Transcript The Taxation of Options

Trader Tax
Management
Spread Trade Systems
Chicago Student Summit
March 28, 2009
Disclaimer
Options
Any strategies used as examples and discussed, using actual securities and
price data, are strictly for illustrative and educational purposes only and are not
to be construed as an endorsement, recommendation or solicitation to buy or
sell securities.
Taxation
Any US tax advice contained in this presentation is not intended to be used,
and cannot be used, for the purpose of (i) avoiding penalties that may be
imposed under the Internal Revenue Code or applicable state or local tax law
provisions, or (ii) providing, marketing or recommending to another party any
transaction or matter addressed herein.
The information presented provides only a general discussion of the tax law
affecting the taxation of options and is not intended to be applicable to any
individual investment and tax situation. You are strongly advised to contact
your own tax professional in considering the tax consequences of your own
specific set of facts and circumstances.
Before We Begin!
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What are we going to do?
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Talk about some of the tax aspects of options trading
You will understand more about tax return preparation
You should be able to talk more intelligently with your
CPA or tax preparer
Questions fielded at the end
What we are not going to do?
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Teach you to prepare your own tax return
Cover options taxation exhaustively
Investment / Options Taxation
Agenda
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Securities taxation in general
Trader vs Investor
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Wash sale rules
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How to spot the difference
Mark to Market
What it is
Attempting to avoid it
Section 1256 Contracts
Reporting
Securities Taxation
Overview
What Triggers Tax?
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Completed transaction – generally
Acquisition
Sale
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Stock
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Purchase
Short Sale
Sale
Cover
Options
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BTO
STO
STC/Expiration
BTC/Expiration
What is Taxed?
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Sales of stock/securities determined on a:
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First In First Out (FIFO) basis (IRS presumption)
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First shares purchased are the first shares sold
Used when cannot or does not identify which shares
sold [Reg 1.1012-1(c)(1)]
Specific Lot Identification basis
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Shares must be identified to broker
Broker must confirm in writing
[Reg 1.1012-1(c)(3)]
How is it Taxed?
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Stocks/securities are capital assets
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Holding periods
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Closing transaction generates capital gain/loss
Mark-to-market deems sale/repurchase but character
is changed to ordinary gain/loss
Short-term – one year or shorter
Long-term – longer than one year
Generally begins on day after acquisition
Generally ends on day of disposition
Pass-through entities – retain character
Ordering Rules
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Short-term capital losses
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Long-term capital losses (28%)
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Reduce long-term capital gains (28% > 25% > 15%)
Long-term capital losses (15%)
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Reduce short-term capital gains
Reduce net long-term capital gains (28% > 25% > 15%)
Reduce long-term capital gains (28% > 25%)
Net LTCL can offset net STCG
Basis for Gain or Loss
Type
Purchase
Gift prop sold for
GAIN
Basis
Holding Period
Purchase price +
commissions
Day after date of
acquisition
Donor’s basis
Date donor’s holding
period began
Donor’s basis
Date donor’s holding
period began
FMV on gift date
Day after gift date
FMV on
decedent’s DOD
Long-term
Gift prop sold for
LOSS – Lesser of:
Inherited prop
Investor vs Trader
Investor vs Trader
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Why? – Subject to different tax rules
Definitions:
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Investor –
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Trader –
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Stock purchase for capital appreciation/dividends
Little regard for short-term fluctuations; buy and hold
Regularly and continuously trade stock/securities
Trade in own account
Profit from short-term fluctuations
Can be BOTH trader and investor
IRS presumption
Investor
Investor vs Trader
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Taxation of Investors
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Stocks/securities considered capital assets
Gains and losses considered capital
Reported on Schedule D / D-1
Subject to $3000 net capital loss limit
Subject to IRC Sec 1091 wash sale rules
Investment expenses (except interest)
 Schedule A miscellaneous itemized deductions
 Subject to 2% AGI threshold
 Not deductible for AMT purposes
Interest – deductible up to net investment income
 Net investment income does not include
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Long-term capital gains
Qualified dividends
Investor vs Trader
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Taxation of Traders
 Stocks/securities considered capital assets
 Gains and losses considered capital
 Reported on Schedule D / D-1
 Subject to $3000 net capital loss limit
 Subject to IRC Sec 1091 wash sale rules
 Investment expenses
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Schedule C/E* deductions
Interest deductible (for material participation)
Home office deduction eligibility
Gains NOT subject to self-employment tax
Mark-to-Market (MTM) election eligibility
_____________________________________________________________________________________________________
*
Flow-through entity, such as partnership, LLC, S-Corp
Investor vs Trader – Expenses
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Deductible – BOTH Investor and Trader
 Investment counsel/advice
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Subscription services
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OptionsAnimal
OptionsMonster
OptionsAnimal Mentor? – Possibly (see below)
STS tuition? – No?
