Trader Tax Management

Trader Tax Management

Spread Trade Systems

Chicago Student Summit

March 28, 2009

Disclaimer

OptionsAny strategies used as examples and discussed, using actual securities and price data, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation or solicitation to buy or sell securities.

TaxationAny US tax advice contained in this presentation is not intended to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions, or (ii) providing, marketing or recommending to another party any transaction or matter addressed herein.

The information presented provides only a general discussion of the tax law affecting the taxation of options and is not intended to be applicable to any individual investment and tax situation. You are strongly advised to contact your own tax professional in considering the tax consequences of your own specific set of facts and circumstances.

Before We Begin!

What are we going to do? Talk about some of the tax aspects of options trading You will understand more about tax return preparation You should be able to talk more intelligently with your

CPA or tax preparer Questions fielded at the end

What we are not going to do? Teach you to prepare your own tax return Cover options taxation exhaustively

Investment / Options Taxation

Agenda

Securities taxation in general Trader vs Investor

How to spot the difference Mark to Market

Wash sale rules What it is Attempting to avoid it

Section 1256 Contracts Reporting

Securities Taxation

Overview

What Triggers Tax? Completed transaction – generally Acquisition Sale

Stock Purchase Sale Short Sale Cover

Options BTO STC/Expiration STO BTC/Expiration

What is Taxed?

Sales of stock/securities determined on a: First In First Out (FIFO) basis (IRS presumption)

First shares purchased are the first shares sold Used when cannot or does not identify which shares

sold [Reg 1.1012-1(c)(1)] Specific Lot Identification basis

Shares must be identified to broker Broker must confirm in writing

[Reg 1.1012-1(c)(3)]

How is it Taxed?

Stocks/securities are capital assets Closing transaction generates capital gain/loss Mark-to-market deems sale/repurchase but character

is changed to ordinary gain/loss Holding periods

Short-term – one year or shorter Long-term – longer than one year Generally begins on day after acquisition Generally ends on day of disposition

Pass-through entities – retain character

Ordering Rules

Short-term capital losses Reduce short-term capital gains Reduce net long-term capital gains (28% > 25% > 15%)

Long-term capital losses (28%) Reduce long-term capital gains (28% > 25% > 15%)

Long-term capital losses (15%) Reduce long-term capital gains (28% > 25%)

Net LTCL can offset net STCG

Basis for Gain or Loss

Type Basis Holding Period

PurchasePurchase price +

commissionsDay after date of

acquisition

Gift prop sold for GAIN

Donor’s basisDate donor’s holding

period began

Gift prop sold for LOSS – Lesser of:

Donor’s basisDate donor’s holding

period began

FMV on gift date Day after gift date

Inherited propFMV on

decedent’s DODLong-term

Investor vs Trader

Investor vs Trader Why? – Subject to different tax rules Definitions:

Investor – Stock purchase for capital appreciation/dividends Little regard for short-term fluctuations; buy and hold

Trader – Regularly and continuously trade stock/securities Trade in own account Profit from short-term fluctuations

Can be BOTH trader and investor IRS presumption Investor

Investor vs Trader Taxation of Investors

Stocks/securities considered capital assets Gains and losses considered capital Reported on Schedule D / D-1 Subject to $3000 net capital loss limit Subject to IRC Sec 1091 wash sale rules Investment expenses (except interest)

Schedule A miscellaneous itemized deductions Subject to 2% AGI threshold Not deductible for AMT purposes

Interest – deductible up to net investment income Net investment income does not include

Long-term capital gains Qualified dividends

Investor vs Trader Taxation of Traders

Stocks/securities considered capital assets Gains and losses considered capital Reported on Schedule D / D-1 Subject to $3000 net capital loss limit Subject to IRC Sec 1091 wash sale rules Investment expenses

Schedule C/E* deductions Interest deductible (for material participation) Home office deduction eligibility

Gains NOT subject to self-employment tax Mark-to-Market (MTM) election eligibility_____________________________________________________________________________________________________

* Flow-through entity, such as partnership, LLC, S-Corp

Investor vs Trader – Expenses Deductible – BOTH Investor and Trader

Investment counsel/advice Subscription services

OptionsAnimal OptionsMonster

OptionsAnimal Mentor? – Possibly (see below) STS tuition? – No?

