Post Fiscal Cliff Tax Planning For Traders
While most traders generally came out okay in the fiscal cliff deal, upper-income traders should consider a C-corporation and/or S-corporation in 2013 to avoid Obama-era tax hikes.
By Robert A. Green, CPA
The fiscal cliff deal was a nail biter: We went over the fiscal cliff on Dec. 31 but Congress forged a last minute decision before the lame-duck session expired on Jan. 3. Unfortunately, no one could plan his or her taxes with certainty before year-end. Now that the deal has been reached, hopefully we can make better tax planning moves in 2013.
Fiscal cliff news dissected
The good news is Congress and the President made the Bush-era tax cuts and rates permanent for all taxpayers, except the top 2% with incomes over $300,000 (joint filers) and $250,000 (single filers). (To get a good handle on the amounts due, use calculators like this one at http://calculator.taxpolicycenter.org/.)
If you thought the thresholds were $450,000/$400,000, you're not alone. Congress and the media focused on the top tax rate returning to the Clinton-era rate of 39.6% only on incomes over $450,000 for couples and $400,000 for individuals. Many Republicans applauded and Democrats lamented, thinking President Obama waivered from his campaign promise to raise taxes on people making over $250,000/$200,000.
But besides adding a new top tax rate of 39.6%, The American Taxpayer Relief Act included Speaker Boehner's original offer to raise tax revenues through reducing tax expenditures. Starting with incomes over $300,000 (joint filers) and $250,000 (single), the act brings back old tax law for Personal Exemption Phaseout (PEP) and Pease provisions. The Pease provision eliminates itemized deductions up to 80% on incomes over those levels, and PEP eliminates exemptions. For families in high-tax states, it can raise their official 33% tax rate to an effective rate of 38%.
In effect, President Obama got what he wanted with tax hikes on the two top tax brackets, using a combination of official tax rate hikes and reductions of tax expenditures. After you factor in ObamaCare 3.8% Medicare tax hikes which went into effect Jan. 1 on incomes over $250,000 (joint filers) and $200,000 (single), Obama-era taxes on the rich are higher than Clinton-era taxes.
Taxes were raised on the middle class, too. The temporary 2% payroll tax cut expired, reducing the net pay in every paycheck. Traders are not affected by the payroll tax, as trading gains are not subject to payroll taxes. However, when traders pay themselves a small fee to unlock AGI deductions for retirement plans and health insurance premiums, they do owe payroll taxes on salaries or self-employment taxes on administration fees.
The good news is that many traders have incomes under the new tax hike thresholds, so they will continue to benefit from Bush-era tax cuts, which the act makes permanent — if you believe in such fantasies. Most traders won't see their taxes hiked, unless they have a very good year in the markets or they are married to a high-income earner.
More tax reform is on the way
Don't get too comfortable with tax planning certainty for 2013. Before signing the fiscal cliff legislation, President Obama promised he will try to raise more tax revenue as part of a grand bargain to reform taxes, spending and entitlement programs.
Will tax reform discussions focus on further limiting itemized tax deductions and credits for the upper income, rather than hiking more tax rates? With the PEP and Pease provisions already added back, how much more can Congress raise in taxes from limiting tax expenditures?
Tax reform shouldn't hurt business traders much
The good news for business traders is 2013 tax reform will probably not undermine our trader tax strategies and related tax breaks. First, consider trader tax status. If you qualify, you are able to use “above the line” business expense deduction treatment, rather than “below the line” itemized deductions for investment expenses. Investors stand to lose a lot in tax reform, but business traders should be saved any damage on their expensing. The fiscal cliff deal extended bonus depreciation for one year and favorable Section 179 depreciation.
