What if you missed the M2M election deadlines for individuals?

• There are special circumstances when you can use a so-called "retroactive" Mark-to-Marker election.
   
• There is still hope.  If you were profitable for 2005 and ended at 12/31/05 "flat" with no open positions, you can most likely elect for 2006 without too much problem.  If you were profitable for 2005 but ended at 12/31/05 with open positions, you can still most likely elect for 2006 with a little more effort and running mark-to-market calculations on each open position.  See your tax advisor (or become a client here) to discuss if this is advisable for you.  This concept becomes more complicated for certain taxpayers after April 15th.
  
  
• If you were profitable for 2005 and ended at 12/31/05 with substantial additional "paper trading profits" you can most likely elect M2M for 2006 and defer those paper trading profits to be recognized over four-years.  It's like getting an interest-free loan from the Government!  See your tax advisor (or become a client here) to discuss if this is advisable for you.  This concept becomes unavailable for most taxpayers after April 15th.  update: This method which is generally available to most trades or businesses, is not generally available to traders.
  
  
• If you lost money trading during 2005 in excess of the normal $3,000 capital loss limitation your excess capital loss carryover could become "locked" on your Schedule D, while your future gains under a subsequently filed Mark-to-Market election would be fully taxed over on Form 4797.  Before making the election under these circumstances you must see a qualified tax advisor thoroughly familiar with Trader Status and Mark-to-Market accounting (or become a client here) to discuss the ramifications of this as it pertains to your unique situation.
  
  
• The wash sales rule can be your friend.  If you lost money trading during 2005 in excess of the normal $3,000 capital loss limitation your excess capital loss carryover could be pushed into 2006 and be transformed into "ordinary losses" by aggressive compliance with the wash sales rule.   The wash sales rule is designed to disallow losses in one year, pushing their deductibility into the following year.  This can work to your advantage if in the disallowed year you have "capital losses," but for 2005 you elect M2M making those losses "ordinary losses."  Paper losses at December 31^st, likewise, are potentially converted into ordinary losses.  These losses may be subject to a four-year phase in for years prior to 2001.  Before making the election under these circumstances you must see a qualified tax advisor thoroughly familiar with Trader Status and Mark-to-Market accounting (or become a client here) to discuss the ramifications of this as it pertains to your unique situation.
  
  Every month we hear from taxpayers who were ill-advised by normally very competent CPAs and other tax practitioners, but for whom the tricks and traps of Trader Status were unknown to them.  A good CPA does not need to know everything, he only needs to know where to look it up when a problem arises, or when he's doing tax planning.  Unfortunately, the hard facts are that when it comes to Trader Status, the overwhelming majority of tax practitioners have no clue that there even is a Trader Status issue to look up, let alone having the practical hands-on experience necessary to be aware of the tricks and traps to be found.
  
  
• If you lost money trading during 2005 in excess of the normal $3,000 capital loss limitation, you might still be in luck if you formed an entity (S-Corp., LLC, Partnership, etc.) earlier in the year or were deemed to have been trading through such an entity, as we have here.    See your tax advisor (or become a client here) to discuss the ramifications of this as it pertains to your unique situation, it is not as difficult as you may think!
  
  
• If you missed making the IRS Code §475(f) "mark-to-market" election, but really needed to have it for 2000, 2001, 2002 , 2003, 2004 or 2005... retroactively, there is still the Private Letter Ruling route to follow (IRS Rev Proc. 2000-1) [see update below].  There are specific issues (reasons or excuses) that the IRS will consider when granting you a "retroactive election" to use the mark-to-market method.  A Private Letter Ruling is a formal application or request to the National Office of the IRS.  They are time consuming and relatively expensive to prepare; oftentimes running into multiple thousands of dollars in professional fees.  
  
