Execute S-Corp Officer Compensation With Employee Deductions Before Year-End

December 10, 2019 | By: Robert A. Green, CPA

TTS traders need an S-Corp trading company to arrange health insurance and retirement plan deductions. These deductions require earned income or self-employment income. Unlike trading gains, S-Corp salary is considered earned income.

The S-Corp must execute officer compensation, in conjunction with employee benefit deductions, through formal payroll tax compliance before the year-end 2019. Otherwise, traders miss the boat. TTS is an absolute must since an S-Corp investment company cannot have tax-deductible wages, health insurance, and retirement plan contributions. 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. If you are in the QBI phase-out range, you might wish to have higher wages to increase a QBI deduction. For payroll tax compliance services, I recommend paychex.com; it has a dedicated team for our TTS S-Corp clients. Sole proprietor and partnership TTS traders cannot pay salaries to 2% or more owners.

TTS S-Corps may only deduct health insurance for the months the S-Corp was operational and qualified for TTS. Employer-provided health insurance, including Cobra, is not deductible. It doesn’t need to be profitable for the health insurance deduction.

A taxpayer can deduct a contribution to a health savings account (HSA) without TTS or earned income. HSA contribution limits for 2019 are $3,500 individual and $7,100 for family coverage. There’s an additional $1,000 for age 55 or older. Some employers offer a flexible spending account (FSA) for covering health care copayments, deductibles, some drugs, and other health care costs. Both HSAs and FSAs must be fully funded and utilized before the year-end.

TTS S-Corps formed later in the year can unlock a retirement plan deduction by paying sufficient officer compensation in December when results for the year are evident. Traders should only fund a retirement plan from trading income, not losses.

You must open a Solo 401(k) retirement plan for a TTS S-Corp with a financial intermediary before the year-end 2019. Plan to pay the 2019 100%-deductible elective deferral amount up to a maximum of $19,000 (or $25,000 if age 50 or older) with December payroll. That elective deferral is due by the end of January 2020. You can fund the 25% profit-sharing plan (PSP) portion of the S-Corp Solo 401(k) up to a maximum of $37,000 by the due date of the 2019 S-Corp tax return, including extensions, which means Sept. 15, 2020. The maximum PSP contribution requires wages of $148,000 ($37,000 divided by 25% defined contribution rate). Tax planning calculations will show the projected outcome of income tax savings vs. payroll tax costs for the various options.

Consider a Solo 401(k) Roth, where the contribution is not deductible, but the contribution and growth within the Roth are permanently tax-free. Traditional plans have a tax deduction upfront, and all distributions are subject to ordinary income taxes in retirement. Traditional retirement plans have required minimum distributions (RMD) by age 70½, whereas Roth plans don’t have RMD.

Setting up a TTS S-Corp for 2021
If you missed out on employee benefits in 2019, then consider an LLC with S-Corp election for 2020. You can form a single-member LLC by mid-December 2019, obtain the employee identification number (EIN), and open the LLC brokerage account before year-end to begin trading in it on Jan. 1, 2020. The single-member LLC is a disregarded entity for 2019, which avoids an entity tax return filing for the 2019 partial year. A spouse can be added as a member of the LLC on Jan. 1, 2020, which means the LLC will file a partnership return for 2020. If you want health insurance and retirement plan deductions, then your single-member or spousal-member LLC should submit a 2020 S-Corp election within 75-days of Jan. 1, 2020. The S-Corp should also consider making a Section 475 MTM election on securities only for 2020 within 75 days of Jan. 1, 2021.

Clients of our firm GNM should sign up for S-Corp Tax Compliance (Traders) and work with their assigned CPA before the year-end.

If you want to set up an LLC in December with S-Corp election for 2020, start with a 45-minute paid consultation with Robert A. Green, CPA. You can purchase our entity formation service afterward.


Tax Planning At Year-End Generates The Most Savings

October 26, 2019 | By: Robert A. Green, CPA | Read it on

The best way to reduce income taxes is with year-end tax planning. Don’t wait until February when you begin preparation of 2019 tax returns; that’s too late for many tax savings strategies.

If you have an S-Corp that is eligible for trader tax status (TTS), don’t miss that section further down below, which includes essential year-end transactions, including formal payroll tax compliance for officer compensation. That unlocks the health insurance and or retirement plan deductions.

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 2020. We expect tax rates to be the same for 2020, although the IRS will adjust the tax brackets for inflation. 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 2020 should consider income deferral strategies. Conversely, a 2019 TTS trader with ordinary losses, waiting to be in a higher tax bracket in 2020, might want to consider income acceleration strategies.

Taxpayers with trader tax status in 2019 should 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 after 2017, 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 2019 standard deduction of $24,400 married or $12,200 single. If itemized deductions are below the standard deduction, consider a strategy to “bunch” them into one year and take the standard deduction in other years.

Accelerate income and defer certain deductions
A TTS trader with substantial ordinary losses (Section 475) under the “excess business loss limitation” (EBL, see below) should consider accelerating income to soak up the allowable business loss, instead of having an NOL carryover. Try to advance enough income to use 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 2019, but the 10% excise tax on early withdrawals before age 59½ is avoided providing you pay the conversion taxes from outside the Roth plan. One concern is that TCJA repealed the recharacterization option; you can no longer reverse it if the plan assets decline after conversion. There isn’t an income limit for making Roth IRA conversions, whereas there is for making regular Roth IRA contributions. For example, a taxpayer filing single has a $405,000 TTS/475 ordinary loss. However, the excess business loss limitation is $255,000, and $150,000 is an NOL carryover. Consider a Roth conversion to soak up most of the $255,000 allowed business loss, and leave enough income to use the standard deduction and lower tax brackets.

Sell winning positions: Another way a trader can accelerate income is to sell open winning positions to realize capital gains.

Consider selling long-term capital gain positions. The 2019 long-term capital gains rates are 0% for taxable income under $39,375 single, and $78,750 married filing jointly. The 15% capital gains rate applies to taxable income up to $434,550 for filing single and $488,850 married filing jointly. The top bracket rate of 20% applies above those amounts.

Net investment tax: Investment fees and expenses are not deductible for calculating net investment income (NII) for the Affordable Care Act (ACA) 3.8% net investment tax (NIT) on unearned income. NIT only applies to individuals with 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 ACA thresholds for inflation. NII includes capital gains and Section 475 ordinary income.

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 property tax 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 2019, considering going on a shopping spree before January 1. There is no sense deferring TTS expenses because you cannot be sure you will qualify for TTS in 2020.

Employee business expenses: Ask your employer if they have an “accountable plan” for reimbursing employee-business costs. You must “use it or lose it” before the year-end. TCJA suspended unreimbursed employee business expenses. A TTS S-Corp should use an accountable plan to reimburse employee business expenses since the trader/owner is an employee of the S-Corp.

Unreimbursed partnership expenses: Partners in LLCs taxed as partnerships can deduct unreimbursed partnership expenses (UPE). That is how they usually deduct home office expenses. UPE is more convenient than using an S-Corp accountable plan because the partner can arrange the UPE after the year-end. The IRS doesn’t want S-Corps to use UPE.

SALT cap: 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) – and not indexing it for inflation. 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. Stay tuned to news updates about SALT.

Investment fees and expenses: TCJA suspended all miscellaneous itemized deductions subject to the 2% floor, which includes investment fees and expenses. TCJA left just two itemized deductions for investors: Investment-interest expenses limited to investment income, with the excess as a carryover, and stock borrow fees for short-sellers.

Standard deduction: TCJA roughly doubled the 2018 standard deduction and suspended and curtailed several itemized deductions. The 2019 standard deduction is $12,200 single, $24,400 married, and $18,350 head of household. There is an additional standard deduction of $1,300 for the aged or the blind. Many more taxpayers will use the standard deduction, 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 filings where you might get some tax relief for itemizing deductions.

Estimated income taxes and AMT

Estimated income taxes: If you already reached the SALT cap, you don’t need to prepay 2019 state estimated income taxes by December 31, 2019. Pay federal and state estimated taxes owed when due by January 15, 2020, with the balance of your tax liabilities payable by April 15, 2020. You can gain six months of additional time by filing an automatic extension on time, but late-payment penalties and interest will apply on any tax balance due. (See Tax Extensions: 12 Tips To Save You Money.)

Many traders skip making quarterly estimated tax payments during the year, figuring they might incur trading losses later in the year. Catch up with the Q4 estimate due by January 15. Some rely on the safe harbor exception to cover their prior year taxes. TTS S-Corp traders should consider withholding additional taxes on year-end paychecks in connection with retirement plan contributions, which helps avoid underestimated tax penalties since the IRS treats wage withholding as being made throughout the year.

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 in 2019 with SALT capped at $10,000 and because TCJA raised the 2019 AMT exemptions to $510,300 single and $1,020,600 married filing jointly. Taxpayers subject to AMT should not accelerate AMT preference items.

Avoid wash sale loss adjustments

Wash sales: Taxpayers must report wash sale (WS) loss adjustments on securities based on substantially identical positions across all accounts, including IRAs. Conversely, brokers assess WS only on identical positions per the one account. Active securities traders should use a trade accounting program or service to identify potential WS loss problems, especially going into year-end.

In taxable accounts, a trader can 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 his taxable or IRA accounts. Avoid WS between taxable and IRA accounts throughout the year, as that is otherwise a permanent WS loss. (Starting a new entity effective January 1, 2020, can break the chain on individual account WS at year-end 2019 provided you don’t purposely avoid WS with the related party entity.)

WS losses might be preferable to capital loss carryovers at year-end 2019 for TTS traders. A Section 475 election in 2020 converts year-end 2019 WS losses on TTS positions (not investment positions) into ordinary losses in 2020. That’s better than a capital loss carryover into 2020, which might 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. (See How To Avoid Taxes On Wash Sale Losses.)

Trader tax status and Section 475

Trader tax status: If you qualify for TTS (business expense treatment — no election needed) in 2019, accelerate trading expenses into that qualification period as a sole proprietor or entity. If you don’t qualify until 2020, 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. (See How Traders Get Enormous Tax Deductions, And Investors Do Not.)

Section 475 MTM: TTS traders choose Section 475 on securities for exemption from wash-sale loss rules and the $3,000 capital loss limitation — and to be eligible for the 20% QBI deduction. To make a 2019 Section 475 election, existing individual taxpayers had to file an election statement with the IRS by April 15, 2019 (March 15 for existing S-Corps and partnerships). If they filed that election statement on time, they need to complete the election process by submitting a 2019 Form 3115 with their 2019 tax return. Those who missed the 2019 election deadline may want to consider the election for 2020. Capital loss carryovers are a concern; use them up against capital gains but not Section 475 ordinary income. Once you make a 475 election, it remains in effect; you don’t have to elect it every year. You are entitled to revoke a 475 election, in the same manner, you elect it. If you stop qualifying for TTS, then 475 treatment is suspended until you requalify.

If you make a Section 475 election by April 15, 2020, it takes effect on January 1, 2020. In converting from the realization (cash) method to the mark-to-market (MTM) method, you need to make a Section 481(a) adjustment on January 1, 2020. It’s unrealized capital gains, and losses on open TTS securities positions held on December 31, 2019. Do not apply Section 475 to investment positions. If you are not a TTS trader as of year-end 2019, then you won’t have a Section 481(a) adjustment. (See Section 481(a) Positive Adjustment Spread Period Changes.)

