Keep More of Your Hard-Earned Trading Profits!
Editor’s Note:
The following is an interview done by Dave Goodboy in conjunction with
RealWorldTrading.com.
After you read the interview, talk about it
here.
None of the statements made in this interview
should be considered to be tax advice. If you are interested in gaining an
understanding of any of the tax strategies mentioned below, please consult your
own tax expert.
Brice
Hi, my name is Dave Goodboy,
Executive Producer of Real World Trading. Today, I am joined by CPA Robert A.
Green. Mr. Green is CEO of GreenTraderTax.com and GreenTraderLaw PLLC. Tax day
in the United States is April 15th and I can’t think of a more timely
topic. Let’s get started!
Dave:
Thanks for joining me today, Bob. I’m sure there are many last minute tax filers
among our readers so I am looking forward to this interview. Can you provide a
brief summary of your background and how you came to practice in this
interesting area of the tax?
Bob:
I founded Green & Company CPAs in 1983 in New York City and
always specialized in Wall Street traders. The Internet and online trading
revolutions got into full swing around 1997 and at that same time Congress added
the MTM laws for traders. I was the first on the net preaching MTM and our firm
has grown very fast since then. We are now the largest trader tax firm in the
country and have also started our successful law firm GreenTraderLaw PLLC.
Dave: Let’s
start by talking about tax ramifications for individual traders. What is trader
tax status?
Bob:
Business treatment for traders versus the default investor tax status.
Businesses get the golden goose when it comes to tax benefits. Individual
business traders (with trader tax status) file a Schedule C for their
unincorporated business and they get to deduct all their trading related
expenses as ordinary business deductions.
Investors get shafted in the tax code, they are limited to very few types of
investment expenses with all sorts of nasty haircuts and limitations. Plus
investment expenses are added back for Alternative Minimum Taxes (AMT); that
nasty tax which is affecting so many more taxpayers this year. If you qualify,
claim trader tax status after-the-fact, an election is not needed in advance.
Trader tax status is worth about $10,000 or more for most traders in terms of
added tax savings. So it pays to learn more about trader tax status and claim
it. Learn more in my new book The Tax Guide for Traders, published by
McGraw-Hill and available
here or in major
bookstores.
Dave:
How does a person qualify for trader tax status?
Bob:
There are no set rules for trader tax status and it’s defined in case law,
rather than legislative law. Case law calls for trading frequently,
continuously, regularly for quick swings in price rather than long term price
appreciation and portfolio income. Case law doesn’t help much, because most
traders can say they qualify under these very general terms.
The GreenTraderTax golden rule for “slam dunk†trader tax status is: you should
trade every day all day; with holding periods of day trades to a few days; spend
most of your day in your trading business; have the intention to run it like a
business and be a main source of your living; and have a serious trading
business plan and level of expenses. The majority of traders fall short of that
slam dunk status and they are a “close call,†they should consult with a
trader tax expert like our firm before proceeding.
Part-time and/or continual money losing traders can qualify but they should also
consult with an expert before proceeding at their peril on these benefits.
The biggest benefit for money losing traders is mark-to-market (MTM) accounting.
The prerequisite to use MTM is trader tax status; they are two different things
— most traders confuse them as one.
Unlike trader tax status, which can be claimed after year end, you must elect
MTM in advance, by April 15, 2004 for 2004 and April 15, 2005 for 2005.
So, if you lost big money, you need trader tax status and MTM to deduct your
trading business expenses and trading losses; which can save you a fortune in
taxes.
If you don’t elect MTM on time, you are stuck with capital loss limitations of
$3,000 net deduction per year; with the rest carried over to future years.
Problem is most traders never make back enough capital gains to use up their
capital loss carryovers. Plus they dig themselves into a hole for electing MTM
in the future. Learn more below.
Make sure to elect MTM by April 15, 2005 for 2005 by attaching the election
statement to your 2004 tax return or extension. It’s wise to file extensions,
learn more
here. You can get the MTM election statement and learn more about MTM in my
new book. You get the ebook version immediately after online purchase, so you
can read this before the tax deadline.
