Green’s 2020 

Trader Tax 
Guide 
   
 
 

 
 Green’s 2020 
Trader Tax Guide 
 
The savvy trader’s guide to  
2019 tax preparation  
and 2020 tax planning  

 
By Robert A. Green, CPA 
   
 Copyright © 2019 Green & Company, Inc. 
 
Written by Robert A. Green, CPA 
Edited by Molly Flynn Goad 
 
All rights reserved. 
 
ISBN-13: 9780991472567 
 
No part of this document may be reproduced or transmitted in any form or by any 
means, electronic or mechanical, including photocopying, recording, or by any information 
storage and retrieval system, except as permitted under Section 107 or 108 of the 1976 
United States Copyright Act, without permission in writing from the publisher and the 
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Requests to the publisher for permission should be addressed to Green & Company Inc., 
c/o Green CPA, 54 Danbury Rd #351, Ridgefield, CT 06877. 
 
In the publication of this document, every effort has been made to offer the most 
current, correct and clearly expressed information possible. Nonetheless, inadvertent errors 
can occur, and tax law and regulations governing personal finance and investing often 
change. The advice and strategies contained herein may not be suitable for your personal tax 
situation. It’s important to note that there is a risk of loss trading options, stocks, commodity 
futures, and foreign exchange products. Neither the publisher nor the author shall be liable 
for any loss of profit or any other commercial damages, including but not limited to special, 
incidental, consequential, or other damages that are incurred as a consequence of the use and 
application, directly or indirectly, of any information presented in this guide. If legal, tax 
advice, or other expert assistance is required, the services of a professional should be sought. 
This guide is intended for educational use only. 
 
Excerpts from this guide also appear on the author’s website, Greentradertax.com; 
Forbes.com; and third-party websites that feature content from Robert A. Green. 
 
   
  

About Green & Company 

Green & Company, Inc. (GreenTraderTax.com) offers extensive educational resources for 
traders and investment managers on its website, including a blog covering the latest topics, 
trader tax guide, Webinars, videos, and more. For more information, visit greentradertax.com 
or call (888) 558-5257 or (203) 456-1537. 
 
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services, and IRS/state tax exam representation services. 
 
Our motto: Be smart, creative, forward thinking, cutting edge and even aggressive, but 
keep it legal. You deserve excellence in content, ideas, judgment and decision-making. 
Thanks for being our customer and reading our guide. 
 
Thank you to all my fellow professionals at Green, Neuschwander & Manning for their 
help in crafting our strategies. Special thanks to my co-managing member Darren 
Neuschwander, CPA. 
 
Sincerely, 
 
Robert A. Green, CPA, CEO of Green & Company, Inc. 
Owner of GreenTraderTax.com 
Managing Member of Green, Neuschwander & Manning, LLC (our CPA firm) 
888-558-5257 (toll-free in US only) or 203-456-1537 (worldwide) 
www.greentradertax.com 
  
   
 

 
 
Table of Contents 
Highlights 1 
Chapter 1 Trader Tax Status 7 
Chapter 2 Section 475 MTM Accounting 18 
Chapter 3 Tax Treatment of Financial Products 27 
Chapter 4 Accounting for Trading Gains & Losses 37 
Chapter 5 Trading Business Expenses 42 
Chapter 6 Trader Tax Return Reporting Strategies 50 
Chapter 7 Entity Solutions 56 
Chapter 8 Retirement Plans 65 
Chapter 9 Tax Planning 71 
Chapter 10 Dealing with the IRS and States 79 
Chapter 11 Traders in Tax Court 85 
Chapter 12 Proprietary Trading 92 
Chapter 13 Investment Management 96 
Chapter 14 International Tax 100 
Chapter 15 Obamacare Individual Mandate & NIT 107 
Chapter 16 Short Selling 111 
Chapter 17 Tax Cuts and Jobs Act 116 
 
   
 

 
  

Highlights 

Use Green’s 2020 Trader Tax Guide to receive every trader tax break you’re entitled to on 
your 2019 tax returns. Our 2020 guide covers the 2017 Tax Cuts and Jobs Act’s impact on 
investors, traders, and investment managers. Learn various smart moves to make in 2020. 
Whether you prepare your 2019 tax returns as a trader or investor, this guide can help. 
Even though it may be too late for some tax breaks on 2019 tax returns, you can still use this 
guide to execute these tax strategies and elections for tax-year 2020. 

TAX CUTS AND JOBS ACT

Tax Cuts and Jobs Act (TCJA) was enacted on Dec. 22, 2017, and the law changes took 
effect in the 2018 tax year. 
Like many small business owners, traders eligible for trader tax status (TTS) restructured 
their business for 2019 and 2020 to take advantage of TCJA. Two tax changes caught their 
eye: The 20% deduction on qualified business income (QBI) in pass-through entities, and 
suspended investment fees and expenses, which makes TTS even more crucial. (TCJA 
continues to allow itemized deductions for investment-interest expenses and stock borrow 
fees.)  
TCJA didn’t change trader tax matters, including business expense treatment, Section 475 
MTM ordinary gain or loss treatment, and wash-sale loss adjustments on securities; it didn’t 
change TTS S-Corps’, Solo 401(k) retirement contributions and health insurance deductions, 
either. TCJA also retains the lower Section 1256 60/40 capital gains tax rates; the Section 
1256 loss carryback election; Section 988 forex ordinary gain or loss; and tax treatment on 
financial products including options, ETFs, ETNs, swaps, precious metals, and more.  

2018 AND 2019 TAX FORMS

TCJA required significant revisions to the 2018 income tax forms. Some of those changes 
confused taxpayers, so the IRS revised the 2019 tax forms. The redesigned two-page 2018 
Form 1040 resembled a postcard because the IRS moved many sections to six new 2018 
Schedules (Form 1040). It was a block-building approach with the elimination of Form 
1040-EZ and 1040-A.  
The 2019 Form 1040 has three schedules, not six. The IRS moved some items back onto 
the Form 1040. 
The IRS significantly changed Schedule A (Itemized Deductions). TCJA suspended 
“certain miscellaneous itemized deductions subject to the 2% floor.” These deductions were 

1 
included in “Job Expenses and Certain Miscellaneous Deductions” on the 2017 Schedule A, 
lines 21 through 24. The revised 2018 Schedule A deleted these deductions, including job 
expenses, investment fees and expenses, and tax compliance fees and expenses.  
The 2017 Schedule A also had “Other Miscellaneous Deductions,” not subject to the 2% 
floor, on line 28. That’s where investors reported stock-borrow fees, which are not 
investment fees and expenses. The 2018 Schedule A changed the name to “Other Itemized 
Deductions” on line 16.  
TCJA introduced a new 20% deduction on qualified business income for 2018, but the 
IRS did not draft a tax form for it. Taxpayers used a worksheet for the calculation and 
reported a “qualified business income deduction” on the 2018 Form 1040, page 2, line 9. For 
2019, the IRS introduced Form 8995 (Qualified Business Income Deduction Simplified 
Computation) and Form 8995-A (Qualified Business Income Deduction).  

BUSINESS TRADERS FARE BETTER

By default, the IRS lumps all traders into “investor tax status,” and investors get penalized 
in the tax code — more so with TCJA. Investors have restricted investment interest expense 
deductions, and investment fees and expenses are suspended. Investors have capital-loss 
limitations against ordinary income ($3,000 per year), and wash-sale loss deferrals; they do 
not have the Section 475 MTM election option or health insurance and retirement plan 
deduction strategies. Investors benefit from lower long-term capital gains rates (0%, 15%, 
and 20%) on positions held 12 months or more before sale. If active traders have segregated 
long-term investment positions, this is available to them as well. 
Business traders eligible for TTS are entitled to many tax breaks. A sole proprietor 
(individual) TTS trader deducts business expenses and is entitled to elect Section 475 MTM 
ordinary gain or loss treatment. However, to deduct health insurance and retirement plan 
contributions, a TTS trader needs an S-Corp to create earned income with officer 
compensation.  
Don’t confuse TTS with the related tax-treatment election of Section 475 MTM 
accounting. The 475 election converts new capital gains and losses into business ordinary 
gains and losses, avoiding the $3,000 capital loss limitation. Only qualified business traders 
may use Section 475 MTM; investors may not. Section 475 trades are also exempt from 
wash-sale loss adjustments. The 20% deduction on qualified business income includes 
Section 475 ordinary income but excludes capital gains, interest, and dividend income.  
A business trader can assess and claim TTS after year-end and even going back three 
open tax years. But business traders may only use Section 475 MTM if they filed an election 
on time, either by April 15 of the current year (i.e., April 15, 2019 for 2019) or within 75 days 
of inception of a new taxpayer (i.e., a new entity). For more on TTS, see Chapter 1. 

CAN TRADERS DEDUCT TRADING LOSSES?

Deducting trading losses depends on the instrument traded, the trader’s tax status, and 
various elections. 
Many traders bought this guide hoping to find a way to deduct their 2019 trading losses. 
Maybe they qualify for TTS, but that only gives them the right to deduct trading business 
expenses.  

2 
 Securities, Section 1256 contracts, ETNs, and cryptocurrency trading receive capital 
gain/loss treatment by default. If a TTS trader did not file a Section 475 election on 
securities and/or commodities on time (i.e., by April 15, 2019), or have Section 475 from a 
prior year, he is stuck with capital loss treatment on securities and Section 1256 contracts. 
Section 475 does not apply to ETN prepaid forward contracts, which are not securities, or 
cryptocurrencies, which are intangible property.  
Capital losses offset capital gains without limitation, whether short-term or long-term, 
but a net capital loss on Schedule D is limited to $3,000 per year against other income. 
Excess capital losses are carried over to the subsequent tax year(s).  
Once taxpayers get in the capital loss carryover trap, a problem they often face is how to 
use up the carryover in the following year(s). If a taxpayer elects Section 475 by April 15, 
2020, the 2020 business trading gains will be ordinary rather than capital. Remember, only 
capital gains can offset capital loss carryovers. That creates a predicament addressed in 
Chapter 2 on Section 475 MTM. Once a trader has a capital loss carryover hole, she needs a 
capital gains ladder to climb out of it and a Section 475 election to prevent digging an even 
bigger one. The IRS allows revocation of Section 475 elections if a Section 475 trader later 
decides he or she wants capital gain/loss treatment again.  
Traders with capital losses from Section 1256 contracts (such as futures) may be in luck if 
they had gains in Section 1256 contracts in the prior three tax years. On the top of Form 
6781, traders can file a Section 1256 loss carryback election. This allows taxpayers to offset 
their current-year losses against prior-year 1256 gains to receive a refund of taxes paid in 
prior years. Business traders may elect Section 475 MTM on Section 1256 contracts, but 
most elect it on securities only so they can retain the lower 60/40 capital gains tax rates on 
Section 1256 gains, where 60% is considered a long-term capital gain, even on day trades. 
Taxpayers with losses trading forex contracts in the off-exchange Interbank market may 
be in luck. By default, Section 988 for forex transactions receives ordinary gain or loss 
treatment, which means the capital-loss limitation doesn’t apply. However, without TTS, the 
forex loss isn’t a business loss and therefore can’t be included in a net operating loss (NOL) 
calculation — potentially making it a wasted loss since it also can’t be added to the capital 
loss carryover. If taxpayer has another source of taxable income, the forex ordinary loss 
offsets it; the concern is when there is negative taxable income. Forex traders can file a 
contemporaneous “capital gains and losses” election in their books and records to opt out of 
Section 988, which is wise when capital loss carryovers exist. Contemporaneous means in 
advance — not after the fact using hindsight. In some cases, this election qualifies for 
Section 1256(g) lower 60/40 capital gains tax rates on major pairs, not minors. 
A TTS trader using Section 475 on securities has ordinary loss treatment, which avoids 
wash-sale loss adjustments and the $3,000 capital loss limitation. Section 475 ordinary losses 
offset income of any kind, and a net operating loss carries forward to subsequent tax year(s). 
TCJA’s “excess business loss” (EBL) limitation for 2019 is $510,000 married and $255,000 
other taxpayers applies to Section 475 ordinary losses and trading expenses. Add an EBL to 
an NOL carryforward. See TCJA changes in Chapter 17. 

3 
TAX TREATMENT ON FINANCIAL PRODUCTS
There are complexities in sorting through different tax-treatment rules and tax rates. It’s 
often hard to tell what falls into each category. To help our readers with this, we cover the 
many trading instruments and their tax treatment in Chapter 3. 
Securities have realized gain and loss treatment and are subject to wash-sale rules and the 
$3,000 per year capital loss limitation on individual tax returns.  
Section 1256 contracts — including regulated futures contracts on U.S. commodities 
exchanges — are marked to market by default, so there are no wash-sale adjustments, and 
they receive lower 60/40 capital gains tax rates.  
Options have a wide range of tax treatment. An option is a derivative of an underlying 
financial instrument and the tax treatment is generally the same. Equity options are taxed the 
same as equities, which are securities. Index options are derivatives of indexes, and 
broad-based indexes are Section 1256 contracts. Simple and complex equity option trades 
have special tax rules on holding period, adjustments, and more.  
Forex receives ordinary gain or loss treatment on realized trades (including rollovers), 
unless a contemporaneous capital gains election is filed. In some cases, lower 60/40 capital 
gains tax rates on majors may apply.  
Physical precious metals are collectibles; if these capital assets are held over one year, sales 
are subject to the collectibles capital gains rate capped at 28%.  
Cryptocurrencies are intangible property taxed like securities on Form 8949, but 
wash-sale loss and Section 475 rules do not apply because they are not securities. 
Foreign futures are taxed like securities unless the IRS issues a revenue ruling allowing 
Section 1256 tax benefits.  
Several brokerage firms classify options on volatility exchange-traded notes (ETNs) and 
options on volatility exchange-traded funds (ETFs) structured as publicly traded 
partnerships as “equity options” taxed as securities. There is substantial authority to treat 
these CBOE-listed options as “non-equity options” eligible for Section 1256 contract 
treatment. Volatility ETNs have special tax treatment: ETNs structured as prepaid forward 
contracts are not securities, whereas, ETNs structured as debt instruments are.  
Don't solely rely on broker 1099-Bs: There are opportunities to switch to lower 60/40 tax 
capital gains rates in Section 1256, use Section 475 ordinary loss treatment if elected on time, 
and report wash-sale losses differently. Vital 2020 tax elections need to be made on time. See 
Chapter 3.  

ENTITIES FOR TRADERS

Entities can solidify TTS, unlock health insurance and retirement plan deductions, gain 
flexibility with a Section 475 election or revocation, prevent wash-sale losses with individual 
and IRA accounts, and enhance a QBI deduction on Section 475 income less trading 
expenses. An entity return consolidates trading activity on a pass-through tax return, making 
life easier for traders, accountants, and the IRS. Trading in an entity allows individually held 
investments to be separate from business trading. It operates as a separate taxpayer yet is 
inexpensive and straightforward to set up and manage.  
An LLC with S-Corp election is generally the best choice for a single or married couple 
seeking health insurance and retirement plan deductions. See Chapter 7. 

4 
RETIREMENT PLANS FOR TRADERS
Annual tax-deductible contributions up to $62,000 for 2019 and $63,500 for 2020 to a 
TTS S-Corp Solo 401(k) retirement plan generally saves traders significantly more in income 
taxes than it costs in payroll taxes (FICA and Medicare). Trading gains aren’t earned income, 
so traders use an S-Corp to pay officer compensation.  
There’s also an option for a Solo 401(k) Roth: If you are willing to forgo the tax 
deduction, you’ll enjoy permanent tax-free status on contributions and growth within the 
plan. See Chapter 8.  

20% DEDUCTION ON QUALIFIED BUSINESS INCOME

TCJA introduced a new tax deduction for pass-through businesses, including sole 
proprietors, partnerships and S-Corps. Subject to haircuts and limitations, a pass-through 
business could be eligible for a 20% deduction on qualified business income (QBI).   
Traders eligible for TTS are a “specified service activity,” which means if their taxable 
income is above an income cap, they won’t receive a QBI deduction. The taxable income 
(TI) cap is $421,400/$210,700 (married/other taxpayers) for 2019, and $426,600/$213,300 
(married/other taxpayers) for 2020. The phase-out range below the cap is $100,000/$50,000 
(married/other taxpayers), in which the QBI deduction phases out for specified service 
activities. The W-2 wage and property basis limitations also apply within the phase-out range. 
Investment managers are specified service activities, too. 
QBI for traders includes Section 475 ordinary income and loss and trading business 
expenses. QBI excludes capital gains and losses, Section 988 forex and swap ordinary income 
or loss, dividends, and interest income.  
TCJA favors non-service businesses, which are not subject to an income cap. The W-2 
wage and property basis limitations apply above the TI threshold of $321,400/$160,700 
(married/other taxpayers) for 2019, and $326,600/$163,300 (married/other taxpayers) for 
2020. The IRS adjusts the annual TI income threshold for inflation each year. For more 
information, see Chapter 17. 

AFFORDABLE CARE ACT

TCJA did not change the Affordable Care Act’s (ACA) 3.8% Medicare tax on unearned 
income. The net investment tax (NIT) applies on net investment income (NII) for individual 
taxpayers with modified AGI over $250,000 (married) and $200,000 (single). The threshold 
is not indexed for inflation. Traders can reduce NIT by deducting TTS trading expenses, 
including salaries paid to them and their spouses. Traders may also reduce NII with 
investment expenses that are allowed on Schedule A, such as investment-interest expense 
and stock borrow fees. Investment fees and other investment expenses suspended from 
Schedule A also are not deductible for NII.
ACA’s individual health insurance mandate and shared responsibility fee for 
non-compliance, exchange subsidies, and premium tax credits continue to apply for 2019 
and 2020. However, TCJA reduced the shared responsibility fee to $0 starting in 2019.  
For more information, see Chapter 9 and Chapter 15. 

5 
INVESTMENT MANAGEMENT CARRIED INTEREST
TCJA modified the carried interest tax break for investment managers in investment 
partnerships, lengthening their holding period on profit allocation of long-term capital gains 
(LTCG) from one year to three years. If the manager also invests capital in the partnership, 
he or she has LTCG after one year on that interest. The three-year rule only applies to the 
investment manager’s profit allocation — carried interest. Investors still have LTCG based 
on one year. 
Investment partnerships include hedge funds, commodity pools, private equity funds, and 
real estate partnerships. Many hedge funds don’t hold securities for more than three years, 
whereas, private equity, real estate partnerships, and venture capital funds do. 
Investors also benefit from carried interest in investment partnerships. TCJA suspended 
“certain miscellaneous itemized deductions subject to the 2% floor,” which includes 
investment fees and expenses. Separately managed account investors are out of luck, but 
hedge fund investors can limit the negative impact by using carried-interest tax breaks. 
Carried interest reduces a hedge fund investor’s capital gains instead of having a suspended 
incentive fee deduction. 

INTERNATIONAL TAX MATTERS

When it comes to global tax matters, we focus on the following types of traders: U.S. 
residents living abroad, U.S. residents with international investments, U.S. residents moving 
to U.S. territories like Puerto Rico (with substantial tax breaks), U.S. residents surrendering 
citizenship or green cards, and nonresident aliens investing in the U.S. with individual U.S. 
brokerage accounts or through an entity. See Chapter 14.   

DESK REFERENCE
Some readers use our guide as a desk reference, to quickly find answers to specific 
questions in a given area. Others read this guide in its entirety. To accommodate 
desk-reference readers, we edit each chapter to stand alone, which inevitably means some 
chapters will contain information covered in others.  

6 
  

Chapter 1 
 
Trader Tax Status 

Trader tax status (TTS) constitutes business expense treatment and unlocks an assortment 
of meaningful tax benefits for active traders who qualify. The first step is to determine 
eligibility. If you do qualify for TTS, you can claim some tax breaks such as business expense 
treatment after the fact and elect and set up other breaks — like Section 475 MTM and 
employee-benefit plans — on a timely basis.  

THERE’S NO ELECTION FOR TTS

There’s no election for TTS; it’s an optional tax status based on facts and circumstances 
only. A trader may qualify for TTS one year but not the next. 
TTS qualification can be for part of a year, as well. Perhaps a taxpayer qualified for TTS 
in 2018 and quit or suspended active trading on June 30, 2019. Include the period of 
qualification on Schedule C or the pass-through entity tax return and deduct business 
expenses for the partial-year period. If elected, use Section 475 for trades made during the 
TTS period, too.  

BUSINESS EXPENSE TREATMENT

Qualifying for TTS means a trader can use business treatment for trading expenses. 
Business expenses include home-office, education, Section 195 startup expenses, Section 
248 organization expenses, margin interest, tangible property expense, Section 179 (100%) 
or 100% bonus depreciation, amortization on software, self-created automated trading 
systems, seminars, market data, stock borrow fees, and much more. As an example of the 
potential savings, if TTS business expenses and home office deductions are $20,000, and the 
taxpayer’s federal and state tax bracket is 35%, then income tax savings is about $7,000. 
TCJA suspended “certain miscellaneous itemized deductions subject to the 2% floor,” 
including investment fees and expenses, commencing in 2018. This is more incentive for 
traders to try to qualify for TTS. 
Hedge funds with TTS also save taxes for their investors, passing through advisory fees as 
a business expense rather than suspended investment fees and expenses. TTS qualification 
can be assessed and claimed after year-end; it doesn’t need to be elected in advance like 
Section 475 MTM and the forex election to opt out of Section 988. TTS is allowed for the 

7 
tax year that just ended and for the prior three tax years with amended returns by including a 
Schedule C as a sole proprietor on individual accounts or by changing the character of 
expenses on partnership or S-Corp tax returns and related Schedule K-1s. (Note: Filing 
amended tax returns may increase the odds of IRS questions or exam so before choosing 
this route, taxpayers should be sure they qualify for TTS.) 
Full-time active traders generally qualify for TTS. Part-time traders can also qualify, but 
it’s more difficult to do so. The bar is raised in the eyes of the IRS — especially if the trader 
has significant trading losses with business ordinary-loss treatment (Section 475) rather than 
capital-loss limitations. For more information about business expenses for TTS traders, see 
Chapter 5.  

HOW TO QUALIFY
It’s not easy to qualify for TTS. Currently, there’s no statutory law with objective tests for 
eligibility. Subjective case law applies. Leading tax publishers have interpreted case law to 
show a two-part test to qualify for TTS:
1. Taxpayers’ trading activity must be substantial, regular, frequent, and continuous. 
2. Taxpayer must seek to catch swings in daily market movements and profit from these 
short-term changes rather than profiting from long-term holding of investments. 
IRS agents often refer to Chapter 4 in IRS Publication 550, “Special Rules for Traders.” 
Here’s an excerpt:  
The following facts and circumstances should be considered in determining if your activity is a securities 
trading business. 
● Typical holding periods for securities bought and sold. 
● The frequency and dollar amount of your trades during the year. 
● The extent to which you pursue the activity to produce income for a livelihood. 
● The amount of time you devote to the activity.  
The words “substantial, regular, frequent, and continuous” are robust terms, yet case law 
doesn’t give a bright-line test with exact numbers. Plus, a few recent tax court cases have set 
a further precedent (see Chapter 11). 
The publication mentions holding period, frequency, and dollar amount of trades, as well 
as time devoted by the taxpayer. It also mentions the intention to make a livelihood, an 
important element in defeating the hobby-loss rules. Trading is not personal or recreational, 
which are the key terms used in hobby-loss case law. 
We hope to make further headway in establishing the importance of “continuous business 
standard” vs. frequency of trades. Plenty of traders meet the continuous business standard as 
they have been trading actively for several years, but some fall short of the required volume 
and frequency rate of trades in a given year. Over the past few years, we have seen that more 
day traders are moving to swing trading and trading options, thereby reducing their 
frequency of trades and lengthening their holding period. In recent years, average holding 
period has become the most critical factor; it must be 31 days or less per the Endicott court 
case. The tax court has not addressed the continuous business standard for a trader. 

GOLDEN RULES
Our golden rules are based on trader tax court cases and our vast experience with IRS 
and state controversy for traders. We tweak them each year based on new cases. Volume, 

8 
frequency and average holding period are the “big three” because they are easier for the IRS 
to verify. 
Volume: The 2015 tax court case Poppe vs. Commission is a useful reference. Poppe 
made 720 total trades per year/60 per month. We recommend an average of four trades per 
day, four days per week, 16 trades per week, 60 trades a month, and 720 per year on an 
annualized basis. Count each open and closing trade separately, not round trips. 
Here’s an example calculation of volume and frequency. The securities markets are open 
approximately 250 days, but let’s account for some personal days or holidays, and figure 
you’re available to trade 240 days per year. A 75% frequency of 240 days equals 180 days per 
year, so 720 total trades divided by 180 trading days equals four trades per day.  
Some traders scale into and out of trades, and you can count each of those trades 
separately.  
Options traders have multi-legged positions on “complex trades.” We believe you may 
count each trade confirmation of a complex options trade if you enter the trades separately, 
although the tax court has not addressed that issue yet. Some traders enter a complex 
options trade and the broker breaks down the legs, so you cannot count the legs separately. 
If you initiate a trade order and the broker breaks down the lot sizes without your 
involvement, it’s wise not to count the extra volume of trades in this case. 
Forex and futures aren’t listed line by line on tax returns (unlike securities trades), so the 
IRS can’t see the volume of trading done in the details of the tax forms. It’s essential to 
provide a detailed description of trading volume in tax return footnotes about TTS. 
In the 2013 Endicott and Nelson tax court cases, the IRS further delineated between 
“substance” and “volume.” Substance refers to the size of trades and materiality, whereas 
volume is the number of transactions during the year. See Chapter 11 for further 
information about the case on this point. 
Cryptocurrency traders might appear to have thousands of trades, but they have far less. 
Many coin exchanges break down one trade order into tens or hundreds of trade executions. 
Cryptocurrency traders should count orders — not the multiple executions they did not 
initiate. 
Trade executions count; not unexecuted trades. 
Frequency: Execute trades on close to four days per week, around a 75% frequency rate. 
The tax courts require “regular, frequent, and continuous” qualification for TTS. If you enter 
or exit a trading business during the year, then maintain the frequency rate during the TTS 
period. Time off from the execution of trades should be for a reasonable amount of 
vacations and other non-working days. Think of TTS like it’s a job, only the markets are your 
boss.  
In the following trader tax court cases, the IRS denied TTS to options traders, including 
Holsinger, Assaderaghi, Endicott, and Nelson. They only traded on two to three days per 
week; hence, I suggest executing trades on close to four days per week. 
Holding period: The IRS stated that the average holding period is the most crucial TTS 
factor. In the Endicott court, the IRS said the average holding period must be 31 days or 
less. That’s a bright-line test. If your average holding period is more than 31 days, it’s 
disqualifying for TTS, even if all your other TTS factors are favorable.  

9 
 It’s more natural for day traders and swing traders to meet the holding period 
requirement. In the holding period analysis, don’t count segregated investment accounts and 
retirement accounts; only count TTS positions.  
Monthly options traders face challenges in holding periods. They may have average 
holding periods of over one month if they trade monthly and longer expirations and keep 
them over a month. Holsinger was a monthly options trader, and his holding periods 
averaged one to two months. More often now, TTS traders are focused on trading weekly 
options expirations, and many of them are eligible for TTS.  
Consider the following example of a trader in equities and equity options. If he holds 
80% of his trades for one day and the other 20% for 35 days, then the average holding 
period is well under 31 days. It’s not evident if the IRS might apply weighted averages to the 
average holding period. 
Trades full time or part time, for a good portion of the day, almost every day the 
markets are open. Part-time and money-losing traders face more IRS scrutiny, and 
individuals face more scrutiny than entity traders.  
Full-time options traders actively trading significant portfolios may not qualify because 
they don’t have enough volume and frequency, and their average holding period is over 31 
days. On the other hand, a part-time trader with a full-time job may qualify as a day and 
swing trader in securities meeting all our golden rules.  
Hours: Spends more than four hours per day, almost every market day working on his 
trading business. All-time counts, including execution of trade orders, research, 
administration, accounting, education, travel, meetings, and more. Most active business 
traders spend more than 40 hours per week in their trading business. Part-time traders 
usually spend more than four hours per day. In one tax exam our firm handled, the IRS 
agent brought up “material participation” rules (Section 469), which require 500 hours of 
work per year (as a general rule). Most business traders easily surpass 500 hours of work. 
However, Section 469 doesn’t apply to trading businesses, under its “trading rule” 
exemption. Without this exemption, taxpayers could generate passive-activity income by 
investing in hedge funds and the IRS did not want that.  
Avoid sporadic lapses: A trader has few to no sporadic lapses in the trading business 
during the year. The IRS has successfully denied TTS in a few tax court cases by arguing the 
trader had too many sporadic lapses in trading, such as taking several months off during the 
year. Traders can take vacations, sick time, and personal time off just like everyone else. 
Some traders take a break from active trading to recover from recent losses and learn new 
trading methods and markets. Breaks should be carefully explained to the IRS in tax-return 
footnotes. We believe retooling and education during a lapse in trade executions still may 
count for the continuous business activity (CBA) standard, although the IRS currently does 
not give credence to CBA. We recommend traders keep proper records of their time spent as 
support.  
Comments from an IRS official about the Chen tax court case point out the IRS doesn’t 
respect individual traders who are brand new to a trading activity and who enter and exit it 
too quickly — especially if the trader seeks a large IRS refund by deducting a Section 475 
MTM ordinary loss on an individual tax return. 

10 
 Some traders must temporarily stop for several months for health reasons. It’s not clear if 
the IRS will respect that as a valid interruption of a trading business activity. That seems 
unfair, but it may be the reality.  
Intention: Has the intention to run a business and make a living. Traders must have the 
intention to run a separate trading business — trading his or her own money — but it 
doesn’t have to be one’s exclusive or primary means of making a living. The key word is “a” 
living, which means it can be a supplemental living.  
Many traders enter an active trading business while still working a full-time job. Advances 
in technology and flexible job schedules make it possible to carry on both activities 
simultaneously.  
It’s not a good idea to try to achieve TTS within a business entity already principally 
conducting a different type of business activity. It’s better to form a new trading entity. 
Trading an existing business’s available working capital seems like a treasury function and 
sideline, which can deny trader tax breaks if the IRS takes a look.  
Filing as a sole proprietor on a Schedule C is allowed and used by many, but it’s not the 
best tax filing strategy for a part-time trader. An individual tax return shows a taxpayer’s job 
and other business activities or retirement, which may undermine TTS in the eyes of the IRS. 
The IRS tends to think trading is a secondary activity, and it may seek to deny TTS. It’s best 
to form a new, separate entity dedicated to trading only. (Chapter 7 covers entities.)  
Several years ago, we spoke with one IRS agent who argued the trader did not make a 
living since he had perennial trading losses. That’s okay because the rule speaks to intention, 
not the actual results. The hobby-loss rules don’t apply to TTS traders because trading is not 
recreational or personal in nature.  
Part-time traders often tell me they operate a business to make a supplemental living and 
intend to leave their job to trade full-time when they become profitable enough.  
Operations: Has significant business equipment, education, business services, and a 
home office. Most business traders have multiple monitors, computers, mobile devices, cloud 
services, trading services and subscriptions, education expenses, high-speed broadband, 
wireless, and a home office and/or outside office. Some have staff. The IRS needs to see 
that a taxpayer claiming TTS has a serious trading business operation. How can one run a 
business without a dedicated space? Casual investors rarely have as elaborate an office set up 
as business traders do. Why would a long-term investor need multiple monitors? If a trader 
uses a home-office space exclusively for business rather than personal use, the tax return 
should reflect this because it is not only a valid home-office deduction, but it also further 
supports the fact there is legitimate business activity being conducted. The home-office 
deduction is no longer a red flag with the IRS, and it is not a complicated calculation. (Home 
office is covered in Chapter 5.) Some TTS traders just use a laptop and that’s okay. 
Account size: Has a material account size. Securities traders need to have $25,000 on 
deposit with a U.S.-based broker to achieve “pattern day trader” (PDT) status. With this 
status, he or she can day trade using up to 4:1 margin rather than 2:1. Without PDT status, 
securities traders, which include equities and equity options, can’t day trade and will have a 
hard time qualifying for TTS. The $25,000 amount seems substantial enough to impress the 
IRS.   
Many new traders don’t want to risk $25,000 day trading securities; they prefer to trade 
futures or forex, all allowing mini-account sizes of $5,000 or less. However, a small $5,000 

11 
account size likely won’t impress the IRS — a taxpayer probably needs more capital to 
qualify. We like to see more than $15,000.  
Adequate account size also depends on one’s overall net worth and cash flow. Millionaires 
may need larger account sizes, whereas some unemployed traders without much cash flow or 
very young traders may get by with lower account sizes. A trader may also be able to factor 
in capital invested in equipment and startup costs. 

WHAT DOESN’T QUALIFY?

Four types of trading activity aren’t counted for TTS qualification: Automated trading 
without much involvement by the trader (but a trader creating his or her own program 
qualifies); a trade copying service or software; engaging a professional outside investment 
manager; and trading in retirement funds. These trades should not be included in the golden 
rule calculations. 
1. Outside-developed automated trading systems. These programs are becoming 
more popular. An entirely canned automated trading service (ATS) — sometimes referred to 
as an “expert advisor” program in the forex area — with little to no involvement by the 
trader doesn’t qualify for TTS. The IRS may view an outside-developed ATS the same as a 
trader who uses a broker to make most buy/sell decisions and executions. On the other 
hand, if the trader can show he’s very involved with the creation of the ATS — perhaps by 
writing the code or algorithms, setting the entry and exit signals, and turning over only 
execution to the program — the IRS may count the ATS-generated trades in the TTS 
analysis. It’s helpful if the trader can show he spends more than four hours per day working 
in his trading business, including time for ATS maintenance, back-testing, and modifications. 
We have not yet seen the IRS challenge ATS for TTS in exams or court cases, but we feel it 
may react this way when it comes up. 
Self-creation of the ATS needs to be significant to count for TTS. Just making a few 
choices among options offered in an outside-developed ATS building-block service does not 
qualify for TTS.  
When I consult traders, and they mention dozens of trades per day, and they also have a 
demanding full-time job, I ask if they use an ATS. If they only spend 30 minutes per day, I 
suspect they might not qualify for TTS and could be relying on an outside-vendor ATS. This 
is a growing trend now that more ATS are available, and brokers use them with investors — 
they are not business traders. Some try active trading, and if it doesn’t work out, they turn to 
an ATS. Investors often rely on investment advice from these providers, but many times the 
broker and ATS provider each claim exemption from that responsibility — they are not 
registered investment advisers. Plus, their websites may show off incredible trading results 
that are not audited or put through proper vetting by regulators and accountants. Proceed 
with caution.  
If traders spend a lot of money on an ATS that don’t qualify as part of their trading 
business, then those expenses are suspended as investment expenses on Schedule A. (See 
how TTS traders expense self-created ATS in Chapter 5.) 
Traders need to know the IRS may connect the dots and realize they are using an ATS. A 
full-scale exam can uncover these facts. Consider the analogy of an airplane pilot using 
manual and automated systems. A trader needs to be in the cockpit, not in the cabin as a 
passenger.  

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 2. Trade copying service. Some traders use “trade copying software” (TCS). Trade 
copying is similar to using a canned ATS or outside adviser, where the copycat trader might 
not qualify for TTS on those trades. 
As an example, a trade coaching and education company offers a TCS that suggests 
several trades each day, with exact entry and exit points and stop-loss orders. The trader 
decides which trades to make and executes them manually. If the trader follows the TCS 
tightly and does not significantly depart from its suggestions, then an IRS agent might feel 
that he or she does not qualify for TTS. On the other hand, if the trader cherry picks a 
minor percentage of the suggested trades, sets different stop-loss orders, and waits longer on 
entry and exit executions, then he or she might qualify for TTS (providing all the TTS 
factors are met).   
3. Engaging a money manager. Hiring a registered investment adviser (RIA) or 
commodity trading adviser (CTA) — whether they are duly registered or exempt from 
registration — to trade one’s account doesn’t count toward TTS qualification. However, 
hiring an employee or independent contractor under the trader’s supervision to help trade 
his or her own funds should qualify providing the taxpayer is a competent trader. This is a 
similar concept to the previous point. There are decades-old tax court cases that show using 
outside brokers and investment advisers to make trading decisions undermines TTS.  
When a taxpayer sets up a small LLC, there are nuances between engaging an 
independent outside manager vs. a supervised inside trader. If the engaged trader is a 
registered investment adviser, he’s clearly in the business of being an external manager, and 
TTS is not achievable. But if the trader only trades inside the taxpayer’s LLC under the 
taxpayer’s direction, it may be possible to achieve TTS.  
Proprietary trading firms engage employees, independent contractors (IC) or 
LLC-member proprietary traders to trade the firm’s capital. In this situation, TTS is achieved 
on the firm level, not on the individual trader level. Prop traders are not trading their own 
funds, although some do have a retail trading account on the side. In most cases, 
non-employee prop traders can deduct their business expenses on their individual return’s 
Schedule C for independent contractors and Schedule E for LLC K-1 members. (See 
Chapter 12 on proprietary trading.)  
With married couples, if spouse A has an individual brokerage account in his or her 
name only and gives power of attorney to spouse B for it, the IRS won’t grant TTS even if 
spouse B meets all the golden rules for TTS. Why? Spouse B is not deemed an owner of the 
account. In this case, the IRS will treat spouse A as an investor and spouse B as an 
investment manager. Married couples can solve this problem by using a joint individual 
account or trading in a spousal-owned entity. It’s best to list the trader spouse first on the 
account. 
4. Trading retirement funds. TTS is achieved through trading taxable accounts. Trading 
activity in non-taxable retirement accounts doesn’t count for purposes of TTS qualification. 
Trading in retirement plans can be an excellent way to build tax-free compounded returns, 
especially if the taxpayer doesn’t qualify for TTS in their taxable accounts. It is possible to 
actively trade retirement accounts and at the same time qualify for TTS in taxable accounts. 
Caution: it’s dangerous to trade substantially identical positions between an individual taxable 
account and IRA accounts since this can trigger a wash-sale loss in a taxable account that 
moves into the IRA. That’s a permanent wash sale loss. See wash sale losses in Chapter 4. 

13 
FALLING SHORT
If trading activity falls short of the conditions laid out in trader tax court cases, the IRS 
may scrutinize a return and challenge TTS. The IRS may examine a return anyway, but if the 
taxpayer met our golden rules, he or she has a good chance to win TTS. Anytime there is 
uncertainty surrounding qualification, we recommend consulting a trader tax expert to 
review the facts and circumstances to be sure there is a solid position for claiming TTS. 
Filing an entity tax return is safer than filing a Schedule C as a sole proprietor because an 
entity attracts less IRS attention. If a taxpayer is trading in an entity, the same golden rule 
standards apply for TTS qualification to use business expense treatment, Section 475 MTM, 
and have employee-benefit plan deductions — otherwise it’s an investment company just like 
most hedge funds. On an entity return, however, trading income, losses, and expenses are 
displayed alongside business expenses, so a profitable trading business looks profitable, 
which could warrant less attention. Conversely, on an individual return, Schedule C traders 
look like a losing business since trading gains are reported on other tax forms like Form 
8949 for securities, Form 6781 for futures, and Form 4797 for Section 475 MTM trades. The 
IRS often does not make a connection between Schedule C expenses and those other tax 
forms where you report business-related trading gains and losses. This is a structural 
problem for sole proprietor traders; we have some solutions in Chapter 6 (the 
income-transfer strategy and footnotes).
Part-time traders with full-time jobs (with wages reported on a W-2) should consider a 
separate entity tax return to claim TTS safely. A stand-alone trading business looks better on 
the entity rather than on individual tax returns. There are extra costs to forming and 
operating an entity, and it might not be worth those costs to appear better in the eyes of the 
IRS. 