  This little known rule, granting relief to taxpayers who missed the formal filing of their IRS Code §475(f) "mark-to-market" election (described below for any given year), may be used by certain taxpayers who meet several of the following criteria:
  each of these:
  1) You acted "reasonably and in good faith" at all times with regards to what should have been the timely filing of the election.  i.e. you do not base your request for relief on hindsight, now that your situation has changed since 4/17/2000 (or 4/16/01 or 4/15/02 or 4/15/03 or 4/15/04 or 4/15/05).
  2) Your situation is "unusual" or there are other "compelling circumstances" for the IRS to consider before granting relief.
  
  one or more of these:
  3) You were totally unaware of §475(f).
  4) You studied §475(f) but were confounded by the rules surrounding it.
  5) You were unable to make the §475(f) election due to circumstances beyond your control.  i.e. extreme illness.
  
  two or more of these:
  6) You paid for professional advice and were told there was no election to be filed or otherwise was given the incorrect information regarding the need to file the §475(f) election by this paid professional.
  7) You paid for a professional to produce any necessary election(s) but the results of his work were defective in one way or the other, making your formal §475(f) election invalid or leaving it late-filed or unfiled.
  8) You can obtain a detailed affidavit from the tax advisor you used for the §475(f) election advice; which affidavit restates the incorrect advice as originally given to you.
  9) You took a copy of a free §475(f) election off the internet that was defective, but filed it thinking it was properly prepared.
  
  one or more of these:
  10) Your §481(a) adjustment is not "necessary."  i.e. your annual end-of-year inventories of stock positions always have less than a $25,000 built-in aggregate gain or loss.
  11) Preferably, you never hold any stock positions over any 12/31/XXXX year-end period, making a §481(a) adjustment "unnecessary."  (this concept was successfully challenged by the IRS, see the "update" below).

If you meet the criteria in three or more of the above groupings see your tax advisor immediately (or become a client here) to discuss how to proceed.

UPDATE:  The IRS has approved few or none of the PLRs (see PLR1  PLR2  PLR3  PLR4  PLR5 ) filed with them for the retroactive granting of Trader Status M2M accounting.  The IRS apparently is waiting for a taxpayer with a rejected PLR to go to Tax Court to set precedent for the IRS to follow.  (add'l information  6   7   8   9 )

2006 UPDATE: The US Tax Court has struck down the IRS long-standing policy to reject out-of-hand all PLR requests for late M2M elections.  The IRS policy was to continue rejecting all such requests and let the courts decide.  In (L.S. Vines v. Commissioner, 126 TC No. 15 , May 11, 2006)  the first case we know of has resulted in a victory for the taxpayer.  While the facts in this case were unique, at least the IRS has what it was waiting for - a decision by the court to provide guideance going forward.  Fairmark Press editorial regarding this case.
 

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• Finally, for many traders the best way to handle this now is one of these methods.  At this time we are not suggesting that taxpayer's who have already filed improperly - now prepare amended tax returns without the guidance of a qualified tax attorney.

1. Dealer-Status method under IRS Revenue Ruling 97-39
   If you missed making the IRS Code §475(f) "mark-to-market" election, but really needed to have it for 2001, 2002 or ...2006... retroactively, you may qualify to file under Dealer Status if you trade very actively using ISLAND and the other ECNs.  This little known rule requires anyone filing under Dealer Status to use the mark-to-market method of accounting and therefore there IS no election deadline, i.e. you "elect" M2M when you file your tax return: on time, on extension, or even if filed late!  To qualify to file under Dealer Status you need to deal with customers not market makers.  e.g. trading through an ECN like ISLAND or REDI.  You should not trade as a customer of the market makers themselves.  A Trader is a customer himself, who trades for his own account by selling to a market maker and buying from a market maker.  A Dealer trades with customers as Agency (for customers, with customers) or as Principal (for his own account, with customers).  Trading through an ECN links you to customers as you trade as Principal, for your own account.
   
   If you have a healthy amount of activity, say 1,000 to 2,000 or more trades in a year and you use the ISLAND or other ECNs exclusively, see your tax advisor immediately (or become a client here) to discuss how to proceed in retroactively establishing yourself under Dealer Status, and utilizing the mark-to-market method of accounting without the need to file a §475(f) election.
   
    If you have less than 1,000 trades, dealer status may still work for you if, by using ECNs, you feel strongly that: (1) you deal primarily with customers, (2) that your securities are basically "property held primarily for sale to customers in the ordinary course of your trade or business," (3) that your income therefore is based on a service provided by yourself in providing liquidity to the marketplace rather than being based on your reaction to fluctuations in the market value of securities and (4) You expected to profit due to your labor as a middleman by buying at the "bid" to fulfill future buying orders by selling at the "ask" (Kemon v Comm).
   
