement funds
The Act allows victims to make “qualified hurricane distributions” from their retirement plans of up to $100,000, with exemption from the 10% early withdrawal penalty. Taxpayers can spread this income over a 3-year period.

Charitable deduction limitations suspended
To help spur more donations to victims, the Act suspends the majority of charitable deduction limitations.

– IRS Offers Help to Hurricane Victims: A Recap of Key Tax Relief Provisions Available Following Harvey, Irma and Maria

IR-2017-160, Sept. 26, 2017

WASHINGTON – The Internal Revenue Service today offered a rundown of key tax relief that has been made available to victims of Hurricanes Harvey, Irma and Maria.

In general, the IRS is now providing relief to individuals and businesses anywhere in Florida, Georgia, Puerto Rico and the Virgin Islands, as well as parts of Texas. Because this relief postpones various tax deadlines, individuals and businesses will have until Jan. 31, 2018 to file any returns and pay any taxes due…(Read more.)


New Tax Law Favors Hedge Funds Over Managed Accounts

August 28, 2018 | By: Robert A. Green, CPA | Read it on

Hedge fund investors benefited from tax advantages over separately managed accounts (SMA) for many years. The 2017 Tax Cuts and Jobs Act (TCJA) widened the difference by suspending all miscellaneous itemized deductions, including investment fees. SMA investors are out of luck, but hedge fund investors can limit the negative impact using carried-interest tax breaks. TCJA provided a new 20% deduction on qualified business income, which certain hedge fund investors might be eligible for if they are under income caps for a service business.

TCJA penalizes investors with separately managed accounts
SMA investors cannot claim trader tax status (TTS) since an outside manager conducts the trading, not the investor. Therefore, investment expense treatment applies for advisory fees paid.

Beginning in 2018, TCJA suspended all miscellaneous itemized deductions for individuals, which includes investment fees and expenses. If a manager charges a 2% management fee and a 20% incentive fee, an individual may no longer deduct those investment fees for income tax purposes. Before 2018, the IRS allowed miscellaneous itemized deductions greater than 2% of AGI, but no deduction was allowed for alternative minimum tax (AMT); plus, there was a Pease itemized deduction limitation. (Taxpayers are still entitled to deduct investment fees and expenses for calculating net investment income for the Net Investment Tax.)

For example: Assume an SMA investor has net capital gains of $110,000 in 2018. Advisory fees are $30,000, comprised of $10,000 in management fees and $20,000 in incentive fees. Net cash flow on the SMA for the investor is $80,000 ($110,000 income minus $30,000 fees). The SMA investor owes income tax on $110,000 since TCJA suspended the miscellaneous itemized deduction for investment fees and expenses. If the individual’s federal and state marginal tax rates are 40%, the tax hike might be as high as $12,000 ($30,000 x 40%). (See Investment Fees Are Not Deductible But Borrow Fees Are.)

Investment managers do okay with SMAs
In the previous example, the investment manager reports service business revenues of $30,000. Net income after deducting business expenses is subject to ordinary tax rates.

An investment manager for an SMA is not eligible for a carried-interest share in long-term capital gains, or 60/40 rates on Section 1256 contracts, which have lower tax rates vs. ordinary income. Only hedge fund managers as owners of the investment fund may receive carried interest, a profit allocation of capital gains and portfolio income.

Additionally, if the manager is an LLC filing a partnership tax return, net income is considered self-employment income subject to SE taxes (FICA and Medicare). If the LLC has S-Corp treatment, it should have a reasonable compensation, which is subject to payroll tax (FICA and Medicare).

Hedge funds provide tax advantages to investors
Carried interest helps investors and investment managers. Rather than charge an incentive fee, the investment manager, acting as a partner in the hedge fund, is paid a special allocation (“profit allocation”) of capital gains, Section 475 ordinary income, and other income.

Let’s turn the earlier example into a hedge fund scenario. The hedge fund initially allocates net capital gains of $110,000, and $10,000 of management fees to the investor on a preliminary Schedule K-1. Next, a profit allocation clause carves out 20% of capital gains ($20,000) from the investor’s K-1 and credits it to the investment manager’s K-1. The final investor K-1 has $90,000 of capital gains and an investment expense of $10,000, which is suspended as an itemized deduction on the investor’s individual tax return. Carried interest helps the investor by turning a non-deductible incentive fee of $20,000 into a reduced capital gain of $20,000. Carried interest is imperative for investors in a hedge fund that is not eligible for TTS business expense treatment. With a 40% federal and state tax rate, the tax savings on using the profit allocation instead of an incentive fee is $8,000 ($20,000 x 40%). To improve tax savings for investors, hedge fund managers might reduce management fees and increase incentive allocations.

TCJA modified carried interest rules for managers
Hedge fund managers must now hold an underlying position in the fund for three tax years to benefit from long-term capital gains allocated through profit allocation (carried interest). The regular holding period for long-term capital gains is one year. I’m glad Congress did not outright repeal carried interest, as that would have unduly penalized investors. The rule change trims the benefits for managers and safeguards the benefits for investors. The three-year holding period does not relate to Section 1256 contracts with lower 60/40 capital gains rates, where 60% is a long-term capital gain, and 40% is short-term.

Trader tax status and Section 475 tax advantages
If a hedge fund qualifies for TTS, then it allocates deductible business expenses to investors, not suspended investment expenses. I expect many hedge funds will still use a profit allocation clause since it might bring tax advantages to the investment manager — a share of long-term capital gains, and a reduction of payroll taxes on earned income vs. not owing payroll taxes on short-term capital gains.

TCJA 20% QBI deduction on pass-through entities
The TCJA included a lucrative new tax cut for pass-through entities. An individual taxpayer may deduct whichever is lower: either 20% of qualified business income (QBI) from pass-through entities or 20% of their taxable income minus net capital gains, subject to other limitations, too. (Other QBI includes qualified real estate investment trust REIT dividends and qualified publicly traded partnership PTP income.)

