TRADERS
GUIDES: TRADER TAX LAW & BENEFITS

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Guide Highlights:

Are you a “business trader”?
If you actively trade financial products (securities, commodities, futures and/or currencies) with the intention of making a living (as an individual or an entity), you can qualify for business treatment with “trader tax status.”

It is well worth your time and effort to learn about trader tax laws and benefits. Learn how to deduct every business-related expense possible including home-office, education and much more, generating average savings much greater than $10,000 per year. Elect mark-to-market (MTM) accounting on time so you can get immediate tax refunds on all your trading losses, without limitation (in other words, MTM acts as “tax loss insurance”). Without MTM, you are stuck with capital loss limitations and wash-sale rule deferrals. Learn how to use entities for added tax savings on retirement and fringe benefit plans. Investors get the shank in the tax laws, but traders get the golden goose – the only problem is that you must learn about these laws and make key elections and filings on time. Most traders miss the boat, but you just caught it by finding this guide. Now read it and prosper.

Business tax returns
Individuals who qualify as being in the business of trading rise to the level of “trader tax status” from the default level of “investor tax status.” With business rather than investor tax treatment, these individuals file business tax returns as part of their individual tax returns on a Schedule C (Business Profit or Loss).

Individuals may also operate their trading businesses in an entity and, providing they reach trader tax status on the entity level, they are allowed to use business treatment for all their expenses on the entity tax returns. Both individual and entity tax returns for trading businesses report business expenses rather than investment expenses, leading to significant tax savings.

Trading business expenses are treated as “ordinary” expenses and they can be offset against any type of taxable income (ordinary, portfolio, capital or passive). Negative income (excess expenses) contribute to Net Operating Losses (NOL), which may be carried back two tax years, also against any type of income, for immediate tax refunds.

You may use business expenses on your current year and prior three-year tax returns (if amended). No election is required and you and/or your accountant make this determination on your own. Trader tax status is the most important determination, so carefully read the laws and cases and be certain you qualify; otherwise you may have trouble with the IRS – and if you do, learn how to win your case.

Mark-to-market accounting
Qualifying traders may elect to use mark-to-market (MTM) accounting (IRC § 475) by the election deadline of April 15 of the current tax year. As an example, if you wanted to use MTM for tax year 2004, you needed to elect MTM by April 15, 2004. If you did not elect MTM, then you may not use MTM and you must use the default "cash method." The cash method is the same as what investors use, meaning that all trading gains and losses are treated as capital gains and losses and are subject to the wash-sale rules (a real headache). MTM converts capital gains and losses to ordinary gains and losses, so there is no limit on the amount of losses that can be deducted (there is a $3,000 limit on capital losses). MTM traders are also exempt from wash-sale rules. If you tried to elect MTM on time but did not do so because you got bad advice from your accountant, or you have some other reasonable excuse, there are limited opportunities to file extensions.

MTM is good for securities business traders and losing commodities traders, but it is not recommended for profitable commodities traders who want to retain the 60/40 benefits of IRC § 1256. If you have capital loss carryovers (i.e., tax baggage), there are many nuances and some gambles in electing MTM. Learn all the nuances and complexities, so you make the right decision about MTM and you save more tax money.

The capital loss limitation rules are a joke for active business traders who can make or lose much more than the miniscule allowed annual deduction of $3,000 per year. Every trader that misses making the right decisions on MTM is putting themselves at great disadvantage. The biggest cause of failed trading businesses is large capital losses that can’t generate immediate tax refunds to help keep traders in the game with capital to trade.

Net Operating Losses (NOLs)
In addition to MTM, business taxpayers are allowed another huge tax benefit – Net Operating Losses (NOL) – that non-business taxpayers entirely miss out on. NOL tax laws provide the opportunity to carry back or forward business losses, business expenses and MTM trading losses in excess of your other income. In effect, you can average your income and losses out over three tax years, which is perfectly suited to the special needs of business traders. Make a fortune in one year, pay your taxes, then lose a fortune in the following years and carry back your NOLs for immediate tax refunds to replenish your trading accounts and stay in the business.

NOL carryback tax returns are complex for traders and the IRS is watching closely, obstinate about not paying huge refunds – although traders are clearly entitled to them. Learn how to properly file an NOL return – one that creates the fewest red flags – and how to deal with the IRS if they raise any questions. Do one little thing wrong and you may cause an exam and jeopardize your tax refunds. When it comes to NOLs, it’s wise to consult with a CPA or tax attorney who is an expert in trader tax and NOL returns. Be on the lookout for states suspending NOL carrybacks or carryforwards.