   This method is used for sole proprietorships and, with some difficulty, for for separate trading entities.
   
   IRS Revenue Ruling 97-39
   ISSUES AND HOLDINGS
   Issue 3: If a taxpayer's sole business consists of trading in securities (that is, the taxpayer does not purchase from, sell to, or otherwise enter into transactions with customers), is the taxpayer a dealer in securities within the meaning of section 475(c)?
   
   Holding 3: No. A taxpayer whose sole business consists of trading in securities is not a dealer in securities within the meaning of section 475(c) because that taxpayer does not purchase from, sell to, or enter into transactions with, customers in the ordinary course of a trade or business.
    
2. Mandatory Retroactive §448 Limitation Method
   Under §448 an entity is prohibited from using the normal "cash method of accounting" if a c-corporation acquires an ownership interest and if gross receipts exceed $5,000,0000 (as an average over the three preceding years).  Merely selling a small ownership interest to a c-corporation can subject the entity to this requirement.
   
   Per the law, under §448 in the case of any taxpayer required by this section to change its method of accounting for any taxable year-- §448(d)(7)(A) such change shall be treated as initiated by the taxpayer and §448(d)(7)(B) such change shall be treated as made with the consent of the Secretary.
   
   If a c-corporation is needed for this method, an existing s-corporation can be changed into a c-corporation by several methods of making it ineligible to continue as an s-corporation or by electing revocation of its s-corporation status.
   
   1.448-1T(f)(2)(iv)(A) Determination of gross receipts--
   The term "gross receipts" means gross receipts of the taxable year in which such receipts are properly recognized under the taxpayer's accounting method used in that taxable year (determined without regard to this section) for federal income tax purposes. For this purpose, gross receipts include total sales (net of returns and allowances) and all amounts received for services. In addition, gross receipts include any income from investments, and from incidental or outside sources. For example, gross receipts include interest (including original issue discount and tax-exempt interest within the meaning of section 103), dividends, rents, royalties, and annuities, regardless of whether such amounts are derived in the ordinary course of the taxpayer's trade of business. Gross receipts are not reduced by cost of goods sold or by the cost of property sold if such property is described in section 1221 (1), (3), (4) or (5). With respect to sales of capital assets as defined in section 1221, or sales of property described in 1221 (2) (relating to property used in a trade or business), gross receipts shall be reduced by the taxpayer's adjusted basis in such property. Gross receipts do not include the repayment of a loan or similar instrument (e.g., a repayment of the principal amount of a loan held by a commercial lender). Finally, gross receipts do not include amounts received by the taxpayer with respect to sales tax or other similar state and local taxes if, under the applicable state or local law, the tax is legally imposed on the purchaser of the good or service, and the taxpayer merely collects and remits the tax to the taxing authority. If, in contrast, the tax is imposed on the taxpayer under the applicable law, then gross receipts shall include the amounts received that are allocable to the payment of such tax.
   
    
3. Regs § 1.1366-1 Shareholder's share of items of an S corporation Method
   Under IRS Regulation § 1.1366-1 (reproduced below) a trader may be able to convert unlimited capital losses from existing long-term investment holdings into ordinary losses.  The appropriate formation of a corporation or LLC with timely elections to be taxed under subchapter S and to use the mark-to-market method of accounting coupled with the transfer of long-term investments with paper losses into the newly formed entity can result in the realization of ordinary losses (as opposed to potentially non-deductible capital losses). 
   
   Note #1 it is imperative that the entity not be used primarily for selling the long-term investment holdings.
   
   Note #2 this law is somewhat inconsistent with parallel partnership law found at IRS Code § 724. Therefore this may be challenged by the IRS when they realize the inconsistency exists.
   
   Note #3 How do irrational inconsistencies like this creep into the Tax Code?  Answer: Probably some Congressman's son had an s-corporation and wanted to convert his unusable long-term capital losses into valuable ordinary losses.
   