Reg 1.212-1(g) – paid or incurred by the taxpayer … for the
management, conservation, or maintenance of investments
held by the taxpayer for the production of income
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Office expenses – administrative, supplies
Pro-rata portion of computer/software used to determine/manage
investments – must be able to substantiate
Investor vs Trader – Expenses
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Non-Deductible for Investor
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Shareholder meeting/transportation expense
Expenses to produce tax-exempt income
Investment-related seminars – THIS EVENT!
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IRC Sec 274(h)(7) –
“No deduction shall be allowed under [IRC] Sec 212 for expenses
allocable to a convention, seminar or similar meeting”
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IRC Sec 212 –
“… there shall be allowed as a deduction all the ordinary and
necessary expenses paid or incurred … (1) for the production … of
income”
Investor vs Trader – Expenses
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Investor expenses – Summary
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All expenses for the production of income (Sec 212)
Deducted on Sch A as Miscellaneous Deductions
Subject to 2% AGI threshold
Interest expense deductible to the extent of net
investment income – does not include LTCG / Div
No Sec 179 expensing election
No home office deduction
Investor vs Trader – Expenses
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Trader expenses - Summary
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All ordinary and necessary expenses (Sec 162)
Interest expense on margin accounts – if material
participation, otherwise, for a limited partner, to
extent of net investment income
Sec 179 expensing of computers, software
Eligible for home office deduction
Automobile expenses from principal place of
business (home) deductible – if for business
purpose
Investor vs Trader
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So what’s the difference?
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IRC Sec 212 – Investor
“… there shall be allowed as a deduction all the ordinary and
necessary expenses paid or incurred … (1) for the production
… of income”
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IRC Sec 162 – Trader
“There shall be allowed as a deduction all the ordinary and
necessary expenses paid or incurred … in carrying on any
trade or business …”
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As an Investor you are producing income
As a Trader you are in a trade or business
Investor vs Trader – Cases
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Firm name, business cards, separate bank
account, computerized investment analysis
system; Traded 5-12 days during each of 3
years buying only 16-44 contracts per year
Investor, Steffler (TC Memo 1995-271)
Over 2,000 transactions in 2 years, shortest
holding period for stock was 3 months, some
over 1 year
Investor, Estate of Yeager (2nd Cir, 1989)
Investor vs Trader – Cases
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Made 46 purchases and 16 sales in 1st year;
109 purchases and 103 sales in 2nd year;
Rarely spent more than 10 days/month and
never 5 days/wk trading
Investor, Cameron (TC Memo 2007-260)
Made 326 sales of which 205 were stocks
held less than 31 days; Mostly 3 months of
year and not regular and continuous
Investor, Paoli (TC Memo 1991-351)
Investor vs Trader – Cases
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Traded through individual brokerage account; Created
LLC, made MTM election; Did not transfer stock to
LLC name or Tax ID; Traded less than 40% of trading
days on individual account and 45% with LLC
Investor, Holsinger (TC Memo 2008-191)
Most of working day engaged in research on
companies to identify attractive trades and making
stock transactions
Trader, Levin (Ct Cl, 1979)
Investor vs Trader – Cases
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Summary
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In Holsinger, Tax Court remarked in its opinion
that trading activity of over 1,100 trades or the
value of securities traded over $9 million was
deemed substantial
Levin – most of working days; substantial time
Regular and continuous
Short holding periods
Substantial number of trades
Investor vs Trader
Mark-to-Market
Investor vs Trader
– MTM Election
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What is Mark-to-Market (MTM)?
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Traders can elect to mark their stock holdings to
market value at the end of the tax year
IRC Sec 475(f) –
“… In the case of a person who is engaged in a trade or business
as a trader in securities …”
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Gains and losses treated as ordinary gain/loss
Adjustment to stock basis for unrealized gain/loss
Not subject to self-employment tax
Reported on Form 4797, Part II
Investor vs Trader
– MTM Election Benefits
Two restrictions no longer apply:
$3,000 net capital loss limit
Wash sale rule
Investor vs Trader
– MTM Election
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Election is effective for the year for which it is
made and all subsequent years unless revoked
with IRS permission (mandatory)
Must make the election by the unextended due
date for the tax return for the year … before the
year … the election is to be effective
We need an example
Investor vs Trader
– MTM Election
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Eric is actively trading stocks and believes he
can generate significant income by trading, on a
regular and continuous basis, the short-term
fluctuations in the stock market. In July 2008 he
begins trading full-time.
