Investors

The IRS defines an investor as someone who typically buys and sells securities, and expects income from dividends, interest, or capital appreciation. IRS Pub 550 provides tax treatment guidance for investors. Income generated by investors, is for example, subject to the capital loss limitations in IRC Sec. 1211(b), and the wash sale rules outlined in Sec. 1091. Investors are permitted to deduct the expenses of producing taxable investment income as miscellaneous deductions, if those expenses exceed 2 percent of adjusted gross income (AGI).

Interest paid on money to buy or carry investment property that produces taxable income is also deductible, but under Sec. 163(d), the deduction cannot exceed the net investment income. Commissions and other costs of acquiring or disposing of securities are not deductible, but must be used to figure gain or loss upon disposition of the securities.

Investors are not eligible for tax trader status and cannot generally elect mark-to-market (MTM) accounting. However, investors can take advantage of a whole assortment of tax benefits that Congress have made available. I briefly touch on a few of these investor tax incentives in the pages that follow.

Capital Gains and Losses

When an investor sells a capital investment at a profit, he or she usually has to pay taxes on this profit. Selling within the first year of the investment, results in the investor paying tax at ordinary rates as high as 35 percent. Fortunately, for investors, the IRC encourages longer-term investments. By holding investments for at least a year before selling, investors pay a lower rate — a maximum of 15 percent for most stocks, mutual funds, and other investments.

Investors also pay capital gains tax on some mutual fund distributions, even if they do not sell shares of the fund. It is important to note that when the fund sells some of its holdings, the taxable gains are passed on to investors.
Special rates apply on other types of investments such as futures contracts. As discussed in Chapter 5, futures contracts are marked-to-market at the end of each tax year, with investors reporting these contracts as capital gains and losses on Form 6781: Gains and Losses from Section 1256 Contracts and Straddles. This allows them to split the gains and losses 60/40 on Schedule D (60 percent long-term/ 40 percent short-term), regardless of the holding period.

We all incur losses on investments eventually. Generally, capital losses are netted against capital gains. Up to $3,000 ($1,500 if married filing separately/MFS) of excess capital losses are deductible against ordinary income each year. Unused net capital losses are carried forward indefinitely and may offset capital gains, plus up to $3,000 ($1,500 if MFS) of ordinary income during each subsequent year.

Selling investments that have losses is a common technique late in the tax year. However, be careful of the 60 days-wash sale rules, which can take away your deduction, if you try to buy back what you’ve sold within 30 days.

Dividends

In addition to profits from selling investments, investors pay tax on any interest, dividends, or rental or other income they receive. Again, the IRC encourages some investments over others. Tax on qualified dividends on stocks and stock mutual funds are eligible for the same lower maximum 15 percent rate as long-term capital gains. In contrast, interest on bonds, income from rental property, and most other investment income typically is taxed at higher ordinary rates. One exception is interest from municipal bonds, which is tax-free on your federal returns and can offer state income-tax benefits as well.

Below is a table showing the various tax rates for capital gains and dividends depending on the taxpayer’s ordinary tax rate bracket. You can see the preferential tax rates granted to investors for long-term capital gains and qualified dividends.

Table: 3.1 – Capital Gain and Dividend Tax Rates – 2009 1

* 50%  (60% for certain businesses in empowerment zones) of the gain is excluded so the maximum effective rate is 14%.

** 90 days in the case of preferred stock.

1040 Quickfinder® Handbook – Form 1040 2009 Tax Year, Thomson Reuters

Cost-Basis Tax Reporting

Late in 2009, the IRS issued proposed regulations on cost-basis tax reporting. Under the proposed regulations, brokers would be required to report to the government the cost of equities sold by their customers starting in 2011. For 2012, they will have to report similar information about mutual-fund sales and, in 2013, options and fixed-income cost bases. At present, the cost basis of transactions is communicated only to clients, who are responsible for reporting it to the IRS.

Investors who use online brokers have long complained that they have trouble getting accurate cost-basis information from these firms, and having your cost-basis information reported to the IRS is, quite frankly, a little scary for me. However, if online firms use this new IRS reporting requirement as an opportunity to upgrade their technology to offer pre-trade tax analysis tools to investors and traders then it could be a real positive.

Principal Residence Gain Exclusion

One of the best tax benefits available to investors is the principal residence gain exclusion. Investors can exclude up to $250,000 of gain from the sale of their personal residence. Investors must have owned and occupied the home as a principal residence for at least two out of the last five years before selling. Married couples filing a joint return can exclude up to $500,000 of gain.

The married couple ownership test allows either or both spouses to have owned the home for at least two out of the last five years before selling. However, both have had to use the home as their principal residence for at least two out of the last five years prior to a sale. In addition, there is a frequency test, which states that neither spouse may have sold their principal residence within the last two years. If either spouse does not meet the use and frequency test then the allowable exclusion is reduced to the sum of the amounts that each spouse would be qualified to exclude if they had not been married.