ADD SCHEDULE C
If you realize you qualified for TTS in 2019 and you have trading business expenses, 
startup costs and home office expenses, then you can add a Schedule C to your 2019 
individual tax return. Even though you may not be able to take an ordinary business 
deduction for your trading capital losses since you missed the April 15, 2019 Section 475 
election deadline, claiming TTS will allow the deduction of your trading expenses as business 
expenses, which could generate some significant tax savings.
Some business traders feel satisfied to operate as sole proprietors (with a Schedule C) 
because it appears less complicated than using a separately filed entity return, they can claim 
TTS after year-end, and it often costs less than forming an entity.  

DON’T GO OVERBOARD WITH EXPENSES

In their landmark losing trader tax court cases, Assaderaghi, Nelson, and Endicott 
triggered IRS exams with unrealistic amounts of business expenses on Schedule C and 
ordinary losses from trading on Form 4797 (Section 475 MTM). Most traders have a 
reasonable level of business expenses (under $15,000), and if traders don’t also report a 
significant Form 4797 ordinary trading loss under Section 475, it may not be enough to draw 
IRS attention. Assaderaghi, Nelson, and Endicott each reported huge and unbelievable 
Schedule C business expenses and substantial Section 475 MTM ordinary trading losses, all 
conditional on TTS qualification. No wonder the IRS sought to pull the TTS rug out from 

14 
under their tax returns. The denial of TTS resulted in the disallowance of all these ordinary 
business deductions (losses and expenses) on their respective returns.
Business traders should consider using a Schedule C for 2019 (if there is no trading entity 
in place) and forming a trading entity for 2020. A single-member or spousal-member LLC 
electing S-Corp treatment unlocks additional tax breaks like deductions for high-deductible 
retirement plans and health insurance premiums paid during the entity period.  

DON’T BE AFRAID TO CLAIM TTS

If a trader has significant trading gains, the IRS may not be inclined to challenge a 
reasonable level of business-expense deductions. Our income-transfer strategy zeros out 
Schedule C, so it doesn’t show a net loss. Even if a trader has small trading losses, if 
business-trading expenses aren’t very high, it’s probably not worth it for the IRS to audit the 
tax return. On the other hand, if a trader has a significant trading business loss comprised of 
substantial Schedule C expenses and Section 475 MTM ordinary trading losses, the IRS or 
the state may ask questions before or after paying a significant tax refund. Be prepared to 
defend TTS, as it’s a requirement for Section 475 MTM ordinary loss treatment. 
Traders may consider soaking up ordinary trading losses under the excess business loss 
(EBL) limitation with a Roth IRA conversion executed before year-end. Consider it a way to 
convert an IRA inexpensively. (Chapter 8 contains more on Roth IRA conversions and 
chapter 9 shows examples of this tax planning strategy.)  
After filing thousands of tax returns for business traders since the online revolution in 
1997, only a small number of our clients have been audited, and we received excellent results 
on those cases. Our audit percentages are considerably less than the national averages. We 
attribute this successful record to proper analysis of TTS, correct tax reporting techniques, 
accuracy and attention to detail, and detailed footnotes that are included with trader tax 
returns. (Read about footnotes in Chapter 6.) Our footnotes generally answer most IRS 
questions. (Read Chapter 10 on dealing with the IRS and states.) 

QUALIFYING CAN BE TRICKY

The IRS and states focus on the objective factors that they can verify such as volume of 
trades, frequency, and average holding period. It’s hard to prove hours per day and business 
intention, although traders should do their best to document those factors. Some brokers 
save login sessions and traders should keep contemporaneous diaries. The biggest challenge 
is explaining how TTS fits in with a taxpayer’s other jobs, businesses, and daily lifestyle. It’s 
better if a trader’s trading hours don’t conflict with his or her other business activity or job 
hours.  

CLOSE CALLS
The following are examples of business traders whose trader tax determination would be 
considered close calls. If a taxpayer’s facts are similar to those below, he should proceed with 
caution with it comes to claiming TTS.
West Coast trader trades early in the morning and monitors positions at his regular day 
job. Many West Coast traders operate a trading business early in the morning before 
commuting to their day jobs. Securities markets open at 6:30 a.m. PT, providing them with 
several hours of trading time during peak market activity in the morning session. Many 
traders have browser-based trading platforms which they can easily access at their jobs, with 

15 
or without employer approval. Many traders use mobile devices and apps to execute trades 
when not in their home office. These traders often spend considerable amounts of time in 
their trading business at lunch, on breaks, in the evenings, and on weekends. Again, the IRS 
can challenge claims made about time and effort spent and business intention, so make sure 
the number of trades, frequency, and holding periods are strong and verifiable. Traders 
should document trading purpose with a well-crafted business plan, document all time spent, 
and establish a reasonable daily trend line in their calendars.  
East Coast trader has a day job and trades futures, options, forex, cryptocurrencies, or 
other global markets at night. Many markets operate around different time zones; U.S.-based 
traders can trade for significant time periods outside of their weekday job hours. The IRS 
can question the number and purpose of late-night hours, so again, traders should keep their 
numbers strong and maintain a serious account size.  
Flextime employees and individuals transitioning into a full-time trading business. Many 
professionals work flexible hours and structure day jobs around trading and market hours. 
Many intend to leave their current jobs to become full-time traders. Many business owners 
have reliable employees running their businesses and focus most of their time on trading.  
An employee wants to operate a trading business on the side. Many traders want to 
retain their employment and actively trade to increase income and financial independence. 
They have the intention to run a business and make a supplemental living trading. They don’t 
plan to quit their job to pursue full-time trading, and that’s okay. 
Stay-at-home parent wants to fit a home-based business into his or her multi-tasking 
activities. Many stay-at-home parents turn to trading to pursue their entrepreneurial dreams 
or help pay the bills while taking care of the children. The IRS can be doubtful of the trader’s 
sincerity here, so traders should avoid sporadic lapses in executing trades and keep trading 
businesses open for several years. Profitability helps, too. Traders should be professional in 
their approach and discipline.  
Early retiree wants to enhance insufficient retirement assets. While many people may 
decide to retire from their full-time careers around age 62, they are not ready to call it quits 
on staying mentally active and want to enhance their income. Retirees seek new income 
opportunities, and a trading business can be ideal. Many retirees self-direct their retirement 
funds and investment accounts, so they already have one foot in the trading business door.  
Others are offered early retirement or are laid off in their 50s and may decide to pursue a 
trading business.  
The IRS tends to be skeptical of retirees, thinking they are retired from business entirely. 
That’s not true, so taxpayers need to impress the IRS with their professionalism and business 
acumen.  
An unemployed person’s last resort and dream may be a trading business. While 
considering new employment opportunities, many out-of-work individuals are attracted to 
the ease and possibility of a trading business. Most people already have the key necessities — 
a computer, mobile devices, and wireless — in place. There’s no need to obtain an office 
lease, hire employees, get a professional license, and attract customers. Even so, traders can 
also lose money very fast. It’s best to attain a trading education first, and there are plenty of 
free and premium educational resources available. In most states, a trader can continue to 
collect unemployment benefits while trading because it is considered an investment activity 
rather than a job by most unemployment agencies. Perhaps some states don’t allow this, but 

16 
we don’t know of any at this time. In most states, traders can also form a trading entity 
without jeopardizing those benefits, either. However, we advise against taking compensation 
from the trading entity, as that is a conflict. It’s a wise idea for taxpayers to check with their 
federal, state, or other unemployment benefits/disability benefits provider.  
Some traders find new jobs and give up trading after experiencing losses or low 
profitability. A short period in a trading business can negate TTS in the eyes of the IRS. In 
Chen vs. Commissioner — another landmark tax court case denying TTS — Chen only 
traded for three months before losing his trading money, thereby exiting his trading activity. 
Chen kept his job during his three months of trading, so his case is different from the 
unemployed trader. But this case indicates the IRS wants to see a longer time period in order 
to establish TTS. Some IRS agents like to intimidate taxpayers with a full year requirement, 
but the law does not require that. Hundreds of thousands of businesses start and fail within 
three months and they aren’t challenged on business status. The IRS is rightfully more 
skeptical of traders vs. investors. The longer a trader can continue his business trading 
activity, the better his chances are with the IRS. We often ask clients about their trading 
activities in the prior and subsequent year as we prepare their tax returns for the year that 
just ended. Strong subsequent-year trading activities and gains add credability to the tax 
return being filed. We mention these points in tax return footnotes, too. Traders can start 
their trading business in Q4 and continue it into the subsequent year.

ALTERNATIVE STRATEGIES
Trade actively in your traditional retirement plans for deferral of taxable income and 
losses. Trade in Roth retirement plans for permanent tax-free income.  
In taxable accounts, trade Section 1256 contracts subject to lower Section 1256 60/40 tax 
rates, since that is not predicated on having TTS. The same goes for forex with a capital 
gains election into Section 1256(g). (Read more about forex tax treatment in Chapter 3.) 
If taxpayers have employee-benefit plan deductions for health insurance and retirement 
plans and general business expenses through another business, job, or their spouse, then they 
don’t need an S-Corp pushing the envelope on TTS. Also, if a trader’s trading business 
expenses are not material, he might want to skip using TTS on a Schedule C. A trader can 
achieve business tax status as an investment manager, too. TTS is not for everyone, but it’s a 
pity to get stuck with wasted losses and expenses when one could otherwise have made the 
elections to have Section 475 MTM ordinary-loss treatment (with TTS as a prerequisite), 
generating federal and state income tax refunds.  

TAX CUTS & JOBS ACT FAVORS TTS TRADERS

TCJA makes TTS even more valuable for two reasons. First, business expenses are 
deductible, whereas, investment expenses are not. Second, a TTS/475 trader is eligible for 
the 20% deduction on qualified business income providing the taxpayer is under the taxable 
income cap for specified service activities. (See why a family office might pursue TTS 
business expense treatment, and why a hedge fund might pursue TTS and Section 475 
ordinary income in Chapter 17.)

17 
  

Chapter 2 
 
Section 475 MTM Accounting 

The most significant problem for investors and traders occurs when they’re unable to 
deduct trading losses on tax returns, significantly increasing tax bills or missing opportunities 
for tax refunds. Investors are stuck with this problem, but business traders with trader tax 
status (TTS) can avoid it by filing timely Section 475 mark-to-market (MTM) elections for 
business ordinary tax-loss treatment for securities and/or commodities (Section 1256 
contracts). (Section 1256 contracts include futures, broad-based indexes, options on futures, 
options on broad-based indexes, and several other instruments; these are covered in Chapter 
3.) 
By default, securities and Section 1256 investors are stuck with capital-loss treatment, 
meaning they’re limited to a $3,000 net capital loss against ordinary income. The problem is 
that their trading losses may be much higher and not useful as a tax deduction in the current 
tax year. Capital losses first offset capital gains in full without restriction. After the $3,000 
loss limitation against other income is applied, the rest is carried over to the following tax 
years. Many traders wind up with little money to trade and unused capital losses. It can take 
many years to use up their capital loss carryovers. What an unfortunate waste! Why not get a 
tax savings from using Section 475 MTM right away? 
Business traders qualifying for TTS have the option to elect Section 475 MTM accounting 
with ordinary gain or loss treatment in a timely fashion. When traders have negative taxable 
income generated from business losses, Section 475 accounting classifies them as net 
operating loss (NOL) carryovers. Caution: Individual business traders who missed the 2019 
Section 475 MTM election date (April 15, 2019) can’t claim business ordinary-loss treatment 
for 2019 and will be stuck with capital-loss carryovers to 2020.   
Consider a Section 475 election for 2020 by April 15, 2020, or March 16 for existing 
partnerships and S-Corps. Warning: 475 is ordinary income, and if you have a significant 
capital loss carryover, you will prefer to have capital gains rather than ordinary income. 
A “new taxpayer” (new entity) set up after April 15, 2020 can deliver Section 475 MTM 
for the rest of 2020 on trading losses generated in the entity account if it files an internal 

18 
Section 475 MTM election within 75 days of inception. This election does not change the 
character of capital loss treatment on the individual accounts before its inception.  
Ordinary business losses under the “excess business loss” limitation can offset all types of 
income on a joint or single filing, whereas capital losses only offset capital gains. Plus, 
business expenses and business ordinary trading losses comprise an NOL and carryforward 
NOLs. It doesn’t matter if you are a trader or not in a carryforward year. Business ordinary 
trading loss treatment is the biggest contributor to federal and state tax refunds for traders.  
Starting in 2018, TCJA repealed the two-year NOL carryback, except for certain farming 
losses and casualty and disaster insurance companies. These TCJA changes mean NOLs are 
carried forward indefinitely (20 years before the TCJA changes), and the deduction of 
NOLs are limited to 80% of the subsequent year’s taxable income. TCJA’s 2019 “excess 
business loss” (EBL) limitation is $510,000 married and $255,000 for other taxpayers. EBL 
is added to an NOL carryforward. (See Chapters 7 and 9.)  
TCJA has another tax benefit on Section 475 ordinary income: the qualified business 
income deduction. QBI includes 475 ordinary income and losses, net of trading business 
expenses, but it excludes capital gains and losses, Section 988 forex and swap ordinary 
income and loss, dividends, and interest income. Trading is a specified service activity, so a 
taxable income cap and phase-out range applies. (See Chapter 17.) 
There are many nuances and misconceptions about Section 475 MTM, and it’s important 
to learn the rules. For example, taxpayers are entitled to contemporaneously segregate 
investment positions that aren’t subject to Section 475 MTM treatment, meaning at year-end, 
they can defer unrealized gains on properly segregated investments. Taxpayers can have the 
best of both worlds — ordinary tax losses on business trading and deferral with lower 
long-term capital gains tax rates on segregated investment positions. We generally 
recommend electing Section 475 on securities only, in order to retain lower 60/40 capital 
gains rates on Section 1256 contracts. Far too many accountants and traders confuse TTS 
and Section 475; they are two different things, yet very connected.  

SECTION 475 IS TAX-LOSS INSURANCE

Because Section 475 MTM allows current-year trading losses to be treated as unlimited 
ordinary business losses rather than a $3,000 capital loss limitation, it generates significant 
tax breaks immediately, rather than being stuck with large capital-loss carryovers to 
subsequent tax years.  
A Section 475 election on securities exempts the trader from wash sale loss adjustments 
on securities, which defer tax losses to replacement positions. If that happens around 
year-end, it might create phantom taxable income because it defers tax losses to the 
subsequent year. See more information on wash sale loss adjustments in Chapter 4. 
Section 475 MTM also reports year-end unrealized gains and losses as marked-to-market, 
which means one must impute sales for all open trading business positions at year-end using 
year-end prices. Many traders have no open business positions at year-end, anyway. They are 
reporting realized and unrealized gains and losses, similar to Section 1256 which has MTM 
built in by default — but don’t confuse Section 1256 with Section 475. 
We coined the term “tax-loss insurance” for Section 475 because if a taxpayer’s trading 
house burns down, he can deduct Section 475 trading losses right away and get a huge tax 
break (refund or lower tax bill). It’s a free insurance premium on securities because 

19 
short-term capital gains are taxed with ordinary tax rates in the same manner that Section 
475 MTM ordinary gains are taxed. But, Section 475 ordinary losses can be deducted in the 
current year, up to TCJA’s excess business loss limitation, offsetting any other taxable 
ordinary income, which could generate immediate tax benefits and refunds (like insurance 
recovery), whereas capital losses do not since they have the $3,000 net capital loss deduction 
limitation. It’s entirely different with Section 1256 contracts where the tax-loss insurance 
premium is expensive. Electing Section 475 on Section 1256 contracts means a taxpayer has 
to give up the lower Section 1256 60/40 tax rates in exchange for ordinary income rates. 
Plus, there is a Section 1256 loss carryback election (discussed later). There are more nuances 
to consider as well.  

CAPITAL-LOSS CARRYOVER MISCONCEPTIONS 

Many traders mistakenly think they can only utilize $3,000 of capital-loss carryovers each 
year going forward, so they worry it can take a lifetime to use up these losses. They don’t 
realize capital losses are offset without limitation against subsequent-year capital gains, which 
means if they remain in capital gains treatment (rather than electing Section 475 MTM 
ordinary income), they can use these capital losses. The $3,000 limitation is against 
non-capital gains income, not capital gains. 
Here’s an example: If a taxpayer’s capital-loss carryover is $50,000 and his subsequent year 
capital gains are $60,000, he can apply the $50,000 capital-loss carryover in full on Schedule 
D; his net capital gain would be $10,000. Conversely, if the subsequent year capital gain is 
$35,000, the net capital loss before limitation would be $15,000. Up to $3,000 is allowed 
against other income, and the remaining capital-loss carryover to the following year would be 
$12,000.  
Some traders mistakenly think individually generated capital-loss carryovers incurred 
before trading in a new pass-through entity will be lost. The new entity can forgo a Section 
475 election and pass through capital gains on a Schedule K-1 to individual tax returns 
(Schedule D), where they are offset by individual capital-loss carryovers. This is the best way 
to climb out of a capital-loss carryover hole. If the entity has capital gains before the 
475-election internal resolution is due (within 75 days of entity inception), skip it to soak up 
capital-loss carryovers. Conversely, if the entity has losses in those first 75 days, elect Section 
475 for ordinary loss treatment. The entity can then revoke Section 475 in the subsequent 
year to get back to capital gains treatment to soak up capital-loss carryovers. 
Using up capital-loss carryovers is a critical challenge for many traders. Proper Section 
475 MTM election planning and entities are the answer. It pays to think out the nuances 
carefully and not make a blanket decision to skip Section 475 as that can cost a taxpayer big 
time!  

SECTION 475 IS IDEAL FOR SECURITIES TRADERS…

Securities traders should usually elect Section 475 MTM unless they already have 
significant capital-loss carryovers. Traders can’t offset MTM ordinary trading gains with 
capital-loss carryovers; only capital gains (such as gains from segregated investment positions 
or Section 1256 contracts) can be used in such a manner. On the other hand, if a trader 
generates large new trading losses before April 15, 2020, he or she might prefer to elect 
Section 475 MTM for 2020 by that sole proprietor election date to have business 

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ordinary-loss treatment retroactive to Jan. 1, 2020. The trader can form a new entity 
afterward for a “do over” to use capital gains treatment and get back on track with using up 
capital loss carryovers. Alternatively, the trader can revoke the Section 475 election in the 
subsequent tax year.  

…BUT IS NOT ALWAYS WELL SUITED FOR HEDGE FUNDS…

Many hedge-fund managers find it too restrictive to deal with the segregation of 
investment rules within Section 475 and skip the election. These managers have trouble 
determining business positions vs. segregated investment positions on the day they purchase 
a security, which is required for segregating investments. Many seek to defer capital gains at 
year-end to save their investors a tax bill, to avoid investor redemption requests to pay 
related taxes, and to seek lower long-term capital gains tax rates. Running afoul of the 
segregation rules can drag long-term positions into Section 475 MTM ordinary gains 
treatment at year-end and thereby forgo both deferral and lower long-term capital gains tax 
rates. Many hedge funds generate trading gains and don’t need tax-loss insurance with 
Section 475 MTM. Many hedge fund investors want capital gains treatment to use up their 
own capital loss carryovers; they don’t want or expect Section 475 ordinary income. 
Hedge funds that conduct short-term trading qualifying for TTS without any investment 
positions should consider a Section 475 election. Some hedge funds are bifurcated with both 
treatments on tax returns. In 2014, the IRS warned 475 traders — especially in hedge funds 
— to be careful not to run afoul of segregation rules that can prejudice the government. 
(Read our blog IRS Warns 475 Traders, https://tinyurl.com/irs-warns.) 

… AND OFTEN NOT ADVISED FOR 1256

Section 1256 contract traders should generally not elect Section 475 in order to retain the 
lower 60/40 capital gains tax rates. Section 475 would override Section 1256 and, therefore, 
all trading gains would be subject to the short-term ordinary tax rate. In Section 1256, 60% 
of trading gains are considered long-term capital gains — even on day trades — taxed at 
lower tax rates (0%, 15% and 20% in 2019 and 2020), and 40% are short-term capital gains 
taxed at ordinary tax rates (up to 37% in 2019 and 2020). The maximum 2019 and 2020 
blended tax rate on Section 1256 contracts is 26.8% vs. 37% for securities at the ordinary 
rate, a meaningful 10.2% difference. The zero long-term rates correspond with the 10% and 
12% ordinary brackets, and there is meaningful savings throughout the tax brackets. (See the 
2019 Section 1256 tax table in the Green Trader Tax Center at https://greentradertax.com.)
Investors and business traders may elect to carry back Section 1256 contract losses three 
tax years, but they are only applied against net Section 1256 contract gains on Form 6781, 
not other types of income. Check box D on top of Form 6781 before filing by the due date 
of the return including extensions. Section 1256 contracts are also marked-to-market on a 
daily basis, but it’s a different type of MTM than Section 475 that can be elected.  
If a trader trades Section 1256 contracts and loses a bundle before the April 15, 2020 
Section 475 election deadline for individuals, or the March 16, 2020 deadline for existing 
partnerships and S-Corps, or within 75 days of inception for a new taxpayer entity 
formation, he may want to make the Section 475 election for commodities, especially if he 
doesn’t have the option to carry back Section 1256 contract trading losses against Section 
1256 gains in the prior three tax years (i.e., there is only Section 1256 losses in the prior three 

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years). Why not take the opportunity to lock in a sizeable ordinary business loss? A taxpayer 
can revoke Section 475 on commodities (including Section 1256 contracts) in the following 
year by the tax return due date to get back into lower 60/40 tax treatment on Section 1256 
contracts.  

DIGGING OUT OF A CAPITAL-LOSS HOLE

We design our trader tax strategies to prevent traders from falling into a hole of having 
unused capital losses. But many traders inevitably fall into that hole. In this section, we focus 
on how best to climb out using capital gains to soak up capital loss carryovers, and how not 
to dig a bigger hole by making a Section 475 MTM election. Traders need to choose one tax 
treatment or the other, but at least they have some hindsight in this decision. Whenever 
possible, traders may choose the tax treatment that’s best for the hindsight period — i.e., Jan. 
1 to April 15. 
Here are some examples. If a taxpayer individually has a $50,000 capital-loss carryover 
going into 2020 and his Q1 2020 trading gains are $50,000, he should skip the 2020 
individual Section 475 MTM election as a sole proprietor, since he wants to offset his capital 
loss carryover against current-year capital gains. In this example, the taxpayer is at breakeven 
on using up his capital-loss carryovers as an individual, so it might be wise to form a new 
entity to trade with Section 475 MTM for the rest of 2020. It’s best to elect Section 475 
when taxpayers have a “clean slate” — meaning, no material remaining capital loss 
carryovers or unrealized capital losses. Substantial trading losses incurred in Q3 or Q4 will 
be an ordinary business loss. Take into account unrealized gains and losses on open 
positions, too. 
Conversely, if a trader has an individual $50,000 capital-loss carryover going into 2020, 
and he loses $40,000 in Q1 2020, it’s probably wise to elect Section 475 MTM as a sole 
proprietor for business ordinary loss treatment — and related tax relief — rather than 
digging a bigger hole of unutilized capital losses. Again, the trader can form a new entity for 
a “do over” to get back to capital gains treatment, so he can use up his capital loss 
carryovers. The taxpayer has 75 days of additional hindsight once the entity commences 
business to file an internal Section 475 MTM election resolution for the entity trading. 
Ideally, the taxpayer will generate capital gains in the entity to use up his remaining 
capital-loss carryovers and put off the Section 475 MTM election to the following year.  
There are many variations on these examples. No matter how much thought you put into 
it, there is still some risk on how it all works out, and it won’t always be a perfect result. Use 
hindsight where allowed, yet keep in mind these opportunities are limited by the IRS.  
In a “Clean Up Project for Section 475,” the IRS said it might institute a “mark and 
freeze” Section 475 election with the effective date of accounting change being the election 
date rather than Jan. 1. If enacted, this rule change would negate the few months of 
hindsight. This project appears to be on the back burner as the IRS focuses on its priorities.  

ELECTION PROCEDURES
Section 475 MTM is optional with TTS. Existing taxpayer individuals that qualify for TTS 
and want Section 475 must file a 2020 Section 475 election statement with their 2019 tax 
return or extension by April 15, 2020. Existing partnerships and S-Corps file in the same 
manner by March 16, 2020. 

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 Election statement. The MTM election statement is a straightforward paragraph; 
unfortunately, the IRS hasn’t created a tax form for it. It’s a version of the following: 
“Pursuant to Section 475(f), the Taxpayer hereby elects to adopt the mark-to-market method 
of accounting for the tax year ending Dec. 31, 2020, and subsequent tax years. The election 
applies to the following trade or business: Trader in Securities as a sole proprietor (for 
securities only and not commodities/Section 1256 contracts).” If a trader expects to have a 
loss in trading Section 1256 contracts, he can modify the parenthetical reference to say, “for 
securities and commodities/Section 1256 contracts.” But remember, the lower 60/40 tax 
rates on Section 1256 contracts will no longer apply. If the taxpayer trades in an entity, he 
should delete “as a sole proprietor” in the statement.  
Form 3115 filing. Don’t forget an essential second step: Existing taxpayers complete the 
election process by filing a Form 3115 (change of accounting method) with the election-year 
tax return. A 2019 MTM election filed by April 15, 2019, is perfected on a 2019 Form 3115 
filed with 2019 tax returns — by the due date of the return including extensions. Some 
accountants and taxpayers confuse this two-step procedure and file the Form 3115 as step 
one on the election statement date. The IRS usually sends back the Form 3115, which can 
jeopardize ordinary-loss treatment. It may be possible to treat this filing as tantamount to the 
MTM election statement, but the taxpayer should still refile a Form 3115 correctly and on 
time.  
Form 3115 is sent in duplicate — one goes with Form 1040 or the entity tax return filing 
and a second goes to the IRS national office. There’s no fee to file the Form 3115, and the 
election is automatic. That means the IRS should not confirm this election statement or the 
Form 3115 filing. Some accountants and taxpayers make an error here — they think a fee is 
required along with IRS confirmation.  
We suggest an additional document with the filing of a Form 3115. This is a perjury 
statement affirming the Section 475 MTM election was filed on time. The IRS system for 
recording Section 475 elections indeed needs improvement, which is why the perjury 
statement is a good idea. (See Poppe tax court ruling in Chapter 11.) 
Some traders change their mind after they file their Section 475 election statement, and 
they want to skip the Form 3115 filing. That’s wrong, and it’s incumbent on them to perfect 
the election. One proper way to skip perfection of a Section 475 MTM election is to take the 
posture that you fall short of TTS and therefore can’t use Section 475, but that must be 
based on accurate facts and circumstances and not on a whim. It’s important to be 
consistent and credible with the IRS. (See “Null and Void and Suspended Elections” later in 
this chapter.) 

INTERNAL ELECTIONS FOR NEW TAXPAYERS

The Section 475 election procedure is different for “new taxpayers” like a new entity. 
Within 75 days of inception, a new taxpayer may file the Section 475 election statement 
internally in its records. The new entity does not have to submit a Form 3115 because it’s 
adopting Section 475 from inception, rather than changing its accounting method. One way 
to file an internal resolution is for the taxpayer to send himself an email resolution (election), 
which has a timestamp for proof of timely election. 

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SECTION 481(A) ADJUSTMENT
Form 3115 includes a section for reporting a Section 481(a) adjustment, which is required 
when a change of accounting is made. The rest of the multi-page Form 3115 relates to tax 
law and code sections, etc. 
In the case of changing to Section 475 MTM, a trader’s section 481(a) adjustment is the 
unrealized capital gain or loss on TTS positions as of Dec. 31 of the prior tax year. If a 
taxpayer didn’t have TTS as of the prior year-end, then there is no Section 481(a) adjustment. 
In other words, the only positions included in the Section 481(a) adjustment are trading 
positions; segregated investment positions are not included. 
A section 481(a) loss is deductible in full; whereas a taxpayer must prorate a gain of 
more than $50,000 over four years. If the 481(a) income is $50,000 or less, the IRS permits 
the taxpayer to elect to report the entire gain in the first year. Income proration is favorable 
to taxpayers for deferral reasons — but don’t forget to report these deferred items in later 
tax years. The taxpayer must accelerate the proration and report all remaining deferred gains 
as taxable if he exits the trading business before the entire deferred amount is reported as 
taxable. 
Section 1256 contract traders don’t have to worry about a 481(a) adjustment since MTM 
is already built into Section 1256. For a 2019 Section 475 MTM election, the 481(a) 
adjustment is reportable as a Jan. 1, 2019 transaction on the 2019 Form 4797 Part II, along 
with MTM trading gains and losses for 2019 (which start the year at market values for cost 
basis). Trade accounting software should make this adjustment.  

SECTION 481(A) POSITIVE ADJUSTMENT SPREAD PERIOD CHANGES

According to tax research service Thomson Reuters CheckPoint, “Under the new 
procedures for filing a Form 3115 for tax year 2015 and forward, the four-year spread period 
generally applicable to a positive Section 481(a) adjustment has been modified as de minimis 
§ 481(a) adjustment amount increased. Under a de minimis provision, a positive adjustment 
may be spread over one year (vs. four years) at the taxpayer’s election. The new procedures 
increase the de minimis threshold to $50,000 from $25,000. The election is made on the new 
Form 3115 (Rev 12-2015), Part IV, Line 27.” 
This means that a trader with a Section 481(a) income adjustment up to $50,000 can elect 
to report the entire amount of income in the current tax year rather than spread it over four 
years. The IRS is probably hoping fewer taxpayers defer income and some may forget to 
report that income in subsequent tax years.  
For example, if a trader’s 2019 Section 481(a) adjustment is $40,000, he or she may elect 
to report the full income on 2019 Form 3115 and Form 4797 Part II ordinary gain or loss. 
Conversely, if the income adjustment is $60,000, the trader would have to spread it over four 
years, reporting $15,000 each year. 

ELECTION TO REVOKE SECTION 475

There was good news for traders about Section 475 MTM buried in the IRS annual 2015 
update on procedures for changes of accounting method. It had always been free and easy to 
elect Section 475 MTM, yet difficult and costly to revoke that election. With this rule change, 
the IRS makes revocation a free and easy process, mirroring the Section 475 election and 
automatic change of accounting procedure for existing taxpayers.

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 Before this rule change, the Section 475 revocation procedure cost several thousand 
dollars in filing fees (close to $7,000 for hedge funds), and the outcome was uncertain since 
it required advanced consent from the IRS, which could be denied. Few traders opted for 
revocation; most traders used other options like suspension or exit. 
The new revocation procedure is similar to the election procedure. An existing individual 
must file a 2020 notification statement of revocation with the IRS by April 15, 2020 (March 
16, 2020 for existing partnerships and S-Corps). The second step is to file 2020 Form 3115 
for revocation of Section 475 with the 2020 tax return. As with the 475-election process, 
there is no IRS fee for revocation.  
Historically, our trader clients navigated around the costly and uncertain revocation 
procedure by “suspending” their Section 475 election. By disqualifying themselves for TTS, 
they became investors who could not use Section 475 as of the disqualification date. In that 
case, the Section 475 election was suspended until the trader qualified again (if ever) for TTS. 
While the IRS may have preferred that the trader follow the costly revocation procedure at 
that time, we suggested suspension as another option free of cost. 
Taxpayers appreciate having this choice to revoke Section 475 instead of leaving it 
suspended on their individual returns if they elected it as a sole proprietor trader. See our 
blog post New IRS Rules Allow Free and Easy Section 475 Revocation, 
https://tinyurl.com/475-revocation. 

NULL AND VOID AND SUSPENDED ELECTIONS

We had discussions with the IRS regarding Section 475 MTM elections for traders who 
never qualified for TTS or those who exited TTS with a current Section 475 MTM election. 
Here’s one example: A new trader is not yet sure if he will qualify for TTS in 2020, but he 
must file the 2020 Section 475 MTM election by April 15, 2020. If he doesn’t end up 
qualifying, he may not use Section 475 MTM. In that case, the 2020 election would be “null 
and void” and he can skip filing a 2020 Form 3115. If he wants Section 475 for 2021, he 
needs to start fresh and file a 2021 Section 475 MTM election statement by April 15, 2021.
Suppose an existing sole proprietor business trader elected and used Section 475 MTM in 
2019. She stopped trading at year-end 2019. She should file an election to revoke Section 475 
by April 15, 2020 effective Jan. 1, 2020. Conversely, if she stops TTS after the revocation 
election date and doesn’t revoke it by April 15, 2020, she can suspend use of Section 475 
after that date and for the remainder of 2020 until filing an election to revoke by April 15, 
2021. She will use Section 475 until the date of existing qualification for TTS and use the 
realization (cash) method after that date. 

EXTENSION FOR SECTION 475 IS UNLIKELY

If you miss the March 16 or April 15 deadline, you can consider a private letter ruling 
(PLR) for a six-month extension under Section 9100 relief; but the IRS has denied PLR 
MTM extension requests in the past except one that we know about. The Vines vs. 
Commissioner case is the only one where the taxpayer prevailed in tax court. Vines, an 
attorney/trader, had several million dollars of trading losses before the Section 475 MTM 
election deadline of April 15. He did not know about MTM, he did not trade after the MTM 
election deadline, and he did not use hindsight to prejudice the IRS. Vines had a perfect set 
of factors which other taxpayers will be unlikely to duplicate. 

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 A PLR is an expensive process. To win a PLR on an MTM extension procedure, a trader 
needs to prove he or she did not use “hindsight.” Examples of hindsight are: having a 
capital-loss carryover to start the year, having unrealized capital losses, having commingling 
investment positions, trading Section 1256 contracts with lower 60/40 capital gains rates, or 
having capital gains at the beginning of the year turn into trading losses after the MTM 
election date. A taxpayer also needs to show “unusual and compelling” facts and 
circumstances, which is difficult to do.  
A better solution is to form a new entity and file the 475 MTM election statement 
internally within 75 days of inception. But this won’t help with pre-entity losses if a taxpayer 
misses the MTM election on April 15. Many new traders don’t begin trading until after April 
15; an entity is wise if they want Section 475 MTM.  

IRS CAN DENY ORDINARY-LOSS TREATMENT

If traders don’t follow both Section 475 MTM election steps by the deadline, the IRS may 
seek to deny ordinary-loss treatment, thereby taking away MTM tax-loss insurance. 
Traders need to be careful to apply Section 475 MTM properly on their tax return using 
Form 4797. In several tax court cases, the IRS has debated TTS, but it will act forcefully to 
deny ordinary trading loss treatment if the taxpayer elected Section 475 MTM too late or 
botched and couldn’t prove the election. This is evident in the October 2015 Poppe tax 
court ruling covered in Chapter 11.  

PROFITABLE TRADERS SHOULD ELECT 475

In prior years, I focused on the tax-loss insurance advantage of Section 475, but in 2019 
and 2020, there is a reason for profitable traders to elect Section 475, too. 
If a TTS trader wants to be eligible for a 20% qualified business income (QBI) deduction, 
he or she should consider electing Section 475 ordinary income treatment. Section 475 
ordinary income is included in QBI, whereas, QBI excludes capital gains. (See Chapter 17.) 
   

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Chapter 3  
 
Tax Treatment of Financial 
Products 

Tax treatment of financial products affects investors, traders, and hedge funds. But sadly, 
many taxpayers overlook important differences in tax treatment for these groups, resulting in 
overpayments. Education is key. This chapter contains valuable information about how the 
various instruments are treated come tax time, including U.S. and international equities, U.S. 
futures and other Section 1256 contracts, options of all kinds, ETFs, ETNs, forex, precious 
metals, foreign futures, cryptocurrencies, and swap contracts. 
It’s important to distinguish between securities vs. Section 1256 contracts with lower 
60/40 capital gains rates vs. other types of financial products like forex or swaps with 
ordinary income or loss treatment. Plus, there are various elections available to change tax 
treatment. 

DON’T SOLELY RELY ON 1099-BS

One might expect that broker-issued 1099-Bs would handle all of these issues, but for 
some tax treatments, they do not. For example, some brokers categorize CBOE-listed 
options on volatility ETNs and ETFs as securities, but there is substantial authority to treat 
these CBOE-listed options as “non-equity options” included in Section 1256, which might 
be more tax advantageous.  
Broker compliance rules are different than rules taxpayers must follow on wash-sale loss 
adjustments on securities. Some brokers mislabel Section 1256 contracts, too. It depends on 
the taxpayer’s facts and circumstances and elections made as to how the activity is actually 
reported on the taxpayer’s return. There is no way for every broker to police all their clients’ 
elections, qualification for trader tax status (TTS), and whether or not they have filed an 
election for Section 475 MTM on time. Brokers should issue 1099-Bs for the “everyman,” 
not based on each taxpayer’s individual facts, circumstances and elections filed. This is the 
reason why it is very important that taxpayers review the 1099-Bs completely and only use 
the information if it agrees with their particular facts and circumstances and election filed. 

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 Many financial products like spot forex and cryptocurrencies are not “covered securities” 
for 1099-B issuance. U.S. cryptocurrency exchanges issue a Form 1099-K (Payment Card and 
Third Party Network Transactions) to investors who reach a certain threshold of 
transactions. Brokers issue Form 1099-Bs for securities and Section 1256 contracts to 
investors and traders. 

CAPITAL GAINS VS. ORDINARY INCOME

Most financial instruments — including equities, futures, options, ETFs, ETNs, precious 
metals, and cryptocurrencies held as a capital asset — are subject to capital gains treatment. 
But, some of these financial products like U.S. futures qualify as Section 1256 contracts with 
lower 60/40 capital gains rates. By default, forex contracts and swap contracts are subject to 
ordinary gain or loss treatment. The distinction between ordinary capital gains, and 60/40 
capital gains treatment makes a big difference. The capital-loss limitation is a problem for 
traders and investors who may have trouble using up large capital-loss carryovers in 
subsequent tax years. Traders with TTS and a Section 475 MTM election have business 
ordinary-loss treatment, which is more likely to generate tax savings or refunds faster. Some 
financial products don’t qualify for a Section 475 election, including forex, cryptocurrencies, 
and ETNs structured as prepaid forward contracts. ETNs structured as debt instruments, 
however, are securities eligible for Section 475 treatment.  

SECURITIES
Securities traders have ordinary tax rates on short-term capital gains, wash sale loss 
adjustments, capital-loss limitations, and accounting challenges. 
Securities include: 
● U.S. and international equities (stocks) 
● U.S. and foreign equity (stock) options 
● narrow-based indexes (an index made up of nine or fewer securities) 
● options on narrow-based indexes 
● securities ETFs structured as registered investment companies (RIC) 
● options on securities ETF RICs 
● commodities ETFs structured as publicly traded partnerships (PTP) 
● volatility ETNs, structured as debt instruments 
● bonds 
● mutual funds 
● single-stock futures 
 
The IRS taxes securities transactions when a taxpayer closes an open trade — hence the 
term “realization method.” Taxpayers can defer capital gains by holding open securities 
positions at year-end. With “tax-loss selling,” investors realize losses before year-end. Be 
careful not to re-enter those positions within 31 days; otherwise, the planned tax loss might 
defer to 2020 as a wash sale loss adjustment. 
Short-term capital gains (STCG) use ordinary tax rates, with progressive tax brackets 
currently up to 37% for 2019 and 2020. Long-term capital gains (LTCG) rates are 
significantly lower, and they apply to sales of securities held for 12 months or more. The 

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LTCG rates are 0% for the 10% and 12% ordinary brackets, 15% in the middle brackets, and 
20% in the top 37% bracket.  
With the realization method for securities, enter each securities opening and closing 
trade, and wash sale loss adjustment on Form 8949, which feeds into Schedule D where 
short- and long-term capital gains rates apply. (See accounting and tax reporting for 
securities in Chapter 4.) 
The mark-to-market (MTM) accounting method is different from the realization method. 
MTM taxes realized and unrealized capital gains and losses at year-end, by imputing sales of 
open positions using year-end prices. Traders eligible for trader tax status (TTS) are entitled 
to elect Section 475 MTM ordinary gain or loss on securities and or commodities. Section 
475 trades are exempt from wash sale loss adjustments and the $3,000 capital loss limitation. 

