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How to deduct a loss on the sale of your home, avoid debt extinguishment income in foreclosure and deal with abusive mortgages

Traders and others should start focusing on tax and legal planning in connection with declining real estate values and (predatory) mortgages.

Learn how to convert non-deductible losses on the sale of your home into ordinary loss tax deductions.

If you face foreclosure, learn how to avoid phantom taxable income on debt extinguishment by claiming insolvency.

Finally, did your bank or mortgage broker sell you a fraudulent mortgage that was the worst available product and can you get it fixed, without incurring too much pain? Read the NY Times Sunday 8/26/07 expose article on the (predatory) unsavory sales practices at Countrywide (the largest mortgage broker). Countrywide promised the “best” mortgage product, but highly compensated their brokers to instead sell customers the “worst” mortgage product. Isn’t that fraud?

Convert non-deductible home sale losses into ordinary and capital losses
There is a nasty flipside to the tax-beneficial rules of owning your principal residence. Yes, the capital gains are tax-free until you exceed the home sale exemption amounts: $250,000 for single status and $500,000 for married filing joint status.

But tax losses on the sale of your home are not allowed! Few taxpayers realize this unfortunate tax fact until it’s far too late.

If your real estate is not your principal residence, it can be deemed an "investment property" and normal capital gains and loss rules apply. But then the dreaded capital-loss limitation of $3,000 comes into play. Add stock losses with declining markets to the mix and you are again stuck with unutilized losses.

We saw a huge housing price correction before, in the late 1980s and early 1990s. Here's a nifty tax planning strategy that worked well then and should work great again now in this correction:

Rather than incur a non-deductible loss on the sale of your principal residence, convert your home to a rental property first (a short period of time can work) and then incur an (allowable) ordinary tax loss on Form 4797.

There are some nuances to this tax strategy, so check with an expert (such as our firm). When you convert your property to a rental property (income-producing use), you are supposed to use the lower of cost or fair market value (FMV). But FMV on an illiquid and unique home is not readably available, so there is some leeway here.

Avoid phantom income taxation in foreclosure
If you can't pay your mortgage and you suffer home foreclosure, understand that you will be given a Form 1099 for debt extinguishment income from your lender. That's taxable income on your tax return.

But there is a way out of this income. If you are financially insolvent (negative net worth) at the time of debt extinguishment, you don't have to report that phantom income. Many who face foreclosure are probably insolvent.

Demand that your broker and bank fix your mortgage
After you read the NY Times article on the alleged wide-scale abusive sales practices of Countrywide, you should examine your own mortgage loan terms carefully and consider engaging an attorney to help you. I am guessing these types of abusive lending practices are more widespread and not unique to any one mortgage broker.

Don’t think the term “predatory” only applies to sub-prime mortgages for lower income people. Reports of wide-scale lending excesses based on poor credit and highly risky loan terms (zero down payments) seem to support the position that abusive mortgage sales practices were used by many providers across the board, especially if the underlying loans could be repackaged as mortgage-backed securities and sold to unsuspecting investors. This process took the cooperation of several (knowing and perhaps conspiring) banks and brokers.

In my initial view, many mortgage holders can probably engage an expert to review their mortgage terms to hunt for conflicts of interest, compensation tied to selling them the inappropriate terms and other abuses.

These types of abusive lending practices seem very worthy of wide-scale legal attack by consumers and regulators (who are charged with protecting consumers). Maybe it’s not on the scale of asbestos and tobacco, but it’s still very important to millions of families. Fraudulent lending practices may not kill you from a health standpoint, but over-burdening fraudulent mortgages are destroying many people’s finances, which can go on to ruin families and health. Will families have to cancel health insurance to pay for fraudulent mortgage interest-rate hikes and endless fees?

I don’t think everyone should just pay for these abusively generated mortgages without a fight first. Will judges award home deeds to (perhaps fraudulent) abusive mortgage holders in light of this fiasco? I imagine that several law firms will start class-action lawsuits against these mortgage brokers and banks soon to get to the bottom of these abusive lending actions. Many mortgage brokers that have not already succumbed to market changes will go out of business to avoid this onslaught. In my view, this is Enron-like, only on a much bigger and wider scale.

If attorneys do attack mortgage brokers, don’t you think it’s “catching a falling knife” to buy mortgage lenders’ stocks now? Don’t misinterpret recent investment and loan support from larger banks to distressed mortgage brokers; that may be an effort to constrain legal attacks away from their own borders. Again, the mortgage brokers cooperated closely with other banks to package and sell these mortgage-backed securities based on carefully constructed excess (rather than reduced) risk. Isn't that a conflict of interest, too? Shouldn't the cooperating banks try to assemble lower-risk securities, rather than building excess risk? If the securities fail, shouldn't the seller of the securities be liable for the losses if they built in excess risk on purpose and did not disclose it (just to get more fees for themselves)?

This mortgage meltdown story is getting bigger, not smaller, in my view. I fully support the Federal Reserve Bank for adding liquidity and lowering the discount rate. In my view, that is putting out financial market fires (that can burn everyone), and that’s not a moral hazard. But it will be a moral hazard for regulators to interfere with (coming) legal attacks on mortgage brokers and banks that participated in these alleged abusive sales and business practices.

Here’s the bottom line:
If you have a brewing loss on a recently purchased home, consider converting it to a rental property, so you can deduct your loss for tax purposes. If you can’t pay your mortgage and you get foreclosed, don’t get hit with a tax bill on that phantom income by reporting insolvency. If you think you were subjected to abusive lending practices and you face high adjustable interest-rate hikes plus fees, seek legal help before proceeding.

Feel free to contact our firm for help. We can help plan and execute the above tax strategies. We can also refer you to legal counsel, although we don't know any law firms that have taken on this challenge yet.

Robert A. Green, CPA & CEO

Carried Interest Update

Special Topic: Follow-up on the Carried Interest debate.

By Robert A. Green, CPA & CEO of GreenTraderTax and GreenTraderFunds

We covered this hot topic on a prior conference call and on our blog. This debate is taking on feverish proportions on Wall Street, in Washington DC, in the mainstream media, and elsewhere.

Most coverage focuses on attacking the billionaire private equity and hedge-fund managers who benefit from the lower long-term capital gains tax rates (rather than paying ordinary income tax rates like almost everyone else on their working income). 

There has been little coverage of potential tax and market consequences for investors.

Here is one good tax question: If the carried interest is redefined as ordinary income for managers, will that reclassification also apply to investors? In other words, will investors face higher taxes as well because they need to deduct fees rather than have reduced capital gains? Consider that most investors don’t get the full benefit of incentive-fee deductions. We considered this question on a prior conference call and on our blog.

There’s good news on this front from one of our tax attorneys, Mark Feldman JD. Investors should not face any tax changes in connection with current Senate and House bills to revise carried interest rules.

• We looked at the House bill and it seems that we need not be concerned that the amounts paid on carried interests will be non-deductible to the investors who do not exceed 2 percent of AGI limitation. The bill does not treat this as a fee paid by the partnership but as a distributive share of the partnership's capital gains and losses; on the partner level, the manager/partner treats the income as ordinary income.

 

• The Joint Committee on Taxation (2007 TNT 133-9) explains the bill as such: 
  ”The bill generally treats net income from an investment services partnership interest as ordinary income for the performance of services. Thus, the bill recharacterizes the partner's distributive share of income from the partnership, regardless of whether such income would otherwise be treated as capital gain, dividend income, or any other type of income. Such income is taxed at ordinary income rates and is subject to self-employment tax.” 
  
  
• This also seems to the intent of the House bill, as it provides:
  "(a) TREATMENT OF DISTRIBUTIVE SHARE OF PARTNERSHIP ITEMS. – For purposes of this title, in the case of an investment services partnership interest –
  
  "(1) IN GENERAL. – Notwithstanding section 702(b) –
  
  "(A) any net income with respect to such interest for any partnership taxable year shall be treated as ordinary income for the performance of services.

Just attacking managers without hurting investors may make these tax changes more palatable for Congress.

But Congress should also consider that not all carried interest receivers are billionaires; many are regular, hard-working entrepreneurs (our clients) forgoing salaries to make a share of capital gains only when their investors also make those capital gains.

I think the more limited Senate bill to repeal the carried interest on the private equity firms going public is much smarter than the more wide-scale House bill attack on all carried interest receivers.

The House bill is not addressing a key tax-theory concept, which supports the long-standing carried interest tax break.

The underlying income in focus is the allocation of capital gains to the managers. This income is capital gain in the first place, so it doesn’t make much tax sense to re-characterize it as ordinary income.