Qualifying business traders may elect Section 475 MTM accounting (ordinary gain or loss treatment), which we call “tax loss insurance” because it exempts business traders from onerous wash sale loss deferral rules and the dreaded $3,000 capital loss limitation against ordinary income. We haven't heard any discussion in Congress or the administration about reversing these tax breaks for business traders. In 1997, Congress expanded Section 475 MTM from dealers to qualifying business traders. Economic and marked-to-market (MTM) reporting makes more sense and its good public policy.
We also haven't heard any discussion about denying forex trading gains into Section 1256(g) treatment, after a duly filed Section 988 opt-out “capital gains election.”
If Congress raises revenue from disallowing corporate tax deductions for employer-provided health insurance, then we expect it to carry through across the board, disallowing health insurance premium AGI deductions for everyone. AGI deduction strategies using an entity for attractive retirement plan deductions will still make sense.
Is the 60/40 tax break on futures in jeopardy?
While some in Congress called Section 1256 and its lower 60/40 tax rates a tax loophole, others defended it. I defend the rates and Warren Buffett calls them a loophole in the New York Times article “An Addition to the List of Loopholes” by Andrew Ross Sorkin.
As long as there are two rates there should be a blended (long-term and ordinary) tax rate for Section 1256. With MTM baked into Section 1256 by default, traders and investors may not defer capital gains to get the lower long-term capital gains tax rate or enjoy tax deferral over years, but investors in securities (Mr. Buffet) can. Hopefully Congress and the President won't try to change the blended mix of rates from 60/40 to 40/60 or some other mix.
The Bowles Simpson Deficit Commission advocated one tax rate to simplify the tax code and do away with income conversion strategies from ordinary to capital gains, like carried interest. Bowles Simpson suggested one tax rate of 23%, which happens to be the Bush-era top 60/40 blended tax rate. The problem is that Democrats want tax reform with one rate of 30% or higher. That matches Obama's Buffett Rule minimum tax proposal for million dollar incomes taxed at a minimum rate of 30%. I doubt Republicans will ever agree to one rate if that rate is above 23%, so the parties are worlds apart over tax reform (see prior blogs on this subject). Starting in 2013, the Obama-era top 60/40 blended rate is 28%.
Top individual rates are 10% higher than the corporate rate
Marginal tax rates are “progressive” meaning they climb higher as income goes higher. Taxpayers often seek opportunities to manipulate or manage their income to avoid higher tax rates, and or to arbitrage diverging individual vs. corporate tax rates. Other taxpayers seek to convert ordinary income into long-term capital gains, but that cottage industry on Wall Street was mostly shut down with tax shelter reform.
The 2013 top individual tax rate returns to the Clinton-era tax rate of 39.6%, and after PEP and Pease limitations are factored in, it's almost 41%. The second top Bush-era rate of 33% remains, but after PEP and Pease limitations, it can range up to 38% for large families in high-tax states. Plus there's the ObamaCare 3.8% Medicare tax on unearned income.
Compare these new tax rates to the corporate income tax rates of 15%, 25% and 34%. If you pay royalties to a corporation and make $50,000 per year in the corporation taxed at 15% and then pay qualifying dividends taxed at 15% (plus the 3.8%), that's a total of 34%, vs. Obama-era top individual rates of 45% (41% + 3.8% Medicare tax). The difference is 11%.
In 2012, the top individual rate was just 2% higher than the second rate (35% and 33%), and the top rate was equivalent to the small business corporate tax rate of 34%. It wasn't worth the trouble and cost of dealing with an extra corporation. Now the gaps in tax rates have increased, so some upper income taxpayers may consider income shifting with a corporation and income re-characterization with an S-corporation.
Shift income with a corporation
Consider that the corporate tax rates for small business are 15% (first $50,000), 25% (next $25,000) and 34% (thereafter). Large companies are paying up to 38% or 39%. President Obama is discussing lowering corporate tax rates as part of tax reform. He wants to capture more offshore income as part of that grand bargain, and that doesn't really affect traders using a corporation in the U.S.
