Traders Tax rules,, also check out Mr. G's web site..
TRADER TAX RULES & TAX RETURN REPORTING GUIDE – EDITION 3
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
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.
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.
March 25, 1998 - By Robert A. Green, CPA
TRADER TAX RULES & TAX RETURN REPORTING GUIDE – EDITION 3
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
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.
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. |