A “new taxpayer” entity can elect Section 475 within 75 days of inception. That would come in handy if you missed the individual sole proprietor deadline (April 15, 2019) for choosing Section 475. Forming a new entity on November 1, 2019, or later, is too late for establishing TTS for the 2019 short calendar year. Consider waiting until January 1, 2020, for starting a new entity with TTS and electing Section 475.

20% deduction on qualified business income
In August 2018, the IRS issued proposed reliance regulations (Proposed §1.199A) for the TCJA’s 20% deduction on qualified business income (QBI) in pass-through entities. On January 18, 2019, the IRS issued the final 199A regs. The proposed and final 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 receive a QBI deduction. The 2019 taxable income (TI) cap is $421,400/$210,700 (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. Investment managers are specified service activities, too.

QBI includes Section 475 ordinary income and loss, and trading business expenses. QBI excluded capital gains and losses, Section 988 forex and swap ordinary income or loss, dividends, and interest income. Our firm took a favorable position on QBI for traders. (See A Rationale For Using QBI Tax Treatment For Traders.)

TCJA favors non-service businesses, which are not subject to an income cap. The W-2 wage and property basis limitations apply above the 2019 TI threshold of $321,400/$160,700 (married/other taxpayers). The IRS adjusts the annual TI income threshold for inflation each year.

Taxpayers might be able to increase the QBI deduction with smart year-end planning. If taxable income falls within the phase-out range for a specified service activity, or even above for a non-service business, you might need higher wages, including officer compensation, to avoid a W-2 wage limitation on the QBI deduction. Deferring income can also help get under various QBI restrictions and thresholds.

Net operating losses and the Section 1256 loss carryback election

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). Get immediate use of some or all of NOLs with a Roth IRA conversion before year-end and other income acceleration strategies. TCJA repealed NOL carrybacks after 2017 with one exception; farmers may carry back an NOL two tax years. TCJA made NOL carryforwards unlimited, changing the carryforward period from 20 years. Repealing NOL carrybacks negatively impacts TTS traders using 475 ordinary loss treatment. We helped traders obtain significant NOL refunds before 2018, which helped them remain in business. An “excess business loss” (EBL) over the limitation is an NOL carryforward, and accelerating non-business income won’t avoid EBL. (See EBL below.)

Section 1256 loss carryback election: The only remaining carryback for traders is a Section 1256 loss carryback to the prior three tax years, offset against 1256 gains, not other types of income. Any loss remaining is carried forward. Consider making a Section 1256 loss carryback election on a 2019 Form 6781 timely filed with a 2019 tax return.

There are other tax advantages to trading Section 1256 contracts. They have lower 60/40 capital gains tax rates, meaning 60% (including day trades) use the lower long-term capital gains rate, and 40% use the short-term rate, which is the ordinary tax rate. At the maximum tax brackets for 2019, the top Section 1256 contract tax rate is 26.8% —10.2% lower than the highest ordinary rate of 37%. Section 1256 tax rates are 4.2% to 12% lower vs. ordinary rates depending on which tax bracket applies. Section 1256 contracts are marked-to-market (MTM), so you don’t have to do tax-loss selling at year-end. (See Trading Futures & Other Section 1256 Contracts Has Tax Advantages.)

Limitations on excess business losses and business interest expense

Excess business loss limitation: TCJA included an “excess business loss” (EBL) limitation of $500,000/$250,000 (married/other taxpayers) for 2018. (The 2019 inflation-adjusted limit is $510,000/$255,000 (married/other taxpayers). Aggregate EBL from all pass-through businesses: A profitable company can offset another business with losses to remain under the limit. Include wage income in aggregate EBL. Other types of income and non-business losses do not affect the EBL calculation (i.e., capital gains and losses). EBL over the limit is an NOL carryforward.

Example of EBL limitation: TTS/475 trader filing single has an ordinary loss of $500,000 for 2019. It’s considered a business loss. He has income from wages of $100,000, so his net EBL is $400,000. The 2019 EBL limitation is $255,000 and the 2019 NOL carryover to 2020 is $145,000 ($400,000 minus $255,000).

Business interest expense: TCJA introduced a limitation on deducting business interest expense in Section 163(j). The 30% limitation should not impact most TTS traders because the $25 million three-year average “gross receipts” threshold applies to net trading gains, not proceeds. That’s good news because if gross receipts used total sales proceeds on trades, then a TTS trader with trading losses might have a business interest expense limitation. With net trading gains being the standard, only more substantial hedge funds might be impacted.

S-Corp officer compensation, health insurance, and retirement plan deductions
TTS traders need an S-Corp trading company to arrange health insurance and retirement plan deductions. These deductions require earned income or self-employment income, and trading gains are not that. S-Corp salary is considered earned income.

2019 S-Corp: The S-Corp must execute officer compensation, in conjunction with employee benefit deductions, through formal payroll tax compliance before the year-end 2019. Otherwise, traders miss the boat. TTS is an absolute must since an S-Corp investment company cannot have tax-deductible wages, health insurance, and retirement plan contributions. 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. Keep an eye out for the QBI deduction; if you are in the QBI phase-out range, you might wish to have higher wages to increase a QBI deduction. For payroll tax compliance services, I recommend paychex.com; they have a dedicated team for our TTS S-Corp clients. Sole proprietor and partnership TTS traders cannot pay salaries to 2% or more owners.

Health insurance deduction: A TTS S-Corp may only deduct health insurance for the months the S-Corp was operational and qualified for TTS. Employer-provided health insurance, including Cobra, is not deductible. A TTS S-Corp doesn’t need to be profitable for the health insurance deduction.

Health Savings Account: A taxpayer can deduct a contribution to a health savings account (HSA) without needing TTS eligibility or earned income. HSA contribution limits for 2019 are $3,500 individual and $7,100 for family coverage. There’s an additional $1,000 for age 55 or older. Fully fund and utilize the HSA before year-end.

Flexible Spending Account: Some employers offer a flexible spending account (FSA) for covering health care copayments, deductibles, some drugs, and other health care costs. Fully fund and utilize the FSA before year-end.

Solo 401(k) retirement plan: A TTS 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. Traders should only fund a retirement plan from trading income, not losses.

You must establish (open) a Solo 401(k) retirement plan for a TTS S-Corp with a financial intermediary before the year-end 2019. Plan to pay the 2019 100%-deductible elective deferral amount up to a maximum of $19,000 (or $25,000 if age 50 or older) with December payroll. That elective deferral is due by the end of January 2020. You can fund the 25% profit-sharing plan (PSP) portion of the S-Corp Solo 401(k) up to a maximum of $37,000 by the due date of the 2019 S-Corp tax return, including extensions, which means September 15, 2020. The maximum PSP contribution requires wages of $148,000 ($37,000 divided by 25% defined contribution rate). Do tax planning calculations to see the projected outcome of income tax savings vs. payroll tax costs for the various options.

Consider a Solo 401(k) Roth, where the contribution is not deductible, but the contribution and growth within the Roth are permanently tax-free. Traditional plans have a tax deduction upfront, and all distributions are subject to ordinary income taxes in retirement. Traditional retirement plans have required minimum distributions (RMD) by age 70 ½, whereas Roth plans don’t have RMD.

Setting up a TTS S-Corp for 2020
If you missed out on employee benefits in 2019, then consider an LLC with S-Corp election for 2020. If you wait to start your entity formation process on January 1, 2020, you won’t be ready to trade in an entity account on January 1, 2020. Instead, you can form a single-member LLC by mid-December 2019, obtain the employee identification number (EIN), and open the LLC brokerage account before year-end. The single-member LLC is a disregarded entity for 2019, which avoids an entity tax return filing for the 2019 partial year. If desired, add your spouse as a member of the LLC on January 1, 2020, which means the LLC will file a partnership return. If you want health insurance and retirement plan deductions, then your single-member or spousal-member LLC should submit a 2020 S-Corp election by March 15, 2020. The S-Corp should also consider making a Section 475 MTM election on securities only for 2020 by March 15.

Tax-loss selling of financial instruments
If you own an investment or trading portfolio, you have the opportunity to reduce capital gains taxes via “tax-loss selling.” If you realized significant short-term capital gains year-to-date in 2019 and have open positions with substantial unrealized capital losses, you should consider selling (realizing) some of those losses to reduce 2019 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 the 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.

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 positions reporting realized and unrealized gains and losses.

Married couples should compare filing joint vs. separate
Each year, married couples choose between “married filing jointly” (MFJ) vs. “married filing separately” (MFS). TCJA fixed several inequities in filing status, including the tax brackets by making single, MFJ and MFS equivalent, except for divergence at the top rate of 37% for single filers, retaining some of the marriage penalty. There are other issues to consider, too.

Married couples may be able to improve QBI deductions, AGI, and other income-threshold dependent deductions, and credits with MFS in 2019. It’s wise to enter each spouse’s income, gain, loss, and expense separately and have the tax planning and preparation software compare MFJ vs. MFS. In a community property state, there are special rules for allocating income between spouses.

Filing MFS might unlock a QBI deduction, where one spouse might price the other spouse out of a QBI deduction based on exceeding the income cap for a specified service activity.

Miscellaneous considerations for individuals
Sell off passive-loss activities to utilize suspended passive-activity losses.

Maximize contributions to retirement plans. That lowers AGI and other income thresholds, which can unlock more of a QBI deduction, reduce net investment tax, and unlock credits and other tax benefits. Consider non-deductible IRA contributions.

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 philanthropic 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 (RMD) by age 70½ unless it’s a Roth IRA. Per TCJA, consider directing your traditional 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 charitable contributions.

TCJA improves family tax planning: 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 (check with your state). The 2019 annual gift exclusion is $15,000, and its $155,000 to noncitizen spouses; the 2019 unified credit for federal estate tax is $11.40 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. (See How To Save Taxes With Children.)

TCJA created Qualified Opportunity Zones (QOZ) “to spur economic development and job creation in distressed communities throughout the country and U.S. possessions by providing tax benefits to investors who invest eligible capital into these communities. Taxpayers may defer tax on eligible capital gains by making an appropriate investment in a Qualified Opportunity Fund and meeting other requirements,” per Opportunity Zones Frequently Asked Questions.)

Adam Manning CPA contributed to this blog post. 

This blog post is an updated version of chapter 9 on tax planning in Green’s 2019 Trader Tax GuideFree upgrade: If you purchase Green’s 2019 Trader Tax Guide after October 15, 2019, we will email you online access to Green’s 2020 Trader Tax Guide around the middle of January 2020.

Our CPAs are standing by in November and December to help clients with 2019 year-end tax planning. Our tax compliance service includes tax planning and preparation, and we look forward to helping you execute the above tax strategies. Please contact us soon.

Consider a 45-minute consultation with Robert A. Green, CPA to discuss eligibility for TTS and if an entity if helpful to you. Upgrade to our entity formation service after, if warranted.

Join my upcoming Webinar on November 13, 2019, or watch the recording after to learn more about this content: Tax Planning At Year-End Generates The Most Savings

 

 


How To Save Taxes With Children

October 8, 2019 | By: Robert A. Green, CPA

Children are lovely, but they also cost a lot of money on childcare and education costs. With careful tax planning, you can generate significant tax savings.

Consider shifting a portion of investment income from the parent’s tax return to the children. However, avoid having too high unearned income for younger children as that might trigger the “kiddie tax,” which defeats the intended purpose. (See below: The “kiddie tax” rules and how they affect you.)