A C-corporation is otherwise called a “corporation” and it has entity-level taxes. Public companies are corporations. Certain small businesses may elect S-corporation tax status, which makes the corporation a pass-through entity. S-corps have no entity-level taxes with the income, expense, gain or loss passed through to the owner's tax returns.
Business traders can also pay a royalty to their own corporation for the use of intellectual property created in connection with their trading strategies, systems and algorithms. For example, a trader can set up a corporation in the U.S. or offshore to own and lease out their trading intellectual property (IP). Their trading business pass-through entity — husband and wife general partnership/LLC or single-member LLC with S-Corp election — can pay a royalty to this new corporation.
Managing double taxation in a corporation
One big concern with shifting income from individuals to corporations is double taxation — Corporations pay entity-level taxes and taxes on dividends. There are plenty of ways to limit or avoid double taxation. Traditionally, owners of small corporations pay out compensation and interest to owners to reduce entity-level net income, as both are tax deductible in the entity. Conversely, dividends are not tax deductible. Tax reform may consider a change on that disparity of dividends vs. interest, as current tax policy is faulted for encouraging debt and leverage over equity.
The fiscal-cliff deal made the qualifying dividends and long-term capital gains tax rates permanent. It raised the Bush-era 15% qualifying dividends and long-term capital gains tax rate to 20% when incomes exceed $450,000/$400,000. (The higher 20% tax rate only applies to qualifying dividends and long-term capital gains income that exceed the threshold.)
C-corporations are bad trading vehicles
Unlike S-corporations, C-corporations don't pass through trading losses and expenses to the owner's individual tax return, where they could otherwise generate immediate tax refunds. Losses are trapped in the corporation, awaiting subsequent corporate income to soak them up. Corporate tax returns don't allow lower 60/40 tax rates on Section 1256 contracts. Paying a salary or fee to avoid double taxation causes payroll taxes which otherwise aren't due on trading gains.
We strongly advise new traders to skip promoters' schemes suggesting an LLC and C-Corp. These promoters promise business deductions passed through to individual tax returns, even when traders won't qualify for trader tax status (business treatment). That's wrong and it doesn't work.
We recommend multiple entities for upper-income traders only.
Factor in corporate state income taxes, too
If you live in a state that doesn't have a corporate state income tax, then you don't need to worry about state double taxation using up any of the federal tax savings. But if you live and work in a high corporate tax state like New York or California, then this strategy may not be cost beneficial. It's a challenge to land your corporation housing IP in Delaware. Tax auditors in New York may think your corporation is doing business in New York.
Texas has a margins tax of 1% and it only applies to gross margin over $300,000. A royalty C-corp will have margin under that amount. State tax “nexus” issues are complex and beyond the scope of this article. Consult an expert on this topic before you proceed.
Example: 2013 tax savings using entities
Suppose you make $500,000 as a joint filer in 2013, which breaks down as follows: Your spouse's W-2 income of $260,000, your trading business K-1 income of $200,000, and $40,000 of other “unearned income.” These amounts are over the thresholds for the Obama-era tax hikes, so your total unearned income of $240,000 is subject to ObamaCare's 3.8% Medicare tax. That's a new tax hike of $9,120 on unearned income. Your spouse's W-2 is also subject to the 0.9% Medicare tax hike on the amount over the threshold.
Consider using an S-corporation. Instead of paying a fee of $30,000 from your trading business partnership to your Schedule C to unlock the AGI deductions — which we usually recommend — use a new middle-man S-corporation to first pay a fee of four times that amount ($120,000).
The trading business partnership tax return's unearned income will be reduced to $80,000 from $200,000. That reduces the ObamaCare Medicare unearned taxable income by $120,000. This equals a Medicare tax savings of $4,560.
The S-corporation then pays a $30,000 administration fee or salary to the individual owner. This takes advantage of the S-corporation self-employment (SE) tax reduction loophole (which we covered on our blog before and in Green's 2012 Trader Tax Guide).
