Trader tax reporting strategies
By Robert A. Green, CPA
Forms, forms, and more forms. Which form should you use if you’re a forex trader? Which form is best for securities traders using the cash method? The different reporting strategies for the various types of traders make tax time not so cut-and-dried.
The IRS hasn’t created specialized tax forms for trading businesses as it has done for just about every other type of business. For example, other sole-proprietorship businesses report revenues, cost of goods sold, and home-office expenses on Schedule C. But for traders, only business expenses are reported on Schedule C. Trading gains and losses are reported on various forms, depending on the situation.
Securities can be reported on Schedule D (cash method) with capital losses limited to $3,000 per year; or Form 4797 (Section 475 MTM method) with unlimited business ordinary loss treatment. Futures and forex traders (opting into Section 1256g) should use Form 6781, unless the futures trader elected Section 475 (in that case, use Form 4797).
In the forex arena, if the trader doesn’t qualify for trader tax status, by default without an opt-out election he should use line 21 of Form 1040; qualifying traders report on Form 4797. It can be confusing because the Section 475 MTM and Section 988 elections don’t have tax forms; traders must figure it out on their own. Don’t forget if you filed a 475 election statement, existing taxpayers need to follow up with a Form 3115 filing, too.
With these tax-reporting requirements, the IRS may automatically view a trading business Schedule C as unprofitable even if it has large net trading gains on other forms; the IRS may audit sole-proprietorship trading-business tax returns.
Transfer trading gains to Schedule C
The most important tax strategy for sole proprietorship business traders is to transfer some trading gains, if possible, to Schedule C to zero the income out, but not show a net profit. Showing a profit could cause the IRS to inquire about a self-employment (SE) tax, which is otherwise not due for traders who aren’t members of a futures or options exchange.
This special income-transfer strategy also unlocks the home-office deduction and Section 179 (100-percent) depreciation deduction, both of which require income. This strategy isn’t included on tax forms or form instructions. It’s an industry-accepted practice to date designed to deal with insufficient tax forms for sole-proprietorship trading businesses, and it must be carefully explained in footnotes — another important strategy for business traders.
For the complete article, see the December 2010 issue of Active Trader magazine. Click here to subscribe.