Dave: What choices does a part time trader have? Can a part-timer still
qualify for trader tax status?
Bob:
A part-time trader can qualify as stated above. Read about a very important part
time trader case, Frank Chen vs. IRS on our site,
here.
Dave:
Can you have multiple losing/break-even years and still qualify for trader tax
status?
Bob:
Yes, you can but proceed with caution and get expert advice. Don’t invite the
IRS to exam your returns by botching your reporting.
The IRS may try to apply the “hobby loss†rules to disallow your losing years.
Use our book to win on this point. If you prove your intention was to run your
trading activity as a business activity, then you are not subject to the second
rule; the well known making profits in 3 out of 5 years test. Trader tax status
is the same as your business intention test under the hobby rules, so if you
have trader tax status, you automatically are exempt from the 3 out of 5 year
profit test. Little nifty logic wins the day here.
Dave: Please
explain MTM a little deeper.
Bob:
We explained that MTM is “tax loss insurance†previously.Only securities
business traders should elect MTM, but not commodities, futures and Forex
traders.
Tax loss insurance is great for all traders — ordinary loss treatment — but it’s
too expensive for commodities, futures and Forex traders; who would have to give
up that precious 60/40 tax treatment. 60% of capital gains are subject to the
lower long-term capital gains rates up to 15%, and the other 40% is short term
ordinary tax rates up to 35%. Do the math; the combined tax rate goes up to 23%.
That’s 12% less than securities traders pay on capital gains ordinary tax rates
up to 35%.
So for securities traders, MTM is always the wise move, unless you have large
capital loss carryovers. Here’s the predicament. If you elect MTM, you have
ordinary trading gains and then you can’t offset those MTM gains with your
capital loss carryovers. If you have trading gains, you will be sorry you made
the election, but if you have losses you will be very happy you did since you
will get immediate tax refunds on your ordinary MTM losses; rather than
increasing your already unutilized capital loss carryovers.
Get the best of both worlds with a new entity that can elect MTM internally
within 75 days of inception; so you have more time and flexibility.
Dave: Is
it too late now for a trader to elect “mark to market†accounting for 2005?
Bob:
No, you have until April 15, 2005 for an individual or partnership MTM election
for 2005.
Dave:
For this year, if a trader did not elect “mark to market†accounting, what are
the choices?
Bob:
You still can use trader tax status and get all the business tax deduction
benefits. MTM is most important for losing traders. Profitable traders can also
be hurt without MTM because they are subject to wash sales, another way to defer
losses to the next tax year.
Dave:
What differentiates a trader from an investor in the eyes of the IRS?
Bob:
The IRS is prejudiced against traders and that’s allowed within
the law. The IRS thinks all investing activities look alike. It’s hard for them
to distinguish between a trading business versus an investment activity.
Trading businesses get tons of tax breaks so the IRS wants to force most traders
into investor tax status. That’s very unfair, of course, and traders need to
stand their ground and not sell themselves short.
If you get examined by the IRS (a tax audit), we strongly suggest that you do
not reply to the IRS without first engaging a top trader tax expert to represent
you. Don’t let the IRS pick on you, force them to deal with a smart CPA or tax
attorney. This is where we earn our salt!
GreenTraderTax and
GreenTraderLaw have an incredible winning percentage. In most exams, we get the
IRS to “reconsider†(retract) the exam before it even gets underway. That means
we get the IRS to close the case before they proceed.
First we educate the IRS about trader tax status in our tax return footnotes, to
nip their questions in the bud. Then when an exam starts we come on very strong
with further explanation of the law and why our trader client qualifies under
case law.
Dave: If
one is successful in obtaining trader tax status, what type of expenses can be
deducted? Data feeds, home office, meals during trading hours— anything having
to do with the business?
