Although it is too late to elect Section 475 mark-to-market (MTM) for fiscal 2020, the opportunity for 2021 is now available. In this blog post, I'll cover the scenarios that make it prudent to get Section 475 for fiscal 2021 and how the election will play out.
Before we dive in, let's take a look at the deadlines, as they are fast approaching. Traders qualified for Trader Tax Status (TTS) can choose 2021 Section 475 MTM on Securities and Commodity from April 15, 2021, for individuals and March 15, 2021, for corporations and partnerships. The IRS has extended the tax filing deadline from April 15, 2021, to June 15, 2021, for residents of all counties in Texas, following a federal disaster declaration in February 2021)
Why is section 475 so attractive?
Exempt securities transactions from wash sale adjustments and the capital-loss limitation of capital losses on other income (tax loss insurance.) Profitable TTS/475 traders can deduct 20% of their qualified business income (QBI) if they are below the QBI taxable income limit.
Who should choose section 475?
Capital gains are necessary to absorb capital losses, so if you have large transfer losses or unrealized capital losses in separate investment positions, choosing MTM would be a gamble. Suppose a TTS trader experiences further trade losses in 2021 from the start of the year before the election deadline. In that case, an MTM Section 475 option in 2021 is generally preferred as it allows for normal loss management and does not add any additional losses recycled capital losses.
Existing individuals and entities
To make the election, write this statement on a piece of paper with your name and Social Security number (or EIN) on it.
Under IRC 475(f), the taxpayer currently elects to adopt the mark-to-market accounting method for the year ended December 31, 2021, and subsequent years. The election applies to the following business or trade: the trader who is into securities as a sole proprietor (for securities and not Section 1256 contracts).
Attach the 475 election declaration to your 2020 income tax return or extension. If you plan to file your tax return or income extension electronically, send the 475 election return with a letter of intent to the IRS.
If you need to apply section 475 to 1256 contracts, modify the declaration to include the commodities. Usually, the best option is to keep capital gain rates below 60/40 on 1256 contracts.
The election declaration is only the first part of the process and the most important part. You must also complete Form 3115 with your 2021-2022 tax return and fax a copy to the IRS.
You can revoke elections in section 475 before expiration dates in a mirror process.
Section 475 MTM does not apply to properly separated investment positions.
New Entities
The 475 election method is different for a new taxpayer, a newly incorporated entity, or a person filing taxes for the first time. You must enter the following statement in the books and records within 75 days of starting the new entity (new LLC / partnership or S-Corp). It is safest to use the date you obtained your Employer Identification Number (EIN).
Under IRC 475(f), the taxpayer currently elects to adopt the accounting market value method for the year ended December 31, 2021, and subsequent years. The election applies to the following business or trader: trader in securities as an entity (securities only and not contracts referred to in Section 1256).
A new taxpayer does not have to submit a Form 3115 for Section 475 MTM internal elections. The new entity has adopted the 475MTM accounting method since its inception.
If you want to incorporate section 1256 contracts in 475 elections, revise the election statement to include "goods" (section 1256 contracts). This action is prudent if large losses occur during the first 75 days of these contracts.
20% deduction on QBI (qualified business income)
The TCJA 2017 introduced a new tax deduction for pass-through companies, including sole proprietorships, corporations, and S corporations. Subject to reductions and limitations, a pass-through business may be entitled to a 20% deduction from qualified business income (QBI).
Qualified TTS traders are considered a "specific service activity," which means that if their taxable income exceeds the income limit, they will not receive a QBI deduction. The taxable income limit for 2020 is $426,600 for married couples and $213,300 for other taxpayers and $429,800 for married couples, and $214,900 for other taxpayers for 2021. The phase-out limit is $100,000 for married and $50,000 for other taxpayers. The W-2 ownership and basis limitation also apply within the phase-out interval. Investment managers are service-specific activities too.
The QBI for traders includes normal income and losses under Section 475 and business expenses. QBI excludes capital gains and losses, ordinary income or losses per Section 988 forex ordinary income or loss, dividends, and interest income.
TCJA favors non-service businesses that are not subject to an income limit. The W-2 basis salary and ownership restrictions apply above the taxable income limit of $326,600 for married and $163,300 for other taxpayers for 2020 and $329,800 for married, and $164,900 for other taxpayers until 2021. The IRS annually changes the annual limit for inflation.
Individual owner-owned TTS traders cannot pay their wages, so they may not be able to use the phase-out interval, and the threshold is their limit.
Segregation of investments
Suppose a trader holds investment positions in stocks and trades identical stock positions in stocks or equity options using the TTS and section 475. The IRS can redefine trades as investments or vice versa, whichever works best for them. For instance, the IRS could reclassify an investment position in Tesla stocks currently carried over to long-term capital gains in the 475 MTM income section at the end of the year. Alternatively, the IRS could again characterize the usual losses in the 475 MTM section of Tesla's options as major losses that trigger a loss limit of more than $3,000.
Traders who overlap between investing and trading activities should consider entering into the TTS/475 agreement with one entity and carrying out their investing activities individually. Such a solution would solve the potential problem for the IRS.
Here's an example: John has an investment portfolio in stocks. He leverages on his investments by using portfolio margins to trade stock options around those investment positions to manage portfolio risk and take advantage of the option premium. John doesn't sell naked options because he owns equity investments and trades on the same brokerage account. John must choose to use Section 475 or the Portfolio Margining.
475 Fixes Wash Sale with IRAs for TTS Trades
Suppose there is an overlap between the amounts traded in taxable accounts and what is invested in the IRA. In that case, the merchant should avoid triggering permanent losses in laundry sales throughout the year. If a trader has a loss on a taxable account and acquires a substantially identical security position 30 days before or after an IRA, the loss becomes permanent.
Traders can avoid this with a "do not invest" list to avoid this overlap. One strategy is to trade stocks and stock options in taxable accounts and invest in ETFs, mutual funds, and REITs in IRAs.
TTS (Trader tax status) merchants can choose Section 475 to eliminate wash sale between transactions and the IRA, so overlap is not a problem.
Consider all suitable IRA applications, including traditional IRAs, Roth IRAs, transfer IRAs, and SEP IRAs. Do not include qualified plans such as Solo 401(k) or 401 (k) plans.
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