SECTION 1256 CONTRACTS

Section 1256 contracts enjoy lower 60/40 capital gains tax rates, summary tax reporting, 
and easier mark-to-market (MTM) accounting. 
Section 1256 contracts include: 
● U.S. regulated futures contracts (RFCs) 
options on U.S. RFCs 
● U.S. broad-based indexes made up of 10 or more underlying securities – also known 
as stock index futures 
● options on U.S. broad-based indexes 
● foreign futures if granted Section 1256 treatment in an IRS revenue ruling (lists are 
online at https://greentradertax.com/tax-treatment-for-foreign-futures/)   
● non-equity options (a catchall) 
● CBOE-listed options on commodity ETF publicly traded partnerships 
● CBOE-listed options on precious metals ETF publicly traded trusts 
● CBOE-listed options on volatility ETN prepaid forward contracts and ETN debt 
instruments 
● forward forex contracts with the opt-out election into Section 1256(g) on the major 
pairs, for which futures trade (we make a case for spot forex, too) 
● forex OTC options (Wright court) 
 
Section 1256 contracts have lower 60/40 capital gains tax rates: 60% (including day trades) 
subject to lower long-term capital gains rates, and 40% taxed as short-term capital gains 
using the ordinary rate. At the maximum tax bracket for 2019 and 2020, the blended 60/40 
rate is 26.8% — 10.2% lower than the highest ordinary bracket of 37%.   
There are significant tax savings throughout the income brackets. The LTCG rate in the 
lowest two ordinary brackets is 0%. (See our table online at 
https://tinyurl.com/section-1256.) Regular state tax rates apply because they do not include 
a long-term rate.  
Section 1256 contracts are marked-to-market (MTM) daily. For tax purposes, MTM 
reports both realized activity from throughout the year and unrealized gains and losses on 
open trading positions at year-end.  
With MTM and summary reporting, brokers are able to issue simple one-page 1099-Bs 
reporting “aggregate profit or loss on contracts” after taking into account realized and 

29 
unrealized gains and losses. That amount is reported on Form 6781 Part I, which breaks it 
down to the 60/40 split and then moves those amounts to Schedule D capital gains and 
losses. 
There is a Section 1256 loss carryback election. Rather than use the 1256 loss in the 
current year, taxpayers may deduct 1256 losses on amended tax return filings, applied against 
Section 1256 gains only. Using Form 1045 is better than 1040X; the IRS issues the refund 
faster and the process is less complicated. It’s a three-year carryback; unused amounts carry 
forward. TCJA repealed most NOL carrybacks, so this is the only remaining carryback 
opportunity for traders. (For details on executing this 1256 loss carryback election, see 
Chapter 6.) Section 1256 traders should also learn about the “mixed straddle election” and 
“hedging rules” in Section 1256(d) and (e), and as discussed on Form 6781. Offsetting 
positions between Section 1256 contracts and securities can generate tax complications 
under certain circumstances involving the hedging rule. The IRS is concerned about traders 
reporting Section 1256 MTM unrealized losses and deferring unrealized gains on offsetting 
securities positions, so there are rules intended to prevent this.  

EXCHANGE-TRADED FUNDS
Securities, commodities, and precious metals ETFs use different structures, and tax 
treatment varies. 
Securities ETFs usually are regulated investment companies (RICs). Like mutual fund 
RICs, securities ETFs pass through their underlying ordinary and qualifying dividends to 
investors. Selling a securities ETF is deemed a sale of a security, calling for short- and 
long-term capital gains tax treatment using the realization method. A securities ETF is a 
security, so wash sale loss adjustments or Section 475 apply if elected. 
Commodities/futures ETFs. Regulators do not permit commodities/futures ETFs to use 
the RIC structure, so usually they are structured as publicly traded partnerships (PTPs). 
Commodities/futures ETFs issue annual Schedule K-1s passing through their underlying 
Section 1256 tax treatment to investors, as well as other taxable items. Selling a commodities 
ETF is deemed a sale of a security and calls for short- and long-term capital gains tax 
treatment using the realization method.  
Taxpayers invested in commodities/futures ETFs may need to make some cost-basis 
adjustments on Form 8949 to capital gains and losses, ensuring they don’t double count 
some of the Schedule K-1 pass-through items. For example, if the K-1 passes through 
Section 1256 income to Form 6781, the taxpayer should also add that income to the cost 
basis on Form 8949. Otherwise, it will be double counted and thus will cause an 
overstatement of tax liability. Form 1099-Bs and trade accounting solutions do not 
automatically make these cost-basis adjustments from K-1 income/loss, so be sure to make 
the adjustments manually on Form 8949. 
Master limited partnerships (MLPs) are PTPs issuing Schedule K-1s to investors with 
pass-through income. Purchasing a PTP that has business dealings, such as oil and gas 
operations, in a retirement account will probably cause unrelated business taxable income 
and tax (UBIT) and Form 990 filings since the K-1 passes through business income. See our 
blog post warning Retirement Plan Investments in Publicly Traded Partnerships Generate 
Tax Bills, https://tinyurl.com/retirement-ptp. 
 

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 Physically backed precious metals ETFs. These ETFs may not use the RIC structure 
either. Although they could use the PTP structure, they usually choose the publicly traded 
trust (PTT) structure (also known as a grantor trust). A PTT issues an annual Schedule K-1, 
passing through tax treatment to the investor, which, in this case, is the “collectibles” capital 
gains rate on sales of physically backed precious metals (such as gold bullion). Selling a 
precious metal ETF is deemed a sale of a precious metal, which is a collectible. If collectibles 
are held over one year (long-term), sales are taxed at the “collectibles” capital gains tax rate 
— capped at 28%. (If your ordinary rate is lower, use that.) That rate is higher than the top 
regular long-term capital gains rate of 20% (2019 and 2020). Short-term capital gains are 
taxed at the ordinary rate. Physically backed precious metals ETFs are not securities, so they 
are not subject to wash-sale loss adjustments or Section 475 if elected. (For more 
information, see our blog Tax Treatment for Precious Metals at 
https://tinyurl.com/rrmbg87, which includes discussion on all sorts of precious metal 
ETFs.)  

OPTIONS
Options cover the gamut of tax treatment. They are a derivative of their underlying 
instrument and generally have the same tax treatment. For example, equity options are a 
derivative of the underlying equity, and both are taxed as securities. Tax treatment for 
options is diverse, including simple (outright) and complex trades with multiple legs.
Options taxed as securities: 
● equity (stock) options 
● options on narrow-based indexes 
● options on securities ETFs RIC 
Options taxed as 1256 contracts: 
● non-equity options (a catchall) 
● options on U.S. regulated futures contracts and broad-based indexes 
● CBOE-listed options on commodity ETF publicly traded partnerships 
● CBOE-listed options on precious metals ETF publicly traded trusts  
● CBOE-listed options on volatility ETN prepaid forward contracts and ETN debt 
instruments 
● forex OTC options (Wright appeals court) 
Generally, options listed on a commodities exchange, a qualified board or exchange 
(QBE), are a 1256 contract unless the reference is a single stock or a narrow-based stock 
index.  
For options taxed as securities, wash-sale loss rules apply between substantially identical 
positions in securities, which means between equity and equity options, such as Apple stock 
and Apple stock options at different expiration dates. Because wash-sale loss rules only apply 
to securities, they do not apply to options taxed as Section 1256 contracts. 
Simple vs. complex option trades. Simple option trading strategies like buying and selling 
call and put options are known as “outrights.” Complex option trades known as “option 
spreads” include multi-legged offsetting positions like iron condors; butterfly spreads; 
vertical, horizontal and diagonal spreads; and debit and credit spreads. 
Tax treatment for outright option trades is fairly straightforward. However, complex 
trades trigger a bevy of IRS rules geared toward preventing taxpayers from tax avoidance 

31 
schemes: deducting losses and expenses from the losing side of the trade in the current tax 
year, while deferring income on the offsetting winning position until a subsequent tax year. 
There are three things that can happen with outright option trades: 
1. Trade option (closing transaction): Trading call and put equity options held as a capital 
asset is taxed the same as trading underlying equities. Report proceeds, cost basis, wash sale 
loss adjustments, and net capital gain or loss and holding period (short-term vs. long-term 
held more than 12 months) from realized transactions only on Form 8949. Section 1256 
options are reported in summary form with MTM on Form 6781.  
2. Option expires (lapses): There’s a minor twist on the above scenario. Rather than 
realizing a dollar amount on the closing out of the option trade, the closeout price is zero 
since the option expires worthless. Use zero for the realized proceeds or cost basis, 
depending on whether you’re the “writer “or “holder” of the option and if it’s a call or put. 
Use common sense — collecting premium on the option trade is proceeds and therefore the 
corresponding worthless exercise represents zero cost basis in this realized transaction. For 
guidance on entering option transactions as “expired” on Form 8949, read IRS Pub. 550 – 
Capital Gains And Losses: Options. 
3. Exercise the option: This is where tax treatment becomes more complicated. 
Exercising an option is not a realized gain or loss transaction; it’s a stepping-stone to a 
subsequent realized gain or loss transaction on the underlying financial instrument acquired. 
The original option transaction amount is absorbed (adjusted) into the subsequent financial 
instrument cost basis or net proceed amount. Per IRS Pub. 550:  
“If you exercise a call, add its cost to the basis of the stock you bought. If you exercise a 
put, reduce your amount realized on the sale of the underlying stock by the cost of the put 
when figuring your gain or loss. Any gain or loss on the sale of the underlying stock is long 
term or short term depending on your holding period for the underlying stock …  
“If a put you write is exercised and you buy the underlying stock, decrease your basis in 
the stock by the amount you received for the put …  
“If a call you write is exercised and you sell the underlying stock, increase your amount 
realized on the sale of the stock by the amount you received for the call when figuring your 
gain or loss.”  
Some brokers interpret IRS rules differently, which can lead to confusion when 
attempting to reconcile broker-issued Form 1099-Bs to trade accounting software. A few 
brokers may reduce proceeds when they should add the amount to cost basis. Brokers 
reported equity options for the first time on 2014 Form 1099-Bs. Exercising an option gets 
to the basics of what an option is all about: It’s the right, but not the obligation, to purchase 
or sell a financial instrument at a fixed “strike price” by expiration date. Exercise may happen 
at any time until the option lapses. An investor can have an in-the-money option before 
expiration date and choose not to execute it, but instead hold or sell it before expiration. 
Holding period for long-term capital gains: When an equity option is exercised, the 
option holding period becomes irrelevant and the holding period for the equity begins anew. 
The holding period of the option doesn’t help achieve a long-term capital gain 12-month 
holding period on the subsequent sale of the equity. When an option is closed or lapsed, the 
option holding period does dictate short- or long-term capital gains treatment on the capital 
gain or loss, with these exceptions recapped in IRS Pub. 550:  

32 
 “Buying a put option is generally treated as a short sale, and the exercise, sale, or 
expiration of the put is a closing of the short sale. If you have held the underlying stock for 
one year or less at the time you buy the put, any gain on the exercise, sale, or expiration of 
the put is a short-term capital gain. The same is true if you buy the underlying stock after 
you buy the put but before its exercise, sale, or expiration.” 
For more information about tax treatment for options including complex trades, 
straddles, offsetting positions, and wash sales on options, see our blog post Tax Treatment 
for Trading Options, https://tinyurl.com/gtt-options. Trade accounting software generally 
does not automatically account for offsetting positions on complex trades, so be prepared to 
make manual adjustments. I recommend Section 475 for complex options traders to avoid 
complications with offsetting option positions.  

FOREX
“Forex” refers to the foreign exchange market (also known as the “Interbank” market) 
where participants trade currencies, including spot, forwards, or over-the-counter (OTC) 
option contracts. Forex differs from trading currency-regulated futures contracts (RFCs). 
Currency RFCs are considered Section 1256 contracts reported on Form 6781 with lower 
60/40 capital gains tax treatment.
Forex tax treatment. By default, forex transactions start off receiving ordinary gain or loss 
treatment, as dictated by Section 988 (foreign currency transactions). The good news is 
Section 988 ordinary losses offset ordinary income in full and are not subject to the $3,000 
capital loss limitation — that’s a welcome relief for many new forex traders who have initial 
losses and offset the losses against wage and other income. 
Section 988 allows investors and business traders — but not manufacturers — to 
internally file a contemporaneous “capital gains election” to opt-out of Section 988 into 
capital gain or loss treatment. This is a way to generate capital gains to use up capital loss 
carryovers, which otherwise may go wasted for years. 
The capital gains election on forex forwards allows the trader to use Section 1256(g) 
treatment with lower 60/40 capital gains rates on major currency pairs if the trader doesn’t 
take or make delivery of the underlying currency. The definition of a “major currency pair” is 
a forex pair that also trades as a regulated futures contract on U.S. futures exchanges. There 
are lists of currency pairs that trade on U.S. futures exchanges available on the Internet 
(search FX products on CME).  
Spot vs. forwards. Most online trading platforms and brokers only offer forex spot 
contracts. The critical tax question for most retail off-exchange forex traders is how to 
handle spot forex. Guidance from the IRS is uncertain on spot forex. We’ve done extensive 
work on forex taxation, and spot forex in particular. We believe that in many cases, spot 
forex can be treated like forex forwards, qualifying for lower 60/40 tax rates in Section 
1256(g) on major currency pairs only. If you have significant trading gains on spot forex 
contracts, these tax rates may be very desirable. We lay out a case for Section 1256(g) 
treatment on spot forex transactions, with certain conditions and restrictions. It’s important 
to use proper tax return footnote disclosure.  
We’ve learned from discussions with the IRS Chief Counsel’s office on forex taxation that 
the authors of Section 988 never contemplated retail trading in spot forex transactions. IRS 
attorneys figured the spot forex marketplace was for corporations to exchange currency in 

33 
the ordinary course of their trade or business, and those transactions would be ordinary gain 
or loss per Section 988. Manufacturers and other global businesses transact in the Interbank 
market (to hedge and exchange currency). Why would they want to file a capital gains 
election to opt-out of Section 988? Only traders or investors holding forex as a capital asset 
can file that capital gains election per Section 988. 
IRS attorneys understood that professional forex traders were trading forex forwards and 
there was a clear pathway into Section 1256(g). Also, spot forex isn’t mentioned in Section 
1256(g). That makes sense since retail spot forex trading began around the year 2000, 
whereas Section 1256(g) was added around 1986. 
To gain entry into Section 1256(g), the IRS requires that spot forex settle in cash and be 
traded in the Interbank marketplace, but it’s debatable what constitutes this marketplace. 
Read our blog post, A Case For Retail Forex Traders Using Section 1256(g) Lower 60/40 
Tax Rates, https://tinyurl.com/forex-1256g. 
Forex tax reporting. Summary reporting is used for forex trades, and brokers offer useful 
online tax reports. Spot forex brokers aren’t supposed to issue Form 1099-Bs at tax time. 
Section 988 is realized gain or loss, whereas with a capital gains election into Section 1256(g), 
MTM treatment should be used. 
Section 988 transactions for investors are reported in summary form on line 8 “other 
income or loss” of 2019 Schedule 1 (Form 1040). Watch out for negative taxable income 
caused by forex losses without TTS; some of those losses may be wasted. (TTS traders use 
Form 4797 Part II instead, and the negative income may generate an NOL carryover 
depending on the taxpayer’s income from other sources.) Section 1256(g) treatment uses 
Form 6781 just like other Section 1256 contracts. 
Rollover trades. Forex spot contracts clear within two days, whereas forex forward 
contracts clear in over two days. If a trader wants to stay in a spot trade longer than two days, 
the broker offers a “rollover trade” which technically is a realized sale and purchase of a new 
position (but not all brokers treat it that way). Forex spot traders don’t take delivery of the 
foreign exchange.  
Forex brokers handle rollover interest and rollover trades differently. In most cases, it’s 
not interest expense, but rather part of trading gain or loss.  
The Section 988 opt-out election. The election to opt out of Section 988 must be filed 
internally (meaning you don’t have to file an election statement with the IRS) on a 
contemporaneous basis (meaning the IRS does not allow hindsight — the election is 
effective from the date it was made going forward). Section 988 talks about the election on 
every trade, but you can also make a “good to cancel” election which is more practical. The 
election can be made and withdrawn throughout the year.  
Forex OTC options: Few retail traders have access to trade forex OTC options. Per 
TaxNotes, “Representing a turnaround from what was understood to be prior law, the Sixth 
Circuit Court of Appeals held Jan. 7, 2016 in the Wright decision, that over-the-counter 
(OTC) foreign currency options are subject to mark-to-market accounting under section 
1256.” In 2007, the IRS had barred forex OTC options from Section 1256. (I cover the 
Wright decision and its implications for forex traders in A Case For Retail Forex Traders 
Using Section 1256(g) Lower 60/40 Tax Rates.) 
A word of caution: Forex trading losses can become wasted for non-TTS traders who 
don’t elect out of Section 988 and have negative taxable income. Forex losses become a part 

34 
of NOL for those who qualify for TTS; but again, investors don’t have NOL treatment. 
Investors with no other source of income may be better off electing out of Section 988, so 
their forex losses can be classified as capital-loss carryovers and not wasted forever. 
Physically held currency: Tax treatment varies when holding physical foreign currency. 
Section 988 rules apply, however, the IRS does not permit a capital gains opt-out election, as 
it does on forex contracts. That means investing in physical currency is ordinary gain or loss 
treatment in Section 988.  
For personal use of currency such as on vacation, losses are not deductible, while gains 
are considered capital gains. Section 988 and the capital gains election don’t apply to 
personal use of currency. Some traders find this answer about personal use currency taxation 
in IRS publications, but it doesn’t apply to investing and trading forex. Traders and investors 
use Section 988 by default.  

OTHER INSTRUMENTS
Traders have a bevy of new financial products to choose from these days, but 
unfortunately, the IRS is a bit slow to issue tax guidance. It often waits to see how traders 
use the new instruments, how they report the transactions on tax returns, and how 
the markets react. 
Cryptocurrencies. Selling, exchanging, or using cryptocurrency triggers capital gains and 
losses for traders. The IRS treats cryptocurrencies as intangible property; not a security or a 
commodity. 
The realization method applies to short-term vs. long-term capital gains and losses. If you 
invested in cryptocurrencies and sold, exchanged, or spent some during the year, you have to 
report a capital gain or loss on each transaction. Include cryptocurrency-to-currency sales, 
crypto-to-alt-crypto trades, and purchases of goods or services using crypto. 
U.S. cryptocurrency exchanges issue a Form 1099-K to accounts with transactions over a 
certain threshold. The problem for the IRS is that many cryptocurrency transactions on 
exchanges around the world are not evident for tax reporting. Cryptocurrency investors 
should download all crypto transactions into a crypto accounting program that is 
IRS-compliant. 
Wash sales do not apply to intangible property. Use the first-in-first-out (FIFO) 
accounting method. Intangible property should use the specific identification method, but 
that requires broker confirmation of each trade, which is not possible. 
TCJA restricted Section 1031 like-kind exchanges to real property, starting in 2018. That 
rules out using like-kind exchange on crypto-to-crypto trades (i.e., Bitcoin for Ethereum). It’s 
questionable whether crypto traders could have used Section 1031 before 2018 to defer 
capital gains taxes. The IRS recently mailed tax “education” notices to thousands of crypto 
traders and released a new set of FAQs about hard forks, airdrops, and other open questions. 
See https://tinyurl.com/cryptocurrency-considerations. 
Volatility ETNs. There are many different types of volatility-based financial products to 
trade, and tax treatment varies. For example, CBOE Volatility Index (VIX) futures are taxed 
as Section 1256 contracts with lower 60/40 MTM tax rates. The NYSE-traded SVXY is an 
ETF taxed as a security. 

35 
 Volatility ETNs are structured as “prepaid forward contracts” or as “debt instruments.” 
Our tax counsel says that an ETN prepaid forward contract is not considered a security by 
the IRS, whereas, ETN debt instruments are.  
Sales of ETN prepaid forward contracts use the realization method on sales. Long-term 
capital gains rates apply if held 12 months or longer. Because it’s not a security, ETN prepaid 
forward contracts (i.e., VXX) are not subject to wash-sale loss adjustments and Section 475 
(if elected). ETNs debt instruments (i.e., UGAZ) are securities and are subject to wash sale 
losses and Section 475 (if elected). Check the tax section of the ETN prospectus. 
There is substantial authority to treat CBOE-listed options on volatility ETNs, and on 
volatility ETFs structured as publicly traded partnerships as “non-equity options” with 
Section 1256 treatment. See our blogs: How To Apply Lower Tax Rates To Volatility Options
(https://tinyurl.com/volatility-option), and ETNs Have Different Structures With  Varying
Tax Treatment (https://tinyurl.com/gtt-etns)   
In preparing Form 1099-Bs, many brokers use the tax classification determined by 
exchanges for labeling securities vs. 1256 contracts. Some brokers treat both types of ETNs 
as securities on 1099-Bs with wash sale loss adjustments, even though prepaid forward 
contracts do not fall in that category. Some brokers treat CBOE-listed options on volatility 
ETNs and ETF PTPs as securities on Form 1099-Bs, even though they are eligible for 
Section 1256 treatment. Taxpayers can depart from 1099-Bs based on substantial authority
positions and explain why in a tax return footnote. 
Swap contracts. The Dodd-Frank financial regulation law promised to clear private swap 
transactions on exchanges to protect the markets from another swap-induced financial 
meltdown — remember those credit default swaps with insufficient margin? When 
Dodd-Frank was enacted, traders hoped that clearing on futures exchanges would 
allow Section 1256 tax treatment. They were wrong: Congress and the IRS immediately 
communicated that Section 1256 would not apply to swap transactions, and they confirmed 
ordinary gain or loss treatment. Read our blog post: Tax Treatment for Swaps Options, 
https://tinyurl.com/gtt-swaps. 
Foreign futures. By default, futures contracts listed on international exchanges are not 
Section 1256 contracts. If the international exchange wants Section 1256 tax treatment, they 
must obtain an IRS Revenue Ruling granting 1256 treatment. Only a handful of international 
futures exchanges have Section 1256 treatment: Eurex, LIFFE, ICE Futures Europe, and 
ICE Futures Canada. Foreign futures are otherwise ST or LT capital gains. (Read our blog 
Tax Treatment for Foreign Futures, https://tinyurl.com/foreign-futures, to see the list of 
exchanges with this IRS approval.) Remember, Section 1256 tax treatment uses MTM 
accounting at year-end. Foreign futures without Section 1256 are reported like securities 
using the realization method for ST vs. LT capital gains.  
Precious metals. Physical precious metals are “collectibles,” which are a particular class of 
capital assets. If you hold collectibles over one year (long-term), sales are taxed at the 
“collectibles” capital gains tax rate — capped at 28%. That rate is higher than the top regular 
long-term capital gains rate of 20% (2019 and 2020). (If your ordinary rate is lower than 
collectibles rate, then use that.) If you hold collectibles one year or less, the short-term 
capital gains ordinary tax rate applies no different from the regular STCG tax rate. Precious 
metals are not securities, so wash-sale loss adjustments, and Section 475 does not apply. Read 
our blog post: Tax Treatment for Precious Metals, https://tinyurl.com/gtt-precious. 

36 
  
 

Chapter 4 
 
Accounting for Trading Gains & 
Losses 

When it comes to a trading activity, it’s wise to do separate accounting for gains and 
losses vs. expenses. A consumer off-the-shelf accounting program is fine for keeping track 
of expenses, non-trading income, home office deductions, and itemized deductions. But 
when it comes to trade accounting for securities, one may need a specialized software 
program or professional service. Futures gain/loss accounting may not be necessary, as 
traders generally can rely on the one-page 1099-B with summary reporting, using MTM 
reporting. For forex contracts, taxpayers can rely on the broker’s annual tax reports and 
should use summary reporting. Spot forex is not a “covered security,” so there are no Form 
1099-Bs.  
U.S.-based cryptocurrency exchanges issue a Form 1099-K to taxpayers reaching a certain 
threshold of transactions, and most provide online tax reports. Consider a cryptocurrency 
trade accounting solution.  

SECURITIES ACCOUNTING IS CHALLENGING

Securities brokers made advances in tax-compliance reporting due to Congressional 
legislation and implementation of IRS cost-basis reporting regulations phased in between 
2011 and 2017.
Taxpayers report proceeds, cost basis, wash-sale loss and other adjustments, holding 
period, and capital gain/loss on Form 8949. According to the form’s instructions, taxpayers 
without wash sales and other adjustments to cost-basis may enter totals from broker 1099-Bs 
directly on Schedule D and skip filing a Form 8949. After all, the IRS gets a copy of the 
1099-B with all the details.  
But many taxpayers believe that they don’t have wash sales, when in fact they often have 
many to report to be in compliance with IRS rules for taxpayers, which vary from rules for 
brokers.  

37 
FORMS 8949 AND 1099-B ISSUES
Per IRS rules for brokers, 1099-B reports wash sales per that one brokerage account 
based on identical positions. The IRS rules are different for taxpayers, who must calculate 
wash sales based on substantially identical positions across all their accounts including joint, 
spouse, and IRAs. It’s expected that in many cases, broker-issued 1099-Bs might report 
different wash-sale losses than a taxpayer must report on Form 8949. A taxpayer may trigger 
a wash-sale loss between a taxable and IRA account, but a broker will never report that on a 
1099-B. In some cases, a broker can report a wash-sale loss deferral at year-end, but the 
taxpayer may have absorbed the loss in another account, thereby eliminating the problem. 
This problem of different rules on wash sales for brokers vs. taxpayers is still unknown to 
many taxpayers and tax preparers. Many continue to file an incorrect Form 8949 relying 
solely on broker 1099-B reporting when they should be using a securities trade accounting 
software or service to calculate and report wash-sale loss adjustments more accurately.  
A predicament for some tax preparers who do understand the problem is that calculating 
wash sales correctly leads to unreconciled differences between Form 8949 and 1099-Bs. 
Some tax preparers don’t want to draw attention to those differences, fearing IRS notices 
generated from IRS 1099-B automated matching programs. It’s ironic that the mission of 
Congress in cost basis legislation was to “close the tax gap” providing more opportunities 
for matching 1099-Bs, but it seems to have caused a mess over the issue of wash sales.  
There is one scenario where a taxpayer can confidently rely on a 1099-B and skip filing 
Form 8949 by entering 1099-B amounts on Schedule D: when the taxpayer has only one 
brokerage account and trades equities only with no trading in equity options, which are 
substantially identical positions. Plus, the taxpayer must not have any wash-sale loss or other 
adjustments to carry into the current year from the prior year. That’s unlikely to be the case 
for an active equities trader. 
This problem is the biggest for taxpayers who have multiple accounts. One solution is for 
traders who qualify for TTS to trade in an entity and elect Section 475 MTM, which is 
exempt from wash-sale rules. Another way to avoid wash-sale loss adjustments is to trade 
Section 1256 contracts. Traders can keep investment accounts with far less wash-sale loss 
activity on the individual level.  

WASH-SALE LOSS RULES

Per IRS Publication 550: “A wash sale occurs when you (a taxpayer) sell or trade stock or 
securities at a loss and within 30 days before or after the sale you: 
● Buy substantially identical stock or securities, 
● Acquire substantially identical stock or securities in a fully taxable trade, 
● Acquire a contract or option to buy substantially identical stock or securities, or 
● Acquire substantially identical stock for your individual retirement account (IRA) 
or Roth IRA.” 

WASH-SALES REPORTED ON 1099-BS

Broker 1099-Bs report “wash sale loss disallowed” (box 1g), and it’s not uncommon to 
see an enormous amount for an active securities trader. The 1099-B also reports “proceeds” 
(box 1d), “cost or other basis” (box 1e) and several other related amounts. For example, 
$10M proceeds minus $9.9M cost or other basis, plus $150,000 of wash sale loss disallowed, 

38 
equals $250,000 of taxable capital gains. The 1099-B cover page has summary numbers, and 
supplemental schedules include each securities trade for all of these boxes. 
The essential point is that WS loss disallowed in box 1g is for the entire tax year. 
However, WS losses deferred at year-end cause phantom income in the current tax year. 
Many WS losses during the year might fade away by year-end (more on this later). 
Unfortunately, brokers do not report WS losses deferred at year-end, and clients need that 
information. If a trader uses trade accounting software, they need this information to reverse 
WS loss deferrals from the prior year-end on January 1 of the current tax year. 
For example, two different traders can have $1M of WS loss disallowed in box 1g. Trader 
A doesn’t have WS losses at year-end, and she is not concerned with those adjustments 
during the year. She sold all open positions by year-end and did not repurchase substantially 
identical positions in January. Trader B also sold all positions by year-end, but he made 
repurchase trades in January, which triggered $50,000 of WS losses deferred at year-end. 
Trader B delayed the December WS loss to the subsequent tax year. 
Traders need ongoing WS loss information throughout the year to prevent this 
predicament. Some monthly brokerage statements include cost basis amounts for month-end 
open positions listed on the report, and other monthly brokerage statements do not. 
Most traders don’t realize they have a WS loss problem until they receive 1099-Bs in late 
February. That’s too late to avoid WS losses.  
Many traders and tax preparers who are not well versed in the rules may leap to import 
1099-Bs into tax software, but they will probably not comply with the rules for taxpayers.  
We implore Congress and the IRS to address these structural conflicts in the wash-sale 
rules. I had hoped Congress would consider changes as part of tax reform discussions in 
2017, but TCJA did not address these issues.  

STRATEGIES TO AVOID WASH-SALE LOSSES ON SECURITIES

Consider a “Do Not Trade List” to avoid permanent wash-sale losses between taxable 
and IRA accounts.  
For example, a trader could trade tech stocks in his individual taxable accounts and 
energy stocks in his IRA accounts. Otherwise, he can never report a wash-sale loss with an 
IRA, as there is no way to record the loss in the IRA — it’s a permanent wash sale loss. 
Taxpayers can “break the chain” on wash-sale losses at year-end in taxable accounts to 
avoid deferral. If a trader sells Apple equity on Dec. 20, 2020, at a loss, he shouldn’t 
repurchase Apple equity or Apple equity options until Jan. 21, 2021, avoiding the 30-day 
window for triggering a wash-sale loss and breaking the chain.  
Wash-sale loss adjustments during the year in taxable accounts can be absorbed if traders 
sell/buy those open positions before year-end and don’t buy/sell them back in 30 days. It 
means there won’t be a wash-sale loss deferral at year-end.  
Consider a Section 475 election. Business traders qualifying for TTS are entitled to 
elect Section 475 mark-to-market (MTM) accounting, which exempts them from wash-sale 
loss adjustments and the capital-loss limitation. Section 475 business trades are not reported 
on Form 8949; they use Form 4797 Part II (ordinary gain or loss). Although Section 475 
extricates securities traders from the compliance headaches of Form 8949, it does not 
change their requirement for line-by-line reporting on Form 4797. We recommend trade 
accounting software to generate Form 4797. If a taxpayer elects Section 475, he will need 

39 
that software to calculate the Section 481(a) adjustment, too. (Learn more about this 
adjustment in Chapter 2.) 
Don’t trade securities. Trade Section 1256 contracts and other financial instruments that 
are not considered securities for tax purposes, like ETN prepaid forward contracts, 
cryptocurrencies, precious metals, and swap contracts. Only securities are subject to wash 
sale loss adjustments. (See https://tinyurl.com/wash-sale-loss.) 

ACCOUNTING FOR FOREIGN SECURITIES CAN BE CONFUSING

Many traders have trading accounts in foreign countries, and the reporting can be 
challenging. The tax rules involve an election to keep books in a foreign currency — a 
qualified business unit — which makes accounting easier than having to convert each trade 
into U.S. dollars on the day of the transaction. Instead, a taxpayer could use an average 
currency conversion rate for the year.  

SECTION 1256 TRADERS HAVE IT EASIER

Traders probably do not need a trade accounting solution for Section 1256 contracts 
since broker-issued 1099-Bs for those contracts are generally accurate. Section 1256 includes 
U.S. futures, broad-based indexes, options on both, and non-equity options (see Chapter 3). 
Summary reporting and MTM accounting mean a taxpayer can just enter the “aggregate 
profit or loss on contracts” net amount from the separately issued one-page 1099-B on 
Form 6781 Part I. MTM is exempt from wash-sale rules since there are no open positions or 
adjustments to consider at year-end. Broker tax reporting matches taxpayer reporting.  
Certain instruments may qualify for Section 1256 treatment, like options on commodity 
ETFs and CBOE-listed options on volatility ETNs, but the broker may not report it that 
way. Conversely, the broker may report 1256 treatment (such as on foreign futures), and that 
may not be correct. A good securities accounting program can download all trades and you 
can properly classify Section 1256 contracts vs. securities.  
Futures brokers establish separate accounts from securities accounts since the 
CFTC/NFA regulate futures and the SEC regulates securities. There are also different 
regimes for protecting your money: SIPIC for securities and NFA segregation rules for 
futures. Separation for regulatory purposes jives nicely with separation for tax reporting 
purposes.  

FOREX TRADERS HAVE IT FAIRLY EASY

Most forex traders trade spot contracts, but spot is not a covered instrument for 1099-B 
issuance. Online forex brokers issue trade accounting reports, and summary reporting is 
used for net forex trading gain or loss on tax returns (by broker). (Read more about forex tax 
treatment in Chapter 3.) 
Spot forex brokers provide online tax reports for calendar-year net trading gain or loss. 
Transaction costs, rollover interest (in most cases), and other items should be combined into 
the net trading gain or loss amount reported in summary fashion.  
Section 988 accounting. Most brokers use the realization (cash) method of reporting for 
realized Section 988 transactions. Few include gain or loss on unrealized positions at 
year-end. Section 988 doesn’t require MTM but using Section 1256(g) does. If a taxpayer 
opts out of Section 988 into Section 1256(g) lower 60/40 tax treatment on major currencies, 

40 
MTM accounting is used. This means she should report unrealized gains and losses at 
year-end. Learn more about Section 1256(g) in Chapter 3. 
Rollover transaction reporting isn’t always clear. Forex brokers often report rollover 
interest income or expense when generated. It’s not really interest but rather a trading gain or 
loss element in the transactions. However, some experts view the “roll open, roll 
close” method used by some forex brokers as true interest income or expense. 
Most spot forex brokers don’t report the flip side of the rollover transaction: The 
appreciation or depreciation of the string of underlying rollover transactions until those 
rollover trades are closed out. We think brokers should report rollovers as closed trades with 
a replacement trade opened, rather than kick the can down the road on the appreciation or 
depreciation of the rollover transaction.  

KEEP TRACK OF EXPENSES YEAR ROUND

If a taxpayer qualifies for TTS, he can benefit from business expense deductions. Many 
traders are not sure if they will qualify for TTS until year-end, so it’s important for them to 
keep track of all trading and other expenses in their accounting solution throughout the year. 
They can use a consumer accounting program, solution, or app of their choice. At a 
minimum, traders should keep track of all expenses using a simple spreadsheet. 

TRADING ENTITY
If a trader has a trading entity, he should also keep track of additions and withdrawals of 
capital, purchases of fixed assets and intangible assets, debt, and distributions of profit. An 
entity tax return includes a balance sheet with all of these items, so it is vital to reconcile all 
asset, liability, and equity items in addition to income and expenses.    

41 
  
 

Chapter 5  
 
Trading Business Expenses 

Business traders can deduct all reasonable business expenses, whether they have trading 
gains or losses, saving around $5,000 per year on average. These deductions hinge on 
qualifying for trader tax status (TTS), of course.  
TCJA suspended “certain miscellaneous itemized deductions subject to the 2% floor,” 
including investment fees and expenses, job expenses, and tax compliance fees and expenses. 
TCJA did not suspend investment-interest expenses or “other itemized deductions” on 2019 
Schedule A line 16, which includes stock-borrow fees.  
The good news is TTS can still be claimed for 2019 and 2020, and even other open tax 
years (usually up to three years prior). Unlike Section 475 MTM (mark-to-market) 
accounting, which must be elected by the April 15 deadline (i.e., April 15, 2020 for 2020), 
TTS can simply be claimed by a taxpayer after the fact, based on facts and circumstances. 
Taxpayers new to TTS might still be in luck for 2019.  

INVESTORS
Investors are stuck with few itemized deductions after TCJA suspended investment fees 
and expenses.  
Many investors will choose the 2019 standard deduction of $24,400 married filing jointly, 
$12,200 single and married filing separately, and $18,350 for head of household — these are 
roughly doubled by TCJA as compared to prior tax law. There is an additional standard 
deduction of $1,300 for the aged or the blind. For 2020, the standard deduction increases to 
$24,800 married filing jointly, $12,400 single and married filing separately, and $18,650 for 
heads of household. 
Investment-interest expenses remain an itemized deduction if they don’t exceed net 
investment income (on Form 4952), with the excess over investment income carried over to 
the following tax year(s). 
With TTS, margin interest paid on business positions is treated as a business-interest 
expense, and it’s deductible on Schedule C or a separate entity business tax return. TCJA 
introduced a “business interest limitation” Section 163(j) applicable to taxpayers with average 

42 
annual gross receipts over $25 million. For TTS traders, gross receipts are trading gains. See 
TCJA changes in Chapter 17. 
Let’s presume a taxpayer easily qualifies for TTS, either individually or in an entity. Which 
business expenses are deductible, and which ones are not?  

BUSINESS EXPENSES
Business deductions include: 
● Tangible personal property like a computer, up to $2,500 per item, providing the 
taxpayer files a Sec. 1.263(a)-1(f)) safe harbor election with the tax return. 
● Section 179 (100%), 100% bonus, and/or regular depreciation on computers, 
equipment, furniture, and fixtures. 
● Amortization of startup costs (Section 195), organization costs (Section 248), 
and software. 
● Education expenses paid and courses taken after commencement of the trading 
business activity.  
● Section 195 startup costs may include education expenses within six months of 
beginning TTS. 
● Books/publications, market data, charting services, online and professional 
services, cloud services, chat rooms, mentors, coaches, supplies, phone, internet, 
travel, meals, seminars, conferences, assistants, consultants, office rent and more. 
● Home-office expenses for the business use portion of a trader’s home (share of 
rent, mortgage interest, real estate tax, depreciation on home, utilities, repairs, 
insurance, and all other home costs). 
● Margin interest expenses (not limited to investment income). 
● Stock-borrow fees and other costs for short sellers.  
● Self-created software for automated trading systems. 
 
Business deductions don’t include: 
● Vehicles  
● Commissions 
● Employee-benefit plan deductions (TTS S-Corps can arrange health insurance 
and retirement plan contributions in connection with officer compensation) 
Vehicles aren’t usually deductible because traders don’t need a car to visit clients or 
companies. Mileage for driving to seminars, etc., might qualify as travel expense at the 
standard mileage rate. 
Commissions are deductible against trading gains and losses; they aren’t a separately 
stated business expense. If a taxpayer exceeds the net capital loss limitation of $3,000 per 
year, commissions are deferred as part of the capital-loss carryover. With Section 475 MTM, 
the trading loss is unlimited in ordinary loss treatment. 
Sole-proprietor traders may not deduct employee-benefit plan deductions unless they 
trade in an S-Corp or have an S-Corp or C-Corp management company and pay themselves 
officer’s compensation. Employee benefits include health insurance premiums paid during 
the entity period and retirement plan contributions. See Chapters 7 and 8. 