Bob:
Yes, all of those and much more. Every dime connected to your trading business
(margin interest, training, education, seminars, travel, phone, supplies,
postage, computers, equipment, furniture, software, subscriptions, books, gifts,
accessories, services and more) plus you can convert some of your home personal
expenses into business expenses with the valuable home office deduction. Learn
more about all types of expenses and the home office deduction in my new book.
Dave:
Are there any unusual deductions that a trader may not think of?
Bob:
Home office is the biggest and best deduction, but most traders don’t understand
how to use it. It’s no longer a red flag and that’s because in order to deduct a
home office, you must have business income.
To unlock a home office deduction, follow this special GreenTraderTax strategy.
Report your business expenses on Schedule C and your trading gains on Schedule D
(cash method) or Form 4797 (MTM). Then transfer a portion of your trading
business gains to Schedule C to “zero out†Schedule C. This unlocks your home
office deduction and section 179 100% depreciation. Learn more about this
strategy in my book and our trader tax examples guides. We give you actual
examples on tax forms.
Dave:
Are commodity traders treated differently than stock traders by the IRS?
Bob:
Yes! Everything you can trade–which is a lot these days–basically breaks down
into three tax camps; and then with a little further reduction into two tax
camps. The three camps are securities, commodities and Forex. Forex traders
should elect out of IRC 988 to be treated like commodities, breaking it down
into two tax camps.
Securities are taxed at short term and/or long term capital gains tax rates. All
traders can segregate investment positions aside from trading business
positions. Securities traders can elect MTM on business positions and MTM does
not then apply to segregated investment positions. They get the best of all
worlds! But their active trading gains are taxed at the higher ordinary rates,
since few active traders hold business positions over 12 months. By default that
would undermine your trader tax status. MTM gives securities traders’ ordinary
loss treatment which is always good.
Commodities and futures are section 1256 contracts with 60/40 tax treatment as
explained above. The highest blended rate is 23%, which is 12% less than
securities traders. Section 1256 contract losses may be carried back three tax
years but only against section 1256 contract gains in those years. Conversely,
MTM securities traders may have net operating losses (NOLs) from MTM, and NOLs
can be carried back two tax years and be applied against any type of income,
whether you traded or not in prior years. Ordinary losses are always much better
than capital losses.
Forex is by default ordinary
gain or loss treatment. That’s good news for most new Forex traders because many
may have losses and be happy to have ordinary loss treatment by default. No
other type of trader gets ordinary loss treatment by default.
Profitable Forex traders should elect of our IRC 988, the Forex tax laws to be
treated as section 1256 contracts, so they get that 12% lower tax rates on Forex
trading gains. Elect out of IRC 988 internally in your own books and records. We
have more information on Forex tax issues in my new book.
Securities include stock options, mutual funds, bonds, single stock futures,
narrow based indexes (with 9 or fewer stocks), and ETFs.
Commodities and futures include all regulated futures contracts and broad based
indexes (with 10 or more underlying securities).
Foreign futures may qualify for section 1256 contract treatment. Learn more
here.
Dave: Interest is growing rapidly in the Forex market. Can one strictly
trade Forex and still qualify for trader tax status?
Bob:
Yes, any type of trader can qualify for trader tax status and you
should consider the various types of elections covered above. Every type of
trader has expenses and wants tax relief from deducting their expense as
business deductions.
Dave: How
about option traders. For instance, I know several full time option traders, can
they obtain trader tax status?
Bob:
Yes.
Dave:
Does the IRS view option traders differently than stock or commodity traders?
Bob:
Yes, it’s a little easier to navigate around the IRS prejudice
against traders if you only trade options. After all, how many traders buy and
hold options for long term price appreciation or portfolio income; the
definition of an investment activity.
Dave:
Many traders don’t think about retirement. Can someone with trader tax status
set up tax deferred retirement plan?
Bob:
Yes, but you need to first set up a separate entity to create
earned income. Trading gains are not earned income and therefore you can’t
contribute to a retirement plan based on trading gains. If you trade in an
entity, that entity can pay you an administration fee which is earned income.
Then you are all set for a retirement plan deduction as well as other earned
income related benefits like health insurance premium deductions and various tax
credits.
