The US tax code is a complex maze. It is 73,954 pages long and includes more than 1,999 different publications and tax forms. In order to win in the tax game, you need to have the proper knowledge and expertise that can help you reduce your tax liability and stay in compliance.
In this 3 part series, we are going to zoom in and focus on trader taxation laws and the top ten mistakes traders make when preparing their tax returns. These mistakes lead to IRS audits, penalties and fines. These mistakes are costly and may cause you to pay thousands of dollars in unnecessary taxes.
Let’s count backwards from least to worst:
10. Not filing a tax return due to trading losses or minimal trading
There are people who are under the impression that they are required to file a tax return only if they had trading profits. Or, they are exempt from filing a tax return if they had a handful of trades, or experienced losses in the market. They are absolutely wrong! Failure to report your trading activity, even if you only had losses, or minimal gains may lead to IRS notices, penalties and interest. Take note that the IRS receives a copy of your 1099 from your brokerage company and if there is not a match between the trades on the 1099 form to the trades reported on your tax return they will send you a notice. What is worse is that the IRS will assume that your total taxable profits equal your total proceeds, and you will be taxed at the highest tax bracket allowable. In the last 13 years, I have seen many IRS notices like this, asking taxpayers to pay up to hundreds of thousands of dollars in taxes. The clients typically are astonished when they receive these alarming notices. The issue is usually resolved by doing one simple action – filing a tax return.
9. Reporting your gains and losses on Schedule C:
Unfortunately, some traders experience losses that are greater than $3,000. In attempt to fully write off their losses they report it on Schedule C. They claim that they are business traders and therefore they are allowed to report their losses on Schedule C. This is a sure way to get on the IRS radar. The IRS code and publications clearly states that all capital transactions must be reported on Schedule D. Therefore, you are limited to claiming $3,000 of your losses in the year they occurred. The remainder of the disallowed losses gets carried over to future years. The only way to claim losses in excess of $3,000 is by electing the MTM accounting method which must be made by April 15th of the tax year in question. Most traders are not aware of this election and fail to make it on time. Reporting losses on your Schedule C will most likely generate an IRS notice or examination. The result of this notice will surely be additional tax liability, penalties and interest. Avoid this mistake and consult with your trader tax professional on strategies you can use.
8. Paying self-employment (SE) taxes on trading
Many traders elect to trade via a business entity such as a corporation, partnership or LLC. When doing so they report all of their trading income as ordinary income and they subject their trading income to self employment tax. You should know that trading income is not considered to be earned income and only earned income is subject to self-employment tax. Therefore, reporting your gains as earned income subjects you to an additional 15.3% of unnecessary taxes. Let’s assume that Joe trader made $100,000 and reported all income as subject to self employment tax, this would mean that Joe would pay $15,300 in self employment tax. Only full members of futures exchanges are obligated to pay SE taxes on futures trading gains. However, too many traders out there are paying SE taxes on these gains. If you think the IRS will correct this error for you, you are simply wrong. The IRS hardly ever corrects mistakes in their favor.
7. Mixing up the tax treatment between securities, 1256 contracts, forex and options.
Stocks, bonds, and mutual funds belong to the securities group and are taxed at the long term capital gain rate if held more than a year. If the position is held for less than a year it is taxed at the short-term capital gain rate. Which essentially is your ordinary income tax bracket. Securities are also subject to the wash sale rule unless you have elected MTM accounting. Futures contracts are part of Section 1256 contracts which are entitled to a special tax treatment known as the 60/40 split. This allows futures traders to pay on 60% of their gains at long term capital gain rate of 15% and pay short-term capital gain rate on the remaining 40%; creating a maximum tax savings of up to 15%. Misreporting Section 1256 contracts as securities on Form 8949 rather than on Form 6781 causes you to lose your lower 60/40 tax treatment and potentially pay thousands of dollars in unnecessary taxes. Not all brokers report Section 1256 contracts correctly, especially instruments that are not clearly designated as such including some E-mini indexes and options on those indexes. You need to make sure you are reporting your trades correctly and not missing on any tax breaks available to you. Forex can be taxed either as ordinary income or as section 1256(g) that qualifies to the 60/40split mentioned earlier. You will need to know what tax election to make and when to make it. Failure to do so may cost you thousands of dollars in unnecessary tax payments.
Next week, we will continue with items 4-6 on our top ten mistakes traders make when filing their taxes. Until then, have a successful week.
To find out more about how you can avoid audits, reduce taxes legally and keep more of your profits, please visit OTA Tax Pros http://www.tradingacademy.com/otatax/.