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Republicans are pushing forward with their bold tax reform agenda despite drama from the White House, promising massive tax cuts and simplification, paid for with closing tax expenditures and related economic growth. Many traders and small business owners feel like a deer caught in headlights. They are anxious to make smart moves for 2017 tax planning based on current law and are uncertain if tax reform changes will enhance or undermine their maneuvers.
Good news: I don’t expect Congress to repeal trader tax benefits. Repeal should affect investors using investment expense treatment and other types of taxpayers.
Traders qualifying for trader tax status (TTS) should consider forming a trading business entity to maximize 2017 tax breaks based on current law including business expense, health insurance, and retirement plan deductions. I expect tax reform to improve their tax benefits for 2018 with lower tax rates on business income, investment income, and ordinary income.
Example: Proper 2017 tax planning for traders
TTS traders can form a single-member LLC with S-Corp. election. They can execute payroll in December 2017 to deduct officer health insurance premiums and a solo 401(k) retirement plan contribution. Assume the health insurance deduction is $1,000 per month for six months, allowed during the entity period (not before). If the trading entity is profitable, the trader can execute a solo 401(k) retirement plan 100%-deductible elective deferral of $18,000 (2017 limit), plus a “catch-up provision” (if the trader is age 50 or older) of $6,000. If the entity is highly profitable, the trader can also execute a solo 401(k) 25%-deductible profit sharing plan contribution up to $36,000 (2017 limit). This adds up to $66,000 of income tax deductions, so this trader may save over $35,000 of income taxes for 2017 based on using the top tax rate, state rates, and deducting 50% of payroll taxes. The payroll tax cost on $144,000 of wages is about $20,000, so net savings could be $15,000. There are additional tax savings from deducting trading business expenses and home-office deductions.
If and when major tax reform takes effect, these tax breaks should continue in effect plus tax rates should drop for all types of income including ordinary, business, and investment income. Tax reform should add icing on a trader’s cake. The House plan calls for “reasonable compensation” in pass-through entities, ensuring the owner pays the ordinary rate on some income and the business rate on the rest. This requirement jives nicely with the tax planning strategy outlined here.
Tax reform lowers tax rates and repeals AMT
The Republican tax plans shrink “progressivity” by narrowing seven individual tax brackets down to three. They consolidate the lower brackets, and the real gem is a significant reduction of the highest rates, lowering the top rate from 39.6% to 35% (President Trump) and 33% (Paul Ryan’s House). David Camp’s House plan from 2014 reduced the top rate to 25% with two brackets.
Republican tax plans repeal AMT tax, the second tax regime intended to prevent the wealthy from avoiding taxes. By repealing many itemized deductions and AMT preferences, AMT becomes less relevant. Why keep something complicated without much relevance and tax revenue generated?
GOP tax plans feature a lower maximum tax rate on businesses: Trump 15% on corporations and pass-through entities (PTE), and the House 20% for corps and 25% for PTE and sole proprietorships. David Camp’s 2014 House tax plan had 25% corporate and individual top rates.
Republican tax reform favors saving and investment income
The White House uses one-half the ordinary tax rates, and the House excludes half of investment income, which has a similar effect. Republicans explain that tax incentives for investments spur growth, and they depend on “dynamic scoring” to project tax revenues from growth rates over 3% per annum. With “static scoring,” their tax plans raise the deficit significantly.
The devil will be in the details. The tax reform plans define investment income as “capital gains, dividends and interest income.” Current law has a lower tax rate on long-term capital gains (held 12 months) and qualified dividends, but not interest income or short-term capital gains. Section 1256 contracts including futures have 60/40 capital gains rates, meaning 60% receive the lower long-term capital gains rate and 40% receive the short-term, ordinary rate. The Section 1256 blended rates are about 10% lower than “ordinary” rates throughout the marginal tax brackets.
Republicans include interest income to level the playing field with dividends, and they seem to include all types of dividends, not just qualified dividends meeting certain requirements.
Are short-term capital gains included?
When Congress discusses capital gains, it usually refers to long-term capital gains. It seems too good to be true that short-term capital gains may qualify for the lower investment income rate. That’s drastically expanding tax breaks on investment income. Traders will cheer. If the new lower tax rate on investment income applies to short-term and long-term capital gains and with 50% off ordinary rates, why should they continue the tax code complexity of Section 1256 contracts? There would be no meaningful difference in the outcome.
