Option Investor
Educational Article

The Tax Man Cometh

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It's tax time again! How would you like to save some money and AVOID (not evade) some Uncle Sam outlay this year?

Many would. And so it is tonight that I'll ask veteran readers to hang in there for benefit of our new readers. Heck, even veterans can use a refresher course from time to time. But I want to get back into the subject of "Trader Status", which I encourage all to investigate. So do you have trader status with the IRS?

"That's almost an insulting question! Of course I have trader status. I'm a trader! Err, well, maybe I qualify. OK, I lost $100,000 last year and quit trading after March, so maybe not. But boy, how I wish I could claim the whole loss suffered in instead of using a measly $3,000 per year over the next 34 years for what seems like eternity." (Either that or plan on making exactly $97,000 trading profits next year so you net out at $0 earned from trading.)

Anybody utter these words to themselves over the last three years? We get plenty of reader e-mail from those who have. Invariably, they go on to ask if we know what is/how to get trader status that would allow deductions for substantial losses exceeding the $3,000 annual limit. While we are not accountants (at least none of the folks I know at OIN are) and we don't even play them on TV, we know people who are.

So we figured, "what the hey". Not only would this make a great article of immense benefit to fellow readers, it would also give us an excuse to seek out and ask the questions of an expert in the field. Just as we would never entrust our hard-earned dollars to a brick maker for the purpose of buying fine jewelry, so too should we avoid trusting our accounting issues to Fundamentals Guy or any other analyst, market strategist, and trader on our staff.

While we know tidbits, we are in no way qualified to talk specifics on the subject of trader status and tax liability. For those issues, we need an expert. And that expert is Jim Crimmons of www.tradersaccounting.com.

Here's the reader e-mail that got the ball rolling on this:


Would you please direct this question to the most appropriate individual at option investor? I realize that you are not accountants but you all do the same thing with options.

I have discussed for many years the tax strategies with my accountant and to date have always been an investor and not a trader and have not marked to market. I make over 400 option transactions per year, create a lot of margin debt and had huge losses over the past two [now three since this e-mail was written] years that would have been better offsetting earned income rather than the current $3000 per year until offset by future capital gains.

Would some please devote an article to trader Vs investor? My accountant say that the rules are deliberately ambiguous so that most people will end up investors and not risk going into unchartered waters where they are subject to audits, penalties and interest for trying to write off home office expenses, and use mark to market today. He says that one has to get permission from the IRS to go back from market status to investor status after making their first election so that in years where there are huge capital gains one would regret that they no longer can have long-term capital gains. He says that having separate accounts at separate brokerage firms does not allow one to be a trader in one account and an investor in another account as there has been no ruling and that at an audit one would have to pay penalties and interest and then go to tax court to try to win your case without any ruling.

Would someone at Option investor please comment on the tax options available to option investors/traders.

Thank you"

Dear Reader - Your day is here!

Rather than try to answer our fellow reader's question with just a paragraph from one of us here, we posed the question to Jim Crimmons, founder of www.tradersaccounting.com. What we got back was detailed enough to answer almost anyone's questions on the entire subject. I'll let Jim do the talking from here.

Me: What say you, Jim?


Executive Summary: Tax planning is worthless unless it is put in place. Probably the biggest reason people do not follow through is that the idea is either too complex, or forces them to change their lifestyle in a dramatic fashion. While the following suggestions may sound intimidating and complex initially, their operation is fairly simple and is designed not to make any major changes in your current lifestyle. Remember the idea is to plan ahead to establish your Tax Efficient Trading Plan, which dove tails with your overall Trading Plan.

Treat it as a business: Establish an LLC for your trading. Advantages. Since you can treat the LLC as a pass-through entity, you will not be subject to double taxation as you could with a C corporation, but you can run your business deductions through it. This account will be your active trading account and will provide you with liquidity and asset protection. When there is sufficient trading activity, you can adopt the Mark to Market method of accounting, which allows you to ignore both the Wash Sale Rule, as well as the $3,000 cap on Capital Loss Deduction. Because many of the expenses you are now paying out of your own pocket can be expensed out through your trading company, you will be lowering the amount of money you need to live on, and by this means lowering your personal income taxes.

Learn to deduct expenses that you cannot fully do personally, like education, meetings, and trading expenses. For example, Healthcare costs - Your company can pay Medical Insurance premiums.

Medical Savings Account - If you are funding your own medical insurance, a Medical Savings Account for your family generally saves our clients a lot of money, as well as add to their retirement income. If you are unfamiliar with MSA's order our free special MSA report by e-mailing us at questions@tradersaccounting.com, enter the words MSA in the subject box. [Shameless plug for Jim :-)]

Work With Your Tax Advisor Quarterly: As the year progresses, because of the extremely volatile nature of trading, you need to evaluate your tax strategy needs. You cannot wait until this time next year and enact any strategies for this year. A pro-active tax advisor will work with you on a quarterly basis, to ascertain what you need to do to lower your taxes.

Traders Education: Learning from others can often be the least costly. As a former dean of Harvard put it: "If you think education is expensive, try ignorance." Investment seminars and publications present important learning opportunities that are essential to mastering your trading skills.

Me: Sounds good so far, Jim, but why should we trade in a business entity?

Jim: Some clients have traded as a business, and others have traded in their own name and are considered investors. When we talk with the last group we are always asked, "Why should I trade in a business entity?" It is important that you understand both the pros and cons of trading as a trader and as an investor. Trading as an "investor" limits you in several aspects, the first being taxes.