If you have a family business, consider hiring your children to shift earned income to the children’s lower tax brackets. For sole proprietorships and LLC/partnerships, you might also save social security taxes. (See below: Tax benefits of putting junior family members on the payroll.)

There is a litany of tax planning strategies to consider while saving for education, including college. These include qualified tuition programs (“529 plans”), tax-exempt bonds, Coverdell education savings accounts, tuition tax credits, employer educational assistance programs, college expense payments by grandparents and others, the student loan interest deduction, borrowing against retirement plan accounts, and withdrawals from retirement plan accounts. (See below: Tax planning for college, and Qualified tuition programs-”529 plans”)

As a working parent, you might qualify for the dependent care credit or an employer-provided dependent care flexible spending account (FSA). Determine which one is better for your tax bracket and needs. (See below: Dependent care credit/dependent care flexible spending account.)

The new tax law, TCJA, made the child tax credit (CTC) more valuable, and more taxpayers should qualify for this credit. (See below: Child tax credit.)

Client Letters from Thomson Reuters/Tax & Accounting:

  • The “kiddie tax” rules and how they affect you (page 3)
  • Tax benefits of putting junior family members on the payroll (page 5)
  • Tax planning for college (page 7)
  • Qualified tuition programs-”529 plans” (page 14)
  • Dependent care credit/dependent care flexible spending account (page 16)
  • Child tax credit (page 20)

We are emailing a PDF file containing the above Client Letters, so sign up for our Email List.

If you would like to discuss any of these tax planning strategies, contact your assigned CPA in our firm, or consider a consultation. Contact us with any questions.

Thank you,

Robert A. Green, CPA
CEO, GreenTraderTax.com
Managing Member, Green, Neuschwander & Manning, LLC

 


What You Trade Can Make A World Of Tax Difference

September 29, 2019 | By: Robert A. Green, CPA | Read it on

There’s a bevy of financial products to trade with a wide assortment of tax treatment. Traders have access to U.S. and international equities, futures and other Section 1256 contracts, options, ETFs, ETNs, forex, precious metals, foreign futures, cryptocurrencies, and swap contracts. Broker-issued Form 1099-Bs might not provide the best available tax treatment, and in some cases, there are no 1099s issued.

Securities
Securities traders have ordinary tax rates on short-term capital gains, wash sale loss adjustments, capital-loss limitations, and accounting challenges.

Securities include:
- U.S. and international equities (stocks)
- U.S. and foreign equity (stock) options
- narrow-based indexes (an index made up of nine or fewer securities)
- options on narrow-based indexes
- securities ETFs structured as registered investment companies (RIC)
- options on securities ETF RICs
- commodities ETFs structured as publicly traded partnerships (PTP)
- volatility ETNs, structured as debt instruments
- bonds
- mutual funds
- single-stock futures

Securities don’t include:
- Section 1256 contracts
- precious metals (collectibles)
- ETFs structured as publicly traded trusts (PTT)
- CBOE-listed options on ETF PTPs and ETF PTTs
- CBOE-listed options on ETNs
- volatility ETNs structured as prepaid forward contracts (PFC)
- cryptocurrencies (intangible property)
- forex (spot and forwards contracts)
- swap contracts

The IRS taxes securities transactions when a taxpayer closes an open trade – hence the term “realization method.” Taxpayers can defer capital gains by holding open securities positions at year-end.

With “tax-loss selling,” investors realize losses before year-end. Be careful not to re-enter those positions within 31 days; otherwise, the planned tax loss might defer to 2020 as a wash sale loss adjustment.

Short-term capital gains (STCG) use ordinary tax rates, currently up to 37% for 2019 and 2020. Long-term capital gains (LTCG) rates are significantly lower, and they apply to sales of securities held for 12 months or more. The LTCG rates are 0% for the 10% and 12% ordinary brackets, 15% in the middle brackets, and 20% in the top 37% bracket. (See 2019 Tax Brackets.)

The mark-to-market (MTM) accounting method is different. MTM taxes realized and unrealized capital gains and losses at year-end. Traders eligible for trader tax status (TTS) are entitled to elect Section 475 MTM ordinary gain or loss on securities and or commodities. (See How Traders Get Enormous Tax Deductions, And Investors Do Not.) Section 1256 contracts have MTM by default. (See 1256 contracts below).

Capital losses, including capital loss carryovers, offset capital gains without a limitation. A net capital loss for the year is limited to $3,000 against other income like wages. Capital loss carryovers don’t expire; they are deferred tax assets. If you have excess capital losses, don’t rush to elect Section 475 ordinary income as you need capital gains to use up capital losses. Look at all sources of capital gains, including sales of real property and intangible property. Trading entities and hedge funds can pass capital gains to the owner’s tax return.

Section 1256 Contracts
Section 1256 contracts enjoy lower 60/40 capital gains tax rates, summary tax reporting, and easier mark-to-market accounting.

Section 1256 contracts include:
- U.S. regulated futures contracts (RFCs)
- options on U.S. RFCs
- U.S. broad-based indexes made up of 10 or more underlying securities – also known as stock index futures
- options on U.S. broad-based indexes
- foreign futures if granted Section 1256 treatment in an IRS revenue ruling (see list)
- non-equity options (a catchall)
- CBOE-listed options on commodity ETF publicly traded partnerships (PTP)
- CBOE-listed options on precious metals ETF publicly traded trusts (PTT)
- CBOE-listed options on volatility ETN prepaid forward contracts and ETN debt instruments
- forward forex contracts with the opt-out election into Section 1256(g) on the major pairs, for which futures trade (we make a case for spot forex, too)
- forex OTC options (Wright court)

Section 1256 contracts have lower 60/40 capital gains tax rates: 60% (including day trades) subject to lower long-term capital gains rates, and 40% taxed as short-term capital gains using the ordinary rate. At the maximum tax bracket for 2019 and 2020, the blended 60/40 rate is 26.8% — 10.2% lower than the highest ordinary bracket of 37%. There are significant tax savings throughout the income brackets. The LTCG rate in the lowest two ordinary brackets is 0%. (See our table Section 1256 tax rates vs. ordinary rates.)

Section 1256 contracts are marked-to-market (MTM) daily. For tax purposes, MTM reports both realized activity from throughout the year and unrealized gains and losses on open trading positions at year-end. The 1099-B is one page with summary reporting.

There is a Section 1256 loss carryback election. Rather than use the 1256 loss in the current year, deduct 1256 losses on amended tax return filings, applied against Section 1256 gains only. Form 1045 is better than 1040X. It’s a three-year carryback; unused amounts carry forward. TCJA repealed most NOL carrybacks, so this is the only remaining carryback opportunity for traders. (See Trading Futures & Other Section 1256 Contracts Has Tax Advantages.)

Options
Tax treatment for options is diverse, including simple (outright) and complex trades with multiple legs.

Options taxed as securities:
- equity (stock) options
- options on narrow-based indexes
- options on securities ETFs RIC

Options taxed as 1256 contracts:
- non-equity options (a catchall)
- options on U.S. regulated futures contracts and broad-based indexes
- CBOE-listed options on commodity ETF publicly traded partnerships (PTP)
- CBOE-listed options on precious metals ETF publicly traded trusts (PTT)
- CBOE-listed options on volatility ETN prepaid forward contracts and ETN debt instruments
- forex OTC options (Wright appeals court)

Generally, options listed on a commodities exchange, a qualified board or exchange (QBE), are a 1256 contract unless the reference is a single stock or a narrow-based stock index. A securities ETF RIC is like a stock in this regard.

Three things can happen with outright option trades:

- Trade option (closing transaction).
- The option expires (lapses).
- Exercise the option.

There are special rules for the holding period for long-term capital gains. (See Tax Treatment Can Be Tricky With Options and ETFs.)

Exchange-Traded Funds (ETF)
Securities, commodities, and precious metals ETFs use different structures, and tax treatment varies.

Securities ETFs: Securities ETFs are registered investment companies (RICs). Selling a securities ETF is deemed a sale of a security, calling for short-term and long-term capital gains tax treatment on the realization method. As a security, wash sale loss adjustments or Section 475 apply if elected.

Commodities ETFs: Commodities ETFs use the publicly traded partnership (PTP) structure. PTPs issue annual Schedule K-1s passing through Section 1256 tax treatment on Section 1256 transactions to investors, as well as other taxable items. Selling a commodity ETF is deemed a sale of a security, calling for short-term and long-term capital gains tax treatment using the realization method. It’s a security, so it’s subject to WS losses and a 475 election if elected.

Taxpayers invested in commodities ETFs should adjust cost-basis on Form 8949 (capital gains and losses). That ensures they don’t double count Schedule K-1 pass-through income or loss. Form 1099-B and trade accounting software do not make this adjustment, so you need to make a manual adjustment.

Physically backed precious metals ETFs: They usually choose the publicly traded trust (PTT) structure (also known as a grantor trust). A PTT issues an annual Schedule K-1, passing through tax treatment to the investor, which in this case is the “collectibles” rate on sales of physically-backed precious metals (such as gold bullion). Selling a precious metal ETF is deemed disposition of a precious metal, which is a collectible. For collectibles held over one year (long-term), sales use the “collectibles” rate —capped at 28%. Short-term capital gains use the ordinary rate. Precious metals and ETFs backed by precious metals are not securities, so they are not subject to WS loss adjustments, or Section 475 if elected.

Forex
Forex transactions start off receiving an ordinary gain or loss treatment, as dictated by Section 988 (foreign currency transactions). Ordinary losses are generally better than capital losses, providing the trader has other income to absorb the loss. With eligibility for TTS, an excess ordinary business loss is a net operating loss (NOL) carryforward.

Section 988 allows traders to file a capital gains election to opt-out of Section 988 ordinary treatment. It must be done contemporaneously in your books and records. You can make, or retract, the opt-out election on a “good to cancel” basis at any time during the year. If you have a capital loss carryover, then consider a capital gains election.

The capital gains election on forex forwards allows the trader to use lower 60/40 capital gains rates in Section 1256(g). There are two requirements: It must be on “major currencies,” and the trader must not take or make delivery. “Major currencies” means currency pairs, which also trade as futures on U.S. commodities exchanges. We make a case for including “spot” forex in Section 1256(g). (See A Case For Retail Forex Traders Using Section 1256(g) Lower 60/40 Tax Rates.)

Foreign futures
By default, futures contracts listed on international exchanges are not Section 1256 contracts. If the international exchange wants Section 1256 tax treatment, they must obtain an IRS Revenue Ruling granting 1256 treatment. Only a handful of international futures exchanges have Section 1256 treatment: Eurex, LIFFE, ICE Futures Europe, and ICE Futures Canada. Foreign futures are otherwise ST or LT capital gains. (See Tax treatment for foreign futures.)

Precious metals
Physical precious metals are “collectibles,” which are a particular class of capital assets. If you hold collectibles over one year (long-term), sales are taxed at the “collectibles” tax rate — capped at 28%. (If your ordinary rate is lower, use that.) If you hold collectibles one year or less, the short-term capital gains ordinary tax rate applies no different from the regular STCG tax rate.

Volatility products
There are many different types of volatility-based financial products to trade, and tax treatment varies.

CBOE Volatility Index (VIX) futures are Section 1256 contracts with lower 60/40 MTM tax rates. The NYSE-traded SVXY is an exchange-traded fund (ETF), taxed as a security. The iPath S&P 500 VIX Short-Term Futures (VXX) is an exchange-traded note (ETN).

