5.1) I am single and file Form 1040. If I decide to start trading for a living as a sole proprietor, how do I tell the IRS I’m going to file under Trader Status and when must I tell them?
You tell them by filing a Schedule C along with your Form 1040.
You usually need to do that by April 15th of the following year.
5.2) Ok, so I’m going to start filing under Trader Status as a sole proprietor, how do I now tell the IRS I’m going to use the mark-to-market method of accounting right from the start and when must I tell them?
You tell them by filing an election statement attached to either
Form 1040 or Form 4868 no later than April 15th of the year in
which you started trading. e.g. the previous year’s tax return.
The election statement must be clear that it applies to your
securities trading or your commodities trading (or both
your securities trading and your commodities trading).
5.3) Hold on! What if I only decided to start trading as a sole proprietor after April 15th?
Then you may file under Trader Status and take all the deductions
allowed against your income. But you may not use the mark-to-market
method for this, your first calendar year of trading, unless you somehow
had the foresight to file the mark-to-market election with the IRS by April 15th.
5.4) What? But that isn’t fair!
I agree, it is not fair. It is simply the law, as it now stands.
5.5) So I file under Trader Status as a sole proprietor for the first year, how do I then elect to use mark-to-market for a following year and when must I tell the IRS?
You tell them by filing an election statement attached to either
Form 1040 or Form 4868 no later than April 15th of the year which
you will start using the mark-to-market method and you also file
two copies of Form 3115; one with your Form 1040 by April 15th of the
next year and at the same time, one with the National Director’s office.
5.6) You keep mentioning trading as a “sole proprietor.” What if I use a separate entity, does this make any difference?
The rules are basically the same for trading through an entity, with one
notable exception: If the entity (or taxpayer) was not required to file a
federal income tax return for the taxable year immediately preceding
the election year (the year before the year security trading started),
then the requirement to file the mark-to-market election along with
the tax return for the year before the election is waived. In lieu of
that an appropriate election is filed in the taxpayer’s own files, and
then when the first federal income tax return is filed, the election is
attached to that tax return.
5.7) What is UBTI?
The Unrelated Business Taxable Income tax is imposed on the
unrelated business taxable income of most exempt organizations.
The purpose of the tax is to prevent unfair competition by exempt
organizations that could use their tax exempt status to gain an
advantage over taxable businesses. Gross income subject to the
tax consists of income from a trade or business activity, if the
business activity is not substantially related to the organization’s
exempt purposes and is regularly carried on by the organization.
The deductions directly connected with the business income as
well as specified modifications are taken into account in
determining unrelated business taxable income. The tax is
imposed at the corporate or trust income tax rates, depending upon
the legal form of the exempt organization.
Capital Gains, dividends, interest, rents, royalties, and similar payments
are normally excluded from the scope of the unrelated business income
tax, but such investment income is subject to tax if derived from a
controlled entity or from debt-financed property e.g. use of margin debt.
There is an annual deduction that offsets the first $1,000 of UBTI.
The tax on such income is called unrelated business income tax (UBIT).
Tax-exempt organizations include Self-Employed 401(k) Plans,
IRA’s, Keogh Plans and other retirement plans.
UBTI is an acronym for Unrelated Business Taxable Income.
UBTI generally occurs when a plan generates income
from operating a business, acquiring or improving property through
debt financing, or certain partnerships from which the plan owns an
interest. Refer to IRC § 512(a) (1).
UBTI is income generated by a trust when engaging in business activity
that is unrelated to its general purpose. Self-directed IRAs were created
for long term investing, and when it purchases an asset that produces
income unrelated to the intent of the “plan” then that income is subject
to taxation – which means your IRA will be paying taxes on profits
generated from your business purchase.
UBTI is subject to Unrelated Business Income Tax or UBIT. UBIT is a
very steep and complicated form of taxation. Much like Federal Income
Taxes, UBIT is set to a laddered schedule. However it is compressed
on much tighter levels. In 2005, UBIT is taxed at the following rates:
- $0 – $2,000 = 15%
- $2,000 – $4,700 = 25%
- $4,700 – $7,150 = 28%
- $7,150 – $9,750 = 33%
- Over $9,759 = 35%
UBIT was implemented to keep the playing field even between plans
that open businesses and the typical small business owners. If a plan
or self-directed IRA was able to purchase a business and did not have
to pay any taxes, it would be able to deliver an identical product at a
discount. UBIT mitigates that risk for the typical business owner.
