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TRADER TAX RULES & TAX RETURN REPORTING GUIDE - EDITION 5 - Free Excerpt
Traders and Investors may order our entire 31-page trader tax guide for same day email delivery by emailing your order to rgreen@greencompany.com After your email receipt of the guide, please mail us a check for $25 payable to Green & Company Inc. at 415 East 37th St, 39th floor, New York, NY 10016. If you would like to consult with Robert Green, CPA about your tax return call him at 212-684-4394. There is tons of free tax information for Traders and Investors at our Web site at greencompany.com Good luck with your tax returns.
Free Excerpt
Table of Contents
...Tax benefits for Traders, tax penalties for Investors
...A step by step Tax Forms Guide for Traders
...Executive Summary for Traders
...A definition of a Trader by CCH and RIA
...Distinguishing characteristics of a Trader
...Tax Research - Whether taxpayer is a trader or an investor
...Tax Research - Traders in securities -- a business or investment activity?
...Tax Research - Whether a taxpayer managing his own investments is in a trade or business
...How a trader may elect the new mark-to-market accounting method to get unlimited ordinary losses on Schedule C
...Wash sales apply to investors but not to traders electing mark to market rules
...How to avoiding the hobby-loss restrictions from a Schedule C trading loss
...Like Kind Exchanges - Investors may not defer gains on stock options by replacing them with new contracts with longer expiration dates. Traders may in very limited cases be able to do so
Tax benefits for Traders, tax penalties for Investors
"Traders" are not treated as "investors" or as "dealers." They have special hybrid treatment under the IRS tax code. - The new tax law of 1997 passed some attractive new rules for traders electing the new mark-to-market accounting method.
1. Investors are penalized on their taxes because they can not deduct more than $3,000 of net capital losses in any given tax year. Many active traders have significant losses in 1997, especially paper losses at the end of year. They are being forced to pay large tax bills on April 15, 1998 because they think their losses are limited and they can not take their paper losses. Relief - Traders electing the new 1997-tax law "mark-to-market accounting method" may deduct an unlimited amount of year-end unrealized trading losses as ordinary losses.
a. The new law states that, "for tax years ending after August 5, 1997, traders in securities or traders in commodities may elect the same mark-to-market treatment that applies to dealers in securities, except that a trader does not maintain an inventory that must be marked to market." According to RIA (see below in bold), "the trader recognizes gain or loss on any security held in connection with the trade or business at the close of any tax year as if the security were sold for its fair market value on the last business day of the tax year, and (Code Sec. 475(f)(1)(A)(i)) any gain or loss is taken into account for the tax year. Any gain or loss recognized by an electing taxpayer is ordinary gain or loss. (Com Rept, see 5111).
b. I don't think taxpayers should push the envelope on this issue until it is further clarified. If you take an unrealized trading loss on Schedule C and the result is a large overpayment credit, I suggest you do not claim a refund but rather apply any overpayment credit to the following tax year's estimated taxes. Feel free to consult with us on this issue.
2. Investors are penalized by being allowed to deduct only certain limited types of investment expenses. For investors, margin interest expenses are limited to investment income, which in effect doesn't allow the interest deduction if you have few dividends and capital losses. Traders can deduct unlimited amounts of trading expenses and interest expenses on Schedule C- no limitations or restrictions of any kind.
3. Investors receive long-term capital gains tax rate treatment. Traders also receive long-term capital gains tax rate treatment. Traders electing the new mark-to-market accounting method have ordinary gains and losses. Mark-to-market traders can still designate trading positions as capital rather than ordinary positions, and then hold those positions for long-term to rates. Most traders don't hold positions over 12-months anyway.