The IRS only requires compensation for 25% of net income, so 75% avoids SE or payroll taxes. The other $90,000 of S-corporation profits — $120,000 revenue minus the $30,000 compensation to owner — isn't subject to SE taxes on earned income or ObamaCare Medicare taxes on unearned income. It goes into the blank box.
In an earlier blog (“High-income traders are hit with ObamaCare's 3.8% Medicare tax on investment income”), I argued that an S-corporation trading company doesn't reduce the ObamaCare 3.8% Medicare tax on unearned income. While that statement is still true, our new idea is different, carving out fee income into an earned-income related S-corporation. The ObamaCare 3.8% Medicare tax applies to “net” unearned income and this administration fee reduces the net trading income in the trading business partnership return.
This idea and tax strategy is new and we are still vetting it further. You have time to add these entities to the mix later in the year, so wait for our updates on this strategy.
Pay royalties to your own C-corporation. Another strategy is to pay a royalty (up to $75,000) on intellectual property (IP) to your own C-corporation. The first $50,000 of corporation net income is taxed on the corporate federal tax return at 15%, and the next $25,000 of net income is taxed at a 25% rate. After $75,000, the tax rate rises to 34%. That's a nice savings compared to the top individual tax rate of 39.6% (effectively 41% with PEP and Pease).
The initial tax savings on the C-corporation strategy is $13,000: $50,000 taxed at 15% vs. 41%.
Your corporation can defer paying a qualifying dividend to you for several years. When you pay the dividend, you will owe an additional $7,500 ($50,000 dividend times the 15% dividend rate). That reduces your net tax overall federal tax savings to $5,500. Try to pay the dividend in years your income is under the 20% dividend tax threshold of $450,000/$400,000.
Investment managers and other businesses can consider the corporation housing IP tax strategy, too. Coupled with a Web-based ecommerce strategy, you may be able to land the corporation in Delaware.
Be aware of the corporate “Accumulated Earnings Tax.” This 15% tax incentivizes corporations to pay out dividends when their accumulated earnings exceed their working capital needs. Don't wait for an IRS auditor to assess this tax with interest owed over the years, too. Consult with an expert about it.
Even with double taxation factored in, there is net tax savings. The fiscal cliff deal is good news since it makes the qualifying dividend's tax rate permanent. We've avoided the C-corp strategy in the past since the differential in individual vs. corporate tax rates was inconsequential, and we worried about the Bush-era rates expiring and the dividend rate jumping back to 39.6%. That's no longer a concern and the difference is rates are significant. C-corporations are clearly not for every high-income trader, but some many want to consider using one.
Unsure how much profit you will make?
It's often hard to predict if you will be over the $450,000 threshold. Tax attorney Mark Feldman suggests creating a partnership or an LLC (taxed as a partnership) to hold the IP. So long as it's a partnership, this will not really affect your tax situation. When it becomes clear you're going to exceed the threshold, you can make a “check the box” election to treat the partnership or LLC like a corporation for tax purposes. The election can be retroactive for 75 days (with the possibility of going back further if you made a mistake and have a good excuse). From that point forward, all income received by the check-the-box corporation will not be considered your income as an individual, and you can thereby avoid hitting the $450,000 threshold. (Note that once you make the election, you cannot reverse it for five years.)
For more information
There are plenty of good articles around about the fiscal cliff tax changes. Here are a few that I liked.
** Fidelity newsletter.
**The Stealth Tax Hike, WSJ Opinion Jan. 4, 2013
**How Much Will Your Taxes Jump?, WSJ Tax Report Jan. 4, 2013, By Laura Saunders
The media and leading tax publishers have been good about publishing plenty of details on the fiscal cliff negotiations and the final tax changes. That's why we focus on ideas for savings for our trading business and investment management clients. We are working on these ideas further and we expect to publish updates soon.
The following article is from one of our external contributors. It does not represent the opinion of Benzinga and has not been edited.