Yes, there have been many tax shelter abuses over the years; where creative accountants, tax lawyers and brokerage firms have conspired to turn ordinary income into long-term capital gains with “tax products.” These tax shelters were rightfully busted. In most, they abused basic tax theory. They did convert ordinary income into long-term capital gains or no income at all, using phantom loss techniques.

 

With carried interest it’s entirely different. The underlying income is capital gains and it’s usually deferred. The managers are simply in the same boat as the investors – which is what the investors want – and they are receiving the same type of income at the same tax rates. There are no shenanigans here.

Don’t confuse that with some more advanced tax schemes in the Blackstone deal, where the managers get long-term capital gains and ordinary tax-loss treatment on amortization of goodwill. That’s over the top in my view, too.

If Congress strips long-term capital gains benefits from private equity firms, these firms may have the incentive to get out of their investments even faster – in less than 12 months, the holding period required for a long-term capital gain. We should encourage longer-term investing.

Democratic presidential contender John Edwards was one of the first political heavyweights to attack the carried-interest benefit and he now seems to be using it to galvanize his wider campaign to attack the Bush tax cuts.

But how much credibility does John Edwards have on tax issues? Didn’t John Edwards avoid payroll tax on more than $50 million in legal fees by running those legal fees through an S-Corp, which is not supposed to be used by professionals? Senator Hillary Clinton won kudos for her health care initiative in the early 1990s and she is credited with the idea for the Medicare (payroll) tax of 2.9 percent applying to all earned income, not just the social security base (currently $94,200).  Senator Clinton is also attacking the carried interest tax rule.

New York state senator Chuck Schumer, the protector of Wall Street, seems to be alone in trying to safeguard the carried-interest breaks. He says what’s good for the goose should also be good for the gander, so also repeal the break for oil and gas and farms – which he knows have even greater political protection in Washington. 

But Schumer may feel too much political heat and have to capitulate soon. He is in charge of raising money for the Democrats to win the White House, and if this issue is the rally cry, how can he be caught in this hypocritical predicament? Is Schumer just defending his constituency and supporters with lip service to keep his stripes?
 
At this point, the debate is taking on French Revolution proportions, and it’s going to be hard to stop the riotous mobs. The private equity and hedge-fund managers are being painted as Aristocrats, who were tax-free. That is counter to our tax system in place from day one – graduated progressive tax rates, intended for the rich to pay more.

It’s just too easy to rally Main Street against Wall Street now. The perceptions reinforced by media de jour are that Wall Street is up to its dirty old tricks again. Buying and selling Main Street with reckless abandon, using junk bonds and big-city bank financing, to carve up assets, equity, jobs and people with little care for the long-term.

This political attack has two mutually supporting goals: Win votes on Main Street, since those voters greatly outnumber Wall Streeters; and win political campaign contributions from Wall Streeters desperate to hold off this tax change.

I have many concerns about the private-equity craze underway and some fears on how it might play out in our markets and economy. Take a look at my reply on the New York Times Deal Book on this issue, at the bottom of this article.

Why did U.S. stock markets tank the week of July 23-27? Was it because these issues are real and it’s a problem and/or because Wall Street is sending a warning shot to Congress to stand down.

U.S. Treasury Secretary Paulson is the ex-CEO of Goldman Sachs, the pre-eminent Wall Street firm with a great stake in private equity and hedge funds. Secretary Paulson has said the attack on the carried-interest tax break is a mistake because there will be collateral damage. He suggests more careful study first. Secretary Paulson also serves at the wishes of President Bush, who has defined himself as the tax cutter on investment gains – and he considers that to include carried interest (both in the oil patch and on Wall Street).

Remember the old axiom: The Japanese sell Americans Toyotas and Americans sell the Japanese U.S. T-bills, along with U.S. arms to defend shipping lanes and oil supplies.  The Chinese sell Americans almost everything (Wal-Mart is their fifth-biggest trading partner) and Americans also sell the Chinese U.S. T-bills.

Does the T in T-bills stand for tribute? American power is based on freedom as an ideology, but also as a money concept with free-markets and free flows of money around the world (global trade and investing). Can Washington politicians, the seller of T-bills, really attack Wall Street, their partner in profit in selling T-bills and American stocks around the world?

Let’s ask the original great hedge funder turned philanthropist and economist and now Democratic campaign sage (founder of MoveOn.org), Mr. George Soros. I really liked his book that included his new concept on market “Reflexivity.”  Perhaps, Soros learned this concept when he almost successfully shook down the Bank of England in the early 1990s by attacking the British Pound. Some argue this led to the Euro, which protects European currencies from speculator attack. 

Soros realized that what matters most is putting out market fires fast with whatever it takes to prevent a wild financial fire from spreading out of control. He also realized that governments should not stand on theory, precedence or political gain, they should just put out the fire. Reflex leads to another reflex, which leads to another small change, which finally fixes things.

I wonder what George Soros has to say about the carried-interest debate now. It can be argued that the U.S. bull market is on its last legs and the U.S. is struggling with high debt loads and bad press around the world. In can also be argued the Asian tigers can jump ship on their T-bills for product exchanges anytime soon. Is it wise to have a French Revolution on Wall Street now?

In my view, a strong argument can be made for taxing gains earned by deal-makers (in private equity, hedge funds, real estate, oil and gas) as ordinary income.

The Bush tax cuts did create an even bigger gulf between ordinary income tax rates and long-term capital gains (20 percent), which caused (over-the-top) tax professionals and private “wealth managers” (the deceiving Wall Street title) to become tax alchemists, turning higher tax rates into lower ones.

My beef is politicizing this issue now and garnering a mob mentality, with little regard for the true underlying tax concepts and potential collateral tax and market damage.

Look at the Sarbanes-Oxley (SOX) experience. The debate at that time was how to fry the Enron, WorldCom and other corporate abusers and prevent that type of corporate fraud from every happening again. SOX socked it to U.S. corporations and it’s been an employment act for accountants and attorneys, which contributed to the private equity bonanza. 

Young and/or distressed mature companies couldn’t afford SOX compliance costs and oversight, so some succumbed to the private equity wolves. Private equity firms repackaged these companies into a fund-of-fund private equity firm, which itself later went public with reduced SOX compliance costs and oversight. This is a classic case of over-regulation and fiscal policy having unintended and equally bad outcomes.

It’s a funny thing about regulation and high taxes. They push activity to lower-regulated areas and lower taxes. Look at my article in Active Trader a few years back on hedge funds. I argued that hedge funds were the least regulated financial service firms and financial impropriety would seek them out. Private equity firms are just like hedge funds in this regard, and they even help each other in their pursuit of profit. http://www.greencompany.com/HedgeFunds/ActiveTraderGreenHedgeFundsJan2006.pdf. Hedge funds assemble voting blocks and then vote for private equity firm takeovers.

Great fortunes with great impropriety built America, and they also built Britain, France, and now China and Russia. Attack the fortune makers and they will find friendlier jurisdictions and new ways to practice their craft. These days, it’s easier than ever for money to flow offshore and then back again in the guise of offshore funds. Let’s be smart about these changes and not have carnage and blood in our Wall Streets.

 

Media attackers of the carried-interest and private-equity players base their argument on the perceived fact that private equity firms are not risking much money (or really anything at all) and therefore don’t deserve capital gains treatment (or any special treatment at all). Others argue that managers are just collecting income from their services, no different from those who earn a salary.

These perceptions are flawed. Private-equity firms are risking their hides, just like the Enron and WorldCom managers. If they rape and pillage an underlying company, or don’t perform as they represented, or their deals just blow up, they can be sued for tremendous sums and even face jail time. In my book, that counts as plenty of risk capital. Certainly more than most who collect ordinary income in other jobs and professions. Yes, doctors, lawyers and accountants have risks, but they also have professional liability insurance, and it's not on the same scale of risk, in my view.

Which one of the media pundits is ready to quit their job, form their own media property or blog, forgo a salary and try their hand at the capitalist dream?

 

 

Robert Green’s entry on the NY Times Deal Book blog on June 8, 2007, in reply to an article on the excesses of private equity:

Deja Vu. In the go-go late 80s, Drexel’s junk bond LBO craze crashed and burned when a recession coupled with higher interest rates crashed the brilliant young MBA’s worksheets (forecasting profits). These worksheets were the entire basis of many M&A deals (not real-world reality). Declining company profits could not cover rising interest payments and many deals were unwound.

No problem for Wall Street. They advised the underlying companies on the original deal and were paid to restructure the deals for banks, many of whom were bailed out by taxpayers in the simultaneous real estate crash. Wall Street eventually took many of these companies public again in the returning go-go 90s.

