Section 475 Traders May Be Eligible For Pass-Through Tax Cuts


Owners of a trading business are anxious to learn if they will qualify for tax cuts with the House’s 25% pass-through rate or the Senate’s 17.4% pass-through tax deduction. While the two bills have a few things in common, they are vastly different, and both contain nuances for a trading business.

The House bill provides little relief for active owners of a service business, which likely includes a trading business. The Senate bill has a more generous provision for service companies.

Last week, the House passed its bill, the “Tax Cut & Jobs Act” (H.R.-1), and the Senate Finance Committee approved its modified mark. The Senate expects the Joint Committee on Taxation (JCT) to complete drafting its bill this week and release it for floor debate the week after Thanksgiving. Republican Senator Ron Johnson came out in opposition to tax reform proposals, saying they don’t go far enough to help small-business pass-throughs vs. big corporations. He’s right. In current form, the Senate’s modified mark is better than the House bill for active owners of pass-throughs, and I hope GOP leaders choose the Senate’s pass-through proposals, with further improvement, for final legislation.

Here are the steps required for a trading business to achieve tax relief under the House vs. Senate proposals. (Spoiler alert: It’s much easier in the Senate.)

The first requirement is business income

Because the House and Senate bills limit pass-through tax cuts to business income, a big question remains: Does income in a pass-through entity meet the definition of “qualified business income”? A trading business, eligible for trader tax status (TTS), with capital gains income, is likely not included in the definition of business income. But a trading business with Section 475 MTM ordinary income might be included.

Here’s my rationale. The House bill’s summary states, “Certain other investment income that is subject to ordinary rates such as short-term capital gains, dividends, and foreign currency gains and hedges not related to the business needs, would also not be eligible to be recharacterized as business income.”

The House bill goes on to state, “Net business income or loss shall be determined with respect to any business activity by appropriately netting items of income, gain, deduction, and loss with respect to such business activity.” The bill notes “certain investment-related” exceptions, a list that includes short-term and long-term capital gains, dividend income, any interest income other than interest income that is properly allocable to a trade or business, and annuities.

Section 475 ordinary income and rental income are not on the exceptions list. A TTS futures trader has lower Section 1256 contract 60/40 capital gains tax rates (60% is a long-term capital gain), so it’s doubtful he or she could qualify for the more moderate pass-through rates.

The Senate mark (JCX-51-17, Nov. 9) states, “Qualified business income or loss does not include certain investment-related income, gain, deductions, or loss.” This language is similar to the House summary.

A TTS forex trader has foreign currency ordinary income (Section 988) that is business-related. Without TTS, that forex trader’s ordinary income is investment-related. Forex traders may want to consider a capital gains election to be eligible for Section 1256(g) 60/40 tax rates on “major” pairs, but that may disqualify them from pass-through benefits. They can consider which is better for them.

Section 475 ordinary income is also considered business-related for TTS traders. Steven Rosenthal, Senior Fellow, Urban-Brookings Tax Policy Center, weighs in: “Section 475 treats the gain as ordinary income,” he says. “Section 64 provides that gain that is ordinary income shall not be treated as gain from the sale of a capital asset.” Mr. Rosenthal thinks Section 475 income is business income under the House bill and Senate mark. (Section 475(f)(1)(D) excludes Section 475 ordinary income from self-employment income and self-employment tax.)

The next requirements for receiving pass-through tax cuts vary significantly in the House vs. Senate bills.

Does the House bill consider a trading business a service activity?

It’s essential because active owners of service businesses may receive a tiny pass-through tax cut in the House bill. The bill states, “The term ‘specified service activity’ means any activity involving the performance of services described in section 1202(e)(3)(A), including investing, trading, or dealing in securities (as defined in section 475(c)(2)), partnership interests, or commodities (as defined in section 475(e)(2)).” When my partner Darren Neuschwander, CPA, and I read this definition two weeks ago, we thought it expressly included a trading business.

The House summary that accompanies the bill is different from the actual bill, it states, “certain personal services businesses (e.g., businesses involving the performance of services in the fields of law, accounting, consulting, engineering, financial services, or performing arts) would be zero percent.” Notice the summary version dropped the second part, “including investing, trading, or dealing in securities.” Section 1202(e)(3)(A) lists the personal service fields.

The thousand dollar question is: Does the House consider a trading business a specified service activity, or not? Rosenthal believes a hedge fund with Section 475 ordinary income does not meet the House definition of specified service activity. His interpretation is that an investment manager offers trading services to a hedge fund and the fund receives those services. The manager is a service activity; the hedge fund is not. It’s about how Rosenthal interprets the comma placement in the definition, which he knows well because he used to be a legislation counsel at JCT.

