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By "default" security traders are usually taxed under the
oftentimes undesirable capital gains method
of accounting, just the same as most other taxpayers.
But taxpayer businesses that maintain a complete and separable set of
accounting books and records which qualify under IRS
Regs. §1.446-1(d)(1) and that otherwise qualify to file with
Trader Status may
optionally elect in advance,1 by a filing with the IRS, to irrevocably2
use as their accounting system the "Mark-to-Market" (M2M) method for the election year and all ensuing
years, as
described below. This accounting method
treats what would normally be Schedule D "capital gains
and losses" as Form 4797 "ordinary gains and losses." The IRS expected
approximately one thousand taxpayers to have made the election by
year 20003. (the first and last year this information was
made available)
I suspect that there have been many times those official M2M
election numbers. If there is a huge
influx of M2M elections filed on self-prepared tax returns, it is very
possible that the Internal Revenue Service will take a closer look at
all returns electing M2M, and any resulting
NOL carrybacks and especially those prepared by taxpayers
without the benefit of professional guidance as evidenced by a
"paid preparer" on the signature page. Starting with the 2000/2001
tax filing seasons the Internal Revenue Service added information
for securities traders in their filing forms
instructions,
publications
(pdf),
and on their
FAQ
web site.
It is also possible, but not necessarily probable, that due to
widespread filing of defective as well as inappropriate M2M elections
(by both self-preparers and by paid professionals) that there may be
some relief offered to taxpayers to retroactively correct errors made.
As of 2011, limited relief has been made available; to the contrary, the IRS
and the Courts have strictly construed the election requirements.
Some other features of the Mark-to-Market election
Tax Summary of the
§475(f)(1)
election for Securities:
forgo making the election and...
Securities are
limited for deductibility of any trading losses if
§475 M2M is
not elected.
Securities are
subject to the
Wash Sale Rule if
§475 M2M is not
elected.
Paper losses in securities
held at year-end are not
deductible if
§475 M2M is
not elected.
Paper gains in securities
held at year-end are not
taxable if
§475 M2M is
not elected.
Gains in securities held over 12 months are taxed at long-term tax
rates if
§475 M2M is
not elected.
Substitute payment <46-day rule for short sales may cause certain short
dividends to be not deductible if
§475 M2M is
not elected.
make the election and...
Securities are
not limited for deductibility of
any trading losses if
§475 M2M is elected.
Securities are
not subject to the
Wash Sale Rule if
§475 M2M is elected.
Paper losses in securities
held at year-end are
deductible if
§475 M2M is elected.
Paper gains in securities
held at year-end are
taxable if
§475 M2M is elected.
Gains in securities held over 12 months are
not taxed at long-term tax rates
if
§475 M2M is elected.
Substitute payment <46-day rule for short sales generally has no effect if
§475 M2M is elected.
Old Capital Loss Carryforwards may be trapped on Schedule D if
§475 M2M is elected.
Tax Summary of the
§475(f)(2)
election for Futures/Commodities/§1256Contracts:
forgo making the election and...
§1256 contracts
have a nice long-term gain rate for 60% of gains if
§475 M2M is
not elected.
§1256 contracts are
limited for deductibility of any trading losses if
§475 M2M is
not elected.
make the election and...
§1256 contracts have
no long-term gain rate for 60% of
gains if
§475 M2M is elected.
§1256 contracts are
not limited for deductibility of
any trading losses if
§475 M2M is elected.
Old Capital Loss Carryforwards may be trapped on Schedule D if
§475 M2M is elected.
Trade both Securities
and Futures/Commodities/§1256Contracts and you have a dilemma:
If you are guaranteed to be
profitable in Futures/Commodities/§1256Contracts then the choice often is
simple: Do not elect §475 M2M for Futures/Commodities/§1256Contracts.
You will be taxed at the favorable 60/40 tax rates.
The problem, the needed compromise, comes if there is a possibility
that you might have a year with a loss in
Futures/Commodities/§1256Contracts.
Example: consider making $400,000 in securities gains with §475 M2M
and then losing $400,000 in futures with no §475 M2M - a potential disaster
waiting to happen - $400,000 being taxed at your top income tax rate,
and no current year deduction for $397,000 of the capital losses.
