While the 2017 Tax Cuts and Jobs Act did not change trader tax status, Section 475 MTM, wash-sale loss rules on securities, and more, there is still plenty to consider. To Get The Most Out Of Tax Reform, Traders Need To Act Fast covered critical moves to make before the calendar year expires. But that’s just the tip of the hat. Read on for more action items to initiate sooner, rather than later.
ARTICLE CONTINUES AFTER ADVERTISEMENT Wash sales : Securities traders must comply with wash-sale loss rules, but the IRS makes it difficult by applying different standards for taxpayers vs. brokers on tax reports and Form 1099-Bs. Taxpayers must report wash sales on substantially identical positions across all accounts, whereas brokers report only identical positions per account. Active securities traders should use a trade accounting program or service to identify potential wash sale loss problems going into year-end.
In taxable accounts, break the chain by selling the position before year-end and not repurchasing a substantially identical position 30 days before or after in any of your taxable or IRA accounts. Avoid wash sales between taxable and IRA accounts throughout the year, as that is otherwise a permanent wash sale loss. (Starting a new entity effective Jan. 1, 2019, can break the chain on individual account wash sales at year-end 2018 provided you don’t purposely avoid wash sales with the related party entity.
) Read strategies to avoid wash sale losses . Wash sales only apply to securities; not Section 1256 contracts, cryptocurrencies as intangible property, and volatility ETNs structured as prepaid forward contracts.
Wash sale losses might be preferable to capital loss carryovers at year-end 2018 for TTS traders.
A Section 475 election in 2019 converts year-end 2018 wash sale losses on TTS positions (not investment positions) into ordinary losses in 2019. That’s better than a capital loss carryover into 2019, which might then give you pause to making a Section 475 election. You want a clean slate with no remaining capital losses before electing Section 475 ordinary income and loss.
(Learn more about wash sales and capital loss limitations in a video on our Website.)
Trader tax status : If you qualify for TTS (business expense treatment — no election needed) in 2018, accelerate trading expenses into that qualification period as a sole proprietor or entity. If you don’t qualify until 2019, try to defer trading expenses until then. You may also capitalize and amortize (expense) Section 195 startup costs and Section 248 organization costs in the new TTS business, going back six months before commencement. TTS is a prerequisite for electing and using Section 475 MTM. (Learn more about trader tax status in a video on our Website.
Section 475 MTM : TTS traders choose Section 475 on securities for exemption from wash-sale rules and the $3,000 capital loss limitation — and to receive the new 20% QBI deduction. Existing individual taxpayers had to elect Section 475 by April 17, 2018, for 2018 (March 15 for existing S-Corps and partnerships). They need to complete the election process by filing a 2018 Form 3115 with their 2018 tax return. If you missed the 2018 election deadline, then consider the election for 2019.
Capital loss carryovers are a concern.
Trading entities: A “new taxpayer” entity can elect Section 475 within 75 days of inception. But it’s getting late to form a new trading entity by the middle of November, and still qualify for TTS in that short period before year-end. Elect 475 once, and it applies in subsequent years in which you are eligible for TTS unless you revoke the election.
(Learn more about Section 475 in a video on our Website.)
Net operating losses : Section 475 ordinary losses and TTS business expenses contribute to net operating loss (NOL) carryforwards, which are limited to 80% of taxable income in the subsequent year(s). TCJA repealed two-year NOL carrybacks, except for farmers. For some traders, this is the worst change in TCJA as traders have counted on quick NOL carryback refunds to replenish their trading accounts and remain in business.
Get immediate use of NOLs with a Roth IRA conversion before year-end and other income acceleration strategies.
ARTICLE CONTINUES AFTER ADVERTISEMENT Excess business losses: TCJA introduced an “excess business loss” (EBL) limitation of $500,000/$250,000 (married/other taxpayers), per tax year. Aggregate EBL from all pass-through businesses: A profitable company can offset another business with losses to remain under the limit. EBL is an NOL carryforward. For example, if a single TTS/475 trader has an ordinary loss of $300,000, his EBL is $50,000, and it’s an NOL carryforward.
2018 S-Corp: TTS traders use an S-Corp trading company to arrange health insurance and retirement plan deductions.
The S-Corp must execute officer compensation, in conjunction with these employee benefit deductions, through formal payroll tax compliance before year-end. Otherwise, you will miss the boat. TTS is an absolute must since an S-Corp investment company cannot have tax-deductible wages, health insurance, and retirement plan deductions.
This S-Corp is not required to have “reasonable compensation” as other types of businesses are, so a TTS trader may determine officer compensation based on how much to reimburse for health insurance, and how much they want to contribute to a retirement plan. Some use a dual-entity solution: An LLC/partnership trading company, and a management company, organized as a C-Corp, or S-Corp. In that case, the management company executes year-end payroll and these employee benefits.
(C-Corps can have other types of employee benefits, too.)
TTS traders organized as a sole proprietorship (an unincorporated business), cannot have health insurance and retirement plan deductions because they don’t have self-employment income (SEI) from trading income. A TTS Schedule C does not have a net income, and the IRS does not permit a TTS sole proprietor to pay officer compensation (wages) to themselves as owners. A TTS partnership faces obstacles in attempting to arrange health insurance and retirement plan deductions because the partnership passes through expenses for reducing SEI, whereas, an S-Corp does not pass through expenses or losses for SEI — that’s why the S-Corp works for traders.