The current spin on this same old story may have started with over-reaching SOX, intended to put out Enron “off-balance-sheet” type fires. It’s sadly ironic because this has led to a rush to be private to avoid SOX and go even more off balance sheet. Just imagine the schemes and deal-making that private equity firms can cook up with their Wall Street and banking brethren, outside of the public’s view, with little reporting to private equity investors and not enough real business players at the table. Enron shareholders could sell, but private equity firm investors rarely can with lockups.  

Here’s the big problem and question: Do you really think the private equity firms can run these target companies better than the existing management and ownership? I seriously doubt it. Private equity firms’ management is being stretched very thin with the rash of deals and their managers are trained as traders and deal-makers, not operating company managers. It’s easy to insult management, but much harder to make a product that customers want to buy in a profitable way for the company over the long-term. Plus, private equity firms add on layers of fees and are accustomed to manipulating companies as suits them best.

 

Don’t worry just for the investors, worry for the workers in these target companies. It’s Enron all over again, with disappearing jobs and pensions and wrecking of long-standing established companies.

 

Yes, lots of existing management sticks around, but the entire chemistry is off and existing management is not given enough say.

I view these private equity funds as becoming similar to a class of Funds of Funds, as they exist in the hedge fund space. Again, there are probably lots of added fees and conflicts of interest draining the underlying target companies.

Funds-of-Funds hedge funds and private equity firms are competing to rush to market themselves as the next high priced IPO. They are rushing together portfolios, and their MBAs are crunching worksheet numbers to dwarf the Drexel junk bond guys.

All industry players have a stake in building this house of cards. It’s all transaction canon fodder for NYC’s financial power machine, made up of private equity, Wall Street, banks, big accounting and law firms, and their supportive institutional and wealthy private investors.

 

As you stated, this craze is putting pressure on other public companies to initiate and continue major share buybacks.

This has the effect of reducing the available stock to buy publicly, which is classic financial inflation – more demand and less supply.

SOX has not cleaned up the playing field or reigned in the players, it’s only moved the game into a new arena – private equity and hedge funds.

In my attached article for Active Trader, I pointed out how financial impropriety moves to the least-regulated entities like hedge funds.

To date, everyone is winning this game including hedge-fund investors (sellers), the private equity buyout companies (buyers), the banks (enablers), the service firms (selling the gold picks and shovels) and even online traders (based on hype with volatility).

But these types of cooperative power plays based on hype usually end badly for many investors.

If things turn bad – as you point out from rising interest rates – how will investors in private equity funds and hedge funds sell their interests? The answer is they are locked in usually and they won’t be able to sell. How convenient is that for the power players? SOX and liquid securities protect investors, but few investors are protected in hedge funds and private equity funds.

Plus you rightly pointed out that bond investors in these deals may rush to sell and drive up interest rates even further.

Carried Interest in Jeopardy

Special Topic:
House Democrats Propose Bill to Tax Carried Interest at Ordinary Rates.

Warning! If this proposed tax bill is enacted, many advisors and investors in hedge funds will face significantly higher tax liabilities.

Money managers typically charge 2-percent management fees and 20-percent incentive fees or "carried interest" profit allocations.

By treating an incentive fee as a carried interest in a fund, advisors are able to subject the lion's share of their compensation to lower long-term capital gains tax rates; plus they significantly reduce their income subject to self-employment (SE) taxes.

Recent media reports of billion-dollar pay days for hedge fund and private equity firms going public is attracting U.S. and UK government tax officials to attack (and possibly repeal) the precious "carried interest" tax loophole.

An obvious reason is to repeal what's deemed to be an unfair special tax break for the (perceived) super rich. But these rule changes will also raise the tax bills for many investors in these funds. Perhaps tax officials also consider these investors fair targets for tax increases.

Currently, the tax advantage of a hedge fund vs. managed accounts is that an advisor can receive a "carried interest" or profit allocation in lieu of an incentive fee. Conversely, with a managed account, an advisor can only receive an incentive fee.

Incentive fees are taxed as "ordinary income," plus they are also subject to SE taxes. Ordinary income tax rates are far higher than long-term capital gains tax rates; ordinary tax rates currently rise to 35 percent (and political winds indicate they will be raised soon) while long-term capital gains tax rates are as high as 15 percent -- that's a 20-percent tax rate difference! SE tax rates are 15.3 percent of the SE tax base ($94,200 for 2007) and 2.9 percent on all income above that base. So the maximum tax difference at stake here can be 35 percent (20-percent income tax plus 15.3-percent SE tax); a huge amount for taxpayers.

By structuring their hedge funds with a "carried interest" rather than an incentive fee, advisors were able to treat this compensation as a capital gain, which also means there is no SE tax to pay. These capital gains are often subject to lower tax rates; 15 percent if a long-term capital gain on securities held longer than a year, and 23 percent if on IRC 1256 contracts with 60/40 treatment. Many Forex funds have futures treatment, too, since they elect out of IRC 988 (the Forex rules).

Investors will be hurt too.
Unless a hedge fund qualifies for "trader tax status" (business treatment), it's taxed as an investment partnership. In that case, compensation/fees paid to advisors are reported on Schedule K-1 as "deductions from portfolio income."

Investors report these fees as "investment expenses" under miscellaneous itemized deductions. Unfortunately, few investors wind up with tax savings in connection with investment-expense deductions. First, investment expenses are subject to a hurdle of 2 percent of adjusted gross income. Second, there is an itemized deduction phase-out. Worst of all, investment expenses are not deductible at all for the Alternative Minimum Tax (AMT), which is snagging many hedge fund investors as their income levels fall into the AMT ranges.

With a carried interest profit allocation, an investor just reports a lower capital gain amount, which is tantamount to a full tax deduction. It's much more efficient.

What advisors may want to do if these rule changes are passed.
In some cases, advisors can reduce SE taxes by using an S-Corp. rather than an LLC. SE income passes through an LLC (partnership tax return) but not an S-Corp return. The IRS does look for reasonable compensation (salaries with payroll taxes) in an S-Corp, but not for the full income amount. Current guidance talks about a 30-percent to 40-percent salary-to-net-income percentage.

If advisory fees and net profits are multi-million dollar amounts, a case can be made that only a portion of the income is subject to SE tax in an LLC, considering some of the income is being derived from the brand and capital rather than services.

Tax planning is complex and important, and we recommend a consultation with us to pursue the best plan for your situation.

There are some other ideas too.
An advisor can look to sell their management company, which still gets long-term capital gains rate treatment.

More information.
For more background information on current tax rules for advisors and fund investors, see Robert Green's article, click here.

For more information about these current tax bill proposals, click here or Google "carried interest."

 

PROPRIETARY TRADING FIRMS - SPECIAL NOTE ON THREATENING REGULATORY DEVELOPMENTS

October 1, 2006 News Update, by Robert A. Green, CPA & CEO

Join our free conference call October 5, 2006, Thursday, 4:15 - 5:15 pm ET to discuss these important matters. Click here to learn more.

The NASD and Securities and Exchange Commission recently declared some smaller proprietary day-trading firms to be in violation of Regulation T margin rules, which determine the borrowing power a trader has at a given moment.

The regulators appear to be selectively forcing targeted firms – on a case-by-case basis rather than through published guidance – to immediately comply. Targeted firms face a stark choice of either quickly restructuring their operations to cure the violation or eliminating their prop trading activity.

The NASD and SEC have substantial legal authority and it is unlikely any court will overturn their jurisdiction. It’s been our opinion for the past several years – while these and other related issues were evident – that the prop trading industry is living on borrowed time from the regulators.

In 1998, there were more than 100 prop trading firm broker/dealers, and now there are only a few left. Most have exited the business for a variety of reasons, including regulator actions, connections with hedge fund investments and more.

Regulators have indicated they are now applying more stringent rules but, again, that’s on a case-by-case basis, during audit or enforcement proceeding.

We are not ringing an alarm bell yet. We have no indication if wider industry application of these more-stringent rules will happen anytime soon.

Are deposits going to be barred for prop traders?
Previously, traders’ deposits – cash deposited to guarantee performance with the prop trading firm’s guidelines and, in some cases, used to start an account from which the trader’s losses are deducted – were allowed in prop day-trading firms in all three current business models (employment, independent contractor, and LLC K-1).

We understand that regulators want to bar deposits across the board. Deposits will be allowed for retail customer accounts only.

