The current GameStop short-squeeze episode supplied some eye-opening drama. It additionally brings consideration to the question of who’s eligible for the favorable federal revenue tax remedy that’s accessible to people who commerce shares with adequate depth to qualify as securities merchants for tax functions.
Less-favorable tax remedy applies to people who actively commerce shares, however with inadequate enthusiasm to be labeled as something aside from garden-variety traders with quick consideration spans.
In my subsequent column, I’ll cowl what it takes to qualify as a securities dealer beneath the tax guidelines. This column is dedicated to why it issues. Here goes.
Tax advantages of dealer standing
Achieving dealer standing confers extra tax advantages than easy lively investor-hood. Of course, it additionally comes with the inherent monetary dangers of being a dealer. In this column, I’ll go into extra element on what it takes to fulfill the tax-law definition of a “trader” and what occurs should you do.
Deduct bills on Schedule C and luxuriate in self-employment tax exemption
Let’s assume you qualify as a securities dealer for tax functions. The IRS now considers you to be in the enterprise of shopping for and promoting shares for a revenue. You are subsequently entitled to totally deduct your trader-related bills on Schedule C of Form 1040 similar to another sole proprietor. However, in contrast to most sole proprietors, you don’t must pay the dreaded self-employment (SE) tax in your web revenue from buying and selling. That’s nice, however there’s extra.
Make the mark-to-market election
Once you are labeled as a dealer for tax functions, you turn into eligible to make the particular “mark-to-market” election. If you make the election two vital tax advantages come your means.
- First, you don’t have to fret about the dreaded wash-sale rule, which defers your tax loss if you purchase the identical inventory inside 30 days earlier than or after a loss sale. If you make tons of trades, this could occur all the time. The disallowed wash sale loss will get added to the foundation of the shares that triggered the drawback. But with the mark-to-market election you gained’t must spend any time on bookkeeping to conform with the wash sale rule. You can spend all of your time researching and buying and selling shares. Good.
- You are additionally exempt from the dreaded $3,000 annual restrict on deducting web capital losses ($1,500 should you use married submitting separate standing). That’s as a result of as a mark-to-market dealer, all of your buying and selling positive factors and losses are thought-about “ordinary” positive factors and losses similar to garden-variety enterprise revenue and bills. If you could have dangerous 12 months, you’ll be able to absolutely deduct your web buying and selling loss if you would in any other case be restricted to a mere $3,000 (or $1,500) write-off. Good.
The value to be paid
If you make the mark-to-market election, should faux to promote your total buying and selling portfolio at market on the final buying and selling day of the 12 months and embrace all the ensuing tax positive factors and losses in your Form 1040. If you could have an total achieve, your tax invoice goes up accordingly.
Next, you could faux to purchase every thing that you just pretended to promote at year-end again at the identical value. So, shares in your buying and selling portfolio will begin off the new 12 months with tax foundation equal to market worth and no unrealized positive factors or losses. That’s the mark-to-market idea in motion. However, should you empty out your buying and selling portfolio at the finish of the 12 months, or practically so, this mark-to-market stuff is both N/A or comparatively inconsequential.
For positive factors from shares held in your buying and selling portfolio, you’ll be able to’t profit from the preferential 15% or 20% federal income-tax charges on web long-term capital positive factors However, this actually isn’t an issue since you shouldn’t have something however short-timers in your buying and selling steady anyway. See beneath relating to segregating your non-trading investments in a separate account.
Mind the mark-to-market election deadline
Unfortunately, many of us who can qualify as merchants already missed the probability to make the mark-to-market election for 2020. And you’ll miss out for 2021 as properly should you’re not cautious. Here’s why. According to IRS Revenue Procedure 99-17, you could have made the election for the 2020 tax 12 months by attaching an election assertion to your 2019 return filed by 7/15/20 or to an extension request (Form 4868) for your 2020 return filed by that date.
To make the election for your 2021 tax 12 months, you could connect an election assertion to your 2020 return filed by just-changed deadline of 5/17/21 or to a request to increase the submitting deadline for your 2020 return (Form 4868) filed by that date. See here.
The backside line
Many merchants gained’t be capable of take benefit of the mark-to-market guidelines till the 2021 tax 12 months at the earliest. If you match into this class, write a word to your self to connect an election assertion for the 2021 tax 12 months to your 2020 return filed by 4/15/21 or to a request to increase your 2020 return (Form 4868) filed by that date. Your tax professional may also help you do what it takes to make the election for your 2021 tax 12 months.
One other thing
If you weren’t correctly labeled as a securities dealer for the tax 12 months earlier than the 12 months your mark-to-market election takes impact, making the election counts as an “accounting-method change.” That requires filling out IRS Form 3115 (an advanced sucker beforehand recognized solely to seasoned tax execs). For instance, say you certified as a dealer in 2020 and make the mark-to-market election for your 2021 tax 12 months (don’t neglect the 5/17/21 deadline). You’ll must deal with Form 3115 if you put together your 2021 return someday in subsequent 12 months. You might want skilled help with that.
How merchants ought to deal with inventory positive factors and losses
If you are a dealer who has not made the mark-to-market election, your capital positive factors and losses from buying and selling go on Form 8949 and Schedule D, the identical as positive factors and losses from common investing exercise. Your buying and selling bills go on Schedule C, which implies you’ll routinely present a loss on that type, as a result of it doesn’t embrace any income out of your buying and selling efforts. That might make the IRS nervous, so that you connect an announcement to Schedule C explaining that the income aspect of your buying and selling enterprise is proven on Schedule D. The assertion also needs to quantify your web buying and selling achieve. At least we hope there’s a achieve, and we hope it’s greater than sufficient to offset your buying and selling bills.
If you’ve made the mark-to-market election, report all of your buying and selling positive factors and losses on Part II of IRS Form 4797 (Sales of Business Property). Then connect an announcement to Schedule C to clarify that the income aspect of your buying and selling enterprise is proven on Form 4797.
Segregate your non-trading investments
You might be each a securities dealer and an investor at the identical time. So, long-term positive factors out of your non-trading portfolio will nonetheless qualify for that good 15% or 20% federal income-tax charge with out diminishing the tax advantages accessible for your buying and selling exercise.
To occupy this “best-of-both-worlds” situation, your data should clearly determine non-trading investments as such on the day you purchase them. Also, the IRS says you could maintain funding shares and buying and selling shares in separate brokerage accounts should you’re investing in and buying and selling the identical points. In any case, please take my recommendation and simply use separate accounts. That will make issues simpler for the IRS to know should you ever get audited.
The final phrase
You now perceive the federal revenue tax advantages of securities dealer standing. But we’ve not but coated the way to resolve should you qualify as a dealer. My subsequent column will probably be dedicated to answering that question. Please keep tuned.