TAX TREATMENT FOR TRADERS
See our Updated Trader
Tax Center pages.
We cover these topics in Green's
2012 Trader Tax Guide.
There are lots of new strategies and tax-court case updates to consider
on these topics. We define the standard for trader tax status, so read
chapter 1 in the above 2012 guide.
OLDER CONTENT: It's a must to
read our newer content, but this older content gives some perspective,
if you are interested.
Tax treatment, trader tax status and MTM
Tax treatment on new products is confusing. Add trader tax status and
mark-to-market accounting to the mix and traders have a full plate of
tax issues to consider this tax season. Use this resource for some quick
answers to get the (tax) breaks you deserve.
By Robert A. Green, CPA
New trading products are being created almost as fast
as new traders. But who is a business trader and who is a regular
investor? It's potentially a $64,000 question on your tax return.
What is the tax treatment on all these new products? There is widely varying
tax treatment for securities vs. commodities and futures vs. forex (interbank
currency trading) vs. precious and base metals.
Does it matter if you are a member of an exchange?
There are lots of good questions to consider this tax season; here is
a good assortment.
Are you a business trader or investor? Start with the
By default, the IRS considers buying and selling of financial products
(trading) to be an "investment activity."
Unless a trader rises to the level of trading as a business ("trader tax
status"), they are required to follow the tax laws for investment activities.
There are many special tax laws for investment activities, including but
not limited to: capital-loss limitations and carryovers; IRC 1256 contracts
(commodities and futures) with special 60/40 treatment; forex with IRC
988 ordinary gain or loss transactions; restrictions on investment interest
and other expenses; lower tax rates on qualifying dividends and long term
capital gains (up to 15 percent); deferring realized losses on wash sales,
straddles and constructive receipts; bond accrued interest, original issue
discount and amortization of premiums; short selling; covered call options;
and much more.
There are plenty of good tax resources around
The IRS Web site (www.irs.gov) is excellent. Start with IRS Publication
550 (Investment Income and Expenses). Chapter 4 (page 72), "Special Rules
for Traders in Securities," is for business traders.
Another good resource is "A Guide for the Individual Investor Р
Taxes and Investing," prepared by Ernst & Young LLP and available at the
CBOE Web site.
Also consider my book, "The Tax Guide for Traders," published by McGraw-Hill
and available in most bookstores or at www.greencompany.com.
It's tough for the IRS to keep up with the tax treatment
for all these new products
Tax treatment on the following new products is not always clear from the
outset: single-stock futures, ETFs, indices (narrow and broad-based),
options and futures (on indices and ETFs), foreign futures and other products,
HOLDRs, LEAPS, and more to come soon.
Existing U.S. and foreign exchanges are forming alliances to create and
list new hybrid products. However, hybrid products create challenges for
The problem is that the IRS historically placed products into a few different
established tax-treatment baskets. Securities were treated differently
from commodities and futures (IRC 1256 contracts) and forex (IRC 988).
For example, should single-stock futures be treated as stocks or futures?
Find out below.
Brokerage firm reporting and trade accounting is also
Brokers report most transactions on Form 1099s after year-end. They report
securities on a separate 1099 from commodities and futures. They are not
supposed to report forex.
The securities 1099 should list each stock sale and a total of option
proceeds. The IRC 1256 contract 1099 should report aggregate profit or
loss. Brokers are still not required to report single-stock futures and
some other new products.
Brokers' tax and information reporting departments are stressed by all
the changes, and some smaller firms don't quite get it right.
Taxpayers are obligated to report accurate income and taxes, and they
can't get out of paying a tax bill from the IRS because a 1099 received
Many brokers offer online accounting reports, but many traders claim they
Consider good trader-tax accounting software such as GTT TradeLog (sold
by this writer's company) or Gainskeeper. Annual accounting formulas are
in "The Tax Guide for Traders" by Robert Green.
Popular tax-treatment questions on new products
How are E-minis taxed vs. ETFs? After all, the two products are very similar
in nature? The QQQQ ETF is a similar product to the NASDAQ 100 E-Mini;
both trade the NASDAQ 100. ETFs are taxed like securities, but E-minis
are IRC 1256 contracts.
