Tax preparers and their software-based counterparts often come up short with traders. It’s not uncommon for them to botch handling trader tax status, elections, forms, entities, the treatment of financial products, employee benefit deductions, and investment expenses.
Be as diligent in preparing your taxes as you are when exploring the best low cost options trading platforms. Use these seven tips this tax-filing season.
Tax time isn’t so cut-and-dry for traders, in part because the IRS does not offer specific tax forms for individual trading businesses. Information regarding portfolio income, gains and losses and business and investment expenses are entered on numerous forms, which often leads to confusion. For example, if you’re a forex trader, which form should you use? What’s the best form for security traders who use the Section 475 MTM method?
Sole-proprietor business traders may confuse the IRS by reporting business expenses on Schedule C and trading income/loss and portfolio-related income on other tax forms. It may view a trading business’s Schedule C as unprofitable, even if it has substantial net trading gains on other forms, which is why we recommend an entity.
We recommend mitigating this red flag by transferring a portion of business trading gains to Schedule C if possible — doing so will “zero it out.” Be sure not to report a net income on Schedule C, though, because doing so would invite IRS computers to search for self-employment (SE) tax, which is something traders do not owe on their trading income.
We advise business traders always to include thorough, well-written footnotes on their tax returns that explain trader tax law and benefits, as well as how and why you qualify for TTS (business treatment), whether you’ve elected Section 475 MTM or out of Section 988, and other tax treatment, such as the aforementioned income transfer strategy. Part-time traders should use footnotes to explain how they’ve allocated their time between trading and other activities. Doing so takes a step to address any questions the IRS may have about TTS qualification and the various aspects of its reporting on your return before it has a chance to ask.
Tax savings can be significantly impacted by which financial products you trade and where you trade them.
Ordinary Income vs. Capital Gains
Most financial instruments, including securities, options, ETFs, indexes, options, Section 1256 contracts, Bitcoin and precious metals are held as capital assets, which means they are subject to capital gains treatment. This distinction makes a world of difference.
The capital-loss limitation is a problem for investors and traders who may have trouble using large capital-loss carryovers in subsequent tax years. Traders who have TTS and a Section 475 MTM election have business ordinary loss treatment, which is more likely to generate tax savings or refunds faster. Section 1256 contract traders, however, enjoy 60/40 tax rates and summary reporting, and have no need for accounting.
S-Corp and Partnership trading business tax returns show trading gains, business expenses, and losses on one set of forms; plus, the IRS won’t see the filer’s other activities, which looks much better than a schedule C.
Form 1065 is used for general partnerships and multi-member LLCs choosing to be taxed as partnerships. Form 1120S, however, is used when an S-corporation and an LLC elect to be taxed as an S-Corp. Forms 1065 and 1120S issue Schedule K-1s to the owners, which makes it so taxes are paid at the owner level instead of the entity level, thus avoiding double taxation. Ordinary income and loss (mostly business expenses) get summarized on Form 1040 Schedule E instead of in detail on Schedule C. Section 179, though, is split up on Schedule E — as are unreimbursed partnership expenses (UPE), which includes home office expenses.
The “trading rule” exception in Section 469’s passive-activity loss rules designates trading business entities as “active” and not “passive loss” activities, making losses allowed in full. Portfolio income is passed to Schedule B. Capital gains and losses go to Schedule D in summary form. Pass-through entities draw less attention from the IRS than a detailed Schedule C filing. Net taxes don’t change, though, as they are still paid on the individual level. Pass-through entities use Form 8949 and/or Form 4797 to file at the entity level.
S-Corps provide additional tax breaks, which include opportunities for employee benefit plans, like retirement plans and health insurance premium tax deductions, two breaks sole proprietor and partnership traders cannot use, though, unless they have a source of earned income. Nonetheless, health insurance is a great deduction through trader S-Corp because there is no payroll tax on that portion of W-2 wages.
Tax treatment elections are sometimes confusing because the Section 988 and Section 475 MTM elections don’t have tax forms. New taxpayers file Section 475 MTM elections internally within 75 days of inception; however, existing taxpayers file a statement by the due date of the prior year’s tax return or extension with the IRS and perfect it later with a Form 31154 filing by the deadline. Unfortunately, it’s too late to elect Section 475 for 2016 taxes. The next priority is for 2017 for existing partnerships and S-Corps.
Forex Section 988 capital gains election is only filed internally, and is done on a contemporaneous basis.
If you are filing as an investor, you should report trading gains and losses according to the earlier explanation. You cannot elect and use Section 475 MTM and Form 4797 ordinary gain or loss treatment, though, as that election requires TTS.
Report investment interest expense (margin interest) using Form 4952. It is limited to investment income and investment expenses, and the balance is an investment interest expense carryover to future tax years. The deduction is taken on Schedule A, where it could be subject to the Pease limitation, but it is deductible for alternative minimum tax.
Report investment expenses as miscellaneous itemized deductions on Schedule A. Miscellaneous itemized deductions are only allowed more than 2% of adjusted gross income (AGI). The allowed amount is subject to the Pease limitation, and it’s not deductible for AMT. Many states limit or do not allow itemized deductions. Business expense treatment with TTS is much better.
Investment expenses are allowed for the production of investment income. Investment expenses exclude home office, education, seminars, travel to seminars, and startup expenses. Computers and monitors are allowed if they are predominantly used for managing investments.
Don’t sell yourself short on tax breaks available for traders this tax season, and don’t forget to contact us today if you are currently looking for the best charting software for day trading.
Author: Bob Green, Green Trader Tax
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