I pointed out to Rosenthal that a management company is the general partner of a hedge fund limited partnership, to bring trader tax status to the fund level, which is a requirement for the hedge fund using Section 475. For this blog post, I assume a trading business is a service company based on how I read the House bill’s definition.

The House gives little benefit to active owners of service companies

An active owner of a non-service activity receives a 70% labor percentage and a 30% capital percentage. Calculate the pass-through benefit as “distributed” business income, multiplied by the capital percentage, multiplied by the maximum pass-through rate (25% for the 35% and 39.6% ordinary brackets and 9% for 12% ordinary bracket).

Active owners of a service business get a 100% labor percentage and 0% capital percentage. If they have a significant investment in business equipment and other fixed assets, they may have an “alternative capital percentage,” providing it’s at least 10%. Most TTS trading businesses won’t have an alternative capital percentage and therefore won’t get any relief in the House bill, except for the preferential 9% rate.

The House bill’s summary states, “Under the provision, the first $75,000 of an active owner or shareholder’s net business taxable income would be subject to a 9-percent rate in lieu of the ordinary 12-percent rate. Owners or shareholders in personal service businesses would be eligible for the preferential 9-percent rate.” This provision gives a small tax benefit to a service business.

The House bill favors passive business activities

The bill summary states, “Net income derived from a passive business activity would be treated entirely as business income and fully eligible for the 25-percent maximum rate.”

The original House bill had a sneaky proposal to expand self-employment tax on the labor percentage of active owners and for all limited partner income. After blowback, the House scrapped the self-employment tax provisions, yet it retained the significant tax break on limited partners. Active owners of non-service businesses get 30% of the benefits vs. limited partners. Many active-owners of service companies will get very few benefits.

I think Congress and the IRS will object to active owners restructuring their interests into general partner vs. limited partner ownership stakes to cash in on the House bill provisions favoring limited partners.

Will hedge fund limited partners get the 25% pass-through rate?

The House bill’s summary states, “The determination of whether a taxpayer is active or passive with respect to a particular business activity would rely on current law material participation and activity rules within regulations governing the limitation on passive activity losses under Code section 469. Under these rules, the determination of whether a taxpayer is active generally is based on the number of hours the taxpayer spends each year participating in the activities of the business.”

Some tax advisers suggest limited partners in hedge funds with TTS and Section 475 income can get the 25% House rate. I think there is likely a problem with that position. Under the “trading rule” exception to Section 469, a hedge fund investment is not a passive activity. Hedge fund investors are “non-active” owners, rather than passive-activity owners so that the House bill may treat them as an active owner of a service business with 0% capital percentage.

The Senate proposal is better for TTS Section 475 traders and funds

The Senate mark’s definition of a “specified service activity” does not include a trading company, but it has not yet released the final bill. It’s conceivable that the Senate could render a trading company a service activity. But, service companies fare much better in the Senate modified mark vs. the House bill.

Active owners of non-service businesses get the full benefit of the Senate pass-through proposals. The Senate’s original mark allows a 17.4% pass-through deduction on net business income, limited to 50% of owner wages.

The Senate’s original mark excluded service activities unless the owner had taxable income under $150,000 married and $75,000 for other individuals. (See How The Pass-Through Tax Cut Is Better In The Senate.)

The Senate modified mark significantly improved the provision for all owners of pass-throughs, including non-service and service businesses. It doesn’t mention passive activity owners or limited partners, so I presume they should be able to get the benefits since the Senate waived the wage limitation under the income threshold.

The modified mark states, “Under a special rule, the W-2 wage limit does not apply in the case of a taxpayer with taxable income not exceeding $500,000 for married individuals filing jointly or $250,000 for other individuals. The application of the W-2 wage limit is phased in for individuals with taxable income exceeding this $500,000 (or $250,000) amount over the next $100,000 of taxable income for married individuals filing jointly or $50,000 for other individuals.

“The modification further provides that the exception allowing the 17.4-percent deduction in the case of certain taxpayers with income from a specified service business applies to those whose taxable income does not exceed $500,000 for married individuals filing jointly or $250,000 for other individuals. The benefit of the deduction for service businesses is phased out over the next $100,000 of taxable income for married individuals filing jointly or $50,000 for other individuals.” (See Senate Juices Up Tax Cut For Pass-Throughs.)

