Green's 2013 Trader Tax Guide is our best ever

Many traders and investment managers don't take advantage of all available tax breaks and they fall into common pitfalls costing thousands. Unfortunately, far too many accountants still don't know these breaks or the many nuances and pitfalls that accompany them.

After reading our guide, you should claim as many tax benefits as possible for tax-year 2012, file your 2013 tax-treatment elections on time and consider an entity and retirement plan to receive more tax breaks for 2013 and subsequent years. Use

to receive every trader tax break you're entitled to. Whether you self-prepare your tax returns using consumer tax preparation software, or engage a CPA firm or local tax storefront, this guide can help everyone through the process. The topics below and much more are covered in this 90-page guide. For more information,

Business traders who qualify for trader tax status (TTS) are entitled to several tax breaks, whereas investors are not. By default, the IRS lumps all traders into “investor tax status,” and investors get penalized in the tax code with restricted investment interest and investment expenses, capital-loss limitations ($3,000 per year), wash-sale loss deferrals, no retirement plans and more.

Investment expenses exclude home-office deductions, most education expenses and Section 195 startup expenses. Investment expenses must exceed 2% of adjusted growth income (AGI), and they aren't permitted as a deduction for alternative minimum taxes (AMTs).

To qualify for trader tax status, business traders must first learn these mostly unpublicized rules, navigate around the vague, yet strict business-qualification requirements, and execute the strategies properly on their tax return (which also is somewhat difficult and often botched by untrained accountants). The burden is on you to get what you're entitled to. That may be unfair, but rules are rules — take them or leave them!

Don't confuse trader tax status with the related tax-treatment election of Section 475 mark-to-market (MTM) accounting, which converts capital gains and losses into business ordinary gains and losses. Only qualified business traders or dealers may use Section 475 MTM; investors may not.

A business trader can assess and claim use of trader tax status after year-end, even going back three open tax years. But business traders may only use Section 475 MTM if they filed a timely election, either by April 15 of the current year (i.e., April 15, 2012 for 2012), or within 75 days of inception of a new taxpayer (i.e., a new entity).

In the 2012 fiscal cliff agreement to extend the Bush-era tax rates, Congress restricted itemized deductions (Pease limitations) and exemptions (PEP) for the upper income starting in 2013. For these tax hikes, the threshold is AGI over $300,000 (married) and $250,000 (single).

As of late January 2013, Congress and the President are discussing tax reform; some leaders have suggested more tax hikes on the upper income through restricting itemized deductions even more. We cover these tax changes in full.

Many traders will use our guide hoping to find a way to deduct their 2012 trading losses. Maybe they qualify for trader tax status, but that only gives them the right to deduct their trading business expenses.

Securities trading receives capital gain/loss treatment by default, and there is a $3,000 capital loss limitation against ordinary income. Yes, Section 475 MTM would have made those losses business ordinary losses, but you had to file the Section 475 MTM election on time. If you did not do this, you are stuck with capital loss treatment and your next problem is how to use up a capital loss carryover in the next year(s).

If you traded Section 1256 contracts, you may be in luck if you have Section 1256 gains in the prior three tax years. On top of Form 6781 (for reporting Section 1256 contracts), you can file a Section 1256 loss carryback election, but only to apply them on Form 6781 in the prior three tax years. Business traders may elect Section 475 MTM on Section 1256 contracts, but most elect it on securities only so they can retain the lower 60/40 tax rates on Section 1256 gains.

If you traded forex, you are probably in luck. By default, Section 988 receives ordinary gain or loss treatment, which means the capital loss limitation doesn't apply. But without trader tax status, the loss isn't a business loss and if you have negative taxable income, the negative part is wasted — it's not a business net operating loss (NOL) or capital loss carryover. Forex traders can file a contemporaneous “capital gains and losses” election to opt out of Section 988.

If you realize you qualified for trader tax status in 2012 and you have material trading business expenses, you can add a Schedule C to your 2012 tax return. Even though you can't take an ordinary business deduction for your trading capital losses, deducting your trading expenses can be helpful to your tax savings. Plus, claiming TTS for 2012 can help in deducting 2012 wash sale losses as ordinary business losses in 2013 — with a 2013 Section 475 MTM and Section 481(a) adjustment from year-end 2012.

Some business traders are satisfied to operate as sole proprietors (with a Schedule C) because it appears less complicated than using a separately filed entity return, they can claim trader tax status after year-end and it appears to cost less than forming an entity. But Schedule Cs are increasingly drawing more IRS attention especially for business traders, because they have trading gains and losses reported on other tax forms.

