Recent years’ tax acts don’t change trader tax status (TTS), Section 475 MTM accounting, wash-sale losses on securities, or the tax treatment on financial products, including futures (Section 1256 contracts) and cryptocurrencies (intangible property), states Robert Green of GreenTraderTax.com.
It’s helpful to consider IRS inflation adjustments in income and capital gains tax brackets, various income thresholds and caps, retirement plan contribution limits, standard deductions, and more. The IRS increase for 2023 is about 7%.
Excess Business Losses and Net Operating Losses
Some traders eligible for trader tax status (TTS) and who filed a timely Section 475 election incurred ordinary business losses for 2022. Before the Tax Cuts and Jobs Act (TCJA) started in 2018, a TTS/475 trader could carry back a net operating loss (NOL) for two years, generating a tax refund. TCJA introduced an “excess business loss” (EBL) limitation, with the excess being an NOL carryforward. TCJA repealed NOL carrybacks (except for farmers) and limited NOL carryforwards to 80% of the subsequent year’s taxable income. CARES suspended TCJA’s EBL and NOL changes for 2018, 2019, and 2020 and allowed five-year NOL carrybacks (i.e., a 2020 NOL carryback to 2015). TCJA’s EBL and NOL carryforward rules apply for tax years 2021 through 2028.
Defer Income and Accelerate Tax Deductions
Consider deferring income and accelerating tax deductions if you don’t expect your taxable income to decline in 2023.
Traders eligible for trader tax status in 2022 should consider accelerating trading business expenses, such as purchasing business equipment with first-year expensing using Section 179 or bonus depreciation.
Consider delaying sales of investments to defer capital gains. Defer bonuses at work.
Accelerate Income and Defer Certain Deductions
A TTS trader with substantial Section 475 ordinary losses should consider accelerating income to soak up the EBL. Try to advance enough income to use the standard deduction and take advantage of lower tax brackets. Stay below the threshold for unlocking various AGI-dependent deductions and credits. A higher income can lead to an IRMA adjustment raising Medicare premiums.
Roth IRA Conversion
Consider a “Roth IRA Conversion,” changing a traditional IRA or 401(k) into a Roth IRA. Distributions from a standard retirement plan are taxed as ordinary income (not capital gains), whereas with a Roth IRA, distributions are tax-free.
On the conversion date, the market value of the traditional retirement account is conversion income taxed at ordinary rates. Futures growth and capital in the Roth IRA account are tax-free. If your retirement portfolio is depressed in value, you might enjoy recovery of values inside a Roth IRA.
Generally, there’s a 10% excise tax on “early withdrawals” from retirement plans before age 59½. With a Roth IRA conversion, you can avoid excise tax by paying conversion taxes outside the Roth plan. TCJA repealed the recharacterization option, so you can no longer reverse the conversion if the plan assets decline. Roth IRA conversions have no income limit, unlike regular Roth IRA contributions.
As an illustration, a taxpayer filing single has a $405,000 TTS/475 ordinary business loss. However, the excess business loss limitation for a single filing status in 2022 is $270,000 ($540,000 for married), so $135,000 is an NOL carryover. The taxpayer should consider a Roth conversion to soak up most of the $270,000 allowed business loss and leave enough income to use the standard deduction and lower tax brackets.
Zero Tax Rate on Long-Term Capital Gains in the Lowest Tax Bracket
If you have a low income, consider realizing long-term capital gains by selling open positions held for more than 12 months. The 2022 long-term capital gains rates are 0% for taxable income in the 10% and 12% ordinary tax brackets. The 15% capital gains rate applies to the regular middle brackets, and the top capital gains rate of 20% applies to the top 37% ordinary income bracket. Remember, if you go $1 over the zero-rate bracket, all the long-term gains are subject to the 15% capital gains rate; it doesn’t work like progressive marginal ordinary tax brackets.