The process is moving fast

I look forward to reading the Senate bill after Thanksgiving, and I will update this blog post accordingly. I hope GOP leaders agree to use the Senate bill as the vehicle for passage as they rush to pass tax reform legislation before year-end.

The timing is right for taxpayers and accountants. If Congress finalizes the legislation by mid-December, TTS traders will have time to consider a new tax plan for 2018, which might include a revised entity solution and a Section 475 election.

TTS traders with Section 475 should not count their tax chickens on pass-through tax breaks before they hatch. Stay tuned for updates.

Darren Neuschwander CPA contributed to this blog post.

Robert A. Green, CPA
Author of Green’s 2017 Trader Tax Guide
Managing Member, Green, Neuschwander & Manning, LLC

April 15 tax extensions and Section 475 election

March 15, 2015 | By: Robert A. Green, CPA

Securities brokers issue corrected 1099Bs close to and sometimes even after the April 15 tax deadline due to complications over cost basis reporting. Schedule K-1s often come late, too.

When tax information is incomplete near the deadline, it’s wise to file an automatic six-month extension. Caution: It’s not a payment extension; so try to pay at least 90% of your tax liability to avoid late-filing and late-payment penalties. If you don’t pay 90%, hopefully the IRS will accept your “reasonable cause” spelled out in a letter seeking penalty abatement. Retaining tax funds as working capital for trading is not reasonable cause in my view.

April 15 is also the important deadline for individual and partnership traders qualifying for trader tax status to file a Section 475 MTM election statement with the IRS for 2015 and subsequent years. The election statement is attached to the federal extension.

There are many advantages to filing extensions. One negative is waiting longer for a tax refund, but traders often apply overpayment credits to estimated taxes due on trading income instead of claiming a refund.

Extensions for individuals
If you don’t owe taxes, the extensions are easy. Enter taxes paid (including credits) with the same amount for tax liability reflecting a zero balance due. Perhaps your spouse has a W-2 with ample tax withholding and you have trading business losses, itemized deductions and nominal other income. You don’t need to prepare detailed draft tax returns before April 15.

If you think you may owe taxes, then continue working on your tax filings. Prepare draft tax returns based on tax information in hand, accounting and estimates of missing information to generate the extensions from tax software. If you have year-to-date trading gains in 2015, it’s wise to be conservative with extension payments figuring you can apply overpayment credits toward 2015 estimated income taxes.

Extensions for entities
Tax extensions for pass-through entities are March 16, 2015 for S-Corps (since 15th is a Sunday) and April 15, 2015 for partnerships with an extension due date of Sept. 15. Pass-through entities are tax filers, not taxpayers, so the federal extension is simple to prepare without any tax liability. Be sure to file it on time because the late-filing penalty for missing the election is $195 per month per partner or shareholder up to a maximum of twelve months.

Some states have nominal franchise taxes or minimum taxes so check with your state or tax advisor. The state taxes are generally due with the extension filing. March 16 is also the deadline for an existing entity – LLC, C-Corp or general partnership (in most states) to elect S-Corp tax status (see our recent blog on S-Corps).

Section 475 MTM election
Active securities traders qualifying for trader tax status should consider a Section 475 MTM election for ordinary business loss treatment (tax loss insurance). Generally, you should elect Section 475 on securities only, not Section 1256 contracts so you retain lower 60/40 tax rates on those. Section 475 converts capital losses — otherwise subject to a $3,000 capital loss limitation and wash sales — into unlimited business ordinary losses. If you have large trading losses in 2015, you should consider a Section 475 election to lock in those losses as business ordinary losses. Ordinary losses are far better than capital losses.

If you have material capital loss carryovers, you can form a new trading entity to pass-through capital gains to your individual tax return, thereby using up capital loss carryovers. In the last-minute rush of tax season, many taxpayers and tax preparers make the wrong decision on Section 475 and it costs them thousands of dollars in tax savings.

Existing partnerships and individuals elect Section 475 for 2015 by attaching an election statement to their 2014 federal extension filed by April 15, 2015. For existing S-Corps, the election date is March 16, 2015. The second step is to file a Form 3115 (Change of Accounting Method) with your 2015 tax return filed in 2016. Learn more about Section 475 and see the election statement in Green’s 2015 Trader Tax Guide. Consult a trader tax expert before the election deadline.