The proposed QBI regulations confirm that traders eligible for TTS are considered a service business (SSTB). Upper-income SSTB owners won’t get a deduction on QBI if their taxable income (TI) exceeds the income cap of $415,000/$207,500 (married/other taxpayers). The phase-out range is $100,000/$50,000 (married/other taxpayers) below the income cap, in which the QBI deduction phases out for SSTBs. The W-2 wage and property basis limitations apply within the phase-out range, too.

Hedge funds with TTS are an SSTB if the fund is trading for its account through an investment manager partner. A hedge fund with TTS is entitled to elect Section 475 ordinary income or loss. Hedge fund QBI likely includes Section 475 ordinary income. QBI excludes all capital gains, commodities and forex transactions, dividends, and interest. The SSTB taxable income thresholds and cap apply to each investor in the hedge fund; some may get a QBI deduction, whereas, others may not, depending on their TI, QBI aggregation, and more. (See How Traders Can Get 20% QBI Deduction Under IRS Proposed Regulations.)

The proposed QBI regulations also describe investing and investment management as an SSTB. QBI includes advisory fee revenues for investment managers earned from U.S. clients, but not foreign clients. QBI must be from domestic sources. I presume QBI should exclude a carried-interest share (profit allocation) of capital gains but will include a carried-interest percentage of Section 475 ordinary income.

TCJA might impact the investment management industry
Many investors are upset about losing a tax deduction for investment fees and expenses. Some just realized it. I recently received an email from an investor complaining to me about TCJA’s suspension of investment fees and expenses. He was about to sign an agreement with an investment manager for an SMA but scrapped the deal after learning he could not deduct investment fees. Most hedge funds only work with larger accounts and adhere to rules for accredited investors and qualified clients who can pay performance fees or profit allocations.

Larger family offices may have a workaround for using business expense treatment without TTS, as I address on my blog post How To Avoid IRS Challenge On Your Family Office.

Managed accounts vs. hedge fund
Investment managers handle two types of investors: separately managed accounts (SMAs) and hedge funds (or commodity or forex pools). In an SMA, the client maintains a retail customer account, granting trading power to the investment manager. In a hedge fund, the investor pools his money for an equity interest in the fund, receiving an annual Schedule K-1 for his allocation of income and expense. It’s different with offshore hedge funds.

In an SMA, the investor deals with accounting (including complex trade accounting on securities), not the investment manager. In a hedge fund, the investment manager is responsible for complicated investor-level accounting, and the fund sends investors a Schedule K-1 that is easy to input to tax returns.

There are several other issues to consider with SMAs vs. hedge funds; tax treatment is just one critical element. “SMAs provide transparency, and this is important to many clients, particularly tax-exempts or fiduciary accounts,” says NYC tax attorney Roger D. Lorence.

Roger D. Lorence contributed to this blog post.

 


How To Save U.S. Taxes For Nonresident Aliens

August 21, 2018 | By: Robert A. Green, CPA | Read it on

The U.S. stock markets have been stellar, and many non-U.S. persons have been accessing them from their home country. Other foreign individuals and entities prefer to open U.S.-based brokerage accounts for lower commissions, and better trading platforms.

In either case, the foreign individual or foreign company is subject to U.S. tax withholding on U.S. dividends and certain other U.S. passive income. The default withholding tax rate is 30%, and income tax treaties provide for lower rates, usually around 15% or less. U.S. brokers handle this tax withholding and pay those taxes to the Internal Revenue Service (IRS). The foreign investor does not have an obligation for U.S. tax compliance if withholding is done correctly.

The critical point is that capital gains are not taxable in the U.S. if the nonresident alien does not spend more than 183 days per year in the U.S. Most active traders don’t generate significant dividend income paid by U.S. companies, so tax withholding is not a problem. Many of them get a foreign tax credit for U.S. tax withholding in their resident country.

Some nonresident aliens establish a spousal-member LLC in the U.S. and file a U.S. partnership tax return. The LLC/partnership opens a U.S.-based brokerage account as a domestic entity. The LLC files a W-9 with a U.S. tax identification number. The broker treats the U.S. LLC/partnership as a U.S. account, which means the broker does not handle the tax withholding on dividends and other passive income for the foreign owners of the LLC.

Therefore, the nonresident alien owners must file a W-8BEN with the U.S. partnership. The U.S. partnership assumes responsibility for tax withholding on dividends and other portfolio income, and payment of those taxes to the IRS on a timely basis. It’s extra tax compliance work, but it’s not too complicated.

U.S. estate tax might come into play. Estate tax treaties may exempt brokerage accounts for nonresident aliens or provide higher exemptions from the tax. U.S. partnership interests are likely not includible in an estate for a nonresident alien. Brokers are not responsible for estate tax compliance, so it’s a tax matter for nonresident aliens and their tax advisors. Brokers require a conclusion of IRS estate proceedings before releasing assets from the account of the deceased.

Nonresident alien U.S. income tax treatment
In this scenario, nonresident aliens are subject to U.S. tax withholding on dividends paid by U.S. companies and on other “fixed or determinable, annual, or periodic” (FDAP) income. Per IRS Taxation of Nonresident Aliens: “FDAP income is passive income such as interest, dividends, rents or royalties. This income is taxed at a flat 30% rate unless a tax treaty specifies a lower rate.” Many countries have a tax treaty with the U.S. providing for 15% or lower withholding tax rate on FDAP income. Interest income on bonds and commercial paper issued by U.S. companies, by the U.S. Treasury, and by U.S. government agencies is generally exempt from U.S. tax withholding, although it’s reportable on Form 1042-S.

