Among its objectives, President Trump’s tax proposal is supposed to simplify tax reporting for the majority of Americans while at the same time creating more favorable tax conditions for business activity – including the business of trading. And while the tax benefits of managing a trading business have always been excellent, they appear to be getting much better in the new Trump tax proposal.
The average taxpayer will see this in 2018. Many of the standard deductions from your itemized tax statement are gone – sad for itemized deduction filers. Instead, the IRS has significantly raised the standardized deduction – and for approximately 90 percent of taxpayers, the newly standardized deduction will be better than the “old itemized” deductions.
And what about the need for a simpler filing system? Consider one trader at the Apiary Fund who processed $328,140,000 in trades in 2017. Imagine the complexity of filing Form 8949 - Sales and Other Disposition of Capital Assets. An investor would have to download every trade into a spreadsheet, print it off, pack it up and ship it to the IRS in order to fulfill the filing obligations.
Currently, Form 8949 is the form used by the IRS to collect information about a taxpayer's investment activity. It includes a report of all the proceeds, cost basis, wash sale loss, adjustments, holding period and capital gain or loss (short or long-term) for the year. And for active traders like those at Apiary, it’s Kafkaesque in an epic way.
While most people who derive income from investing are considered investors for tax purposes, there is another, lesser known, tax designation that is much friendlier to traders (people who make a business of investing). Section 475 of the IRS code allows a trader to obtain an exemption for investment income if the income is your business. Robert Green, CEO of Green Trader Tax, coined the term “trader tax status” and it can make the above scenario a much simpler process, and it provides significant advantages to the more common “investor tax status.”
Laws governing Internal Revenue Service allows for an exemption from capital loss limitations and wash-sale adjustments, allows more straightforward accounting reporting, opens up a slew of deductions for a business expense and even allows employees of a trading business (you) a benefit plan and lets you exempt payments for health insurance from your trading profits. It is called a 475 election, and in short, it gives traders greater flexibility in managing tax liability by allowing you to write off more expenses, better control income and have fewer limitations than the typical investor.
The 475 election can be made by either an individual or business. However, the evidence for justifying the election is strengthened when your trading activity is managed in a legally operating trading entity.
But what about all those itemized deductions we currently enjoy? We’re all sad to see them go – unless you happen to own a trading business. Qualifying trading business may still be able to deduct many expenses to offset taxable income. Some of these include:
- Home office expense
- Phone, internet, and other office expenses.
- Computers and equipment
- Depreciation of assets.
- Costs related to trading (Data, software, etc.)
- Educational, mentoring and seminars
- Travel expense
- Health Insurance premiums
- Retirement & employee benefit plans
This is just a sampling of what you might be able to expense in a trading business. The exciting news for traders is that they get the best of both worlds. More straightforward filing and more significant deductions as an individual and you get to retain many of the deductions you enjoyed through itemizing your tax return and more in your trading business.
Here is the icing on the cake. The new Trump tax plan significantly lowers the maximum tax rate for income generated through a pass-through entity such as LLC’s, and S-corps. In previous years these entities passed income (after expenses) through the entity directly to the owner(s) who claimed the income on their tax bills. The maximum tax rate before the Trump tax plan was 39.6 percent. Under the new tax plan, income from your trading business may be deducted on your tax returns.
For example, if you have $100,000 of personal income for the year and your trading business generated another $100,000 of income (after expenses), then your gross income would be $200,000. A portion of your trading income, say 25 percent or $25,000, could be deducted from your total income reducing your income on your statement to $175,000. Policymakers recognized the potential abuse in this area of the tax bill so they are still working on rates, rules, and limitations on how this will ultimately work. Stay tuned for updates and discuss it with your tax advisor for your situation.
A word of caution, before you run out and set up your new trading business. There are no specific designations or rules spelled out in tax code for traders to qualify for “trader tax status.” In tax-speak, that means there are no bright line tests to say with surety that you qualify for the preferential tax treatment as a trading business. Tax experts tend to agree that to qualify you need to meet the following requirements as per IRS Publication 550, “Special Rules for Traders.”
1. Taxpayers’ trading activity must be substantial, regular, frequent and continuous.
2. Taxpayers must seek to catch the swings in the daily market movements and profit from these short-term changes rather than profiting from the long-term holding of investments.
In the right situation, it’s worth considering setting up a trading business entity and start building your case for qualifying for trader tax status. Traders who are eligible for a funded account at Apiary Fund are required to enter a contractual relationship between two established business before trading the fund. One of the many reasons Apiary requires the contract is to help strengthen the case for our traders to establish their trader tax status – possibly giving them an opportunity to benefit from the preferential tax treatment by the IRS. However, working with a trading company does not guarantee the IRS will agree with your claim to trader tax status. Hopefully, it will help strengthen your case. You still need to be personally responsible and make sure your business entity meets the guidelines established by the IRS code.