An S-Corp formed later in the year can unlock a retirement plan deduction for an entire year by paying sufficient officer compensation in December when results for the year are evident. The S-Corp may only deduct health insurance for the months the entity was operational and qualified for TTS.
ARTICLE CONTINUES AFTER ADVERTISEMENT Another reason to create officer compensation is to increase the 20% QBI deduction if you are in the phase-out range subject to the 50% wage limitation. (See my other blog posts and Webinars on year-end planning for TTS S-Corps to execute health insurance, make retirement plan contributions, and generate a QBI deduction.
2019 S-Corp : If you missed out on employee benefits in 2018, then consider an LLC/S-Corp for 2019. Starting 2019 with trading in the new S-Corp is beneficial. That breaks the chain on wash sales with your individual account at year-end 2018. If you start later, you will have tax compliance for your individual return and S-Corp return in dealing with broker 1099Bs and more.
If you wait to start your entity formation process on Jan. 1, 2019, you won’t be ready to trade in an entity account on Jan. 2, 2019. Instead, you can form a single-member LLC by mid-December 2018, obtain the employee identification number (EIN) at irs.
gov, and open the entity brokerage account before year-end.
If desired, add your spouse as a member of the LLC on Jan. 1, 2019, which means the LLC will file a partnership return. If you want health insurance and retirement plan deductions, then your LLC should submit an S-Corp election for 2019 by March 15. The S-Corp should also consider making a Section 475 MTM election on securities only for 2019 by March 15.
Solo 401(k) : A Solo 401(k) retirement plan for a TTS S-Corp must be established (opened) with a financial intermediary before year-end.
Plan to pay (or fund) the 2018 elective deferral amount up to a maximum $18,500 (or $24,500 if age 50 or older) executed with December payroll by Jan. 31, 2019.
Plan to pay (fund) the 25% profit-sharing plan (PSP) portion of the S-Corp Solo 401(k) up to a maximum of $36,500, by the due date of the 2018 S-Corp tax return, including extensions, which means Sept. 15, 2019. The maximum PSP contribution requires wages of $146,000 ($36,500 divided by 25% defined contribution rate.) A SEP IRA is less attractive; it doesn’t have a 100%-deductible elective deferral, which means a similar contribution requires more compensation that is subject to Medicare taxes.
ARTICLE CONTINUES AFTER ADVERTISEMENT Cryptocurrencies : Report realized capital gains and losses for all sales of cryptocurrencies.
The IRS classifies cryptocurrencies as intangible property.
Include crypto-to-altcoin sales, crypto-to-currency sales, hard forks if you have control and there is a fair market value and purchases of items using crypto. Many crypto traders inappropriately deferred 2017 income on crypto-to-altcoin sales claiming Section 1031 like-kind deferral treatment.
TCJA restricted Section 1031 usage to real property only starting in 2018. Bitcoin, Ethereum and other crypto are not securities so wash sale loss rules, and Section 475 MTM elections do not apply. The SEC recently stated that some ICOs and tokens are securities, but not Bitcoin and Ethereum. The IRS has not changed its designation as intangible property, and I expect updated crypto tax guidance from the IRS soon. (See the cryptocurrencies section of our Website.)
Fill in the gaps in tax brackets
If you own an investment portfolio, you have the opportunity to reduce capital gains taxes via “tax loss selling.” You may wish to sell winning positions to accelerate income, perhaps to use up a capital loss carryover or an NOL. TTS traders want a “clean slate” — meaning no capital loss carryovers — so they can make a Section 475 election in the subsequent tax year.
If you are in the lowest two “ordinary” tax brackets for 2018 (10% or 12%), try to take advantage of the 0% long-term capital gains rate. The 12% ordinary income bracket applies on taxable income up to $37,800/$77,400 (single/married). For example, if your single taxable income is $30,000, you can realize $7,500 of long-term capital gains with zero federal tax.
If you realized significant short-term capital gains year-to-date in 2018 and had open positions with substantial unrealized capital losses, you should consider selling (realizing) some of those losses to reduce 2018 capital gains taxes.
Don’t repurchase the losing position 30 days before or after, as that would negate the tax loss with wash-sale-loss rules.
ARTICLE CONTINUES AFTER ADVERTISEMENT The IRS has rules to prevent deferral of income and acceleration of losses in offsetting positions that lack sufficient economic risk. These rules include straddles, the constructive sale rule, and shorting against the box.
Also, be aware of “constructive receipt of income” — you cannot receive payment for services, turn your back on that income, and defer it to the next tax year. (See Some Proprietary Traders Under-Report Income .)
Tax-loss selling is inefficient for short-term positions that reduce long-term capital gains.
It’s also a moot point with Section 1256 and Section 475 positions since they are mark-to-market (MTM) positions reporting realized and unrealized gains and losses.
Taxpayers should review tax brackets, Social Security and retirement contribution limits, standard deductions, and more. See Tax Rates, other tax charts, and analysis of TCJA at Tax Foundation . There are differences in filing status.
We recommend discussing year-end planning with your tax adviser by early December. Don’t wait until the last minute!
Darren L. Neuschwander CPA contributed to this blog post.
ARTICLE CONTINUES AFTER ADVERTISEMENT Webinar: Traders Have Unique Issues For Year-End Planning . Come to the Dec. 5, 2018 event or watch the recording after..