Nonresident alien individuals fill out W-8BEN (Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting – Individuals) and furnish it to the broker. Don’t overlook Part II to claim tax treaty benefits. The broker then withholds taxes on U.S.-source dividends and other FDAP income at the appropriate tax treaty rates, or 30% if there is no tax treaty, and pays those taxes to the IRS directly. As a withholding agent, the broker is required to report all U.S.-source FDAP to the IRS and the client on Form 1042-S. There are other types of W-8 forms including W–8BEN–E (entities), W–8ECI (ECI from U.S. business), W–8EXP (foreign government or organization), and W–8IMY (foreign intermediary or branch).

Capital gains 183-day rule
If the nonresident alien spends more than 183 days in the U.S., he owes taxes on net U.S. source capital gains, even though he may not trigger U.S. residency under the substantial presence test. (U.S. residency is triggered with legal residence status or by meeting the substantial presence test. The IRS taxes U.S. residents on worldwide income.)

See IRS The Taxation of Capital Gains of Nonresident Alien Students, Scholars and Employees of Foreign Governments:

“Nonresident alien students and scholars and alien employees of foreign governments and international organizations who, at the time of their arrival in the United States, intend to reside in the United States for longer than 1 year are subject to the 30 percent taxation on their capital gains during any tax year (usually calendar year) in which they are present in the United States for 183 days or more, unless a tax treaty provides for a lesser rate of taxation. These capital gains would be reported on page 4 (not page 1) of Form 1040NR and would not be reported on a Schedule D because they are being taxed at a flat rate of 30 percent or at a reduced flat rate under a tax treaty.”

Income tax treaties
Per IRS Taxation of Nonresident Aliens:

“The United States has income tax treaties with a number of foreign countries. For nonresident aliens, these treaties can often reduce or eliminate U.S. tax on various types of personal services and other income, such as pensions, interest, dividends, royalties, and capital gains. Each individual treaty must be reviewed to determine whether specific types of income are exempt from U.S. tax or taxed at a reduced rate. More details can be found in IRS Publication 901, U.S. Tax Treaties.”

“Form 8833 does not apply to a reduced rate of withholding tax on noneffectively connected income, such as dividends, interest, rents or royalties.”

A nonresident alien may owe U.S. estate tax
U.S. estate tax considerations also may come into play in this situation. Nonresident aliens should learn how repatriation of funds work on death; they might have delays due to probate of the estate and getting IRS estate tax clearance. By opening a U.S.-based brokerage account, it lands the account in the U.S., which could potentially trigger U.S. estate taxes if over the estate exemption. While many types of funds like U.S. bonds are exempt from estate tax, U.S. equities are includible in an estate. (Nonresidents holding U.S. securities in a foreign brokerage account must count those U.S. securities in a U.S. estate.) The default estate exemption for nonresident aliens is $60,000; however, many estate tax treaties provide a significantly higher threshold. The estate tax rate starts at 18% and rises to 40%. An estate tax treaty beneficiary may be exempt from U.S. estate tax entirely on U.S. financial assets.  (Learn more about nonresident alien accounts income and estate taxation on Schwab’s Website and Schwab’s U.S. Tax, and Estate Disclosure to Non-U.S. Persons.)

Here is an IRS list of Estate & Gift Tax Treaties (International). The U.S.–Canada Income Tax Treaty includes estate tax issues. Canadians have a $2,000,000 estate exemption instead of the default $60,000 threshold.

Some nonresident aliens open a U.S. partnership account
Some U.S. brokers are not set up to accommodate nonresident aliens or other foreign persons including foreign corporations, partnerships, and trusts. They might recommend forming a U.S. LLC entity to open a U.S. entity account instead of a nonresident alien or foreign entity account. This U.S. entity account should be treated like other U.S. persons or entities, not subject to tax withholding on dividends by the broker. The U.S. LLC entity account should receive a Form 1099-B reporting dividends, interest, sale proceeds and cost basis, and other items of income or loss. The LLC files a W-9 with U.S. tax id number, not a W-8BEN-E for foreign entity status.

There are problems using a single-member LLC (SMLLC). Without classification as a partnership or C-Corp, an SMLLC is a disregarded entity. That would mean the SMLLC disregards to the nonresident alien individual, who should then file a W-8BEN-E. Nonresident aliens may not own an S-Corp. If the broker did treat the SMLLC disregarded entity as a domestic entity, the owner would have to file a complicated Form 1040NR in the event there is a U.S. tax liability (i.e., on U.S. dividends).

As stated above, it’s better to have a spousal-member LLC to file a partnership return. The U.S. partnership takes over the role as tax withholding agent from the broker, and the U.S. partnership must issue the Form 1042-S to the nonresident alien owners. Using a company does not avoid withholding taxes on U.S.-source FDAP income for nonresident owners.

“The Chapter 3 withholding regulations on U.S. source payments to foreign persons make clear that there is no U.S. withholding on payments to U.S. persons, which includes a partnership formed under U.S. law,” says tax attorney Roger D. Lorence. “The partnership is the withholding agent, and it is required to withhold on U.S. source dividends allocable to non-U.S. partners (nonresident aliens).” (See IRS Publication 515, Withholding of Tax on Nonresident Aliens and Foreign Entities.)

The Form 1065 U.S. partnership tax return can be reasonably straightforward because all owners are non-resident aliens. The partnership can report zero capital gains and losses but reconcile to the 1099-B for IRS matching purposes. The partnership can omit expenses as they do not affect U.S. income taxes. In the tax return footnotes, the partnership should explain that the nonresident owners do not owe capital gains taxes, because they are in the U.S. under 183 days per year.

Usually, the partnership can allocate dividends and portfolio income to partners on the last day of the year, so tax deposits for withholding can wait until early January of the subsequent year. It’s one accounting period, which reduces the stress of making tax payments on a timely basis to avoid penalties.

There might be challenges to establishing an LLC bank account, and repatriating funds to a foreign country.

