Year-End 2009 Tax Planning Tips for Traders

11/26/2009 12:03 am EST


Robert Green, CPA


It’s never too early to begin planning your year-end tax approach, and this year there are several unique strategies to keep in mind as you prepare your tax return. The first step to gaining a handle on your unique situation is to prepare a “pro forma” (estimated) tax return.

Preparing a Pro Forma Tax Return

Using a trade accounting program or reports from your broker, figure out your trading gains and losses well before you receive Form 1099-Bs in February. We recommend preparing a pro forma income tax return for the current tax year—which is fairly easy to do with tax software—to see exactly how things work out tax wise. Our (internal) software helps you view tax planning over several years as well.

If you’re a close call on trader tax status, see how your pro forma tax return looks with investor tax status instead. Perhaps you don’t have business trading losses or material wash-sale conditions, and therefore you may not need to use Section 475 MTM (ordinary gain or loss treatment), which is conditional on having trader tax status. Perhaps you can benefit from investment expense treatment on Schedule A miscellaneous itemized deductions (home office and education expenses are not allowed).

If your pro forma tax return shows there’s not much benefit to investment expense treatment, consider classifying your 2009 trading expenses as “start-up” costs (under Section 195) to be amortized when you may qualify for trader tax status in 2010. Start-up costs have an expense election for the first $5,000, and the rest is amortized over 180 months. The same treatment applies to organization costs too, with a second $5,000 expense election.

It’s smart to prepay all state income taxes before year-end for an additional tax deduction, but if your pro forma return shows the alternative minimum tax (AMT) is triggered, prepaying some or all of your state income taxes is a big mistake because state taxes are not deductible for AMT. Instead, you should pay just enough fourth quarter estimated state income taxes before year-end to equal the AMT threshold and pay the balance when it is due the following year—either January 15 (for the estimated income tax safe harbor exception), April 15, or the extension due date. If you can’t avoid AMT, consider embracing its historic and relatively low rate (28%), versus the higher regular tax rates (35%, which will rise to 39.6% in 2011).

AMT preferences include the following types of itemized deductions: State taxes (income, real estate, and property), investment interest expense, and miscellaneous itemized deductions including investment expenses (if you don’t qualify for trader tax status), plus Form 2106, unreimbursed employee business expenses.

Do NOL Planning Before Year End

Pulling together a pro forma return before year end will give you plenty of time to determine your tax strategy if you end up with a net operating loss (NOL). NOL carrybacks are one method to consider, but they are for business taxpayers only. Business taxpayers are entitled to carry back NOL business losses two tax years to claim immediate tax refunds with interest. (Unfortunately, the special five-year NOL carryback add-on rule only applied to 2008.)

Traders might consider soaking up a NOL with a Roth IRA conversion instead. Or, if a trader just barely qualifies for trader tax status in 2009, he or she should consider carrying the NOL forward instead. (Note that NOL carrybacks were frozen in California and Hawaii; those states only allow NOL carry forwards.)

Set Up an Entity

To deflect IRS scrutiny on trader tax status, house your trading business within an entity for 2010 and beyond. It’s easy to set up and the costs are reasonable. A simple husband and wife general partnership is usually all that is needed for married traders. There are no state filing fees, annual fees, or state taxes, and it’s portable from state to state. Single traders can have a general partnership too. They need a second entity such as a C or S corp to own 1% of their general partnership. This is a good idea in states such as California and New York. In most states, only an S corp is needed without any other partnership.

2009: Adjust Your Strategy

You have two choices this year end: 1) Minimize 2009 taxes as best you can to safeguard cash flow—paying as little taxes as possible and maximizing your refund; or 2) Assess your tax situation over the next several years and minimize taxes over the long term. That second choice may mean accelerating income into 2010 to pay more taxes at lower tax rates and avoid the higher tax rates later on.

With the long-term capital gains rate scheduled to rise to 20% in 2011 (from 15%), consider selling long-term capital gains positions before year-end 2009 if the markets are at high levels. Holding short-term positions into 2010 to gain long-term status is another potentially worthwhile strategy. You can sell these positions before year-end 2010 and avoid the tax increase in 2011. The tax savings could be greater than the time value of money.