Regulators seem bent on considering deposits in prop trading firms to be disguised customer deposits. If the relationship is customer/broker rather than prop trader, the firm must apply the Reg T margin rules, with much lower margin allowed than in a prop trading firm. The implications for this change are fundamental and striking.

Transaction fees and commissions are a problem, too
Regulators don’t like prop-trading firms charging their prop traders for transaction fees (commissions).
That resembles the broker/customer relationship.

Will prop traders have to share in firm-wide profits?
The predominant prop day-trading firm model is the LLC K-1 model (learn more below).

Fundamental to this model is that prop traders are separate ownership class members in the LLC, and each trader shares only in their own trading profits.

Firms allocate between 60 and 100 percent of each trader’s respective gains and losses to their own sub-trading account within the firm. Law articles on this subject have concluded that payouts over 80 percent are too high and again resemble a broker/customer relationship.

The problem regulators have now is much more fundamental, it seems. Traders do not currently share with other traders in the firm and they also don’t get a share of trading commissions earned by prop trading firms organized as broker/dealers.

Regulators say they want to bar special allocations in this manner and only allow firm-wide sharing of profits and losses.

If this is true, it would probably be a deal killer for the prop trading firm industry. Very few traders would want to share in the losses of a neighbor trader within the same firm and very few firms would want to share commissions with their prop traders.

How might day trading prop trading firms reorganize?
These firms could adopt the proven models used by large Wall Street broker/dealers with significant proprietary trading divisions.

Hire a prop trader as an employee and do not require a deposit. Pay that trader a hefty wage bonus based on their contributions to profits in the firm.

If that employee trader becomes highly successful for the firm, offer them ownership in the firm. It’s that simple!

Or, firms might revert to handling retail customer accounts and charge for a long list of services offered to their traders. They could charge for office space, community, training, risk management systems and, of course, commissions.

But can retail traders make a good living?
Some firms argue that retail traders cannot make a significant income with the current margin rules (4-to-1 for pattern day traders).

We have hundreds of retail traders who do make a good living. We do agree that leverage can be helpful in making more money on a smaller capital size. But leverage comes with risks, too. There are other changes brewing in the margin rules that can help retail traders (hedging margin and more).

The history
The proprietary day-trading firm industry involves very active trading in equities and, sometimes, equity derivatives and futures using the firm’s capital.

Requiring deposits from traders is what sets prop firms apart from major brokerage firms on Wall Street, who have large profit-centers from prop trading activities, too.

Major brokerage firms pay their prop traders as employees with annual W-2s (wage reporting statements), and the firms rarely require employees to make good faith deposits. Come bonus time, the firms look to each trader’s individual trading results, or more commonly as part of an employee trading pool, and wage bonuses are a significant part of a prop trader employee’s annual compensation.

This is in stark contrast to most prop day-trading prop firms that require deposits from traders before they allow them to join a firm to trade – usually as an LLC member, and in some smaller firms as independent contractors or employees.

Another key difference is Wall Street firms pay traders from a bonus pool, whereas prop day-trading firms pay traders a high percentage of what a prop trader makes in a separate sub-trading account. Plus, prop day-trading trading firms charge their traders for their losses, by applying losses against their deposit accounts and requiring prop traders to replenish their deposits with the firm.

Another problem that occurred in prior years – and it’s mostly been corrected by regulators – is that some prop day-trading firms counted these deposits in their net capital computations, and that was not proper.

Connect the dots between trading gains and losses and deposits and you can understand why regulators have concluded that in some cases, firms are disguising retail/customer accounts and violating the Reg T margin rules in the process.

Regulators may act selectively but forcefully
Regulators may force selected firms on a case-by-case basis (either during an audit or enforcement process) to change how they do business or cease doing business in their current manner.

Unfortunately, once regulators act, it’s often immediate and dramatic. Prop traders and firms will need more time to restructure. This may be why regulators are rolling out these changes (apparently) on a selected basis. That begs the question – is this arbitrary and selective enforcement, and is that proper?

Ask your firm what’s going on
It’s wise to consider asking your firm’s management about these matters. You may find it advisable to reduce your deposit size or even do away with it. Also, it may be wise to draw as many of your trading gains as possible out of the firm.

Can you consider retail trading if need be? Forming a hedge fund is another way to trade other people’s money. Learn the differences below between prop trading, retail and hedge funds.

You don’t want to have your capital and trading access frozen by regulators before you can do anything about it. Once the regulators act, you may not hear about it until it’s too late. Most firm managements do not disclose these matters to their prop traders, even though they may be LLC owners. Lower classes of ownership do not have a seat at the table.

Most firms don’t allow overnight positions and, presumably, their deposits are kept separate from net capital. They should be able to comply with any strict regulatory action without putting your deposit at risk. But your trading access could be denied nonetheless.

Remember Refco and Worldco
Read the stories about the demise of Worldco (a large prop day-trading firm) and Refco (who also had some prop traders) and learn those lessons.

Some of Refco’s prop traders sought government insurance from SIPC for lost deposits, claiming they were disguised retail customer accounts. Prop traders don’t get SIPC insurance, but retail customers do. The Refco demise may have been a rallying cry for the regulators to take more concerted action per above.

Here are the current business models and how they may be changed by regulators
Note that regulators have been forcing other changes on this industry for many years, but these new changes appear to be much more fundamental with potentially drastic consequences.

Employment model: All or some of the prop traders can be employees of the firm and receive IRS Form W-2 (wages).

The employee model appears to continue to pass muster with the regulators, but deposits from prop traders may no longer be allowed (again, on a case-by-case basis during regulatory audit or enforcement proceedings).

Now we will see how many firms are truly offering “jobs” (with W-2s) to traders. In the past, we pointed out that some job ads were really “come-ons” to attract deposits and earn commissions and other fees for the firms.

LLC K-1 model: All or some of the prop day traders are LLC members of the LLC prop day-trading firm and receive a Schedule K-1 (share of partnership income) based on “special allocations” of their specific trading profits in the firm.

Management of the firm (the true owners) own Class A shares, and prop traders own a lower class, like B, C or D. Only Class-A members share in firm-wide profits.

Regulators may only allow this LLC K-1 model going forward if the firm allocates profits to members on a firm-wide basis and doesn’t bar the prop trader classes from sharing in these profits.

This apparent new requirement could render this LLC K-1 model unattractive to both firms and trader alike. Firms may not want to share commissions and other profits with prop trader LLC members, and the prop traders may not want to risk sharing in losses caused by other traders in the firm.

This LLC K-1 model has been the most prevalent for larger prop day-trading firms, so we are concerned about how regulatory enforcement actions might upset the industry in this regard.

Independent contractor model: All or some of the traders are independent contractors and receive IRS Form 1099-Misc. (with Non-Employee compensation or Other Income boxes checked).

Regulators apparently don’t want these relationships at all going forward. Most broker/dealers went away from this model, but smaller boutique non-broker/dealer LLCs use it. Again, no deposits will be allowed.

Non-broker/dealer prop trading firms
The industry has also grown a branch of smaller boutique prop trading firms that are not broker/dealers. These smaller LLCs recruit prop traders who are not licensed brokers and allow lower deposit requirements; usually $3,000 to $10,000.

These smaller firms fly below the regulators’ radar screens since they do not file reports required from broker/dealers (FOCUS reports and more). One particular problem for these smaller non-BD firms is that their managers may “quote rates” – commissions and transaction costs. Only brokers can quote rates, so this is an illegal activity and the regulators are concerned with it.

Some larger prop day-trading firm broker/dealers utilize many smaller boutique non-broker/dealer LLCs to recruit more trading and business. An entrepreneur prop trading broker in the broker/dealer firm spins off his own “sub-LLC” to recruit smaller non-broker traders with lower deposit amounts. That broker may quote rates and it can be troublesome.

What one large firm says about this story now?
We spoke with one large prop day-trading firm and they say the regulators are not pressing these issues with them at this time.

Perhaps this is the reason the regulators are dealing with this issue on a case-by-case basis – so they don’t cause havoc overnight in the industry.

That’s the name of the regulatory game over the past decade – be careful not to upset markets and keep the lid on changes (George Soros’s concept of "Reflexivity").

Paperwork is not always reality
In all the above models, the prop traders sign lengthy detailed agreements provided by the prop day-trading firms in which the trader agrees that he or she is not a “customer” of the trading firm (but, rather, an employee, independent contractor, or member, depending upon the structure used).

Just because a trader and a firm call a deposit what they like doesn’t mean the regulators cannot call it what it appears to be in their view – a disguised customer deposit. However, for the regulators to succeed on this view in court, they might have to show that the traders are “disavowing” (i.e., reneging) on agreements they entered into as consenting adults.