“The U.S. partnership is not engaged in a trade or business in the U.S. with effectively connected income (ECI). It’s an investor partnership with FDAP and a Section 864 exemption,” Lorence says. “Although not free from doubt, the better view is that it is not included in a U.S. estate of a nonresident alien owner. Intangible assets like partnership interests are situated where the owner resides and dies. Legal situs is where the owner is located on death.”

Four ways nonresidents trade U.S. financial markets

1. Some foreign-based brokers offer limited access to U.S. financial markets. Even on foreign-based brokerage accounts, there is U.S. tax withholding on dividends paid by U.S. companies and other FDAP income. Foreign brokerage accounts do not issue a Form 1042-S as a U.S.-based broker does for nonresident aliens. There are U.S. estate tax considerations for U.S. securities.

2. Leading U.S. brokers open affiliate brokerage firms in some countries. There may be affiliates in Canada and some European and Asian countries. It’s the same tax treatment as the previous: tax withholding on U.S.-source FDAP income, no 1042-S issuance, and potential U.S. estate tax on U.S. securities.

3. Some U.S. brokers open accounts for nonresident aliens. The nonresident alien files a W-8BEN claiming tax treaty benefits, if applicable. The U.S. broker is an income tax withholding agent on U.S.-source FDAP with a default tax rate of 30% unless overridden by a treaty rate of usually 15% or less. The U.S. broker issues Form 1042-S reporting U.S. source income and withholding tax. There are some U.S. estate tax considerations for the nonresident so check if there is an estate tax treaty with your country, perhaps providing a higher exemption amount or exclusion. Some nonresident aliens form a foreign corporation, partnership or trust to open the brokerage account with a U.S. broker, which helps avoid potential U.S. estate taxation.

4. Some U.S.-based brokers suggest the nonresident alien open a U.S. LLC to create an account and file as a partnership. The broker treats the account like a U.S. person or entity issuing an annual tax report Form 1099-B. The broker does not withhold taxes on dividends paid by U.S. companies or on other U.S.-source FDAP income. The U.S. partnership takes over that role as tax withholding agent and issues the 1042-S to the IRS and nonresident owner of the partnership. There is probably no U.S. estate tax on a U.S. partnership interest in an investment company. There are challenges to establishing an LLC bank account, and repatriating funds to a foreign country. Consult a tax advisor.

Roger D. Lorence, JD contributed to this blog post.


How Traders Can Get 20% QBI Deduction Under IRS Proposed Regulations

August 15, 2018 | By: Robert A. Green, CPA | Read it on

The IRS recently released proposed reliance regulations (Proposed §1.199A) for the 2017 Tax Cuts and Jobs Act’s new 20% deduction on qualified business income (QBI) in pass-through entities.

The proposed regulations confirm that traders eligible for trader tax status (TTS) are a service business (SSTB). Upper-income SSTB owners won’t get a deduction on QBI if their taxable income (TI) exceeds the income cap of $415,000 married, and $207,500 for other taxpayers. The phase-out range is $100,000/$50,000 (married/other taxpayers) below the income cap, in which the QBI deduction phases out for SSTBs. The W-2 wage and property basis limitations apply within the phase-out range, too. Hedge funds eligible for TTS and investment managers are also SSTBs.

The new law favors non-service business (non-SSTB), which don’t have an income cap, but do have the W-2 wage and property basis limitations above the TI threshold of $315,000/$157,500 (married/other taxpayers). The 2018 TI income cap, phase-out range, and threshold will be adjusted for inflation in each subsequent year.

A critical question for traders
The proposed regulations do not answer this essential question: What types of trading income are included in QBI? The proposed regulations define a trading business, so I presume tax writers contemplated some types of ordinary income might be included in QBI. They probably wanted to limit tax benefits for traders by classifying trading as an SSTB subject to the income cap.

In my Jan. 12, 2018 blog post, How Traders Can Get The 20% QBI Deduction Under New Law, I explained how the statute excluded certain “investment-related” items from QBI, including capital gains, dividends, interest, annuities and foreign currency transactions. That left the door open for including Section 475 ordinary income for trading businesses. After reading the proposed regulations, I feel that door is still open.

Trading is a service business
See the proposed regulations, REG-107892-18, page 67. The Act just listed the word “trading,” whereas, the proposed regulations describe trading in detail and cite TTS court cases.

“b. Trading: Proposed §1.199A-5(b)(2)(xii) provides that any trade or business involving the “performance of services that consist of trading” means a trade or business of trading in securities, commodities, or partnership interests. Whether a person is a trader is determined taking into account the relevant facts and circumstances. Factors that have been considered relevant to determining whether a person is a trader include the source and type of profit generally sought from engaging in the activity regardless of whether the activity is being provided on behalf of customers or for a taxpayer’s own account. See Endicott v. Commissioner, T.C. Memo 2013-199; Nelson v. Commissioner, T.C. Memo 2013-259, King v. Commissioner, 89 T.C. 445 (1987). A person that is a trader under these principles will be treated as performing the services of trading for purposes of section 199A(d)(2)(B).”

QBI excludes certain items
See REG-107892-18, page 30: “Section 199A(c)(3)(B) provides a list of items that are not taken into account as qualified items of income, gain, deduction, and loss, including capital gain or loss, dividends, interest income other than interest income properly allocable to a trade or business, amounts received from an annuity other than in connection with a trade or business, certain items described in section 954, and items of deduction or loss properly allocable to these items.”

See REG-107892-18, page 144: “Items not taken into account” in calculating QBI. Here’s an excerpt of the list.

 “(A) Any item of short-term capital gain, short-term capital loss, long-term capital gain, long-term capital loss, including any item treated as one of such items, such as gains or losses under section 1231 which are treated as capital gains or losses.

(B) Any dividend, income equivalent to a dividend, or payment in lieu of dividends.

(C) Any interest income other than interest income which is properly allocable to a trade or business. For purposes of section 199A and this section, interest income attributable to an investment of working capital, reserves, or similar accounts is not properly allocable to a trade or business.