UBIT is one of the most complicated areas of taxation in the Internal
Revenue Code. It is imperative you seek professional help to make
sure you do not incur any severe tax penalties.
5.8) What is UDFI?
The Unrelated Debt Financed Income tax is imposed on the unrelated
debt financed income of most exempt organizations. The purpose of
the tax is to prevent unfair competition by exempt organizations that
could use their tax exempt status to gain an advantage over taxable
businesses. Gross income subject to the tax consists of income from
an activity that creates income through the use of debt or leverage.
The deductions directly connected with the debt financed income as
well as specified modifications are taken into account in determining
unrelated debt financed income. The tax is imposed at the corporate
or trust income tax rates, depending upon the legal form of the exempt organization.
There is an annual deduction that offsets the first $1,000 of UDFI/UBTI.
UDFI stands for Unrelated Debt Financed Income. UDFI is income
generated by an IRA, or other retirement plans, through debt-financing
or leverage. UDFI is taxed much like UBTI and is similarly as complicated.
UDFI only applies to the profit realized through debt and is based on the
highest amount of leverage carried within the past 12 months.
Refer to IRC § 514(a)(1).
For example: Your self-directed IRA purchased a piece of raw land in 1999
for $100,000 using a non-recourse loan with 50% down. In 2004, you sold
that same piece of property to a developer for $200,000. Your IRA had
secured a 50% loan to value (LTV) on the property, and let’s assume that
you never paid down any principle because it was an interest only note. Fifty
percent of the profit would be subject to UBIT because it was generated by
money that was not related to the self-directed IRA.
As a side note – UDFI does not apply if the debt is paid off 12 months prior
to the sale of the property. If the self-directed IRA can pay off its loan
early – it may not have to pay UBIT at all! If you are intending to purchase
assets inside a self-directed IRA using debt-financing, please consult with a
competent tax advisor.
5.9) Can an IRA account be a type 2 “Margin Account” or must it be a type 1 “Cash Account”?
There is no SEC law or regulation making IRA Margin Accounts illegal.
There is no DOL law or regulation making IRA Margin Accounts illegal.
There is no IRS law or regulation making IRA Margin Accounts illegal.
In spite of this, many retail brokerage houses do not allow margin
accounts for IRAs and other retirement plans.
One big reason for this is that SEC staff opinions erroneously informed
brokerage houses that it was illegal, per the IRS. The SEC punctuated
this by prosecuting Ameritrade/Datek in 2002 with a fine in the amount
of millions of dollars allegedly for this offense.
It was typical bureaucratic confusion. The facts are that the Ameritrade
fine was for allowing free-riding in cash accounts (not necessarily IRA accounts).
The SEC had allowed their non-tax-experts to go off and publish “staff
opinions” that said the IRS outlawed margin borrowing. (but they had
misread the gobbledy-gook words in the IRS regs)
TraderStatus.com spent about 12 months or so “battling” on a professional
level with the SEC until they agreed to retract all “staff opinions” that said
the IRS outlawed margin accounts. I then also continued the “battle” to get
the SEC to publish a firm retraction and correction of their prior error (and
not just quietly withdraw the staff opinions).
But understandably to “save face,” they would not do so until the IRS
affirmatively told them that the documentation package I had put together
for them got an official IRS blessing.
Unfortunately the IRS has many other projects on their plate and they have
kept putting off this low-priority SEC request.
5.10) What is a Federal Tax Lien?
A federal tax lien (pronounced “lea-en” similar to the 2nd
syllable in the word “alien”) is the U.S. Government’s legal claim
against your property when you neglect or fail to pay a tax debt.
The lien protects the government’s interest in all your property,
including real estate, personal property and financial assets. A
federal tax lien exists after the IRS:
- Assesses your liability;
- Sends you a bill that explains how much you owe
(Notice and Demand for Payment); and
- You neglect or refuse to fully pay the debt in time.
5.11) What is a Tax Levy?
A lien is not a levy. A lien secures the government’s
interest in your property when you don’t pay your tax debt. Whereas,
a levy actually takes the property to pay the tax debt. If you
don’t pay or make arrangements to settle your tax debt, the IRS can
levy, seize and sell any type of real or personal property that you
own or have an interest in.
5.12) What is the U.S. Code?
The United States Code is most all of the laws of the United States
of America. The tax laws are the Internal Revenue Code which is
also know as “Title 26” as contained with the U.S. Code. You may
search the U.S. Code here: