Monthly Archive: November 2014

Mark to Market: Trader or Investor?

Welcome to TaxView with Chris Moss CPA

Most of you all have invested in stocks and bonds or other publicly traded securities with the help of a “securities dealer” or stock broker. But if you are “trading” in securities on a regular basis for yourself and family, IRS Topic 429 says you may be upgraded to a “trader”. Why is this important? If you “substantially” trade to profit “from daily movement in the prices of securities” the Government gives you valuable tax benefits as provided in Section 162(a) and Section 475(f) of the IRS Code. More specifically, you can deduct “ordinary losses” not subject to the $3000 per year capital loss limitation by electing the “mark to market” method of accounting. This could be a huge tax saver if your husband or wife has substantial W2 income. But beware, IRS has set multiple Trader Traps (TTs) to trip up “traders” right in their investment tracks. So if you are a trader or are thinking about becoming one, stay tuned on TaxView with Chris Moss CPA to find out how to avoid TTs and to successfully defend your preferred “Trader” status to save you taxes in the event of an IRS audit years later.

Section 475(f) of the Taxpayer Relief Act of 1997 allows a “trader in securities” to elect under Rev Proc. 99-17 to “mark to market” stocks held in connection with your trading business. According to the Joint Committee on Taxation 12/17/1997 Report, “mark-to-market accounting imposes few burdens and offers few opportunities for manipulation”. So what exactly is “mark to market” for a trader? If you are a trader an elect mark to market you compute taxable income based on the market value rather than cost and you get the entire loss as a deduction not subject to the $3000 capital loss limitation.

So where are the TTs? The vast majority of TTs are set by the IRS to keep you from ever breaking out your “investor” chains to “trader” freedom. The first of the TTs is simply to make the election. But it is shocking how many of you miss a timely election to mark to market including Knish v IRS (2006). The facts are simple: Knish began trading securities in 1999 to 2001 and did not elect the mark to market method of accounting on his tax return until 2001. Knish then carried back losses from 1999 and 2000 to 1996. The IRS audited and disallowed all the losses claiming the election was 18 months too late. Knish appealed to US Tax Court in Knish v IRS. The Court found for the Government. There are no exceptions here folks, you must make the election or get downgraded to investor and pay large amounts of tax. IRS wins, Knish loses. See also Kantor v IRS (2008) and Assaderaghi and Lin v IRS (2014)

The second of the TTs focus us on the “frequency of the trades” and takes us to Van Der Lee v IRS (2011). Van Der Lee filed a 2002 tax return claiming to be a trader with gross receipts of almost $4.4 Million and expenses of $5 Million resulting in a $1.4 Million loss. Van Der Lee offset this loss against W2 income. The IRS audited and disallowed all losses claiming even if an election was made which it was not, Van Der Lee was still not a trader because his trades were not substantial. Van Der Lee appealed to US Tax Court Van Der Lee v IRS (2011) Judge Marvel notes that Van Der Lee did not trade with sufficient frequency to qualify as a trader. Brokerage statements show that between April 15 and Dec 31 2002 Van Der Lee executed 148 trades through Merrill Lynch and 11 trades through Prudential. Trading was sporadic with trades averaging 3 or 4 trading days per month citing Kay v IRS (2011). IRS wins Van Der Lee loses.

This brings us to the third and fourth final of the TTs, the time a trader spends on trading and the way the trader profits from short term swings in the market. Kay reported on his 2000 tax return a “trader” loss of over $2 Million from sales of securities. Kay also owned a business with large profits which he offset by his trader losses. The IRS audited and disallowed all losses. Kay appealed to US Tax Court in Kay v IRS (2011). The Court concluded that Kay’s trading activity was insubstantial citing Chen v IRS (2004) and his stock positions were more of a long term nature rather than seeking profit from short term swings in the market citing Mayer v IRS (1994). The Court also noted that Kay’s trading activity was infrequent. Kay traded 29% 7% and 8% in 2000, 2001 and 2002 citing Holsinger and Mickler v IRS (2008) Also see WSJ 9/2/2008. Finally, the Court concluded that Kay’s income from his profitable business and not his trader business was his primary source of income and (See Chris Moss CPA Hobby Loss) therefore concluded that based on all the facts presented to the Court that Kay was not a trader. IRS wins Kay loses.

