Tax season
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Traders use different tax forms because the IRS did not create specific tax forms for individual trading companies. Traders enter profits and losses, portfolio income, and business expenses in a variety of forms. It's often confusing. What Form Should Forex Traders Use? Which form is correct for securities traders using the MTM method according to § 475? Can I report trading profits directly on a Schedule C? The different reporting strategies for different types of traders don't make tax time that easy.
Sole proprietorship business
Trader Tax Status (TTS) is a treatment of the cost of doing business and provides a number of significant tax benefits for active traders who qualify. The first step is to determine the eligibility. Our golden rules require four trades a day, almost four days a week, and an average holding period of less than 31 days. See Merchant Tax Status: How to Qualify for all requirements.
If a trader qualifies for TTS, he can retrospectively claim some tax breaks (e.g. treatment of business costs) and select and set up other benefits (e.g. § 475 MTM and pension plans for employees) in good time. You can evaluate and claim TTS business expense deductions for all or part of 2020.
Other sole proprietorships report income, cost of goods sold, and expenses in Appendix C. However, TTS traders only report trading costs in Appendix C. Trading profits and losses are shown in different forms depending on the situation.
Trading Profits and Losses
Sales of securities must first be reported (line by line) on Form 8949 based on the realization method with cost base adjustments including wash sale (WS) losses. Form 8949 then flows into short-term capital gains as set out in Appendix D using the normal tax rate and long-term capital gains for securities held for 12 months using the lower capital gains rate. Capital losses fully offset capital gains, and net capital losses are capped at $ 3,000 per year versus ordinary income (the remainder is a carryover of capital losses to subsequent years).
Some brokers offer Form 8949 in addition to Form 1099-B. Consider using trade accounting software to calculate WS loss adjustments. See Form 8949 & 1099-B Issues.
TTS traders who use MTM accounting under Section 475 for securities report their TTS trades (line by line) on Form 4797 Part II. "MTM" means that open positions are valued at year-end at market prices. Form 4797 Part II provides normal business loss treatment and avoids limiting capital loss and adjusting wash sale losses. Form 4797 losses are included in the calculation of net operating loss (NOL). Consider using trade accounting software to generate Form 4797 for Section 475 trades. Without losses in washing sales, the dealer deviates from the 1099-B and should explain this in a footnote to the tax return.
Section 1256 contracts (i.e. Regulated Futures Contracts) use MTM accounting and are reported on Form 6781 (unless the TTS trader has chosen Section 475 for commodities / futures contracts; in which case Form 4797 is used). Section 1256 Traders rely on a one-page Form 1099-B detailing their net profit or loss on trading (“Total Results on Contracts”). You can simply enter this amount in summary form on Form 6781 Part I. With 1256 contracts there are no laundry losses.
Section 1256 contracts have lower capital gains tax rates of 60/40: 60% (including day-to-day operations) are subject to lower long-term capital gains rates and 40% are taxed as short-term capital gains using the normal tax rate. For the maximum tax bracket for 2020, the mixed tax rate of 60/40 is 26.8% – 10.2% below the highest normal tax rate of 37%. See Section 1256 Contracts.
If the trader had a significant loss under section 1256 in 2020, he should consider carrying back those losses for three tax years, but only apply them against profits under section 1256 in those years. To get this choice, check box D labeled “Net Loss on Contracts 1256” at the top of Form 6781. You can make this choice with a timely filing tax return including renewals.
Forex traded on the interbank market uses the ordinary profit or loss treatment set out in Section 988. Forex traders who do not qualify for TTS should use line 8 (Other Income or Loss) in 2020 Schedule 1 (Form 1040). TTS Forex Traders should use Form 4797, Part II, Ordinary Profit or Loss. What is the difference? Form 4797 Part II losses contribute to NOL lectures on any type of income, while Form 1040's "Other Losses" do not. The latter is wasted when the taxpayer has a negative income.
In this case, a simultaneous selection of the foreign exchange capital gains in the transactions under Section 988 is better. If the taxpayer has submitted the Section 988 Opt-Out (Capital Gains) option, they should use Form 8949 for minor currencies and Form 6781 for major currencies. Forex uses summary reporting. See forex.
Selling, exchanging, or using cryptocurrency triggers capital gains and losses. The IRS treats cryptocurrencies as intangible property. The realization method applies to short-term or long-term capital gains and losses, and there is no WS or 475 for intangible assets. Report a capital gain or loss on any transaction, including cryptocurrency-to-currency sales, crypto-to-crypto trades, and purchases of goods or services using crypto. Answer the IRS question about cryptocurrency on the 2020 Form 1040 page 1 above.