Retirement Accounts

Investors can take advantage of a wide array of special types of accounts to get additional tax breaks. Traditional IRA and 401(k) contributions can reduce your taxable income and give you tax-deferred growth, where you will only pay tax when you take money out. Roth IRAs do not reduce taxable income, impose no tax on interest and dividends, and allow you to withdraw the money at retirement, tax-free. Chart 3.2 compares the contribution limits and income restrictions between traditional IRAs and Roth IRAs.

Chart 3.2: IRA Chart

Note: personal service corporations (those whose employees spend at least 95 percent of their time in the field of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting) are taxed at a flat rate of 35 percent of net profits.

As the table shows, corporations generally have the same, or a higher tax rate imposed on their income compared to those subject to individual tax rates. Also, keep in mind that the rate comparison is only part of the tax picture to consider. Distributions (money taken out) from a partnership are generally taxable only once on the partners’ individual returns, while distributions made by a corporation to its shareholders after corporate tax is paid are taxed again as dividends on the shareholder’s returns.

In comparing the tax advantages of operating as a partnership or sole proprietorship rather than as a corporation, remember that not all of the corporate profits will be subject to double taxation. The operators of the corporation may withdraw reasonable salaries, which are deductible by the corporation. These salaries are therefore free from tax at the corporate level (though the recipients will have to pay income tax, and both recipients and the business will have to pay FICA tax, on them). In some cases, salaries to the owners may offset the entire net profit, so that no corporate income tax is due.

Like individuals, corporations can become subject to an Alternative Minimum Tax (AMT), if they have gained the benefit of “too many” tax preference items. As of 2008, the corporate AMT will not apply to any corporation if:
the corporation is in its first year of existence, or the corporation was treated as a small corporation exempt from AMT for all prior tax years after 1997, and its average annual gross receipts for the last three years ending before the 2008 tax year did not exceed $7.5 million ($5 million if it only existed for one prior year).

For corporations that are subject to AMT, the general rate is 20 percent (the rate is reduced to 15 percent for certain specific items).

General Partnership – spousal

Putting your trading business in a general partnership with your spouse often makes a lot of sense for personal, business and tax reasons. Often times, a portion of the trading capital comes from the spouse. So from an estate perspective, it is important to have the spouse as part of the trading business. There are also several tax advantages to doing it this way. But be sure to list your spouse on the brokerage statements if you do not have a separate business name for your partnership. It is also important that your spouse places a role in the business, whether it is bookkeeper, researcher, trader or manager. Trading partnerships seem to be exempt from the passive activity rules as far as their MTM losses are concerned but their trading expenses are another matter and are still subject to the PAL limitations. Therefore, make sure your spouse is active in the business in some capacity.

A partnership is a flow-through entity meaning that the taxable income or loss first gets reported on a partnership return and then winds up on a taxpayer’s personal tax return. Entities that would normally be considered a partnership may elect to not be treated as partnerships for income tax purposes if the income of the partners can be determined without computing the entity’s income first or in the case of certain husband-wife partnerships. In the case of a husband and wife trading business, the income and expenses can either be reported on Form 1065 (partnership rerturn) or on two Schedule C’s (sole proprietor) on Form 1040 (individual tax return). In either case, the income and expenses are reported on the personal tax return and effect ones individual taxes.

Limited Partnership

A limited partnership is an entity that is used primarily to raise money from passive investors, who become the “limited partners” of the entity. This type of entity works well for traders that want to raise trading capital from outside investors. Limited partners do not participate in the management or operations, and they are not responsible for the debts and civil claims of the limited partnership beyond their investment in the business. A limited partnership must have at least one “general partner”, and at least one “limited partner”. The general partner(s) manages the day-to-day operations of the partnership. Each general partner in a limited partnership is personally liable for all of the debts and obligations of the business, including civil claims against the partnership. Because of this liability exposure, often the general partner is a corporation.

A limited partnership is also a good vehicle to use when including family members in a trading business. With active trader status, a limited partnership allows the general partner to control the trading activity yet distribute tax benefits, including ordinary loss treatment, to its investors. Because of a “quirk” in the trader tax laws, passive investors in a trading business are exempt from the passive activity loss rules.

In other words, passive investors get to enjoy all of the tax benefits that an active MTM trader enjoys, including full deductibility of ordinary losses and full deductibility of trading business expenses. The MTM election is made at the entity level and any trading losses pass through to all partners. The one deductibility limitation for passive investors is that they are only able to deduct investment interest expense up to the amount of their investment income. This passive loss loophole for traders is discussed again later in this chapter.

Although limited partnerships are required to file annual tax returns, like general partnerships, they do not pay federal and state income taxes because the profits and losses of the business pass through to the individual partners. Profits and losses in a partnership may be allocated unequally among partners, without regard to proportionate ownership interests, to take advantage of tax benefits.

Partnership tax rules are some of the most complicated sections of the Code and regulations, but provide a great deal of flexibility when structuring a partnership agreement. When drafting a limited partnership agreement, be sure to work with a qualified and experienced tax advisor.