Qualification can be difficult
OK, I’m convinced. Trader tax status and MTM are the only way to go, and I can protect myself on the downside with “tax loss insurance” and get big refunds. It can’t be this easy.

It’s not. Many traders face a difficult task in determining if they qualify for trader tax status. Unless you trade every day all day as your primary means of making a living (and are successful at it), the IRS may attack your status (and IRS audits for traders are on the rise). The IRS is particularly wary and in fact prejudiced against part-time traders, part-year traders and money-losing traders. A large percentage of business traders may fall into one of these special statuses, but don’t be scared off from using and benefiting from trader tax status. Learn about the special circumstances that apply to these statuses, how to reduce the red flags on your tax return and how to deal with the IRS if they attack your status and win.

Watch out for some snake oil salesmen, including other trader tax firms, that promise guaranteed trader tax status using multiple entities schemes. It will cost you thousands extra and it won’t deliver trader tax status – only your actual trading activity will help you qualify. Look before you leap when it comes to entities schemes. The best entities for traders are included in this guide (see below).

Money-losing Traders – be aware of an IRS attack.
Traders who lose money every year may be challenged by the IRS under the "not-for-profit activity loss rules" (otherwise known as the "hobby loss" rules). We explain the rules and show you how to win on this type of IRS attack. We show you also how to build a better case from the start with business plans, accounting systems and diaries to document your “intent” to operate a business.

Part-time Traders – you can qualify, but the bar is raised
Part-time traders may qualify for trader tax status. However, be ready for a fight from the IRS, if you don't trade every day, all day. If you have another job or business activity besides your trading business, you should be aware that the IRS may challenge your trader tax status in a future tax exam. We explain the rules and show you how to win on this type of IRS attack.

IRS Exams
The IRS is examining more traders and attacking their “trader tax status” which, if successful, causes the disallowance of tax deductions for trading business expenses and MTM trading losses. The ugly consequence is no refunds; instead, a tax bill – plus interest and penalties – is possible.

Learn how the IRS works in their audits – what they focus on and how you can expect to be treated. Learn how to beat them at their own game, how to cite trader tax court cases in your favor and how to win an exam even before it’s fully underway. Our firm has had great success with traders all around the country when hired to represent them before the IRS – whether we prepared their returns or others did. We share all our winning experience with you, and you just can’t get this really important stuff anywhere else.

Better yet, after you understand how the IRS may react to your return, you can prepare your tax return with fewer red flags, better footnotes and strategies. This may prevent an exam in the first place. For example, if you are a very close call, don’t file a NOL carryback return and instead carry it forward.

Case Law
Trader tax laws are complex but also very vague, which forces you and the IRS into relying on “case law” – a collection of tax court cases applying to investors and traders. Not only do you need to learn and apply trader tax laws, but you also need to master a huge body of case law, which is not readily available, analyzed or organized – until now, since we have done just that and you can’t find this anywhere else.

We mention the favorite cases the IRS likes to cite in attacking traders and we show you how to use these same cases to support your position rather than the IRS’. We also cite cases that help you and the IRS chooses not to mention. Case law for traders is very new and the IRS seeks to apply cases that are more appropriate for investors and not Internet-era business traders. Our observations, analysis and recommendations bridge the gap and provide the winning argument. Learn all the ropes in this exclusive in-depth “case law” section.

We also include all the trader tax laws as written, point out the vague areas and then add our observations, recommendations and strategies. Our final strategies and recommendations are based on a combination of trader tax law and case law, so we make it simple for you to act with confidence. For the many accountants and lawyers who buy our guides every year, we pack them with all the citations, actual law and details – they like reading this stuff – but you traders can skip those parts if you like.

Securities Trading
Mark-to-market (MTM) accounting (IRC § 475) is the preferred method for securities business traders for four reasons: You don’t give up anything if you have trading business gains (same tax rates for cash and MTM methods on short-term capital gains), you benefit greatly if you have losses (ordinary loss treatment rather than capital loss limitations), you are exempt from the wash-sale (straddle and constructive receipt) rules and you still benefit from lower long- term capital gains rates on your “segregated investment positions.”

Commodities & Futures Trading
Commodities and futures are taxed differently from securities. You need to learn about IRC § 1256 contracts, Form 6781 and special carry backs, and how they relate to IRC § 475, the new mark-to-market rules.