   IRS Regulation 1.1366-1(b) Character of items constituting pro rata share--
   1.1366-1(b)(1) In general.
   Except as provided in paragraph (b)(2) or (3) of this section, the character of any item of income, loss, deduction, or credit described in section 1366(a)(1)(A) or (B) and paragraph (a) of this section is determined for the S corporation and retains that character in the hands of the shareholder. For example, if an S corporation has capital gain on the sale or exchange of a capital asset, a shareholder's pro rata share of that gain will also be characterized as a capital gain regardless of whether the shareholder is otherwise a dealer in that type of property. Similarly, if an S corporation engages in an activity that is not for profit (as defined in section 183), a shareholder's pro rata share of the S corporation's deductions will be characterized as not for profit. Also, if an S corporation makes a charitable contribution to an organization qualifying under section 170(b)(1)(A), a shareholder's pro rata share of the S corporation's charitable contribution will be characterized as made to an organization qualifying under section 170(b)(1)(A).
   
   1.1366-1(b)(2) Exception for contribution of noncapital gain property.
   If an S corporation is formed or availed of by any shareholder or group of shareholders for a principal purpose of selling or exchanging contributed property that in the hands of the shareholder or shareholders would not have produced capital gain if sold or exchanged by the shareholder or shareholders, then the gain on the sale or exchange of the property recognized by the corporation is not treated as a capital gain.
   
   1.1366-1(b)(3) Exception for contribution of capital loss property.
   If an S corporation is formed or availed of by any shareholder or group of shareholders for a principal purpose of selling or exchanging contributed property that in the hands of the shareholder or shareholders would have produced capital loss if sold or exchanged by the shareholder or shareholders, then the loss on the sale or exchange of the property recognized by the corporation is treated as a capital loss to the extent that, immediately before the contribution, the adjusted basis of the property in the hands of the shareholder or shareholders exceeded the fair market value of the property.
   
   
   IRS Code § 1366. Pass-thru Of Items To Shareholders
   1366(a) Determination Of Shareholder's Tax Liability
   
   1366(a)(1) In General
   In determining the tax under this chapter of a shareholder for the shareholder's taxable year in which the taxable year of the S corporation ends (or for the final taxable year of a shareholder who dies, or of a trust or estate which terminates, before the end of the corporation's taxable year), there shall be taken into account the shareholder's pro rata share of the corporation's--

   1366(a)(1)(A) items of income (including tax-exempt income), loss, deduction, or credit the separate treatment of which could affect the liability for tax of any shareholder, and

   1366(a)(1)(B) nonseparately computed income or loss. For purposes of the preceding sentence, the items referred to in subparagraph (A) shall include amounts described in paragraph (4) or (6) of section 702(a).
   
   
   IRS Code § 724. Character Of Gain Or Loss On Contributed Capital Loss Property
   724(c) Contributions Of Capital Loss Property
   In the case of any property which--
   724(c)(1) was contributed by a partner to the partnership, and
   724(c)(2) was a capital asset in the hands of such partner immediately before such contribution, any loss recognized by the partnership on the disposition of such property during the 5-year period beginning on the date of such contribution shall be treated as a loss from the sale of a capital asset to the extent that, immediately before such contribution, the adjusted basis of such property in the hands of the partner exceeded the fair market value of such property.
   
   
   IRS 2004 form 1065 instructions, page 9
   
   Dispositions of Contributed Property
   Generally, if the partnership disposes of property contributed to the partnership by a partner, income, gain, loss, and deductions from that property must be allocated among the partners to take into account the difference between the property’s basis and its FMV at the time of the contribution. However, for contributions made after October 22, 2004, if the adjusted basis of the contributed property exceeds its fair market value at the time of the contribution, the built-in loss can only be taken into account by the contributing partner. For all other partners, the basis of the property in the hands of the partnership is treated as equal to its fair market value at the time of the contribution (see section 704(c)(1)(C)).
   
   For property contributed to the partnership, the contributing partner must recognize gain or loss on a distribution of the property to another partner within 5 years of being contributed. For property contributed after June 8, 1997, the 5-year period is generally extended to 7 years. The gain or loss is equal to the amount that the contributing partner should have recognized if the property had been sold for its FMV when distributed, because of the difference between the property’s basis and its FMV at the time of contribution.
   
   See section 704(c) for details and other rules on dispositions of contributed property. See section 724 for the character of any gain or loss recognized on the disposition of unrealized receivables, inventory items, or capital loss property contributed to the partnership by a partner.
   