Older writing from before the news above
In certain cases, the trader must place funds in a type of surety account, in effect, to ensure that when they trade the firm’s capital they do not act recklessly, because their account can be depleted. In some cases, the trader agrees to be liable for trading losses incurred by the firm arising from the trader’s activities, above the amount placed in the surety-type account.

For some time now, we have been advised that the NASD is investigating proprietary trading firms, on a case-by-case basis, regarding the proper characterization of traders as traders or “customers.”

We recently learned that the NASD, acting in conjunction with the SEC, acted to force one or more prop day-trading firms to revise their model as laid out in general above – to either treat their traders as retail customers or conform to the limited ways of carrying on a prop day-trading firm activity.

The NASD reviews were sparked by the actions of some former proprietary traders of Refco Inc. These traders argued that they were customers of Refco, not traders, because when Refco entered bankruptcy, they would have a better position in the bankruptcy court. In addition, as customers they could claim SIPC insurance for brokerage accounts. While we wait for the wheels of justice to grind on further, proprietary trading firms and traders would be well-advised to review very carefully the structure of the firm, the rights and liabilities of members, and regulatory developments. Our recent news stated above is a call for immediate action.

It is a fact of life in this industry that proprietary trading is viewed with disfavor, even downright suspicion, in some quarters. Monitoring developments, therefore, is a must for all concerned.

Even before the Refco Inc. bankruptcy, we alerted the prop trading industry to this same concern. Click here to follow our prop trading industry news.

Proprietary Trading compared with Retail Trading and Hedge Funds
You can trade actively in a number of different ways: retail, proprietary trading, or in a hedge fund.

• Retail trading: The majority of business traders open their own "customer accounts" with a direct-access and/or online brokerage firm. They are known as "retail traders." Active retail trading often triggers the "pattern day-trader (margin) rules," which sets minimum account sizes of $25,000.

We cover all the tax and accounting issues for retail business traders on our site and in our guides. Retail business traders also need to do their own accounting using our recommended GTT TradeLog and general ledger programs, such as Quicken, for their expenses. Retail traders are entrepreneurs who are entirely on their own.

• Proprietary trading: This phrase was originally created when larger full service Wall Street brokerage firms and other financial institutions employed traders to trade their capital. However, don't confuse this “true” type of employee prop trading with the general proprietary trading industry, which evolved from the day-trading firms of the 1990s. Most prop traders that are members of, or work in, a "proprietary trading firm" are asked to risk their own capital in front of the firm's capital. They are not employees with a job on Wall Street!

These proprietary traders are very much like retail traders because, in reality, they are risking their own money. The big difference is that these prop traders have access to far greater leverage than retail traders, who have 4-to-1 leverage or margin under the pattern day-trader rules and 2-to-1 otherwise. Proprietary traders often get 10-to-1 or 20-to-1 leverage because a proprietary trading firm may allocate money to traders within a firm however it likes. Broker/dealer prop trading firms are limited to 6-to-1 leverage overall.

• Hedge fund trading: There is a third way to trade: in your own hedge fund. This is truly trading "other people’s money." GreenTrader helps start up hedge funds. Hedge-fund manager/traders usually earn a 20-percent profit allocation or incentive fee on new high net profits, plus a 2-percent management fee, based on funds under management.

New traders need to build an excellent performance record in the business before they can be successful in a hedge-fund business. The GreenTrader Incubator Fund strategy is a great way to start building your historical performance record at very low cost.

Although a proprietary trading firm's sales pitch may imply otherwise, these types of proprietary traders are not really trading "other people's money" but rather risking their own money to cover their own trading losses (generated in sub-accounts of the firm) and paying for their own expenses incurred within the firm (such as margin interest, training, office usage, and more). In the majority of cases, the firm does not ultimately pay for any of the traders’ losses and expenses.

This is the opposite of proprietary trading on Wall Street where the firm pays for all losses, expenses, and salaries to the trader. Proprietary trading firms do not pay salaries, and the traders lose their own money. So, using the term "proprietary trading" is deceiving.

"Entrepreneur proprietary traders" risk their own money in the same manner a "retail business trader" does. The big difference is that entrepreneur proprietary traders have access to more leverage than retail traders do. A better phrase would be to say a proprietary trader is "trading other people's leverage."

Proprietary trading firms’ sales pitches can sound very attractive to business traders who believe they do not independently have sufficient risk capital and leverage to make a living. Joining a firm to get access to "other people’s leverage" is the main attraction here.

Caution: Leverage can be expensive and dangerous. Leverage is not free; you must pay market interest rates for using the firm's capital. Trading with too much leverage can burn you out of positions faster and with bigger losses.

A key point to understand upfront is that proprietary trading firms will strictly police how you use their leverage. These firms know they are attracting many unsophisticated (and new) traders and they strictly restrict your trading privileges. Almost all firms disallow overnight positions. They limit the securities you can trade, and they will force you out of positions when they like.

Some prop traders flourish under these restricted conditions, and they appreciate the firm's oversight and discipline. They do well with leverage, but many others burn out faster with leverage and lose their initial deposits and much more. Before you join a proprietary trading firm, carefully read the fine print and understand what you are getting into.

It also is important to learn about how tax issues differ between proprietary and retail traders. Like retail business traders, entrepreneur proprietary traders can deduct their business expenses (outside of the firm) with "unreimbursed partnership expenses" (UPE) deducted on Schedule E (if they are LLC members of the firm), or as business deductions on Schedule C (if they are independent contractors of the firm).

Proprietary traders must maintain deposits of $25,000 or more if the firm is a registered broker/dealer. These firms require their proprietary traders to have a current brokerage license. Most firms require that a proprietary trader join as an LLC member. Some still allow independent contractors and/or employees. Smaller boutique prop trading firms are not organized as broker/dealers and are not members of an exchange. These firms allow lower minimum deposits, and they do not require brokerage licenses.

Retail and prop traders' share many tax benefits in common, but there also are many important differences. Learn the special rules for prop traders in the proprietary traders section.

Remember, your interests are not fully in line with the firm's interests. The firm earns significant commission income on your forced hyperactive day trading and you only make money when you generate consistent trading gains. You are not taking a job with a salary.

Compare having your own hedge fund with proprietary trading. In a proprietary trading firm you can receive between 60 percent and 99 percent of your trading profits, which is considerably higher than the 20-percent profit allocation in a hedge fund. But with a proprietary trading firm you have much greater risk. You are responsible for 100 percent of your losses in a proprietary trading firm whereas in a hedge fund you are not responsible for any losses. Again, the proprietary trading firm has many restrictions on your trading, whereas you write your own trading program in your own hedge fund. Moreover, with a hedge fund, you can hold positions overnight, which is the norm for hedge funds; plus, an entrepreneur can gain more value over the long term by building a hedge-fund brand.

The bottom line is that there are many ways to trade, and you should choose which informed way is best for you. Note that proprietary trading tax and business issues are complex and highly nuanced. Few professionals understand all the issues, but our professionals have many of the answers you need. Whether you are joining a prop trading firm, or operating a firm, we can help you.

Use this section on proprietary trading to learn the ins and outs. When you are ready for our help, go back to our business traders section to learn more and sign up for consultations, preparation, entity formations, retirement plans, IRS exam representation, and more.

There also is an entire chapter on proprietary trading in Robert Green's book, The Tax Guide for Traders, published by McGraw-Hill. Click here to learn more and buy the book online.

Some of our leading tax attorneys provide legal services to prop traders and prop trading firms through their independent law firm.

We cover the proprietary trading industry looking for stories that can impact our clients. Click here to read some of the stories we are working on.

Please also email us any comments you have about the industry and the new developments above.

If you have any questions or comments about propriety trading, feel free to contact us. We look forward to working with you soon.

Robert A. Green, CPA & CEO

Famous MTM election case brewing

Right on the heals of the recent trader-friendly Vines tax court decision - granting MTM to a trader who the court says deserved it - famous hockey star Jagr is suing his former accountant to build his case for MTM ordinary loss treatment. Millions of dollars in taxes are on the line.

Read the below article in the newspaper and my email to the author. I also offered help to Jagr's attorney. Let's see what happens in this interesting case. I will write more about it soon, this is a quick blog post tonight.

http://www.pittsburghlive.com/x/pittsburghtrib/sports/penguins/s_465310.html
By David Conti
TRIBUNE-REVIEW
Wednesday, August 9, 2006

Dear David:

Nice story but it’s got some incorrect facts.