For information on the tax treatment of options, ETFs, ETNs, precious metals, foreign futures and swaps, see Tax treatment of financial products.
Schedule business expenses C.
With TTS, a dealer can add a Schedule C to deduct business expenses including these items:
- "Tangible Personal Property" up to $ 2,500 per item for equipment and furniture.
- Section 179 (100%) depreciation of fixed assets. Otherwise bonus and regular depreciation.
- Amortization of start-up costs (§ 195), organizational costs (§ 248) and software.
- Education costs paid and courses taken after the start of the TTS. Otherwise, pre-company training may not be deductible. (Alternatively, you can include pre-company training in Section 195 Formation Costs.)
- Subscriptions, Scanners, Publications, Market Data, Professional Services, Chat Rooms, Mentors, Trainers, Consumables, Telephone, Travel, Seminars, Conferences, Assistants and Consultants.
- Home office expenses for the division of the home.
- Margin Interest Expenses.
- Stock borrowing fees for short sellers.
- Internal software for self-created automated trading systems.
Home office (HO) expenses are first reported on Form 8829. HO is one of the most important tax deductions for traders. It requires trading profits to unlock most of the withdrawal. Mortgage interest and real estate tax portions of HO do not require income.
When you start with TTS, you look back six months to capitalize on the starting cost of Section 195, including the cost of trading education. The merchant can spend up to $ 5,000 in the first year and spend (amortize) the remainder over 15 years.
Make Schedule C better
The IRS may consider a trading company's Schedule C to be unprofitable even if it makes significant net trading profits on other forms and is profitable on an expense basis.
To mitigate this red flag, transfer a portion of the trading profits to Appendix C "Other Income" (not income) to zero out expenses but not show net income. Showing a profit could lead the IRS to inquire about Self Employment Tax (SEI) on Self Employment Income (SEI). Trading costs reduce the SEI, but trading profits and losses are not an SEI. For information on implementing this transfer strategy, see Green's Green 20 Trader Tax Guide.
Section 475 MTM accounting
Only TTS dealers can choose and use Section 475, not investors. Section 475 transactions are exempt from WS loss adjustments for securities. Section 475 ordinary losses are also not subject to the capital loss limit of USD 3,000 against ordinary income. Section 475 Losses and TTS Expenses contribute to Net Operating Losses (NOLs). Hence our phrase "tax loss insurance".
We normally recommend a § 475 option for securities to maintain lower capital gains rates of 60/40 on § 1256 (goods) contracts.
Profitable traders could also benefit from section 475. TCJA introduced a 20% Qualified Business Income (QBI) deduction in pass-through businesses, and TTS dealers with 475 choices are eligible for the deduction. QBI includes income from Section 475 minus TTS expenses. However, QBI excludes capital gains and other portfolio income. TTS dealers are a "specific service activity". If your taxable income is above an income limit, you will not receive a QBI allowance. The 2020 Taxable Income (TI) limit is $ 426,600 / $ 213,300 (married / other taxpayers). The exit range below the cap is $ 100,000 / $ 50,000 (married / other taxpayers). The W-2 wage and property base restrictions also apply within the exit area. Use Form 8995 or Form 8995-A for QBI deductions.
Section 475 Electoral Procedure
To receive Section 475 as an individual, you must file an election return of Section 475 from 2021 with your 2020 tax return or renewal due by April 15, 2021. Existing partnerships and S-Corps must submit an election declaration for Section 475 by March 15, 2021.
“New taxpayers” such as new companies submit an internal MTM election resolution under Section 475 within 75 days of their incorporation.
Traders who have submitted 475 2020 elections on time (by July 15, 2020 for individuals) must complete the process by submitting a 3115 form to the national office with the 2020 tax return and a duplicate.
For more information on Section 475, its pros, cons, and nuances, see Green's Green 20's Trader Tax Guide. The guide contains the electoral declaration that you can use for your submission.
Tax extensions
The income tax return for private individuals for 2020 is due by April 15, 2021. However, most active traders are not yet ready to file a full tax return. Some brokers issue corrected 1099-Bs up to or beyond the deadline. Many partnerships and S-Corps file extensions will last until March 15, 2021 and will not release the final Schedule K-1 to investors until after April 15.