Taxes: Because the IRS treats an investor as a hobbyist, educational expenses and the related expenses of attending seminars such as travel and meals are not deductible. If you are a trader like I am, you realize that from time to time you need to go to an educational workshop to hone your skills. This generally is an on-going process, many of us go to at least one trade show or workshop each year, and the expenses can be pretty substantial. The rub is we bump up against the 2% threshold the IRS imposes for expenses on our personal tax return. What this means is that if our Adjusted Gross Income for the year is $100,000 the first $2,000 of expenses we have cannot be deducted. Let's look at two examples where our taxpayer has made money:

John is an investor trading in his own name without benefit of a business. At the end of the year he finds he has made $40,000 trading. He and his spouse both work; together they have made an additional $100,000. Their trading expenses look like this:

Telephones       $480            Seminars           $3500*
                                 Travel &
Fees            $1200              Entertainment     $650*
                                 Home Office        $1800*
Cable            $360            Office Equipment  $10000*
DSL              $240            Sub-Total         $15950

Margin Interest $6000            
Sub-Total       $8280            TOTAL             $24230
Of this amount, how much could be deducted by John? He can claim only $8,280 in expenses. He cannot claim the items above which are marked with an asterisk, since he is classified an investor, and the hobby rules indicate that he cannot deduct these items. He and his spouse have approx. $140,000 in income for the year, so the first 2% of his expenses are not deductible. This would mean that $2,800 in expenses could not be deducted, leaving John with $5,480 he could deduct, which at a 30% tax bracket would save him $1,644! (Obviously for illustration this example is flawed in its simplicity. Most taxpayers will have other deductions as well as adjustments to their gross earnings.)

Susan on the other hand has set up a business entity to trade in. Within the business she has filed for the Mark to Market Accounting Method. Assuming she is in the same exact situation that John is with the same total income and expenses, Susan would be able to deduct the additional $15,950. According to section 162 of the IRS code, a business can deduct "all ordinary and necessary expenses." Susan, also in the 30% tax bracket, is able to deduct the entire $24,230. Susan saves $7,269 in taxes.

Lets see: the difference between John and Susan is $5,625 more in Susan's trading account at the end of the year-that's quite a difference!

Ok, we have seen that Susan wins out when they both have made $40,000 in trading income, but what happens when they have a losing year. Let's remain consistent with our expenses, the same as before, but this year each has lost $40,000 with their trading. Now John really gets stiffed because he has the same limitations on his expenses that he had in example one, but since he did not make money trading he cannot deduct his margin expense. (You can only deduct margin interest to the extent that you have made money trading securities or options.)

At this point he has $2,280 in deductible expenses. Since he lost money trading, his AGI has dropped to $100,000, which means that the first $2,000 of expenses is not deductible. He is now able to deduct only $280 in expenses this year, and $3,000 of his capital loss for a total of $3,280 of deductions.

Assuming he remains at the 30% tax level he will save a whopping $984 in tax saving! Oh yes, in addition to this he has a $37,000 loss carryover, which he can use at $3,000 a year in subsequent years!

However, Susan is still able to save the complete $7,269 in taxes, (all ordinary and necessary expenses for the business). Plus, since she is a trader who has taken Mark to Market, she can offset her regular income of $100,000 with her $40,000 loss, bringing her AGI to $60,000, so she saves another $12,000, for a total savings of $19,269 in taxes.

The difference this year? $18,285 more for Susan's Account. So, no matter whether you make or lose money in the market, it makes sense to be trading as a business! Lets summarize:

Example              John           DIFFERENCE          Susan
1.  $40K gain
Tax Savings          $1644         $ 5625               $7269
2.  $40K loss        
Tax Saving           $ 984         $18825              $19269
Me: Wow! That's quite a difference. It really does seem to pay off if we establish a separate trading entity and run it like a business.

Jim: In addition to the huge difference in the tax savings, when you trade as a business there are other issues that we should bring to your attention.

Wash Sales
When your entity is set up properly and you are trading at a level to validate using Mark to Market Accounting, you no longer have to worry about the Wash Sale Rules, which has been a boon to those active traders who trade the same stock over and over throughout the year.

[Note: Wash Sale rules can affect persons who trade the same stock repeatedly throughout the year. An example of one of the rules should suffice to illustrate. You buy Microsoft at $50, it goes to $45; you sell for a loss of $5. If you buy Microsoft again within 30 days, you cannot claim the $5 loss; rather you must increase your basis. In this situation if you buy Microsoft at $30, then your basis would be increased by the amount of the prior loss to $35. See "Beat the Tax Man" from March 19, 2002, Trader's Corner.]

Fringe Benefits
When you trade as a business, you have the ability to pay for health insurance, set up higher education plans, and provide for retirement plans, child care and other benefits for your employees. Most traders have immediate family members as their only employees, so this can be a huge benefit, lowering your taxes by increasing the legitimate expenses of your trading business. In my opinion there is absolutely no reason you would not want to trade as a business. Whether you use Mark to Market accounting needs to be investigated thoroughly. Don't wait another day, as you gain nothing doing so, and will probably penalize yourself by losing money each day you wait.

Me: Thanks, Jim for that information that could save us traders countless thousands of dollars!

As we can see, Jim has a wealth of knowledge on the subject and has barely broken through the surface on the topic. Many of you are probably wondering about "trader status", which is a topic worthy of a full column in and of itself. So we don't have to wait a full week, check out the following links of previous articles for a plethora of tax-saving ideas.


Until next time, make a great weekend for yourselves!


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