This same concept can be applied to your traditional retirement plan accounts in connection with a year-end Roth IRA conversion.


Roth IRA Conversion

The last scheduled tax break from the Bush administration is the Roth IRA conversion loophole in 2010, waiving the normal “income threshold” for tax year 2010 only and making it possible for any taxpayer to convert to a Roth IRA. For any other year, the Roth conversion option is only available to taxpayers with a modified adjusted gross income (MAGI) of $100,000 or less for both joint and single filings.

The biggest drawback to the Roth conversion is that you need sufficient cash flow to pay the conversion income taxes, and you can’t use the converted amounts to pay those taxes, either. But the 2010 tax break also allows you to pay the conversion taxes over two years, with half of the income resulting from the conversion to be included in gross income in 2011 and the other half in 2012. (Taxpayers in the upper two brackets can opt out of the two-year tax deferral so they don't pay taxes at higher rates in 2011.)

Traders need to keep in mind that the highest two tax brackets are scheduled to increase in 2011. The highest marginal rate will rise from 35% to 39.6%.

In addition to taking advantage of the income threshold tax break, we also encourage traders to make annual tax deductions to a traditional retirement plan during high-income years (when taxes are paid at higher rates). In years with losses, traders can convert to a Roth IRA, paying taxes at lower rates.

Roth IRA distributions can help taxpayers qualify for other middle-class tax breaks that are dependent on AGI because the distributions are tax-free. Roth IRA distributions can also prevent Social Security benefits from being subject to income tax. If the combined adjusted gross income (AGI) is more than another income threshold amount ($44,000 for tax year 2009), then up to 85% of Social Security benefits are subject to income tax. If AGI falls under that income threshold amount, Social Security benefits are tax free. Traditional IRA distributions may take you over the AGI threshold, whereas a Roth IRA distribution doesn’t count toward taxable income. Roth IRA distributions can help taxpayers qualify for other middle-class tax breaks that are dependent on AGI because the distributions are tax free.

Roth Recharacterization

Suppose you convert to a Roth IRA before year end, pay taxes on the converted amounts, and then face a large loss on the Roth trading account (even in the following tax year). This unfortunate loss on permanently tax free money can’t be deducted on your taxes.

Not to worry, there’s a fix: The IRS allows taxpayers to change their minds. The process is known as a Roth IRA recharacterization. Generally, a taxpayer has until October 15 of the following tax year to undo a Roth conversion. For example, a Roth conversion completed in December 2009 may be recharacterized by October 15, 2010. If a taxpayer already filed his or her 2009 tax return before October 15, 2010, the return can be amended, but it’s better to wait with an extension (also due October 15).

Wash Sale Woes

A wash sale occurs when you trade securities at a loss, and within 30 days before or after, you trade substantially identical securities (which includes options on that security). Rules require wash sales to be computed across all accounts, including IRA accounts and entity accounts. Year-end trading gains often absorb wash sales from earlier in the tax year. Remaining year-end wash sale losses must be deferred to the following tax year.

It’s almost impossible for active traders and tax professionals to figure wash sales by hand. The only software program we know about that currently calculates wash sales correctly is TradeLog from Armen Computing.

A Section 475 MTM election exempts you from wash sale reporting on your business trading accounts. If you elect Section 475 MTM in 2010, 2009 wash sales become part of your 2010 Section 481a ordinary loss adjustment, which converts wash sales into ordinary losses—a good thing. The 2010 Section 481a adjustment is the 2009 year-end unrealized gain or loss. In this example, wash sales are better than capital loss carryovers, as the latter can’t be converted into ordinary loss treatment.

Bottom Line

Make sure to run the numbers and compare different scenarios with your pro forma returns. As always, consult your tax advisor and don’t let any tax breaks fall through the cracks. It’s much harder to save money after year end than before!

By Robert A. Green, CPA,

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