Office expenses – administrative, supplies Pro-rata portion of computer/software used to determine/manage

investments – must be able to substantiate

Reg 1.212-1(g) – paid or incurred by the taxpayer … for the management, conservation, or maintenance of investments held by the taxpayer for the production of income

Investor vs Trader – Expenses

Non-Deductible for Investor Shareholder meeting/transportation expense Expenses to produce tax-exempt income Investment-related seminars – THIS EVENT!

IRC Sec 274(h)(7) –

“No deduction shall be allowed under [IRC] Sec 212 for expenses allocable to a convention, seminar or similar meeting”

IRC Sec 212 – “… there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred … (1) for the production … of income”


Investor expenses – Summary All expenses for the production of income (Sec 212) Deducted on Sch A as Miscellaneous Deductions Subject to 2% AGI threshold Interest expense deductible to the extent of net

investment income – does not include LTCG / Div No Sec 179 expensing election No home office deduction


Trader expenses - Summary All ordinary and necessary expenses (Sec 162) Interest expense on margin accounts – if material

participation, otherwise, for a limited partner, to extent of net investment income

Sec 179 expensing of computers, software Eligible for home office deduction Automobile expenses from principal place of

business (home) deductible – if for business purpose

Investor vs Trader

So what’s the difference? IRC Sec 212 – Investor

“… there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred … (1) for the production … of income”

IRC Sec 162 – Trader“There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred … in carrying on any trade or business …”

As an Investor you are producing income As a Trader you are in a trade or business

Investor vs Trader – Cases

Firm name, business cards, separate bank account, computerized investment analysis system; Traded 5-12 days during each of 3 years buying only 16-44 contracts per year

Investor, Steffler (TC Memo 1995-271) Over 2,000 transactions in 2 years, shortest

holding period for stock was 3 months, some over 1 year

Investor, Estate of Yeager (2nd Cir, 1989)


Made 46 purchases and 16 sales in 1st year; 109 purchases and 103 sales in 2nd year; Rarely spent more than 10 days/month and never 5 days/wk trading

Investor, Cameron (TC Memo 2007-260)

Made 326 sales of which 205 were stocks held less than 31 days; Mostly 3 months of year and not regular and continuous

Investor, Paoli (TC Memo 1991-351)


Traded through individual brokerage account; Created LLC, made MTM election; Did not transfer stock to LLC name or Tax ID; Traded less than 40% of trading days on individual account and 45% with LLC

Investor, Holsinger (TC Memo 2008-191) Most of working day engaged in research on

companies to identify attractive trades and making stock transactions

Trader, Levin (Ct Cl, 1979)


Summary In Holsinger, Tax Court remarked in its opinion

that trading activity of over 1,100 trades or the value of securities traded over $9 million was deemed substantial

Levin – most of working days; substantial time

Regular and continuous Short holding periods Substantial number of trades

Investor vs Trader

Mark-to-Market

Investor vs Trader – MTM Election

What is Mark-to-Market (MTM)? Traders can elect to mark their stock holdings to

market value at the end of the tax yearIRC Sec 475(f) –

“… In the case of a person who is engaged in a trade or business as a trader in securities …”

Gains and losses treated as ordinary gain/loss Adjustment to stock basis for unrealized gain/loss Not subject to self-employment tax Reported on Form 4797, Part II

Investor vs Trader – MTM Election Benefits

Two restrictions no longer apply:

$3,000 net capital loss limit

Wash sale rule


Election is effective for the year for which it is made and all subsequent years unless revoked with IRS permission (mandatory)

Must make the election by the unextended due date for the tax return for the year … before the year … the election is to be effective

We need an example


Eric is actively trading stocks and believes he can generate significant income by trading, on a regular and continuous basis, the short-term fluctuations in the stock market. In July 2008 he begins trading full-time.

Does Eric qualify as a trader?