Net Investment Income Tax
Investment fees and expenses are not deductible for calculating net investment income (NII) for the Affordable Care Act (ACA) 3.8% net investment tax (NIT) on NII. NIT only applies to individuals with NII and modified adjusted gross income (AGI) exceeding $200,000 single, $250,000 married filing jointly, or $125,000 married filing separately. The IRS does not index these ACA thresholds for inflation. NII includes portfolio income, capital gains, and Section 475 ordinary income.
Business Expenses and Itemized Deduction vs Standard Deduction
Business expenses: TTS traders are entitled to business expenses and home-office deductions. The home office deduction requires income, except for the mortgage interest and real property tax portion. The SALT cap on state and local taxes does not apply to the home office deduction.
TCJA expanded first-year expensing of business property; traders can deduct 100% of these costs in the year of acquisition, providing they place the item into service before year-end. Traders with TTS in 2022 may consider going on a shopping spree before January first. There is no sense in deferring TTS expenses because you cannot be sure you will qualify for TTS in 2023.
Employee business expenses: Ask your employer if they have an “accountable plan” for reimbursing employee-business costs. You must “use it or lose it” before year-end. TCJA suspended unreimbursed employee business expenses. TTS S-Corps should use an accountable plan to reimburse employee business expenses since the trader/owner is its employee.
Unreimbursed partnership expenses: Partners in LLCs taxed as partnerships can deduct unreimbursed partnership expenses (UPE). That is how they usually deduct home office expenses. UPE is more convenient than an S-Corp accountable plan because the partner can arrange the UPE after year-end. The IRS doesn’t want S-Corps to use UPE.
SALT cap: TCJA capped state and local income, sales, and property taxes (SALT) at $10,000 per year ($5,000 for married filing separately) and did not index it for inflation. About 25 states enacted SALT cap workaround laws. Search “(Your state) SALT cap workaround” to learn the details for your state. Most states follow a blueprint approved by the IRS.
Generally, elect to make a “pass-through entity” (PTE) payment on a partnership or S-Corp tax return filed by your business. It doesn’t work with a sole proprietorship filing a Schedule C. PTE is a business expense deduction shown on the state K-1 like a withholding credit. Most states credit the individual’s state income tax liability with the PTE amount. Essentially, you convert a non-deductible SALT itemized deduction (over the cap) into a business expense deduction from gross income. Act well before year-end; otherwise, you might delay the benefit to next year.
Investment fees and expenses: TCJA suspended all miscellaneous itemized deductions subject to the 2% floor, which includes investment fees and expenses. TCJA left an itemized deduction for investment-interest expenses limited to investment income, with the excess as a carryover.
Standard deduction: TCJA roughly doubled the 2018 standard deduction and suspended and curtailed several itemized deductions. The standard deduction for married couples filing jointly for the tax year 2023 rises to $27,700, up $1,800 (about 7%) from $25,900 in 2022. For single and married individuals filing separately, the standard deduction rises to $13,850 for 2023, up $900 from $12,950 in 2022, and for heads of households, the standard deduction will be $20,800 for the tax year 2023, up $1,400 from $19,400 in 2022.
Many taxpayers use the standard deduction, simplifying their tax compliance work. For convenience, some taxpayers may feel inclined to stop tracking itemized deductions because they figure they will use the standard deduction. Don’t overlook the impact of these deductions on state tax filings, where you might get some tax relief.
Estimated Income Taxes
Those who have reached the SALT cap don’t need to prepay 2022 state-estimated income taxes by December 31, 2022 (a strategy before TCJA). Taxpayers should pay federal and state estimated taxes owed by January 17, 2023, and the balance by April 18, 2023.
Many traders skip making quarterly estimated tax payments during the year, figuring they might incur trading losses later in the year. They can catch up with the Q4 estimate due by January 17, 2023, but might still owe an underpayment penalty for Q1 through Q3 quarters. Some rely on the safe harbor exception to cover their prior year’s taxes.
Adjust Withholding on Year-End Paychecks
Employees should consider withholding additional taxes on year-end paychecks, which helps avoid underpayment penalties since the IRS treats wage withholding as being made throughout the year. This goes for officers/owners of TTS S-Corps.