MTM (IRC 475) is not a preferred method for profitable commodities and futures business traders for one reason: With the default method, commodities and futures trading gains are 60 percent long-term and 40 percent short-term (and long-term rates are significantly lower); MTM (IRC 475) commodities and futures trading gains are all short-term. IRC § 1256 also has a loss carry back feature; you can carry back commodities and futures trading losses three tax years, but only against commodities and futures trading gains in those years (so you may be able to forgo the IRC § 475 ordinary loss carry back benefits).

Not confused enough yet - between the two types of MTM and tax differences between IRC § 475 and IRC § 1256 – you will be confused further between what is a security versus a commodity or future to begin with.

What’s the (Tax) Difference?
There has been a bevy of new financial products launched by securities and commodities exchanges the past few years, including but not limited to ETFs (Exchange Traded Funds), E-minis (an index), single-stock futures, plenty of other new stock indexes, and options and futures on almost everything. Before you start trading an instrument, find out how it’s taxed. Generally all new instruments are either taxed like securities or IRC § 1256 contracts (commodities and futures) and the later currently enjoy a significant lower tax rate savings.

Single-stock futures are taxed like their underlying securities (stock, options and narrow based indices) and not like commodities (commodities, futures, and wide based indices).

Stock indexes that are “narrow-based” are taxed like securities. Conversely, if the index is comprised of ten or more securities, it is considered a “broad-based” index taxed like commodities.

Interbank (Forex) currency traders are entitled to "elect out" of IRC § 988 (the ordinary gain or loss rules for special currency transactions) to achieve IRC §section 1256 treatment; providing for the lower "60/40" capital gains tax rates.

Find your way through the myriad of new financial products and how they are taxed in this guide. Learn strategies for electing the best tax treatment for different types of vehicles and how to combine all these strategies into one program with trader tax status benefits maintained. There are many nuances and you won’t find this stuff anywhere else.

Entities for traders
A trader entity allows you to establish a retirement plan and/or other tax-deductible and tax-deferred fringe benefit plans. These are not available for sole proprietor traders (who otherwise receive all trader tax status and MTM accounting benefits). A trader entity can also deliver business tax breaks to your spouse or investors. If you miss the April 15th MTM election as an individual, you can form an entity to elect MTM for the balance of the tax year – since you make an internal election as a “new taxpayer.”

An excellent solution for many traders, with some hidden gems for late MTM elections, is husband/wife general partnerships. They are free to form, the paperwork is easy to assemble and there are rarely any state taxes to pay. Plus you can achieve all the best strategies, whether your spouse is active in the business or not.

If you are not married, a single-member LLC is a great entity for many traders. A separate tax return is not required for this entity and you save accounting fees every year by reporting this activity on your individual tax return.

Part-time traders who are not married may benefit from an S-Corp, as a separate tax return may deflect some IRS questions about part-time trader tax status.

Whatever you do, stay clear of C-Corps to avoid double taxation and trapped losses that don’t provide any tax benefits. C-Corp/LLC schemes sound good on the drawing board, but they are highly expensive and don’t provide most of the benefits promised.

Every state has different tax rules and rates for various types of entities, so make sure to customize your entity for your home state. Traders face trouble when they use entities in tax-free states, outside their home state, because they live and work in their home state. When it comes to entities, watch out for snake oil salesmen and consult with a CPA or attorney you can trust and who are experts in trader taxation.

Retirement plans for traders – which ones are best for you?
Profitable traders should save for their retirement, just like all other businesses and individuals. Uncle Sam makes it worth you while with tremendous tax incentives, including generous deductions and tax credits. Consider these excellent initial returns on your money. Plus consider the power of compounded tax-free annual returns – wow can your money grow fast!

A Mini 401(k) plan is the plan of choice for traders. You get both an elective deferral from a traditional 401k plan plus a maximum defined contribution plan, all in one. Big earners can sock away even more with defined benefit plans including 412(i) plans. Roth IRAs are also very attractive for traders.

If you want to use your retirement plan accounts as part of your trading business, watch out, you could be in for some nasty surprises from the IRS and ERISA! Learn the rules and some limited ways to navigate around the rules.

Retirement plan assets can grow to become your most important and biggest nest egg, so use this guide to customize the best type of retirement plan for traders and learn how to stay out of trouble when trading those assets. It’s just too great an asset to risk losing.

Fringe Benefit Plans
By employing your spouse and classifying yourself as a “spouse of a non-owner/employee,” you can unlock valuable fringe benefit plan tax savings in a pass-through entity; the preferred choice for traders. Fringe benefit plan amounts are the same for C-Corps and pass through entities, when utilizing this strategy.