We recommend pass through entities like single or multi member LLCs, S-Corps or
general partnerships. Learn more
here.
We recommend Mini 401k plans for traders since you can optimize your retirement
plan deduction and reduce your payment of self employment taxes on the fee paid.
Learn more
here.
Dave: Is
it legal to actually trade retirement funds?
Bob:
Yes, it’s legal to trade retirement plan funds but there are
restrictions in the tax code and with some brokers; plus there are usually
higher commissions that apply to retirement account transactions. It’s better to
trade your retirement accounts than to take out the money and be subject to
income taxes and a 10% excise tax penalty. Learn more about this topic
here.
Dave: Do
individual traders need to pay self employment tax?
Bob:
Not unless the trader is also a dealer on a commodities or options exchange.
Trading gains are otherwise exempt from SE taxes whether or not you have trader
tax status and MTM.
Dave:
Moving on to proprietary trading. I have noticed some firms require the trader
to be licensed and some do not. Can you explain this?
Bob:
Prop trading firms that are organized as broker dealers require brokerage
licenses for their LLC (prop trading) members. This is required by the
regulators and stock exchanges.
Dave:
There are some rumors floating around that the SEC will soon be clamping down on
prop firms. What’s your feeling on this issue?
Bob:
We continue to cover this developing story
here. The
latest we heard is that as long as a prop trading firm has true 1% firm wide
sharing of profits (most don’t) there should not be a problem with large payouts
to traders. If the relationship is a disguised retail customer account where the
trader puts up money to trade there can be problems. Prop trading firms have
very special rules on not counting traders deposits in their net capital. This
whole area is complex and we advise prop traders to read my book and consider a
consultation with our attorneys at GreenTraderLaw. Prop trading can be a great
solution for many traders hungry for additional capital and leverage to trade.
But look before you leap.
Dave: I
have heard the phrase “mandatory redeemable equity†and how this may affect prop
firms in the near future. Can you shed any light in this regard?
Bob:
That’s the net capital rules I mentioned and otherwise too complex for this
interview.
Dave:
Many traders dream of one day setting up a hedge fund. Is this a difficult
process?
Bob:
No it’s not. But it’s a highly regulated business and there is a
lot of red tape. Our law firm GreenTraderLaw can do everything you need. I
suggest a separate interview on this subject with our chief attorney of
GreenTraderLaw PLLC, Ms. Hannah Tehune, very soon.
We conceived of a great new idea, the incubator hedge fund. You can break down
the process into two phases so you can start your hedge fund business plan
sooner than later and at much lower cost initially.
We set up your hedge fund and management company and SEC and/or state filings
and you can only trade your own money. You build up a nice track record that you
can show investors later on; whereas without this incubator strategy you can’t
show prior performance without jumping through very tight and vey expensive
hoops. If you do well, we can complete the process later on. We then do the rest
of the paperwork (offering documents to show your investors, LLC Operating
Agreement and subscription materials).
Dave:
What is the main paperwork needed for a hedge fund?
Bob:
Registration filings, company structure and formations, offering
documents, LLC Operating Agreements, subscription materials and more.
Dave: I
know there is going to be several new regulations effecting hedge funds in the
near future. What are these regulations?
Bob:
More registration is in the works. Not necessarily a bad
thing. More on this with Hannah’s interview soon.
Dave:
Do they apply to all hedge funds regardless of size?
Bob:
There is lots of confusion on these points and whether state or
federal law applies. Hannah will cover all these important topics in her
interview soon.
Dave: We
are almost out of time. How can our members contact you and your firm should
they have any additional questions?
Bob:
See our contact us
page. We have weekly PalTalks and a Message Board. We offer consultations,
preparation, GTT TradeLog software, guides, my book and much more. Thanks.
Dave:
Thank you for joining me today. I am looking forward to having you back soon to
delve deeper into some of these issues.
Bob:
Thanks Dave for your excellent questions and helping traders out
like this just before the tax deadline.