Avoid Year-End Wash Sale Loss Adjustments
Taxpayers should report wash sale (WS) loss adjustments on securities based on “substantially identical” positions across all accounts, including IRAs. Substantially identical means equity, an option on that equity (equity option), and those equity options at different exercise dates.
Conversely, brokers assess WS only on identical positions per the one account and report on the 1099-B for that account. Active securities traders should use a trade accounting program to identify potential WS loss problems across all their accounts, especially going into year-end.
In taxable accounts, a trader can “break the chain” by selling the position before year-end and not repurchasing a substantially identical position 30 days before or after in any taxable or IRA accounts. Avoid WS between taxable and IRA accounts throughout the year, as that is a permanent WS loss.
Starting a new entity effective January first, 2023, can break the chain on individual account WS at year-end 2022, provided you don’t purposely avoid WS with the related party entity. The new entity can also elect Section 475 MTM.
WS losses might be preferable to capital loss carryovers at year-end 2022 for TTS traders. A Section 475 election in 2023 converts year-end 2022 WS losses on TTS positions (not investment positions) into ordinary losses in 2023. That’s better than a capital loss carryover into 2023, which might give you pause when making a 2023 Section 475 election. You want a clean slate with no remaining capital losses before electing Section 475 ordinary income and loss.
Trader Tax Status and Section 475
Traders who qualified for TTS in 2022 may accelerate trading expenses into that qualification period as sole proprietors or entities. Those who don’t qualify until 2023 should try to defer trading expenses until then. Traders may also capitalize and amortize (expense) Section 195 startup costs and Section 248 organization costs in the new TTS business, going back six months before commencement. TTS is a prerequisite for electing and using Section 475 MTM.
TTS traders choose Section 475 on securities to be exempt from wash-sale loss rules and the $3,000 capital loss limitation and be eligible for the 20% QBI deduction. To make a 2022 Section 475 election, individual taxpayers had to file an election statement with the IRS by April 18, 2022 (March 15, 2022, for existing S-Corps and partnerships). If they filed that election statement on time, they need to complete the election process by submitting a 2022 Form 3115 with their 2022 tax return. Those who missed the 2022 election deadline may want to consider the election for 2023. Capital loss carryovers are a concern—they can be used against capital gains but not Section 475 ordinary income. The 475 election remains in effect each year until it is revoked in the same manner as the election was made.
A Section 475 election made by April 18, 2023, takes effect on January first, 2023. When converting from the realization (cash) method to the mark-to-market (MTM) method, a Section 481(a) adjustment needs to be made on January first, 2023. The adjustment essentially reports in 2023 taxable income the unrealized capital gains and losses on open TTS securities positions held on December 31, 2022. The adjustment should not be made for year-end investment positions, and those who don’t qualify for TTS at year-end 2022 won’t have a Section 481(a) adjustment to report for the 2023 tax year. A “new taxpayer” entity can elect Section 475 within 75 days of inception—a good option for those who missed the individual sole proprietor deadline (April 18, 2022). Forming a new entity on November first, 2022, or later is too late for establishing TTS for the 2022 year within the entity; we like to see all of Q4 for entity TTS eligibility at a minimum. Consider waiting until January first, 2023, to start a new TTS entity and elect Section 475.
20% Deduction on Qualified Business Income
In 2018, TCJA introduced a 20% qualified business income deduction (QBI). In a simple scenario, on a QBI of $100,000, the owner might be able to deduct $20,000. That’s a tax deduction without spending any money.
Trading is a “specified service trade or business” (SSTB), which means an income cap applies. If your taxable income is over that cap, there is no QBI deduction. QBI includes Section 475 ordinary income, less TTS expenses, and excludes capital gains, portfolio income, and forex trading income.