43 
CASH VS. ACCRUAL
A trading business may elect either cash or accrual accounting methods for business 
expenses only. Trading gains and losses are dictated by other rules, including Section 475 
MTM, Section 1256, Section 988, and the various code sections for capital gains and losses.  
Most business traders choose the cash method for expenses, meaning expenses are 
deductible when paid, not when they are incurred. The accrual method deducts expenses 
when incurred. Under the cash method, a credit card charged by Dec. 31 or a check dated 
Dec. 31 is considered a year-end tax cash deduction, provided the item is placed in service 
before year-end.  
Here’s one case where the accrual method may be better: Suppose a new trader purchases 
$10,000 of trading training (not classic education) on Dec. 1, 2019. The trader starts classes 
in December and continues them through March 2020. The trader begins his TTS trading 
business halfway through the training in January 2020. The cash method classifies the 
$10,000 as a Section 195 startup cost, with $5,000 deducted in 2020 as “expense allowance” 
amortization and the balance amortized over 15 years. With the accrual method, the trader 
will have the same amortization amount ($5,000) on his 2020 tax return, and he can deduct 
the other $5,000 in full as a post-business-commencement education expense in 2020 
because half took place after business commencement in January. Pre-business education is a 
nuanced area that’s widely misunderstood.  

DEPRECIATION ON HARD ASSETS

Some expenses or costs must be capitalized and depreciated (on hard assets) or amortized 
(on soft or intangible assets) over their “useful life,” according to the IRS. Computers and 
equipment are depreciated over five years, with various accelerated methods or the 
straight-line depreciation method. The same rules apply to furniture and fixtures, but their 
useful life is seven years. Residential property, including a home office, has a 39-year useful 
life and only straight-line depreciation is allowed. For more information on depreciable 
assets and depreciation methods, see IRS Publication 946: How To Depreciate Property.  
When appropriate, taxpayers should skip capitalization and depreciation and use full 
expensing for “tangible personal property” like a computer, up to $2,500 per item, providing 
she files a Sec. 1.263(a)-1(f)) safe harbor election with the tax return. In some situations 
(including profit from trading or wages required), Section 179 applies, which allows 100% of 
the cost of the item to be written off even if over $2,500 per item. 
TCJA allows “full expensing,” or 100% bonus depreciation for qualified property 
acquired and placed in service after Sept. 27, 2017, and before Jan. 1, 2023. 

SECTION 179 DEPRECIATION

At the end of the 2015 Congressional session, Congress retroactively renewed “tax 
extenders” for 2015. The Section 179 $500,000 limit was made permanent, and the 50% 
bonus depreciation continues through 2019.  
Section 179 depreciation requires business income or wages to offset it; otherwise, it’s a 
carryover item. In that case, regular depreciation may be preferable. Taxpayers can’t take 
Section 179 or bonus depreciation on assets they owned prior to forming their business, so 
regular depreciation is applied. The assets must be new to the taxpayer, so they could have 
been used by other taxpayers beforehand. 

44 
 Certain assets (such as computers, equipment, furniture, and fixtures) qualify for Section 
179 depreciation, which allows an immediate 100% write off per specific IRS rules.  
TCJA increased the Section 179 limit to $1 million and indexed it for inflation after 2018. 

TANGIBLE PERSONAL PROPERTY EXPENSING

In general, a business must capitalize property for purposes of depreciation. For smaller 
purchases, the IRS allows expensing under its tangible property regulations, since it’s 
inconvenient to maintain depreciation records on small amounts. The IRS increased the de 
minimis expensing amount to $2,500 from $500 for 2016 and forward and allowed early 
adoption to 2015 tax filings.  
If a business trader purchases a new workstation for $7,500, he should try to break down 
the purchase into separate items, each under $2,500. For example, he could buy the 
computer separate from the monitors and other equipment. With all invoices under $2,500, 
the entire $7,500 can be a current-year business expense without any capitalization for fixed 
assets and related depreciation. That leads to faster expensing, tax benefits, and less 
compliance work. 
The purchases can be on one invoice, but it may draw more IRS attention and require 
more time to breakout. Separate invoices are good practical guidance to avoid this issue. 
Under the change, the new $2,500 threshold applies to any such item substantiated by an 
invoice. 

STARTUP AND ORGANIZATION EXPENSES

Startup expenses can be capitalized and amortized over 15 years (Section 195). The 
first-year expense allowance is $5,000, whether a taxpayer starts the business toward the 
beginning or later in the year. Startup expenses are limited to “investigating and inquiring” 
about a new business. Otherwise, they may be capitalized to the cost of an investment in a 
new business and not amortized at all. Organization expenses (Section 248) are similar to 
Section 195, and they also have a $5,000 first-year expense allowance with the balance 
amortized on a straight-line basis over 15 years. Organization costs include attorney and 
accounting fees for forming a trading entity.  

EDUCATION
Educational expenses incurred after a trading business commences are tax deductible, 
provided the education maintains or improves the business. Pre-business education 
expenses, however, are a problem for tax-deduction purposes. Before 2018, education did 
not qualify as “investment expenses” (Sections 212 and 274(h)(7)). We advise TTS traders to 
squeeze a reasonable amount of pre-business education expenses into Section 195 startup 
expenses, which may be appropriate under certain circumstances. Trading education isn’t 
classic secondary school education, and this approach can work in some cases. The 
education has to be in the recent past (around six months before active trading begins), and 
traders should only capitalize a reasonable amount.  

C-CORPS DON’T NAVIGATE AROUND TTS

Stay clear of tax promoters promising business deductions for pre-business education 
using C-Corps and going back over six months. Those schemes don’t work: C-Corps are for 
business, not pure investing without TTS. A C-Corp may deduct business and ancillary 

45 
investment expenses, but not just investment expenses if it doesn’t have a business purpose. 
The dangerous scheme calls for an LLC (a dual entity) to pay advisory fees to the C-Corp so 
it can make a profit and utilize the education expenses dumped into it. Pre-business 
education is not capitalized to Section 195 without a business purpose later on in the 
C-Corp. The LLC is an investment company — it does not qualify for TTS — and its fees 
paid to the C-Corp will pass through as suspended investment expense on the LLC Schedule 
K-1 to the owner’s individual tax return. The IRS will view the C-Corp as trading one’s own 
money without TTS and not allow it to use business expense treatment. That’s a lot of 
scheming and fees paid to promoters to wind up with no business deduction. Plus, the 
C-Corp is breaking tax rules in our view and risking back taxes, tax penalties, and interest 
expenses. Don’t fall prey to the snake oil salesmen. (See our blog post How To Avoid IRS 
Challenge On Your Family Office, https://tinyurl.com/gtt-family.)  

AUTOMATED TRADING SYSTEMS

Increasingly, traders are writing computer code for developing automated trading systems. 
The IRS allows a few different choices for expensing “internal-use software.”  
If a taxpayer qualifies for TTS before incurring software development costs, he may 
deduct them like other research expenses in Section 174(a) in the year paid.  
If a taxpayer doesn’t qualify for TTS before incurring software development costs, he may 
capitalize them under Section 174(b). In this situation, a taxpayer has two choices. Once the 
software is completed, the taxpayer can wait until he qualifies for TTS to amortize (expense) 
the intangible asset over 60 months. Or, he can wait until he places the software in service 
with qualification for TTS to amortize the intangible asset over 36 months.  
Traders may qualify for TTS using an automated trading system if they write the code or 
have other significant involvement with its creation and modification. Conversely, if a trader 
purchases an off-the-shelf automated trading system providing entry and exit signals and 
trade execution, he probably doesn’t get credit toward TTS for the volume and frequency of 
trades made by it. If the trader does not create the ATS, then the related costs are a 
suspended investment expense.  

TRAVEL AND MEALS

Many traders travel to seminars and workshops to further their trading education. Many 
trading seminars are hosted in resorts or fun cities such as Las Vegas and New York City. 
This travel is a business expense provided the education qualifies as a business expense, too, 
as their tax treatment is connected. Travel for classes, seminars, and conferences looks to the 
underlying tax treatment of that item itself as a non-deductible investment expense (Section 
274(h)(7)), Section 195 startup cost, or allowable business expense after business 
commencement. Deducting a trading seminar trip hinges on previously qualifying for TTS, 
too. The precedent here is a 2008 IRS revenue ruling that said an investor couldn’t deduct 
travel expenses to and from a real estate investment seminar because the taxpayer didn’t 
qualify for business status before the trip.  
Meals with trader colleagues may be tax deductible, but the expenses have to be 
reasonable. Visit www.irs.gov to learn the many IRS rules on travel and meals expenses. The 
IRS likes to scrutinize this in tax exams. 

46 
 Starting in 2018, TCJA disallows a deduction for an activity generally considered to be 
entertainment, amusement, or recreation and membership dues for any club organized for 
business, pleasure, recreation, or other social purposes. The 50% limit on meals deduction 
remains and is expanded to meals provided through an in-house cafeteria or otherwise on 
the premises of the employer. It’s a stretch for stay-at-home TTS traders to deduct in-house 
meals.  

HOME-OFFICE EXPENSES
Since 1999, the home-office deduction is no longer a red flag — millions of Americans 
benefit from this deduction each year. Countless Americans run businesses from home, and 
the IRS understands this. The income-requirement rule also limits the use of this deduction 
to profitable businesses, which appeases IRS concerns about abuse and hobby-loss 
businesses. Before the IRS liberalized home-office deduction rules in 1999, a more stringent 
requirement was that taxpayers needed to meet clients in their home office. Now, only 
administration work is required in a home office, and another principal office outside the 
home doesn’t negate the deduction.  
Most traders operate their trading business from a home office. Some traders also trade 
from job locations using browser-based trading platforms or apps accessible on work 
computers, laptops, tablets, and smartphones. They can qualify for the home-office expense 
deduction in this situation, as well. 
Home-office deductions are very beneficial for profitable business traders. Unlike other 
types of business costs, which require new cash outlays, deducting home-office expenses is 
especially rewarding because fixed personal costs are converted into tax-deductible business 
expenses. This same concept applies to many other items such as phone, Internet, furniture, 
fixtures, and more. Keep in mind that trading gains are needed to unlock most home-office 
deductions. If a trader doesn’t have sufficient business trading gains, the otherwise allowable 
home office deductions are carried over to the following tax years. (In this situation, 
hopefully the trader remains in the business and has trading gains in subsequent years to use 
the carryovers.) 
There are several special requirements and rules for the home-office deduction. A home 
office must be exclusively and regularly used for business, meaning children and guests can’t 
use this room. Report “indirect expenses” on Form 8829 and include every expense and cost 
related to the home. For example, include depreciation or rent, utilities, insurance, repairs 
and maintenance, security, cleaning, lawn care, and more.  
Mortgage interest and real property taxes are included, too, and this portion doesn’t 
require income. The non-business portion of mortgage interest and real property taxes are 
considered itemized deductions on Schedule A. Real property taxes on Schedule A are part 
of TCJA’s SALT limitation but the home office portion or real property tax is not subject to 
the SALT limit. 
To calculate the home-office deduction, take the square footage of the home office (and 
all related business areas such as storage, hallways, and bathrooms) and divide by the total 
square footage of the home (10-15% is customary). Alternatively, taxpayers can do the 
apportionment based on the room’s method. Form 8829 multiplies the home-office 
percentage by the indirect expenses. If a trader files a partnership return, home-office 
expenses are reported as unreimbursed partnership expenses (UPE) on Schedule E. We 

47 
prefer an accountable reimbursement plan in S-Corps, which a TTS trader must “use or 
lose” before year-end.  
Including depreciation of the home in the home office deduction doesn’t reduce the gain 
exclusion you are currently allowed under Section 121 if the taxpayer were to sell the 
principal residence in later years. When a taxpayer sells his principal residence, a portion of 
depreciation may have to be recaptured, but this is the case whether or not the depreciation 
expense deduction is taken on Form 8829. The amount to be recaptured is based on the 
amount “allowed or allowable” (an IRS phrase), meaning traders should depreciate their 
home offices on Form 8829 because the IRS will treat it as if they did, anyway. If the 
taxpayer has a gain on the sale of a residence containing a home-office, the recapture of 
home-office depreciation means there was only a temporary tax break for the depreciation 
portion. That is still very helpful. 
If a taxpayer sells his personal residence at a loss, the net loss is not deductible. But the 
recapture of depreciation income may not surpass the loss amount, meaning there is no 
taxable income from depreciation recapture to report on the tax return.  
We explain how traders should execute the home office deduction on their tax returns in 
Chapter 6.  
Starting in 2018, TCJA caps state and local income taxes, sales taxes, real property taxes 
and personal property taxes (SALT) itemized deductions on Schedule A at $10,000 per year 
(any combination thereof), and $5,000 for married filing separately. TCJA also reduced 
itemized deduction limits on mortgage interest expenses and casualty losses.  

A HYBRID CASE
Some traders have both business trading expenses and suspended investment expenses. If 
a taxpayer has an outside-managed account or an outside-developed automated trading 
system, those investment fees and expenses are suspended investment expenses, as they 
aren’t part of the trading business. Traders may have investment interest expense on core 
investment positions and business margin interest on business trading. Be careful to 
apportion these expenses properly. A trader might use margin lending on investment 
positions as capital for trading positions, and that should qualify as business interest. 

NON-ACTIVE SPOUSES
With respect to margin interest expense, non-active spouses/partners in an LLC filing a 
TTS partnership or S-Corp tax return are required to use investment-interest expense 
treatment, but the active spouse/partner in a TTS entity is entitled to business-interest 
treatment. Non-active spouses do get the rest of TTS business expense treatment and use of 
Section 475 if duly elected. Section 469 passive-activity loss rules don’t apply to a trading 
business.   
Spouses/partners are considered “active” if they trade or perform administrative duties. If 
a spouse is not active, and if margin interest is significant, a taxpayer may want to give the 
spouse only 1-10% interest rather than 50% interest in the pass-through entity to limit the 
amount of interest treated as investment-interest expense. However, taxpayers living in a 
community property state may want to use 50/50 ownership. 
If a spouse is active in the TTS business, then consider including the spouse in S-Corp 
compensation and employee benefits. Don’t overpay a related party. 

48 
RETIREMENT PLAN TRADING
If traders conduct business trading and retirement plan trading at the same time, we 
generally consider the latter ancillary to the trading business and don’t believe it is necessary 
to apportion expenses away from the trading business. If the retirement plan trading dwarfs 
the trading business in size and the trading business is immaterial to the level of expenses — 
in other words, if the expenses lead to a large business loss — it may be appropriate to 
apportion some costs to the retirement plan. (More on retirement account trading and 
reimbursement of investment expenses in Chapter 8.) 
 
  
   

49 
 Chapter 6 
 
Trader Tax Return Reporting 
Strategies  

The IRS hasn’t created specialized tax forms for individual trading businesses. Traders enter 
gains and losses, portfolio income, and business expenses on various forms. It’s often 
confusing. Which form should be used if the taxpayer is a forex trader? Which form is 
correct for securities traders using the Section 475 MTM method? Can one report trading 
gains directly on a Schedule C? The different reporting strategies for the various types of 
traders make tax time not so cut-and-dry. 

TAX FORM CHANGES IN 2019

TCJA required significant revisions to 2018 and 2019 income tax forms. This 2020 guide 
refers to 2019 (draft) tax forms, schedules, line items, and worksheets.  
The redesigned two-page 2019 Form 1040 resembles a postcard because the IRS moved 
many line items to three 2019 Schedules 1, 2 and 3 (Form 1040). It’s a block-building 
approach with the elimination of Form 1040-EZ and 1040-A. (In 2018, there were six 
schedules supporting Form 1040.)  
The IRS significantly changed the 2018 Schedule A (Itemized Deductions). TCJA 
suspended “certain miscellaneous itemized deductions subject to the 2% floor.” These 
deductions were included in “Job Expenses and Certain Miscellaneous Deductions” on the 
2017 Schedule A, lines 21 through 24. The revised 2018 and 2019 Schedule A deleted 
miscellaneous itemized deductions, including job expenses, investment fees and expenses, 
and tax compliance fees and expenses.  
The 2017 Schedule A also had “Other Miscellaneous Deductions,” not subject to the 2% 
floor, on line 28. That’s where an investor reports stock-borrow fees, which are not 
investment fees and expenses. The 2018 and 2019 Schedule A changed the name to “Other 
Itemized Deductions” on line 16 and that’s where investors deduct stock borrow fees.  
The QBI deduction is below the standard or itemized deduction. For tax year 2019, it is 
located on Form 1040 (page two, line 10) where taxpayers are instructed to attach Form 
8995 or Form 8995-A. These new forms should be an improvement from tax-year 2018, 
when QBI worksheets generated from tax preparation software were used instead.   

50 
SOLE PROPRIETOR TRADING BUSINESS
Other sole-proprietorship businesses report revenue, cost of goods sold, and expenses on 
Schedule C. But business traders qualifying for trader tax status (TTS) report only trading 
business expenses on Schedule C. Trading gains and losses are reported on various forms, 
depending on the situation. In an entity, all trading gains, losses, and business expenses are 
consolidated on the entity tax return — a partnership Form 1065 or S-Corp Form 1120-S. 
That’s one reason why we recommend entities for TTS traders. 
Sales of securities must be first reported on Form 8949, which then feeds into Schedule 
D (cash method) with capital losses limited to $3,000 per year against ordinary income (the 
rest is a capital loss carryover). Capital losses are unlimited against capital gains. (We cover 
Form 8949 in Chapter 4.) 
Business traders who elect and use Section 475 MTM on securities report their business 
trades (line by line) on Form 4797 Part II. MTM means open business trades are 
marked-to-market at year-end based on year-end prices. Business traders still report sales of 
segregated investments in securities (without MTM) on Form 8949. Form 4797 Part II 
(ordinary gain or loss) has business ordinary loss treatment and avoids the capital loss 
limitation and wash sale loss treatment. Form 4797 losses are counted in net operating loss 
(NOL) calculations. 
Section 1256 contract traders (i.e., futures) should use Form 6781 (unless they elected 
Section 475 for commodities/futures; in that case, Form 4797 is used). Section 1256 traders 
don’t use Form 8949 — they rely on a one-page Form 1099-B showing their net trading gain 
or loss (“aggregate profit or loss on contracts”). Simply enter that amount in summary form 
on Form 6781 Part I.  
If the trader has a large Section 1256 loss, he should consider a Section 1256 loss 
carryback election to carry back those losses three tax years, but only applied against Section 
1256 gains in those years. If he wants this election, check box D labeled “Net section 1256 
contracts loss election” on the top of Form 6781. 
Forex traders with Section 988 ordinary gains or losses who don’t qualify for TTS should 
use line 8 (other income or loss) on 2019 Schedule 1 (Form 1040). TTS traders should use 
2019 Form 4797, Part II ordinary gain or loss. What’s the difference? Form 4797 Part II 
losses contribute to NOL carryforwards against any type of income, whereas Form 1040’s 
“other losses” do not. The latter can be wasted if the taxpayer has negative income. In that 
case, a contemporaneous capital gains election is better on the Section 988 trades. If the 
taxpayer filed the contemporaneous Section 988 opt-out (capital gains) election, she should 
use Form 8949 for minor currencies and Form 6781 for major currencies. Forex uses 
summary reporting. (We cover forex tax treatment in Chapter 3 and forex accounting 
treatment in Chapter 4.) 

SCHEDULE C ISSUES
Sole-proprietor business traders report business expenses on Schedule C and trading 
income/loss and portfolio-related income on other tax forms, which may confuse the IRS. It 
may automatically view a trading business’s Schedule C as unprofitable even if it has 
significant net trading gains on other forms and is profitable after expenses. This is one 

51 
reason why we recommend an entity. To mitigate this red flag, we advocate a special strategy 
to transfer a portion of business trading gains to Schedule C to “zero it out” if possible. 

TRANSFER TRADING GAINS TO SCHEDULE C

In some cases, a good strategy for sole proprietorship business traders is to transfer some 
business trading gains to Schedule C, using the “Other Income” line, to zero the expenses 
out, but not show a net profit. Showing a profit could cause the IRS to inquire about 
self-employment (SE) tax, from which trading gains are exempt. (Traders who are full 
members of a futures or options exchange are an exception here; they have self-employment 
income under Section 1402(i) on their exchange-generated trading gains reported on Form 
6781.)
This special income-transfer strategy can also unlock the home-office deduction and 
Section 179 (100%) depreciation deduction, both of which require income. While Section 
179 depreciation can look to wage income outside the business, the bulk of home-office 
deductions can only look to business income. This transfer strategy isn’t included on tax 
forms or form instructions. It’s our suggested practice designed to deal with insufficient tax 
forms for sole-proprietorship trading businesses, and it must be carefully explained in 
tax-return footnotes. It also has the effect of allowing Schedule C losses in states like New 
Jersey that don’t allow losses. 
There is an alternative to the income-transfer strategy: Report gains from trading (from 
Form 4797, Form 8949, and Form 6781) on Line 8 of the home-office Form 8829. It’s an 
alternative way to provide the necessary income required to generate a home office 
deduction, but it doesn’t fix the red flag of a Schedule C loss, as with the income-transfer 
strategy.  

INCLUDE FOOTNOTES
We recommend that business traders include well-written tax-return footnotes, explaining 
trader tax law and benefits, why and how they qualify for TTS, whether they elected Section 
475 MTM or opted out of Section 988, and other tax treatment, such as the income-transfer 
strategy. If the taxpayer is a part-time trader, she needs to use the footnotes to explain how 
she allocates time between other activities and trading. Footnotes help address any questions 
the IRS may have about TTS qualification and the various aspects of reporting on the return 
before it has a chance to ask the taxpayer.  

SEPARATE ENTITIES ARE BETTER

Partnership and S-Corp trading business tax returns show trading gains, losses, and 
business expenses on one set of forms, plus the IRS won’t see the taxpayer’s other activities 
on the same return as the trading activity. That looks better.
Form 1065 is filed for a general partnership or multi-member LLC choosing to be taxed 
as a partnership. Form 1120S is filed for an S-corporation. Forms 1065 and 1120S issue 
Schedule K-1s to the owners, so taxes are paid at the owner level rather than at entity level, 
thereby avoiding double taxation. Ordinary income or loss (mostly business expenses) is 
summarized on Form 1040 Schedule E rather than in detail on Schedule C (hence less IRS 
attention). Section 179 is broken out separately on Schedule E, along with unreimbursed 
partnership expenses (UPE) including home-office expenses.  

52 
 Under the “trading rule” exception in Section 469 passive-activity loss rules, trading 
business entities are considered “active” rather than “passive-loss” activities, so losses are 
allowed in full on Form 1040 Schedule E in the non-passive income column.  
Portfolio income (interest and dividends) is separately stated on the partnership or 
S-Corp Schedule K-1s and passed through to the individual owner’s Schedule B. Capital 
gains and losses are passed through to Schedule D in summary form. A pass-through entity 
draws less IRS attention than a detailed Schedule C filing. Net taxes don’t change; they’re still 
paid on the individual level. Pass-through entities file Form 8949 and/or Form 4797 at the 
entity level. Schedule K-1 line one “ordinary business income (loss)” consolidates Form 
4797 ordinary income or loss with business expenses, and it’s a net income amount if trading 
gains exceed business expenses. That looks better than a sole proprietor trader. 
TTS S-Corps provide opportunities for deducting retirement plan contributions and 
health-insurance premiums; two breaks sole-proprietor traders and partnership traders can’t 
use unless they have earned income. (Learn more about entities in Chapter 7.) 
QBI on Schedule K-1. Per TCJA changes and the 2019 partnership Schedule K-1, tax 
preparers report QBI amounts on line 20 other information using code Z for Section 199A 
information. For 2019 S-Corp K-1s, use line 17 other information and code V for Section 
199A information. A sole proprietor trader using Section 475 is also eligible for the QBI 
deduction. Look to TTS trading gains on Form 4797 Part II less Schedule C expenses. 

TAX TREATMENT ELECTIONS

Tax treatment elections can be confusing because the Section 475 MTM and Section 988 
elections don’t have tax forms. New taxpayers — such as a new entity — file Section 475 
MTM elections internally within 75 days of inception, but existing taxpayers file an election 
statement by the due date of the prior year tax return or extension with the IRS and perfect 
it later with a Form 3115 filing by the tax return deadline. (See Chapter 2 for important 
details.) Section 988 capital gains elections are only filed internally on a contemporaneous 
basis. (Read forex tax treatment in Chapter 3.) 

FILING AS AN INVESTOR
If a taxpayer is filing as an investor, he should report trading gains and losses as explained 
earlier. The taxpayer can’t elect and use Section 475 MTM with Form 4797 ordinary gain or 
loss treatment, as that election requires TTS.
Investment interest expense (margin interest) is reported on Form 4952. It’s limited to net 
investment income. The excess is a carryover to the subsequent tax year(s). The deduction is 
taken on Schedule A as an itemized deduction. It’s also deductible on Form 8960 for net 
investment tax. (See Obamacare net investment tax in Chapter 15.) 
With the TCJA SALT cap of $10,000 and suspension of all miscellaneous itemized 
deductions, including investment fees and expenses, more traders are expected to choose the 
roughly doubled standard deduction.  
Many states limit or do not allow itemized deductions. Business expense treatment with 
TTS is much better.  
The only other itemized deduction for investors is stock borrow fees as “other itemized 
deductions.” 

53 
REPORTING LARGE TRADING LOSSES ON FORM 8886
If traders have significant trading losses, they may have to file a Form 8886 (Reportable 
Transaction Disclosure Statement). The instructions mention losses of $2 million in any 
single tax year ($50,000 if the losses are from certain foreign currency transactions) or $4 
million in any combination of tax years. If the forex loss is ordinary under Section 988, the 
$50,000 rule applies; however, if the forex transactions have capital gains and loss treatment, 
the $2 million limitation may apply.
File 8886 when due and include a simple explanation. These are not tax shelters, and if 
the IRS sends a tax notice, it should be simple to reply to and close out. Although the 
taxpayer doesn’t need to attach a forex statement from the broker since forex is not covered 
on 1099-Bs, he may want to so the IRS sees the loss is real.  

FOREIGN ACCOUNTS, INCOME, ASSETS

Foreign bank, brokerage, investment, and other types of accounts — including retirement 
and insurance in some cases — must be reported on FinCEN Form 114. The filing 
threshold is $10,000 for all foreign accounts combined. Starting with tax-year 2011, the IRS 
expanded its international compliance with tax form 8938 (Statement of Specified Foreign 
Financial Assets). 
The IRS is busy busting thousands of taxpayers for not filing Foreign Bank Account 
Reports (FBARs) and/or hiding unreported income offshore. Taxpayers might not even 
realize they need to file an FBAR. If any of our readers have any connection with foreign 
matters, it’s important to read Chapter 14.  

TAX EXTENSIONS
The 2019 income tax returns for individuals are due by April 15, 2020 — however, most 
active traders aren’t ready to file a complete tax return by then. Some brokers issue corrected 
1099-Bs right up to the deadline, or even beyond. Many partnerships and S-Corps file 
extensions by March 16, 2020, and don’t issue final Schedule K-1s to investors until after 
April 15. This may be even more common for 2019 tax returns, since business traders and 
other taxpayers have to deal with TCJA’s complicated new qualified business income 
deduction.  
The good news is traders don’t have to rush completion of their tax returns by April 15. 
They should take advantage of a simple one-page automatic extension along with payment 
of taxes owed to the IRS and state. Most active traders file extensions, and it’s helpful to 
them on many fronts. 
Traders can request an automatic six-month extension to file individual federal and state 
income tax returns up until Oct. 15, 2020. The 2019 Form 4868 instructions point out how 
easy it is to get this automatic extension — no reason is required. It’s an extension of time to 
file a complete tax return, not an extension of time to pay taxes owed. The taxpayer should 
estimate and report what he thinks he owes for 2019 based on the tax information he 
received. 
We suggest taxpayers learn how the IRS and states assess late-filing and late-payment 
penalties so they can avoid or reduce them. If a taxpayer cannot pay the taxes owed, he 
should at least estimate the balance due by April 15 and report it on the extension. Be sure 
to at least file the automatic extension on time to avoid the late-filing penalties, which are 

54 
much higher than the late-payment penalty. See the 2019 Form 4868 page two for an 
explanation of how these penalties are calculated. Tax Extensions: 12 Tips To Save You 
Money (https://tinyurl.com/12-tax-tips) is another helpful resource.   

55 
  
 
 

Chapter 7 
 
Entity Solutions 

Forming an entity can save active traders significant taxes. Business traders solidify trader 
tax status (TTS), unlock employee-benefit deductions, gain flexibility with a Section 475 
election and revocation, and limit wash-sale losses with individual and IRA accounts. For 
many active traders, an entity solution generates tax savings in excess of entity formation and 
compliance costs.  
An entity return consolidates trading activity on a pass-through tax return (partnership 
Form 1065 or S-Corp 1120S), making life easier for taxpayers, accountants, and the IRS. It’s 
important to segregate investments from business trading when claiming TTS, and an entity 
is most useful in that regard. It’s simple and inexpensive to set up and operate. 
Additionally, entities help traders elect Section 475 MTM (ordinary-loss treatment) later in 
the tax year — within 75 days of inception — if they missed the individual MTM election 
deadline on April 15. And it’s easier for an entity to exit TTS and revoke Section 475 MTM 
than it is for a sole proprietor. It’s more convenient for a new entity to adopt Section 475 
MTM internally from inception, as opposed to an existing taxpayer who must prepare and 
file a Form 3115 after filing an external election with the IRS.  
Don’t worry, prior capital-loss carryovers on the individual level aren’t lost; they still carry 
over on individual Schedule Ds. The new entity can pass through capital gains if the taxpayer 
skips the Section 475 MTM election to use up those capital loss carryovers. After using up 
capital loss carryovers, the entity can elect Section 475 MTM in a subsequent tax year. 
Business traders often use an S-Corp trading company or an S-Corp or C-Corp 
management company to pay salary to the owner in connection with a retirement plan 
contribution and health insurance deduction. Employee-benefit deductions are difficult to 
arrange in a partnership trading company.  
Trading in an entity can help constitute a performance record for traders looking to 
launch an investment-management business. Finally, many types of entities are useful for 
asset protection and business continuity. A separate legal entity gives the presumption of 
business purpose, but a trader entity still must achieve TTS for business deductions and 
employee benefits.  

56 
AVOID WASH SALES WITH AN ENTITY
Active investors in securities are significantly impacted by permanent and deferred 
wash-sale losses between IRA and individual taxable accounts. (Read about the wash-sale 
loss problem in Chapter 4.)
Trading in an entity might help avoid these problems. The entity is separate from 
individual and IRA accounts for purposes of wash sales since it is a different taxpayer. 
(Single-member LLCs should file an S-Corp election, so it’s not considered a disregarded 
entity.)  
The IRS is entitled to apply related party transaction rules (Section 267) if the entity 
purposely tries to avoid wash sales with the owner’s individual accounts. In that case, it will 
not avoid wash-sale loss treatment.  
If wash sales aren’t avoided, traders can break the chain on year-to-date wash sales in 
taxable individual accounts by switching over to an entity account mid-year or at year-end 
and prevent further permanent wash-sale losses with IRAs. If the entity qualifies for TTS, it 
can consider a Section 475 MTM election exempting it from wash sales (on business 
positions, not investment positions); that also negates related party rules.  
Play it safe on related party transaction rules by avoiding the repurchase of substantially 
identical positions in the new entity after taking a loss in the individual accounts. 

20% DEDUCTION ON QUALIFIED BUSINESS INCOME

TCJA introduced a new tax deduction for pass-through businesses, including sole 
proprietors, partnerships, and S-Corps. Subject to haircuts and limitations, a pass-through 
business could be eligible for a 20% deduction on qualified business income (QBI).  
TTS trading is considered a “specified service activity,” which means if the taxable 
income is above an income cap, the taxpayer won’t receive a QBI deduction. The taxable 
income (TI) cap is $421,400/$210,700 (married/other taxpayers) for 2019, and 
$426,600/$213,300 (married/other taxpayers) for 2020. The phase-out range below the cap 
is $100,000/$50,000 (married/other taxpayers), in which the QBI deduction phases out for 
specified service activities. The W-2 wage and property basis limitations also apply within the 
phase-out range. Investment managers fall into the specified service activity category as 
well. 
QBI for traders includes Section 475 ordinary income and loss and trading business 
expenses. QBI excludes capital gains and losses, Section 988 forex and swap ordinary income 
or loss, dividends, and interest income. 
TCJA favors non-service businesses, which are not subject to an income cap. The W-2 
wage and property basis limitations apply above the 2019 TI threshold of 
$321,400/$160,700 (married/other taxpayers) for 2019, and $326,600/$163,300 
(married/other taxpayers) for 2020. The IRS adjusts the annual TI income threshold for 
inflation each year, so they should be higher for 2021. For more information, see Chapter 17.  

SOLE PROPRIETOR (UNINCORPORATED) BUSINESS

Many active traders ramp up into qualification for TTS. (Read more about TTS in 
Chapter 1.) They wind up filing an individual Schedule C (Profit or Loss from Business) as a 
sole proprietor business trader the first year. That’s fine. They deduct trading business 
expenses on Schedule C and report trading gains and losses on other tax forms. They can 

57 
even elect Section 475 MTM by April 15 of a given tax year (April 15 for 2020) to use 
ordinary gain or loss treatment (recommended on securities only). But a Schedule C owner 
may not pay himself compensation, and the Schedule C does not generate self-employment 
income, either of which is required to deduct health insurance premiums and retirement plan 
contributions from gross income. (The exception is a full-fledged dealer/member of an 
options or futures exchange trading Section 1256 contracts on that exchange; they have SEI 
per Section 1402i.)  
Business traders need an S-Corp for those employee-benefit plan deductions. But traders 
with health insurance coverage from a spouse or elsewhere often prefer to remain a sole 
proprietor TTS trader.  

PASS-THROUGH ENTITIES
We recommend pass-through entities for traders. A pass-through entity means the entity 
is a tax filer, but it’s not a taxpayer. The owners are the taxpayers, most often on their 
individual tax returns. Taxpayers should consider marriage, state residence, and state tax 
rules including annual reports, minimum taxes, franchise taxes, and more when setting up an 
entity. Report all entity trading gains, losses, and expenses on the entity tax return and issue a 
Schedule K-1 to each owner for their respective share — on which income retains its 
character. For example, the entity can pass through capital gains to utilize individual capital 
loss carryovers. Or the entity can pass through Section 475 MTM ordinary gains or losses.  

TTS S-CORP UNLOCKS EMPLOYEE BENEFITS

The default tax treatment for a spousal Limited Liability Company (LLC) is a partnership 
tax return. The default tax treatment for a single-member LLC (SMLLC), also known as a 
“disregarded entity” or a “tax nothing” in the eyes of the IRS, is a Schedule C. That means 
an individual-owned SMLLC, qualifying for TTS, is back to filing a Schedule C, which a 
business trader tries to avoid.  
A multi-member LLC and an SMLLC can elect S-Corp tax treatment within 75 days of 
inception, or by March 15 of the current tax year for existing entities.  
TTS traders should consider an S-Corp election if they want health insurance and 
retirement plan contributions. These employee benefits require earned income, which is 
officer compensation in an S-Corp.  
C-Corps may also elect S-Corp status.  

A FEW STATES TAX S-CORPS

An S-Corp is tax-free on the entity level for federal tax purposes, and some states have 
only small minimum taxes or annual report fees. However, a few state jurisdictions impose 
higher taxes on S-Corps: On S-Corp net income, Illinois has a 1.5% replacement tax, 
California has a 1.5% franchise tax, and New York City has an 8.85% general corporate tax. 
Illinois replacement tax: S-Corps and partnerships operating in Illinois are liable for the 
replacement tax of 1.5% on net income. There’s an important exception applicable to 
traders: an “investment partnership” is exempt. An investment partnership doesn’t have to 
file an IL Form 1065 partnership tax return. (See Illinois Income Tax Act Section 
1501(a)(11.5).) The investment partnership exception does not apply to an S-Corp. If the 
trading company files an S-Corp Form 1120-S federal tax return, it must also file an IL Form 
1120-ST (Small Business Corporation Replacement Tax Return) and pay the replacement 

58 
tax. Consider increasing officer compensation to reduce IL replacement tax or use a 
dual-entity structure; a trading partnership and S-Corp management company.  
California Franchise Tax: S-Corps operating in California are liable for the state’s 
franchise tax of 1.5% on net income. The minimum franchise tax is $800 per year, even in a 
short year; $800 divided by 1.5% equals $53,333. That means an S-Corp owes franchise tax 
above the $800 minimum tax after net income exceeds $53,333. Deduct officer 
compensation and employee benefit plans in calculating net income. General partnerships 
are not liable for an $800 minimum tax, but LLCs are. Only the S-Corp owes 1.5% franchise 
tax.  
Traders may avoid or reduce the California franchise tax by using a dual-entity solution: A 
general partnership trading company and an S-Corp management company. Two entities are 
difficult and costly to administer. But if you expect significant trading gains and are not 
committed to maximizing the retirement plan as described in the following paragraph, then 
consider dual entities. 
Alternatively, traders can use one entity: an S-Corp trading company. The trader should 
plan to maximize the Solo 401(k) retirement plan contribution, and increase officer 
compensation to reduce franchise tax. Higher wages increase 2.9% Medicare tax on earned 
income, but that replaces ACA’s net investment tax (NIT, 3.8% Medicare surtax) on net 
investment income if over the NIT AGI threshold. Increasing officer compensation above 
the amount required for maximizing a Solo 401(k) profit sharing plan of $150,000 for 2020 
does not add to social security (FICA) tax since the social security base amount is $137,700 
for 2020.  
If a California LLC does not file as an S-Corp or C-Corp, there is an LLC fee based on 
gross income: $0 if gross income is under $250,000, $900 if under $500,000, $2,500 if under 
$1 million, $6,000 if under $5 million, $11,790 if over $5 million. Gross income includes net 
trading gains. 
New York City General Corporation Tax (GCT): Taxpayers can have an S-Corp for 
federal and New York State purposes, but New York City does not acknowledge S-Corps. 
NYC assesses a general corporation tax (GCT) on S-Corps of 8.85% times net income 
allocated to NYC. Taxpayers can reduce net income with deductions for officer 
compensation, health insurance, and retirement plans. However, there is an alternative tax: 
“8.85% of 15% of net income plus the amount of salaries or other compensation paid to any 
person, including an officer, who at any time during the taxable year owned more than five 
percent of the taxpayer’s issued capital stock,” according to NYC CGT Tax Rates.
A dual-entity solution might be better: A trading general partnership, which is exempt 
from NYC 4% unincorporated business tax (UBT) providing it only has trading income, and 
not advisory fees or other types of income. The second entity is an S-Corp management 
company for the health insurance and retirement plan deductions. It reduces NYC GCT, but 
two companies are more difficult and expensive to operate. 

IN-STATE VS. OUT-OF-STATE ENTITIES

A trader is entitled to form an entity in a tax-free state like Delaware, but his home state 
probably requires “foreign entity” registration if it operates there. Setting up a mail 
forwarding service in a tax-free state does not achieve tax nexus, whereas, conducting a 
trading business from your resident state does.  

59 
 For a pass-through entity in or out of state, report Schedule K-1 income and loss on your 
federal and state individual income tax returns. Don’t try to avoid state entity-level taxation. 
For example, if you form a Delaware LLC/partnership and live, work, and trade in 
California, then California may charge the LLC its $800 minimum tax and potential LLC 
fees, plus interest and penalties. 