The great news is that traders don't have to expedite their tax returns by April 15th. They may want to send a unilateral auto-renewal along with paying taxes to the IRS and state. (The IRS postponed the April 15, 2021 tax deadline for residents of all Texas counties to June 15, 2021 following a federal disaster declaration in February 2021. That postponement could also apply to the Section 475 election.)
Merchants can apply for a six-month auto-renewal on Form 4868 to file their income tax return by October 15, 2021. States also offer tax extensions, with some states accepting federal elections. However, if the taxpayer owes state taxes, a state tax voucher / renewal form is required.
The instructions on Form 4868 indicate how easy it is to get this auto extension – no need to make a reason. It is an extension of the time to file a full tax return, not an extension of the time to pay taxes owed. The taxpayer should estimate and report what he thinks he owes for 2020 based on the tax information he has received.
On page two of Form 4868, learn how the IRS evaluates late filing and late payment penalties. If a taxpayer is unable to pay the taxes owed, they should estimate the balance due by April 15 and report on the renewal.
Even if a taxpayer cannot pay the balance due, they should at least submit Form 4868 by April 15, 2021. Simply filing the extension avoids the late filing penalties of 5% per month up to 25% which is ten times higher than the default penalty of 0.5% per month up to 25%. The IRS also charges interest.
Many traders made massive trading profits in 2020 with an explosion of new traders with pandemic and market volatility. Some took advantage of the “safe haven” estimated tax payment exemption to cover their 2019 tax liability with an estimated fourth quarter 2020 tax payment by January 15, 2021. You plan to pay the remainder of the taxes due by April 15, 2021. You should take into account the waiver and protection of these tax payments. See Traders should focus on the estimated fourth quarter taxes due on January 15th.
Some traders will risk these 2020 tax payments in the markets by the deadline and they should be careful not to lose them as it will create significant tax problems with the IRS and the state.
Partnerships and S-Corps
The 2020 partnership and S-Corp tax extensions are due on March 15, 2021. They are easy to prepare as they pass on income and loss to the owner, usually an individual. Pass-through companies are typically taxpayers but not taxpayers.
S-Corps and partnerships use form 7004 (request for automatic extension of the deadline for submitting certain trade tax, information and other tax returns). Extensions give six additional months to file a federal tax return – until September 15, 2021.
You must submit the partnership or S-Corp extension in a timely manner. Failure to do so will result in late filing penalties of $ 210 per month per owner for up to 12 months. See the instructions for Form 1065 and 1120S for more details on penalties.
Some states require a state extension while others accept a federal extension. Some states have S-Corp franchise taxes, consumption taxes, minimum taxes, and payments that are usually due due to the March 15th renewals. LLCs filing as partnerships may have minimum taxes or annual reports due to renewal until March 15. States assess penalties and interest rates, often based on payments due.
Recent changes in tax law
The Tax Cut and Jobs Act (TCJA) of 2017 introduced a limit on "excessive business losses": $ 500,000 for married and $ 250,000 for other taxpayers for 2018, which is indexed for inflation each year. Business losses that exceed the EBL limit are a NOL presentation. TCJA also suspended NOL transfers and allowed NOL transfers with a limit of 80% over taxable income for the following year. The rest is carried forward indefinitely.
The CARES Act for 2020 provided for temporary tax breaks: It suspended the EBL rules of the TCJA for the years 2018 to 2020 and allowed five-year NOL transfers for the years 2018, 2019 and 2020. The EBL and NOL rules of the TCJA will apply again in 2021.
For more changes in recent tax laws that affect merchants, see the TCJA, CARES Act, and $ 900 Billion Pandemic Emergency Aid.
We assume that tax legislation will affect traders in 2021. So stay tuned for the latest information in our blog post.
Bring away
Traders should focus on the bigger picture of filing an auto-renewal for 2020 by April 15, 2021. With or without adequate payment of tax, filing the extension will avoid the 5% per month late filing penalty calculated based on the tax amount due. Try to pay 90% of the tax liability to avoid the late payment penalty of 0.5% per month. Traders unsure of TTS qualification can omit the Schedule C trading cost from the tax liability calculations used to file the renewal and resolve this issue before filing the full tax return later. The most important issue could be a Section 475 election in 2021, with an extension to 2020 through April 15, 2021 for individuals and March 15, 2021 for partnerships and S-Corps. Overpaying the renewal payment is advisable for profitable traders to apply the overpayment credit to the quarterly estimated taxes of 2021. It also leaves a cushion for 2020 taxes.