Active Trader FAQs

Short-term capital gain rates for full-time traders

QUESTION: I am a day trader and do not have a job besides trading. If short-term capital gains are taxed at the ordinary income level and I have no ordinary income, what would the tax rate be on my short-term capital gains?  I am also wondering if short-term capital gains are added to ordinary income which could push my tax-rate higher.

ANSWER: While capital gains seem to be taxed differently (and in the case of futures and long term holdings they are), they all add to the total of your income.  To figure out your income tax rate you would use the total of all income received during the year, including your trading.

Are there tax advantages to trading in an LLC?

QUESTION: Are there any tax advantages to trading in a LLC above what I am doing now as a Trader in Securities, Mark-to-Market trader, who already can deduct business expenses and such?

ANSWER: The main advantage is the certainty of being able to deduct your expenses.  The Trader in Securities designation, while sounding very official, is completely absent from the IRS code, and is roughly based upon tax court cases.  My concern is that courts could easily lay down a new ruling, and completely wipe-out your Trader in Securities filing status. You could be trading all year, assuming that you would be classified a Trader in Securities, only to find the law changed in November and you being unable to deduct your expenses.  With that in mind and also the asset protection an LLC will give you, it is much safer to trade in the entity.

How are 1256 contracts taxed?

QUESTION:  How are 1256 contracts taxed? And how does Mark-to-Market affect them?

ANSWER: 60% of the gain or loss of a 1256 contract is treated as a long-term capital gain or loss and the other 40% is treated as a short-term capital gain or loss. This is regardless of the actual length of your holding period.

All indexes, such as 1256 contracts, are treated as Mark-to-Market. Typically, the mark -to-market treatment changes the nature of the income from capital to ordinary. However, in the case of 1256 contracts, it remains a capital gain or loss.

You have the choice of electing Mark-to-Market for your accounting method, and converting the tax treatment of your 1256 contracts to ordinary income (losses). The largest benefit is if you lose a lot of money trading. Then, the loss is considered ordinary and offsets other ordinary income you may have. With just an ordinary loss, the $3,000 capital loss limitation is also removed.

In general, taking the Mark-to-Market election would not be a good idea for someone who only traded 1256 contracts or index options because changing the capital gains to ordinary income would remove the benefit of the 60% – 40% split.  However the Mark-to-Market rule does allow you to treat some of your trading as Mark-to-Market and identify other positions as not Mark-to-Market.  To do this you must identify those positions that you do not want to be Mark-to-Market with a note in your business records at the time of purchase.

Mark-to-Market accounting for an LLC

QUESTION 4: When Mark-to-Market accounting is used by an LLC and the net income is determined, how is that reported by the individual members if reporting as a partnership?

ANSWER 4: The Mark-to-Market election in the LLC will allow all income to be reported as net income or net loss, which will then flow through to each of the partners via the K1 that is part of the LLC tax return.

Retirement funding options for traders

QUESTION: What kind of retirement funding alternatives are available to the
independent trader?

ANSWER: I believe this is the most powerful thing that Traders Accounting teaches.  Everyone who is in the business of trading has the ability to have their business sponsor and form a 401(k) for their  business.  The benefits are wonderful in each of two different scenarios:

1.  Let’s say you are trading, or beginning to trade and have a 401(k) or 403(b) from a previous employer, or you have rolled one into an IRA, or you have a self funded IRA. You probably don’t know this, but you have the ability to set up your own 401(k) and transfer all of your funds into it.  This would make you a Trustee of your own plan at this point, giving you the freedom to make any “prudent” investment. What this means to a trader is that you can make your own investment decisions for your retirement funds, rather than leaving your money with professional money managers who are cutting your capital in half, effectively making your 401(k)s into 201(k)s! In addition to the wonderful benefit of being able to control all of your retirement investment decisions, you can borrow up to $50,000 from it to augment your own personal trading account.

2.  The second type of funding has to do with secondary tax strategies in your Tax Efficient Trading Plan. In the years that you make money trading, when you need a powerful vehicle to lower your taxes, you and your business can contribute up to $40,000 to your 401(k)!  Not only is this contribution an expense to the business, and lowers your taxable income, it is not income to you until you retire, and have reaped the benefits of years of compounded growth.

Long-term capital gain rates for traders

QUESTION:  What is the rule for long-term capital gain rates and the trader?

ANSWER: Long-term capital gains occur when you own a position for longer than 12 months and one day and sell it for a gain. This is considered a long term capital gain and is taxed at a tax rate of 10% at the low end to 20% at the high end.

If you trade 1256 contracts, (commodities & futures) all gain or loss is treated as 60% long term and 40% short-term capital gains and losses.

If you trade options on “cash settled indexes” they too are taxed the same as 1256 contracts. This type of trading is certainly advantageous to the typical trader who may be trading in indexes but does not know of this benefit.

How do you elect Mark-to-Market accounting?

QUESTION:  How do you elect Mark-to-Market accounting?

ANSWER: First, you must be considered a trader by definition, as the Mark-to-Market accounting election isn’t available to investors.  You also need to be proactive, and decide ahead of time what you want.  To make the election for the current tax year, you must file a statement with your tax return for the previous year.  That means by April 15th.

If you miss your deadline, you can’t elect Mark-to-Market accounting until the next year, unless you establish a legal entity. Then, you’ll have two months from opening to notate in your meeting minutes that Mark-to-Market accounting is your accounting method of choice.

Once you’ve properly elected Mark-to-Market accounting, fill out Form 3115, an Application for Change in Accounting Methods, and submit it when you file your current years tax return.

Within Form 3115, you’ll find a Section 481(a) adjustment, which is a dollar amount based on your change in accounting methods.  When you make the MTM election, you’ll adjust the securities to market value at the beginning of the year.  The difference between last years ending balances, which were recorded at cost, and the fair market value at election, is your 481(a) adjustment.  If the adjustment is less than $25,000, you may deduct the full amount on your tax return.  If its greater than $25,000, deduct one-fourth of the value each year for the next four years.

Please note if you elected the Mark-to-Market accounting method on your legal entities first tax return a 3115 is not required.

Joint brokerage account tax liabilities

QUESTION:  If you share a joint brokerage account with someone else but the brokerage account is in you name and social security number can you assign a portion of the trading activity to the other party?

ANSWER: No, unfortunately the trading activity will be reported (by your broker) to the person whose name and social security number is on the account.  At the end of the year a  Form 1099B will be provided to you and the IRS by your broker.  This form reports all of your trading activity for the year.  Therefore, the IRS will be looking to you to report all of the trading activity on your tax return.  If you change the name and social security number on your brokerage account to the other party than it will be from that time forward that the trading activity will be reported to the other party.

Tax treatment of QQQ, DIA or SPYs

QUESTION: Does trading the QQQ, DIA or SPY get 1256 tax treatment similar to cash settled index options?

ANSWER: Yes, they are considered 1256 contracts.

Filing status of one person LLCs

QUESTION: If a person applies as a one person LLC, and doesn’t qualify for partnership reporting, does the person than have to report his business on a schedule 1040 Schedule C — or does the IRS always allow an LLC to file as a partnership?

ANSWER: The IRS views a single member LLC as a disregarded entity.  As such, they are not expecting you to file a Form 1065 to report your LLC’s activity.  Instead you would report that activity on a schedule C and include it in your 1040 return.