Volatility ETNs. Many issuers structure volatility ETNs as prepaid forward contracts (PFC), which provides a deferral of taxes until sale (realization). Long-term capital gains rates apply if held 12 months or longer. (i.e., VXX). However, prepaid forward contracts are not securities. Therefore, they are not subject to WS loss adjustments and Section 475 if elected. Many 1099-Bs treat ETN PFC as securities subject to WS. Consider departing from the 1099-B with footnote disclosure. Some ETNs, like UGAZ, are debt instruments taxed as securities, which means they are subject to WS losses and Section 475 if chosen. (Check the tax section of the ETN prospectus and see Other Financial Products.)

Cryptocurrencies
Selling, exchanging, or using cryptocurrency triggers capital gains and losses for traders. The IRS treats cryptocurrencies as intangible property; not a security or a commodity.

The realization method applies to short-term vs. long-term capital gains and losses. If you invested in cryptocurrencies and sold, exchanged, or spent some during the year, you have to report a capital gain or loss on each transaction. Include cryptocurrency-to-currency sales, crypto-to-alt-crypto trades, and purchases of goods or services using crypto.

U.S. cryptocurrency exchanges issue a Form 1099-K to accounts with transactions over a certain threshold. The problem for the IRS is that many cryptocurrency transactions on exchanges around the world are not evident for tax reporting. Cryptocurrency investors should download all crypto transactions into a crypto accounting program that is IRS-compliant.

Wash sales do not apply to intangible property. Use the first-in-first-out (FIFO) accounting method. Intangible property should use the specific identification method, but that requires broker confirmation of each trade, which is not possible.

TCJA restricted Section 1031 like-kind exchanges to real property, starting in 2018. That rules out using like-kind exchange on crypto-to-crypto trades (i.e., Bitcoin for Ethereum). It’s questionable whether crypto traders could have used Section 1031 before 2018 to defer capital gains taxes. The IRS promised the public more advice on crypto, and it recently mailed tax “education” notices to crypto traders. I hope the IRS addresses Section 1031, hard forks or chain splits, and several other open questions. (See Watch Out Cryptocurrency Owners; The IRS Is On The Hunt.)

Swap contracts
The Dodd-Frank financial regulation law promised to clear private swap transactions on exchanges to protect the markets from another swap-induced financial meltdown. Remember those credit default swaps with insufficient margin? When Congress enacted Dodd-Frank, traders hoped that clearing on futures exchanges would allow Section 1256 tax treatment. They were wrong: Congress and the IRS immediately communicated that Section 1256 would not apply to swap transactions, and they confirmed ordinary gain or loss treatment.

Roger D. Lorence JD contributed to this blog post.

Join my upcoming Webinar on October 23, 2019, or watch the recording after to learn more about this content: Trader Tax Strategies 2019 Year-End Update

For more information on wash sales and Section 475, see How Traders Get Enormous Tax Deductions, And Investors Do Not.

For more in-depth information, see Green’s 2019 Trader Tax Guide


How Traders Get Enormous Tax Deductions, And Investors Do Not

September 28, 2019 | By: Robert A. Green, CPA | Read it on

Traders eligible for “trader tax status” (TTS) deduct business expenses, startup costs, and home office deductions. A TTS trader may elect Section 475 for exemption from wash sale loss adjustments (deferrals), the $3,000 capital loss limitation, and to be eligible for a 20% qualified business income (QBI) deduction. Trading income is not self-employment income, so TTS traders don’t owe SE taxes. Using an S-Corp, TTS traders create earned income to maximize health insurance and or retirement plan deductions.

Lacking TTS, investors get peanuts in the tax code. TCJA, the new tax code suspended investment fees and expenses along with all other miscellaneous itemized deductions subject to the 2% floor. Two itemized-deductions for investors survived tax reform: Investment-interest expense limited to investment income, and stock-borrow fees. With the state and local tax (SALT) limitation and roughly-doubled standard deduction, many investors don’t get any tax deductions for investment-related expenses.

The IRS does not permit investors to elect Section 475, so they are stuck with wash sale loss adjustments, and the $3,000 capital loss limitation. Short-term capital gains are subject to ordinary tax brackets. Investors benefit from long-term capital gains, providing the investor holds a position open for 12-months or more. Long-term capital gains rates are 0%, 15% and 20% for 2019 and 2020. Traders can have segregated investments for LTCG, too. 

How to qualify for trader tax status
Satisfy the below requirements based on my analysis of tax court cases and years of experience working with traders. 

· Substantial volume – at least four total trades per day, 15 per week, 60 per month, and 720 per year annualized (Poppe court). Count open and closing trades separately.
· Frequency – a trade execution on 75% of available trading days. That’s close to four days per week.
· Average holding period under 31 days (Endicott court bright-line test).
The above factors are the “big three.”
· Continuous trading with few sporadic lapses.
· Time – four hours per day, including trading, research, and administration.
· Intention to run a business and to make a living. It doesn’t have to be a primary living.
· Business setup (multiple trading devices, monitors, and a home office).
· Materiality (Pattern Day Trader minimum for securities of $25,000; $15,000 otherwise).

Assess your facts and circumstances for TTS towards the year-end. If you rise to the level of TTS, then deduct business expenses, startup costs, and home office expenses on Schedule C, a partnership, or S-Corp tax return. TTS business expenses do not require an election with the IRS; whereas, Section 475 does require a timely election. TTS does not convert capital losses into ordinary losses; a Section 475 election is necessary for ordinary gain or loss treatment. 

TTS business expenses
If you are eligible for TTS, you are entitled to deduct the below items, and more:

· Tangible personal property up to $2,500 per item, including computers, monitors, desks, and mobile devices.
· Section 179 (100%) depreciation, 100% bonus depreciation, and or regular depreciation.
· Amortization (expensing) of startup costs (Section 195), organization costs (Section 248), and software.
· Education expenses after the commencement of TTS.
· Section 195 startup costs may include education expenses within six months of beginning TTS.
· Publications, subscriptions, market data, charting services, self-created automated trading systems, cloud computing, professional services (accountants and attorneys), chat rooms, mentors, coaches, supplies, media, communications, travel, meals, seminars, conferences, supplies, assistants, office rent, and consultants.
· Home-office expenses for the business portion of your home. (See Home Office Tax Deductions Are Fantastic: Learn How To Do It.)
· Margin interest expenses. (Not limited to investment income like investment interest is.)
· Stock-borrow fees and other costs for short-sellers.

Wash sale loss adjustments
Wash sale loss adjustments on securities cause headaches and potentially higher tax bills. If a taxpayer repurchases substantially identical securities within 30 days before or after realizing a tax loss on securities, the IRS uses the wash sale (WS) loss rule. That defers a tax loss to the replacement position’s cost basis.

For example, if you sell Apple stock at a tax loss on December 15, 2019, and repurchase a substantially identical position (Apple stock or option) on January 10, 2020, the 2019 wash sale loss defers to 2020. It’s critical to avoid WS at year-end in taxable accounts by breaking the 30-day chain. Sell the position by year-end for a tax loss, and don’t repurchase a substantially identical position for 31 days. If you want to catch a rally in January, then consider it may not be so bad to defer a loss as it’s just a timing issue.

It’s essential to prevent WS losses throughout the year between taxable and IRA accounts because it’s a permanent WS loss. The IRS does not allow a WS loss to be added to cost basis in the IRA. 

There are other ways to avoid WS. TTS traders can elect Section 475 on securities to be exempt from WS. Traders can choose to trade instruments that are not considered securities, including futures, forex, precious metals, and cryptocurrencies. 

WS rules for taxpayers and brokers are different. The IRS requires taxpayers to calculate WS losses based on substantially identical securities positions (i.e., Apple equity vs. Apple options), across all taxpayer’s brokerage accounts, including IRAs and spousal accounts if married/filing joint. Conversely, the IRS requires brokers to calculate WS based on identical securities (an exact symbol) per the one brokerage account. This apples vs. oranges is problematic since the IRS seeks to match broker 1099-Bs with taxpayer Form 8949s. Many accountants and taxpayers do not know these differences in the rules. Consider trade accounting software that is compliant with IRS rules for taxpayers, and you should explain overall differences in tax return footnotes. (See How To Avoid Taxes On Wash Sale Losses.)

Elect Section 475 for additional tax benefits
The IRS permits TTS traders to elect Section 475 ordinary gain or loss treatment on securities and or commodities. Section 475 trades are exempt from wash sale loss rules, and the $3,000 capital loss limitation. Short-term capital gains use the same ordinary rate as Section 475, except 475 also unlocks a potential QBI deduction. There are significant tax benefits on Section 475 ordinary losses vs. capital losses. TTS traders can deduct a 475 ordinary business loss against wages and other income; thereby bypassing the capital loss limitation. Excess ordinary losses are a net operating loss (NOL) carry forward.

TCJA introduced a 20% qualified business income (QBI) deduction for sole proprietors, partnerships, and S-Corps. TTS trading is a “specified service trade or business” (SSTB) subject to a taxable income threshold, phase-in and phase-out range, and taxable income cap. If you exceed the taxable income cap, you don’t get a QBI deduction on an SSTB. QBI includes Section 475 income/loss net of trading business expenses; whereas, QBI excludes capital gains/losses, interest, dividends, and other investment income. (See A Rationale For Using QBI Tax Treatment For Traders.)

Most futures traders prefer to skip a 475 election to retain Section 1256 60/40 capital gains rates; they don’t want ordinary income. However, if you have a significant trading loss in 1256 contracts, then consider a 475 election on commodities. You can revoke a Section 475 election in a subsequent year, in the same manner, you elected it. (See more about Section 475 and how to choose it in my blog post, Traders Elect Section 475 For Massive Tax Savings.)

Join my upcoming Webinar on October 23, 2019, or watch the recording after to learn more about this content: Trader Tax Strategies 2019 Year-End Update

For more in-depth information, see Green’s 2019 Trader Tax Guide


Home Office Tax Deductions Are Fantastic: Learn How To Do It

August 24, 2019 | By: Robert A. Green, CPA | Read it on

Since 1999, the home-office deduction is no longer a red flag — millions of Americans benefit from this deduction each year. Countless taxpayers run businesses from home, and the IRS understands this. The income-requirement rule also limits the use of this deduction for profitable enterprises, which appeases IRS concerns about abuse and hobby-loss businesses. Before the IRS liberalized home-office deduction rules in 1999, a more stringent requirement was that business taxpayers needed to meet clients in their home office. Now, the only requirement is administration work, and another principal office outside the home doesn’t negate the deduction.

Many small-business owners, including traders eligible for trader tax status (TTS), operate from a home office. Some of them also conduct their business from job locations using cloud computing, apps, and mobile devices. They can qualify for the home office expense deduction in this situation, as well. The IRS does not permit investors to take a home office deduction.

Convert personal home costs into business expense deductions. This same concept applies to many other items such as phone, Internet, furniture, fixtures, and more. Keep in mind that business income or TTS trading gains are needed to unlock most home-office deductions. If a business doesn’t have sufficient net income, the otherwise allowable home office deductions are carried over to the following tax years. (In this situation, hopefully, the person remains in the business and has net income in subsequent years to use the carryovers.)

There are several special requirements and rules for the home office deduction. A home office must be exclusively and regularly used for business, meaning children and guests can’t use this room. Report “indirect expenses” on Form 8829 and include every expense and cost related to the home. For example, include depreciation or rent, utilities, insurance, repairs and maintenance, security, cleaning, lawn care, and more.

Include mortgage interest and real property taxes, too, and this home-office portion doesn’t require income. The remaining part of mortgage interest expense and real property taxes are Schedule A itemized deductions.

Real property taxes on Schedule A are part of the new tax law (TCJA) SALT limitation. However, the home office portion or real property tax is not subject to the SALT limitation.

To calculate the home-office deduction, take the square footage of the home office (and all related business areas such as storage, hallways, and bathrooms). Divide that by the total square footage of the home (10-15% is customary). Alternatively, taxpayers can do the apportionment based on the room’s method. Form 8829 multiplies the home-office percentage by the indirect expenses. If the business files a partnership return, report home-office expenses as unreimbursed partnership expenses (UPE) on Schedule E. For S-Corps, use an accountable reimbursement plan before year-end.

Per Thomson Reuters/Tax & Accounting Client Letter (see list below):

“Sales of homes with home offices. If you sell-at a profit-a home that contains, or contained, a home office, the otherwise available $250,000/$500,000 exclusion for gain on the sale of a principal residence won’t apply to the portion of your profit equal to the amount of depreciation you claimed on the home office.”

Depreciation expenses on the home office over the years save taxes at ordinary income tax rates. Recapture of depreciation on a sale of the principal residence is taxed up to a 25% capital gains rate, which is unique to Section 1250 property. Tax deferral is another value. The rest of the home enjoys the exclusion of capital gain up to the limit.

If a taxpayer sells his principal residence at a loss, the net loss is not deductible. However, the recapture of depreciation income might not exceed the loss amount, meaning there is no taxable income from depreciation recapture to report on the tax return.

TCJA capped state and local income taxes, sales taxes, real property taxes, and personal property taxes (SALT) itemized deductions on Schedule A at $10,000 per year (any combination thereof), and $5,000 for married filing separately. TCJA also reduced itemized deduction limits on mortgage interest expenses and casualty losses.

Home office tax benefits for employees
Employers require some employees to work from a home office. The new tax law (TCJA) suspended unreimbursed employee business expenses as itemized deductions. That leaves only one other way to arrange a tax benefit for home office expenses. An employee can seek reimbursement from an employer for home office expenses through an accountable reimbursement plan. The employer deducts home office expenses and does not include this payment on the employee’s W-2 as taxable income.

Our below Thomson Reuters/Tax & Accounting Client Letter for “telecommuting employees” states:

“The convenience of the employer requirement is satisfied if: you maintain your home office as a condition of employment-in other words, if your employer specifically requires you to maintain the home office and work there; your home office is necessary for the functioning of your employer’s business; or your home office is necessary to allow you to perform your duties as an employee properly. The convenience of the employer requirement means that you must maintain your home office for your employer’s convenience, and not for your own. This requirement isn’t satisfied if your use of a home office is merely “appropriate and helpful” in doing your job.”

Client Letters from Thomson Reuters/Tax & Accounting:

  • Home office expense deduction for a self-employed taxpayer
  • Exclusion of gain on sale or exchange of principal residence
  • How the home sale exclusion applies to a residence used for residential and business (nonresidential) purposes or to produce rental income
  • Office at home for telecommuting employees
  • Converting a home into rental property

For access to these Client Letters from Thomson Reuters/Tax & Accounting, please join our email list. We send bulk emails a few times per month and include links to Client Letters.


How To Be Eligible For Independent Contractor Tax Status

August 17, 2019 | By: Robert A. Green, CPA | Read it on

There are significant tax advantages for independent contractors (IC) vs. employees.

  • ICs deduct business expenses, whereas, the new tax law (TCJA) suspended “unreimbursed employee business expenses” as miscellaneous itemized deductions.
  • ICs are eligible for TCJA’s 20% qualified business income (QBI) deduction, whereas, employees are not.
  • ICs owe 100% of social security and Medicare taxes (SE tax) on net business income, whereas employers and employees share social security and Medicare taxes 50/50 on salaries.
  • ICs are not enrolled in employer health insurance and retirement plans, whereas employees are. ICs can have individual health insurance and retirement plan AGI-deductions.

You cannot make this determination of IC vs. employee status based on your preference alone. Learn the IRS rules on worker classification. (See IRS resources and Client Letters below.)

Current developments
Some “self-employed individuals” (SEI) hire “professional employer organizations” (PEOs), known as employee leasing companies, to join the PEO payroll and employee benefit plans. The SEI reimburses the PEO for these employment costs, plus a fee. The IRS recently balked at this practice for SEIs.

IRS Chief Counsel Advice (CCA) 201916004 dated April 19, 2019, stated that PEOs could not treat SEIs as employees. PEOs should issue SEIs a Form 1099-MISC for non-employee compensation; not a W-2. This reclassification precludes the SEI from participation in a PEO employee benefit plan. The IRS does not permit sole proprietors, and partners to pay themselves wages. A partnership reports “guaranteed payments” to partners.

Trading income is unearned income. TTS traders use an S-Corp to have officer compensation for arranging employee benefits, including health insurance and retirement plans.

The IRS recently released draft 2020 Form 1099-NEC (non-employee compensation). For the 2019 tax year, a business should continue to report non-employee compensation on Form 1099-MISC box 7. The 2020 Form 1099-NEC will give the IRS more capability to track non-employee compensation. I expect the IRS to examine more companies and challenge their worker classification. Get on the right side of this issue now.

IRS Independent Contractor (Self-Employed) or Employee?
Understanding Employee vs. Contractor Designation

For access to this full blog post, which includes the above-listed Client Letters from Thomson Reuters/Tax & Accounting, please join our email list. We send bulk emails a few times per month and include links to PDFs with Client Letters.

Darren Neuschwander CPA contributed to this blog post.


How To Avoid Taxes On Wash Sale Losses

August 5, 2019 | By: Robert A. Green, CPA | Read it on

Many securities traders incur significant tax bills on phantom income caused by “wash sale losses disallowed” on form 1099-Bs. Traders are often surprised because most brokers don’t report wash sale (WS) loss calculations during the year. In this blog post, learn how to deal with WS loss adjustments and how to avoid them in the first place.

WS loss reporting on 1099-Bs is confusing
Broker 1099-Bs report “wash sale loss disallowed” (box 1g), and it’s not uncommon to see an enormous amount for an active securities trader. The 1099-B also reports “proceeds” (box 1d), “cost or other basis” (box 1e) and several other related amounts. For example, $10M proceeds minus $9.9M cost or other basis, plus $150,000 of wash sale loss disallowed, equals $250,000 of taxable capital gains. The 1099-B cover page has summary numbers, and supplemental schedules include each securities trade for all of these boxes.

The essential point is that WS loss disallowed in box 1g is for the entire tax year. However, WS losses deferred at year-end cause phantom income in the current tax year. Many WS losses during the year might fade away by year-end (see how below). Unfortunately, brokers do not report WS losses deferred at year-end, and clients need that information. If a trader uses trade accounting software, they need this information to reverse WS loss deferrals from the prior year-end on January 1 of the current tax year.

For example, two different traders can have $1M of WS loss disallowed in box 1g. Trader A doesn’t have WS losses at year-end, and she is not concerned with those adjustments during the year. She sold all open positions by year-end and did not repurchase substantially identical positions in January. Trader B also sold all positions by year-end, but he made repurchase trades in January, which triggered $50,000 of WS losses deferred at year-end. Trader B delayed the December WS loss to the subsequent tax year.

Traders need ongoing WS loss information throughout the year to prevent this predicament. Some monthly brokerage statements include cost basis amounts for month-end open positions listed on the report, and other monthly brokerage statements do not.

Most traders don’t realize they have a WS loss problem until they receive 1099-Bs in late February. That’s too late to avoid WS losses. Some traders and tax preparers import 1099-Bs into tax preparation software. Others enter the amounts to Form 8949 and then attach the 1099-B for details. If the taxpayer has cost basis adjustments, the IRS requires Form 8949; listing each securities proceeds, cost basis, WS losses, and other cost basis adjustments. However, there’s a problem relying solely on 1099-Bs because IRS WS rules for taxpayers vary from WS rules for brokers in preparing those 1099-Bs.

WS rules for taxpayers and brokers are different
Taxpayers must calculate WS losses based on “substantially identical securities” (i.e., Apple equity vs. Apple options), across all taxpayer’s brokerage accounts, including IRAs and spousal accounts if married/filing joint. Conversely, brokers calculate WS based on “identical securities” (an exact symbol) per the one brokerage account. This apples vs. oranges is problematic since the IRS seeks to match broker 1099-Bs to Form 8949 prepared by taxpayers.

Trade accounting software can help
Traders should consider using an IRS-compliant trade accounting software or a professional service using such software. Contemporaneous use of the program allows traders to avoid WS loss adjustments with potential WS loss reports. The software/service also gives taxpayers a second opinion vs. broker 1099-Bs.

Taxpayers and accountants are entitled to depart from 1099-Bs and explain why in the tax return footnotes. For example, a 1099-B might treat an ETN prepaid forward contract (i.e., BATS: VXX) as a security with wash sales. However, an ETN structured as a prepaid forward contract (PFC) is not a security, so WS losses don’t apply. A CBOE-listed option on an ETN/PFC is a “non-equity option” in Section 1256, although most 1099-Bs treat these options as securities subject to WS losses. Many brokers rely on tax treatment provided by exchanges, who try to fit financial instruments into two boxes: securities vs. section 1256 contracts.

Traders should try to reconcile Form 8949 proceeds with 1099-B proceeds. However, they should not expect to match cost-basis information, if trade accounting software calculates WS losses differently.

Trade accounting software downloads all trades, and the program automatically calculates WS losses based on IRS rules for taxpayers, not brokers. The program explains the rationale and provides details on various tax reports.

The 1099-Bs might use FIFO or specific identification and try to reflect the same accounting method in a trade accounting program.

For the first year of using trade accounting software, traders should enter open positions from the prior year-end with original-cost basis. Additionally, traders should enter deferred WS losses applied to those open positions. Traders should also enter WS losses deferred on closed-positions repurchased within 30 days in January. Trade accounting programs do not download this information from the prior year.

It would come in handy if the broker provided the WS loss deferred at year-end. If that amount was available, you could enter it as a cost basis adjustment, in addition to open positions with an original cost basis.

In the second year of use, the trade accounting program will automatically carry over open positions and wash sale loss adjustments from the prior year. Consult the program vendor and or trade accounting expert.

Jason Derbyshire of TradeLog software says: “If brokers provide detailed reporting of WS loss deferrals at year-end, TradeLog could utilize that information to help automate input into the software. This information would enable traders to accurately track those deferred losses in the software, and make more informed decisions to capture those losses, if needed, in the following tax year.”

What exactly is a wash sale loss?
A wash-sales loss is a timing issue. If you sell a security for a loss and repurchase it 30 days before or after, you cannot deduct the economic loss immediately in a taxable account. You must add the WS loss to the replacement position’s cost basis, which kicks the can (loss) down the road.

WS loss adjustments made during the year in taxable accounts might not be a problem at year-end. Some fade away. For example, a trader can trigger a WS loss every month during the year but absorb it with a significant capital gain on that security toward year-end. Additionally, the trader can “break the chain” at year-end by selling the position and not repurchasing it for 30 days.