A business trader needs to elect mark-to-market (MTM) accounting IRC 475 by April 15^th of the current tax year and then file a Form 3115 (Change of Accounting Method) by the due date of that year’s tax return including extensions – in order to deduct trading losses as ordinary rather than as capital losses.

Thousands of active traders have gotten stuck with capital loss limitations ($3,000 on an individual tax return); in fact it’s the biggest pitfall for active traders.

Only qualifying business traders – who qualify for trader tax status – may elect MTM and use it on their tax return.

The IRS rules for qualification for trader tax status are vague. In general, figure a trader needs to trade every day all day. Traders with other jobs can qualify, but the bar is raised to combat IRS prejudice.

Many CPAs and other tax preparation professionals did not know the rules a few years ago – more know them now – and it was common for tax preparers to miss the election deadline. It was also common for tax preparers to (sometimes incorrectly) assume their client did not qualify.

Jagr says he turned over all forms to his accountant. If Jagr or his accountant filed a proper MTM election on time, the IRS has a copy of it. So lost paperwork is not an valid excuse. Did Jagr also file a Form 3115; apparently not.

The IRS is rejecting Jagr’s new accountant’s appeal for trader tax status and MTM. Trader tax status can be claimed after the fact, but MTM must be elected on time and it was apparently not done. A recent tax court decision (Vines vs Commissioner) has probably emboldened Jagr’s attorney to try and obtain MTM for those old years. 

Jagr says he needs an "Election to be treated as an occupational trader" for his appeal. That is incorrect; he needs an "Election of IRC 475 MTM.”  You don’t elect trader status, you claim it, and its okay to claim it after-the-fact, while a tax return is still open – 3 years after filing.

This sounds like Jagr and his new professionals are using hindsight from a tax court decision (Vines) to gain MTM and a better tax posture.

It will depend on what Jagr instructed his prior accountant to do and I think it's too late after-the-fact to win this case; even considering the Vines victory. Before Vines, no way no how could Jagr win this case.

See my blog on the Vines tax court victory on May 12, 2006. Go to the archive section of the blog.

Feel free to call me with any questions.

Robert A. Green, CPA & CEO
Customer Service: 877-662-2014 (toll-free), or 646-216-8061
Author of The Tax Guide for Traders published by McGraw-Hill
Green & Company CPAs, LLC www.greentradertax.com www.greencompany.com

Forex Tax

Uncertainty in the tax code makes tax filings for forex traders very confusing. Fortunately, GreenTraderTax is making it easier for currency traders to make smart tax decisions.

Use the links below to access the following articles, interviews, and other content from GreenTraderTax. See why the media (and also the leading forex brokerage) look to GreenTraderTax for clarity in the confusing world of forex taxation.

Matthew Swibel, “Betting Against the Dollar,” Forbes Magazine, International Investing Guide (July 24, 2006), quotes me on the taxation of gains on currency futures.

Robert Green, "In-Depth Tax Information for Traders Including Forex," on the Robin Dayne Show, VoiceAmerica Radio (July 5, 2006).

Radio show with Robert Green on Forex Trading Taxes, TraderInterviews.com (April 3, 2006).

Robert Green, Workshop on "FX Trading & Taxes," Currency Trading Expo. (June 3, 2006).

Robert Green, "Trading Across Borders: The Tax Issues," SFO Magazine (February 2006).

Robert Green hosts the Forex Tax Forum on DailyFX.com. Use the link on the right to visit the DailyFX Tax Forum. Several other leading forex sites soon will be distributing GreenTraderTax's Forex Tax and Forex Fund content as well.

Robert Green will be giving a workshop on forex taxation at the Forex Trading Expo in Las Vegas, Nevada on Friday, September 8th from 2:00 p.m. - 3:00 p.m. Follow the link for details.

GreenTrader Cutting-Edge Content on Forex Taxation:

Taxation of forex is confusing and uncertain in the tax code and that makes tax filings difficult for forex traders. The tax-problem is that some types of forex are treated as IRC 1256 contracts with lower 60/40 tax treatment and other types of forex are treated as IRC 988 foreign currency transactions with ordinary gain or loss treatment. Plus IRC 1256 and IRC 988 are dueling and conflicting tax code sections.

By Robert A. Green, CPA of GreenTraderTax CPAs.

Traders prefer the best of all tax-worlds with ordinary tax treatment for losses, so they are exempt from capital loss limitations. And capital gains (60/40) tax-treatment for gains, so they save up to 12% in tax rates (23% versus 35% at current tax rates). Traders should learn the complex rules for forex taxation before they start trading forex so they can make the necessary elections in-advance to ensure the best overall tax treatment. Can forex traders have their (tax) cake and eat it too?

Here is how the different types of forex are taxed:

Currency futures and options listed on U.S. commodities and futures exchanges are by default treated as 1256 contracts. There is no confusion in the tax code about it and traders or investors get lower 60/40 tax-treatment by default.

But for these U.S. listed forex futures and options, few traders know they may also elect out of IRC 1256 for IRC 988 (foreign currency transaction) ordinary gain or loss treatment. But this is not a big problem in the real world since very few individual traders would want to exchange lower 60/40 tax-treatment for higher ordinary gain tax-treatment? This election is very strict and it must be made on January 1 or the start of trading later in the year, and once made can only be revoked with IRS consent.

You can't cherry pick the election after-the-fact, when you know you have losses. This election is mostly used by corporations and hedgers to avoid capital loss treatment. Don’t panic about forex futures losses, IRC 1256 losses may be carried back 3 tax years; but only applied against IRC 1256 gains in those years.

Currency futures and options listed on foreign (not U.S. exchanges are treated differently by default, but possibly in the same manner after doing some leg work. IRC 1256 contracts include not only contracts listed on U.S. exchanges but certain non-exchange traded contracts also. Two things can help you get foreign currency futures treated as IRC 1256 contracts.

First, we have argued recently that foreign futures are similar to U.S. futures and should be afforded IRC 1256 treatment. Otherwise, the U.S. may be in contravention of tax treaties with many other countries.

Second, on spot forex taxation, we argue that a trader or investor may elect out of IRC 988 for IRC 1256 on foreign currency futures listed on foreign exchanges. Therefore, we believe that like spot forex discussed below, you may claim IRC 1256 treatment on for foreign currency futures listed on foreign exchanges, providing you also timely elect out of IRC 988.

Over-the-counter currency options are a huge marketplace. They are not futures or options contracts listed on U.S. or foreign exchanges; nor are they interbank-traded spot or forward currency contracts. OTC currency options are a breed apart and traded often by sophisticated traders. Even though the IRS never cleared up dueling and conflicting older tax law code sections IRC 1256 and IRC 988 in connection with spot forex taxation, the IRS did make the tax rules clear for OTC forex options in their 2003 tax notice (2003-81). In the notice, the IRS clearly states that OTC forex options are IRC 1256 contracts, but if you want 60/40 treatment, you still have to elect it.

Notice a trend developing here. IRC 1256 recognizes some foreign currency contracts as being 1256, while dueling IRC 988 also recognizes those same contracts as being IRC 988. Which tax code section wins and applies?

It’s reasonable to conclude that the trend shows you can claim 1256 treatment, but you should also elect out of IRC 988. Join the 60/40 lower tax club, but also get permission first to leave the higher-taxing IRC 988 club.

Here’s the skinny on IRC 988 foreign currency transactions. They are ordinary gain or losses reported in summary form on line 21 of Form 1040. Conversely, IRC 1256 foreign currency futures are reported on Form 6781; where they are split 60/40 before being moved over to Schedule D (Capital Gain or Losses).

IRC 988 interbank forex includes spot forex, forward forex and other types of forex contracts mentioned in the articles below. Spot forex differs from forward forex contracts in that spot settles in cash in no more than 2 days, and forward contracts settle in more than 2 days.

IRC 988 clearly states that a trader or investor (holding a capital asset versus a hedger or regular business) may elect out of IRC 988 for the more tax-beneficial IRC 1256 on forex forward contracts and foreign forex futures.

IRC 988(a)(1)(B) requires that if you want 60/40 treatment for a forex future (meaning foreign exchange listed), options or forward, you have to elect it (which we recommend using the global good till cancelled type of election).

Here is where the big tax uncertainty comes into play. Notice that IRC 988 does not specifically mention that you may elect out of 988 on spot forex. This glaring omission unfortunately leads many tax professionals to shortsightedly concur that spot forex may only be treated with ordinary gain or loss treatment.

We argue that you can dig deeper to find a way to treat spot forex as IRC 1256, as long as you play it safe and also elect out of IRC 988 on spot forex too.