Does Eric qualify as a trader?
Investor vs Trader
– MTM Election
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Eric is actively trading stocks and believes he
can generate significant income by trading, on a
regular and continuous basis, the short-term
fluctuations in the stock market. In July 2008 he
begins trading full-time.
Does Eric qualify as a trader?
Can he elect MTM for 2008?
Investor vs Trader
– MTM Election
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Eric would have had to file an election by:
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April 15, 2008, or,
Attach the election to his extension (Form 4868)
Eric can make a MTM election for 2009
anytime before April 15, 2009, however,
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If this is not the first year as a trader (it is not) then
Eric will be required to file Form 3115, Application
for Change in Accounting Method
A Sec 481(a) adjustment is also required
Investor vs Trader
– Making the MTM Election
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Attach the following statement to the timely
filed Form 1040 or extension Form 4868
Trader in Securities Election to Mark to Market
Taxpayer hereby elects under IRC Sec 475(f) to use the mark-to-market
method of accounting for securities. The election will first be effective for the
tax year ended [20##]. The election is made for the following trade or
business: [trade or business name, EIN]
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There is relief for late elections – PLR request
New pass-through entity for late election
New taxpayer – elect by 15th day of third month
Investor vs Trader - Summary
Criteria
Investor
Trader MTM Trader
Reporting gain/loss
Sch D
Sch D
Form 4797
Reporting expenses
Sch A
Sch C/E
Sch C/E
Reporting interest
Sch A
Sch C/E
Sch C/E
Invest int exp limits
Yes
No
No
Home office eligible
No
Yes
Yes
Subject to S-E tax
No
No
No
Wash sale rules
Yes
Yes
No
$3000 Cap loss limit
Yes
Yes
No
Wash Sale Rules
Wash Sale Rules
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Loss on wash sale of stock is not currently deductible
What is a wash sale? –
 Loss on sale of stock – does not apply to gains
 Within 30 days BEFORE/AFTER the loss sale:
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Acquire stock*
Buy* call – Reg 1.1091-1(a) “option to acquire”
Sell* ITM put – Rev Rul 85-87
Impact
 Basis – disallowed loss added to cost of newly acquired stock
 Holding period – newly acquired stock now has holding period
of the stock for which the loss was disallowed
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* substantially identical
Wash Sale Example 1
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Tim buys 500 shares of C for $23 on 10/1/08
Tim sells 300 shares for $4 on 11/21/08
Tim buys 300 shares for $8.50 on 12/10/08
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Is there a loss?
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Any repurchase within 30 days either side of 11/21?
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Yes, $19 per share on 11/21/08 ($4.00 - $23.00)
Yes, on 12/10/08
Loss is Not Deductible
Basis of 12/10/08 shs – $27.50 ($8.50 + $19.00)
Wash Sale Example 2
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Tim buys 500 shares of C for $23 on 10/1/08
Tim buys 300 shares for $4 on 11/21/08
Tim sells 300 shares for $8.50 on 12/10/08
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Is there a loss?
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Any repurchase within 30 days either side of 12/10?
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Yes, $14.50 per share on 12/10 ($8.50 – $23.00)
Yes, on 11/21/08
Loss is Not Deductible
Basis of 11/21/08 shs – $18.50 ($4.00 + $14.50)
Wash Sale Example 3
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Tim buys 500 shares of C for $23 on 10/1/08
Tim sells 500 shares for $4 on 11/21/08
Tim buys 300 shares for $8.50 on 12/10/08
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Is there a loss?
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Any repurchase within 30 days either side of 11/21?
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Yes, $19 per share on 11/21/08 ($4.00 - $23.00)
Yes, on 12/10/08, but
Loss on 300 shs is not deductible
Loss on 200 shs is deductible
Basis of 12/10/08 shs – $27.50 ($8.50 + $19.00)
Wash Sale Strategy
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Definition of security
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Related parties
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IRC Sec 1091 limits the wash sale rules to stocks
or securities BUT defines options as a security
Sale and purchase collapsed
61-day window (IRC Sec 267)
IRA is a related party
Does not apply if sale made in connection with
the taxpayer’s trade or business (if MTM)
Wash Sale Strategy
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Reduction in holdings (Rev Rul 56-602)
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Bona fide sales in order to reduce holdings of a security
Maybe: Naked put assigned unintentionally and then sold
Puts
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Rev Rul 85-87
Facts: Phil sustained a loss on the sale of stock. The next day he sold a
put two months out. The put was substantially ITM at the time of sale.