Ordinary income vs. capital gains income
David Camp’s 2014 House tax reform plan proposes a new tax treatment of derivatives, which include equity options. His plan called for mark-to-market (MTM) accounting with ordinary gain or loss treatment. Under current law, equity options are considered securities, are taxed when sold (the realization method), and receive capital gains treatment. Trade accounting for equity options, especially complex options transactions with offsetting position “legs” is confusing. It’s a pain to deal with wash sale loss adjustments and straddle loss deferral rules. MTM would be refreshing tax simplification, but it changes the dynamics of ordinary vs. capital gains income or loss.
Do Republican tax writers want to bring derivatives to a level playing field with Section 1256 contracts (futures), requiring both to use MTM and ordinary income treatment? If Congress wants to achieve simplification for traders, allow TTS traders to use MTM ordinary income treatment on all financial products they trade.
How tax reform may affect Section 475 elections
To avoid the $3,000 capital loss limitation and wash sale loss adjustments, TTS traders make a Section 475 MTM election on securities. Section 475 trading losses contribute to net operating losses (NOLs), which may generate quick tax refunds. Securities trading gains use the same ordinary rate, with or without Section 475, so it’s free “tax loss insurance” for securities traders.
It’s not clear how tax reform will affect Section 475 elections. Only a trading business may have Section 475 ordinary income, so hopefully, that ordinary income qualifies for the lower business tax rate in a PTE. If not, maybe it will be included in investment income benefiting from that lower rate.
If Section 475 MTM income does not qualify for either the lower tax rate on business income or investment income, then traders may easily revoke Section 475 to qualify for the investment income rate, assuming it includes short-term capital gains.
Dual entity solution
If a trading entity does not qualify for the business or investment income tax rates, a dual entity solution may help. A trading partnership could pay fees to a management company, and that income would likely qualify for the business rate.
Net operating losses
The House tax plans repeal NOL carrybacks. NOL carry forwards would continue under this plan, but with some changes: The 20-year carry forward limit is removed, and taxpayers may only apply NOLs against 90% of taxable income in subsequent years. Repealing NOL carrybacks negatively affects traders who depend on immediate NOL tax refunds from carrybacks to replenish their trading accounts to stay in business.
Tax simplification
GOP tax reform achieves simplification by repealing many code sections including most itemized deductions for individuals (all except mortgage interest and charitable donations). They compensate by significantly increasing the standard deduction easing tax filings for many taxpayers.
Tax reform favors investment income, but it disfavors investment expenses — an even trade for some taxpayers. Investment expenses include stock borrow fees for short sellers and investment advisor fees paid outside managers. The plans repeal investment interest expenses, too. Commissions are part of trading gains and losses; they are not investment expenses. TTS traders are unaffected; it’s business expense treatment for them.
Carried interest tax breaks
The tax plan outlines do not address carried interest (CI) tax breaks for hedge fund and private equity fund managers and investors. President Trump campaigned on repealing it. CI reclassifies “incentive fees” as a “profit allocation” of capital gains and other investment income. If the partnership and investors benefit from long-term capital gains, the manager does, too. Repealing CI reclassifies profit allocation as an advisory fee, and the manager may then benefit from a lower business tax rate after tax reform. Investors won’t fare as well since they won’t have investment expense treatment. Perhaps Congress will repeal CI for the manager, but retain it for the investor, as Democrats proposed in the Obama administration.
Repealing other code sections is okay for traders
Full “expensing” on equipment, fixed assets, and intangible assets is helpful. Traders already use full expensing with “tangible property expenses” (TPE) up to $2,500 per item, and 100%-deductible Section 179 depreciation.
Condensing education and family tax credits is a good idea, and it will make tax filings easier for middle- and lower-income taxpayers. Many traders fall into middle- and lower-income tax brackets after leaving a job to trade full-time and perhaps losing money in the initial years.
Middle- and upper-income traders living in a high-tax state won’t appreciate losing state and local tax (itemized) deductions including income, sales, real estate, and property taxes. I’ve seen an idea to take a business deduction for state and local taxes that relate to business income. That idea may have more relevance after tax reform so that I will take a closer look at it. Some high-tax states may decouple from federal tax law which would cause havoc and complexity.
Tax plans do not repeal charitable itemized deductions, but many taxpayers may not have enough charitable deductions and mortgage interest expense for itemized deductions to exceed the enhanced standard deduction amounts. That means these taxpayers won’t feel they receive any tax benefit from making charitable contributions, which could dampen charitable giving. Congress may get an ear full from their local religious leaders and university officials.
Tax reform is not a done deal. It will take heavy lifting from Republicans, and they need to act in unison. Be prepared either way.
Darren Neuschwander CPA and Adam Manning CPA contributed to this blog post.