(D) Any item of gain or loss described in section 954(c)(1)(C) (transactions in commodities) or section 954(c)(1)(D) (excess foreign currency gains) applied in each case by substituting “trade or business” for “controlled foreign corporation.”

(E) Any item of income, gain, deduction, or loss taken into account under section 954(c)(1)(F) (income from notional principal contracts) determined without regard to section 954(c)(1)(F)(ii) and other than items attributable to notional principal contracts entered into in transactions qualifying under section 1221(a)(7).

(F) Any amount received from an annuity which is not received in connection with the trade or business.”

Section 954 is for “foreign base company income,” and tax writers used it for convenience sake to define excluded items including transactions in commodities, foreign currencies (forex) and notional principal contracts (swaps). The latter two have ordinary income, but they are excluded from QBI.

Section 475 ordinary income
The new tax law excluded specific “investment-related” items from QBI. In earlier blog posts, I wondered if QBI might include “business-related” capital gains. The proposed regulations dropped the term “investment-related,” which seems to close that door of possibility.

I searched the QBI proposed regulations for “475,” and there were 20 results, and each instance defined securities or commodities using terminology in Section 475. None of the search results discussed 475 ordinary income and its impact on QBI. The proposed regulations seem to allow the inclusion of Section 475 ordinary income in QBI.

TTS traders are entitled to elect Section 475 on securities and/or commodities (including Section 1256 contracts). For existing taxpayers, a 2018 Section 475 election filing with the IRS was due by March 15, 2018, for partnerships and S-Corps, and by April 17, 2018, for individuals. New taxpayers (i.e., a new entity) may elect Section 475 internally within 75 days of inception. Section 475 is tax loss insurance: Exempting 475 trades from wash sale losses on securities and the $3,000 capital loss limitation. With the new tax law, there’s now likely a tax benefit on 475 income with the QBI deduction.

Section 1231 ordinary income
See REG-107892-18, page 37: “Exclusion from QBI for certain items.”

“a. Treatment of section 1231 gains and losses. (Excerpt)
Specifically, if gain or loss is treated as capital gain or loss under section 1231, it is not QBI. Conversely, if section 1231 provides that gains or losses are not treated as gains and losses from sales or exchanges of capital assets, section 199A(c)(3)(B)(i) does not apply and thus, the gains or losses must be included in QBI (provided all other requirements are met).”

If you overlay Section 475 on top of the above wording for Section 1231, there is a similar result: Section 475 ordinary income is not from the sale of a capital asset, and it should be included in QBI since it’s not expressly excluded.

Section 1231 is depreciable business or real property used for at least a year. A net Section 1231 loss is reported on Form 4797 Part II ordinary income or loss. Section 475 ordinary income or loss for TTS traders is reported on Form 4797 Part II, too. A net Section 1231 gain is a long-term capital gain.

Section 64 defines ordinary income
“The term ordinary income includes any gain from the sale or exchange of property which is neither a capital asset nor property described in section 1231(b). Any gain from the sale or exchange of property which is treated or considered, under other provisions of this subtitle, as ordinary income shall be treated as gain from the sale or exchange of property which is neither a capital asset nor property described in section 1231(b).”

The tax code does not define business income.

TTS traders with 475 ordinary income
A TTS trader, filing single, has QBI of $100,000 from Section 475 ordinary income, and his taxable income minus net capital gains is $80,000. He is under the TI threshold of $157,500 for single, so there is no phase-out of the deduction, and W-2 wage or property basis limitations do not apply. His deduction on QBI is $16,000 (20% x $80,000) since TI minus net capital gains is $80,000, which is lower than QBI of $100,000.

If his TI is greater than $157,500 but less than the income cap of $207,500 for a service business, then the deduction on QBI phases-out and the W-2 wage and property basis limitations apply inside the phase-out range.

If his TI is higher than the income cap of $207,500, there is no deduction on QBI in a trading service business.

Anti-abuse measures
The proposed regulations prevent “cracking and packing” schemes where an SSTB might contemplate spinning-off non-SSTBs to achieve a QBI deduction on them. “Proposed §1.199A-5(c)(2) provides that an SSTB includes any trade or business with 50 percent or more common ownership (directly or indirectly) that provides 80 percent or more of its property or services to an SSTB. Additionally, if a trade or business has 50 percent or more common ownership with an SSTB, to the extent that the trade or business provides property or services to the commonly-owned SSTB, the portion of the property or services provided to the SSTB will be treated as an SSTB (meaning the income will be treated as income from an SSTB).”

Other anti-abuse measures prevent employees from recasting themselves as independent contractors and then working for their ex-employer, which becomes their client.

Aggregation, allocation and QBI losses
There are QBI aggregation and allocation rules which come in handy for leveling out W-2 wage and property basis limitations among commonly owned non-SSTBs. If you own related businesses and one has too much payroll and property, and the other not enough, you don’t need to restructure to improve wage and property basis limitations. Aggregation rules allow you to combine QBI, wage and property basis limitations to maximize the deduction on aggregate QBI. Allocation rules are a different way to accomplish a similar result.

There are also rules for how to apply and allocate QBI losses to other businesses with QBI income and carrying over these losses to subsequent tax year(s).

Section 199A is a complicated code section requiring significant tax planning and compliance. The proposed regulations close loopholes, favor some types of businesses and prevent gaming of the system, which otherwise would invite excessive entity restructuring.

Hedge funds and investment managers
If a hedge fund qualifies for TTS, the fund is trading for its account through an investment manager partner. As a TTS trading business, the hedge fund is an SSTB.

A hedge fund with TTS is entitled to elect Section 475 ordinary income or loss. A hedge fund with TTS and Section 475 has ordinary income, which is likely includible in QBI. The SSTB taxable income thresholds and cap apply to each investor in the hedge fund; some may get a QBI deduction, whereas, others may not, depending on their TI, QBI aggregation and more.