Analysis: In light of the spread between the value of the underlying stock
and the exercise price of the put, the term of the put, the premium paid,
the historic volatility in the value of the stock, and other objective factors,
there was at the time the put was sold no substantial likelihood that the
put would not be exercised
Wash Sale Strategy
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Criteria for an ITM naked put
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Distance ITM
Term of the put
Historic volatility of underlying stock
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Substantial likelihood of exercise
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Wait 31 days to repurchase stock
Bull call entered 31 days before sale
Bull put entered 31 days before sale
Sec 1256 Contracts
Index Options
Section 1256 Contracts
A Section 1256 Contract is any:
 Regulated futures contract – daily MTM
 Foreign currency contract
 Dealer equity option – market maker/specialist
 Dealer securities futures contract
 Non-equity option
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Broad-based stock index option (SEC determined)
Cash-settled options
Examples – DJX, SPX, OEX, NDX (not ETFs)
Sec 1256 Contracts
– Mark-to-Market
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At the end of the tax year (last business day)
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Treat contract as sold
At FMV on the last business day of year
Gain or loss recognized
Recognized gain/loss taken into consideration upon
ultimate disposition of contract
60/40 rule –
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60% of recognized gain/loss is long-term
 40% of recognized gain/loss is short-term
 No matter what the actual holding period
A net loss can be carried back 3 years
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Report on Form 6781
We need an example
Sec 1256 Contracts
– Mark to Market Example
Sec 1256 Contracts
– Mark to Market Example
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100 SPX Jun 08 1250 calls bought for 145 on
7/17/06
SPX Jun 08 1250 call at 252 on last business day of
2006
Mark-to-Market requirements:
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SPX LC deemed SOLD on 12/29/06 at 252
SPX LC deemed REPURCHASED on 12/29/06 for 252
Gain 107 (252 – 145)
 Long-term 64.20 (60% x 107); 15% max tax rate
 Short-term 42.80 (40% x 107); 35% max tax rate
Sec 1256 Contracts
– Mark to Market Example
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SPX Jun 08 1250 LC declines to 228 by 3/12/2007
and is sold
What is the gain/loss?
How is it taxed?
Deemed repurchase at 252 on 12/29/06
Sale
228
Basis
252
Loss
<24>
LTCL <14.40> - 60%
STCL <9.60> - 40%
 Loss may be carried back three years
Cow Options Investor at Her
Wits End …
Is this a put straddle constructive sale,
unrecognized wash sale or mocha
cappuccino latte???
Reporting
Reporting
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Schedule D/Schedule D-1
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Used by both investor and trader
Name, dates, sale, cost, gain/loss
Use of “VARIOUS” designation for dates of block
purchases or sales; still separate ST and LT
Reporting
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Wash sales
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Report full amount of loss in gain/loss col (col f)
Date of share purchase disallowed loss added to (col b; optional)
Report “Wash Sale” in col a and loss disallowed in col f
Reporting
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Expired options
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Long options
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Name, expiration date in col c, “EXPIRED” in col d
Short options
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Name, expiration date in col b, “EXPIRED” in col e
Reporting
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Form 4797
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Used for MTM Traders
Reported in Part II, ordinary gains/losses
Favorable capital gain rates do not apply
Wash sale rules do not apply
$3000 net capital loss limit does not apply
Reporting
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Form 6781 – Gain/Loss on Sec 1256
So Now That You Understand
the Rules and Reporting …
April 14, 11 pm
Honey, do you remember
that really neat trade
involving those 14 Iron
Condors that we adjusted
into …
Final Thoughts
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Tax considerations should be secondary
Why? We trade options to make money in
any market conditions, if money is made, tax
is paid – it’s all good
There is no 100% marginal tax rate
I don’t believe you will ever be selected for
audit simply because you missed a wash sale
or reported a Sec 1256 contract incorrectly
Contact Information
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Gregory L Buhrow, CPA, PC
2355 Gus Thomasson Road
Dallas, TX 75228-3004
Telephone: (214) 327-0700
Facsimile: (214) 327-0740 (7am-6pm CT)
Website: www.buhrow.com
Emails: [email protected]
[email protected]
[email protected]
Thank You!
Trader Tax Management
STS Chicago Student Summit
March 28, 2009