How are options on ETFs taxed Р like their underlying ETFs or otherwise?
The IRS has still not issued guidance, so there is no clear answer.
How are foreign futures taxed Р like U.S. futures (1256 contracts)
or securities? We cover this question in-depth in my separate article
in this issue on global tax.
How are precious and base metals taxed? Futures are IRC 1256 contracts,
physical base metals are like securities and physical precious metals
are collectibles. See more below.
How is spot forex taxed, like forward forex contracts or otherwise? Again,
we are waiting on guidance from the IRS. A case can be made for treating
spot forex like forwards in terms of electing out of IRC 988 for IRC 1256
treatment. See more below.
How are single-stock futures taxed, like stocks or futures? Like ETFs,
they are treated like securities.
Securities involve short-term versus long-term treatment
Short-term capital gains on securities are taxed at ordinary income tax
rates (currently up to a maximum of 35 percent).
If a trader or investor holds a security for 12 months or longer, they
benefit from significantly lower long-term capital gains tax rates (currently
up to a maximum of 15 percent). That's a 20-percent difference! Most active
traders don't hold positions for 12 months, though.
The definition of "securities" includes stocks, stock options, bonds,
mutual funds, single-stock futures, narrow-based indices (made up of nine
or fewer underlying securities), and exchange traded funds (ETFs). Tax
treatment for options on broad-based ETFs is still unclear at this time.
Commodities and futures are taxed very differently
First, lower tax rates apply (60/40 treatment). Secondly, unlike securities,
commodities and futures are marked-to-market at year-end; this means unrealized
gains and losses on open positions are reported during the tax year, not
deferred to the next tax year.
Don't confuse IRC 1256 mark-to-market (MTM) accounting with IRC 475 MTM.
IRC 1256 MTM applies to all commodities and futures, regardless of trader
tax or investor tax status. IRC 475 MTM may be elected only by business
traders, and it's recommended for securities only (commodities and futures
traders must give up 60/40 treatment when they elect IRC 475 MTM).
IRC 1256 contracts also include a capital-loss carry-back feature, but
only against IRC 1256 contract gains in the prior three tax years.
The definition of "commodities and futures" includes regulated futures
contracts, non-equity options, broad-based indices such as E-Minis (made
up of 10 or more underlying securities) and forex when a forex trader
(vs. a manufacturer) elects out of IRC 988.
Learn more about the tax treatment for securities vs. commodities and
futures at www.greencompany.com/EducationCenter/GTTRecSecuritiesVsCommodities.shtml
Forex is also taxed very differently
Traders in forex, both forward and spot contracts, are by default subject
to ordinary gain or loss treatment under IRC 988 (foreign currency transaction
IRC 988 is intended to address currency conversion in the large global
economy. For example, manufacturers may exchange dollars for euros or
yen, and the gain or loss is part of their ordinary course of doing business
Р so ordinary gain or loss rules make great sense.
But these rules don't make sense for traders, who are not hedging inventories
of autos or otherwise; they are just speculating in forex as another product
Thankfully, there is an exception in IRC 988 for traders who trade in
forex forward contracts as a capital asset. Traders may elect out of IRC
988 for the more tax-beneficial IRC 1256 60/40 treatment. Rather than
pay taxes on forex gains at higher ordinary tax rates (up to 35 percent),
they are able to pay taxes at the lower 60/40 rates (up to 23 percent).
Notice the rule says forward contracts and it does not mention spot forex,
which the majority of traders trade. An argument can be made for applying
these same rules to spot forex, too. GreenTrader is working with the IRS
national office to clarify these rules so there is no further uncertainty.
The IRS recently issued guidance saying that over-the-counter forex contracts
on foreign exchanges are considered IRC 1256 contracts by default. Go
The election must be made on a contemporaneous basis internally Р
that means in your own books and records, as opposed to an external election
filed with the IRS. There is some vagueness on how to make the election.
We suggest you make it on a global basis for the entire year.
If you have losses, you will wish you did not make the election to opt
out of IRC 988. Ordinary losses are better than capital losses, which
are subject to a $3,000 limitation.
Forex is still the Wild West in terms of brokerage, trading, reporting
and tax guidance, so tread carefully.