Here is how it works and how you can do it.

Although it is not widely known by the forex trading marketplace, IRC 1256 recognizes many types of spot forex contract currencies as 1256 contracts.

Again, the problem is that IRC 988 also specifically recognizes spot forex contracts as IRC 988 transactions. Again, these two tax code sections conflict and cause uncertainty and risk for return positions on spot forex.

Does IRC 988 trump 1256 or does IRC 1256 trump 988 or must they co-exit? The prudent answer seems to be they must co-exist.

If 1256 trumped 988 on spot forex, then spot forex would always be 1256 and you could not even elect out of 1256 for 988 as that is allowed for U.S. exchange listed currency futures and options only. So you would be stuck with 60/40 treatment, which is not good if you have large spot forex trading losses, as you would prefer ordinary loss treatment with IRC 988. Be careful what you wish for.

So it’s a good thing that our firm and consensus professionals believe that spot forex is IRC 988 by default (sort of trumping 1256), so you start with ordinary gain or loss treatment. We explain why we believe that spot forex is sufficiently similar to forward forex contracts so you can also elect out of 988 on spot forex too.

It seems like our logic on spot forex pays good dividends. You can argue that spot forex is 1256 as long as you elect out of 988 first. Have your cake and eat it too.

Again, tax law for forex is very confusing and complex and the only thing that is certain is that there are major conflicts in the tax code with IRC 1256 and IRC 988.

A note of caution. You can have your cake and eat it too with ordinary loss treatment and 60/40 gain treatment by using internal elections wisely. But don't fool around with making these elections. If you wind up with 60/40 treatment on gains and ordinary loss treatment on losses from year-to-year, that will appear to be “cherry picking” after-the-fact, even though the elections must be made in advance of trading.

We expect IRS clarification, but possibly also a requirement for external elections like with IRC 475 mark-to-market accounting for business traders.

It’s also very important to read the fine-print on this subject. Start with our excellent articles.

March 18, 2006. We submitted this article on spot forex taxation to Currency Trader magazine for publishing in their June 2006 issue.

December 20, 2005. Robert A. Green, CPA wrote two articles for SFO magazine on tax treatment (including some on forex and foreign futures) and global tax matters (which covers having a foreign forex brokerage account). Click here to read these articles.

April 2004. Currency traders face complexities and nuances come tax time. Currency futures are treated like other types of futures; your accounting is a snap and you enjoy lower 60/40 blended tax rates. However, cash forex can be an accounting nightmare and you face higher ordinary tax rates unless you “elect out” of IRC 988 for 60/40 treatment. Click here to read this article.

If you have any questions, e-mail us at info@greencompany.com or call us.

Take care,
Robert A. Green, CPA & CEO
Direct dial: 212-579-2945
Customer Service: 877-662-2014 (toll-free), or 646-216-8061
Author of The Tax Guide for Traders published by McGraw-Hill
Green & Company CPAs, LLC www.greentradertax.com www.greencompany.com

STATE LAW CHANGES

Several large states - which traders also happen to call home - have repealed taxes or made other important changes that traders should know about.

This GreenTrader state tax alert includes news about Florida’s intangible tax, California’s LLC user fee, Texas’s franchise tax on entities, and New York State LLC publishing requirements.

Florida

Florida’s Senate repealed the intangible personal property tax effective January 1, 2007, and Florida Governor Bush indicated he would sign this repeal.  Learn more about the current tax here http://www.myflorida.com/dor/taxes/ippt.html.

 

The current tax rate was cut in half in 2005, and it is assessed on non-cash portfolios at year end. Most traders avoid this tax by going to cash at year end. With its coming full repeal, sunny Florida becomes even more of a tax-free state, with no income tax or intangibles property tax.

Florida is very popular with traders; Florida entities are very inexpensive to form and maintain, and also have zero pass-through entity-level income taxation.

Come visit us at the Traders Expo in Ft. Lauderdale, Florida on June 7.  Learn more here http://www.greencompany.com/EducationCenter/InteractiveTradeShows.shtml.

California

California has the highest income tax rates for individuals.

For traders interested in entities, California also has high annual minimum taxes ($800), plus some nasty stealth taxes on pass-through entities like LLCs and S-Corps.

Traders consider entities for late year MTM elections, retirement plan and health insurance premium deductions, and other good reasons. Learn more here http://www.greencompany.com/Traders/TraderEntities.shtml.

 

The entity of choice in California for business traders only is the general partnership.  It lacks liability protection on the entity level, but the good news is that traders don’t usually need that. Plus, there are no minimum taxes of any kind. 

The next best entity of choice for business traders is the LLC. You have entity-level protection, but you pay for that with the $800 annual minimum tax, plus there is a sneaky LLC user fee. See LLC user fee information here http://www.ftb.ca.gov/law/legis/01_02bills/ab898_050101.pdf. The fee has been reduced over the years.

Currently, if your income is between $250,000 and $500,000, the LLC user fee is $900, which is not too bad. There also has been confusion about whether the income number applies to trading proceeds (which can be huge for traders) or net trading gains (the real income). We have determined that it applies to the trading gain amount. 

Good news alert. Recently, a California court ruled that the California LLC user fee is unconstitutional. Of course, California is expected to fight this decision; so don’t count your chickens until they are hatched. It is advised to file refund claims now.

California S-Corps owe a 1.5% franchise tax, so traders often skip S-Corps in CA. There is no sense in paying that franchise tax on capital gains, which rate applies with or without mark-to-market accounting.

S-Corps are useful to reduce payroll or self-employment (SE) taxes, but these taxes don’t apply to most traders (who are exempt from self-employment tax) on trading gains. Only traders that are members of options or futures exchanges owe SE tax.

Money managers absolutely need entity-level liability protection, so we recommend LLCs or S-Corps for them. It depends on whether they get incentive fees or profit allocations; the former is subject to self employment taxes in LLCs, and the latter is not. Conversely, S-Corps do not pass through earned income, so they are useful when incentive fees are collected, as opposed to profit allocations. Learn more about the difference here http://www.greencompany.com/HedgeFunds/OffDocGTTTaxStrategies.shtml. 

Texas

Texas probably is the largest individual tax-free state, and many traders call it home. Like similar states not taxing individuals (e.g., Washington state), Texas has taxed entities to help balance their budget.

Good news alert. Texas just passed significant relief to its franchise tax on entities, providing for lower tax rates, higher hurdle rates for triggering the tax, and some additional exemptions. The new law seems to help small businesses more.

Currently, Texas assesses a franchise tax on all entities other than general and limited partnerships, which remain exempt in the new law as well. Traders often choose general partnerships to avoid the tax, and money managers choose the limited partnership, as they need liability protection.

The Texas franchise tax kicks in if your entity has “receipts” (or revenues) of $150,000 or more. Trading gains (with or without MTM) equate to receipts, not trading proceeds.

Once you trigger the Texas franchise tax, all net income is subject to a tax rate of 4.5%. You can reduce the tax with expenses, including guaranteed payments or salaries to owners.

The rule changes take effect January 1, 2008, and the hurdle (receipts) rate is raised to $300,000 from $150,000, so fewer companies will trigger this tax. The franchise tax rate also is reduced to 1%.

New York Sate

New York State has made its publishing requirement for LLCs & LPs mandatory, effective June 1, 2006. Corporations and general partnerships have no publishing requirement in New York State.

The cost for publishing in a compliant manner is approximately $1,200, which includes two newspapers. It costs less to get compliant for older LLCs.

In the past, many business traders – as opposed to money managers – skipped the LLC publishing requirement to save money. They figured they did not need court protection, as they have no customers.

Money managers need liability protection, and they should be compliant with New York State LLC publishing rules. For their business plans, the added $1,200 publishing cost is reasonable.

Unless you formed your LLC in NYS before Jan 1, 1999, you should consider publishing in one paper, rather than the normal two required papers, before the June 1, 2006 deadline in order to become compliant (and grandfathered) under the new rules. Otherwise, you chance possible suspension. Pre-1999 LLCs can skip the publishing requirement and still be grandfathered.

It’s not yet clear what the consequences of suspension are for noncompliance on the publishing requirement.

With suspension, existing business trader LLCs may remain on similar ground, not being able to use the court system. There is no mention in the law about fines or closing non-compliant LLCs. Worst case: Business traders can close their LLCs and form general partnerships or S-Corps.

LLCs user fees in New State are $250 per partner, whereas general partnerships have zero taxes on the entity-level.

Contact us for more information about your situation. We also can arrange your LLC publishing at low rates.