We suggest using a Schedule C for 2012 (if you didn't have an entity) and forming a trading entity for 2013. A Schedule C works well for 2012 business expense treatment, but an entity works better and it also unlocks additional tax breaks like AGI deductions for retirement plans and health insurance premiums.

Accounting for trading gains and losses is the responsibility of securities traders; they must report each securities trade on a trade-by-trade basis on IRS Form 8949. This new form came about after the IRS beefed up compliance for securities brokers starting in 2011, causing traders, tax professionals and brokers headaches, confusion and additional tax preparation cost.

Broker-issued securities Form 1099Bs provide lots of cost-basis reporting information, but they're not reliable for inputting into a taxpayer's tax return. The 1099-B leaves out many items. They don't account for trader tax status and tax treatment elections. Also, the IRS permits brokers to report wash sales on a more limited “identical position” basis, which means between the same stock symbols. Conversely, the IRS requires taxpayers to use “substantially identical positions” which means wash sales between the same stock and stock option symbols, even at different option expiration dates.

Option traders generally don't day trade; rather they execute multi-leg positions. While many option traders may execute trades only a few days per week, they have a position on almost every day of the week. In last year's guide, we showed how the “continuous business activity” (CBA) standard can help traders who fall a little short on the required frequency of trades standard. We explained how CBA works and how you may be able to benefit from it.

We haven't seen any developments with the IRS on this standard since last year, and unfortunately CBA remains untested in tax court. We fall back on the CBA standard when traders have over 300 round-trip trades, but under our golden rule number of 500 round-trip trades. While option traders often have less frequency of trades, they usually have solid CBA. While trading monthly options may be a challenge for claiming trader tax status, in the past year we've noticed more clients trading weekly options, which is better for TTS.

Futures traders, other section 1256 contract traders and forex traders have it much easier. Futures brokers report Section 1256 contracts in summary fashion, with mark-to-market accounting for realized and unrealized gains and losses, on a one-page 1099 that is simple to understand and use for tax compliance. Taxpayers can rely on a futures 1099 to report net “aggregate profit and loss” in summary fashion on Form 6781, Part I. See Chapter 4 for more details.

There are complexities in sorting through different tax-treatment rules and tax rates, and it's often hard to tell which financial instrument falls into which category. Sometimes you can make an election to change tax treatment; sometimes it's conditional on having trader tax status, and other times not. This guide lays out which instrument falls into each category, and how they are treated tax-wise.

Existing taxpayer individuals and partnerships that qualify for TTS must file a 2013 Section 475 election statement with their 2012 tax return or extension filing by April 15, 2013. The next step is to “perfect” the Section 475 election statement by filing a 2013 Form 3115 (Change of Accounting Method) with the 2013 tax return, also on time. We tell you how to do this in our guide. We also describe a scenario when you might want to skip that second Form 3115 and treat your Section 475 MTM election as “suspended.”

We strongly recommend a trading entity to claim and use trader tax status related tax breaks. Business deductions save traders around $8,000 or more per year. A trading entity unlocks AGI deductions for retirement plans and health insurance premiums, saving traders $2,000 to $17,000 more. A trading entity disconnects wash sale loss treatment with your individual return and in your IRA, and it doesn't have to file Form 8949.

A new entity provides more flexibility for electing, using and exiting from Section 475 MTM. If you have a big capital loss carryover to work your way out of, the entity gives you the flexibility to use up those capital losses with capital gains passed through from the entity.

Retirement plans provide significant tax savings for traders in several different ways. Annual tax-deductible contributions to retirement plans generally save traders more in income taxes than they cost in self-employment (SE) or payroll taxes. A married couple can save up to $17,000 by establishing defined-contribution Individual 401(k) plans for each of them. An SE or payroll tax is charged on the declared earned income component only. (One exception: Members of a futures exchange are subject to SE taxes on their trades made on those exchanges.) This guide provides the math so you can see exactly how this tax savings strategy works. It's a very powerful savings tool and a good idea overall.

Upper-income traders and investment managers impacted by the Obama-era tax hikes may want to consider a defined-contribution plan where they can deduct $200,000 from gross income.

This year's guide contains our tax strategies for traders filing extensions. Late-filing and late-payment penalties are confusing, so we lay out the rules and strategies to avoid those penalties as best you can. To avoid penalties, make sure you use “good faith” to estimate your tax liabilities. Run TradeLog well before the extension deadline. We also cover what to do if you can't afford to pay your taxes owed.

Planning your taxes well before year-end is important for traders. Whether it's pre-paying state income taxes for an additional tax deduction (without triggering AMT or the 2013 Pease limitation), accelerating other expenses and deferring income and therefore taxes, it's important to get a handle on trader tax status, your trade accounting and other tax matters.