Broker 1099Bs and confusion over wash sales
Many securities brokers are issuing corrected 1099Bs — it’s the new normal. Brokers continue to face many challenges with new IRS cost-basis reporting rules, including wash sale loss adjustments.Options and simple debt instruments purchased on or after Jan. 1, 2014 are considered “covered securities” and are included on 2014 Form 1099Bs for the first time.

Broker and taxpayer rules differ on calculations for wash sales. Brokers calculate wash sales based on the same equity or symbol (identical position) per account. Conversely, taxpayers must calculate wash sales based on substantially identical positions — i.e., between stocks and stock options and options at different expiration dates — across all individual accounts including all IRAs, even Roth IRAs.

Taxpayers can’t rely on 1099Bs and profit and loss reports from brokers if they trade securities and options or have multiple accounts. In these cases, taxpayers should use securities trade accounting software like TradeLog, which calculates wash sales correctly based on substantially identical positions across all accounts. It’s important to reconcile TradeLog results to 1099Bs, so taxpayers need to account for corrected 1099Bs on tax filings. TradeLog and other software publishers release program updates late in tax season or after April 15, too.

Traders are not simple like employees
Employees have taxes withheld on each paycheck and many wind up over-withheld generating material tax refunds, which they are anxious to collect. Many employees have simple tax filings and they can file early. Don’t wait for tax refunds every year — update your W-4 for more allowances and less tax withholding. Traders don’t have tax withholding on trading income. They generally owe taxes on trading income on April 15 because many prefer to underpay estimated taxes.

Traders with large Section 475 ordinary losses may be due large tax refunds. These traders have a lot riding on trade accounting and trader tax status; they should not rush their tax filings, especially if corrected 1099Bs are expected. Rushing may lead to errors, delays in tax refunds and potential tax exams, which can hold up refunds.

Futures and forex traders
If you trade Section 1256 contracts (futures), your broker issues a simple one-page 1099-B listing “aggregate profit and loss” based on marked-to-market accounting (realized and unrealized gains and losses). Correct 1099-Bs are rare for Section 1256 contracts. Likewise, forex brokers provide an online tax report that is reliable.

Extensions provide benefits for retirement plans
2014 contributions to Individual 401(k), SEP IRA and employer 401(k) profit-sharing plans must be funded by the due date of your tax return — Oct. 15 if you filed for an extension. That helps your cash flow. But IRAs must be funded by the original due date of April 15.

If your 2014 Roth IRA conversion didn’t work out well — perhaps the securities dropped significantly in value and you paid conversion taxes on the higher value — you’re entitled to “re-characterize” (reverse) the Roth IRA conversion up until the extended due date of Oct. 15. If you already filed your 2014 tax return, you’ll have to amend it to reflect the re-characterization.

Pressuring your tax preparer may lead to errors
If you engage a quality CPA firm for tax compliance, you should not expect them to focus on completing your tax returns during the last few weeks of tax season when filing an extension is a better option. Quality firms have internal deadlines and they avoid error-prone working conditions. I’ve seen countless cases of clients coming to us with botched prior year tax returns where they also missed vital tax elections like Section 475 because they focused on filing a complete return rather than filing an extension and making this election.

Early filers may get audited more
“The early bird gets the worm.” But in this case, the IRS is the bird and your tax return may be the worm selected for audit. I’ve always believed that audit quotas are met based on early filers. The IRS also wants to get started early with exams, and not wait until Oct. 15.

At the start of tax season, the IRS commissioner said there would be delays due to complications over Obamacare taxes, late renewal of “tax extenders” and the IRS being short of resources and staff.

Late-filing and late-payment penalties
Read federal automatic extension Form 4868 with instructions, especially the Page 2 sections on late-filing and late-payment penalties and how to avoid them.

State extensions
Some states don’t require an automatic extension if you’re overpaid and they accept the federal extension. Generally in all states, if you owe taxes, you need to file a state extension with payment. States tend to be less accommodating than the IRS in waiving penalties, so it’s usually wise to cover your state first if you are short on cash. Check the extension rules in your state.

U.S. citizens and resident aliens abroad
Excerpt from the IRS website: “If you are a U.S. citizen or resident alien residing overseas, or are in the military on duty outside the U.S., on the regular due date of your return, you are allowed an automatic 2-month extension to file your return and pay any amount due without requesting an extension. For a calendar year return, the automatic 2-month extension is to June 15. If you qualify for this 2-month extension, penalties for paying any tax late are assessed from the 2-month extended due date of the payment (June 15 for calendar year taxpayers). However, even if you are allowed an extension, you will have to pay interest on any tax not paid by the regular due date of your return (April 15 for calendar year taxpayers).”