ENTITY TAX RETURNS

S-Corporation tax return: Trading in an S-Corp tax structure means a management 
company is not needed. This is the best and most simple solution if there is no or nominal 
tax on S-Corps in your state, which is generally the case.
Plan to have officer compensation covering reimbursement of officer/owner health 
insurance premiums, even if you have trading losses (although, profits look better to the 
IRS). The health insurance deduction is complicated for officer/owners: Add health 
insurance premiums paid by the entity or individually during the entity period to wages in 
box 1 on the officer/owner’s W-2. The health insurance amount in wages is not subject to 
payroll taxes, so omit this amount from Social Security wages in box 3, and Medicare wages 
in box 5. The officer deducts health insurance premiums as an adjusted gross income (AGI) 
deduction on his individual tax return. If you have non-owner employees, deduct their health 
insurance on the S-Corp tax return directly as “insurance expense.”  
If you have sufficient trading profits by Q4, consider establishing a retirement plan 
before year-end. For a Solo 401(k) defined contribution plan, start with the 100% deductible 
elective deferral (ED; $19,000 for 2019 and $19,500 for 2020) and pay it through payroll 
since it’s reported on the annual W-2. For age 50 or older there’s a catch-up provision for an 
additional $6,000 for 2019 and $6,500 for 2020. Add the ED to Social Security wages and 
Medicare wages on the W-2 but not taxable wages in box 1, as that is where the tax benefit 
(deduction) is. The gross wage ED component is subject to payroll taxes, and the S-Corp tax 
return has a deduction for gross wages.  
If you have significant trading gains, consider increasing payroll in December for a 
performance-based bonus to unlock a 25% Solo 401(k) profit-sharing retirement plan 
contribution that you don’t have to pay until the due date of the tax return (including 
extensions by Sept. 15). The maximum Solo 401(k) profit sharing plan amount is $37,000 
for 2019, and $37,500 for 2020. The S-Corp tax return deducts the profit-sharing plan 
contribution. (For details about retirement plans, limits, and savings, see Chapter 8.) 
A C-Corp management company deducts health insurance directly on its tax return, not 
through a W-2. A C-Corp handles a qualified retirement plan in the same way as an S-Corp.  
Partnership tax return: If you trade in a spousal-member LLC filing a partnership return, 
it’s difficult to achieve targeted SEI for health insurance and retirement plan AGI deductions 
because a partnership passes through negative SEI, whereas an S-Corp does not. Traders 
may want to consider an S-Corp election by March 16, 2020, to add these employee benefit 
deductions for 2020.  
Perhaps you have retirement and health insurance arranged in another business or job or 
through your spouse. If you don’t need health and retirement plan deductions, the 
partnership tax structure alone works fine for TTS and Section 475 MTM. 
Ex-employer-provided health insurance, including Cobra, is not deductible. If your spouse 

60 
has health insurance available for the family from his or her employer, then the IRS does not 
permit a self-employed health insurance deduction.  

S-CORP PAYROLL TAX COMPLIANCE

Payroll is not a big deal for a TTS trading S-Corp with spousal or single ownership.
A payroll service includes quarterly payroll tax returns (Form 941), the annual payroll tax 
return (Form 940), state payroll tax returns and federal unemployment insurance with FUI 
tax of under $50 for the owner/trader. In most states, the trader/owner is exempt from state 
unemployment insurance and state workmen’s compensation.  
One benefit is a trader can withhold taxes from payroll in December and have them 
attributed to being made throughout the year. Take advantage of this tax loophole to reduce 
quarterly estimated tax payments during the year. Benefit from hindsight and use of the cash 
flow. 
Plan to execute payroll for the health insurance premium deduction at a minimum, as that 
does not trigger payroll taxes. Once a business starts payroll, the IRS and state expect 
quarterly payroll tax returns, even if there is no payroll during a quarter. The payroll vendor 
handles these filings. 

YEAR-END ENTITY PLANNING

There are important tax matters to implement with entities before year-end. For example, 
S-Corps and C-Corps should execute payroll before year-end. A Solo 401(k) defined 
contribution plan or defined benefit retirement plan must be established before year-end. 
S-Corps must reimburse employee business expenses before year-end. (Read about year-end 
planning in Chapter 9.) 

HEDGE FUNDS USE DUAL ENTITY STRUCTURE

U.S.-based hedge funds use partnerships (limited partnerships or LLCs filing partnership 
returns) for trading and usually S-Corps or C-Corps for their management company. 
Partnerships are the best tax vehicle for a hedge fund because partnership tax filings allow 
“special allocations” for profit-allocation or carried-interest compensation to the manager in 
lieu of incentive advisory fees. Carried interest avoids suspended incentive fee deductions for 
investors. The S-Corp structure prohibits the use of special allocations, and each owner must 
be treated equally with one class of ownership. Retail business traders can trade in an S-Corp 
and receive employee-benefit deductions without needing a special allocation since there are 
no outside investors.  
A hedge fund manager uses a management company to charge management fees and to 
arrange health insurance and retirement plan deductions for the owner/managers and other 
employees. Plus, managers don’t want all their business expenses reported on their hedge 
funds, as most expenses belong on the management company. Retail trading businesses have 
more leeway where they report business expenses, either on the trading partnership or 
management company. Many investment managers prefer an S-Corp to reduce payroll taxes. 
(Read more about investment management taxes in Chapter 14.) 
Partnership tax returns are more favorable vs. S-Corps on owner basis and allocation of 
income and loss rules. By default, hedge funds use investor-level accounting with net asset 
value (NAV) and profit and loss allocated to each partner for only when they are owners. 

61 
That’s not permissible with S-Corps. Again, while this is of utmost importance to a hedge 
fund, it’s not an issue with trading your own funds.  
Bottom line: Hedge funds need a partnership structure and management company, and 
retail traders are better off with just an S-Corp trading company.  

PROPRIETARY TRADING FIRMS USE PARTNERSHIP RETURNS

Proprietary trading firms are similar to hedge funds; they want “special allocations” on a 
partnership tax return. Generally, prop trader LLC owners don’t share in firm-wide profits 
based on their percentage of ownership. Instead, the firm allocates profits based on their 
performance in a sub-trading account. 
Proprietary trading firms are significantly different from retail trading entities, and they 
have special legal, regulatory, business, and tax compliance needs. (Read more about 
proprietary trading in Chapter 12.) 

C-CORP MANAGEMENT COMPANY

For a dual-entity structure, choose between an S-Corp or a C-Corp for the management 
company, and a general partnership or LLC filing a partnership return for the trading 
company eligible for TTS. 
TCJA enacted a 21% flat tax rate for C-Corps starting in 2018. If you live and work in a 
corporate-tax-free state, C-Corp double taxation is less of a concern. If your individual tax 
bracket is well above the C-Corp rate, then you might want to consider a C-Corp 
management company.  
The challenge with a dual-entity structure is how to get the right amount of income into 
the management company to maximize employee-benefit plans, compensation, and desired 
net income. A C-Corp management company needs to guard against losses. S-Corp 
management companies pass through losses to owners, so individuals get tax relief sooner. 
It’s hard to manage net income in a trading business as performance fluctuates significantly. 
For this reason, the S-Corp trading entity and/or management company is the best solution. 
(Read about C-Corps in Chapter 17.)  

MEDICAL REIMBURSEMENT PLANS IN C-CORPS

A C-Corp may have a health reimbursement account (HRA), whereas pass-through 
entities (partnerships and S-Corps) may not for more than 2% owners — and attribution 
rules apply to spousal owners. (Read How To Maximize Tax Savings Using Tax-Favored 
Health Plans.) 

POTENTIAL PROBLEMS WITH C-CORPS

On the trading education and seminar circuit, some service providers recommend a 
C-Corp as a vehicle to cover up the fact that the trader doesn’t qualify for TTS. In that case, 
the C-Corp is an investment company. Contrary to what these promoters promise, the IRS 
doesn’t allow investment expenses in a C-Corp used entirely for investing, and that means no 
deductions at all. 
In another twist, these tax providers recommend two entities: an LLC/partnership 
investment company and C-Corp management company. Again, it doesn’t work since the 
LLC/partnership investment company has suspended investment expense treatment on 
investment fees paid to the C-Corp. Back to square one: there are no business expense 

62 
benefits without qualifying for TTS. The C-Corp is managing the owner’s funds with no 
outside clients, so the C-Corp cannot have business expenses. Rather, it has suspended 
investment expenses.  
Traders who operate a regular business, like manufacturing in a C-Corp and invest 
working capital, have investment expenses that are deductible as business expenses since 
investing is ancillary to established business operations. It’s not a Section 212 investment 
expense but a Section 162 business expense. 
If the C-Corp qualifies for TTS, then it can deduct trading business expenses. But, that’s 
still not a good idea since trading losses don’t pass through to individual tax returns, as is the 
case with a pass-through trading entity. A C-Corp doesn’t have the $3,000 capital loss 
limitation like individuals do or Section 1256 lower 60/40 capital gains tax rates.  
When taking into account TCJA changes, don’t focus solely on the 21% flat tax rate on 
the C-Corp level. There are plenty of other taxes, including capital gains taxes on qualified 
dividends, state corporate taxes in 44 states, and 20% accumulated earnings tax (AET) 
assessed on excess retained earnings. 
When a C-Corp pays qualified dividends to the owner, double taxation occurs with capital 
gains taxes on the individual level (capital gains rates are 0%, 15%, or 20%). If an owner 
avoids paying sufficient qualified dividends, the IRS is entitled to assess a 20% accumulated 
earnings tax AET. It’s a fallacy that owners can retain all earnings inside the C-Corp. Traders 
face difficulties in creating a war chest plan for justifying accumulated earnings and profits to 
the IRS. (Learn more in Chapter 17.) 

ACCOUNTABLE PLAN FOR S-CORP

One formality of using an S-Corp is that it should have an accountable plan for 
reimbursing employee business expenses, including the employee’s home-office deduction. 
Starting in 2018, TCJA suspended certain miscellaneous itemized deductions subject to the 
2% floor, including unreimbursed employee business expenses, making an 
employer-provided accountable plan critical. At least the employer can deduct those 
expenses, with no corresponding income to the employee. With proper usage of an 
accountable plan, the S-Corp reports the deductions on its tax return. “Use or lose” the plan 
properly before year-end. 
Expense reporting is more relaxed with partnership tax structures. Partners may report 
unreimbursed partnership expenses (UPE) on their individual tax return Schedule E, 
including home office deductions from Form 8829. S-corporation shareholders generally 
cannot deduct unreimbursed business expenses on Schedule E because the shareholders are 
categorized as employees when performing services for the corporation. 

LIMITATIONS ON EXCESS BUSINESS LOSSES AND BUSINESS INTEREST EXPENSE

TCJA included an “excess business loss” (EBL) limitation of $500,000/$250,000 
(married/other taxpayers) for 2018. (The 2019 inflation-adjusted limit is $510,000/$255,000 
(married/other taxpayers). Aggregate EBL from all pass-through businesses: A profitable 
company can offset another business with losses to remain under the limit. Include wage 
income in aggregate EBL. Other types of income and non-business losses do not affect the 
EBL calculation (i.e., capital gains and losses). EBL over the limit is an NOL carryforward.  

63 
 Apply EBL to the partner or shareholder’s level. The provision applies after 
implementing the passive loss rules, which don’t apply to a trading company or hedge fund. 
Example of EBL limitation: TTS/475 trader filing single has an ordinary loss of $500,000 
for 2019. It’s considered a business loss. He has income from wages of $100,000, so his net 
EBL is $400,000. The 2019 EBL limitation is $255,000 and the 2019 NOL carryover to 2020 
is $145,000 ($400,000 minus $255,000). 
TCJA introduced a limitation on deducting business interest expense in Section 163(j). 
The 30% limitation should not impact most TTS traders because the $25 million three-year 
average “gross receipts” threshold applies to net trading gains, not proceeds. That’s good 
news because if gross receipts used total sales proceeds on trades, then a TTS trader with 
trading losses might have a business interest expense limitation. With net trading gains being 
the standard, only more substantial hedge funds might be impacted by the business interest 
expense limitation. 

ASSET PROTECTION
Asset protection likely won’t work in your home state if you have not registered your 
out-of-state company there. If another party sues you, it’s generally in your home state, too. 
In our view, legal protection when trading your own money in an entity is not paramount 
since you don’t have any customers or investors. Investment managers trading other peoples’ 
money, however, most certainly need legal liability protection.  
If you want asset protection, also consider a trust in your home state. Convey interests in 
the entity to your trust. Proper insurance is important, too. Consult with an attorney and 
insurance broker about liability protection under laws in your state.    

64 
  
 

Chapter 8 
 
Retirement Plans 

Retirement plans for traders can be used several ways. You can trade in the retirement 
plan, build it up with annual contributions, borrow money from a qualified plan (not an 
IRA) to finance a trading business, and convert it to a Roth IRA for permanent tax-free 
build-up. There are plenty of pitfalls to avoid like early withdrawals subject to ordinary 
income tax rates and 10% excise tax penalties, and penalties on prohibited transactions. 

TAX-ADVANTAGED GROWTH
Many Americans invest in financial markets through their 401(k), IRA, or other types of 
retirement plans. Capital gains and losses are absorbed within the traditional retirement plans 
with zero tax effect on current year tax returns. Only withdrawals (or distributions) generate 
taxable income at ordinary tax rates. The retirement plan does not benefit from lower 
long-term capital gains rates. Traditional retirement plans aren’t disenfranchised from 
deducting capital losses since a reduction of retirement plan amounts due to losses will 
eventually reduce taxable distributions accordingly. Roth IRAs and Solo 401(k) Roth plans 
are permanently tax-free on contributions and growth.  

EARNED INCOME IS NEEDED

Retirement-plan contributions can only be made if that taxpayer has earned income, 
which is subject to the self-employment (SE) tax or wage income. Trading gains aren’t 
earned income and are exempt from SE tax in a partnership or payroll taxes in an S-Corp. 
The exception to this is futures traders who are full-fledged dealer/members of options or 
futures exchanges; their futures gains on that exchange are considered earned income subject 
to SE tax (Section 1402i). TTS traders can use entities like an S-Corp trading company or 
S-Corp or C-Corp management company to pay officer compensation to make retirement 
plan contributions. (see Chapter 7).  

ANTI-DISCRIMINATION RULES
There’s one caveat with all retirement plans: You need to cover all employees in your 
company and other “affiliated service groups” such as a related entity you own. Some traders 

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own the majority of equity in another business that hires many employees. They can’t set up 
a high-deductible retirement plan for themselves in a trading entity without also offering a 
similar employee benefit to their employees in that other business, too. Traders can limit this 
problem by using employee-vesting schedules.  

SOLO 401(K) PLAN

Generally, the best retirement plan for business traders is a defined-contribution Solo 
401(k) for S-Corps established on the entity level in connection with officer compensation 
(payroll). This plan is only allowed with TTS (it’s not for investment companies). It combines 
a 100% deductible “elective deferral” (ED) contribution of $19,000 for 2019 and $19,500 for 
2020 with a 25% deductible profit-sharing plan contribution (PSP) up to a maximum 
$37,000 for 2019 and $37,500 for 2020. There is also an ED “catch-up provision” of $6,000 
for 2019 and $6,500 for 2020 for taxpayers age 50 and over. Together, the maximum 
tax-deductible contribution is $56,000 for 2019 and $57,000 for 2020, and including the 
catch-up provision it’s $62,000 for 2019 and $63,500 for 2020. 
Traders need an entity to generate compensation; we recommend S-Corp trading 
companies or a partnership trading company with an S-Corp or C-Corp management 
company. Employee benefits including retirement and health insurance premiums occur on 
the S-Corp or C-Corp level. 
Many leading brokers offer Solo 401(k) plans on a cookie-cutter basis (which means 
“free”) and some allow active direct-access trading. Some traders are unable to achieve the 
style of trading they do inside a Solo 401(k) plan.  
Traders often save thousands by deducting Solo 401(k) retirement plan contributions and 
health insurance premiums. (The higher amount when both spouses work in the trading 
business and maximize retirement deductions.)  
Tax savings depends on marginal federal and state income tax rate savings vs. payroll tax 
costs. A futures trader with lower 60/40 tax rates in a lower income tax bracket living in a 
tax-free state has less income-tax savings than a securities trader in a top bracket living in a 
high-tax state. With higher income, the futures trader may be able to offset compensation 
and employee benefit deductions against the ordinary income portion of 60/40 rates. (The 
40% portion is taxed at ordinary rates, leading to higher income tax savings.) 

PAYROLL TAX COSTS

Compensation is subject to payroll taxes (FICA and Medicare), which offset some of the 
income tax savings from the retirement plan contribution deduction. FICA is 12.4% of the 
social security base amount limited to $132,900 for 2019 and $137,700 for 2020, and the 
Medicare portion (2.9%) is unlimited; it applies over the base amount. The employer and 
employee each pay half of the FICA and Medicare taxes, and the employer has other minor 
payroll taxes. Consider a retirement plan contribution and deduction if the related income 
tax savings exceeds payroll tax costs. When doing the calculations, factor in that S-Corp 
payroll taxes (the employer portion) are 100% deductible on the S-Corp tax return.  

SOLO 401(K) IS BETTER THAN SEP IRA

A SEP IRA only has a 25% profit sharing plan with a maximum contribution of $56,000 
for 2019 and $57,000 for 2020 and it doesn’t have the catch-up provision of the Solo 401(k).

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 To reach the maximum Solo 401(k) contribution of $57,000 (under age 50) for 2020, 
officer compensation of $150,000 is needed ($57,000 less $19,500 ED equals $37,500 
divided by 25%). Conversely, to reach the maximum SEP IRA contribution, officer 
compensation of $228,000 is needed ($57,000 divided by 25%).  
With lower compensation needed to maximize the Solo 401(k), traders can save $2,262 of 
Medicare taxes on earned income (2.9% Medicare times the difference in compensation of 
$78,000). Net savings depends on the interplay between Medicare assessed on earned 
income vs. ACA’s 3.8% Medicare surtax on net investment income — it’s a trade-off. 
The main reason for this payroll tax savings is because a trader can determine what 
amount of his trading gains will be considered compensation, starting with none. Conversely, 
with other types of small business income reported on a Schedule C or through a 
partnership tax return, the entire income is considered earned income for SE tax, the 
equivalent of payroll tax, and it’s often over the maximum needed anyway. Operating 
businesses like professional services using an S-Corp structure must adhere to reasonable 
compensation guidelines from the IRS, but traders can explain a lower compensation to the 
IRS because the underlying income is not SEI.  
The most significant tax savings of the Solo 401(k) over a SEP IRA come from the 
elective deferral portion — income tax savings from a 100% deduction is far better than a 
25% deduction. Many traders may not have high trading gains, but they do make enough to 
make the elective deferral part that saves the most money anyway. Solo 401(k)s are only 
available to small businesses, and the plan needs to be established before year-end. The 
elective deferral portion must be paid by Jan. 31 (one month after deducting it through 
December payroll) and the profit-sharing plan can be paid up until the due date of the tax 
return including extension. One benefit of a SEP IRA is that it can be established up until 
the due date of your tax return including the extension. 
Solo 401(k) plans require an annual 5500 or 5500-EZ filing, if plan assets exceed 
$250,000, whereas IRAs and SEP IRAs do not have this filing requirement. If there are no 
outside employees in the Solo 401(k), taxpayers may use Form 5500-EZ. Don’t miss that 
separate tax filing deadline of July 31 for calendar-year taxpayers. Taxpayers can file Form 
5558 for an automatic two-and-a-half-month extension.  
All types of IRAs, including SEP IRAs and rollover IRAs, might trigger a wash-sale loss 
adjustment with individual taxable accounts, whereas, a Solo 401(k) does not. (See this 
problem on wash sales in Chapter 4.) 

DEFINED BENEFIT PLANS

Consistently high-income business owners, including trading businesses with 
owner/employees close to age 50, should consider a defined-benefit retirement plan (DBP) 
for significantly higher plan contributions and tax savings vs. a defined-contribution 
retirement savings plan (DCP) like a Solo 401(k).
DBP calculations are more complex than a DCP profit-sharing plan. An actuary is 
required to consider various factors in calculating retirement benefits and annual 
contributions. For more information, read our blog post Defined-Benefit Plans Offer Huge 
Tax Breaks (https://tinyurl.com/defined-benefit). 

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DETERMINING APPROPRIATE OR REASONABLE COMPENSATION
S-Corp service companies should have “reasonable compensation” paid to the 
owner/employee. S-Corps don’t pass through SE income or loss, and without reasonable 
compensation, service companies would otherwise avoid payroll taxes. Industry practice for 
reasonable compensation is 25% to 50% of net income. 
A trading company doesn’t have underlying SE income so reasonable compensation rules 
should not be a problem in our view, although this can come up in an IRS notice or exam.  

LOANS FROM QUALIFIED PLANS

While taxpayers can’t borrow money from an IRA or SEP IRA because they are 
nonqualified plans, they can borrow money from a qualified plan like a Solo 401(k) or 
defined benefit plan for any reason. Many traders borrow money and use it to capitalize their 
trading business entity. 
Limitations and special rules: You can borrow up to a maximum amount of $50,000, 
limited to 50% of retirement plan assets. For example, if your Solo 401(k) has $80,000, you 
can borrow up to $40,000. If it has $120,000, you can borrow up to $50,000. 
You also must pay back the loan on no later than a quarterly fixed-amortization schedule 
over no longer than five years. You need a market rate of interest and that interest is not tax 
deductible. Or, you may use the IRS applicable federal rates (AFR), which the IRS increased 
recently. If you can’t pay back the loan, it’s treated as a withdrawal, which is ordinary income. 
If it’s an early withdrawal from a qualified plan, you will also owe a 10% excise tax penalty on 
Form 5329, included with your Form 1040 filing. Distributions are probably taxable in your 
home state, too. (Note, early withdrawals from an IRA are up until age 59½.)  
If you leave your employer at age 55 or older, you may not be subject to the 10% early 
withdrawal penalty on a qualified plan like a 401(k) providing you follow “substantial 
periodic payment” rules. If you don’t, then these distributions might blow up the retirement 
plan, making it all taxable income. 

IRA CONTRIBUTIONS
Traditional and Roth IRAs allow a small annual contribution if you have earned income: 
For 2019 and 2020, it’s $6,000 per person if under age 50 and $7,000 if 50 and older. If you 
(and spouse) are not active in an employer-sponsored retirement plan, or if you (and spouse) 
are active, but modified adjusted gross income (AGI) doesn’t exceed certain income limits, 
you may contribute to a traditional tax-deductible IRA. You can also contribute to an IRA in 
addition to contributing to a Solo 401(k) retirement plan. 
If you have earned income, you should also consider making a non-deductible IRA 
contribution, which doesn’t have income limits. The growth is still tax-deferred, and you are 
not taxed on the return of the non-deductible contributions in retirement distributions. The 
general rule applies: If you deduct the contribution, the return of it is taxable, but if you 
don’t, the return of it is non-taxable. Income growth within the plan is always taxed unless 
it’s inside a Roth IRA. Report non-deductible IRA contributions on Form 8606 to keep track 
of cumulative non-deductible contributions. 
Consider a non-deductible IRA contribution with simultaneous rollover to a Roth IRA 
for permanent tax-free growth — known as a “back door Roth IRA.” Roth IRAs don’t have 
required minimum distributions (RMD) while the taxpayer is alive. 

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ROTH RETIREMENT ACCOUNTS AND CONVERSIONS
A Roth retirement plan is different from a traditional plan. The Roth has permanent tax 
savings on growth and contributions, whereas the traditional retirement plan only has 
deferral with taxes owed on distributions in retirement. Distributions from a Roth plan are 
tax-free unless you take an early withdrawal that exceeds your non-deductible contributions 
to it over the years (keep accurate records).
Consider annual contributions to a Roth IRA. The rules are similar to traditional IRA 
contributions. Also, consider a Roth IRA conversion before year-end to maximize use of 
lower tax brackets, offset business losses and utilize itemized or standard deductions. 
Here’s an example: Assume a trader left his job at the end of 2019 and incurred trading 
losses in 2020 with trader tax status and Section 475 MTM ordinary loss treatment as a sole 
proprietor. Rather than carry forward an NOL to subsequent years when income isn’t 
projected, this trader enacts a Roth IRA conversion before year-end 2020. He winds up 
paying some taxes within the low ordinary tax-rate brackets. If the trader skipped a Roth 
conversion, he would lose tax benefits on his standard deduction or itemized deductions. 
This trader’s Roth account grows in 2020.  
If a 2019 converted Roth account drops significantly in value in 2020, a taxpayer can no 
longer reverse the Roth conversion. 
TCJA repealed the recharacterization option starting in 2018: “recharacterization cannot 
be used to unwind a Roth conversion. However, recharacterization is still permitted with 
respect to other contributions. For example, an individual may make a contribution for a year 
to a Roth IRA and, before the due date for the individual’s income tax return for that year, 
recharacterize it as a contribution to a traditional IRA.” 
If there are market corrections in indexes and many individual stocks, consider a Roth 
conversion at those lower amounts to benefit from a potential recovery in markets inside the 
Roth IRA where that new growth is permanently tax-free. Converting at market bottoms is 
better than market tops. It’s riskier without the reversal option anymore.  

UNRELATED BUSINESS INCOME TAX

In certain cases, activities within your retirement plans can bring about income taxes and 
unrelated business income taxes (UBIT), even though retirement plans are by design tax-free 
accounts. Be aware of potential tax traps. 
When retirement plans contain activities not permitted by the Department of Labor 
(DOL) or Employee Retirement Income Security Act (ERISA), the IRS has various rules in 
place to tax a portion of these plans.  
Your retirement accounts shouldn’t pay you a fee for managing your own retirement 
funds; the IRS would deem that a prohibited transaction. Conversely, it’s not self-dealing for 
your retirement plan to reimburse you for appropriate investment expenses. Because TCJA 
suspended investment fees and expenses, this might be a good idea. 
IRAs should be cash accounts (not margin accounts). Yet margin accounts are allowed for 
“qualified plans” such as a Solo 401(k).  
Some brokers offer “margin type” IRA accounts permitting day trading on unsettled 
funds. However, these accounts don’t provide overnight lending, and the broker does not 
charge margin interest expense. Some tax attorneys think these margin type IRA accounts 

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are not IRS prohibited transactions, and there is no UBIT due to no margin interest paid. 
The same attorneys think these margin type IRA accounts should pass muster with DOL, 
the regulator for IRAs.   
Having a margin account alone doesn’t trigger UBIT, but if personally guaranteed, it’s 
considered a prohibited transaction. UBIT is triggered when investment/margin-interest 
expense on securities is paid within your IRA or qualified plan account. Investment-interest 
expense only relates to trading securities on margin. Futures and forex may have notional 
leverage with higher risk, but that’s not considered margin-interest expense, so these 
accounts don’t trigger UBIT issues (with one exception discussed in the next section).  
Publicly traded ETFs, MLPs, and private hedge funds are pass-through entities, requiring 
trust or partnership tax returns. They issue the investor a Schedule K-1, which passes 
through the character of the underlying tax matters to the investor. These ETFs, MLPs, and 
hedge funds may pay interest expense on their investments, which is passed on to a 
retirement plan investor. In that case, UBIT may be triggered. Avoidance of UBIT is the 
reason U.S. pension funds invest in offshore funds rather than domestic hedge funds; those 
offshore funds are known as UBIT blockers, as they are organized as corporations without 
pass-through treatment.  
Some MLPs conduct business activities including energy, pipelines, and natural resources. 
When retirement plans conduct or invest in a business activity, they must file separate tax 
forms (990-T) to report unrelated business income (UBI) and often owe UBIT. Many IRA 
owners are surprised to receive a Form 990-T requiring them to pay these taxes. Read my 
blog post Retirement Plan Investments in Publicly Traded Partnerships Generate Tax Bills 
(https://tinyurl.com/retirement-ptp). 

DO’S AND DON’TS

Traders can use intermediary retirement firm administrators offering non-prototype 
retirement plans to facilitate alternative investments like hedge funds, rental real estate, and 
certain types of self-directed trading. But, be careful in choosing trust firms and vet their 
content and suggested strategies carefully. There are many unscrupulous operators offering 
some bad advice, like on IRA-owned LLCs with checkbook control, and IRA-owned trust 
accounts with margin and personal guarantees. We believe these schemes do not work, as we 
consider them IRS prohibited transactions. These can “blow up” a retirement plan, meaning 
the funds become taxable income, which is subject to excise tax penalties too. 
Some traders may want to trade futures or forex in their retirement plans, but their 
brokers don’t provide a plan for that type of trading. Some brokers allow an arrangement 
with an intermediary retirement administration firm to open a trust trading account owned 
by your retirement plan. This should pass muster with futures — and on some forex 
accounts — since there’s no margin interest paid triggering UBIT, or personal guarantees 
triggering a prohibited transaction. Some forex accounts have interest expense, whereas 
most have “rollover interest,” which is not treated as interest expense (see Chapter 3).  
Do not set up a trading business LLC owned by your IRA; that is a prohibited 
transaction. For more details, read our related blog post (https://tinyurl.com/ira-do-dont) 
and watch our Webinar (https://tinyurl.com/ira-webinar). 
   

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Chapter 9 
 
Tax Planning 
 

While TCJA did not change trader tax status, Section 475 MTM, wash-sale loss rules on 
securities, and more, there is still plenty to consider. 
There are 2020 inflation adjustments in income and capital gains tax brackets, various 
income thresholds and caps, retirement plan contribution limits, standard deductions, and 
more. See the 2020 Tax Brackets at TaxFoundation.org.  

DEFER INCOME AND ACCELERATE TAX DEDUCTIONS

Consider the time-honored strategy of deferring income and accelerating tax deductions 
if you don’t expect your taxable income to decline in 2021. We expect tax rates to be the 
same for 2021, although the IRS will adjust the tax brackets for inflation. Enjoy the 
time-value of money with income deferral. 
Year-end tax planning is a challenge for traders because they have wide fluctuations in 
trading results, making income difficult to predict. Those expecting to be in a lower tax 
bracket in 2021 should consider income deferral strategies. Conversely, a 2020 TTS trader 
with ordinary losses waiting to be in a higher tax bracket in 2021 might want to consider 
income acceleration strategies. 
Taxpayers with trader tax status in 2020 should consider accelerating trading business 
expenses, such as purchasing business equipment with full expensing. 
Don’t assume that accelerating itemized deductions is also a smart move. TCJA 
suspended and curtailed various itemized deductions after 2017, so there is no sense in 
expediting a non-deductible item. Even with the acceleration of deductible expenses, many 
taxpayers will be better off using the 2020 standard deduction. If itemized deductions are 
below the standard deduction, consider a strategy to “bunch” them into one year and take 
the standard deduction in other years. 

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ACCELERATE INCOME AND DEFER CERTAIN DEDUCTIONS
A TTS trader with substantial ordinary losses (Section 475) under the “excess business 
loss limitation” (EBL) should consider accelerating income to soak up the allowable business 
loss to avoid a NOL carryover. Try to advance enough income to use the standard deduction 
and take advantage of lower tax brackets. Be sure to stay below the thresholds for unlocking 
various types of AGI-dependent deductions and credits. 
You may wish to convert a traditional IRA into a Roth IRA before year-end to accelerate 
income. The conversion income is taxable in 2020, but the 10% excise tax on early 
withdrawals before age 59½ is avoided providing you pay the conversion taxes from outside 
the Roth plan. One concern is that TCJA repealed the recharacterization option, so you can 
no longer reverse the conversion if the plan assets decline. Roth IRA conversions have no 
income limit, unlike regular Roth IRA contributions.  
For example, a taxpayer filing single has a $405,000 TTS/475 ordinary loss. However, the 
excess business loss limitation is $255,000 (2019 limit), and $150,000 is an NOL carryover. 
The taxpayer should consider a Roth conversion to soak up most of the $255,000 allowed 
business loss and leave enough income to use the standard deduction and lower tax brackets. 
Another way a trader can accelerate income is to sell open winning positions to realize 
capital gains. Consider selling long-term capital gain positions. The 2020 long-term capital 
gains rates are 0% for taxable income in the 10% and 12% ordinary brackets. The 15% 
capital gains rate applies to the middle brackets and the top capital gains rate of 20% applies 
in the top 37% bracket. 
Investment fees and expenses are not deductible for calculating net investment income 
(NII) for the Affordable Care Act (ACA) 3.8% net investment tax (NIT) on unearned 
income. NIT only applies to individuals with NII and modified adjusted gross income (AGI) 
exceeding $200,000 single, $250,000 married filing jointly, or $125,000 married filing 
separately. The IRS does not index these ACA thresholds for inflation. NII includes capital 
gains and Section 475 ordinary income. 

BUSINESS EXPENSES AND ITEMIZED DEDUCTION VS. STANDARD DEDUCTION

Business expenses: TTS traders are entitled to business expense deductions and 
home-office deductions. The home office deduction requires income, except for the 
mortgage interest and real property tax portion. The SALT cap on state and local taxes does 
not apply to the home office deduction. TCJA expanded full expensing of business property; 
traders can deduct 100% of these costs in the year of acquisition, providing they place the 
item into service before year-end. If you have TTS in 2020, considering going on a shopping 
spree before Jan. 1. There is no sense deferring TTS expenses because you cannot be sure 
you will qualify for TTS in 2021. 
Employee business expenses: Ask your employer if they have an “accountable plan” 
for reimbursing employee-business costs. You must “use it or lose it” before year-end. TCJA 
suspended unreimbursed employee business expenses. TTS S-Corps should use an 
accountable plan to reimburse employee business expenses since the trader/owner is its 
employee. 
Unreimbursed partnership expenses: Partners in LLCs taxed as partnerships can 
deduct unreimbursed partnership expenses (UPE). That is how they usually deduct home 

72 
office expenses. UPE is more convenient than using an S-Corp accountable plan because the 
partner can arrange the UPE after year-end. The IRS doesn’t want S-Corps to use UPE. 
SALT cap: TCJA’s most contentious provision was capping state and local income, sales, 
and property taxes (SALT) at $10,000 per year ($5,000 for married filing separately) – and 
not indexing it for inflation. Many high-tax states continue to contest the SALT cap, but they 
haven’t prevailed in court. The IRS reinforced the new law by blocking various states’ 
attempts to recast SALT payments as charitable contributions, or payroll tax as a business 
expense. Stay tuned to news updates about SALT. 
Investment fees and expenses: TCJA suspended all miscellaneous itemized deductions 
subject to the 2% floor, which includes investment fees and expenses. TCJA left just two 
itemized deductions for investors: Investment-interest expenses limited to investment 
income, with the excess as a carryover, and stock borrow fees for short-sellers. 
Standard deduction: TCJA roughly doubled the 2018 standard deduction and 
suspended and curtailed several itemized deductions. The 2019 standard deduction is 
$12,200 for single and married filing separately, $24,400 married filing jointly, and $18,350 
for head of household. For 2020, the IRS increased it to $12,400, $24,800, and $18,650, 
respectively. There is an additional standard deduction of $1,300 for the aged or the blind 
(2019).  
Many more taxpayers will use the standard deduction, which might simplify their tax 
compliance work. For convenience sake, some taxpayers may feel inclined to stop tracking 
itemized deductions because they figure they will use the standard deduction. Don’t overlook 
the impact of these deductions on state tax filings where you might get some tax relief. 

ESTIMATED INCOME TAXES AND AMT

If you have reached the SALT cap, you don’t need to prepay 2020 state estimated income 
taxes by Dec. 31, 2020. Pay federal and state estimated taxes owed when due by Jan. 15, 
2021, with the balance of your tax liabilities payable by April 15, 2021. You can gain six 
months of additional time by filing an automatic extension on time, but late-payment 
penalties and interest will apply on any tax balance due. (See Tax Extensions: 12 Tips To 
Save You Money at https://tinyurl.com/12-tax-tips.) 
Many traders skip making quarterly estimated tax payments during the year, figuring they 
might incur trading losses later in the year. They can catch up with the Q4 estimate due by 
Jan. 15. Some rely on the safe harbor exception to cover their prior year taxes. TTS S-Corp 
traders should consider withholding additional taxes on year-end paychecks in connection 
with retirement plan contributions, which helps avoid underestimated tax penalties since the 
IRS treats wage withholding as being made throughout the year. 
In prior years, taxpayers had to figure out how much they could prepay their state without 
triggering alternative minimum tax (AMT), since state taxes are not deductible for AMT 
taxable income. It’s easier in 2020 with SALT capped at $10,000 and because TCJA raised 
the 2019 and 2020 AMT exemptions.  

AVOID WASH SALE LOSS ADJUSTMENTS

Taxpayers must report wash sale (WS) loss adjustments on securities based on 
substantially identical positions across all accounts, including IRAs. Conversely, brokers 
assess WS only on identical positions per the one account. Active securities traders should 

73 
use a trade accounting program or service to identify potential WS loss problems, especially 
going into year-end. 
In taxable accounts, a trader can break the chain by selling the position before year-end 
and not repurchasing a substantially identical position 30 days before or after in any of his 
taxable or IRA accounts. Avoid WS between taxable and IRA accounts throughout the year, 
as that is otherwise a permanent WS loss. (Starting a new entity effective January 1, 2021, can 
break the chain on individual account WS at year-end 2020 provided you don’t purposely 
avoid WS with the related party entity.) 
WS losses might be preferable to capital loss carryovers at year-end 2020 for TTS traders. 
A Section 475 election in 2021 converts year-end 2020 WS losses on TTS positions (not 
investment positions) into ordinary losses in 2021. That’s better than a capital loss carryover 
into 2021, which might give you pause to making a 2021 Section 475 election. You want a 
clean slate with no remaining capital losses before electing Section 475 ordinary income and 
loss. (See https://tinyurl.com/wash-sale-loss for more details.) 

TRADER TAX STATUS AND SECTION 475

If you qualify for TTS in 2020, you may accelerate trading expenses into that qualification 
period as a sole proprietor or entity. If you don’t qualify until 2021, you should try to defer 
trading expenses until then. You may also capitalize and amortize (expense) Section 195 
startup costs and Section 248 organization costs in the new TTS business, going back six 
months before commencement. TTS is a prerequisite for electing and using Section 475 
MTM.  
TTS traders choose Section 475 on securities for exemption from wash-sale loss rules and 
the $3,000 capital loss limitation, and to be eligible for the 20% QBI deduction. To make a 
2020 Section 475 election, existing individual taxpayers have to file an election statement 
with the IRS by April 15, 2020 (March 15 for existing S-Corps and partnerships). If they file 
that election statement on time, they need to complete the election process by submitting a 
2020 Form 3115 with their 2020 tax return. Those who missed the 2020 election deadline 
may want to consider the election for 2021. Capital loss carryovers are a concern — use 
them up against capital gains but not Section 475 ordinary income. The 475 election remains 
in effect each year until you revoke it in the same manner. If you do not qualify for TTS, 
then 475 treatment is suspended until you requalify. 
A Section 475 election made by April 15, 2021 takes effect on Jan. 1, 2021. In converting 
from the realization (cash) method to the mark-to-market (MTM) method, you need to make 
a Section 481(a) adjustment on Jan. 1, 2021. It’s unrealized capital gains, and losses on open 
TTS securities positions held on Dec. 31, 2020. Don’t apply Section 475 to investment 
positions. If you’re not a TTS trader at year-end 2020, you won’t have a Section 481(a) 
adjustment. A “new taxpayer” entity can elect Section 475 within 75 days of inception — a 
good option for those who miss the individual sole proprietor deadline (April 15, 2020). 
Forming a new entity on Nov. 1, 2020 or later is too late for establishing TTS for the year. 
Consider waiting until Jan. 1, 2021 to start a new TTS entity and elect Section 475. 

20% DEDUCTION ON QUALIFIED BUSINESS INCOME

Lowering your taxable income might unlock a higher QBI deduction. In August 2018, the 
IRS issued proposed reliance regulations (Proposed §1.199A) for the TCJA’s 20% deduction 

74 
on qualified business income (QBI) in pass-through entities. On Jan. 18, 2019, the IRS 
issued the final 199A regs. The regulations confirm that traders eligible for TTS are a 
“specified service activity,” which means if their taxable income is above an income cap, they 
won’t receive a QBI deduction. The taxable income (TI) cap is $421,400/$210,700 
(married/other taxpayers) for 2019, and $426,600/$213,300 (married/other taxpayers) for 
2020. The phase-out range below the cap is $100,000/$50,000 (married/other taxpayers), in 
which the QBI deduction phases out for specified service activities. The W-2 wage and 
property basis limitations also apply within the phase-out range. Investment managers are 
specified service activities, too. 
QBI includes Section 475 ordinary income and loss, and trading business expenses; it 
QBI excludes capital gains and losses, Section 988 forex and swap ordinary income or loss, 
dividends, and interest income.  
TCJA favors non-service businesses, which are not subject to an income cap. The W-2 
wage and property basis limitations apply above the TI threshold of $321,400/$160,700 
(married/other taxpayers) for 2019, and $326,600/$163,300 (married/other taxpayers) for 
2020. The IRS adjusts the annual TI income threshold for inflation each year, so they should 
be higher for 2021. 
Taxpayers might be able to increase the QBI deduction with smart year-end planning. If 
taxable income falls within the phase-out range for a specified service activity, or even above 
for a non-service business, you might need higher wages (including officer compensation) to 
avoid a W-2 wage limitation on the QBI deduction. Deferring income can also help get 
under various QBI restrictions and thresholds. 