Taxpayers might be able to increase the QBI deduction with thoughtful year-end planning. Suppose taxable income falls within the phase-out range for a specified service activity or even above for a non-service business. You might need higher S-Corp wages (including officer compensation) to avoid a W-2 wage limitation on the QBI deduction. Deferring income can also help get under various QBI restrictions and thresholds.
Suspending TTS and Section 475
Tens of thousands of new TTS traders joined the profession during the Covid pandemic in 2020 and 2021, and many did well in those years. With the advent of a bear market correction in 2022, some “Covid traders” incurred substantial losses, and several stopped TTS trading. Perhaps, they are eligible for TTS and Section 475 for part of the year.
Assume a TTS/475 trader stopped trading on June 30, 2022. They must use Section 475 through June 30, 2022, but may not use it for the remainder of the year. TTS and 475 are “suspended” until and unless the trader is eligible again for TTS in a subsequent year. The trader can also revoke the 475 elections for 2023 by April 18, 2023, in a mirror process to making a 475 election. Without 475 going into year-end, the trader should try to avoid wash sale loss adjustments at year-end.
S-Corp Officer Compensation
TTS traders use an S-Corp to arrange health insurance and retirement plan deductions. These deductions require earned income or self-employment income. Unlike trading gains which are unearned income, a TTS S-Corp salary is considered earned income.
S-Corps pay officer compensation in conjunction with employee benefit deductions through payroll tax compliance done before year-end 2022. Otherwise, traders miss the boat. TTS is a must since an S-Corp investment company cannot have tax-deductible wages, health insurance, and retirement plan contributions. A trading S-Corp is not required to have “reasonable compensation,” so a TTS trader may determine officer compensation based on how much to reimburse for health insurance and how much they want to contribute to a retirement plan. Remember, sole proprietor and partnership TTS traders cannot pay salaries to 2% or more owners; hence the S-Corp is needed.
S-Corp wages impact the SALT cap workaround, which hinges on net income after wages. If you fall into the QBI phase-out range, wages are required to increase the QBI deduction. This decision-making has many moving levers, so consult your CPA in early December for year-end tax planning.
S-Corp Health Insurance
S-Corps may only deduct health insurance for the months it was operational and qualified for TTS. Employer-provided health insurance, including Cobra, is not deductible.
The S-Corp reimburses the employee/owner through the accountable reimbursement plan before year-end. Add the health insurance reimbursement to taxable wages but do not withhold social security or Medicare taxes from that portion of W-2 compensation. The officer/owner takes an AGI deduction for health insurance on their tax return.
A taxpayer can deduct a contribution to a health savings account (HSA) without TTS or earned income. HSA contribution limits for 2022 are $3,650 for individuals and $7,300 family, with an additional $1,000 for those aged 55 or older. HSAs must be funded and utilized before year-end.
S-Corp Retirement Plan Contribution
TTS S-Corps can unlock a retirement plan deduction by paying sufficient officer compensation in December 2022 when results for the year are evident. Net income after deducting wages and retirement contributions should be positive.
If desired, you must establish a Solo 401(k) retirement plan for a TTS S-Corp with a financial intermediary before the year-end. Plan to pay the 100%-deductible “elective deferral” amount up to a maximum of $20,500 (or $27,000 if age 50 or older with the $6,500 catch-up provision) with the December 2022 payroll. That elective deferral is due by the end of January 2023. You can fund the 25% profit-sharing plan (PSP) portion of the S-Corp Solo 401(k) up to a maximum of $40,500 by the 2022 S-Corp tax return, including an extension, which means September 15, 2023. The maximum PSP contribution requires wages of $162,000 ($40,500 divided by 25% defined contribution rate). Tax planning calculations will show the projected outcome of income tax savings vs payroll tax costs for the various options.
The IRS raised the 401(k) elective deferral for 2023 to $22,500, up by $2,000 (9.8%) from 2022. The catch-up contribution limit is increased to $7,500, up by $1,000 from 2022.