    

4. Special Disclosures Method using IRS forms 8275 and 8275-R
   Using IRS approved forms and procedures, this method may be considered an alternative to obtaining a Private Letter Ruling (see above for the problems with using actual PLRs at the present time).  While you will not be rejected right out of the box even before you file your 1040, as is currently happening with PLRs, you should be prepared to defend your position (see PLR defenses above) in Tax Court.  To be properly represented in Tax Court, traders need to retain their own separate legal council.  This method is used for sole proprietorships and for separate trading entities.
   
    
5. "Retroactive" Capital Loss Carryback Method using IRS forms 6781 and 1040X
   A Carryback of IRS Code §1256 Losses to offset Prior IRS Code §1256 Gains, while normally elected with the timely filing of the tax return for the year that the loss was created, may nonetheless be carryied back retroactively in many cases.

   This retoractive carryback election applies to Traders as well as to Investors for their IRS Code §1256 Commodities and Futures capital losses. Generally this must be retroactively elected within the three year statute of limitations for either the loss year and/or the carryback year(s).

   Normally the regular carryback election is made by checking Box D on form 6781 on a timely filed Income tax return.
   
   
   
   Each of these methods are the best we have at the present time.  We were waiting (and advised traders to consider holding off their tax return filings) until Congress had passed needed relief for Securities Traders.  Indeed they did give us some needed and fair relief with the passing of the 2002 Job Creation and Worker Assistance Act.  In that new law they gave first-year M2M Traders favorable benefits under §481 so that certain losses can now be deducted in full, rather than over four years.  Also, 2001 & 2002 Net Operating Losses (NOLs) can now be used a) forward, b) back 2 years or c) back 5 years if the taxpayer makes the proper election or takes immediate corrective action when the 2001 election was not properly made.
   
   These methods require a high-level of specialized interest in the planning, presentation and preparation of your federal and your state tax returns.  Due to the complexity of the many issues involved, including much one-on-one tax consultation, the retainer for new clients will be negotiable and higher than the regular retainer amount.
   
   Additional fees may be required to complete your initial tax filings and/or to represent you in any resulting tax examination audits and appeals.    Further, traders must fully understand that there are no positive guarantees when it comes to cutting-edge trader status tax positions.  The IRS is actively seeking taxpayers to challenge and take on in U.S. Tax Court.  When entering these positions (above) you must be prepared to retain legal counsel, if you want to be a lead case in U.S. Tax Court.   TraderStatus.com and Colin M. Cody, CPA are not Attorneys at Law and do not practice law and cannot represent you beyond the standard appeals process.  We are available to consult with qualified tax attorneys retained to represent Tax Court cases.
   
   Often when a taxpayer brings action to Tax Court, the Court will not hear the case until the IRS appeals office gives the taxpayer one additional go-around to try to resolve the matter.  In effect the taxpayer gets three shots at it with a CPA before the expense of going into Tax Court with your Lawyer.
   
    

6. Force a new tax period to begin without waiting until January 1st
   Here a little known rule meant to punish taxpayers can be turned around to their advantage.  Under the law a LLC or Partnership is automatically granted new taxpayer status if there is a properly executed sale or exchange of 50% or more of the total interest in LLC or partnership capital and profits.  Once you have been granted (forced actually) to take on new taxpayer status under §708(b)(1)(B) then a M2M election can be made immediately this year (or retroactively per the new taxpayer procedure) without waiting until the following year.
   
    
7. Nearly fail-safe Section 1244 stock "tax insurance" play (especially good for futures traders)
   Rather than form a LLC, form an S-corporation and issued less than $1,000,000 of stock directly to yourself for cash.  Then as long as the corporation is active and clearly qualifies as a trade or business, any losses can be retroactively made "ordinary" even if the M2M election was forgotten or in the case of a futures trader, purposely not made so the 60/40 capital gains rates would apply to gains.  There are formal technicalities to be wary of, meaning you may want your attorney involved along with your CPA right from the pre-incorporation stage.
   1. the s-corp must issue common stock directly to the owner.
   2. the stock must be purchased for cash
   3. must be a "small business corporation" with less than $1,000,000 in capital
   4. corporation must be active, operating and receive less than 50% of its gross receipts from rents, royalties, dividends and other investment income (IRS Regs §1.1244(c)-1(e))
      
      more on Section 1244
      
       

   Please contact us to discuss your options regarding "retroactive" M2M application.