Eric is actively trading stocks and believes he can generate significant income by trading, on a regular and continuous basis, the short-term fluctuations in the stock market. In July 2008 he begins trading full-time.

Does Eric qualify as a trader? Can he elect MTM for 2008?


Eric would have had to file an election by: April 15, 2008, or, Attach the election to his extension (Form 4868)

Eric can make a MTM election for 2009 anytime before April 15, 2009, however, If this is not the first year as a trader (it is not) then

Eric will be required to file Form 3115, Application for Change in Accounting Method

A Sec 481(a) adjustment is also required

Investor vs Trader – Making the MTM Election

Attach the following statement to the timely filed Form 1040 or extension Form 4868

Trader in Securities Election to Mark to Market

Taxpayer hereby elects under IRC Sec 475(f) to use the mark-to-market method of accounting for securities. The election will first be effective for the tax year ended [20##]. The election is made for the following trade or business: [trade or business name, EIN]

There is relief for late elections – PLR request New pass-through entity for late election New taxpayer – elect by 15th day of third month

Investor vs Trader - Summary

Criteria Investor Trader MTM Trader

Reporting gain/loss Sch D Sch D Form 4797

Reporting expenses Sch A Sch C/E Sch C/E

Reporting interest Sch A Sch C/E Sch C/E

Invest int exp limits Yes No No

Home office eligible No Yes Yes

Subject to S-E tax No No No

Wash sale rules Yes Yes No

$3000 Cap loss limit Yes Yes No

Wash Sale Rules

Wash Sale Rules

Loss on wash sale of stock is not currently deductible What is a wash sale? –

Loss on sale of stock – does not apply to gains Within 30 days BEFORE/AFTER the loss sale:

Acquire stock* Buy* call – Reg 1.1091-1(a) “option to acquire” Sell* ITM put – Rev Rul 85-87

Impact Basis – disallowed loss added to cost of newly acquired stock Holding period – newly acquired stock now has holding period

of the stock for which the loss was disallowed_______________________________________

* substantially identical

Wash Sale Example 1

Tim buys 500 shares of C for $23 on 10/1/08 Tim sells 300 shares for $4 on 11/21/08 Tim buys 300 shares for $8.50 on 12/10/08

Is there a loss? Yes, $19 per share on 11/21/08 ($4.00 - $23.00)

Any repurchase within 30 days either side of 11/21? Yes, on 12/10/08

Loss is Not Deductible Basis of 12/10/08 shs – $27.50 ($8.50 + $19.00)

Wash Sale Example 2

Tim buys 500 shares of C for $23 on 10/1/08 Tim buys 300 shares for $4 on 11/21/08 Tim sells 300 shares for $8.50 on 12/10/08

Is there a loss? Yes, $14.50 per share on 12/10 ($8.50 – $23.00)

Any repurchase within 30 days either side of 12/10? Yes, on 11/21/08

Loss is Not Deductible Basis of 11/21/08 shs – $18.50 ($4.00 + $14.50)

Wash Sale Example 3

Tim buys 500 shares of C for $23 on 10/1/08 Tim sells 500 shares for $4 on 11/21/08 Tim buys 300 shares for $8.50 on 12/10/08

Is there a loss? Yes, $19 per share on 11/21/08 ($4.00 - $23.00)

Any repurchase within 30 days either side of 11/21? Yes, on 12/10/08, but

Loss on 300 shs is not deductible Loss on 200 shs is deductible Basis of 12/10/08 shs – $27.50 ($8.50 + $19.00)

Wash Sale Strategy

Definition of security IRC Sec 1091 limits the wash sale rules to stocks

or securities BUT defines options as a security Related parties

Sale and purchase collapsed 61-day window (IRC Sec 267) IRA is a related party

Does not apply if sale made in connection with the taxpayer’s trade or business (if MTM)

Wash Sale Strategy

Reduction in holdings (Rev Rul 56-602) Bona fide sales in order to reduce holdings of a security Maybe: Naked put assigned unintentionally and then sold

Puts Rev Rul 85-87

Facts: Phil sustained a loss on the sale of stock. The next day he sold a put two months out. The put was substantially ITM at the time of sale.