Consider a Solo 401(k) Roth for the elective-deferral portion only, where the contribution is not deductible, but the contribution and growth within the Roth are permanently tax-free. Traditional plans have a tax deduction upfront, and all distributions are subject to ordinary income taxes in retirement.
Traditional retirement plans have required minimum distributions (RMD) by age 72, whereas Roth plans don’t have RMD. CARES waived RMD for 2020, but RMD applies for 2021, 2022, and subsequent years.
Have Your New Entity Ready on January First, 2023
If you missed employee benefits (health insurance and retirement contributions) in 2022, consider an LLC with an S-Corp election for the tax year 2023. Or maybe you want a spousal-member LLC taxed as a partnership for 2023 to maximize the SALT cap workaround and segregate trading from investing.
If you want the new entity to be ready to trade on the first trading day of January 2023, consider the following plan. Form a single-member LLC in December 2022, obtain the employee identification number (EIN) online, and open the LLC brokerage account before year-end to be ready to trade as of January first, 2023. The single-member LLC is a “disregarded entity” for the tax year 2022, which avoids an entity tax return filing for the 2022 initial short year. You can add your spouse as an LLC member on January first, 2023, creating a partnership tax return for 2023.
If you want health insurance and retirement plan deductions for 2023, then your single-member or spousal-member LLC should submit a 2023 S-Corp election within 75 days of January first, 2023.
The partnership or S-Corp is a “new taxpayer” to make an internal resolution to elect Section 475 MTM on securities only for 2023 within 75 days of January first, 2023. Otherwise, existing partnerships or S-Corps must file an external 475 election statement with the IRS by March 15, 2023.
If you have an investment or trading portfolio, you can reduce capital gains taxes via “tax-loss harvesting” before the year-end. If you realized significant capital gains year-to-date in 2022 and have open positions with substantial unrealized capital losses, consider selling some of those losing positions to reduce 2022 taxes on capital gains.
Be sure to wait 30 days to repurchase those securities to avoid wash sale loss adjustments, which would postpone the 2022 year-end tax loss to 2023, thereby defeating the concept of tax loss selling.
You don’t have to wait if you buy a similar security, providing it’s not “substantially identical.” For example, an exchange-traded fund (ETF) like SPY is substantially identical to options on SPY (the derivative) but not to other ETFs that track the S&P 500. The symbol SPX is a stock index future, a Section 1256 contract, which is not a security, so that’s okay to use to avoid wash sales.
Tax Efficient Sales
If you want to sell some of your portfolios, consider taking long-term capital gains subject to lower tax rates (0%, 15%, and 20%) vs short-term capital gains taxed at ordinary rates. That might require you to use the “specific identification accounting method” vs first-in-first-out (FIFO).
Straddles and the Constructive Sale Rules
The IRS has rules to prevent the deferral of income and acceleration of losses in offsetting positions that lack sufficient economic risk. These rules include straddles, the constructive sale rule, and shorting against the box. Also, be aware of the “constructive receipt of income”—you cannot receive payment for services, turn your back on that income, and defer it to the next tax year.
Selling the losing legs on a complex options trade with offsetting positions can trigger the straddle loss deferral rules.
Consider a charitable remainder trust to bunch philanthropic contributions for itemizing deductions. (Ask Fidelity or Schwab about it.)
Another option is: Donate appreciated securities to charity. You get a charitable deduction at the fair market value and avoid capital gains taxes. (This is a favorite strategy by billionaires, and you can use it, too.)
Consider directing your traditional retirement plan to make “qualified charitable distributions.” That satisfies the RMD rule, and it’s not taxable income. It’s the equivalent of an offsetting charitable deduction, allowing you to take the standard deduction rather than itemize charitable contributions.
In 2020 and 2021, the limit on charitable contributions increased to 100% of AGI. The limit reverts to the 50% limit for 2022.
Tax Relief: Presidentially Declared Disaster Areas
There were many disasters in 2022, including hurricanes and wildfires. Check the irs.gov site for Tax Relief in Disaster Situations.
Learn More from Robert Green at GreenTraderTax.com.