Avoid this possibility (and allow the $400,000 gain to be fully offset
with the $400,000 loss) by electing §475 M2M now for Futures/Commodities/§1256Contracts
- but then
you would give up the special 60/40 taxation benefit that you would
enjoy if you do not elect..
Trade (PTP) Publicly Traded Partnership securities and you can step into a vicious tax trap:
Most PTP do
not elect M2M,
therefore you may receive a Schedule K-1 with short-term or
long-term capital losses or losses from §1256 Futures contracts.
Unless you happen to have capital gains to offset these types of
losses, you may be limited to deducting no more than $3,000 per
year.
Remember that if you have elected M2M for your own Securities trading and/or your own §1256 Futures contracts trading that the gains from those are ordinary gain, and therefore may
not be offset against capital losses passed through the PTP. Further, the PTP pass-through losses will reduce your tax basis in the security position held, resulting in an
even larger taxable ordinary gain or a smaller tax-deductible ordinary loss.
Invest in hedge funds
and pass-through entities, or have managed accounts and you may have
a similar issue as with PTPs:
Many hedge funds, and
other pass-through entities may have capital gains/losses rather
than ordinary gains/losses reported on their Schedule K-1s.
Likewise most managed accounts have capital gains/losses rather than
ordinary. If the net of all your trading and investing result
in large capital losses after applying the
wash sales rule, you may be limited to deducting no more than $3,000 per
year.
Trading in Forex
(which has its own tax elections for ordinary/capital tax treatment) and also trading Securities, (PTP) Publicly Traded Partnership securities and/or Futures/Commodities/§1256Contracts and you can really have a dilemma with very unfortunate income tax consequences:
Each of these four classifications of trading will result in gains and losses. If the year ends with a net of capital losses, you may be limited to deducting a maximum of $3,000. Any ordinary gains will then be taxed without the benefit of being offset by the year's capital losses in excess of that $3,000 amount.
Possible saving grace: a note on Limited
Deductibility of trading losses if
§475 is not made:
This can
vary depending on the taxpayer, but generally for individuals
Securities Losses may be offset against Capital Gains each year and if
losses are greater, then an additional $3,000 is generally used to
offset other income each year. Any remaining is used as a
capital loss
carryforward year-to-year.
For Futures/Commodities/§1256Contracts the rules are similar to the above, but
there is an optional election that can be made to carry the year's
loss back three years to offset other
Futures/Commodities/§1256Contracts gains that were taxed under the
60/40 tax rate.
What if you missed making a timely election?
Elections made for the year 2012
Elections made for the year 2011
Elections made for the year 2010
Elections made for the year 2009
Elections made for the year 2008
Elections made for the year 2007
Elections made for the year 2006
Elections made for the year 2005
Elections made for the year 2004
Elections made for the year 2003
Elections made for the year 2002
Elections made for the year 2001
Elections made for the year 2000
Elections made for the year 1999
Elections made for the year 1998
Elections made for the year 1997
Elections for years prior to 1997, the
NOL,
"retroactive elections" and other
special situations.
IRS reporting
1
Generally for individuals that means no later than
April 15th for the year of the election (i.e. after the beginning and
before the end of the year for which M2M takes effect). For
most corporations that means no later than March 15th for the year of the
election. For new taxpayers, those who have not previously filed an
income tax return (such as a newly formed multi-member LLC, for
example) then that means #1 preparing the actual election statement no
later than 2 months and 15 days after the entity's formation and #2 to
notify the IRS that the election was timely made, the new taxpayer
must attach a copy of the statement to its original federal
income tax return for the election year (after the end of the first
year).
2
In limited situations the §475(f) election may be
revoked with the consent of the Secretary under §475(f)(3).
If a separately filing entity has made the election - in lieu of
revocation the owners may simply stop using the entity, liquidate it
or dissolve it.
3REG-104924-98 January 28, 1999 proposed Regs on
Electing Mark-to-Market Accounting "[13] Estimated number of
recordkeepers: 1,000." |