Brokers are not required to report forex transactions to the IRS, but
you still must determine your gains and losses and report them properly.
Precious metals are taxed differently from base metals
Precious and base metal futures contracts on U.S.-regulated futures exchanges
are IRC 1256 contracts with more-favorable 60/40 capital gains tax rates.
Precious metals held in physical form (warehouse receipts or otherwise)
are considered "collectibles." Short-term sales are taxed at ordinary
income tax rates up to 35 percent and long-term sales (holding periods
longer than 12 months) are taxed up to 28 percent Р the collectibles
rate. That is 13-percent higher than the maximum tax rate applicable to
long-term capital gains on securities. It seems unfair to tax traders
as owning collectibles when they are just trading to make a living.
Base metals held in physical form are taxed like securities.
Precious and base metals traded on foreign futures exchanges may or may
not qualify for IRC 1256 favorable tax treatment. If they are not 60/40,
then securities rules apply. See the discussion of foreign futures in
this author's other tax article in this same issue.
For more information on precious and base metals, see an article by Roger
Lorence, JD LLM, in this issue.
Popular trader tax status questions
How can a trader achieve trader tax status (business treatment)? Read
the very subjective case law and consult with a trader tax professional
unless you trade every day all day, with thousands of trades per year
and holding periods of at most a few days.
Must a taxpayer elect or merely claim (declare) trader tax status? You
may claim it even after the year-end. It's not elected.
What is mark to market accounting (MTM IRC 475) and how do traders elect
or claim it? It exempts traders from wash sales and the annual capital
loss limitation of $3,000. You must elect MTM on time (see below). MTM
imputes sales of open business trading positions at year-end.
Must you apply MTM to your segregated investments positions, where you
are hoping for long-term capital gains on a deferred basis? No, MTM only
applies to business trading positions, not segregated investment positions.
Does the $3,000 annual capital loss limitation mean you can only use $3,000
of your carryover losses each year? No, you may utilize the entire capital
loss carryover in the following tax year, and if you have sufficient gains
you may apply it all. Otherwise, after all activity on Schedule D is combined
the following tax year, you are limited to a $3,000 net loss. Many traders
mistakenly think they can only apply $3,000 per year going forward.
If you elect MTM, do you automatically lose the more beneficial 60/40
treatment on commodities and futures? No, this is another misconception.
Be careful to elect MTM on securities only.
Can you be a business trader in securities, commodities/futures, forex
and a retirement plan at the same time? Yes, on all except retirement
accounts. Be careful to draw a connection with the multiple activities
if you need all to qualify for trader tax status.
Retirement-plan accounts can be actively traded, but you can't run a business
in them and you can't deduct trading expenses in connection with a retirement
What are the main tax breaks for business traders? There are two Р
ordinary loss treatment on expenses and trading losses, and retirement-plans
and health-insurance premium deductions.
Trader tax status is much better than the default investor
It makes sense that business traders would spend more money on trading
expenses than investors; after all, they do it all day every day as a
serious business activity.
So it's imperative and fair that business traders should be allowed to
deduct all their business expenses as ordinary deductions. It's unfair
for active traders to be denied tax deductions because of the arcane rules
Business traders may deduct interest in full, whereas investors may only
deduct investment interest against investment income. When there is insufficient
investment income, investors must carry over investment interest to future
Business traders may deduct every type of expense, including start-up
expenses, home-office and education. Conversely, investors may only deduct
a few types of expenses, not including start-up expenses, home-office
or education. Plus, investors face so many haircuts and limitations, they
often wind up with no deductions at all.
For example, miscellaneous itemized deductions for investment expenses
must first exceed 2 percent of Adjusted Gross Income, the itemized deduction
phase-out, and the standard deduction. Finally, it must not trigger the
AMT. Good luck!
Business traders may deduct every conceivable business expense, and it
offsets all gross income without limitation. Negative taxable income may
generate a Net Operating Loss (NOL) two-year carryback (the rest is carried
forward). Business expenses are part of NOLs.
Trader tax status saves the average trader around $10,000 per year in
There are special rules for home-office deductions and education. Learn
more in "The Tax Guide for Traders," by Robert Green.