There are also permanent WS losses triggered by IRAs, which are catastrophic. When you sell a position at a loss in a taxable account and repurchase a substantially identical position within 30 days in an IRA, there is no way to record the WS loss. Brokers don’t report these types of WS losses since they don’t calculate WS across more than one account at a time. If you trade in an IRA only (i.e., you do not trade in taxable accounts), then you don’t have these WS loss issues.

Strategies to avoid wash-sale losses
Consider a “Do Not Trade List” to prevent permanent WS between taxable and IRA accounts. For example, a trader could trade tech stocks in his taxable accounts and energy stocks in his IRA accounts.

Taxpayers can “break the chain” on WS losses at year-end in taxable accounts to avoid deferral. If a trader sells Apple equity at a loss on December 20, 2019, consider not repurchasing Apple equity or Apple equity options until January 21, 2020. That avoids the 30-day window for triggering a WS loss. In December 2018, many traders realized tax losses before year-end with a market correction. Some didn’t want to wait 30 days and miss the January 2019 rally, thereby triggering significant WS loss deferral at year-end 2018. Deferral of WS losses can become a problem if it causes a capital loss limitation in the subsequent tax year.

WS loss adjustments during the year in taxable accounts can be absorbed if traders sell/buy those open positions before year-end with a profit.

Consider a Section 475 election. Traders eligible for trader tax status (TTS) are entitled to elect Section 475 mark-to-market (MTM) accounting, which exempts them from wash-sale loss adjustments and the capital-loss limitation. I call it “tax loss insurance.” Don’t enter Section 475 trades on Form 8949; use Form 4797 Part II (ordinary gain or loss). Although Section 475 extricates securities traders from the compliance headaches of Form 8949, it does not change the requirement for reporting each trade on Form 4797.

We recommend trade accounting software to generate Form 4797. If a taxpayer elects Section 475, she will need that software to calculate a Section 481(a) adjustment, too. Even with a Section 475 election, the trader still needs to make the manual entries for open positions and opening-year WS loss adjustments mentioned earlier. The 2019 Section 475 election due date for individuals was April 15, 2019, and March 15, 2019, for existing partnerships and S-Corps.

Section 475 ordinary income is “qualified business income” (QBI). A TTS trader with 475 income net of business expenses is eligible for a 20% QBI deduction, providing the trader is under the taxable income thresholds for a “specified service business.” QBI excludes capital gains, interest, and dividend income.

Consider a new entity. Trading in an entity account might help avoid ongoing WS loss problems. The company is separate from the individual and IRA accounts for purposes of wash sales since it is a different taxpayer. The IRS is entitled to apply related party transaction rules (Section 267) if the entity purposely tries to avoid wash sales with the owner’s accounts. If the company qualifies for TTS, it can consider a Section 475 MTM election exempting it from wash sales (on TTS positions, not investment positions). A “new taxpayer” entity is entitled to elect Section 475 by internal resolution within 75 days of inception. That comes in handy after missing the 475-election deadline for individuals by April 15.

Trade accounting for securities is less complicated with a new entity since there are no opening-year manual entries for WS losses deferred from the prior year-end.

Trade Section 1256 contracts and other financial instruments that are not considered securities for tax purposes. Learn about Section 1256 contracts in my blog post: Trading Futures & Other Section 1256 Contracts Has Tax Advantages.

The following financial instruments are not securities or 1256 contracts: ETN prepaid forward contracts, cryptocurrencies, precious metals, forex, and swap contracts. Only securities are subject to wash sale loss adjustments.

GNM CPAs Darren Neuschwander, Christie Kam, and Amanda Smitson contributed to this blog post.

Learn more about wash sale loss rules in Green’s 2019 Trader Tax Guide.


Watch Out Cryptocurrency Owners, The IRS Is On The Hunt

July 31, 2019 | By: Robert A. Green, CPA | Read it on

The massive tax bust of crypto owners has begun with the IRS mailing 10,000 letters to crypto account owners. These letters educate crypto account holders about the rules and tell taxpayers to review their tax reporting for crypto transactions to be sure they reported income correctly. If necessary, taxpayers should file amended tax returns and or late returns. These tax returns should be marked with the corresponding letter type (i.e., Letter 6173, 6174 or 6174-A) and mailed to a particular IRS address. In other words, these tax filings won’t be a needle in the haystack and the IRS will take a close look. Many audits may follow.

IRS Letter 6173

“We have information that you have or had one or more accounts containing virtual currency and may not have met your U.S. tax filing and reporting requirements for transactions involving virtual currency, which include cryptocurrency and non-crypto virtual currencies.”

The IRS might know there is unreported income based on tax information obtained through enforcement actions, which include the summons against U.S. Coinbase customers. You received the letter because you didn’t file a tax return, which should have included virtual currency transactions. Alternatively, you filed a return but did not report virtual currency transactions. You must reply to this tax notice by submitting a correct late tax return or an amended return. If you disagree with the IRS, the letter requires a full explanation with a signed statement declared under penalties of perjury.

Letter 6173 is a severe tax notice, and you should not dig yourself into a bigger hole with an incorrect reply. In some cases, perjury could be a felony. The letter states, “If we don’t hear from you by the “respond by” date we may refer your tax account for examination.”

I wonder how the IRS will conduct its audits of virtual currency transactions. They will need a list of all coin exchanges and private wallets and probably have to use trade accounting software in the same way a taxpayer would.

IRS Letter 6174

“We have information that you have or had one or more accounts containing virtual currency but may not know the requirements for reporting transactions involving virtual currency, which include cryptocurrency and non-crypto virtual currencies. After reviewing the (educational) information below, if you believe you didn’t accurately report your virtual currency transactions on a federal income tax return, you should file amended returns or delinquent returns if you didn’t file a return for one or more taxable years.”

The key phrase is that the taxpayer “may not know” crypto tax treatment. It sounds like the IRS does not have sufficient information indicating unreported income. Letter 6174 is an “educational letter,” and it states, “you do not need to respond to this letter.” If you received this tax notice, then you should review your crypto tax reporting and consider filing an amended tax return, if appropriate. Consider the IRS advice a warning shot across your bow.

Letter 6174-A

“We have information that you have or had one or more accounts containing virtual currency but may not have properly reported your transactions involving virtual currency, which include cryptocurrency and non-crypto virtual currencies. After reviewing the information below, if you believe you didn’t accurately report your virtual currency transactions on a federal income tax return, you should file amended returns or delinquent returns if you didn’t file a return for one or more taxable years. You do not need to respond to this letter.”

The critical phrase is “may not have properly reported.” That’s different from Letter 6173, which states “may not have met” your tax requirements. Letter 6174-A implies the taxpayer reported crypto transactions, but perhaps not in the proper way. For example, maybe the taxpayer used Schedule C (business income) instead of Form 8949 (capital gains). Perhaps they used like-kind exchanges, and the IRS might not allow that. Conversely, Letter 6173 indicates the taxpayer did not report crypto transactions at all.

The IRS has various types of tax information for virtual currency account owners, and it selected the letter that best matched their knowledge base. The IRS is also using third-party services to obtain more tax information. It’s wise to come clean now if you know you have errors in reporting crypto transactions. Historically, taxpayers have performed better in seeking abatement of penalties if they come forward to the IRS before getting busted first.

Civil and criminal prosecution and FBAR reporting
The IRS stressed, “Taxpayers who do not properly report the income tax consequences of virtual currency transactions are, when appropriate, liable for tax, penalties, and interest. In some cases, taxpayers could be subject to criminal prosecution.” The IRS sent mob boss Al Capone to prison for tax evasion, which was less challenging than indicting him for unlawful bootlegging. Learn about accuracy-related penalties and what constitutes reasonable cause for reduction of penalties.

The IRS Virtual Currency Compliance campaign reminds me of IRS initiatives to hunt down hidden offshore bank and brokerage accounts. FATCA legislation forced foreign banks into reporting on U.S. resident accounts. The IRS Offshore Voluntary Disclosure Program (OVDP) helped taxpayers come clean with voluntary reporting. That led to reduced penalties, which otherwise were onerous. Some tax cheats used foreign bank accounts to conceal business income from the IRS. Others protected assets with offshore structures and only did not correctly report portfolio income.

In retrospect, it seems the IRS made a mistake in (unofficially) waiving foreign bank account report FinCEN 114 and Form 8938 for offshore virtual currency accounts. Virtual currency is “property,” which did not meet the requirements for FinCEN 114 and Form 8938 (Statement of Specified Foreign Financial Assets). There are significant penalties for not filing FinCEN 114 (previously known as FBAR) on time with the U.S. Treasury. Once you put Treasury on notice of owning these accounts, it dissuades you from hiding income from the IRS on those same accounts.

Coin-to-coin exchanges
In the educational section of these IRS letters, it states that crypto-to-crypto trades (i.e., Bitcoin for Ether) are taxable capital gains. The letter does not mention Section 1031 or like-kind exchanges being allowed on pre-2018 trades. (The new tax law TCJA restricted like-kind exchanges to real property only, starting in 2018.) Many crypto traders did not report deferred capital gains on coin-to-coin trades. Some may have, but they omitted the required Form 8824.

I’ve questioned whether coin-to-coin trades qualify for like-kind exchange treatment in years before 2018. Different types of virtual currencies might not be eligible as like-kind property, and coin exchanges are not qualified intermediaries. Multi-party like-kind exchanges require both.

Tax information statements and trade accounting
The IRS letters say to report all transactions whether tax information statements (Form 1099) were sent, or not, for crypto accounts held in the U.S., or abroad. Cryptocurrencies are “property,” not a “security,” so it’s not a “covered security” for purposes of 1099-B reporting. Coinbase, the largest U.S. crypto exchange, appeased the IRS during their fight for obtaining taxpayer information, by issuing a Form 1099-K for larger accounts. The IRS intended Form 1099-K for third-party network transactions for merchants; not traders or investors. Only U.S. exchanges might provide 1099-Ks. Coinbase also provided capital gain and loss reports for later years.

Taxpayers should consider using a trade accounting solution or software program to download virtual currency transactions from all coin exchanges and private wallets. Many crypto owners have accounts around the world, and accounting issues are more challenging when trading on margin. The IRS will likely use this same software in an exam.

Additional IRS guidance coming soon
The IRS keeps promising to publish further advice on crypto tax treatment soon. Why did they send 10,000 education letters if they plan to update their education guidance shortly? Perhaps, it would have been better to publish updated guidance before mailing them. This letter campaign seems a bit like a fishing expedition: The IRS wants more tax returns to analyze before it tackles tax treatment issues further.

Additional guidance is expected to address like-kind exchanges; chain splits, permissible accounting methods, wash sales, Section 475, and more. The AICPA issued a letter containing suggested questions and answers. The basics are clear, and the delay in additional guidance is no excuse for non-compliance.

IRS data analytics
The IRS said it would continue to use data analytics, and perhaps other blockchain technology to uncover more non-compliant crypto taxpayers. The IRS successfully used an independent company Chainalysis on recovering tax information from U.S. Coinbase customers. That may have been one of the sources for this first batch of 10,000 account letters.

What tax evaders didn’t initially realize is that virtual currencies may not be an ideal medium of exchange for concealing income and assets from tax authorities. Unlike using cash (dollar bills), blockchain is a distributed ledger which is available to the public. Non-crypto virtual currency may have a private company centralized ledger, but the IRS might be able to get that through a summons, too. AI, blockchain tools, and crypto trade accounting programs will help the IRS bust crypto tax evaders and taxpayers who are honest but misinformed.

