Tax Tips for Traders


Whenever we consider the benefits of trader tax status, the one item
that tops the list is the ability to elect a special accounting
method known as mark-to-market, or MTM for short. While mark-to-
market won't automatically turn your losing positions into winners,
it can have an almost magical effect on your after-tax earnings and
day-to-day record keeping.

Sound too good to be true? Actually, for most traders, MTM is indeed
the magic bullet that enables them to fully deduct their business-
related expenses, avoid the time-consuming wash sale rule and remain
exempt from self-employment tax.

But there is a catch or two to this otherwise generous gesture from
the Internal Revenue Service that could cost you dearly. We'll soon
see why it's a good idea to contact a Traders Accounting tax
professional before you make this one-time, irrevocable election.

Let's take a closer look at the all-important mark-to-market
accounting method election and the trapdoors you need to avoid to
make it work for you.

The Mark-to-Market Method

Since 1997, mark-to-market accounting has enabled traders to change
the tax status of their earnings from capital gains/losses to
ordinary income/losses. This occurs on the last day of the year, at
which time you tally all of your open holdings as if you were
selling them at the market price that day; in other words, they
are "marked to market." On January 1st, you re-tally your holdings
as if you were repurchasing them at the current price. The basis of
each holding is then adjusted to reflect these hypothetical gains
and losses for tax purposes.

Advantages of Mark-to-Market

The advantages of mark-to-market accounting include:

No wash sales: MTM traders are exempt from the wash sale rule;
because holdings are tallied at year's end, there is no need to
account for gains or losses that might occur within the 30-day wash
sale restrictions. Many traders elect MTM specifically to avoid
cumbersome wash sale accounting.
Losses are fully deductible: Because your income/losses are treated
as ordinary income and not capital gains/losses, you are not bound
by the $3,000 capital loss limitation. This means you can deduct all
losses in the year they occur, providing tax relief when you need it
most. Here's how a $40,000 loss would impact Janet Trader (with
trader status and MTM) versus Johnny Investor (without both). Note
that Janet Trader was able to offset her regular $100,000 income
with her $40,000 loss, while Johnny Investor was limited to the
$3,000 capital loss deduction:
Total household income: $140,000
Trading loss: <$40,000>
Trading expenses: $24,230

Janet Trader's tax savings: $19,269
Johnny Investor's tax savings: $984
Benefit of trader tax status & MTM: $18,285

No change to self-employment exemption: Even though MTM income is
not considered capital gain, traders who elect MTM remain exempt
from self-employment tax, the same as investors and non-MTM traders.
Disadvantages of Mark-to-Market

There are three potential disadvantages to electing mark-to-market:

No capital loss carryover: Capital losses can only be offset by
capital gains. If you are carrying forward a substantial capital
loss, beware: by selecting MTM, your gains would be considered
ordinary income moving forward, hence only $3,000 per year could be
used to offset your capital loss.
Loss of long-term capital gains: Forex/futures traders who deal
mainly with 1256 contracts typically avoid MTM in order to retain
the advantageous long-term capital gains tax rate on 60% of their
earnings.
Election is permanent: As an individual trader, once you've made the
MTM election, you're stuck with it. You can petition the IRS, but
don't expect leniency, especially if there is a tax advantage to
you. Below, we'll see how a Traders Accounting tax professional can
help you around this obstacle.
How to Elect Mark-to-Market

To elect mark-to-market as your accounting method, you must enclose
a statement of intent with your tax return or extension request and
file by the appropriate tax deadline (March 15 or April 15) the year
prior to beginning MTM accounting. For example, to use MTM for your
2005 return, you would have had to elect mark-to-market by April 15,
2005. The one exception: if you're filing as a new business entity
(i.e., general or limited partnership, limited liability company or
C Corporation), you have 75 days from opening to note your
accounting preference in your meeting minutes.

Your first year using MTM, you will fill out IRS Form 3115
(Application for Change in Accounting Methods) and submit it with
your tax return. This form contains an adjustment, Section 481(a),
which captures duplications and omissions resulting from the change
in accounting methods. If the adjustment is $25,000 or less, you may
deduct the full amount on your return; if it exceeds $25,000, you
may deduct 25% each year for the next four years.

Exempt Your Investments Before You Elect MTM

Before you elect mark-to-market, be sure to separate your investment
holdings from your trading stocks and options. Why? Because unless
they are clearly separated, you will be required to mark them to
market at year's end and report any gain as ordinary income. That
could prove disastrous for stocks that have greatly increased in
value over the years.

The IRS lets you exempt your personal investments from your trading
business, but only if you identify those investments up front. Like
the MTM election itself, this designation is irrevocable; you cannot
decide later to fold your investment losers into your trading stock
for ordinary losses or cherry-pick your trading winners for capital
gains treatment.

Under the IRS guidelines, you must clearly identify your investment
stock as such in your records by the close of the day on which you
acquired it or when the MTM election was made. There are two ways to
do this: you may establish a separate account for your investment
stocks (the wisest course of action for MTM traders), or simply note
in your records which securities are not part of your trading
business.

Be prepared to convince the IRS that your investments have no
connection whatsoever to your trading business; otherwise, you'll be
required to mark them to market at year's end and report any gains
as ordinary income.

What If You Miss the Election Deadline?

Did you miss the mark-to-market election deadline? You can file for
an extension of up to six months to make your mark-to-market
election via the private letter ruling procedure under IRS Section
301.9100-1 (Extensions of Time to Make Elections). The IRS may
charge a fee for this. In practice, however, most traders who miss
the MTM deadline don't realize it until the following year, and
hence miss the election extension deadline as well.

The tricky business of meeting the MTM election deadline is one
reason we at Traders Accounting encourage individuals to trade under
the umbrella of a business entity. One of the best ways in general
to secure and protect your trader tax status is to trade as a
business entity, but it comes in particularly handy where the mark-
to-market deadline is concerned. The IRS allows newly formed
business entities (including general and limited partnerships, LLCs
and C Corporations) 75 days from formation to note their accounting
preference in their meeting minutes.

Down the road, should the MTM election prove undesirable (say you
shift to trading predominately forex/futures, for example), you may
simply dissolve the business entity and form a new one, thereby
avoiding the one-time-only election rule.

Get Advice Before You Elect MTM

Is the mark-to-market method right for you? Because every trader
faces different circumstances, there is no cookie-cutter approach
when it comes to this all-important decision. For some, MTM is the
obvious solution to the time-consuming task of tracking wash sales.
For others, the ability to fully deduct their losses in the year
they occur can make a big difference starting out.

If you find yourself carrying forward a capital loss or have other
questions relating to mark-to-market accounting, be sure to consult
a Traders Accounting tax professional about your situation before
you decide.



FROM the desk of Fred Meissner