Offering Legal & Fiduciary Services to Traders | Investors | Hedge Funds Trader Tax Status, Mark to Market Accounting & Wash Sales Rules
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Mark-to-Market Tax Election For Securities (Not Commodities) One benefit of being a trader in securities is the ability to elect the Mark-to-Market (MTM) accounting. The tax election is available to day traders and hedge funds and not to investors or dealers in securities. The election is relevant for individuals and entities (i.e., hedge funds) that file U.S. tax returns. Persons or entities trading mainly in 1256 contracts typically would not want to make the MTM election because they would lose the 60% long-term capital gain treatment available for futures trading subject to the 1256/commodities tax rules. Contact Us
What is Trader Tax Status? Close scrutiny exists when it comes to day traders attempting to claim trader tax status (i.e., obtain securities trader business-expense tax deductions). Trading big bucks does not make you a trader for U.S. tax purposes. To qualify as a day trader for tax purposes, you must make substantial trades that attempt to profit off daily swings in the market. Substantial trading activity is dictated by the total number of annual trades, the amount of money in play and the number of days in a year that trades are made. In a recent case, trading securities on almost 50% of available trading days did not qualify the U.S. taxpayer as a day trader for U.S. tax purposes. Click here to read Sharon Nelson v. Commissioner of Internal Revenue November 13, 2013
Hedge Funds and Traders--Check Your Tax Status A hedge fund that previously determined that it qualified as a trader for tax purposes should reexamine its trader tax status every year in which it has a mark-to-market election in place to make sure that its election is not subject to challenge. This tax classification affects the extent to which partners in a partnership may deduct certain items of the partnership’s expenses for U.S. tax purposes.
Are you a Trader, Dealer or Investor for U.S. Tax Purposes? Another recent case (August 28, 2013) demonstrates how hard it is to attain trader tax status in the United States. The U.S. Tax Court ruled that a taxpayer should be classified as an investor and not as a trader for tax purposes because the taxpayer did not seek to capitalize from the short term swings of the market (i.e., did not trade on a daily basis). The U.S. Tax Court identified three classes of taxpayers: dealers, traders or investors. Dealers are generally individuals or entities that buy securities for resale to customers. Traders generally engage in a trade or business of buying and selling securities for their own accounts to take advantage of short-term price changes. Investors likewise buy and sell for their own accounts but generally buy securities for long term appreciation and are not engaged in a trade or business. One's tax status depends on an analysis of all the facts and circumstances involved in one’s activities, taken as a whole. According to the U.S. Tax Court, to be considered a securities trader in any taxable year, a taxpayer must trade daily for such activity to satisfy frequency, continuity and regularity requirements. The U.S. Tax Court held that key factors to examine include number of trades per year, daily trading frequency and the holding period of the securities involved in the trades. Click here to read Endicott v. Commission of Internal Revenue
Electing Mark-to-Market Tax Treatment in the United States Section 475(f) of the tax code allows an active securities trader to treat all securities as: generating ordinary income or loss, and if held at year-end, marked to market (treated as sold for fair market value on 12/31 and then repurchased at that value on 1/1). Mark-to-market refers to the procedure followed at year end when all open positions are marked to market value. In effect a sale of all open positions (long and short) is triggered for tax purposes at year end using the year end market prices. On the first day of the following year those positions are bought back for the same market value. his tax treatment flushes out all realized and unrealized gains and losses for U.S. tax reporting purposes. An active trader may elect MTM for trading gains and losses and use the accrual or cash method of accounting for business expenses. Learn About Trader Taxes
Should I Consider a MTM Election? Only someone who qualifies as an active securities trader can elect MTM treatment. Although the MTM election can be made in a year in which you qualify as an active trader, the MTM election once made applies to subsequent years whether or not you are an active trader in later years.
Before Electing Mark-to-Market Tax Treatment The decision making process is influenced by the fact that this election is a permanent election that can be revoked only with the consent of the IRS. However you could still establish an investment securities account or an investment company whose positions are outside the scope of the election. Trades in these other accounts generate capital gain or loss. Futures contracts (such as most index options) in mark-to-market accounts are still entitled to special tax treatment. MTM is not a preferred accounting method for profitable commodities and futures traders as the default tax rates favor them: 60% long term and 40% short term capital gain. The current maximum blended tax rate on commodities and futures is 23% versus 35% on securities. Electing MTM converts commodities and futures trading capital gains and losses (60/40 treatment) to ordinary gain and loss treatment (a 12% tax rate increase). But if you have large commodity trading losses before April 15 of the current year, electing MTM will allow the losses to be treated as ordinary.