We have new content about post-fiscal cliff tax planning for traders as a result of the tax agreement passed on Jan. 3, 2013. In The American Taxpayer Relief Act, Bush-era tax rates and breaks were permanently extended for taxpayers making under $300,000 (married) and $250,000 (single). To avoid these Obama-era income tax hikes on the upper income, we offer new ideas to shift income to c-corporations and family members.

The ObamaCare 3.8% Medicare tax on unearned income starts in 2013 for taxpayers with AGI over $250,000 (married) and $200,000 (single). We explain how these new rules work in detail, focusing on what affects traders and investment managers in particular. One key point is that the tax applies on net investment income, so traders can reduce it by deducting all their trading and investment expenses, including fees or salaries paid to them and their spouses for administration services.

While administration fees or salaries trigger 3.8% Medicare taxes on earned income, we offer strategies to avoid Medicare taxes on both earned and unearned income: Use an S-corporation to receive the administration fees first, then reduce the SE tax with reasonable compensation and pay a smaller fee to Schedule C for the AGI deductions (retirement plan and health insurance premiums). For more on the new Medicare tax, see Appendix C.

We have several clients that got caught with losses in the sudden bankruptcies of futures brokers MF Global and PFG Best. Futures and forex brokers don't have government-backed FDIC and SIPIC insurance like banks and securities brokers, respectively. This guide covers the full spectrum of tax treatment available to business traders and investors.

Trade actively in your retirement plan and deduct your Section 212 investment expenses and losses within the plan, rather than suffer investment expense restrictions on your taxable account. Usually an intermediary trust firm is required to allow direct payment or reimbursement of investment expenses on behalf of the retirement plan. Or trade Section 1256 contracts subject to lower Section 1256 60/40 tax rates, since that is not predicated on having TTS.

If you have AGI deductions through another business, job or through your spouse, then you don't need a trading entity or to push the envelope on TTS. Also, if your trading business expenses are not material, don't push the envelope on trader tax status.

Proprietary trading vs. retail trading is covered in Chapter 12. The challenge for proprietary traders is deducting their business expenses, including home-office expenses. They're allowed to deduct these expenses even if they also trade from the firm's office.

LLC-member K-1 proprietary (prop) traders have difficulty with AGI deductions since their K-1s don't report any earned income, and it's hard to arrange that using a SMLLC S-corporation, as most firms only allow individual members. Independent contractor (IC) prop traders are issued a Form 1099-Misc for non-employee compensation. IC prop traders owe SE tax on their net income and AGI deductions are allowed since their compensation is earned income.

We also address how to handle education/prop trading firm hybrids and writing off education or deposits.

More traders are rising to the ranks of investment managers. Investment managers seek better tax treatment by using carried-interest tax breaks passed-through in their investment funds. They also reduce SE tax on management fees by using S-corporations. In recent years, Congress and the administration have threatened repeal of both of these breaks but so far, that hasn't happened. That may not last with tax reform and tax hikes in 2013. Learn more about investment management taxation in Chapter 13.

Many traders living in the U.S. have offshore trading and bank accounts to trade on foreign exchanges. Some offshore brokers encourage traders to form foreign entities as a requirement to get access or to set up a foreign brokerage account. Look before you leap: Tax compliance for a foreign entity is significant and there are few to no tax advantages for traders.

Traders with foreign accounts need to learn about Foreign Bank Account Reporting (FBAR), Form 8938 (Statement of Specified Foreign Financial Assets), controlled foreign corporations (CFC), sub-part-F income for foreign corporations operating in the U.S., foreign disregarded entities, Passive Foreign Investment Companies (PFIC), tax treaties and more.

Chapter 14 touches upon these topics, along with the IRS's “come clean” program, the Foreign Account Tax Compliance Act and CFTC regulations.

Many IRS agents still don't fully understand the nuances of their own complex and insufficiently defined rules for trading businesses. There is no bright line test. Don't let a tax exam (audit) spin out of control; seek to have it settled quickly, and get the IRS to accept your trader tax status before the exam gets too far along.

The IRS and state tax agents seem to be getting bolder and more aggressive, so it's wise to engage a trader tax expert CPA and/or tax attorney to help you from the first tax notice received. If you are a novice on taxes and don't have the right help, the IRS and your state may succeed in pushing you around.

Don't tell an agent trading is your hobby, as that will probably open the floodgates for a series of tough questions for denying hobby losses. It's important to let the agent know as soon as he or she broaches this topic that trading should not be considered a hobby loss under any circumstances.