Last week we began exploring the top ten mistakes traders make when filing their taxes. Working up the list from least to worst, let’s consider with numbers 6-4:
6. Using TurboTax® to prepare your taxes as a trader
In recent years TurboTax has become increasingly popular as a way of preparing tax returns. TurboTax can be a good solution for straightforward returns, but when you are attempting to prepare a more complex return that requires unique tax knowledge, do-it-yourself software may not be the best fit.
TurboTax relies on you to provide all the necessary information to prepare an accurate return and the software makes certain assumptions in determining the right treatment. The problem is, there is no tax code that defines who can qualify as a trader in securities. To determine if you qualify you need tax court knowledge and experience in the field of trader taxation. You need to know whether to make the mark-to-market election, how each investment asset is taxed, what deductions are available to you and which deductions are not, and which filling status you can qualify for. Correct determinations in these matters can make a huge difference on your tax liability.
In a Bloomberg interview on Feb 12, 2012, a CPA working for TurboTax said the following about his role in answering questions to the public: “I was getting questions from folks out in Idaho who had a farm and wanted to know about farm income. I’m in New York here. Ask me about stocks, not farms. The interesting thing is I had to answer their question so I had to learn about that on the fly and that’s what a lot of our agents have to do.” You probably don’t want to rely on advice that is learned “on the fly.” In trader taxation you need an experienced firm that specializes in trader taxation, such as OTA Tax Pros.
5. Representing yourself in front of the IRS
If the IRS contacts you and “invites” you to an examination, you should always seek professional representation—especially if you are claiming Trader in Securities status or writing off losses in excess of $3,000. You are at a major disadvantage when representing yourself, and the IRS is well aware of this fact. You are involved emotionally and may make statements that will help the IRS extract even more dollars from you. The IRS expects that a qualified representative will know more about the IRS procedures and the IRS Code than the taxpayer. They are less likely to use scare tactics against your representative.
Advocating takes experience. Just as you would not go to court without an attorney, you should not go to an IRS audit without a qualified representative who knows exactly which areas of your tax return can generate a refund or reduce the impact of lost deductions. Winning takes strategy and proper timing. Your case must be presented in the most favorable position and in a manner that will close the audit as quickly as possible. In addition, it is more cost effective to get a tax trader specialist like OTA Tax Pros involved in the beginning than to seek costly interventions, such as Appeals or Tax Court, in the future.
4. Not forming a business entity or forming the wrong one – “One size fits all”
Some accounting firms take the position that anyone can qualify for Trader in Securities status and write off all their trading expenses and all their trading losses. What’s their strategy? Set up an LLC or corporation to trade through, and you’ll automatically qualify as a Trader in Securities. This strategy is appealing as it promises an easy pass into writing off all your trading related expenses—but it simply does not work and will fail in an IRS audit.
An even worse mistake may be not forming an entity at all, causing the trader to lose substantial tax benefits such as deductible medical premiums, retirement contributions and start-up costs. In addition, a trader reporting as an individual, vs. a business entity, may have increased risk of being selected for an IRS examination.
If you want a strategy that works for you, you need to work closely with a specialist in taxation as it relates to trading. At OTA Tax Pros, for example, at the beginning of a relationship with a new client we take the time to learn about their current tax status, their past tax fillings and their trading goals. We then recommend a tax plan based on each client’s unique factors, providing the best opportunity to reduce tax liability and stay in compliance with IRS rules and rulings. For some traders the best entity for trading may be the Limited Liability Company or LLC, but for others this may prove a terrible choice. As an example, a trader who lives in California and sets up an LLC may be subject up to $12,000 in Annual Limited Liability Company tax. Had this trader set up a partnership or corporation they would avoid that $12,000 tax bill. Examples like this apply to other states as well. Each state has its own set of unique tax rules that may affect your choice of a business entity.
Next week we will review the final three (and the worst) 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/.