Look, what’s the point of winning trades if you risk all your profits by filing taxes incorrectly? Winning trades takes skill; protecting your hard-earned profits at tax time just takes know-how.
Here are the top 10 mistakes traders make when preparing their tax returns. Pay attention, because making any of these mistakes could lead to thousands of dollars in unnecessary taxes, IRS audits, penalties or fines. Let’s count backwards from the bad to the worst.
Top 10 Trader Tax Mistakes
10. Not filing a tax return due to trading losses or minimal trading
There are traders who think they only have to file a tax return if they made profits, or that they don’t have to file if they lost money in the markets, or only made a handful of trades. Those people are dead wrong. Failure to report your trading activity, even if you only had losses or minimal gains, may lead to IRS notices, penalties and interest charges. Your broker sends the IRS a 1099 of your trading earnings and if the numbers don’t match what you claim on your return, you’re going to hear about it from Uncle Sam. What’s 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. The issue is usually resolved with one simple action – filing a tax return.
9. Reporting your gains and losses on Schedule C
Unfortunately, some traders experience losses greater than $3,000. They figure that since they’re business traders, they’re allowed to report and will attempt to write off all their losses using the Schedule C IRS form.
Want to pop up on the IRS’s radar? This is a sure-fire way to do it.
The IRS code and publications clearly states that all capital transactions must be reported on the Schedule D IRS form, which limits loss claims to $3,000 in the year they occur. The remainder of the disallowed losses get carried over to future years. The only way to claim losses in excess of $3,000 is by electing the Market-to-Market (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.
8. Paying self-employment (SE) taxes on trading
Many traders use a business entity such as a corporation, partnership or LLC and report all of their trading income as earned income and calculate it for self-employment taxes. This is a big mistake since trading income is not considered earned income. Reporting your gains as earned income subjects you to an additional 15.3% of unnecessary taxes. Only full members of futures exchanges are obligated to pay self-employment taxes on futures trading gains. If you think the IRS will correct this error for you, you better think again.
7. Mixing up tax treatments 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 gains 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 gains rate, essentially your ordinary income tax bracket. If you haven’t elected MTM accounting you’re also subject to the Wash-Sale Rule, which disallows a deduction if you sell a security at a loss and then buy a similar one within 30 days.
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 the long-term capital gains rate of 15% and pay the short-term capital gains 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.
Forex can be taxed either as ordinary income or as section 1256(g) that qualifies for the 60/40 split.
6. Preparing and submitting your taxes with an online income tax preparation service
In recent years, online tax preparation services have become increasingly popular. While a good solution for straightforward returns, they probably aren’t a good fit for traders with complex filings that require unique tax knowledge. That’s because these services rely on you to provide all the necessary information to prepare an accurate return and the software makes certain assumptions in determining the right treatment. Since there is no tax code that defines who qualifies as a securities trader errors are often made. To determine if you qualify, you need tax court knowledge and experience in the field of trader taxation. You also need to know whether to make the MTM election, how each investment asset is taxed, what deductions are and are not available to you and which filling status you qualify for. Correct determinations can make a huge difference on your tax liability. Traders need professional tax preparers that are well-versed in trader taxation.
5. Representing yourself at an IRS audit
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 may fall prey to scare tactics or make statements that hurt instead of help your case, and the IRS is well aware of this. 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.
4. Not forming a business entity or forming the wrong one
Some accounting firms can do the right math–but on the wrong equation. They’ll tell you that anyone can qualify for Trader in Securities status and write off all their trading expenses and losses by setting up and trading through an LLC or a corporation. Sounds great, doesn’t it? Unfortunately, it simply does not work and will be called out 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 audit.
For some traders the best entity may be a 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 business entity.
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, the maximum capital gains loss that can be claimed in one year. If you aren’t aware of it or miss the deadline to make the election, you could get stuck with capital loss carry forwards. 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. 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.
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.
1. Failing to have a clear tax strategy
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. We’ll wrap by sharing a real story that demonstrates many of the tax mistakes traders make.
Mr. A from southern California attended a seminar by an accounting firm claiming it specialized 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 adopted the firm’s recommendation and structured his own entity. That was his first mistake. He then filed his own return using an online tax preparation service. That was mistake #2, especially since he made a number of errors on the return and was audited by the IRS. Mr. A 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. After his third strike, Mr. A made his first right decision, to seek advice from a professional tax service specializing in assisting traders. They not only helped him establish a clear strategy and a plan but even managed to bring his liability down to about $36,000—more than $40,000 in tax savings!
Benjamin Franklin once said, ‘By failing to prepare, you are preparing to fail.’ Before you start preparing your taxes, make sure you’re prepared. Making even one of these 10 trader tax mistakes could cost you plenty.
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