The proposed regulations also describe investing and investment management as an SSTB (p. 66-67). I presume a carried-interest share (profit allocation) of capital gains should be excluded from QBI, but a carried-interest percentage of Section 475 ordinary income is likely included in QBI. Incentive fees and management fees are also included for management companies, which are SSTBs. QBI must be from domestic sources.

Service businesses
The proposed regulations state: “The definition of an SSTB for purposes of section 199A is (1) any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, and (2) any trade or business that involves the performance of services that consist of investing and investment management, trading, or dealing in securities (as defined in section 475(c)(2)), partnership interests, or commodities (as defined in section 475(e)(2)).”

The proposed regulations exempted some types of service businesses from SSTBs, including real estate agents and brokers, insurance agents and brokers, property managers, and bankers taking deposits or making loans. It also narrowed SSTBs — for example, sales of medical equipment are not an SSTB, even though physician health care services are. Performing artists are service businesses, but not the maintenance and operation of equipment or facilities for use in the performing arts.

The proposed regulations significantly narrowed the catch-all category of SSTBs based on the “reputation and skill” of the owner. The updated definition is “(1) receiving income for endorsing products or services; (2) licensing or receiving income for the use of an individual’s image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity; or (3) receiving appearance fees or income (including fees or income to reality performers performing as themselves on television, social media, or other forums, radio, television, and other media hosts, and video game players).”

Proposed vs. final regulations
The IRS stated that taxpayers are entitled to rely on these “proposed reliance regulations” pending finalization. The IRS is seeking comments, and they scheduled a public hearing for Oct. 16, 2018.

The 2017 Tax Cuts and Jobs Act was a significant piece of legislation for this Congress and President. I presume the IRS will attempt to issue final regulations in time for the 2018 tax-filing season, which starts in January 2019. The IRS needs to produce tax forms for the 2018 QBI deduction, and that is best accomplished after finalization of the regulations. Tax software makers need time to program these rules, too.

The new tax law reduced tax compliance for employees by suspending many itemized deductions. They may have a “postcard return.” However, the new law and proposed regulations significantly increase tax compliance for business owners, many of whom would like to get a 20% deduction on QBI in a pass-through entity.

See IRS FAQs and several examples on Basic questions and answers on new 20% deduction for pass-through businesses. 

Darren Neuschwander CPA contributed to my blog post.

 


Investment Fees Are Not Deductible But Borrow Fees Are

July 12, 2018 | By: Robert A. Green, CPA | Read it on

The Tax Cuts and Jobs Act suspended “certain miscellaneous itemized deductions subject to the two-percent floor,” which includes “investment fees and expenses.” However, the new law retained “other miscellaneous deductions” not subject to the two-percent floor, including short-selling expenses like stock borrow fees.

While individual taxpayers may no longer deduct investment fees and expenses on Schedule A starting in 2018, they are still entitled to deduct investment interest expenses, up to net investment income, as calculated on Form 4952.

The new law (page 95) has a complete list of suspended miscellaneous itemized deductions including “expenses for the production or collection of income.” That list does not include short-selling expenses. Section 67(b) excludes certain deductions from the “2-percent floor on miscellaneous itemized deductions;” including (8) “any deduction allowable in connection with personal property used in a short sale.”

DHN_AW_logo_Daily_News

This blog post was their Top Story on July 16

Carrying charges vs. itemized deductions
Because investment fees and expenses are no longer deductible, some accountants might consider a Section 266 election to capitalize investment management fees as “carrying charges” to deduct them from capital gains and losses. But that won’t work: The IRS said taxpayers could not capitalize investment management fees under Section 266 because they are managerial rather than transactional.

Short-sellers probably could capitalize borrow fees under Section 266 because they are transactional. However, it’s safer to deduct these short-sale costs as “Other Miscellaneous Deductions” on Schedule A (Itemized Deductions) line 28. The new tax law suspended the Pease itemized deduction limitation, so the deduction has full effect on lowering taxable income. One concern: The IRS lists all Section 67(b) exclusion items in the instructions for Schedule A line 28, but it left out (8) for short-sale expenses. The code has substantial authority, and it’s reasonable to conclude that Schedule A instructions for other miscellaneous deductions on line 28 are not an exhaustive list.

Stock borrow fees
Short selling is not free; a trader needs the broker to arrange a loan of stock.

Brokers charge short sellers “stock borrow fees” or “loan premiums.” Tax research indicates these payments are “fees for the temporary use of property.” Watch out: Some brokers refer to stock borrow fees as “interest expense,” which confuses short sellers.

For tax purposes, stock borrow fees are “other miscellaneous deductions” on Schedule A line 28 for investors. Borrow fees are business expenses for traders qualifying for trader tax status (TTS). Borrow fees are not interest expense, so investors should not include them in investment interest expense deductions on Schedule A line 14.

It’s a significant distinction that has a profound impact on tax returns because investment expenses face greater limitations in 2017, and suspension in 2018 vs. investment interest expenses which are deductible up to investment income. Other miscellaneous deductions, including borrow fees, reported on Schedule A line 28 remain fully deductible for regular and alternative minimum tax (AMT).

Investment management fees cannot be capitalized
In a 2007 IRC Chief Counsel Memorandum, the IRS denied investors from capitalizing investment management fees paid to a broker as carrying charges under Section 266. Investors wanted to avoid alternative minimum tax (AMT) and other limitations on miscellaneous itemized deductions, the rules in effect before 2018. The problem is worse in 2018 with investment expenses entirely suspended.

The memo stated:

  • “Consulting and advisory fees are not carrying charges because they are not incurred independent of a taxpayer’s acquiring property and because they are not a necessary expense of holding property.
  • Stated differently, consulting and advisory fees are not strictly analogous to common carrying costs, such as insurance, storage, and transportation.”

Borrow fees might be able to be capitalized
Borrow fees seem to meet the requirements raised in the 2007 IRS Chief Counsel Memorandum for capitalization as carrying charges under Section 266. (It’s safer to deduct them as “other misc. deductions” on Schedule A line 28.)