Analysis: In light of the spread between the value of the underlying stock and the exercise price of the put, the term of the put, the premium paid, the historic volatility in the value of the stock, and other objective factors, there was at the time the put was sold no substantial likelihood that the put would not be exercised

Wash Sale Strategy

Criteria for an ITM naked put Distance ITM Term of the put Historic volatility of underlying stock

Substantial likelihood of exercise Wait 31 days to repurchase stock Bull call entered 31 days before sale Bull put entered 31 days before sale

Sec 1256 Contracts

Index Options

Section 1256 Contracts

A Section 1256 Contract is any: Regulated futures contract – daily MTM Foreign currency contract Dealer equity option – market maker/specialist Dealer securities futures contract Non-equity option

Broad-based stock index option (SEC determined) Cash-settled options Examples – DJX, SPX, OEX, NDX (not ETFs)

Sec 1256 Contracts – Mark-to-Market At the end of the tax year (last business day)

Treat contract as sold At FMV on the last business day of year Gain or loss recognized Recognized gain/loss taken into consideration upon

ultimate disposition of contract 60/40 rule –

60% of recognized gain/loss is long-term 40% of recognized gain/loss is short-term No matter what the actual holding period

A net loss can be carried back 3 years Report on Form 6781 We need an example

Sec 1256 Contracts – Mark to Market Example

Sec 1256 Contracts – Mark to Market Example

100 SPX Jun 08 1250 calls bought for 145 on 7/17/06

SPX Jun 08 1250 call at 252 on last business day of 2006

Mark-to-Market requirements: SPX LC deemed SOLD on 12/29/06 at 252 SPX LC deemed REPURCHASED on 12/29/06 for 252 Gain 107 (252 – 145)

Long-term 64.20 (60% x 107); 15% max tax rate Short-term 42.80 (40% x 107); 35% max tax rate

Sec 1256 Contracts – Mark to Market Example SPX Jun 08 1250 LC declines to 228 by 3/12/2007

and is sold What is the gain/loss? How is it taxed?

Deemed repurchase at 252 on 12/29/06

Sale 228

Basis 252

Loss <24> LTCL <14.40> - 60%

STCL <9.60> - 40% Loss may be carried back three years

Is this a put straddle constructive sale,

unrecognized wash sale or mocha cappuccino

latte???

Cow Options Investor at Her Wits End …

Reporting

Reporting

Schedule D/Schedule D-1 Used by both investor and trader Name, dates, sale, cost, gain/loss Use of “VARIOUS” designation for dates of block

purchases or sales; still separate ST and LT

Reporting

Wash sales Report full amount of loss in gain/loss col (col f) Date of share purchase disallowed loss added to (col b; optional) Report “Wash Sale” in col a and loss disallowed in col f

Reporting Expired options

Long options Name, expiration date in col c, “EXPIRED” in col d

Short options Name, expiration date in col b, “EXPIRED” in col e

Reporting Form 4797

Used for MTM Traders Reported in Part II, ordinary gains/losses Favorable capital gain rates do not apply Wash sale rules do not apply $3000 net capital loss limit does not apply

Reporting

Form 6781 – Gain/Loss on Sec 1256

So Now That You Understand the Rules and Reporting …

Honey, do you remember that

really neat trade involving those 14 Iron Condors that

we adjusted into …

April 14, 11 pm

Final Thoughts

Tax considerations should be secondary Why? We trade options to make money in

any market conditions, if money is made, tax is paid – it’s all good

There is no 100% marginal tax rate I don’t believe you will ever be selected for

audit simply because you missed a wash sale or reported a Sec 1256 contract incorrectly

Contact Information

Gregory L Buhrow, CPA, PC2355 Gus Thomasson RoadDallas, TX 75228-3004

Telephone: (214) 327-0700 Facsimile: (214) 327-0740 (7am-6pm CT) Website: www.buhrow.com Emails: [email protected]

[email protected]@gmail.com

Thank You!

Trader Tax Management

STS Chicago Student Summit

March 28, 2009

Documents

Trader Tax Management