Some Strategies for Making the Election As the election is specific to the active trader, it is best made by an entity, rather than an individual taxpayer. An S corporation is easier to liquidate than an individual. The individual unhappy with his or her election needs to cease trading activities and become inactive (trading in the interim should be conducted through an entity) so that trading status lapses. Make sure you (or your entity) are an active securities trader. There is no bright line test for trader versus investor status based on what little legal precedent exist. Make sure you have significant portfolio turnover on an annualized basis. Other factors (use of a margin account, options, futures, and short selling) can support active trader status. The election for an active trader must be made by the original due date of his tax return for the current year with no exceptions. For a new trading entity, you must elect within 75 days of the start of trading activities, and then include the election in the entity's first tax return. If your mix of positions includes both active trading and buying some positions (or taking some shorts), for the longer term you should establish an investment securities account. This account can be at the same brokerage where your active trading account is maintained.
Compensation Planning A manager of the offshore fund should ensure that his contracts are prepared so as to allow deferral of management and incentive fees. Through the use of properly prepared fund documents and the use of outside directors, a fund manager will be to defer for tax purposes substantial amounts of money (e.g., both the deferred fees and earnings on the fees compounded tax free in the fund).
Need Help? Consultations with veteran fund and international tax attorney Hannah Terhune allow you to customize your legal, regulatory, business and tax plans. She will discuss business development, tax, accounting, reporting and business strategies that will help you with your fund formation. Her focus is your long-term success; not selling you services you don't need. Talk to us at the earliest stages of your plans to avoid wasted time and money. Our focus on tax and securities law, assists with start-ups, incubators, small hedge funds and family offices, as well as establishing investment advisors. All of our legal work incorporates tax services and planning, with individualized tax, legal services and solutions to meet your needs. We do not sell or support canned business plans like our competitors. We offer the best value in the industry, some of the lowest prices in the world, outstanding support and customer service,no-obligation consults and free web and media content so that you can make informed decisions. You can purchase a 30 or 60 minute consultation or by calling the office at (307) 213-4732.
What is the Mark-to-Market Election? The tax election is available to an active trader and not to an investor in securities. The election is available for individuals and entities that file U.S. tax returns. Note that a person or entity trading mainly in 1256 contracts typically would not want to make the MTM election because that person would lose the 60% long-term capital gain treatment available for futures trading subject to the 1256/commodities tax rules.
Before Electing Mark-to-Market Tax Treatment Remember, you can establish an investment securities account or an entity whose trading positions are outside the scope of the mark to market election. Trades in these other accounts generate capital gain or loss. Need Assistance? Contact Us
Trading Futures and Commodities? Futures contracts (such as most index options) in mark-to-market accounts are still entitled to special tax treatment and should be excluded from the scope of the mark to market election. Mark to market is not a preferred accounting method for profitable commodities and futures traders. The reason is that the default tax rules allow for 60% long term and 40% short term capital gain. As a result, the maximum blended tax rate on commodities and futures is 23% versus 35% on securities. Electing mark to market accounting converts commodities and futures trading capital gains and losses (60/40 treatment) to ordinary gain and loss treatment (a 12% tax rate increase). However, if you have large commodity trading losses before April 15 of the current year, electing mark to market accounting will allow the trading losses to be treated as ordinary.
Strategies for Making the Mark to Market Election As the election is specific to the active trader, it is best made by an entity, rather than an individual taxpayer. An S corporation is easier to liquidate than an individual. The individual unhappy with his or her election needs to cease trading activities and become inactive (trading in the interim should be conducted through an entity) so that trading status lapses. Make sure you (or your entity) are an active securities trader. There is no bright line test for trader versus investor status based on what little legal precedent exist. Make sure you have significant portfolio turnover on an annualized basis. Other factors (use of a margin account, options, futures, and short selling) can support active trader status.
Identification of Securities Not Subject to the Election While a trader generally holds securities to capture short term market swings, a trader may nevertheless hold some securities for long term appreciation as an investment. In that circumstance, there is an exception to the market to market election if the taxpayer has clearly identified the investment securities in the trader’s records before the close of the day on which the investment security was acquired or the date the mark to market election was made. You have to be able to demonstrate by clear and convincing evidence that the securities have no connection with his or her trading business. If the electing trader holds an investment security and is also trading in the same or substantially similar security, the identification is not effective unless the investment securities are held in a separate non trading account maintained with a third party. There are two ways to make the exemption identification. The first is to establish a separate brokerage account for investment securities. The second way is to indicate on your own records which securities are not part of your trading business.
Should I Make the MTM Election? Only someone who qualifies as an active securities trader can elect MTM treatment. If you elect MTM tax treatment, it results in a "deemed" sale of your open securities positions on the last business day of the taxable year. The term "mark-to-market" refers to when all open positions are marked to fair market value at year end. In effect a sale of all open positions (long and short) is triggered for tax purposes at year end using the year end market prices. On the first day of the following year those positions are bought back for the same market value. If you make the election and have a security that has gone down in value, you will recognize a loss on that security. If you have a security that has gone up in value, you will recognize a gain on that security. Your tax basis/cost in that security is adjusted up or down to reflect the gain or loss that you recognize on your tax return. This tax treatment flushes out all realized and unrealized gains and losses for U.S. tax reporting purposes. The mark to market tax election applies only to trading gains and losses and not to business expenses. An active trader may elect MTM for trading gains and losses and use the accrual or cash method of accounting for business expenses.