C-Corps are a poor choice of entity for business traders. Double taxation is costly, especially if you are highly successful. If you have trading losses, you can not pass-through those losses to your individual tax return for immediate tax relief. With a “pass-through” entity, a business trader avoids double taxation and gets immediate tax refunds on trading losses. All items of income or loss are passing through to the individual tax level and taxes are not paid on the entity level. There are no remaining advantages to a C-Corp. Business traders can use a pass-through entity coupled with the “spouse of a non-owner employee” strategy to unlock every conceivable tax benefit.

Fringe benefits are known as “perks,” including health, life and disability insurance; education, dependent care and adoption assistance; meals, lodging and parking; and many other types of plans.

Learn how to convert your fixed family expenses into tax deductions which can put another $10,000 of so per year in your pocket. If you have some time and inclination, you can enjoy the same types of perks that corporate America enjoys.

Proprietary Traders
When you take a "job" or "position" with a proprietary trading firm and trade the firm's capital (instead of trading with your own money), you are considered to be "proprietary trading." Proprietary firms handle tax matters in a variety of ways: "employees" get a W-2; a Form 1099-Misc. is used for "independent contractors"; and Form K-1s for LLC members.

In many cases, the firm handles taxes for its traders in a way contrary to the best tax-interests of the trader. In those cases, proprietary traders can benefit from overriding the firm's tax handling, gain trader tax status and report their true economic gains and losses as a "trader in securities and/or commodities."

Proprietary traders receiving Form 1099-Misc for “compensation” generally owe self-employment (SE) taxes on this earned income. However, they can argue they are truly traders in securities responsible for their own trading gains and losses - and the payments are disguised trading gains. With this override, they can avoid owing SE taxes – a significant savings.

Proprietary traders receiving Form K-1s for their share of trading gains, losses (and other income and expense if any) are exempt from SE tax plus they have opportunities to deduct non-reimbursed business expenses, including but not limited to home-office expenses. Caution, if your proprietary trading firm has an expense reimbursement plan make sure to use or lose it before year-end.

Non-U.S. Resident Traders – some may owe U.S. taxes
Many "international taxpayers", who otherwise do not pay US taxes, have opened US based brokerage accounts and they have questions about what US taxes they owe in the US. We provide below, a full set of resources for international investors, traders and proprietary traders.

If the non-resident is a member of a U.S.-based "pass through" taxable entity, in the business of trading securities or commodities, then that person has "effectively connected income" (ECI). That person must file a non-resident tax return, Form 1040NR, to report their ECI income and pay U.S. taxes on that income.

Tax Planning
Wise taxpayers should do special tax planning through-out the year; before April 15 (MTM elections and trader tax status), during the year (to monitor trader tax status) and at year-end (to save taxes in the current and future year). Traders have more to think about then other types of taxpayers.

Don’t wake up to bad news just before April 15th, when it’s usually too late to accomplish much in terms of saving more in taxes. If you are tardy at least make sure to focus on April 15th planning for the current rather then prior year and get your hands around your entire tax affairs in December.

Tax Law Changes for Traders
Congress and the White House is always tinkering or suggesting drastic change to the income tax code. Business traders benefit from having most of their benefits occur “above-the-line” as part of gross income. We address new tax legislation passed and on the agenda and show traders how to benefit and set up tax plans that can stand the test of time and change.

Miscellaneous
Traders are exempt from self-employment taxation, except if they are commodities dealers or traders registered on an exchange, proprietary traders compensated with a Form 1099, or entity traders paying themselves a fee.

Short sales, payments in lieu of dividends and other special types of transactions cause further complications for traders.

Summary
Everything you need to know as a trader for tax purposes are included in our line of trader tax guides (see our companion securities and commodities tax return examples guides and securities accounting guide). You won’t need one other resource. And our entire guides are all new and all researched, written and formulated by GreenTraderTax.com. We don’t use outside experts or sources because there are none more qualified then our own. We have self-published our GTT Guides for Traders for five years and consulted, prepared tax returns and formed entities and retirement plans for thousands of traders all around the country. The more we research and service clients and deal with the IRS, the more nuances and complexities we find. This stuff is not getting any easier, it’s getting harder, and we continue to leave our competition in the dust. Get your advice from the most trusted leading experts in the trader tax business and that’s us.

After you read our guides if you have any questions, use our message boards, attend our PalTalk chats and purchase our consultations. You don’t have to prepare your own tax returns if you find this too complex, you can hire our firm. Click here to learn more about our preparation services. Good luck and thanks for being our customer! We value your business and input.

Robert A. Green, CPA & CEO