One of the common problems we see in our tax law offices in San Diego, Beverly Hills and Orange County has to do with investors and financial traders who have improperly set-up their business and consequently are being audited after taking deductions under Section 475 of the mark-to-market securities tax code.
The IRS established Section 475 of the mark-to-market securities tax code specifically for financial traders. Under ordinary circumstances, investors are stuck with a standard capital-loss treatment which means a maximum $3,000 net capital loss which can only be applied against ordinary income. It can take a lifetime to write off losses in this scenario. But under Section 475, capital losses can be taken as a whole and applied to an entire tax return, even if it’s a joint filing.
It sounds good but, as in most cases involving the IRS, qualifying for this type of tax treatment is complicated and without the help of qualified assistance by people like the tax law experts at RJS LAW who understand Section 475, can trigger tax audits through improper set-up and subsequent deductions which may be disallowed.
To qualify for tax treatment under the Section 475 mark-to-market code, traders have to qualify under the rules for “trader tax status.” This is a set of guidelines established by the IRS to determine who is, and who isn’t considered a business trader.
Caution: Business traders have to declare their intentions to elect to file under Section 475 before April 15th, every year. If you don’t make your election before then, capital losses cannot be treated as ordinary business income. New entities established after April 15th can elect Section 475 MTM for the rest of the current tax year if the entity files an internal Section 475 MTM election within 75 days of inception.
Business traders qualifying for TTS have the option to elect Section 475 MTM accounting with ordinary gain or loss treatment in a timely fashion. When traders have negative taxable income generated from business losses, Section 475 accounting classifies them as unrestricted and unlimited ordinary business losses and net operating losses (NOLs).
The advantages are obvious. Ordinary trading losses can offset all types of income (wages, portfolio income, capital gains, etc.) for you and your spouse on a joint filing, whereas capital losses may only offset capital gains. Business ordinary trading loss treatment is the biggest contributor to tax refunds.
But it’s extremely important to know the rules inside and out. A wrong election or deduction could land you in hot water with the IRS. For example, you’re entitled to segregate investment positions that aren’t subject to Section 475 MTM treatment at year-end, meaning you can defer unrealized gains on properly segregated investments. You can have the best of both worlds — ordinary tax losses on business trading and deferral with lower long-term capital gains tax rates on segregated investment positions.
The tax law pros at RJS LAW are intimately familiar with Section 475 mark-to-market rules and we can help. If you’re a trader being audited in this area, contact us or call (619) 595-1655 immediately. We have offices throughout Southern California in San Diego, Beverly Hills and Orange County and our tax attorneys can guide you.
And if you’re a financial trader, come sit down with our team and let’s map out a strategy for your business to make sure that you’re qualified for 475 treatment and the best way to get you set-up to take advantage of the rules.