Treasury Regulations under 1.266-1(b)(1) highlight several types of expenses that qualify as carrying charges, including taxes on various types of property, loan interest for financing property, costs to construct or improve the property, and expenses to store personal property.

A short seller cannot execute a short sale without borrowing securities and incurring borrow fees; they are a “necessary expense of holding” the position open, and “not independent” of the short-sale transaction. Borrow fees are not for the “management of property,” they are for the “acquisition, financing, and holding” of property.

Investment fees vs. brokerage commissions
Investors engage outside investment advisors and pay them advisory fees including management fees and/or incentive fees. Other investors may pay a broker a flat or fixed fee. These costs are managerial and not transactional, based on how many trades the manager makes. They cannot be capitalized under Section 266 according to the above IRS memorandum.

Brokerage commissions are transaction costs deducted from sales proceeds and added to cost basis on brokers’ trade confirmations and Form 1099-Bs. This tax reporting for brokerage commissions resembles a carrying charge.

Short-seller payments in lieu of dividends
When traders borrow shares to sell short, they receive dividends that belong to the lender — the rightful owner of the shares. After the short seller gets these dividends, the broker uses collateral in the short seller’s account to remit a “payment in lieu of dividend” to the rightful owner to make the lender square in an economic sense.

Section 263(h) “Payments in lieu of dividends in connection with short sales” require the mandatory capitalization of these payments if a short seller holds the short position open for 45 days or less (one year in the case of an extraordinary dividend).

If a short seller holds the short sale open for more than 45 days, payments in lieu of dividends are deductible as investment interest expense.

Investment interest expenses
Section 163(d)(3)(c) states, “For purposes of this paragraph, the term ‘interest’ includes any amount allowable as a deduction in connection with personal property used in a short sale.” A broad reading of “any amount” could be construed as opening the door to borrow fees, but I doubt that. “Any amount” refers to dividends in lieu of dividends held more than 45 days.

Under certain conditions, Section 266 allows capitalization of interest to finance a property.  Short sellers and others might want to consider the possibility of a Section 266 election on investment interest expense, too — especially if they plan a standard deduction or don’t have sufficient investment income. Excess interest is a carryover to subsequent tax years.

Transactional vs. managerial expenses
The following investment expenses seem transactional, and therefore eligible for capitalization in Section 266: Storage of precious metals or cryptocurrency, borrow fees on short sales, excess risk fees on short sales, and margin interest expenses.

The following investment expenses seem to be managerial rather than transactional, and therefore cannot be treated as carrying charges under Section 266: Investment management fees, fixed or flat fees paid to brokers, computers, equipment, software, charting, education, mentors, coaching, monthly data feed fees, market information, subscriptions, travel, meals, supplies, chatrooms, office rent, staff salaries and employee benefits, accounting, tax and legal services, and most other trading-related expenses.

Section 266 election statement and tax reporting

Consider filing a Section 266 election statement with your tax return, including on an extension.

  • “For tax-year 2018, taxpayer herewith elects under Code Section 266 and IRS Regulations 1.266-1 to capitalize short-selling expenses as carrying costs applied to capital gains and losses.”

Explain the election and tax treatment in a tax return footnote.

Report short-selling expenses for realized (closed) short sales as “expenses of sale or exchange” on Form 8949 (Sales and Other Dispositions of Capital Assets) in column (g) “adjustment to gain or loss.” Defer borrow fees paid on unrealized (open) short sales until realized (closed) in the subsequent year.

Consult a trader tax expert on using this potential alternative solution. If you get full deductibility on Schedule A, it’s safer to skip Section 266 capitalization, which the IRS might scrutinize.

Trader tax status
If a short-seller qualifies for trader tax status, then stock borrow fees and other short-selling expenses are deductible as business expenses from gross income.

If a TTS trader engages an outside investment manager, then investment advisory fees remain investment expenses.

Retirement accounts
Investors engage investment managers for taxable and retirement accounts. TCJA suspended investment fees and expenses for taxable accounts, but the new tax law did not repeal investment fees and expenses for tax-deferred retirement accounts. If your retirement account engages an outside investment manager, seek to pay their investment fees and costs directly from the retirement plan. Not all brokerage firms will cooperate if you use a manager other than the firm’s wealth management arm. An expense in a tax-deferred retirement plan is equivalent to a tax-deferred cost. Caution: Don’t have your retirement plan pay fees to you, or family, as investment managers. The IRS will deem it self-dealing and a prohibited transaction, which might blow up your retirement plan. (See The DOs and DON’Ts of using IRAs and other retirement plans in trading activities and alternative investments.)

Darren L. Neuschwander, CPA and Roger Lorence, JD contributed to this blog post.

Webinar July 19, 2018: Investment Fees Are Not Deductible But Borrow Fees Are. Recording available afterward. Click here.

Related blog posts: Short Selling: How To Deduct Stock Borrow Fees and Short Selling: IRS Tax Rules Are Unique.

 


How To Avoid IRS Challenge On Your Family Office

June 28, 2018 | By: Robert A. Green, CPA | Read it on

Investors may no longer deduct investment expenses, including those passed through from an investment partnership. Restructuring these expenses into a management company might achieve business expense treatment providing it’s a genuine family office with substantial staff rendering financial services to extended family members and outside clients.

The IRS might assert the family office is managing “one’s own investments,” not for outside clients, so the management company is also an investment company with non-deductible investment expenses. Before you go in that direction, it’s wise to learn the lessons of the Lender Management court case from December 2017, which is one of the first on family offices.

Size matters
A single-family office serves one ultra-wealthy extended family, whereas, a multi-family office handles more than one family. Well-established single- and multi-family offices offer a wide variety of financial services, including wealth management, financial planning, accounting, tax, and personal finance. They have substantial staff and salaries, offices, equipment, and operations — the markings of an independent financial services company.