NET OPERATING LOSSES AND THE SECTION 1256 LOSS CARRYBACK ELECTION
Section 475 ordinary losses and TTS business expenses contribute to net operating loss 
(NOL) carryforwards, which are limited to 80% of taxable income in the subsequent year(s). 
Get immediate use of some or all of NOLs with a Roth IRA conversion before year-end and 
other income acceleration strategies. TCJA repealed NOL carrybacks after 2017 with one 
exception: farmers may carry back an NOL two tax years. TCJA made NOL carryforwards 
unlimited, changing the carryforward period from 20 years. Repealing NOL carrybacks 
negatively impacts TTS traders using 475 ordinary loss treatment. We helped traders remain 
in business with significant NOL refunds before 2018. An “excess business loss” (EBL) over 
the limitation is a NOL carryforward, and unfortunately, accelerating non-business income 
does not avoid it. 
The only remaining carryback for traders is a Section 1256 loss carryback to the prior 
three tax years, offset against 1256 gains only. Any loss remaining is carried forward. 
Consider making a Section 1256 loss carryback election on a 2020 Form 6781 and file with a 
2020 tax return by the deadline. 
Section 1256 contracts have lower 60/40 capital gains tax rates, meaning 60% (including 
day trades) use the lower long-term capital gains rate, and 40% use the short-term rate, 
which is the ordinary tax rate. At the maximum tax brackets for 2020, the top Section 1256 
contract tax rate is 26.8% — 10.2% lower than the highest ordinary rate of 37%. Section 
1256 tax rates are 4.2% to 12% lower vs. ordinary rates depending on which tax bracket 
applies. Section 1256 contracts are marked-to-market (MTM), so you don’t have to execute 

75 
tax-loss selling at year-end. (See Trading Futures & Other Section 1256 Contracts Has Tax 
Advantages at https://tinyurl.com/ugnv5uf.) 

LIMITATIONS ON EXCESS BUSINESS LOSSES AND BUSINESS INTEREST EXPENSE

TCJA included an excess business loss limitation of $500,000/$250,000 (married/other 
taxpayers) for 2018. (The 2019 inflation-adjusted limit is $510,000/$255,000 married/other 
taxpayers.) The IRS should adjust these amounts for inflation for 2020. Taxpayers can 
aggregate EBL from all pass-through businesses to remain under the limit. Wage income can 
be included in aggregate EBL. Other types of income and non-business losses don’t affect 
the EBL calculation (i.e., capital gains and losses). EBL over the limit is a NOL 
carryforward. 
Example: TTS/475 trader filing single has an ordinary loss of $500,000 for 2020. This is 
considered a business loss. He has income from wages of $100,000, so his net EBL is 
$400,000. The 2020 EBL limitation is $255,000 (2019 limit) and the 2020 NOL carryover to 
2021 is $145,000 ($400,000 minus $255,000). 
TCJA introduced a limitation on deducting business interest expense in Section 163(j). 
The 30% limitation should not impact most TTS traders because the $25 million three-year 
average “gross receipts” threshold applies to net trading gains, not proceeds.. This standard 
will likely only impact more substantial hedge funds. 

OFFICER COMPENSATION, HEALTH INSURANCE, RETIREMENT PLAN DEDUCTIONS

TTS traders need an S-Corp trading company to arrange health insurance and retirement 
plan deductions. These deductions require earned income or self-employment income. 
Unlike trading gains, S-Corp salary is considered earned income. 
S-Corps must execute officer compensation in conjunction with employee benefit 
deductions through formal payroll tax compliance before year-end 2020. Otherwise, traders 
miss the boat. TTS is a must since an S-Corp investment company cannot have 
tax-deductible wages, health insurance, and retirement plan contributions. This S-Corp is not 
required to have “reasonable compensation,” so a TTS trader may determine officer 
compensation based on how much to reimburse for health insurance, and how much she 
wants to contribute to a retirement plan. If you are in the QBI phase-out range, you might 
wish to have higher wages to increase a QBI deduction. For payroll tax compliance services, 
I recommend paychex.com; it has a dedicated team for our TTS S-Corp clients. Sole 
proprietor and partnership TTS traders cannot pay salaries to 2% or more owners. 
TTS S-Corps may only deduct health insurance for the months the S-Corp was 
operational and qualified for TTS. Employer-provided health insurance, including Cobra, is 
not deductible. It doesn’t need to be profitable for the health insurance deduction. 
A taxpayer can deduct a contribution to a health savings account (HSA) without TTS or 
earned income. HSA contribution limits for 2019 are $3,500 individual and $7,100 family. 
There’s an additional $1,000 for age 55 or older. Some employers offer a flexible spending 
account (FSA) for covering health care copayments, deductibles, some drugs, and other 
health care costs. Both HSAs and FSAs must be fully funded and utilized before year-end. 
TTS S-Corps formed later in the year can unlock a retirement plan deduction by paying 
sufficient officer compensation in December when results for the year are evident. Traders 
should only fund a retirement plan from trading income, not losses. 

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 You must open a Solo 401(k) retirement plan for a TTS S-Corp with a financial 
intermediary before the year-end 2020. Plan to pay the 2020 100%-deductible elective 
deferral amount up to a maximum of $19,500 (or $26,000 if age 50 or older) with December 
payroll. That elective deferral is due by the end of January 2021. You can fund the 25% 
profit-sharing plan (PSP) portion of the S-Corp Solo 401(k) up to a maximum of $37,500 by 
the due date of the 2020 S-Corp tax return, including extensions, which means Sept. 15, 
2021. The maximum PSP contribution requires wages of $150,000 ($37,500 divided by 25% 
defined contribution rate). Tax planning calculations will show the projected outcome of 
income tax savings vs. payroll tax costs for the various options. 
Consider a Solo 401(k) Roth, where the contribution is not deductible, but the 
contribution and growth within the Roth are permanently tax-free. Traditional plans have a 
tax deduction upfront, and all distributions are subject to ordinary income taxes in 
retirement. Traditional retirement plans have required minimum distributions (RMD) by age 
70½, whereas Roth plans don’t have RMD. 

SETTING UP A TTS S-CORP FOR 2021

If you missed out on employee benefits in 2020, then consider an LLC with S-Corp 
election for 2021. You can form a single-member LLC by mid-December 2020, obtain the 
employee identification number (EIN), and open the LLC brokerage account before 
year-end in order to begin trading in it on Jan. 1, 2021. The single-member LLC is a 
disregarded entity for 2020, which avoids an entity tax return filing for the 2020 partial year. 
A spouse can be added as a member of the LLC on Jan. 1, 2021, which means the LLC will 
file a partnership return for 2021. If you want health insurance and retirement plan 
deductions, then your single-member or spousal-member LLC should submit a 2021 S-Corp 
election within 75-days of Jan. 1, 2021. The S-Corp should also consider making a Section 
475 MTM election on securities only for 2021 within 75 days of Jan. 1, 2021. 

TAX-LOSS SELLING OF FINANCIAL INSTRUMENTS

If you own an investment or trading portfolio, you can reduce capital gains taxes via 
“tax-loss selling.” If you realized significant short-term capital gains year-to-date in 2020 and 
have open positions with substantial unrealized capital losses, you should consider selling 
some of those losses to reduce 2020 capital gains taxes. Don’t repurchase the losing position 
30 days before or after, as that would negate the tax loss with wash-sale loss rules. 
The IRS has rules to prevent the deferral of income and acceleration of losses in 
offsetting positions that lack sufficient economic risk. These rules include straddles, the 
constructive sale rule, and shorting against the box. Also, be aware of “constructive receipt 
of income” — you cannot receive payment for services, turn your back on that income, and 
defer it to the next tax year. 
Tax-loss selling is inefficient for short-term positions that reduce long-term capital gains. 
It’s also a moot point with Section 1256 and Section 475 positions since they are 
mark-to-market positions reporting realized and unrealized gains and losses. 

MARRIED COUPLES SHOULD COMPARE FILING JOINT VS. SEPARATE

Each year, married couples choose between married filing jointly (MFJ) vs. “married filing 
separately” (MFS). TCJA fixed several inequities in filing status, including the tax brackets by 

77 
making single, MFJ, and MFS equivalent, except for divergence at the top rate of 37% for 
single filers, retaining some of the marriage penalty. There are other issues to consider, too. 
Married couples may be able to improve QBI deductions, AGI, and other 
income-threshold dependent deductions and credits with MFS in 2019. It’s wise to enter 
each spouse’s income, gain, loss, and expense separately and have the tax planning and 
preparation software compare the two options. In a community property state, there are 
special rules for allocating income between spouses. 
Filing MFS might unlock a QBI deduction, where one spouse might price the other 
spouse out of it based on exceeding the income cap for a specified service activity. 

MISCELLANEOUS CONSIDERATIONS FOR INDIVIDUALS

Individuals should sell off passive-loss activities to utilize suspended passive-activity 
losses. 
Individual taxpayers can maximize contributions to retirement plans to lower AGI and 
other income thresholds, which can unlock more QBI deductions, reduce NIT, and unlock 
credits and other tax benefits. Consider non-deductible IRA contributions. 
The IRS has many obstacles to deferring income, including passive-activity loss rules and 
limitations on charitable contributions. Consider a charitable remainder trust to bunch 
philanthropic contributions for itemizing deductions. (Ask Fidelity or Schwab about it.) 
Another option: Donate appreciated securities to charity. You get a charitable deduction 
at the FMV and avoid capital gains taxes. (This is a favorite strategy by billionaires, and you 
can use it, too.) 
Retirees must take required minimum distributions (RMD) by age 70½ unless it’s a Roth 
IRA. Per TCJA, consider directing your traditional retirement plan to make “qualified 
charitable distributions.” That satisfies the RMD rule with the equivalent of an offsetting 
charitable deduction, allowing you to take the standard deduction rather than itemize 
charitable contributions. 

FAMILY TAX PLANNING

TCJA improved family tax planning. Section 529 qualified tuition plans now can be used 
to pay for tuition at an elementary or secondary public, private, or religious school up to 
$10,000 per year (check with your state). The 2019 annual gift exclusion is $15,000, and it’s 
$155,000 to noncitizen spouses; the 2019 unified credit for federal estate tax is $11.40 
million per person, and “step-up in basis” rules still avoid capital gains taxes on inherited 
appreciated property. The IRS will adjust these amounts for inflation for 2020. TTS traders 
should also consider hiring adult children as employees. (See How To Save Taxes With 
Children, https://tinyurl.com/taxes-and-children.) 
TCJA created Qualified Opportunity Zones. According to www.irs.gov, the goal of 
QOZs is “to spur economic development and job creation in distressed communities 
throughout the country and U.S. possessions by providing tax benefits to investors who 
invest eligible capital into these communities. Taxpayers may defer tax on eligible capital 
gains by making an appropriate investment in a Qualified Opportunity Fund and meeting 
other requirements.”)   

78 
  
 

Chapter 10 
 
Dealing with the IRS and States 

The IRS and states have processes for inquiries (notices), exams (audits), appeals and tax 
court.  

TAX NOTICES AND EXAMS

When a tax notice arrives, don’t panic and rush to reply to an IRS agent. Understand 
where the IRS is coming from; it may just be a computer-generated notice asking for a few 
simple open items. If the IRS is getting ready to challenge TTS and Section 475 MTM, it’s 
important to step back and make sure you have a strong case for TTS qualification, and that 
you elected Section 475 correctly by the deadline. 
Don’t expect the IRS to get it right the first time around. The IRS notice may have a 
hobby-loss business or passive-loss activity questionnaire, and a trading business is exempt 
from those rules. Agents often calculate volume, frequency, and other metrics on your 
trading activity to determine TTS qualification in ways that are favorable to them and wrong 
in our view, so do the calculations right.  
If you made an error on your tax return but you clearly qualify for TTS and elected 
Section 475 MTM on time, you may be able to fix things quickly. On the other hand, if 
you’re a close call on TTS and potentially messed up your Section 475 MTM election or 
other matters, you should consider help from a trader tax expert to be your formal 
representative.  

EXAM RECONSIDERATION IS UNLIKELY

Traders can reply to the IRS with a “reconsideration” request, asking the IRS to close its 
exam before it gets underway. If the trader filed a Schedule C with a loss, even though he or 
she had trading gains in excess of expenses, it might be easy to get the exam closed 
(assuming he or she qualifies for TTS). Other types of notices or exams can be closed with 
little work, too. 
The solution can be as simple as filing a corrected tax return with the proper tax 
treatment, i.e., filing Form 4797 rather than MTM losses incorrectly on Schedule C, and 
including a detailed footnote. (Providing you elected Section 475 MTM on time.) 

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 We haven’t noticed many IRS exams being “reconsidered” lately. It seems the IRS agent 
wants to delve into the items listed on the tax notice. It’s important to keep the agent on the 
subject and limit his scope, so it doesn’t grow to more areas of your tax return or more years. 
Often, once the IRS finds a problem, it seeks to expand the exam to prior and subsequent 
tax years.  
IRS notices may include questions about business status. But these agents often use 
standard questions geared to assess “hobby-loss” treatment. TTS requires the intention to 
run a business, thereby trumping the hobby-loss rules. Trading is not a recreational or 
personal activity, two key requirements for a hobby-loss business.  

APPEALS
Expect the IRS agent to deny TTS unless you have a clear-cut case. Agree to disagree 
with the agent and go to the appeals level. Show the appeals officer how you are prepared to 
go to tax court to win based on the application of trader tax court cases. It’s best to have a 
trader tax expert CPA or attorney in your corner to present your TTS qualification, explain 
trader tax law and prepare the appeals letter. Like most tax preparers, most IRS agents and 
appeals officers are not well versed in trader tax law, and many misapply trader tax court 
cases. Be prepared to negotiate in appeals but hang tough to win a favorable outcome. The 
appeals letter should be in a professional style that serves as a precursor to the petition to file 
for tax court. That will earn respect from the appeals officer, and he or she will take you 
more seriously.  

TRANSFER THE EXAM OR APPEALS

If you work with a CPA firm well-versed in trader tax and IRS exams, it’s wise to transfer 
the work to your CPA office and its local IRS office. If your CPA has reviewed prior exams 
with local IRS agents, she probably has educated the agents on TTS, trader tax treatment, 
and Section 475 elections. This helps avoid problems with less informed agents on trader 
tax.  

TAX COURT
If appeals deny TTS and Section 475 MTM, and your trader tax expert thinks you have a 
good case, with a lot of money on the line, then file a petition in tax court. We usually 
suggest a “small case” filing. Engage the trader tax expert to write the tax court petition — 
preferably a tax attorney well versed in trader tax law. 
Here’s an example. A client engaged our CPA firm after making errors on his 
self-prepared tax return filing, inviting an IRS audit, and mishandling the agent and appeals 
officer. After a consultation, we felt he qualified for TTS and elected Section 475 MTM on 
time. Our tax attorney had less than a week to write the petition for tax court. The IRS 
considered our petition, conceded and closed the case, abating a tax bill for well over 
$100,000. Most trader tax court cases to date were cases where we feel the trader did not 
qualify for TTS. The best strategy is to claim TTS only when you clearly qualify for it and 
elect Section 475 MTM correctly. (Read trader tax court cases in Chapter 11.) 

STATES ALSO SEND TAX NOTICES AND INITIATE EXAMS

We’ve noticed more states challenging TTS and related tax breaks on their own, without 
the IRS taking the lead. Arizona tried to apply hobby-loss rules to a bona-fide trading 

80 
business; we said that was wrong, and the state eventually agreed with us. Most states are 
based on or coupled with federal tax law, and they should not depart from federal tax law 
when they feel it’s convenient. Recently, California and a few other state tax authorities 
initiated a state tax exam to challenge TTS for a few of our clients. In these situations, we 
had two choices: try to get the exam reconsidered (closed) claiming TTS is an IRS matter 
(and that probably won’t work) or present a case to win as we would with the IRS. We chose 
the latter and prevailed. When the IRS or state makes changes to your taxes, they advise the 
other tax authority, so expect both federal and state damage on a negative tax adjustment. 
A few states and local tax authorities have entity-level taxes based on gross receipts or 
gross margin. In many of those cases, trading gains are exempt as portfolio-income on the 
sale of capital assets (non-business) in nature, rather than business earned income. In other 
cases, gross margin may include trading gains.  
See our blog for more on defending trader tax, https://tinyurl.com/defend-trader-tax. 

IRS INITIATIVES
The IRS has a few initiatives focused on traders.  
1099-B matching to Form 8949: Down the road, the IRS might develop the capability to 
match cost-basis reporting on 1099-Bs with taxpayer Form 8949s. There are many 
complexities in cost-basis reporting on securities, including wash sales. It’s possible that 
traders might receive tax notices with questions about the differences between 1099-Bs and 
Form 8949 sooner. Cost-basis regulations completed the phase-in process by tax-year 2017, 
but a reconciliation capability is going to be a massive undertaking for the IRS. 
If a taxpayer complies with Section 1091 rules requiring wash-sale calculations based on 
substantially identical positions (between stocks and options) across all accounts including 
IRAs, the taxpayer will likely have discrepancies with broker 1099-Bs based on identical 
positions (exact symbol) for wash sales calculated on a separate account basis only. In this 
case, you should include a tax return footnote with a general explanation of the difference 
between the IRS wash sale loss rules for brokers vs. taxpayers. You don’t have to account for 
each difference per line item.  
(Read about the issues with cost-basis reporting, Form 8949, Form 1099-Bs, and wash 
sales in Chapter 4.) 
Attacks on trader tax status (TTS): Sole proprietor business traders may receive IRS 
questions on Schedule Cs, as only trading business expenses are reported there which causes 
it to look like a losing business (trading-related income is reported on other tax forms). Sole 
proprietor business traders with significant ordinary losses from trading expenses and 
Section 475 MTM losses may hear from the IRS, since such losses will likely generate huge 
net operating loss (NOL) carryforwards. (TCJA repealed NOL carrybacks starting in 2018, 
and NOL carryforwards attract less attention from the IRS vs. NOL carrybacks.) Other 
attention grabbers are perennial money-losing traders and errors on tax return filings on 
TTS, Section 475, tax treatment, and missing footnotes. Although the IRS is underfunded 
and the number of agents is down, some of the slack is being taken up by computer 
matching and computer-generated tax notices. 
We hope more traders assess TTS correctly. Don’t play the audit lottery by trying to cheat 
the IRS and your state on tax treatment. This gives the trading industry a bad name and 

81 
makes our job more difficult. If you have trouble with the IRS or your state, please consult 
an expert.  
With TCJA suspending investment expenses, more taxpayers might attempt to claim TTS. 
Others will form a dual-entity structure with an investment partnership and management 
company. The IRS may scrutinize these family office structures and deny business expense 
treatment unless there are outside clients. 
Section 475 improper identification. The IRS and some states have been playing havoc 
with traders in exams, claiming traders did not properly comply with Section 475 rules for 
segregation of investment positions from trading positions. Noncompliance gives the agent 
license to drag misidentified investment positions into Section 475 mark-to-market (MTM) 
or to boot misidentified trading losses out of Section 475 into capital-loss treatment subject 
to the $3,000 capital-loss limitation. Both of these types of exam changes cause huge tax 
bills, penalties, and interest. 
Traders don’t want to lose capital gains deferral and lower long-term capital gains rates 
on investment positions in securities. With misidentified investments, the IRS has the power 
to drag positions into Section 475, subjecting them to MTM and ordinary income tax rates. 
Section 475 contains a clause to limit unrealized losses on investment positions dragged 
into Section 475. If a security was misidentified as an investment, then there is Section 475 
MTM unrealized loss recognition only against other Section 475 gains, and any excess 
unrealized losses are deferred until the security is sold. Limiting MTM treatment on 
unrealized losses on investment positions is not much different from unrealized capital 
losses on those same positions. 
If you claim trader tax status and use Section 475 MTM, you can prevent this problem by 
carefully identifying each investment position on a contemporaneous basis. When you 
receive confirmation of the purchase of an investment position, email yourself to identify it 
as an investment position as that constitutes a timestamp in your books and records. Don’t 
hold onto winning Section 475 trading positions and morph them into investment positions, 
as that does not comply with the rules. If identifying each separate investment is 
inconvenient, then ring-fence investments into identified investment accounts vs. active 
trading accounts. Use “do not trade” lists for investing vs. trading accounts so you don’t 
trade the same symbol in both accounts. 
But this compliance is not enough. If you hyperactively trade around your investments, 
the IRS can say you failed to segregate the investment in substance. 
Entities navigate around the problem. The simple fix is to form a single-member or 
spousal-member LLC with an S-Corp election. Conduct all business trading with Section 475 
on securities in those entity accounts. (The entity may elect Section 475 MTM internally 
within 75 days of inception.) Trader tax status, business expenses, and Section 475 trading 
gains and losses are reported on the S-Corp tax return. 
Avoiding investment positions in the entity accounts is wise. But some traders want to 
use portfolio margining, and brokers don’t allow that between individual and entity accounts, 
so they want to transfer some large investment positions into the entity accounts. That can 
become a problem for Section 475 segregation of investment rules, especially if you trade the 
same symbols. In some cases, a trader must choose between portfolio margining or Section 
475. 

82 
 Keep investments in your individual investment accounts. The individual and entity 
accounts are not connected for purposes of Section 475 rules since they are separate 
taxpayer identification numbers. 

DON’T LET THE IRS FILE YOUR RETURN

If you trade securities, the IRS receives a broker-issued 1099-B that shows proceeds on 
“covered securities” plus cost-basis information due to cost-basis reporting rules phased-in 
over several years, starting in 2011 and ending in 2017. Due to the cost-basis reporting 
requirements, the IRS has a clearer picture of trading gain or loss. 
File your tax returns before the IRS contacts you, enhancing your chances of reduced 
penalties. While if you have reasonable cause, you should seek abatement of penalties, 
interest is statutory; it can never be abated. File your late returns as soon as possible, 
reporting capital losses. Then you can carry over capital losses to subsequent tax years, which 
isn’t possible unless you file the prior year tax returns. Don’t wait more than three years or it 
will be too late to apply capital-loss carryovers and net operating loss carryovers.  
If you can’t pay your taxes on time, at least file on time and request an installment plan 
(Form 9465); you can make corrections later. Failing to file an automatic tax extension is a 
mistake because “late filing” penalties are much higher than “late payment” penalties. 
Be honest and forthright with the IRS; don’t ignore it. Forget about cheating on your 
taxes with offshore or other schemes.  

AVOID BAD ADVICE

The sad reality is many traders don’t handle their tax affairs correctly, or they’re 
underserved by trusted “professionals” and tax software providers. 
An accountant working in a nationally branded tax storefront or local CPA firm may not 
be qualified to deliver trader tax services. We have seen many cases where traders have 
gotten into tax trouble using tax providers who don’t know trader tax. Some of these 
storefronts offer audit guarantees, but they don’t pay back taxes or pay for a new CPA to fix 
things. That’s a hollow guarantee. How can you recover lost tax savings with these 
“professionals”? Others offer free reviews, but what good is that offer if the person doesn’t 
know trader tax benefits and rules? “Free” often means an opportunity to sell you something 
you may not need like a dual entity scheme. 
The IRS enacted new standards to address what it perceived as too much bad advice 
coming from preparers who don’t have sufficient education or experience (i.e., those who 
aren’t CPAs, attorneys, etc.). The tax preparers’ requirements included registration, 
competency tests, continued professional training, and complying with a set of ethical 
standards. Unfortunately, in early 2013 a federal appeals court overturned these new IRS 
requirements. In 2015, the IRS renewed its efforts on these new standards. CPAs are held to 
higher standards under their licensing authorities, meaning they reach and exceed the 
standards the IRS tried to set for all “other” tax preparers. Be sure to pick an experienced 
trader tax professional so you can rest assured you are getting good advice. 
In the end, far too many active traders miss out on trader tax benefits — they don’t 
deduct allowable business expenses or elect and use ordinary-loss treatment on time. They 
overpay and don’t receive their tax refunds. Even when they do most things right, they file a 
return with a red flag, causing an exam.  

83 
 Conversely, some accountants professing to be trader tax experts disrespect TTS and set 
up schemes for investors to misuse business treatment and Section 475 MTM. Their clients 
clearly don’t qualify for TTS, and they face a heap of trouble from the IRS in an exam.  
You need an experienced trader tax expert in your corner to handle this challenging IRS 
environment.  

AVOID IRS PROBLEMS BY USING AN ENTITY

There are a few tips for dealing with the IRS. The most important ones are to get help 
before setting up your trading business and to get help preparing your tax returns. The 
process includes considering the best entity structure, dealing with startup costs properly, 
adopting tax reporting strategies to reduce red flags, and explaining your TTS and treatment 
in well-written footnotes accompanying the return. A proper business setup and trader tax 
return filed on time will generally not be questioned, except for those with massive ordinary 
losses, especially NOL carrybacks (2017 and prior years). Starting in 2018, TCJA required 
NOL carryforwards. The silver lining is less IRS attention, because NOL carrybacks drew 
more IRS attention. 
   

84 
  
 

Chapter 11 
 
Traders in Tax Court 

The IRS did an excellent job in recent trader tax court cases (Obayagbona, Poppe, 
Assaderaghi, Nelson, and Endicott), in terms of laying out the trader tax laws and 
requirements for qualification and in its analysis of the taxpayers. These cases also involved 
missed or botched Section 475 elections.  
The Poppe court (October 2015) awarded trader tax status (TTS) with 720 trades (60 
trades per month). Obayagbona had insufficient volume and frequency of trades and the 
court agreed with the IRS in denying him TTS. 
The Assaderaghi, Nelson, and Endicott courts denied TTS and all the other tax breaks 
that hinge on it. The facts of those three cases were similar: All three defendants managed 
their substantial investments with options, and they were clearly not business options traders. 
The IRS recap of trader tax law presented in these cases was very informative. There are 
clearer lines for options traders not to cross like the average holding period of 31 days 
(Endicott), over 720 total trades (Poppe), and frequency of trade executions on 
approximately 75% of available trading days. One critical lesson in each of these cases is to 
segregate your investment activity from trading business activity. Otherwise, it all looks like 
an investment program.  
Taxpayers should bring reasonable and winning cases to tax court. The lesson of the 
Obayagbona, Poppe, Assaderaghi, Nelson, and Endicott cases is amateur taxpayers without 
professional representation, or with tax attorneys who lack trader tax expertise, should not 
bring losing cases to tax court. If you’re dealing with IRS or state tax controversy and would 
like to know how to proceed, read Chapter 10. Also, see our blogs: Another Non-business 
Trader (Nelson) Busted in Tax Court (https://tinyurl.com/nelson-gtt) and Tax Court Was 
Right to Deny Endicott TTS (https://tinyurl.com/gtt-endicott). 

OBAYAGBONA VS. COMMISSIONER

Obayagbona was far off the mark with insufficient volume and frequency of trades and 
was denied TTS on Nov. 3, 2016. 
Volume: Obayagbona had 253 total trades in 2008 and 252 total trades in 2009. That’s 
less than half the 720 approved in the Poppe court.  

85 
 Frequency: Our golden rules call for trades on 75% of available trading days, and 
Obayagbona was under 50%. The court emphasized frequency in this case. 

POPPE VS. COMMISSIONER

Let’s break down the William F. Poppe vs. Commissioner court case (Oct. 19, 2015 T.C. 
Memo. 2015-205). In addition to the number of trades per annum, Poppe seems to have 
satisfied our other golden rules on frequency, holding period, intention to run a business, 
serious account size, serious equipment, business expenses, and more. Plus, Poppe had a 
good background as a stockbroker. In some years, Poppe was a teacher and part-time trader, 
fitting trading into his schedule. It helped that he made a lot of money trading in a few years 
in comparison to his teacher’s salary.
Botched Section 475 election. Poppe had substantial trading losses ($1 million in 2007) 
for which he claimed Section 475 ordinary business loss treatment rather than a puny $3,000 
capital-loss limitation against other income. But like other tax court cases (Assaderaghi, 
Nelson, Endicott, Holsinger, and Chen), the court busted Poppe for either lying to the IRS 
about making a timely Section 475 election or making a valid election but not being able to 
prove it to the IRS. Poppe never filed a required Form 3115 to perfect the Section 475 
election, which begs the question: Did he ever file an election statement on time? 
The case opinion states that Poppe intended to elect Section 475 for 2003 and filed his 
2003 tax return late in 2005, omitting a required 2003 Form 3115. Poppe’s tax preparer 
reported 2003 Section 475 trading gains on Schedule C. That’s incorrect and a red flag: 
Section 475 trading gains are reported on Form 4797 Part II ordinary gain or loss. This 
botched reporting indicates to me that Poppe’s tax preparer did not understand Section 475 
tax law, and this probably buttressed the IRS win. 
Many traders are in the same predicament as Poppe and should do their best to document 
the election filing in case the IRS challenges it. We document the process for our clients and 
ask them to record their filings, too. Send yourself an email with the relevant facts as email 
has a timestamp. Safeguard a copy of the election and Form 3115 in your permanent files. 
Poppe’s errors on Section 475. Poppe was not able to verify the external 475 election 
statement (step one) or a Form 3115 filing (step two). It wasn’t just a question of being late 
on a Form 3115 filing; Poppe never filed one, and he was an existing taxpayer individual. 
Traders should file the external Section 475 election statement with certified return 
receipt. But that may not be enough because it only verifies a mailing, which also contains 
the tax return or extension. The IRS recognized this problem and suggested that taxpayers 
include a perjury statement on Form 3115 stating they filed the 475 election on time. 
Is there any relief from the IRS? My partner Darren Neuschwander, CPA spoke with an 
IRS official a few years ago who said the IRS had granted some relief to a few traders 
provided they were only a little late with their Form 3115 filing, but they filed the election 
statement on time. The IRS official pointed out there is no relief for filing the initial election 
statement late. 
But Poppe was not a little late — he never filed a Form 3115. It’s wise to file Form 3115 
on time per the written rules and not rely on hearsay about possible relief from IRS officials, 
which may no longer be granted after the Poppe decision.  
Proprietary trading account or disguised customer account? The court construed Poppe’s 
proprietary trading firm arrangement to be a disguised retail customer account. This ruling 

86 
should be a concern for the proprietary trading firm industry, especially since regulators 
warned clearing firms about disguised customer accounts in the past. By agreement, prop 
traders do not trade their own capital in a retail customer account. They trade a firm 
sub-account with firm capital and far higher inter-firm leverage than is available with a retail 
customer account. See more about this in Chapter 14 on proprietary trading firms.  

ASSADERAGHI VS. COMMISSIONER

The IRS is piling up victories in tax court against individual traders who inappropriately 
use Section 475 MTM business ordinary loss treatment for deducting large trading losses. 
Fariborz Assaderaghi & Miao-Fen Lin v. Commissioner (Feb. 25, 2014, T.C. Memo. 2014-33) 
is one of them. According to Tax Analysts, “The Tax Court held that a husband’s trading 
activity in securities didn’t constitute a trade or business and, thus, he wasn’t eligible for a 
mark-to-market accounting method election under section 475(f), and the couple was limited 
to a $3,000 deduction of losses from the purchase and sale of securities under section 
1211(b) for each year at issue.”
Only traders who qualify for TTS (Schedule C business expenses) may elect and use 
Section 475. A lot is at stake since without TTS or a timely Section 475 MTM election; 
traders are forced to use a puny $3,000 capital loss limitation against other income. 
We agree with the IRS that Assaderaghi did not qualify for TTS in any of the years 
examined. Assaderaghi had many day trades, and he used professional trading equipment and 
charts. But he had a demanding full-time career as an engineer/executive, and the IRS is 
more skeptical toward part-time traders claiming TTS. Assaderaghi was unable to prove his 
hours spent in trading, and his evidence lacked credibility in the eyes of the IRS and tax 
court. 
Most importantly, Assaderaghi came up short on meeting our golden rules for 2008, the 
one year he had a chance to qualify for TTS. He had 535 trades (we now recommend 720 
total trades). He traded just over 60% of available trading days (our golden rules call for 
trade executions on 75% of available trading days). In the other years examined, he came up 
far short of TTS, which displayed an especially weak case when the years were considered 
together. 
Perhaps Assaderaghi could have fought harder to win TTS in 2008, and concede the 
other years, but that was not the main issue. The bigger issue was filing a timely Section 475 
MTM election, which Assaderaghi and his accountant did not do. This was a significant 
point because Assaderaghi’s CPA deducted $374,000 in trading losses on his 2008 Schedule 
C, a red flag, but the IRS forced them to use a puny $3,000 capital loss limitation instead 
since there was no valid Section 475 election made for 2008. Once again, a trader and 
professional went to tax court with a losing case on technical grounds, and nothing could be 
done about it. They caved on TTS when perhaps they could have won that part of the exam.  
Assaderaghi made some tragic rookie tax mistakes, which sealed his fate as a loser with 
the IRS. He asked his local CPA tax preparer to elect TTS and Section 475 MTM, but after 
not getting an answer from his CPA, he didn’t do anything about it. His accountant was 
clueless about trader tax benefits and rules — which is sadly still often the case. When it 
comes to timely Section 475 elections, there is no excuse allowed for relying on an 
accountant, and there is no IRS relief. The IRS is lenient on many things, but not Section 
475 elections. 

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 His accountant grasped the idea of trading as a business — filing a Schedule C — but he 
jumped to the tragic conclusion that he could simply report trading gains and losses on 
Schedule C like other types of businesses. He should have filed a timely election for Section 
475 and reported trading gains and losses on Form 4797 Part II with ordinary gain and loss 
treatment. It’s clear the accountant did not know that Section 475 MTM had to be elected 
for an existing individual taxpayer by April 15, 2008, for 2008 or perfected with a 2008 Form 
3115 change of accounting filed in 2009 with the 2008 tax returns. Had Assaderaghi known 
the golden rules, perhaps he would have traded more to meet them. 
Assaderaghi’s tax return screamed for an IRS beat down. The IRS computers saw trades 
on Schedule C and issued a tax notice. The IRS tried to match broker 1099-Bs to Schedule D 
(in 2008 and Form 8949 after 2010), Form 4797 Part II (section 475 MTM), and Form 6781 
(Section 1256), but none were correctly reported on these forms. The IRS agent asked the 
CPA preparer about his filing of a Section 475 MTM election, and the CPA did not even 
know what the agent was talking about. Case closed — it’s a loser! You can never file a 
Section 475 MTM election late (or with hindsight).  
There is an exception: A six-month extension for filing a Section 475 election based on 
“Section 9100 relief.” It requires filing a private letter ruling (PLR), but the IRS has rejected 
PLRs for this, with the exception of Larry Vines who had no prejudice or hindsight. See 
Chapter 2. 
Lessons learned: Learn trader tax benefits and rules with our content and hire a proven 
trader tax CPA to assist you with qualification for TTS, a Section 475 election, Form 3115, 
Form 4797, and tax return footnotes. 
The Assaderaghi case does not change our golden rules. The Assaderaghi court 
reinforced the notion that business traders must be consistent in trading volume and 
frequency and avoid sporadic lapses in active trading. The tax law requires “regular, frequent 
and continuous trading based on daily market movements and not long-term appreciation.” 
It’s wise to stop trading as an individual and form an entity that qualifies for TTS and files 
an entity business tax return that resembles many active trading hedge funds. As pointed out 
in this guide, a high-ranking IRS person in the TTS and Section 475 area warned at a tax 
conference that the IRS is going after individual traders inappropriately using TTS and 
Section 475 MTM ordinary loss treatment. Get the help you need to be a winner. 

CHEN VS. COMMISSIONER (2004)

It’s been 15 years since this case went to tax court, but an IRS official reiterated the 
importance of it, deeming similar circumstances “Chen cases.” The IRS official was referring 
to sole proprietor traders reporting large Schedule C and Form 4797 (Section 475) ordinary 
losses on individual tax returns and filing for large NOL carryback refunds claims with the 
IRS. All the cases in this chapter are similar: individuals with Schedule C and Form 4797 
losses. It’s much better to file as an entity trader with Section 475. There may be a silver 
lining to TCJA’s repeal of NOL carrybacks and introduction of an excess business loss 
(EBL) limitation with NOL carryforward. The IRS might have fewer reasons to initiate a tax 
exam against TTS traders.
Chen was a part-time trader with a full-time job who entered and exited his trading 
business in three months after losing almost all his money in hyperactive trading.  

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 Chen botched many things in this case. First and foremost, he lied to the IRS about 
electing Section 475(f) MTM on time and then used MTM when he wasn’t eligible. Second, 
he brought a losing case to tax court and made the mistake of representing himself. Once 
Chen was busted on the phony MTM election, he caved in on all points, including TTS.  
The problem for traders is that once MTM ordinary loss treatment is lost — by far the 
biggest tax benefit on the line — poorly represented traders in tax court too easily concede 
TTS, which may only deliver another $5,000 of tax benefits. If you’re paying for legal 
counsel, why continue to pay an attorney to win just a few thousand dollars of tax benefits?  
Even though Chen only traded for three months while keeping his full-time job, it doesn’t 
mean he didn’t start a new business — with every intention of changing careers to business 
trading — and make a full investment of time, money, and activity. Tax code or case law 
doesn’t state that a business must be carried on for a full year’s time or as the primary means 
of making a living. Countless businesses start up and fail in a few short months, and many 
times the entrepreneur hasn’t left his or her job while experimenting as a businessperson. 
Chen may have won TTS had he been upfront with the IRS and engaged a tax attorney or 
trader tax expert to represent him in court. 

HOLSINGER VS. COMMISSIONER (2008)

Holsinger was a close call at best on TTS. (Our CPA firm would not have allowed his 
TTS if we had been preparing his tax returns, as he fell short of our golden rules based on 
the facts we learned in his sub-par presentation to the court.) 
Holsinger also made several errors on his tax return, which rightfully drew IRS attention 
and an exam. Holsinger formed an LLC for his trading business, and he correctly filed an 
internal MTM election. The problem: Holsinger never traded in the LLC’s name and instead 
traded in a joint individual account with his wife. He didn’t elect MTM on the individual level 
(a common error for traders who set up LLCs), so the IRS easily won the denial of MTM in 
tax court.  
Holsinger has similarities to Chen. Holsinger wasn’t entitled to use MTM yet used it 
anyway and tried to defend it in tax court. Like Chen, Holsinger got off on the wrong foot 
and lost credibility with the IRS. He unsuccessfully argued that he individually acted as an 
“agent” for the LLC. Also, he was retired and that raises the bar on TTS qualification in the 
eyes of the IRS, as is the case with part-time and money-losing traders. Had Holsinger traded 
in the LLC, the exam may not have come up in the first place, based on a partnership tax 
filing.  
Holsinger’s number of total trades was less than 320 — well below our golden rule, which 
requires 720 total trades at a minimum. Holsinger’s average holding period was more than 
one month, but it must be under 31 days per the Endicott court. His total cost basis on 
trades was well under $1 million per year, which is low by trader tax standards. Business 
traders usually have cost basis and proceeds in excess of several million dollars per year, 
indicating rapid turnover and materiality.  
In the Holsinger decision, the IRS cited the usual tax court cases on TTS, which included 
a broad range of total trades. On one end of the range, one court case denied TTS on fewer 
than 100 total trades. On the other end, the IRS agreed to TTS with 1,100 total trades. 
Holsinger fell somewhere in the lower middle. Holsinger traded on only 40% of available 
trading days in 2001 and 45% in 2002. Our golden rules call for 75% frequency.  