4. Investors are not subject to self-employment taxes on capital gains. Traders are also not subject to self-employment taxes on capital gains. Traders electing the mark-to-market accounting method convert capital gains to ordinary gains that are reportable on Schedule C, rather than on Schedule D. A Trader's Schedule C net income is considered earned income subject to self-employment taxes and available for retirement account contributions.
a. For tax year 1997, many traders have mark-to-market losses at year-end due to the declining year-end securities markets. Therefore, their mark-to-market positions probably result in ordinary losses rather than ordinary gains. In those cases, self-employment tax is not an issue for them in 1997.
b. For 1998, an electing mark-to-market trader in securities can form and trade through an S-Corporation and thereby not be subject to future self-employment taxation on this ordinary income. S-Corp gains or losses flow-through to their owner's individual income tax returns. Flow-through income from a Schedule C, partnerships, and Limited Liability Companies (LLCs) is considered earned income (for owner/managers) for self-employment tax purposes. Our firm incorporates many new S-Corps and other legal entities through BizFilings (see our Web site greencompany.com, go to Legal & Incorporation, go to e*Commerce tax guide, go to Cybercorps). In our opinion, using an S-Corp. for your trading reduces IRS scrutiny (versus a Schedule C), gives you legal protection, and allows you to take more business expenses (contact us about this point).
5. Investors are subject to the wash sale rules. Traders electing the mark-to-market accounting method under the new 1997 tax law are not subject to the wash sale rules.
6. The IRS rules listed below are clear in subjective terms but not clear in objective terms. The tax courts have issued many ruling over the years that frame the objective tests. We strongly feel recent advances in the Internet and on-line trading brokerage firms have made the trader business much easier to operate. There are now over 4 million on-line trading accounts in the U.S. and many of these traders are very active in the business of trading in securities. Some of these active traders may qualify for the "trader" tax treatment and it could be very advantageous to them under certain conditions.
Tax Forms Guide for Traders versus Investors
1. Traders and Investors both use Schedule D to report all capital gains and losses on "realized" sales of securities during the tax year.
2. Traders electing the mark-to-market accounting method may report their year-end "unrealized" gains and losses on Schedule C. Traders would probably choose this option if they have unrealized losses. We have some reporting strategies in connection with this area, so contact us for a consultation on your specific tax situation.
a. I suggest that Traders electing the mark-to-market accounting method report their unrealized ordinary trading gains or losses on Schedule C, Part I, line 6 "Other Income." Losses should be reported as a negative number on this income line.
b. Trading losses are not expenses and should not be reported in Part II "Expenses." Trading losses are also not Costs of Goods Sold (inventory) and should not be reported in Part I, line 4 "Cost of Goods Sold."
c. On Schedule C, I suggest you use the business Code # 5777 for "Other Financial Services". A trader is not a "broker & dealer of securities" or a "commodity broker or dealer." A trader is also not in business services.
3. Investors report investment expenses on Schedule A subject to investment interest expense restrictions and miscellaneous investment expense limitations and restrictions. Traders report all trading business expenses on Schedule C. By reporting realized capital gains and losses on Schedule D, and trading expenses and excess unrealized trading losses on Schedule C, your Schedule C shows a net loss. This can invite IRS questions about "hobby losses" (see hobby loss rules at the end of this guide).
a. The way to solve this matter is to explain in your memo that you are a Trader in Securities with your realized capital gains and losses reported on Schedule D by law and your trading expenses and excess unrealized losses reported on Schedule C by law. After you combine your Trader gains, losses and expenses from both Schedules D and C you show that you are not subject to hobby loss rules as follows.
b. There are two ways to avoid the hobby loss rules. The first way is to show a profit in at least three out of five consecutive years (two out of seven years for breeding, training, showing, or racing horses). The second way is to run the venture in such a way as to show that you intend to turn it into a profit-maker, rather than operate it as a mere hobby. The IRS regs themselves say that the hobby loss rules won't apply if the facts and circumstances show that you have a profit-making objective. A serious on-line trading business is not a hobby.
4. Both investors and traders with many transactions during the year may instead of reporting every trade during the year, use one line item for each holding period - example, "eSchwab - nominee (detail of trades available on request)." Contact us for some other line-by-line guidance as well as the explanatory note to put in with your tax returns. |
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