Family office requirements
A family office management company with underlying investment partnerships can use business expense treatment when it has the following characteristics, borne out of the Lender Management tax court case and earlier case law:

- It’s a functional financial services company with significant staff and salaries, an office, equipment and bona fide operations.
- It operates in a continuous and business-like manner.
- Its staff has expertise that is valuable to its clients.
- A profit-allocation of capital gains is considered advisory fee compensation for services rendered. It gets paid more than just its share of profits based on capital.
- It should be profitable.
- It caters to many extended family members with diverging financial needs. It does not operate with a single mindset but provides customized services to each family member.
- Family members and their investment partnerships are not obligated to use the family office.
- There should not be a majority of common ownership between the management company and investment partnerships (this factor is critical).
- It’s safer to have third-party clients who are not family members (a suggestion, not a requirement).

Small family offices have trouble
If two spouses own an investment partnership and management company, then the family office has 100% common ownership, which fails the requirements. The micro family office renders services exclusively to the spousal-owned investment partnership. The management company does not function as an independent financial services company, with outside staff or an outside office. It does not stand alone as a financial service provider. In the eyes of the IRS, it oversees its own investments. This management company should not use business expense treatment. (Some trader accounting and law firms sold this scheme to traders who do not qualify for trader tax status. I’ve always said it did not work and the Lender court confirms it doesn’t work.)

Management fees and carried interest
Consider this typical example: An investment partnership pays a 0.5% management fee on funds under management of $1M ($5,000 per year). The investment partnership also pays a 20% profit allocation (carried interest) based on performance (say, $50,000 for the year). The investment partnership passes through an investment expense of $5,000 for the management fee, which the investor cannot deduct on their tax return. The profit allocation avoids the investment expense deduction problem because it carves out a share of capital gains on each investor’s Schedule K-1.

The management company reports $5,000 of revenue for the management fee, which gives the impression of being a trade or business. However, that’s not enough revenue to cover expenses, so it lacks presumption of business purpose. The management company also reports capital gains income of $50,000 from the profit allocation of investment income. Total income is $55,000 minus business expenses of $52,000 equals a net income of $3,000. The capital gains help satisfy the presumption of business purpose test. The owner sacrificed the $5,000 deduction in the investment partnership to arrange $52,000 of deductions in the management company. However, the IRS might disallow the entire $52,000 deduction, asserting the management company is also an investment company with non-deductible investment expenses because it did not satisfy the requirements for a family office under the Lender court.

Hedge funds
Assume a hedge fund manager owns the management company, which deducts business expenses. The hedge fund partnership does not qualify for trader tax status, so it’s an investment partnership. Most hedge funds meet this scenario. The management company is genuine, and there is little common ownership because the hedge fund is predominately owned by outside investors. That satisfies the Lender court requirements for a management company.

It might be different for a startup hedge fund before outside investors become limited partners in the limited partnership. Until and unless that happens, the manager is managing his own investments, and it fails Lender. The limited partnership is probably not paying the management company advisory fees including profit allocation in connection with the managers capital.

Lender Management tax court case
In Lender Management v. Comm. (Dec. 16, 2017), the tax court overruled the IRS by awarding business expense treatment to Lender Management. It was a well-established single-family office servicing many family-owned investment partnerships. Lender provided customized investment and management services throughout the year to many different family members, with varying needs, across an extensive family tree. Lender Management and the investment partnerships did not have too much common ownership according to IRS and tax court calculations. Only a few of Lender’s dozens of family members owned the management company.

The IRS was unable to cite attribution rules that should apply to Lender. The Lender case also dealt with how to handle revocable vs. irrevocable trusts in the overlap test for common ownership. The Lender court did not define how much overlap ownership is permitted.

Other tax court cases
In Higgins v. Comm. (1941), the tax court said, “No matter how large the estate or how continuous or extended the work may be, overseeing the management of one’s own investments is generally regarded the work of an investor.”

In Dagres v. Comm. (2011), “Selling one’s investment expertise to others is as much an expertise as selling legal expertise, or medical expertise.”

Trade or business partnerships
In Higgins, replace the words “business” for “investment” and the outcome is favorable: “Overseeing the management of one’s own businesses is generally regarded as the work of a business.” If there is a trading partnership with trader tax status, or a rental real estate partnership with ordinary income, then the management company can look through to the business treatment.

A C-Corp management company
Some families and tax advisors are considering a C-Corp management company to take advantage of the new tax law’s 21% flat rate.

Be sure the management company meets the Lender court requirements for a family office. Otherwise, the IRS does not permit a C-Corp investment company to deduct investment expenses. Section 212 (investment expenses) applies to non-corporate taxpayers, not corporations. A C-Corp with a trade or business is entitled to deduct business expenses in connection with making ancillary investments, like investing treasury capital.

When taking into account the Tax Cuts and Jobs Act, don’t focus solely on the federal 21% flat tax rate on the C-Corp level. There are plenty of other taxes, including capital gains taxes on qualified dividends, corporate taxes in 44 states, and IRS 20% accumulated earnings tax assessed on excess retained earnings, which is any amount above zero for an investment company. (See How To Decide If A C-Corp Is Right For Your Trading Business.)

Apportionment between investment and business partnerships
Family offices might want to consider having more of their underlying investment partnerships achieve business treatment, like trader tax status or rental real estate income. If a family office does not satisfy the requirements, and it services investment partnerships and business partnerships, it might consider using hybrid reporting to apportion business expenses vs. investment expenses.

Wealthy families diversify their interests and invest in family-owned investment partnerships in securities and commodities, outside hedge funds, private equity funds, venture capital funds, and real estate partnerships and REITs. Consult a tax advisor to learn more about which underlying investment partnerships have investment expense treatment vs. trade or business activities.

Darren Neuschwander, CPA, and Roger Lorence, Esq., contributed to this post.


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