In New York State, the S-Corp is a good alternative to the LLC, except if you live and work in New York City. New York City does not acknowledge S-Corps and instead treats them as C-Corps subject to high entity-level tax rates. C-Corps often avoid double taxation by paying salaries to owners, but New York City also has an alternative tax, which prevents complete avoidance of double taxation in this manner.

 

LLCs are subject to New York City UBT taxes of 4%; but if trading is your only income in the LLC, then you are exempt from NYC UBT taxes. If you mix in some commission income or advisory fee income, you subject the LLC to UBT tax on all income including trading gains.

 

State taxation is complex for all taxpayers, but there are special twists and strategies that are best for business traders and money managers. GreenTrader can help you get the best results.

We hope to hear from you soon.

 

Take care,
Robert A. Green, CPA & CEO
Customer Service: 877-662-2014 (toll-free), or 646-216-8061
Author of The Tax Guide for Traders published by McGraw-Hill
Green & Company CPAs, LLC www.greentradertax.com www.greencompany.com
GreenTraderLaw PLLC www.greentraderlaw.com (non-lawyer member)

skype address: rgreencpa

 

A trader wins an important case in Tax Court about mark-to-market accounting.

L.S. Vines, (May 11, 2006) 126 TC No. 15.

The Tax Court reversed the IRS denial of a taxpayer's private letter ruling request for an extension on filing a mark-to-market accounting election IRC 475(f). The Tax Court said the taxpayer acted reasonably and in good faith and the IRS's interests won't be prejudiced.

Chalk up one big Tax Court victory for business traders in dealing with the IRS and this may help turn the tide in favor of business traders in future dealings with the IRS.

What’s this Tax Court case all about?

Many traders missed the April 15 due date for the current year mark-to-market (MTM) IRC 475(f) election. Without MTM, traders are stuck with "capital loss" treatment and cannot deduct their trading losses as "ordinary losses." This significantly reduces a trader’s opportunity for net operating loss refunds.

If you act by Oct. 15, you may be able to receive an extension of time to file your current year MTM election. Reg § 301.9100-1 "Extensions of time to make elections" provides relief for late elections. Note the maximum extension period is six months. The MTM election due date was April 15, so the extended due date is Oct. 15.

To file the MTM extension, a trader needs to file a private letter ruling (PLR) to elect mark-to-market accounting (MTM) IRC 475 within six months of the election deadline.

Before this latest Tax Court victory, we used to say the following: The PLR procedure is painstaking and expensive, and for traders seeking relief to use MTM, the chance of success is extremely small. To date, the IRS website has published only a few PLRs for traders seeking to use MTM, and the IRS has denied all of these PLRs.

Hurray! This recent Tax Court case victory overturns the IRS, and the Tax Court goes further in chiding the IRS to do a better job in defining the PLR requirements for MTM extensions.

The Tax Court tells the IRS to better define things.

In the Vines TC ruling, the Tax Court instructed the IRS to better define their rules for MTM election extensions using PLRs.

The court further indicated the IRS no longer may overplay their “prejudice” argument to deny extension requests, which has been the case to date for all such IRS rulings on the subject. 

In this writer’s opinion, the prejudice argument can be structurally flawed. Consider that almost every taxpayer request involves a refund; doesn’t that prejudice the government’s position?

It must be prejudice with hindsight.

This case better defines the law. Prejudice alone is not enough; hindsight by the taxpayer must be established by the IRS.

Here is an example of clear taxpayer hindsight that would prejudice the government’s position.

A trader has trading gains for the year-to-date period ending April 15, the date when the MTM election is due. The trader figures he does not need MTM and decides to skip the MTM election on the due date. The trader goes on to lose prior gains and then figures he can benefit from MTM for the entire tax year. The trader files an MTM extension filing using the PLR process before the due date of October 15.

In this example, the IRS can easily argue that the trader, using hindsight, changed his mind, and the government’s position is prejudiced with that hindsight. 

Note that the Vines case is the reverse of the above example. Vines did not trade after April 15; he lost his money before April 15. Therefore, Vines did not use hindsight. 

There are other factors that come into play as well.

Reading between the lines of this Tax Court decision may provide additional leeway to traders in seeking MTM extension filings.

Unless a taxpayer clearly appears to be using hindsight to prejudice the government’s case, there may be more room to win relief filings. 

We recommend that you consult with our firm to study your case and determine the best options to proceed. Learn more about private letter rulings for this type of relief here: http://www.greencompany.com/EducationCenter/GTTRecMTMprivateletterruling.shtml.

We may be able to develop a winning strategy for your case. 

If we feel you don’t have a winning case for a private letter ruling for late MTM election relief, consider achieving MTM in other ways.

For example, you may form a new entity like an LLC, which is a “new taxpayer” and may elect MTM internally within 75 days of inception, but that election will apply for the balance of the tax year only. 

Consider also a defacto husband-wife general partnership, which may apply from the start of the tax year. Learn more about entities for traders here: http://www.greencompany.com/Traders/TraderEntities.shtml.             

If you have any questions about MTM, MTM extensions, private letter rulings, or entities, email us at info@greencompany.com, or call us at 877-662-2014 (toll-free) or 646-216-8061.

Roth IRAs may be expanded

Update on May 12, 2006.

The tax bill passed and there is good and bad news here. The waived income limit on Roth IRA conversions break was included, but the start  date is 2010 only.

==============================

May 3, 2006

Today's Wall Street Journal (5/3) reported that a temporary new tax deal is in the works to allow Roth IRA conversions without regard to an income limit for a one or two year period. Get it while it’s hot!

The current tax law only allows Roth IRA conversions if a taxpayer’s income is under $100,000; which rules out many wealthier taxpayers.

What’s the allure of a Roth IRA? Convert a tax-deferred retirement plan into a permanently tax-deferred retirement plan, simply by converting a regular retirement plan into a Roth IRA.

With regular retirement plans, you only defer taxes until your retirement years. When you can least afford to pay high taxes, you are forced to pay taxes on your retirement fund distributions. Plus the way the budget problem is going; Congress may be forced to raise tax rates just when you retire. Consider that tax rates are at historic low rates and the tide is turning back towards higher rates. 

Conversely, with a Roth IRA, you benefit from permanent tax-deferral as opposed to only timing benefits with regular retirement funds.

There are some catches with Roth IRAs and conversions but they remain the best deal in town for many taxpayers.

You don’t get tax deductions for Roth IRA contributions, since you don’t pay taxes later on the distributions. That’s fair.

When you convert a regular IRA to a Roth IRA you need to square up with the IRS and your state. The converted amount (less any basis) is treated as an “early withdrawal” and subject to income tax. But consider that you are paying at the current low tax rates which may be increased soon. Most importantly, all future build up in the accounts will be permanently tax-free. 

Unlike other early withdrawals from retirement plans, the Roth IRA conversion is not subject to that nasty 10% excise tax penalty.

As far as the federal and state governments are concerned, Roth IRA conversions are a good deal of sorts and a quick fix. They plug immediate revenue shortfalls in exchange for future shortfalls.

For the Bush White House and GOP it's a master stroke in the tax change battles!
The GOP could not successfully change the tax code to free up portfolio income from taxation; although they tried hard on a number of occasions. 

Now with this simple nonchalant rule change, the GOP may be achieving tax change victory.

It’s a master stroke in the face of widespread Democratic opposition to tax changes at this stage of Bush’s precarious political life.

Consider why. The Bush White House has been pushing hard for “loud” tax change to free portfolio income from income taxation. In 2003, the GOP tried to free qualifying dividends from taxation. As a negotiated compromise to tax war, qualifying dividends were afforded long term capital gains rates and those rates were also reduced to 15% from 20%. 

This move makes great sense. Ask yourself, what is permanently tax-free now and the answer is Roth IRA accounts. By relaxing the income test rule for Roth IRA conversions, wealthy (GOP type) taxpayers can free up their retirement plan portfolio income growth from future taxation. Bingo the same desired result! 

This “soft” rule change is not “loud” and it therefore it should not awaken a public outcry. But it can be just as effective; minus the political kudos’ points.

Its smart tax negotiations for the GOP. Currently, they don't have the political capital to continue pushing their prior tax change agenda, so going through a back door makes more sense. The Roth IRA conversion tax payments may be a good tease to win Democratic approval. 

This rule change will be great news for traders.
Traders usually outperform other types of taxpayers in trading and growing their retirement plan accounts. With Roth IRAs, traders have a good opportunity to actively trade for profit in these accounts with zero future taxation.

URL for this WSJ article:
http://online.wsj.com/article/SB11466129421764