Consequences of the MTM Election There are many other important things to know about the mark to market tax election.
1. Change in Tax Character of Gain or Loss. The MTM election changes the character of a trader’s gains or losses from capital gain or loss to ordinary income or loss. For a trader who makes the election, the $3,000 capital loss limitation no longer applies.
2. Wash Sale Rule No Longer Applies. Once the mark to market election is made, the wash sale rule no longer applies. That could be a huge benefit for a trader with a large number of repetitive trades in the same securities.
3. The Election is Permanent. The MTM election is a permanent choice. Once it is made, it cannot be withdrawn without IRS consent.
4. No Self Employment Tax Impact. Mark to market election does not trigger self-employment taxes on the trader’s income.
5. Pre-Election Trading Concerns. Once elected, you will no longer have capital gains or losses as all the gains or losses will be characterized as ordinary. If you have a large capital loss carry forward you would not want to elect mark to market accounting as ordinary income cannot be used to offset the capital loss carry forward.
Mechanics of the Mark to Market Election The mechanics of taking the election involve both the timing and certain required paperwork. The election needs to be made by the due date (without regard to extensions) of the original federal tax return for the taxable year immediately preceding the year in which the election is to be effective (the “election year”). Hence if a taxpayer wants the MTM to be effective for tax year 2013 (the election year), then the election needs to be made by the due date of the 2013 tax return—April 15, 2013. The election must either be attached to that return or to a timely-filed request for an extension of time to file that return.
Paperwork for the Mark to Market Election Attach a written statement to the tax return that provides the following information: the election being made, the first taxable year for which the election is effective, and the trade or business for which the election is made. An existing taxpayer must file a Form 3115, Application for Change in Accounting Method. This Form 3115 must be attached to the taxpayer’s timely filing (including extensions) return for the year of change.
Miss the Mark to Market Election? If a taxpayer blows the timing requirement, then the mark to market election is not available for that desired election year. One way around the timing problem is to form a legal entity from which to trade, such as a LLC. For a new trading entity, you must elect within 75 days of the start of trading activities, and then include the election in the entity's first tax return. If your mix of positions includes both active trading and buying some positions (or taking some shorts), for the longer term you should establish an investment securities account. This account can be at the same brokerage where your active trading account is maintained. Need help? Contact Us Today
Wash Sale Rules If you trade stocks and/or options, you need to be aware of the wash sale rule. Investors very rarely have to deal with wash sales because there is very little turn over in their accounts. Active traders, on the other hand, have numerous of transactions making it very likely that they are subject to wash sale rules. If you trade stocks and/or options, you need to be aware of the wash sale rule. According to the IRS Publication 17, a wash sale occurs when you sell or trade securities at a loss and within 30 days before or after the sale you: 1. Buy substantially identical stock or securities; 2. Acquire a contract or option to buy substantially identical stock or securities; or 3. Acquire substantially identical stock for your IRA or Roth IRA. If your trade falls within these rules, you are subject to the wash sale rule and your loss is disallowed on that transaction. However, the loss does not disappear. The disallowed loss gets added to the cost basis of the new purchase.
EXAMPLE: You buy 1000 shares of XYZ for $10,000 on May 1. On May 15 you sell these shares for $7,500. Then on June 7 (within 30 days of the sell) you purchase 1000 shares of XYZ for $8,000. Your loss of $2,500 on the sale is not deductible. It gets added to the cost of the new purchase of $8,000, making the cost basis $10,500. This process continues until the 30 day window is exceeded.
What About Short Sales? For purposes of the wash sale rule, a short sale is considered complete on the date the short sale is entered into if on that date: 1. You own (or, on or before that date, you enter into a contract or option to acquire) stock or securities identical to those sold short, and 2. You later deliver such stock or securities to close the short sale. Otherwise, a short sale is not considered complete until the property is delivered to close the sale.
EXAMPLE: On June 10, you buy 1000 shares of XYZ for $10,000. You sell short 1000 shares of XYZ for $7,500 on October 10. On October 11, you buy another 1000 shares of XYZ for $7,500. You close out the short position on November 20. The $2,500 loss is not deductible because the date of entering into the short sale is deemed to be the date of sale for wash sale purposes and substantially identical stock was purchased within 30 days of the sale, making this transaction subject to the wash sale rule.
Can a short term trader avoid the wash sale rule? Yes. A short term trader can elect Section 475(f), mark to market accounting for their trading business. A trader who elects the mark to market election is no longer subject to the wash sale rule.
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