Takeaway
This IRS letter campaign is just the beginning of virtual currency enforcement activities to come. You should take this opportunity to get fully educated, review your reporting, and be sure you are tax compliant. Pay tax liabilities and interest expenses, and then seek abatement of penalties when assessed. Some crypto users might try to claim ignorance or argue they received terrible tax advice. Others might assert that the crypto tax rules were too vague and uncertain at the time of filing. Some tax treatment issues are unknown (i.e., like-kind exchanges and hard forks), but the basics are clear. After receiving these education letters, which are warning shots, there are no grounds for continued non-compliance.

Consult a crypto tax expert immediately after receiving any of the above IRS letters. The CPA can reply to Letter 6173 soon and request more time to file amended returns. The 2018 tax return deadlines are coming up on September 15, 2019, for entities, and October 15 for individuals. Plan to work with your CPA after those dates on amended tax return filings.

Breaking news and more resources

IRS IR-2019-132: IRS has begun sending letters to virtual currency owners advising them to pay back taxes, file amended returns; part of agency’s larger efforts. 

WSJ quotes my partner in IRS Sending Warning Letters to More Than 10,000 Cryptocurrency Holders. “When it comes to preparing tax returns involving cryptocurrencies, Darren Neuschwander, a certified public accountant, said many tax preparers are frustrated because the IRS has long promised new guidance on cryptocurrencies that it hasn’t yet released.” “It’s ironic that the IRS is issuing these letters because we’re still waiting to know more rules,” he said.

IRS Sends Out 10,000 Letters to Virtual Currency Investors, Some of Which Demand a Response, By Ed Zollars CPA for Kaplan Financial Education.

Blockchain Analytics Firm Chainalysis Outlines User Data Policy Amid Coinbase Allegations in CoinTelegraph.

The IRS Has Special Software to Find Bitcoin Tax Cheats. Fortune.com

GreenTraderTax cryptocurrency resources:
Tax Center
Blog posts on cryptocurrencies
Green’s 2019 Trader Tax Guide
Trade accounting service for cryptocurrencies

Darren Neuschwander CPA contributed to this blog post.

 


How To Structure A Trading Business For Significant Tax Savings

June 26, 2019 | By: Robert A. Green, CPA | Read it on

If you actively trade securities, futures, forex or crypto, consider setting up a trading business to maximize tax benefits. With a sole proprietorship, a trader eligible for trader tax status (TTS) can deduct business and home-office expenses and make a timely Section 475 election on securities for tax loss insurance and a potential qualified business income (QBI) deduction. By forming an LLC taxed as an S-Corp, a TTS trader can also deduct health insurance premiums and a retirement plan contribution. An investor without TTS cannot get any of these tax benefits.

The new tax law (TCJA) severely limits itemized deductions for investors, while expanding the standard deduction and improving business expensing. TCJA also introduced a 20% deduction on QBI, which includes a TTS trading business with Section 475 income but excludes capital gains and portfolio income. With TCJA, TTS and Section 475 are more valuable than ever before.

Table for choosing a TTS trading business structure

Sole proprietorship
An individual TTS trader deducts business expenses and home office deductions on a Schedule C (Profit or Loss From Business – Sole Proprietorship), which is part of a Form 1040 filing. Schedule C losses are an above-the-line deduction from gross income.

It’s easy to set up a sole proprietorship. First, open an individual brokerage account(s) in the trader’s name and social security number. You don’t need a separate employer identification number (EIN) unless you plan to have employees on the payroll. You can also use a joint individual account but list the trader’s name and social security number first. There is no state filing required for a sole proprietorship as there is for organizing an LLC or incorporating a corporation. You also don’t need a “doing business as” (DBA) name, although you can obtain one if you prefer. There isn’t a federal or state tax election for claiming TTS — it’s determined based on facts and circumstances assessed at year-end.

Don’t confuse TTS with a Section 475 election. Only TTS traders can use Section 475 ordinary gain or loss treatment; however, many TTS traders don’t make a 475 election. TTS is like undergraduate school, and Section 475 is like graduate school: The former is needed to get into the latter, but undergraduates don’t necessarily elect to go on to graduate school. For example, a TTS futures trader might skip a 475 election to retain lower 60/40 capital gains rates on 1256 contracts. You can elect Section 475 on securities only, commodities only, or both.

Here’s an example: An active trader realized in mid-2019 that he qualified for TTS for all of 2018. He can add a Schedule C to his 2018 Form 1040 tax return due on an extension by Oct. 15, 2019. (Traders can use TTS on amended tax returns, too.) A Schedule C provides tax benefits for 2018 and year-to-date in 2019. This trader wants to form an S-Corp later in 2019 to unlock a health insurance deduction for the remainder of 2019 and a high-deductible retirement plan deduction. He realized he qualified for TTS after April 15, so was too late to elect 475 on the individual level for 2019. But a new S-Corp can select Section 475 within 75 days of inception so that the trader will be exempt from wash-sale loss adjustments at year-end 2019.

Section 475 tax benefits
TTS traders are entitled to make a Section 475 election, but investors are excluded from it. I call it “tax loss insurance” because the election exempts securities trades from onerous wash-sale loss adjustments, which can defer tax losses to the subsequent year, and the $3,000 capital loss limitation. Ordinary loss treatment is far better; it can generate tax refunds faster than capital loss carryovers.

A partnership or S-Corp formed during the tax year is considered a “new taxpayer,” which can elect Section 475 internally within 75 days of inception. An individual TTS trader had to choose Section 475 with the IRS by April 15, 2019, so a new partnership or S-Corp comes in handy after the April 15 deadline. An existing taxpayer must also file a Form 3115 (Application for Change in Accounting Method), whereas a new taxpayer adopts 475 from inception, so this filing isn’t necessary.

Prior capital-loss carryovers on the individual level still carry over on Schedule Ds. The new entity can pass through capital gains if the taxpayer skips the Section 475 MTM election to use up those capital loss carryovers. Then, the entity can elect Section 475 MTM in a subsequent tax year. It’s easy to revoke a 475 election in a manner that mirrors making a 475 election.

The qualified business income deduction
TCJA introduced a tax benefit for pass-through businesses, which includes a TTS trader with Section 475 income; whether doing business as a sole proprietor, partnership, or S-Corp. Section 199A provides a 20% QBI deduction on a “specified service trade or business” (SSTB), and TTS trading is an SSTB. However, SSTBs are subject to a taxable income threshold, phase-out range, and income cap. The phase-out range has wage and property limitations, too. Also, the 20% deduction is on whichever is lower: QBI or taxable income minus “net capital gains” defined as net long-term capital gains over net short-term capital losses, and qualified dividends. It’s a complicated deduction, and most traders won’t get a QBI deduction. QBI includes Section 475 ordinary income and trading business expenses and excludes capital gains and losses, dividends, interest income, forex and swap ordinary income, and investment expenses.

For 2019, the taxable income (TI) cap is $421,400/$210,700 (married/other taxpayers). The phase-out range below the cap is $100,000/$50,000 (married/other taxpayers). The TI threshold is $321,400/$160,700 (married/other taxpayers).

Pass-through entities
A pass-through entity means the company is a tax filer, but it’s not a taxpayer. The owners are the taxpayers, most often on their tax returns. Taxpayers should consider marriage, state residence, and state tax rules, including annual reports, minimum taxes, franchise taxes, excise taxes, and more when setting up an entity. In most states, these taxes are nominal costs. (In Green’s 2019 Trader Tax Guide, I address state taxes for S-Corps in California, Illinois, other states, and New York City.)

Partnerships
A trader can organize a spousal LLC and file as a partnership. Alternatively, the trader can form a marital general partnership without liability protection afforded by an LLC. Partnerships file a Form 1065 partnership tax return. Establishing a separate legal entity does not alone generate tax benefits; it’s critical for the organization to qualify for TTS. Otherwise, the company is considered an investment company with suspended investment fees and expenses. An investment partnership cannot have business expenses, officer compensation, and employee benefits, including health insurance and retirement plans.

A TTS trading partnership may deduct business expenses, which the partnership Schedule K-1 reports in line one (“ordinary business income/loss”). The individual owner deducts business expenses. If the partnership agreement provides for it, the partner can also deduct “unreimbursed partnership expenses” (UPE) including home office expenses, on Schedule E page 2 (Supplemental Income and Loss). The amounts are entered on the “non-passive income” column since a TTS loss is exempt from Section 469 passive activity loss rules under the “trading rule” exception.

A partnership tax return looks better to the IRS vs. a Schedule C with different tax forms for trading gains and losses. The partnership return consolidates Section 475 ordinary income/loss with business expenses in line one of Schedule K-1. Partnership capital gains are easy to see on the partnership Schedule K and K-1. On the contrary, there is a red flag with a Schedule C displaying business expenses. Individual-level trading gains and losses are on other tax forms: Form 8949 for capital gains and losses, Form 6781 for Section 1256 capital gains and losses using 60/40 treatment and Form 4797 Part II ordinary gain or loss for Section 475 trades. It’s hard for the IRS to decipher TTS items from investments on an individual tax return. Sole proprietors should use a well-crafted tax return footnote to explain the correlation of a TTS Schedule C with the other tax forms for trading gains and losses.

A partnership (or S-Corp) helps segregate investment positions from TTS/Section 475 trading positions. If you trade substantially-identical positions that you also invest in, it could invite the IRS to play havoc with the reclassification of TTS vs. investment positions. Using a TTS company prevents the IRS from reclassifying TTS positions out of Section 475 ordinary loss treatment into a capital loss limitation on investment positions. And, it prevents the IRS from reclassifying unrealized long-term capital gains on investment positions into TTS/475 MTM ordinary income on TTS positions. Traders cannot use portfolio margining between an entity and an individual account, so they carefully weigh the use of portfolio margining vs. Section 475.

S-Corps
Taxpayers cannot directly create an S-Corp; instead, it’s a tax election. Organize an LLC or incorporate a corporation, and the entity has the option to file an IRS Form 2553 (Election by a Small Business Corporation) within 75 days of inception. Alternatively, in a subsequent year, the S-Corp election is due by March 15. All the owners must be U.S. residents. Most states accept the federal S-Corp election, although some states including but not limited to New York and New Jersey require a separate state election. There is IRS relief for late S-Corp elections; however, you had to have the intention of making the S-Corp election on a timely basis.

New S-Corps (and partnerships) can elect Section 475 within 75 days of inception.

Unlike a partnership, an S-Corp doesn’t require two or more owners. An unmarried trader can form a single-member LLC to elect S-Corp status. Otherwise, a single-member LLC is a “disregarded entity” (a “tax nothing” in the eyes of the IRS), which takes you back to using sole proprietor status on a Schedule C.

The essential tax benefit of an S-Corp is to arrange tax deductions for health insurance premiums and a high-deductible retirement plan contribution through officer compensation.

Sole proprietors and partnerships cannot achieve these employee-benefit deductions in connection with trading income. A Schedule C cannot pay the owner wages, and partnerships should use “guaranteed payments” instead of salaries. Partnership expenses flow through, including a guaranteed payment, creating negative self-employment income (SEI). That makes a health insurance and retirement plan deduction challenging to achieve for a TTS partnership. Conversely, S-Corps don’t pass through negative SEI, and the employee benefit deductions work tax efficiently.