Business traders may also elect IRC 475 MTM
Business traders (only) may elect IRC 475 MTM accounting, converting capital
gains and losses into ordinary gain or loss treatment.
It's like having tax-loss insurance. If your trading house burns down,
you get a large tax refund (insurance) from the IRS (and probably your
home state, too).
IRC 475 MTM is a great election for securities business traders, but not
for commodities/futures traders.
Securities business traders pay the same ordinary tax rates on short-term
sales (so the insurance premium is free) and they unlock ordinary loss
treatment, freeing themselves from capital-loss limitations (the insurance
Conversely, commodities and futures traders pay a stiff premium Р
the loss of 60/40 tax treatment on gains.
Existing taxpayers need to elect MTM "externally" (with the IRS) on time,
by April 15 of the current tax year for individuals and partnerships (March
15 for corporations). Attach the election statement to your prior year
tax return or extension.
New taxpayers (new entities, not new traders) need to elect "internally"
(rather than externally with the IRS) within 75 days of inception.
If you miss the external election deadline, consider setting up a new
entity that has time to elect later in the year (within 75 days of inception).
Learn more about MTM in The Tax Guide for Traders.
Don't confuse trader tax status with MTM
They are two separate and related tax concepts.
You need trader tax status to elect MTM. It's a prerequisite.
You can claim trader tax status after year-end (even up to three years
later, with amended returns). However, you must elect MTM on time. If
you don't, the IRS will deny MTM treatment, and you can never win this
point in a tax-court case or appeal.
Trader tax status is a concept you may argue about and win in appeals
or tax court. It's not clear in the statutory law, whereas an MTM election
Also make sure to complete your MTM election by filing a Form 3115 on
time. New taxpayers (like new entities) adopt MTM rather than request
a change of accounting and therefore don't have to file Form 3115 (change
of accounting method).
Business or investor tax status
If you don't have many trading-related expenses and you are not worried
about losing too much money on securities (although you should be unless
you trade a very small amount), then don't worry about business trader
tax status. You won't miss out on much.
On the other hand, if you frequently trade securities (and can lose much
more than $3,000 in any given tax year) and spend large amounts of money
in this activity, you should determine if you qualify for trader tax status
and make sure to elect MTM on time. No ifs, ands or buts!
Popular tax questions about exchanges
Are members of options and/or commodities exchanges taxed differently
than traders who are not exchange members? Members pay self-employment
(SE) tax and non-members do not.
What about the new corporate membership programs on the Chicago Mercantile
Exchange? Do those members also have to pay SE tax? No, corporate members
have a restricted type of membership.
If you are a member of an options or commodities exchange, you are subject
to SE taxes on your trading gains on that exchange (IRC 1402).
All other types of traders are exempt from SE taxes. That currently saves
non-exchange traders SE taxes of 15.3 percent on the base amount (currently
around $90,000) and 2.9 percent above that base amount. SE taxes are in
addition to income taxes and they add up fast!
The good news is that if you pay SE taxes, not only do you earn social
security and Medicare benefits in retirement, but you may also contribute
to a tax-deductible retirement plan. In fact, by doing so you may save
more in income taxes from the retirement-plan tax deduction than you pay
in SE taxes. Learn more about retirement plans for traders at www.greencompany.com/Traders/TraderRetirement.shtml.
All exchange members are forced to pay SE taxes on their exchange trading
gains, regardless of trader tax status or contributions to a retirement
Non-exchange business traders have more flexibility in dealing with SE
tax and retirement plans. They can form an entity to pay themselves a
fee or salary and use that as the basis for a retirement plan. Learn more
about entities at www.greencompany.com/Traders/TraderEntities.shtml.
Therefore, they can decide on whether or not to create earned income to
drive the SE tax and retirement-plan strategies, so they can maximize
income tax savings vs. SE tax costs. Consult with a trader tax advisor
on the nuances.
At tax time, don't pay the wrong tax rate on your trades. Try to pay 23
percent (with 60/40 treatment) rather than 35 percent ordinary tax rates.
If you are entitled, claim trader tax status for business expense treatment.
Plan the year ahead now by considering mark-to-market accounting and switching
to lower tax-rate trading strategies. Your taxes require some portfolio