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CONTINUOUS BUSINESS ACTIVITY
Unfortunately, these past few years we didn’t make any headway with our “continuous 
business activity” (CBA) argument on easing qualification for TTS (business treatment). 
We’ve been hoping it can help many traders who face difficult qualification standards on 
“frequency of trades.” 
CBA is not yet salvation or replacement for hitting your numbers including volume of 
trades, days per week with executed trades, and average holding periods. But we think CBA 
can save the day on TTS when frequency of trades comes up a little short. Keep in mind a 
large Section 475 MTM ordinary loss is contingent on having TTS, so it’s worth defending in 
many cases. 
CBA can plug the holes on frequency of trades. Let’s say a trader has closer to 600 total 
trades rather than 720, trades three days a week instead of four, and has longer holding 
periods, such as 20 days for options. If that trader can establish CBA, and the appeal or tax 
court case is argued correctly, the trader might win his case for TTS.  
Assaderaghi, Nelson, and Endicott and other traders in tax court have not yet properly 
raised our CBA argument. In our research, we found the IRS inappropriately adopted 
“frequency of trades” as its gold standard after the landmark trader case Paoli vs. 
Commissioner. That’s the nature of tax court case law: The IRS keeps making arguments 
based on prior cases, and case law takes on a life of its own. What went wrong for traders 
here? Paoli tried to cheat the IRS and tax court by claiming he was a full-time business 
trader, but he only had a handful of trades in one month during the year. His attempt was a 
complete fiasco. The tax court rightfully said we need a way to verify a wild statement by a 
taxpayer and prove his activity. Hence, the court turned to the frequency of trades argument 
to check on CBA, but not to replace it. Other types of businesses don’t have to go through 
frequency of business standards either — it’s often presumed they have CBA.  
The IRS conveniently overlooked this important distinction, thereby elevating “frequency 
of trades” as the standard that counts most in its audit manuals. But this is wrong because 
CBA still trumps frequency of trades, which is meant to be a backup test only.  
Consider a hotel analogy: A guest checks in Monday and checks out on Saturday, using 
the front desk execution for two days that week. But the hotel staff serviced that guest for 
six days. Most TTS traders service open trades.  
Impress the IRS with your CBA. Many traders work all or most of the day, every day, 
conducting extensive research, back testing, writing code, making unexecuted trades, demo 
trading, learning new areas, making live trades, and handling administration, accounting, IT, 
and much more. During a tax exam, the amount of work involved, the sophisticated level of 
technology used, and time spent for research and administration often impresses the IRS. 
CBA is not hard to prove for most active traders. 
If a trader establishes CBA, the court should not have the right to overturn that business 
treatment by arguing a trader falls a tiny bit short on some of its often-quoted tax court case 
standards.  
Be prepared to be a guinea pig on arguing for CBA in tax court and make sure it’s worth 
your while regarding outcome vs. cost.   

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HISTORY OF TTS AND SECTION 475
In 1997, Congress recognized business traders as a separate and respected tax class and 
legislated TTS (business treatment) by expanding Section 475 mark-to-market accounting 
(MTM, ordinary gain or loss treatment) from dealers to business traders too. As a result, 
some IRS agents confuse traders with dealers in exams. 
Congress added the new Section 475(f) for “traders in securities” and “traders in 
commodities.” Section 475(f) is recommended for many securities business traders but not 
generally commodities/futures traders because the latter prefer to keep the lower tax rates of 
Section 1256 60/40 tax treatment. While 22 years have passed since enactment of Section 
475(f), the IRS has failed to sufficiently clarify these tax laws, which has made life unduly 
difficult for traders and their accountants. The IRS did expand Publication 550 to include a 
new Chapter 4, “Special Rules for Traders” (available at www.irs.gov), but it speaks in 
generalities.  
By failing to create clear statutory law on eligibility for TTS, the IRS is leaving the matter 
to tax-court judges to write case law. And the IRS appears to be winning this game because 
its agents are depicting unsettled law as settled law and scaring taxpayers into conceding 
TTS, when they rightfully used it on their tax returns.  
A few recent IRS tax court victories are setting a bad precedent for all non-hyperactive 
traders, especially part-time and money-losing traders. Familiarize yourself with these cases, 
so you don’t make the same mistakes. 

IRS CLEAN UP PROJECT FOR SECTION 475

In 2015, the IRS acknowledged lingering problems with Section 475 and announced a 
Clean Up Project welcoming comments from tax professionals. We started a successful 
petition on Rally Congress to fix Section 475 and TTS rules and also sent a cover letter and 
comments to the IRS. The American Bar Association (ABA) Comments on Mark-to-Market 
Rules Under Section 475 are good. Read more about the IRS Clean Up Project for Section 
475 in Chapter 2. The IRS is considering “mark and freeze” for a Section 475 election and 
changing the character of income of Section 481(a) adjustments from ordinary to capital 
gains and losses. We did not hear any news about this IRS project this past year. 
   

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Chapter 12 
 
Proprietary Trading 

Proprietary traders are significantly different from retail traders and have special tax 
compliance needs. They don’t trade their own capital. They trade the firm’s capital, usually 
accessed from a sub-trading account within the firm. A prop trader becomes associated with 
a prop-trading firm either as an LLC member (Schedule K-1), an independent contractor 
(1099-MISC) or an employee (W-2).  
If you fall in the prop trader category, here’s what you need to know. 

INDEPENDENT CONTRACTORS
Profitable independent contractor (IC) proprietary traders receive a 1099-MISC for 
“non-employee compensation.” Sole proprietors use a Schedule C to report fee revenue and 
deduct their business expenses, including home-office deductions, if they qualify. Schedule C 
net income is subject to federal and state income taxes. 
Firms don’t issue 1099-MISC to losing IC traders, since they don’t pay those traders a fee. 
Losing IC traders are still working, so they’re entitled to file a Schedule C, which reports 
expenses only.  
That net income is deemed “earned income” subject to the self-employment (SE) tax. 
The SE tax rate is 15.3% of the social security base amount ($132,900 for 2019 and $137,700 
for 2020). The Medicare portion of SE tax is 2.9%, and it’s unlimited. If your SEI exceeds 
the ACA AGI thresholds of $250,000 (married) and $200,000 (single), there’s an additional 
0.9% surtax matching the ACA net investment tax rate of 3.8%.  
What’s the difference tax-wise between retail traders and IC prop traders? Retail trading 
gains aren’t subject to the SE tax, with the exception of futures traders who are full-scale 
members of a futures or options exchange. IC prop traders have earned income enabling 
them to contribute to tax-deductible retirement plans and deduct health-insurance 
premiums. A retail trader with TTS needs to form an S-Corp to create compensation for 
these employee deductions.  
IC prop traders may also trigger local taxes on earned income, like NYC 4% UBT tax, or 
earned-income related tax credits. Retail TTS traders owe ACA 3.8% Medicare tax (NIT) on 

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unearned income (trading gains) if they exceed the thresholds, so the main difference 
between SE and NIT is the Social Security tax in SE tax.  
Some prop-trading firms may allow the IC trader to form a single-member LLC with an 
S-Corp election, so the trader may be able to reduce SE taxes by up to 50-75%. Some firms 
may try to fool around with the 1099-MISC, completing the “other” box rather than 
“non-employee compensation.” This is likely incorrect; simply reporting the income in the 
wrong box doesn’t mean it’s free from SE tax. 

SOME PROP TRADERS UNDER REPORT INCOME

Reinvested earnings are taxable income: Prop traders generate trading gains on their 
sub-trading account. At the end of a defined period, usually monthly, the firm presents them 
with a choice: Request a fee payment (distribution of earnings) or reinvest income in their 
sub-trading account. 
Some prop firms only include fee payments on annual tax Form 1099-Misc. They don’t 
include reinvested earnings. That’s a problem: In this scenario, reinvested earnings constitute 
“constructive receipt of income,” which should be reportable income. These firm’s prop 
traders are likely under-reporting income since many will inadvertently or purposely 
overlook reporting reinvested earnings on Schedule C. Taxpayers are responsible for 
reporting all income, even if it’s not included on 1099s. (Read our blog Some Proprietary 
Traders Under Report Income, https://tinyurl.com/gtt-under-report.) 

ISSUES FOR LLC MEMBERS WITH K-1S

LLC prop traders don’t have earned income reported on their Schedule K-1s, so they save 
SE tax but can’t contribute to a retirement plan or deduct self-employed health-insurance 
premiums. (One exception: A prop trading firm that trades futures as a full-scale member of 
a futures or options exchange per Section 1402i.) A few firms tried to deliver those 
deductions to K-1 traders, but they were wrong. 
Trading gains on Schedule K-1 are considered net investment income (NII) under ACA 
NIT. (Read about ACA taxes in Chapter 15.) 
Prop trading firms report activity on a Form 1065 partnership tax return. The Schedule 
K-1 reports the LLC member’s share of the firm’s trading gains and expenses they generated 
— in summary form by tax treatment.  
Schedule K-1, Box 1 is for ordinary income or loss. Most prop trading firms elect Section 
475 MTM for securities, so the income is considered ordinary. Other firms pass through 
capital gains and losses and Section 1256 futures or Section 988 forex ordinary income/loss, 
too. The firm qualifies for TTS on the entity level, and it passes it to you on the K-1 with 
business expense treatment. 
Prop trading firms file partnership tax returns, not S-Corp returns since S-Corps do not 
allow special allocations to different ownership classes. Special allocations are fundamental to 
prop trading firms, as prop traders are treated differently from the owners. Partnerships can’t 
pay wages to owners; they must use guaranteed payments instead. Partnerships pass-through 
losses from guaranteed payments to owners so it’s almost impossible to achieve employee 
benefit plan deductions for owners. Retail traders use S-Corps to arrange employee benefit 
plan deductions, and S-Corps don’t pass through negative or positive SEI.  

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PROP TRADER EXPENSES
Like retail traders, many prop traders have material trading-related expenses. The 
expenses charged by the firm to the trader are deducted at the firm level, and the K-1 
ordinary income is already net of those expenses. 
Some prop-trading firms have an “accountable reimbursement plan” that the prop trader 
needs to “use or lose” before year-end. If your firm doesn’t have such a plan, then you can 
deduct your own trading business expenses outside of the firm, including your home office 
expenses, as Unreimbursed Partnership Expenses (UPE). Schedule K-1 ordinary income is 
reported on Schedule E in the active column, as it’s not a passive activity under the “trading 
rule” in Section 469. UPE is deducted in that same area on Schedule E on the next line 
under the Schedule K-1 ordinary income or loss. Most of the home-office deduction 
requires income.  
K-1 trading business expenses can be included when calculating self-employment income 
(SEI) from other sources. But Section 475 MTM trading losses cannot. Check to see if your 
K-1 separately accounts for trading business expenses and doesn’t net them against Section 
475 ordinary trading gains. 
Trading expenses from a prop trading firm K-1 can reduce SEI and/or net investment 
income — that’s good if you owe SE or NIT taxes, perhaps related to other activities.  

TRADING LOSSES
Most prop trading firms take all trading losses at the firm-owner level. They only pay IC 
traders when they reach new high net profits, a concept used in investment management, 
too. With LLC-member prop traders, the Class-A member (that is, company management) 
also takes losses on his own K-1 and doesn’t report ordinary income to the prop trader until 
he makes new high net profits. If you have allocated trading losses on your Schedule K-1, 
make sure you have sufficient basis (equity or debt basis) to take the loss on your current tax 
return. Otherwise, it’s a suspended loss to carry forward to subsequent tax years.  

WRITING OFF LOST DEPOSITS

A key tax issue prop traders face is when to write off deposits lost within the firm. If you 
incur a trading loss, the firm may take it on the owner/manager’s K-1, using your deposit to 
cover it. How can you write off the lost deposit on your own tax returns? 
For an IC trader, the lost deposit is not reflected on the annual Form 1099-MISC. When 
the loss is realized, the IC trader can deduct a business bad debt on Schedule C, as another 
ordinary and necessary business expense. The deposit is considered lost when the trader has 
to replenish it due to trading losses, or if the trader has to leave the firm and the firm doesn’t 
repay it. (If the trader is making money and still has that deposit on file, there’s no 
loss-recognition event.)  
If an LLC-member prop trader has a lost deposit, he or she deducts the deposit as UPE 
on Schedule E.  
For IC traders who spent $10,000 on education before becoming a prop trader in an 
education/prop trading hybrid firm (before TTS qualification), that money is considered 
pre-business education, and it’s either not deductible, or a portion can be capitalized in 
Section 195 business startup costs. 

94 
 If they reclassify part of the $10,000 to a deposit and subsequently lose that money, then 
it could be treated as a deposit loss. Or, if they reclassify some of the education to post 
business education (i.e., they start prop trading and take some classes afterward), they may 
have a business education expense.  
Some IC prop traders never get paid a dime and don’t receive a 1099-MISC. Can they 
deduct post business education or a deposit loss? If they really work as a prop trader, they 
may be able to. 

QBI DEDUCTION
Proprietary traders might be eligible for TCJA’s 20% deduction on qualified business 
income (QBI). Independent contractor prop traders may file a Schedule C or S-Corp tax 
return with revenue for consulting fees. Net income after expenses constitutes QBI, 
providing the prop trading firm is based in the U.S. Consulting is a specified service activity 
like a TTS trading business.  
LLC member prop traders might also be eligible for the QBI deduction providing the 
prop trading firm elected Section 475 ordinary income, which is includible in QBI. The 
Schedule K-1 special allocation should include ordinary income. QBI excludes capital gains 
and losses. (See more on the QBI deduction in chapters 7 and 17.) 
   

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Chapter 13  
 
Investment Management 

Investment managers trade money belonging to investors. As you can imagine, handling 
other people’s money is serious business, therefore, there is a huge body of 
investor-protection law and regulation on securities, commodities, and forex. The investment 
manager may need various licenses and register with the regulator in charge.  

SEPARATELY MANAGED ACCOUNT OR HEDGE FUND?

Investment managers handle two types of investors: separately managed accounts (SMAs) 
and hedge funds (or commodity or forex pools). In an SMA, the client maintains a retail 
customer account, granting trading power to the investment manager. In a hedge fund, the 
investor pools his money for an equity interest in the fund, receiving an annual Schedule K-1 
for his allocation of income and expense. It’s different with offshore hedge funds. 
There are important differences in tax treatment. SMAs cannot claim trader tax status 
(TTS) because the investment manager is responsible for the trading, not the investor. (The 
investment manager also doesn’t have TTS but has business treatment from providing 
investment management services.) Without TTS, the investor can’t elect and use Section 475 
MTM.  
TCJA suspended “certain miscellaneous itemized deductions subject to the 2% floor,” 
including investment fees and expenses. It disenfranchises SMA investors from deducting 
management and incentive fees. Hedge funds use carried-interest, a profit-allocation 
provision, to convert incentive fees into a reduction of capital gains — that’s tantamount to a 
deduction. (See my blog New Tax Law Favors Hedge Funds Over Managed Accounts, 
https://tinyurl.com/gtt-hedge-funds.) TCJA did not suspend stock borrow fees for 
short-sellers as an “other itemized deduction” and investment-interest expenses. TCJA 
introduced a business interest expense limitation if gross receipts (net trading gains) exceed 
$25 million per year.  
The profit allocation has other tax advantages for the manager: A carried-interest share of 
capital gains or Section 475 ordinary income is exempt from payroll taxes, whereas, advisory 
fees are subject to payroll taxes (Social Security and Medicare).  

96 
 With a hedge fund structure, the investment manager is generally an owner/trader of the 
fund and brings TTS to the entity level. A TTS hedge fund reports management and 
incentive fees as a business expense on the partnership tax return.  
In an SMA, the investor deals with accounting (including complex trade accounting on 
securities), not the investment manager. In a hedge fund, the investment manager is 
responsible for complex investor-level accounting, and the fund sends investors a Schedule 
K-1 that is easy to input to tax returns.  

TAX TREATMENT ELECTIONS

There are different types of tax treatment elections that can be made, and it’s important 
to make the right decisions on time. In some cases, these tax elections should be 
contemplated in the development process and included in the private placement 
memorandum. For example, investors with large capital loss carryovers may be searching for 
hedge funds that will generate capital gains rather than Section 475 MTM ordinary income 
on securities or Section 988 ordinary income on forex. A hedge fund and SMA account 
owner can elect capital gains treatment on forex trading. The Section 988 forex capital gains 
election must be filed internally on a contemporaneous basis. (More on forex in Chapter 3.) 
Most investors benefit from TTS, so if your fund qualifies, it’s generally a good idea to 
claim that status. With TTS, the advisor and investors have business expense treatment 
without passive loss activity limitations. (One exception: non-active owners report 
investment interest expense as itemized deductions.) That means investors get the full 
benefit of advisory fees paid “above the line” (from gross income) rather than face 
TCJA-suspended investment fees and expense deductions starting in 2018.  
With TTS, the fund is entitled to elect Section 475 mark-to-market (MTM) (on securities 
only), which exempts it from wash-sale loss adjustments at year-end. Plus, Section 475 
receives business ordinary loss treatment, avoiding capital loss limitations. Some managers 
skip a Section 475 election because they don’t want to be burdened with contemporaneous 
segregation rules for investments vs. business positions, and they don’t want MTM to apply 
at year-end so they can defer capital gains to the next tax year(s). Otherwise, they would pass 
MTM income to investors who might want redemptions to pay taxes on the unrealized 
income, while the manager has not yet actually sold those underlying shares. Some hedge 
funds have TTS and Section 475 MTM on one portfolio, and they properly segregate an 
investment portfolio without TTS, where they generate long-term capital gains. (Read 
Chapter 2 and our blog posts Safeguard Use Of Section 475 By Trading In An Entity, IRS 
Plays Havoc with Traders Misidentifying Investments, and IRS Warns Section 475 Traders. 
The blogs can be found at https://greentradertax.com/blog/archives.) 

QBI DEDUCTION IN PASS-THROUGHS

Investment management companies are specified service activities, and advisory fees from 
U.S. clients count as QBI. A “carried-interest” profit allocation of Section 475 income 
distributed to the management company is also included in QBI. Carried-interest of capital 
gains is not.  
A hedge fund with TTS is like a TTS trading partnership for determining a QBI 
deduction. Hedge fund expenses are negative QBI, and Section 475 income is positive QBI. 

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Some hedge fund accountants disagree based on their interpretation of Section 864(b). For 
more information on QBI, see Chapters 7 and 17. 

CARRIED-INTEREST TAX BREAK

The carried-interest tax break can be used in hedge funds, but it cannot be used in 
separately managed accounts (SMAs). If carried interest provisions are included in the fund’s 
operating agreement and PPM, the general partner investor is allocated a partnership K-1 
share of each item of income — let’s say 20% — in lieu of the fund paying an outside 
advisor an incentive fee. Generally, the general partner and investors receive tax breaks with 
carried interest. The advisor gets a share of lower tax rates on 60/40 or long-term capital 
gains and avoids payroll tax on earned income, and the investor avoids suspended 
investment expense treatment. 
Carried interest can be arranged in offshore funds with a mini-master fund structure. 
There are other nuances in connection with self-employment tax and the ACA 3.8% 
Medicare tax on unearned income (investment income).  

CARRIED INTEREST IS GOOD FOR INVESTORS

Investors are stuck with suspended investment-expense treatment and 
investment-interest-expense limitations for expenses that pass through an investment 
partnership. The biggest investment expense is often advisory fees paid to the investment 
manager. 
Carried interest solves this problem for most investors. It reclassifies incentive fees from 
suspended investment expenses into reduced capital gains, tantamount to a deduction from 
gross income and net investment income.  
For example, an investor with a $100,000 capital gain has a net capital gain of $80,000 
after applying the 20% carried-interest provision. Without carried interest, the capital gain 
would be the full $100,000, and the investor would have a suspended investment expense 
deduction for regular tax and ACA’s 3.8% net investment tax. 

CARRIED-INTEREST MODIFIED IN THE ACT

TCJA modified the carried interest tax break for investment managers in investment 
partnerships, lengthening their holding period on profit allocation of long-term capital gains 
(LTCG) to three years from one year. If the manager also invests capital in the investment 
partnership, he or she has LTCG after one year on that interest. The three-year rule only 
applies to the investment manager’s profit allocation — carried interest. Investors still have 
LTCG based on one year. Investment partnerships include hedge funds, commodity pools, 
private equity funds, and real estate partnerships. Many hedge funds don’t hold securities for 
more than three years, whereas, private equity, real estate partnerships, and venture capital 
funds do. 
Carried interest in Section 1256 lower 60/40 capital gains still works. TCJA did not 
address this point.  

BUSINESS INTEREST EXPENSE LIMITATION

Larger hedge funds might be subject to TCJA’s business interest limitation calculated on 
2019 Form 8990 Limitation on Business Interest Expense Under Section 163(j). The 
threshold is annual gross receipts over $25 million per year, which for a trading company 

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translates to net trading gains. Learn more about the business interest expense limitation in 
Chapters 7 and 17. 

S-CORP TAX REDUCTION STRATEGY

Although investment managers can’t use profit-allocation clauses on SMAs, they can at 
least use the S-Corp SE tax reduction break to reduce social security (FICA) and Medicare 
taxes on earned income. Managed accounts pay advisory fees, which include management 
and incentive fees, whereas funds using profit allocation clauses only pay management fees.
In an LLC management company filing a partnership tax return, earned income passes 
through to the LLC owners as SEI subject to SE tax unless an owner is passive. 
Investment managers can only use profit allocation with investment funds because only 
partners can share special allocations of underlying income. Special allocations are permitted 
and useful on fund partnership tax filings, but not with S-Corp tax returns, since they reverse 
(taint) S-Corp elections. The IRS only allows S-Corps to have one class of stock and insists 
on equal ownership treatment. 
That makes S-Corp elections a wise choice for management companies focused on 
reducing the SE tax on underlying advisory fee earned income. Conversely, partnership tax 
returns are a better choice for investment funds focused on carried-interest tax breaks using 
special allocations, plus there is generally no underlying income subject to the SE tax, 
anyway. 
An existing LLC or C-Corp can file an S-Corp election (Form 2553) by March 15 of the 
current tax year. Many states accept the federal election, but some require a state election. 
The IRS has relief for late S-Corp elections, but it requires a perjury statement saying you 
intended to elect S-Corp status on time.  
The IRS is well aware of this S-Corp SE tax reduction strategy, which is why it insists 
owners pay themselves “reasonable compensation.” Industry practice is 25-50% of net 
income as reasonable compensation. The remaining percentage is free of payroll tax or SE 
tax. The IRS is turning up the heat on S-Corps with tax exams and forcing this type of 
officer’s compensation. The IRS has a computer program to look for reasonable 
“compensation of officers” on Form 1120S S-Corp tax returns. Recent case law is in favor 
of the IRS so don’t skip this requirement. A TTS S-Corp has underlying unearned income, 
so it’s not subject to reasonable compensation guidelines. Learn more about entities for 
traders and investment managers in Chapter 7, including many tips on using an S-Corp. 

C-CORPS WITH 21% RATE

TCJA significantly reduced the C-Corp tax rate to a 21% flat rate, commencing in 2018. 
Investment managers in corporate-tax-free states may prefer a C-Corp structure for their 
management company. (See how TCJA impacts entity choices in Chapters 7 and 17.) 
   

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Chapter 14  
 
International Tax 

U.S. traders move abroad; others make international investments and non-resident aliens 
invest in the U.S. How are their taxes handled? 

U.S. RESIDENT TRADERS LIVING ABROAD

U.S. tax residents are liable for federal tax on worldwide income whether they live in the 
U.S. or a foreign country. A U.S. tax resident has U.S. citizenship or a Permanent Resident 
Card (green card). If you qualify for “bona fide” or “physical residence” abroad, which is 
living abroad for an entire tax year, try to arrange Section 911 “foreign earned income” 
benefits on Form 2555. Avoid the double taxation of paying tax in both a foreign country 
and the U.S. by availing yourself of foreign tax credits reported on Form 1116. If you live in a 
country which charges higher taxes than the U.S., it may make sense to skip the Section 911 
exclusion, because creating officer compensation in a TTS S-Corp also causes some U.S. 
payroll taxes (FICA and Medicare). 
The Section 911 exclusion on foreign earned income is $105,900 for 2019, an amount the 
IRS raises each year. There is also a housing allowance along with maximum amount (cap) 
per location. The problem for traders is that an IRS publication states capital gains and 
trading gains are not “foreign earned income” so they are likely unable to utilize Section 911 
benefits unless they create officer compensation with a TTS S-Corp. (Our tax attorney sees a 
rationale for a TTS trader with Section 475 ordinary income to qualify for the foreign earned 
income exclusion, without needing S-Corp officer compensation.) 
There is a solution: Traders with trader tax status (TTS) can form a Delaware S-Corp to 
pay officer compensation, and that compensation is foreign earned income. Before 
committing to this solution, compare expected net income tax savings, minus payroll tax 
costs vs. using a foreign tax credit.  
The U.S. has tax treaties with many countries, and these agreements specify which 
country is entitled to collect tax on different types of items, like capital gains and retirement 
plan distributions. Cite a tax treaty provision to override a regular tax on Form 8833. It’s 
important to note that tax treaty provisions are used to reduce tax liability; the IRS may not 
use them to increase a tax. 

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 TCJA changed corporate taxation to a territorial tax system from a worldwide tax regime. 
However, the Act did not convert citizen-based taxation to residence-based taxation for U.S. 
residents living and working abroad. Therefore, present law continues for foreign earned 
income and housing allowance exclusions for U.S. residents abroad. TCJA suspended the 
moving expense deduction starting in 2018.  
The IRS grants U.S. residents living abroad 60 days of additional time for the income tax 
return or extension deadline — June 15 instead of April 15. They can file a Form 4868 
extension by June 15 to extend their tax return to Oct. 15. One caveat: If you owe taxes, the 
IRS charges interest from April 15.  

U.S. RESIDENT TRADERS WITH INTERNATIONAL BROKERAGE ACCOUNTS

Some traders living in the U.S. have a foreign brokerage account. It’s complicated when 
traders open these accounts held in a foreign currency. Counterparties outside the U.S. do 
not issue Form 1099-Bs, and accounting is a challenge. Many foreign banks and brokers 
report U.S. resident’s account activity to the U.S. Treasury and IRS per FATCA (more on this 
later). Traders should separate capital gains and losses, including currency appreciation or 
depreciation, from changes in currency values on cash balances, which are Section 988 
ordinary gain or loss.
Some foreign brokers encourage traders to form foreign entities as a requirement to get 
access or to set up an account. Look before you leap: Tax compliance for an international 
entity is significant, and there are few to no tax advantages for traders. International tax 
compliance is very complex, and there’s a risk of messing up tax reporting. It’s very rare to 
achieve material deferral on foreign income, and there are plenty of tax penalties for 
non-compliance. But all this being said, there are plenty of good reasons to trade foreign 
markets. Just get the right advice beforehand and make sure the reason to do so is 
compelling.  
Foreign countries may withhold income taxes on various types of portfolio income, and 
traders should review income and estate tax treaties for provisions that might apply.  
Some U.S.-based brokers offer access to financial markets outside the U.S., and the broker 
maintains the account in U.S. dollars, making it more convenient for the taxpayer.  

REPORT OF FOREIGN ACCOUNTS

U.S. residents with a foreign bank, brokerage, investment, and another type of account 
(including retirement and insurance in some cases) who meet reporting requirements must 
e-file FinCEN Form 114, Report of Foreign Bank and Financial Account (known previously 
as Foreign Bank Account Reports or “FBAR”). If your foreign bank and financial institution 
accounts combined are under $10,000 for the entire tax year, you fall under the threshold for 
filing FinCEN Form 114 and no filing is required.
Filing due date: A new law enacted on July 31, 2015, changed the due date from June 30 
to April 15 starting with 2016 filings in 2017. Congress added an automatic extension for six 
months to Oct. 15 to coordinate FinCEN Form 114 with individual income tax returns. 
In recent years, we have learned that many taxpayers omitted foreign bank account 
reports when they should have filed them. Many taxpayers just didn’t realize they had a filing 
requirement. Some had financial interest in family accounts offshore if they were foreign 
nationals before moving to the U.S. Or some taxpayers gained the interest by marrying a 

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foreign person. Others may have international retirement or insurance accounts that they 
never realized were subject to FBAR reporting. 
The FBAR rule states “a financial interest in, signature authority or other authority over 
foreign financial accounts.” Traders and executives of hedge funds and other financial 
institutions and trustees typically have signature authority or other authority over foreign 
financial accounts triggering FBAR filings. 
Most taxpayers owning foreign accounts reported their foreign income and were not 
trying to cheat the IRS by hiding it offshore. Because they reported foreign income correctly, 
many are allowed to file a late FBAR and avoid penalties. Otherwise, there is a highly 
complex and nuanced penalty regime in connection with late or incorrect FBAR filings. 

IRS OFFSHORE VOLUNTARY DISCLOSURE PROGRAM

The IRS closed the 2014 IRS Offshore Voluntary Disclosure Program (OVDP) on Sept. 
28, 2018. OVDP encouraged taxpayers to come clean before getting busted by the IRS. The 
OVDP penalties are high (though there are exceptions). It’s not amnesty by any means, and 
it’s an expensive undertaking with tax attorneys and accountants. But if you waited to get 
busted by the IRS, your foreign bank, or anyone else, the penalties are far higher. Criminal 
penalties may apply too unless you joined the program first. On July 1, 2014, the IRS created 
a “streamlined” program for those taxpayers who were negligent in not filing FBARs (but 
did not do so on purpose). U.S. resident taxpayers pay just a 5% penalty with this streamlined 
program. This program closed too.  
While OVDP was a good plan for some (such as tax cheats in potential trouble), it was 
not appropriate for those discussed earlier who reported their income but just missed an 
FBAR filing. 
It’s wise for American taxpayers to turn themselves in before getting busted. It can make 
a significant difference in treatment and penalties.  

FOREIGN RETIREMENT PLANS

Don’t assume international retirement plans are like U.S. pension plans with tax deferral 
on income until you take taxable distributions. For U.S. tax purposes, the IRS considers many 
international retirement plans taxable investment accounts because they aren’t structured as 
qualified plans under Section 401 unless they qualify under Section 402(b) as an employees’ 
trust established by an employer. While that seems unfair and counterintuitive to many, it’s 
the rule, and it catches many unsuspecting taxpayers and accountants off guard. To the 
extent that Section 402(b) does not apply, you may have to pay a high Passive Foreign 
Investment Company (PFIC) tax. Include these retirement plans on the annual FinCEN 
Form 114 each year, whether or not the plan has deferral.
In October 2014, the IRS acknowledged the tax-deferral problem on Canadian retirement 
plans and assisted. In Revenue Procedure 2014-55, the IRS repealed the need for filing a tax 
election, which means Canadian retirement plans automatically qualify for tax deferral. These 
rules are retroactive, so it abates back taxes, interest, and penalties. It’s no longer needed to 
file Form 8891 (U.S. Information Return for Beneficiaries of Certain Canadian Registered 
Retirement Plans). This relief does not apply to international retirement plans outside of 
Canada. 

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FOREIGN ASSETS REPORTED ON FORM 8938
Tax Form 8938 is more about giving the IRS a heads up regarding your international 
assets. It’s not about reporting income and loss — there are other tax forms for that. The 
filing threshold for Form 8938 is materially higher than the FBAR threshold, and it’s even 
higher for Americans living out of the country. (See Form 8938 instructions.) 

U.S. TRADERS MOVE TO PUERTO RICO TO ESCAPE CAPITAL GAINS TAXES

Puerto Rico (PR) is not a U.S. state or foreign country; it’s a U.S. “territory” with its own 
government and tax system. Residents of PR report particular types of income to Puerto 
Rico and other forms of income to the IRS. Trading gains are capital gains on “personal 
property” taxed where the seller’s tax home is, which could be in PR.
PR enacted tax incentive acts that are tailor-made for traders/investors, investment 
managers, and financial institutions. Passed in 2012, PR Act 22 allows investors and traders 
with bona-fide residence in Puerto Rico to exclude from PR and U.S. taxes under Section 
933 100% of all short- and long-term capital gains from the sale of personal property 
accrued after moving there. Personal property includes stocks, bonds, and other financial 
products. Act 22 does not require investment in Puerto Rican stocks and bonds; trades can 
be made with a U.S. broker or on any exchange around the world. This capital gain tax break 
applies to professional traders using the default realization method, or Section 475 MTM. 
There is a different PR tax incentive act for investment managers, who charge advisory 
fees. They sell their services to investors outside of PR and hence, they can qualify for PR 
Act 20 tax incentives for “export service businesses.” The Act 20 tax incentive is a 4% flat 
tax rate on net business income. The owner also receives Act 22 100% exclusion on 
dividends received from the PR business entity, and exclusion from U.S. tax, since PR 
residents exclude PR-sourced dividends from U.S. tax. 
A new $5,000 annual PR charity requirement was added to Act 22 in 2017. (For more on 
these 2017 changes, see BDO PR Newsletter: Act 43 & 45 – Amendments To Incentive Acts 
20 & 22 at www.bdopr.com.) 
When Hurricanes Irma and Maria severely damaged PR in September 2017, many newly 
established residents had to evacuate the island. These former U.S. residents were concerned 
they would not meet the required day count in PR for residency due to hurricane damage, 
subjecting them to U.S. taxation on capital gains. There is some relief from the IRS. (See my 
blog How To Protect Puerto Rico Tax Incentives In The Wake Of Hurricanes Irma And 
Maria, https://tinyurl.com/irma-maria-taxes.)  
These PR tax benefits are not easy to arrange. Moreover, the hurricane damages and 
political and economic conditions create uncertainty. Traders and investment managers need 
to move their family and operations to PR to get these tax breaks while they retain the 
benefit of U.S. citizenship with a passport.

RENOUNCING U.S. CITIZENSHIP OR SURRENDERING A GREEN CARD

Some countries have lower tax rates than the U.S. and a few countries exempt capital 
gains from tax. Increasingly, traders, investment managers, and other taxpayers are 
surrendering their U.S. resident status (citizenship or green card), which requires potentially 
paying a Section 877A expatriation tax. The expatriation tax only applies to “covered 
expatriates” who have a net worth of $2 million or five-year average income tax liability 

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exceeding $165,000 (2018 Form 8854). The IRS assesses the expatriation tax on unrealized 
capital gains on all assets — fair market value less cost-basis including debt — on the 
expatriation date. Only the net amount over $600,000 is taxable. Deferred compensation and 
IRAs are included and taxable, too.
While the expatriation tax is likely to take a big tax bite out of the wealthy, it won’t apply 
to the majority of online traders who may not have significant unrealized net gains and who 
are not covered expatriates. There are other tax issues to consider including U.S. real 
property and estate planning in connection with beneficiaries residing in the U.S. Learn more 
about the expatriation tax on IRS 2018 Form 8854. There’s an election to defer tax, and 
regular income tax rates apply 

NON-RESIDENT ALIENS ARE OPENING U.S. BROKERAGE ACCOUNTS

The U.S. stock markets have been stellar, and many non-U.S. persons have been accessing 
them from their home country. Other foreign individuals and entities prefer to open 
U.S.-based brokerage accounts for lower commissions, and better trading platforms. 
In either case, the foreign individual or company is subject to U.S. tax withholding on U.S. 
dividends and certain other U.S. passive income. The default withholding tax rate is 30%, 
and income tax treaties provide for lower rates, usually around 15% or less. U.S. brokers 
handle this tax withholding and pay those taxes to the IRS. The foreign investor does not 
have an obligation for U.S. tax compliance if withholding is done correctly. 
The critical point is that capital gains are not taxable in the U.S. if the nonresident alien 
does not spend more than 183 days per year in the U.S. Most active traders don’t generate 
significant dividend income paid by U.S. companies, so tax withholding is not a problem. 
Many of them get a foreign tax credit for U.S. tax withholding in their resident country. 
Some nonresident aliens establish a spousal-member LLC in the U.S. and file a U.S. 
partnership tax return. The LLC/partnership opens a U.S.-based brokerage account as a 
domestic entity. The LLC files a W-9 with a U.S. tax identification number. The broker treats 
the U.S. LLC/partnership as a U.S. account, which means the broker does not handle the tax 
withholding on dividends and other passive income for the foreign owners of the LLC. 
Therefore, the nonresident alien owners must file a W-8BEN with the U.S. partnership. The 
U.S. partnership assumes responsibility for tax withholding on dividends and other portfolio 
income, and payment of those taxes to the IRS on a timely basis. It’s extra tax compliance 
work, but it’s not too complicated. 
U.S. estate tax might come into play. Estate tax treaties may exempt brokerage accounts 
for nonresident aliens or provide higher exemptions from the tax. U.S. partnership interests 
are likely not includible in an estate for a nonresident alien. Brokers are not responsible for 
estate tax compliance, so it’s a tax matter for nonresident aliens and their tax advisors. 
Brokers require a conclusion of IRS estate proceedings before releasing assets from the 
account of the deceased. 
Nonresident alien U.S. income tax treatment. In this scenario, nonresident aliens are 
subject to U.S. tax withholding on dividends paid by U.S. companies and on other “fixed or 
determinable, annual, or periodic” (FDAP) income. Per IRS Taxation of Nonresident Aliens 
(at www.irs.gov): “FDAP income is passive income such as interest, dividends, rents or 
royalties. This income is taxed at a flat 30% rate unless a tax treaty specifies a lower rate.” 

104 
 Many countries have a tax treaty with the U.S. providing for 15% or lower withholding tax 
rate on FDAP income. Interest income on bonds and commercial paper issued by U.S. 
companies, by the U.S. Treasury, and by U.S. government agencies is generally exempt from 
U.S. tax withholding, although it’s reportable on Form 1042-S. 
Nonresident alien individuals fill out W-8BEN (Certificate of Foreign Status of Beneficial 
Owner for United States Tax Withholding and Reporting – Individuals) and furnish it to the 
broker. Don’t overlook Part II to claim tax treaty benefits. The broker then withholds taxes 
on U.S.-source dividends and other FDAP income at the appropriate tax treaty rates, or 30% 
if there is no tax treaty, and pays those taxes to the IRS directly. As a withholding agent, the 
broker is required to report all U.S.-source FDAP to the IRS and the client on Form 1042-S. 
There are other types of W-8 forms including W-8BEN-E (entities), W-8ECI (ECI from U.S. 
business), W-8EXP (foreign government or organization), and W-8IMY (foreign 
intermediary or branch). 
Capital gains 183-day rule. If the nonresident alien spends more than 183 days in the 
U.S., he owes taxes on net U.S. source capital gains, even though he may not trigger U.S. 
residency under the substantial presence test. (U.S. residency is triggered with legal residence 
status or by meeting the substantial presence test. The IRS taxes U.S. residents on worldwide 
income.) 
See IRS The Taxation of Capital Gains of Nonresident Alien Students, Scholars and 
Employees of Foreign Governments (at www.irs.gov):  
“Nonresident alien students and scholars and alien employees of foreign governments 
and international organizations who, at the time of their arrival in the United States, intend 
to reside in the United States for longer than one year are subject to the 30 percent taxation 
on their capital gains during any tax year (usually calendar year) in which they are present in 
the United States for 183 days or more, unless a tax treaty provides for a lesser rate of 
taxation. These capital gains would be reported on page 4 (not page 1) of Form 1040NR and 
would not be reported on a Schedule D because they are being taxed at a flat rate of 30 
percent or at a reduced flat rate under a tax treaty.” (Learn more in my blog post How To 
Save U.S. Taxes For Nonresident Aliens, https://tinyurl.com/gtt-nonresident-aliens, and 
Webinar recording How Non-U.S. Residents Save U.S. Taxes On U.S. Brokerage Accounts, 
https://tinyurl.com/webinar-nonresident-aliens.) 