S-Corp health insurance premiums
TTS traders with significant self-employed health insurance (HI) premiums should consider an S-Corp to arrange a tax deduction through officer compensation; otherwise, they cannot deduct HI.

Not everyone needs a health insurance deduction, but if you do, crunch the numbers. An S-Corp is worthwhile if the HI tax deduction is meaningful, and the tax savings exceed the entity costs of formation and maintenance. A retirement plan deduction adds icing on the cake.

Examples: An unmarried futures trader living in a tax-free state might be in the lowest two tax brackets of 10% and 12%, after taking the standard deduction. With 60/40 treatment on Section 1256 contracts, her blended tax rate is 4% and 4.8%. If her HI deduction is $3,600, then the tax savings is $173. That’s far less than the cost of maintaining an S-Corp. A payroll service provider might cost $600 per year.

On the other hand, a married securities trader in a high-tax state might have a $24,000 HI deduction for family coverage, and with a 40% combined federal and state tax bracket, the tax savings for the HI deduction is $9,600. An S-Corp is a good idea for this trader.

The health insurance deduction is complicated for officer/owners: Add health insurance premiums paid by the entity or individually during the entity period to wages in box one on the officer/owner’s W-2. The health insurance amount in salary is not subject to payroll taxes, so omit this amount from Social Security wages in box 3, and Medicare wages in box five. The officer deducts health insurance premiums as an adjusted gross income (AGI) deduction on his Form 1040 personal tax return. The taxpayer deducts non-owner employees’ health insurance on the S-Corp tax return directly as “insurance expense.”

S-Corp retirement plan contributions
Taxpayers need self-employment income (SEI) to make and deduct retirement plan contributions; however, trading income is not SEI. (The exception is a full-fledged dealer/member of an options or futures exchange, trading Section 1256 contracts on that exchange.) There are tax costs and benefits to SEI: It triggers SE tax but also unlocks a HI and retirement plan deduction. SE tax is the same as payroll tax (FICA and Medicare), which I explain below.

A TTS trader uses an S-Corp to pay officer compensation for these employee benefit deductions. The trader is in control of how much to run through payroll, picking an amount to maximize employee benefit deductions but not to pay too much in the payroll tax.

You should fund retirement plan contributions from net income, not losses. It’s best to wait on the execution of an annual paycheck until early December when there is transparency for the year. A trader should not have a base salary throughout the year. Some traders make money during the year, only to lose it before year-end.

If you have sufficient trading profits by Q4, consider establishing a Solo 401(k) retirement plan before year-end. It’s a defined contribution plan; start with the 100% deductible elective deferral (ED; $19,000 for 2019) and pay it through payroll since it’s reported on the annual W-2. Add the ED to Social Security wages and Medicare wages on the W-2 but not taxable wages in box 1, as that is where the tax benefit (deduction) is. The gross wage ED component is subject to payroll taxes, and the S-Corp tax return has a deduction for gross wages. Taxpayers 50 years and older have a “catch up provision” of $6,000, raising the ED limit to $25,000 per year.

If you have large trading gains, consider increasing payroll in December for a performance-based bonus to unlock a 25% deductible Solo 401(k) profit-sharing plan (PSP) contribution that you don’t have to pay into the retirement plan until the due date of the S-Corp tax return (including extensions by Sept. 15). The maximum PSP amount is $37,000. The total limit for a Solo 401(k) is $62,000 ($19,000 ED, $6,000 catch-up ED, and $37,000 PSP). The S-Corp tax return deducts the PSP.

A “traditional” retirement plan is tax deductible, and the related wages are subject to a payroll tax, which includes 12.4% FICA up to the SSA base of $132,900 for 2019, plus 2.9% Medicare tax without a base limit. If the trader is in a high tax bracket, then the income tax savings can well exceed the payroll tax cost, which is also 50% deductible. Crunch the numbers in December for year-end tax planning and consider whether you can afford to save this cash flow until retirement, starting at age 59½ for required minimum distributions.

As an example: Assume an unmarried trader, age 51, has S-Corp net trading income of approximately $225,000 and individual taxable income of $200,000. That puts her in a 32% marginal federal tax bracket, and she lives in a tax-free state. On officer compensation of $25,000, she contributes the maximum Solo 401(k) ED of $25,000, saving $8,000 in federal income taxes. Her payroll tax on $25,000 wages is $3,825, which is 50% tax deductible, so it generates additional income tax savings of $612. She has federal unemployment insurance (FUI) of $50 and is exempt from state workmen’s compensation insurance. Her net overall tax savings is $4,737. She will enjoy tax-free compounding of growth in the retirement plan until she must begin taking required minimum distributions by age 70½, which is taxable income at ordinary rates.

Consider a Roth Solo 401(k) contribution in the years when you can skip an income tax deduction. Roth plans are permanently tax-free for growth and contributions. Early withdrawals can trigger a 10% excise tax penalty. If you have another job with annual wages over the SSA base, then TTS S-Corp wages will convert new FICA to a federal tax credit, since the IRS does not double-charge FICA on a Form 1040. This credit gives a nice incentive to consider a Roth plan.

S-Corp payroll
To arrange employee benefits including health insurance and retirement plan deductions through an S-Corp, you’ll need to pay officer compensation through a formal payroll before year-end. You’ll likely need to engage a payroll service provider for payroll tax compliance. (Our firm works with a dedicated team at Paychex for a price of approximately $600 per year.) If you don’t need employee benefits in a given tax year, you can skip paying officer compensation for that year. IRS “reasonable compensation” rules for S-Corps probably don’t apply to traders since the S-Corp has unearned income. However, the IRS could take the position that reasonable compensation is required in all cases. Once you begin a payroll, you must continue to file payroll tax returns quarterly and annually, even if they are zero returns due to no salary in any given period.

A payroll service includes quarterly payroll tax returns (Form 941), the annual payroll tax return (Form 940), state payroll tax returns and federal unemployment insurance with FUI tax of under $50 for the owner/trader. In most states, the trader/owner is exempt from state unemployment insurance and state workmen’s compensation. The payroll service provider also prepares the W-3s and W-2s

One benefit is you can withhold taxes from payroll in December and have them attributed to being made throughout the year. Take advantage of this tax loophole to reduce quarterly estimated tax payments during the year. Benefit from hindsight and use of the cash flow.

Avoid wash sales with an entity
Permanent wash-sale losses between individual taxable accounts and IRAs and deferred wash-sale losses inside and between taxable accounts significantly impact active investors.

Trading in an entity account might help avoid these problems. The entity is separate from the individual and IRA accounts for purposes of wash sales since it is a different taxpayer. The IRS is entitled to apply related party transaction rules (Section 267) if the entity purposely tries to avoid wash sales with the owner’s accounts. If the company qualifies for TTS, it can consider a Section 475 MTM election exempting it from wash sales (on business positions, not investment positions).

Trade accounting for securities is more comfortable with a new entity since there are no opening-year wash-sale loss adjustments to reverse from the prior year-end, which is sometimes difficult to determine.

Miscellaneous
S-Corps are more formal than partnerships. For example, a TTS trader needs to use an accountable reimbursement plan before year-end for reimbursing the officer’s business expenses. A partnership is less formal; it can use unreimbursed partnership expenses (UPE).

Form the pass-through entity in your state of residence since it passes income to that state, anyway. Don’t be fooled by asset-protection salesman promoting entity formation in tax-free jurisdictions. You live, work, and trade in your home state.

C-Corps are not ideal for traders since the IRS might charge a 20% accumulated earnings tax on top of the 21% flat tax. It’s hard for a trader to have a war chest plan to justify retaining earnings and profits (E&P). There’s double state taxation to consider, too. (See Green’s 2019 Trader Tax Guide.)

Some brokers charge higher professional rates for data feed fees on entity accounts, even though you don’t have investors. A sole proprietor individual account pays non-professional rates, which can save $125 or more per month depending on how many data vendors you have. Inquire about this issue with your brokers.

Qualifying for trader tax status
Many traders and tax advisers don’t fully comprehend TTS, including how to use it properly. Rather than deal with its many nuances, they skip TTS and overlook or miss the 475-election deadline. It’s sad to explain to new clients why they cannot deduct trading expenses and losses.

TTS is the linchpin for the related tax advantages of using an entity. Before forming a company, determine if you qualify for it. An entity does not deliver business expense treatment or automatically provide an opportunity for employee benefits. The organization must be eligible for TTS; otherwise, it’s an investment company like the majority of hedge funds.

To be eligible for claiming TTS, a trader needs approximately four total trades or more per day, trade executions on close to four days per week, with more than 15 total trades per week, 60 trades per month, and 720 trades per year (annualized), per the Poppe court. Average holding periods must be under 31 days per the Endicott court. There are several other factors including having material account size ($25,000 for pattern day trader designation on securities and $15,000 for other instruments), spending over four hours per day, having the intention to run a business to make a living, having trading computers and multiple monitors, and a dedicated home office.

If you have segregated investment positions, it’s better to house your TTS trading in a separate entity. Otherwise, the IRS might drag investment positions into the TTS analysis, which can lengthen holding periods over the 31-day requirement.

Investment vs. TTS business expenses
TCJA suspended all investment fees and costs except for two: investment-interest expense limited to investment income, and stock borrow fees, which are considered “other itemized deductions.” Many traders will use the roughly doubled standard deduction instead of itemized deductions, especially considering the SALT itemized deduction cap of $10,000. The 2019 standard deduction is $12,200 single and $24,400 married.

Trading commissions are not separate expenses; the broker deducts them from sales proceeds and adds them to cost-basis for purchases. Commissions are therefore part of trading gain or loss. With net capital gains, commissions are equivalent to a tax deduction; however, with a capital loss limitation, commissions are part of a capital loss carryover. This can’t be changed even with TTS.

TTS business expenses include expensing of computers, monitors, and mobile devices, home-office expenses if exclusively used for business, post-TTS commencement education costs, Section 195 startup costs including pre-business education going six months back, and Section 248 organization expenses. Additional expenses include data and market information services, subscriptions, charting and other software, platform fees, self-created algorithms and automated trading systems, margin interest, stock borrow fees, coaches, mentors, chatrooms, supplies, seminars, travel, meals, professional expenses including tax advice, and more.

A typical TTS trader has annual business expenses ranging between $5,000 and $25,000 per year. Expect higher costs if there are significant stock borrow fees, margin interest expenses, an outside office, staff, or using a Bloomberg terminal. Forex traders tend to have few costs.

With a TTS S-Corp, the health insurance deduction could range from a few thousand to $24,000 or more per year depending on if the trader is single, married, and has children with family coverage. It could be low with an Obamacare subsidy. A Solo 401(k) retirement plan deduction could be up to $62,000 per year per working spouse.

If you want an entity for 2019, you should set it up by the end of Q3. Come November, the window of opportunity closes as two months is too short a period for TTS and to build up employee benefits. In that case, form it in December to be ready for use Jan. 1, 2020.

Consider a 45-minute consultation to review eligibility for TTS, an entity formation plan, Section 475 election, and more. If an entity is a good idea for you, then consider our entity formation service. We also offer our tax compliance service, starting with year-end planning in December.

GNM CPAs Darren Neuschwander, and Adam Manning contributed to this blog post.

For more in-depth information on entities for traders, health insurance, retirement plans, trader tax status, Section 475, QBI and other issues discussed in this blog post, see Green’s 2019 Trader Tax Guide.

Attend our upcoming Webinars on this subject and watch the recording after.


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