3. Not filing with the Mark-to-Market (MTM) accounting method
Failure to make the section 475 MTM election on securities means you can deduct a maximum of $3,000 in trading losses because that is the maximum capital gains loss that can be claimed in one year. We’ve met literally hundreds of traders who got stuck with capital loss carry forwards, either because they were not aware of the MTM election or because they missed the deadline to make the election. Unfortunately, you can’t fix a missed or botched Section 475 election. Your only recourse is to form a new entity and use the “new taxpayer” exception allowing an internal Section 475 election within 75 days of inception.
If you’re a consistently profitable trader, you may not be interested in the tax loss insurance that MTM provides—but you’re probably interested in being exempt from the burdensome wash sale loss deferrals rules that apply to non-MTM traders. For example, you may be profitable for the year, but have hundreds of wash sale transactions during the year. You would not be able to include those in your profit/loss calculation, thus increasing your tax liability substantially. Reporting wash sales is time consuming and may increase your tax filling costs significantly. In most cases you can’t rely on your brokers to issue a 1099 that would accurately reflect your wash sales and you will need the assistance of a trader tax expert.
There are many nuances to electing MTM and strategies to consider. The election is not automatic to all and the decision to make the election is individually based and must be made only after consulting with a trader tax specialist.
2. Not claiming trader tax status—or claiming it when you are not entitled to it
Active traders can save on average $5,000 or more using business expense treatment. That’s because business expenses are 100% deductible from gross income, whereas investment expenses are considered miscellaneous itemized deductions and are only deductible “below the line” and in excess of 2% of your adjusted gross income (AGI). Investment expenses are also added back for the Alternative Minimum Tax (AMT) calculation, which can eliminate the tax reduction originally generated by these expenses. In addition, filing as a business allows traders to claim home-office deductions, education expenses and startup costs, whereas investment expenses do not. Quite simply, missing out on trader status can cost you thousands of dollars in unnecessary taxes.
On the flip side, many traders are eager to write off their trading expenses that may be as high as $50,000 in their first year. They either file on their own or pressure their accountants to claim these expenses. They are putting themselves at risk. If they are not able to substantiate their position as a business trader, they will have to pay substantial penalties to the IRS.
1. Failing to have a clear tax strategy
Benjamin Franklin once said that, “By failing to prepare, you are preparing to fail.” We’ll wrap by sharing a real story that demonstrates many of the mistakes discussed in this series.
Mr. A from Southern California, attended a seminar by an accounting firm that claims it specializes in trader taxation. The firm offered him a simple “one size fits all” solution for a “small fee” of $4,500. He decided to pass –but then he adopted the firm’s recommendation and structured his own entity. That was his first mistake. He then attempted to get professional accounting advice and interviewed four different firms. He decided they couldn’t help him, so he filed his own return using TurboTax. That was mistake #2, especially because he made a number of errors on the return and was audited by the IRS.
Since Mr. A likes a do-it-yourself approach he decided to be his own representative at the IRS—mistake #3. The IRS asked him to pay more than $76,000 in taxes and penalties. At this point Mr. A attended our Core Tax Strategies class and asked OTA Tax Pros to represent him. Our analysis found that he was actually vulnerable for an even higher tax liability than the IRS had requested. However, with careful strategic planning we were able to bring his liability down to about $36,000—more than $40,000 in tax savings! What’s the moral of this story? Let the tax experts do their job!
When you need a diagnostic on your medical condition you would seek your doctor’s advice. You might research your symptoms on the internet, but when it comes to picking the right medicine or medical procedure you would have the good sense to consult a professional. Although trader taxation may not be a matter of life and death, you still should seek the same expert advice.
You need an action plan to achieve your goal, and an expert to guide you through the process. Our role is to reduce your tax liability, save you money, help you build your wealth faster by paying less taxes and keep you out of trouble with the IRS. Your responsibility is simple: seek expert advice and execute on it.
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/