FOREIGN ACCOUNT TAXPAYER COMPLIANCE ACT

Foreign Account Taxpayer Compliance Act (FATCA) regulations went into effect in July 
2014. The IRS and U.S. Treasury are intimidating foreign banks into reporting their 
American clients — even in countries like Switzerland known for bank secrecy. 
FATCA penalizes foreign banks and brokers for not helping with tax compliance on U.S. 
citizens and residents. The FATCA rules are so onerous, tedious, and costly to comply with 
that many smaller foreign banks and brokers now refuse to do business with Americans; it’s 
just not worth the burden and risk. Some of these brokers ask their U.S. clients to form 
offshore entities as a means of navigating around FATCA, but that often doesn’t work, and it 
can wind up being a huge problem for U.S. taxpayers. FATCA is highly controversial in this 
regard and Congress may water it down in the future.  
Some countries appreciate the reciprocal exchange of tax information. 

105 
FOREIGN-BASED FOREX BROKERS/BANKS
CFTC rules require foreign forex brokers and banks to be registered with the National 
Futures Association (NFA) and U.S. bank regulator, respectively, if they want to handle 
American retail customers. These CFTC rules limit allowable leverage to 50:1 on major 
currencies and 20:1 on minor currencies. These CFTC rules don’t apply to U.S. “eligible 
contract participants” (ECP) meeting those high net worth thresholds. 
The NFA “hedging rule” requires “First In, First Out” only, which disallows hedging or 
“spread betting.”  
These U.S. rules have upset many forex traders with their trading programs, and they’ve 
considered all possible angles for working with offshore forex brokers or banks. CFTC rules 
don’t apply directly to customers, but rather to forex brokers. It might not be safe doing 
business with an unregistered foreign forex broker who might become subject to CFTC 
enforcement actions. Offshore companies don’t help evade these rules according to a CFTC 
enforcement attorney. 
   

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Chapter 15 
 
Obamacare Individual Mandate & 
NIT 

The 2012 Patient Protection and Affordable Care Act (ACA or Obamacare) has two tax 
matters that affect traders: the health insurance mandate for individuals and the 3.8% Net 
Investment Income Tax (NIT) on upper income individuals and trusts. 

INDIVIDUAL HEALTH INSURANCE MANDATE

The individual health insurance mandate took effect in 2014, and many taxpayers 
continue to face confusion over penalties, exemptions, premium tax credits, and claw backs 
of subsidies (advanced credits). 
Those who received premium subsidies through an Obamacare marketplace or exchange 
in 2019 and 2020 must file a Form 8962 to calculate a premium tax credit or a tax liability. 
Taxpayers who did not have ACA-compliant health insurance coverage for 2019 and 2020 
(that includes large gaps in coverage) and did not qualify for an exemption will owe a 
shared-responsibility payment (tax penalty) in 2019, but not in 2020.  
For 2018, the ACA shared responsibility payment for non-compliance was $695 per adult 
and $347.50 per child (up to $2,085 for a family), or 2.5% of household income above the 
tax return filing threshold for the filing status — whichever is greater.  
Starting in 2019, TCJA reduced the ACA shared responsibility payment for 
non-compliance to zero. That takes the bite out of the individual mandate for 2019 and 
2020.  
There are Form 1095 ACA information filings including: Forms 1095-A (Health 
Insurance Marketplace Statement), Form 1095-B (Health Coverage), and Form 1095-C 
(Employer-Provided Health Insurance Offer and Coverage). Taxpayers should receive these 
forms and use them when preparing their tax returns. 

NET INVESTMENT INCOME TAX

ACA has many new and different types of taxes to finance the law. One of these tax 
regimes — the “Net Investment Income Tax” (NIT) originally referred to as the “ACA 3.8% 

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Medicare surtax on unearned income” — affected upper-income taxpayers as of Jan. 1, 
2013. It only applies to individuals with net investment income (NII) and modified adjusted 
gross income (AGI) exceeding $200,000 single, $250,000 married filing jointly, or $125,000 
married filing separately. These thresholds are not indexed for inflation. (Modified AGI 
means U.S. residents abroad must add back any foreign earned income exclusion reported on 
Form 2555.) The tax also applies to irrevocable trusts (and estates) on the undistributed NII 
in excess of the dollar amount at which the highest tax bracket for trusts begins.
TCJA did not suspend or modify ACA’s NIT. 

NET INVESTMENT INCOME

Notice the terms “investment income” and “unearned income.” People who receive 
“earned income” from a job pay Social Security tax (on the social security base amount) and 
Medicare on their wages or self-employment income. In general, unearned income includes 
interest, dividends, rents, royalties, capital gains, income and loss from companies in which 
you are passive, and income and loss from pass-through investment and trading companies. 
With ACA’s NIT, this type of income is subject to Medicare taxes, too — albeit at 
upper-income brackets only. 
NII requires segregation of different types of unearned income into three different 
buckets. (Take a look at Form 8960 and the final IRS regulations.)  
NII buckets include the following: 
● Portfolio income (includes interest, dividends, and annuity distributions), royalties 
(net of oil and gas depletion expenses), and rents (net of depreciation); 
● Passive activity income and loss from pass-through entities and investment and 
trading companies; 
● Capital gains net of capital losses. 
NII excludes: 
● Wages and self-employment income;  
● Tax-free municipal bond interest income;  
● IRA and qualified plan distributions; 
● Income from the disposition of, or pass-through from, active (earned-income 
related) LLCs, partnerships and S-corps;  
● Capital gain received from the sale of your company (and you have been active in 
the company);  
● Income from rental real estate; and  
● The “exclusion” portion of a capital gain on the sale of a primary residence. The 
taxable portion above the exclusion amount is included in NII.  

IRS REGULATIONS AND FORM 8960

The IRS released its final regulations for this tax in December 2013 and instructions for 
Form 8960 in early 2014. Earlier proposed regulations disenfranchised traders; they were not 
allowed to deduct trading losses against trading gains due to not being able to combine 
bucket #2 investment/trading company income and loss with bucket #3 capital gains and 
losses. That was very unfair and against the spirit of the tax code, so we mounted a 
successful petition campaign on RallyCongress.com. Thankfully, the final regulations fixed 
this problem for business traders, who now can deduct trading losses against trading gains 

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and even Section 475 MTM ordinary losses against other tax buckets. Otherwise, you’re not 
allowed to apply losses in any of the three buckets in calculating net investment income. 

NIT CALCULATIONS
NIT is assessed on whatever is lower: NII or the AGI amount over the threshold. Here’s 
an example: A single taxpayer has $300,000 AGI, which is $100,000 over the $200,000 
modified AGI threshold for filing single. NII is $125,000 after deducting available trading 
business expenses and certain investment expenses, including stock borrow fees and 
investment-interest expense. (Trading business expenses on Schedule C or E offset 
self-employment income first, and any excess may be deducted against NII.) Since NII is 
higher than the AGI amount over the threshold, NIT is calculated on the lower amount, or 
$100,000 in this example: 3.8% x $100,000 = $3,800 of NIT on Form 8960. If the taxpayer 
had $75,000 NII, then NIT would be calculated on that lower amount instead (3.8% 
x $75,000 = $2,850).  

NII DEDUCTIONS
Starting in 2018, TCJA suspended “certain miscellaneous itemized deductions subject to 
the 2% floor,” including investment fees and expenses. The IRS removed those line items 
from the 2018 and 2019 Schedule A.
Section 1411 regulations for NIT require that a permissible deduction for NII must first 
be allowed elsewhere on an income tax return and investment fees and expense are no 
longer deductible on Schedule A or otherwise. Therefore, it may be best to not deduct 
investment fees and expenses on Form 8960 in determining NII.  
The 2018 and 2019 Form 8960 Part II “Investment Expenses Allocable to Investment 
Income and Modifications” allows line item deductions for investment-interest expenses, 
state, local and foreign income taxes, and miscellaneous investment expenses. The last item, 
miscellaneous investment expenses may include non-2%-floor items like stock borrow fees, 
which are reported on a 2018 and 2019 Schedule A line 16 “other itemized deductions.” 

GOOD NEWS ON TRADING LOSSES

The regulations state: “To minimize the inconsistencies between chapter 1 and Section 
1411 for traders, the final regulations assign all trading gains and trading losses to section 
1411(c)(1)(A)(iii) (bucket 3). The final regulations also permit a taxpayer to deduct excess 
losses from the trading business of a Section 475 trader from other categories of income 
(other buckets). Part 5.C of this preamble describes the treatment of those excess losses.”
Consider the example of a Section 475 MTM trader who arbitrages securities trades 
against interest income. He has interest income in bucket #1 and securities trading gains and 
losses in bucket #3. With the final regulations, it’s possible to offset bucket #1 interest 
income with net Section 475 MTM ordinary losses in bucket #3.  
Also, a $3,000 capital loss and a passive-activity loss — if allowed for regular tax — are 
allowed against other NII buckets. And the NII components of NOL carryforwards may be 
used against other NII buckets, too. Capital loss carryovers offset current year capital gains 
in the normal way for both income and NIT. 

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MISCELLANEOUS
While the Medicare tax on earned income is 50% tax deductible, it’s not deductible on 
unearned income.
Traders with low income or losses probably appreciate help from ACA in obtaining 
Medicaid or subsidized health insurance on an exchange. If your income is higher than 
projected, you may have to pay back some of the exchange subsidies on Form 8962. If your 
actual income is less than projected, you may qualify for a premium tax credit on Form 8962.  
   

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Chapter 16 
 
Short Selling 

The essence of trading is buying and selling financial products for income. If you think 
the asset will rise in value, buy first and sell afterward — this is what’s known as a “long 
position.” If you want to speculate on it declining in value, borrow the security to sell it first, 
and then buy it back later to close the short position — this is “selling short.” (There are 
other ways to speculate on market drops like buying put options or inverse ETFs, both of 
which are long positions.) 
There are two types of short sales: (1) a short sale and (2) a short sale against the box. 
Both involve borrowing securities from another account holder, arranged by a broker. 

CONSTRUCTIVE SALES ON APPRECIATED POSITIONS

In the old days, owners stored stock certificates in safe deposit boxes. They could borrow 
and sell securities, but not the ones stored in their box — hence the moniker, “short sale 
against the box.” It became a popular tax shelter to defer capital gains taxes.
The Taxpayer Relief Act of 1997 mostly closed the deferral loophole by adding new 
Section 1259 Constructive Sales Treatment For Appreciated Financial Positions. Before these 
changes, a trader could own security A with a large unrealized capital gain and short it 
against the box before year-end to economically freeze the capital gain but defer realization 
of the capital gain until the following year. Exception: A trader can still achieve tax deferral 
on an open short against the box position at year-end if he buys to cover the open short 
position by Jan. 30 and leaves the long position open throughout the 60-day period 
beginning on the date he closes the transaction — so there is an economic risk. 
An example from Pub. 550 Investment Income and Expenses, Short Sales: “On May 7, 
2015, you bought 100 shares of Baker Corporation stock for $1,000. On Sept. 10, 2015, you 
sold short 100 shares of similar Baker stock for $1,600. You made no other transactions 
involving Baker stock for the rest of 2015 and the first 30 days of 2016. Your short sale is 
treated as a constructive sale of an appreciated financial position because a sale of your Baker 
stock on the date of the short sale would have resulted in a gain. You recognize a $600 
short-term capital gain from the constructive sale and your new holding period in the Baker 
stock begins on Sept. 10.” 

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 The constructive sale rules apply on substantially identical properties, which include 
equities, equity options (including put options), futures, and other contracts. For example, 
Apple equity is substantially identical with Apple call and put equity options. Traders use a 
bevy of financial products, and they may inadvertently trigger Section 1259 constructive 
sales. Report gains on constructive sales, not losses. 
Brokers do not report constructive sales on appreciated positions on Form 1099-Bs. 
Traders need to make manual adjustments on Form 8949. We recommend using 
tax-compliant software or a service provider that uses tax-compliant software. 

SHORT-TERM VS. LONG-TERM CAPITAL GAINS AND LOSSES

Most traders understand capital gains rules for long positions. For securities using the 
realization method, a position held for 12 months or less is a short-term capital gain or loss 
subject to marginal ordinary tax rates (up to 37% for 2019 and 2020). A position held for 
more than 12 months is a long-term capital gain with lower capital gains tax rates (up to 20% 
for 2019 and 2020).
According to Pub. 550, “As a general rule, you determine whether you have short-term or 
long-term capital gain or loss on a short sale by the amount of time you actually hold the 
property eventually delivered to the lender to close the short sale.” 
If you sell short without owning substantially identical property (stock or option) in your 
account, the holding period starts when you later buy the position to close the short sale. 
The holding period is one day, so it’s a short-term capital gain or loss. Most investors think 
selling short is the reverse of going long and the holding period should start on the date you 
short the security — but that is not the case. 
Holding period rules are complicated when you short against the box. Special anti-abuse 
rules contained in Section 1233 prevent traders from converting short-term capital gains into 
long-term capital gains and long-term capital losses into short-term capital losses. 

SPECIAL RULES IN IRS PUB 550

Gains and holding period. If you held the substantially identical property for one year or 
less on the date of the short sale, or if you acquired the substantially identical property after 
the short sale and by the date of closing the short sale, then:
● Rule 1. Your gain, if any, when you close the short sale is a short-term capital 
gain, and  
● Rule 2. The holding period of the substantially identical property begins on the 
date of the closing of the short sale or on the date of the sale of this property, 
whichever comes first. 
Losses. If on the short sale date, you held substantially identical property for more than 
one year, any loss you realize on the short sale is a long-term capital loss, even if you held the 
property used to close the sale for one year or less. Certain losses on short sales of stock or 
securities are also subject to wash sale treatment. 

DIVIDENDS AND PAYMENTS IN LIEU OF DIVIDENDS

When traders borrow shares to sell short, they receive dividends that belong to the lender, 
the rightful owner of the shares. After the short seller receives these dividends, the broker 
uses collateral in the seller’s account to remit a “payment in lieu of dividend” to the rightful 

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owner to make the lender square in an economic sense. But there are complications, which 
may lead to higher taxes. 

DIVIDEND ISSUES FOR THE SHORT SELLER

If a short seller holds the position open for 45 days or less, add the payment in lieu of 
dividend to cost basis of the short sale transaction reported on Form 8949 (realization 
method) or Form 4797 (Section 475 MTM method). Watch out for a capital loss limitation. 
Traders with trader tax status (TTS) using Section 475 are not concerned as they have 
ordinary loss treatment. If the position is held open for more than 45 days, payments in lieu 
of dividends are deductible as investment interest expense (reported on Form 4952). Watch 
out, because the current year tax deduction is limited to net investment income, which 
includes portfolio income, minus certain investment expenses including stock borrow fees, 
but not other investment expenses suspended as itemized deductions in TCJA. (See Form 
4952 instructions.) Carry over disallowed investment interest expense to the subsequent tax 
year(s). With itemized deduction limitations, some short sellers come up short on investment 
interest expense deductions. (If a short seller holds the sale open for more than 45 days in 
connection with a TTS business, payments in lieu of dividends are deductible as business 
expenses.) 

DIVIDEND ISSUES FOR THE LENDER

When investors’ sign margin account agreements, few realize they are authorizing their 
broker to lend their shares to short sellers. Instead of issuing the account owner (lender) a 
Form 1099-DIV, which may include ordinary and qualified dividends, the broker issues a 
Form 1099-MISC or similar statement for “Other Income.” The lender forgoes the qualified 
dividends tax break on common stock held at least 60 days. Lower capital gains rates apply 
on qualified dividends.
Lenders report this substitute dividend payment as “Other Income” on 2019 Schedule 1 
(Form 1040). Don’t overlook including substitute dividends in investment income entered 
on Form 4952 used to limit investment interest expense. Some brokers offer to compensate 
lenders for losing the qualified dividend rate. Institutional or large stock lenders may earn 
credit interest on lending out their shares. Substitute dividend income is included in net 
investment income for the ACA net investment tax. 

STOCK BORROW FEES AND LOAN PREMIUMS

Short selling is not free; a trader needs the broker to arrange a loan of stock. Brokers 
charge short sellers “stock borrow fees” or “loan premiums.” Tax research indicates these 
payments are “fees for the temporary use of property.” Watch out: Many brokers refer to 
stock borrow fees as “interest expense,” which confuses short sellers.
For investors, stock borrow fees are “other itemized deductions” on line 16 of the 2019 
Schedule A (Itemized Deductions). For 2017 tax returns, stock borrow fees were reported as 
“other miscellaneous deductions” on line 28 of Schedule A. Instructions for 2017 Schedule 
A line 28 are the same as 2018 and 2019 Schedule A line 16 — they include the same items 
including stock borrow fees. TCJA did not suspend these deductions, whereas, TCJA 
suspended investment fees and investment expenses (i.e., trading expenses without TTS).  
With TTS, stock borrow fees are considered Section 162 business expenses. Stock borrow 
fees are not “interest expense” so investors can’t include them in “investment interest 

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expense” deductions. Stock borrow fees are deductible for net investment income for ACA’s 
net investment tax.  

SUPPORT FOR THIS TAX POSITION

According to New York City tax attorney Roger D. Lorence: “Short sale expenses (stock 
borrow fees) are not investment interest expense. To support any interest deduction, there 
must be a valid interest-bearing obligation under state or federal law. (See Stroud v. U.S.) The 
IRS has ruled that short sales do not give rise to an interest-bearing indebtedness (Revenue 
Ruling 95-8, 1995-1 CB 107). Rather, the short sale borrower has a liability under state law to 
return the borrowed stock and pay fees, but this is not interest expense. This is why short 
sales do not give rise to Section 514 UBIT (no debt-financed property), which is the specific 
code section in issue in the ruling. The revenue ruling is based on Deputy v. du Pont. The du 
Pont case applies by analogy here because there can be no interest expense generated in a 
short sale.” 

EASY VS. HARD TO BORROW FEES

Very liquid securities are “easy to borrow,” and many brokers charge small fees to short 
sellers for lending out those shares. Non-liquid securities are “hard-to-borrow” and brokers 
update their “hard to borrow lists.” Brokers charge higher “hard to borrow fees,” and most 
publish those rates with sample calculations on their websites. Hard to borrow fee rates rise 
as demand for shorting increases. A few brokers specialize in finding very hard to borrow 
stocks, and they charge “up front borrow fees” in addition to hard to borrow fees 

BROKERS CONFLATE STOCK BORROW FEES WITH INTEREST EXPENSES

There is a lack of clarity in separating stock borrow fees from interest expenses. The 
distinction matters since borrow fees are “other itemized deductions,” whereas interest is an 
investment interest expense.
I wonder if some brokers prefer using the term interest expense since customers may find 
that more logical with borrowing shares under securities lending agreements. Customers may 
also object to paying significant fees. 
For example, one leading online broker calls the “interest rate charged on borrowed 
shares” a “fee rate” and also “net short stock interest.” This broker does not report the fees 
on Form 1099. 
A few other online brokers mention interest on shorted shares as a “fee rate.” They 
report “miscellaneous non-reportable deductions” on Form 1099; not interest expense. 
One of the largest online brokers states on its website: “When you borrow the shares, you 
pay interest to the brokerage house for this loan, and the harder the shares are to find, the 
higher the interest rate.” I called customer support, and a support person admitted it’s a 
stock borrowing fee and not interest expense. 
It would be helpful if brokers cleaned up their language to be clear about stock borrow 
fees vs. interest expense. 

ACTIVE TRADERS USING SECTION 475 HAVE IT EASY

Active traders qualifying for trader tax status with a Section 475 election have an easy 
time reporting short-sale trades and related expenses, and they maximize tax advantages. 
They are unaffected by special rules for short sales for constructive sales on appreciated 

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positions and holding period rules. (Section 475 exempts traders from the $3,000 capital loss 
limitation against other income, wash-sale losses, and short sale adjustments.)
With Section 475 mark-to-market accounting, traders impute sales at year-end on open 
positions. That negates the need to make “constructive sales on appreciated positions” from 
selling short against the box. Short-term vs. long-term holding periods are not an issue with 
Section 475. TTS unlocks Section 162 business expense treatment, so expenses related to 
selling short (including stock borrow fees and interest expense) are deductible from gross 
income. Sole proprietors use Schedule C for reporting business expenses.  
   

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Chapter 17 
 
Tax Cuts and Jobs Act 

The 2017 Tax Cuts and Jobs Act (TCJA) impacts investors, traders, and individuals in 
both positive and negative ways, beginning in tax-year 2018. In this chapter, I explore TCJA’s 
impact on these groups.  

INVESTORS
TCJA suspends “certain miscellaneous itemized deductions that are subject to the 
two-percent floor under present law.” These include investment fees and certain investment 
expenses, unreimbursed employee business expenses (job expenses), and tax compliance fees 
for non-business taxpayers.  
Suspended investment expenses include trading expenses when the trader is not eligible 
for trader tax status (TTS), and investment advisory fees and expenses paid to investment 
managers. A few investment expenses remain itemized deductions, including stock borrow 
fees as “other itemized deductions,” and investment-interest expenses. TTS traders have 
business expense treatment, so qualification for that status is essential in 2018 and 2019 to 
receive a tax benefit for trading-related expenses.  
Suspended investment expenses are also not deductible for ACA’s net investment tax. 
Retirement plans, including IRAs, are entitled to deduct investment expenses, although it 
may be difficult to arrange with the custodian. 
Family offices. A family office (FO) refers to a wealthy family with substantial 
investments, across multiple asset classes. The FO hires staff, leases office space, and 
purchases computers and other fixed assets for its investment operations. An FO produces 
investment income, and the majority of its operating costs are investment expenses. 
Potentially losing the investment expense deduction comes as a shock to them. Some FOs 
are evaluating which activities might qualify for business expense treatment to convert 
non-deductible investment expenses into business deductions from gross income. Some FOs 
investing in securities and Section 1256 contracts might ring-fence an active trading program 
into a separate TTS entity for business expenses. Some of them are not natural TTS traders, 
so it will be a challenge. Other FOs invest in rental real estate and venture capital, which 
might have business expense treatment. The goal is to allocate general and administrative 

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expenses to business expenses. Some family offices have outside clients, other than family 
members, and their management company passes IRS muster for business expense 
treatment.  
A trader without TTS cannot merely form a dual-entity structure including a trading 
partnership and S-Corp management company and expect the management company to be a 
family office with business expense treatment. It won't work because the trader is managing 
his own money and there are no outside clients. (See my blog How To Avoid IRS Challenge 
On Your Family Office, https://tinyurl.com/gtt-family.)  
Investment interest expenses retained. TCJA did not suspend or modify investment 
interest expense on Schedule A. Investment interest expense remains deductible up to the 
extent of investment income, which is net of allowable investment expenses (i.e., stock 
borrow fees). The excess is carried over to the subsequent tax year. (See 2018 Form 4952 
and instructions.) 
Short seller. If a short seller does not qualify for TTS, the stock borrow fees are 
considered “other itemized deductions” on line 16 of the 2018 Schedule A. Line 16 
corresponds with the 2017 Schedule A line 28 “other miscellaneous deductions,” which were 
not suspended by TCJA. (Some brokers use the term “interest charges” — in reality, these 
expenses are stock borrow fees. See Chapter 16.)
Business interest expense modified. On Nov. 26, 2018, the IRS and Treasury issued 
proposed regulations (REG-106089-18) for TCJA’s new business interest limitation in 
Section 163(j). The IRS just released new tax form 8990. Business interest expense is limited 
to the sum of 30% of adjusted taxable income, business interest income, and floor plan 
financing interest. The excess amount carries over indefinitely to subsequent tax years.  
TTS traders have business interest expense treatment deducted from gross income. 
Investors have investment-interest expense treatment, which is an itemized deduction limited 
to investment income, with the excess carried over.  
The proposed regulation states, “A small business taxpayer, other than a tax shelter, is not 
subject to this Section 163(j) limitation if the taxpayer’s average annual gross receipts are $25 
million or less for the three taxable years immediately preceding the current year.” 
When TCJA passed, we figured most TTS traders wouldn’t have a business interest 
limitation because they wouldn’t exceed $25 million per year in net trading gains — the 
equivalent of gross receipts for a TTS trader. More substantial TTS hedge funds certainly 
could reach that threshold.  
After seeing the proposed regulations and reading what other tax writers had to say about 
it, we wondered if the IRS might seek to treat trading proceeds as gross receipts. That would 
snag many smaller TTS traders. For example, a TTS trader with gross trading proceeds over 
$25 million and a net trading loss would have zero business expense after the 30% income 
limitation.  
The gross receipts test should look to net trading gains, not gross proceeds on the sale of 
capital assets. TTS traders don’t have gross receipts from business operations. TTS traders 
use Section 162 for business expenses only, and capital gains and losses or Section 475 
ordinary income or loss on the sale of capital assets.  
Section 163(j) says to use the definition of “gross receipts” contained in Section 448, and 
the code does not include gross proceeds from the sale of securities. TCJA law and Section 
163(j) regs do not include trading proceeds in gross receipts, either. In all other ways that we 

117 
have addressed gross receipts before on the federal or state level, we have used net trading 
gains as gross margin, which corresponds with gross receipts.  
The answer is in Treasury Reg. 1.448-1T(f)(2)(iv)(A), which supports my view that net 
trading gains equates to gross receipts for a TTS trader: “Gross receipts are not reduced by 
cost of goods sold or by the cost of property sold if such property is described in section 
1221(1), (3), (4) or (5). With respect to sales of capital assets as defined in section 1221, or 
sales of property described in 1221(2) (relating to property used in a trade or business), gross 
receipts shall be reduced by the taxpayer’s adjusted basis in such property.” 
A TTS hedge fund has business interest expense for active owners and 
investment-interest expense for non-active owners. Section 163(j) applies to the partnership 
level.  
Carried interest modified. TCJA modified the carried interest tax break for investment 
managers in investment partnerships, lengthening their holding period on profit allocation of 
long-term capital gains (LTCG) to three years from one year. If the manager also invests 
capital in the investment partnership, he or she has LTCG after one year on that interest. 
The three-year rule only applies to the investment manager’s profit allocation — carried 
interest. Investors still have LTCG based on one year. Investment partnerships include hedge 
funds, commodity pools, private equity funds and real estate partnerships. Many hedge funds 
don’t hold securities for more than three years, whereas, private equity, real estate 
partnerships and venture capital funds do. 
Investors also benefit from carried interest in investment partnerships. Had the new tax 
law repealed carried interest outright, investment partnerships without TTS would be stuck 
passing investment advisory fees (incentive fees) through on Schedule K-1 as suspended 
investment fees and expenses. Carried interest fixes that: The partnership allocates capital 
gains to the investment manager instead of paying incentive fees. The investor winds up with 
a lower capital gain amount vs. a higher capital gain coupled with a suspended investment 
expense. For example, if the investor’s share of net income is $80,000, he or she is happy to 
report $80,000 as a net capital gain. Without carried interest, the investor would report a 
$100,000 capital gain and have a $20,000 (20%) suspended investment fee. 
Long-term capital gains rates retained. TCJA maintains the LTCG rates of 0%, 
15%, and 20%, and the capital gains brackets are almost the same for 2018 and 2019. LTCG 
rates apply if an investor holds a security for more than 12 months before sale or exchange. 
TCJA did not change the small $3,000 capital loss limitation against other income, or capital 
loss carryovers to subsequent tax years. TCJA also retains LTCG rates on qualified 
dividends. 
60/40 capital gains rates retained. The 60/40 capital gains rates on Section 1256 
contracts are intact, and TCJA did not change the Section 1256 loss carryback election. At 
the maximum tax bracket for 2018 and 2019, the blended 60/40 rate is 26.8% — 10.2% 
lower than the top ordinary rate of 37%. 
Wash-sale loss rules and Section 475. TCJA did not fix wash sale loss rules for 
securities. For more on this lingering issue, see Chapter 4. TCJA does not make any changes 
to Section 475 MTM ordinary income or loss. It does not change tax treatment for various 
financial products including spot forex in Section 988, ETFs, ETNs, volatility options, 
precious metals, swap contracts, foreign futures, and more. 

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C-CORPS
When taking into account TCJA, don’t focus solely on the federal 21% flat tax rate on the 
C-Corp level. There are plenty of other taxes, including capital gains taxes on qualified 
dividends, state corporate taxes in 44 states, and accumulated earnings tax assessed on excess 
retained earnings. 
When a C-Corp pays qualified dividends to the owner, double taxation occurs with capital 
gains taxes on the individual level (capital gains rates are 0%, 15%, or 20%). If an owner 
avoids paying sufficient qualified dividends, the IRS is entitled to assess a 20% accumulated 
earnings tax (AET). It’s a fallacy that owners can’t retain all earnings inside the C-Corp. 
Traders face difficulties in creating a war chest plan for justifying accumulated earnings and 
profits to the IRS. (See our blog post How To Decide If A C-Corp Is Right For Your 
Trading Business, https://tinyurl.com/c-corp-trading.) 

INDIVIDUALS
The individual tax cuts are temporary through 2025, which applies to most provisions, 
including the suspension of certain investment expenses.  
There are new tax reform bills (2.0) making their way through Congress, which would 
make the individual tax changes permanent, make some minor corrections, and 
modifications to TCJA.  
TCJA brings forth a mix of changes for individuals. The highlights for 2018 limits 
include: 
● Lower tax rates in all seven brackets to 10%, 12%, 22%, 24%, 32%, 35%, and 
37%; four tax brackets for estates and trusts: 10%, 24%, 35%, and 37%; 
● Standard deduction raised to $24,000 married, $18,000 head-of-household, and 
$12,000 for all other taxpayers, adjusted for inflation; 
● An expanded AMT exemption to $109,400 married and $70,300 single. 
● Many itemized deductions and AGI deductions suspended or trimmed (more on 
this later); 
● Mortgage debt was lowered on new loans; 
● Personal exemptions suspended; 
● Child tax credit increased; 
● New 20% deduction for pass-through income with many limitations; 
● Pease itemized deduction limitation suspended; 
● ACA shared responsibility payment lowered to zero for non-compliance with the 
individual mandate starting in 2019; 
● Children’s income no longer taxed at the parent’s rate; kids must file tax returns to 
report earned income, and unearned income is subject to tax using the tax 
brackets for trusts and estates. 
SALT capped at $10,000 per year. The most contentious deduction modification is to 
state and local taxes (SALT). After intense deliberations, conferees capped the SALT 
itemized deduction at $10,000 per year ($5,000 for married filing jointly). TCJA allows any 
combination of state and local income, sales, real estate taxes, or domestic property tax. 
SALT may not include foreign real property taxes. 

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 TCJA prohibited a 2017 itemized deduction for the prepayment of 2018 estimated state 
and local income taxes. Individuals were entitled to pay and deduct 2017 state and local 
income taxes by year-end 2017. 
TCJA permits a 2018 itemized deduction for the advance payment of 2019 real property 
taxes, providing the city or town assessed the taxes before 2019. For example, a taxpayer 
could pay real property taxes before Dec. 31, 2018, and deduct it in 2018, on an assessment 
for the fiscal year July 1, 2018, to June 30, 2019. These IRS rules are similar for all prepaid 
items for cash basis taxpayers. (See IRS Advisory: Prepaid Real Property Taxes May Be 
Deductible in 2017 if Assessed and Paid in 2017.) 
Many business owners deduct home-office (HO) expenses, which include real estate taxes 
and that allocation is not subject to the $10,000 SALT limit. Here’s a tip: To maximize the 
HO deduction on Form 8829, enter real estate taxes from Schedule A on line 11, and 
“excess real estate taxes” not subject to the SALT limitation on line 17.  
When you factor in a more substantial standard deduction for 2019, and how AMT 
trimmed the state tax deduction for prior years, many individuals may not lose as much of 
their SALT deduction as they fear. With lower individual tax rates, they might still end up 
with an overall tax cut. 
TCJA does not permit a pass-through business owner to allocate SALT to the business 
tax return. For example, an S-Corp cannot reimburse its owner for his or her individual state 
and local income taxes paid in connection with that pass-through income. 
Medical expenses modified. TCJA retained the medical-expense itemized deduction, 
which is allowed if it’s more than the AGI threshold. In 2017, the AGI threshold was 10% 
for taxpayers under age 65, and 7.5% for age 65 or older. TCJA uses a 7.5% AGI threshold 
for all taxpayers in 2018, and a 10% threshold for all taxpayers starting in 2019.  
Mortgage debt lowered on new loans. As of Dec. 15, 2017, new acquisition 
indebtedness is limited to $750,000 ($375,000 in the case of married taxpayers filing 
separately), down from $1 million, on a primary residence and second home. Mortgage debt 
incurred before Dec. 15, 2017 is subject to the grandfathered $1 million limit ($500,000 in 
the case of married taxpayers filing separately). If a taxpayer has a binding written contract to 
purchase a home before Dec. 15, 2017 and to close by Jan. 1, 2018, he or she is 
grandfathered under the previous limit. Refinancing debt from before Dec. 15, 2017 keeps 
the grandfathered limit providing the mortgage is not increased. 
Per the IRS site, “TCJA suspends the deduction for interest paid on home equity loans 
and lines of credit, unless they are used to buy, build or substantially improve the taxpayer’s 
home that secures the loan.” Home equity loans must fit within the overall mortgage limits 
above.  
If deducting home office expenses, enter “excess mortgage interest” on Form 8829 line 
16. The mortgage debt limit only applies to Schedule A itemized deductions.  

SUSPENDED DEDUCTIONS
Unreimbursed employee business expenses. TCJA suspends unreimbursed employee 
business expenses (job expenses) deducted on Form 2106 — there is no Form 2106 for 
2018. Speak with your employer about implementing an accountable reimbursement plan 
and “use it or lose it” before year-end 2019.  

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 Tax prep and planning fees. TCJA suspended tax compliance (planning and 
preparation) fees as itemized deductions. If you operate a business, ask your accountant to 
break down their invoices into individual vs. business costs. The business portion is allowed 
as a business expense. 
Miscellaneous itemized deductions. TCJA suspended “certain miscellaneous itemized 
deductions subject to the two-percent floor” in the Joint Explanatory Statement p. 95-98. 
Here are the highlights of suspended deductions.  
Expenses for the production or collection of income: 
● Clerical help and office rent in caring for investments; 
● Depreciation on home computers used for investments; 
● Fees to collect interest and dividends; 
● Indirect miscellaneous deductions from pass-through entities; 
● Investment fees and expenses; 
● Loss on deposits in an insolvent or bankrupt financial institution; 
● Loss on traditional IRAs or Roth IRAs, when all amounts have been distributed; 
● Trustee’s fees for an IRA, if separately billed and paid. 
Unreimbursed expenses attributable to the trade or business of being an employee: 
● Business bad debt of an employee; 
● Business liability insurance premiums; 
● Damages paid to a former employer for breach of an employment contract; 
● Depreciation on a computer a taxpayer’s employer requires him to use in his 
work; 
● Dues to professional societies; 
● Educator expenses; 
● Home office or part of a taxpayer’s home used regularly and exclusively in the 
taxpayer’s work; 
● Job search expenses in the taxpayer’s present occupation; 
● Legal fees related to the taxpayer’s job; 
● Licenses and regulatory fees; 
● Malpractice insurance premiums; 
● Medical examinations required by an employer. 
Occupational taxes: 
● Research expenses of a college professor; 
● Subscriptions to professional journals and trade magazines related to the 
taxpayer’s work; 
● Tools and supplies used in the taxpayer’s work; 
● Purchase of travel, transportation, meals, entertainment, gifts, and local lodging 
related to the taxpayer’s work; 
● Union dues and expenses; 
● Work clothes and uniforms if required and not suitable for everyday use; 
● Work-related education. 
Other miscellaneous itemized deductions subject to the 2% floor include: 
● The share of deductible investment expenses from pass-through entities. 
Personal casualty and theft losses suspended. TCJA suspends the personal casualty 
and theft loss itemized deduction, except for losses incurred in a federally declared disaster. 

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If a taxpayer has a personal casualty gains, he or she may apply the loss against the gain. If 
deducting home office expenses,, enter “excess casualty losses” on Form 8829, line 29.  
Gambling loss limitation modified. TCJA added professional gambling expenses to 
gambling losses in applying the limit against gambling winnings. Professional gamblers may 
no longer deduct expenses more than net winnings. 
Alimony deduction. TCJA suspends alimony deductions for divorce or separation 
agreements executed in 2019, and subsequent years, and the recipient does not have taxable 
income. 
Moving expenses. Starting in 2018, TCJA suspends the AGI deduction for moving 
expenses, and employees may no longer exclude moving expense reimbursements, either. 
“Except for members of the Armed Forces on active duty who move pursuant to a military 
order and incident to a permanent change of station.” 

MORE TCJA CHANGES

20% QBI deduction. TCJA states, “An individual taxpayer generally may deduct 20 
percent of qualified business income from a partnership, S-corporation, or sole 
proprietorship, as well as 20 percent of aggregate qualified REIT dividends, qualified 
cooperative dividends, and qualified publicly traded partnership income. Special rules apply 
to specified agricultural or horticultural cooperatives. A limitation based on W-2 wages paid 
is phased in above a threshold amount of taxable income. A disallowance of the deduction 
with respect to specified service trades or businesses is also phased-in above the threshold 
amount of taxable income.” 
QBI includes Section 475 ordinary income and loss, and trading business expenses. QBI 
excludes capital gains and losses, Section 988 forex and swap ordinary income and loss, 
dividends and interest income. 199A regulations state that a TTS trading business is a 
specified service activity, so the taxable income cap of $415,000 married/$207,500 other 
taxpayers apply for allowing a QBI deduction. The QBI deduction has a phase-out range 
below the income cap of $100,000 married and $50,000 other taxpayers. There is also a 50% 
W-2 wage and property limitation in the phase-out range. However, Section 864 might deny 
QBI treatment to traders. (Stay tuned for updates on my blog.) 
Ordinary tax rates reduced. TCJA lowered tax rates on ordinary income for individuals 
for almost all tax brackets and filing status. It decreased the top rate to 37% in 2018 and 
2019, from 39.6% in 2017. Short-term capital gains are taxed at ordinary rates, so investors 
receive this benefit. 
Filing status equalization. TCJA fixed several inequities in filing status, including the 
tax brackets by making single, married-filing jointly (MFJ), and married-filing separately 
(MFS) brackets equivalent, except for divergence at the top rate of 37% for single filers, 
retaining some of the marriage penalty. See the 2019 tax brackets: MFS brackets are exactly 
half the MFJ brackets throughout all the rates, so MFS filers are not penalized on rates. 
Filing separately could unlock a QBI deduction.  
Repeal of recharacterization for Roth IRA conversions. If a 2017 converted Roth 
account dropped significantly in value in 2018, a taxpayer could have reversed the Roth 
conversion with a “recharacterization” by the due date of the tax return including extensions 
(Oct. 15, 2018). That option is no more; TCJA repealed it starting with 2018 Roth IRA 
conversions. 

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 Charitable contribution deduction limitation increased. TCJA raised the 50% 
limitation of AGI for cash contributions to public charities, and certain private foundations 
to 60%. Excess contributions can be carried forward for five years. 
TCJA retained charitable contributions as an itemized deduction. But, with the 
suspension of SALT over the $10,000 cap and certain miscellaneous itemized deductions 
subject to the 2% floor, many taxpayers are expected not to itemize. Some taxpayers won’t 
feel the deduction effect from making charitable contributions.  
Consider a bunching strategy, to double up on charity one year to itemize, and contribute 
less the next year to use the standard deduction. Another bunching strategy is to set up a 
charitable trust. 
Per TCJA, retirees who must take required minimum distributions by age 70½ should 
consider “qualified charitable distributions” (QCD). That satisfies the RMD rule with the 
equivalent of an offsetting charitable deduction, allowing you to take the standard deduction 
rather than itemize. 
Expanded use of 529 account funds. TCJA significantly expanded the permitted use of 
Section 529 education savings account funds. “Qualified higher education expenses” include 

 
tuition at an elementary or secondary public, private, or religious school. (Check with your 
state.)
 

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