What does all this mean us? First and most important, make the “Mark to Market” election on the first year of trading with the assistance of your tax attorney and document the election appropriately as you file your tax return before signing and filing you return. Your tax attorney should be prepared to sign the return and act as a witness years later if needed during an IRS audit. Second, keep track of your trades and time spent on the trading business. Remember, your trading must be substantial. You should be able to easily prove to the IRS that you spent the majority of each working day trading stocks and bonds and other securities. Third keep track of daily profit taking. You will need to prove you focused each day on short term daily profits, not long term positions or appreciation. Finally if you plan on offsetting W2 or 1099 income either from a separate business you own or from your husband or wife’s W2 income, be prepared if audited for the Government to allege you were being supported by your spouse if the pattern of losses persists year after year. In conclusion, if you are a trader you get amazing tax benefits that justify the risk of IRS audit. Be prepared and be ready to bullet proof your tax return from the TTs before filing, Happy trading and see you next time on TaxView! Thank you for joining us on TaxView with Chris Moss CPA

Kindest regards,

Chris Moss CPA

IRS Whipsaw Tax Audit

Welcome to TaxView with Chris Moss CPA

The IRS defines a “whipsaw case” as a settlement in one case that can have a contrary tax effect in another case.” IRS Manual 8.2.3.13 All of you at some point will most likely experience a whipsaw case during an IRS audit of a partnership, ex-spouse, related beneficiary and even your own personal tax return if you and your spouse filed separately. Whipsaws never end well because one of you is going to lose in order for the other to win. One of the most litigated of all whipsaw cases is alimony. For example one of your ex-husbands deducts alimony and you say its nontaxable support. Another common whipsaw case is between partners in a partnership. Your partner takes a distribution as capital gain, but you say nontaxable. Various beneficiaries can whipsaw each other as you claim your inheritance to be nontaxable but your sister claims it is ordinary income. Finally, if you file separately and your husband itemizes and you take the standard deduction, watch out folks, that is an automatic IRS whipsaw audit. If you are potentially in any of these situations, sit tight and stay tuned to TaxView with Chris Moss CPA to find out how the US Tax Court decides whipsaw cases and how best to prevent a whipsaw from spinning your way during an IRS audit.

The first whipsaw case we are going to look at will apply to many of you invested in partnerships. Brennan v IRS and Ashland v IRS US Tax Court 7/23/2012 Ashlands and Brennans were partners in Cutler. After Cutler filed its partnership return Form 1065 for 2003 and 2004 Ashlands filed Joint Federal returns for 2003 and 2004 as did Brennans. Ashlands reported capital gains in 2003 and Brennans did not. Note that inconsistent filing by partners almost always results in an IRS whipsaw audit. In fact, the IRS did indeed audit both Brennans and Ashlands finding that both Ashlands and Brennans should have capital gains for 2003 and 2004. Both Ashlands and Brennans appealed to US Tax Court in Brennan v IRS and Ashland v IRS (2012). Judge Kroupa finds for the Government and concludes that both Ashlands and Brennans are subject to tax in 2003 and 2004. IRS wins Ashlands and Brennans lose.

The second whipsaw case we look at will be alimony, but first a little Congressional history. The Supreme Court heard its first alimony case almost 100 years ago in Gould v Gould US Supreme Court 1917. Back in those days alimony was a duty for the “husband to support the wife” and was not considered income to the wife. The 2001 Joint Committee Taxation report further explains that in 1942 alimony was made a tax deduction to allow husbands to avoid the hardship of not having enough money to pay taxes and other bills after he paid alimony to his ex-wife at income tax rates approaching 90%.

Now fast-forward to US Tax Court Case Daugharty v IRS and Daugharty v IRS. Before we unpack Daugharty keep in mind that if the IRS receives two related tax returns that do not exactly match, there is almost a certainty of an IRS “whipsaw” audit. That means both ex-H and ex-W are going to get audited and one of them is going to have to prove the other was wrong. This is exactly what happened to the Daugharty’s in 1997. After a 22 year marriage with 3 kids, John and Faye Daugharty divorced. One of the provisions in the property settlement was that John would pay Faye $2500 per month for remainder of her life or until she remarried. John paid Faye $30,000 per year from 1988 to 1993 and deducted these payments on their tax returns as alimony. Faye did not file any tax returns from 1988 to 1993 claiming these payments were not taxable to her as a property settlement distribution.

The IRS audited and both John and Faye disallowing all deductions and requiring Faye to recognize income. Both John and Faye appealed to US Tax Court and both cases were consolidated in Daugharty v IRS 1997. The principal issue for the Court was whether or not John’s payments of $30,000 per year were alimony as John claimed or whether these payments were part of the property settlement and not taxable as Faye claimed. In this classic whipsaw case Judge Ruwe ultimately decides for John and against Faye. John wins IRS loses. IRS wins Faye loses.

Our final case is going to take a look at a whipsaw trust and estate case Ballantyne v IRS and Ballantyne v IRS 2002. The facts are simple: Jean survived her husband Melvin. Brother Russell was a partner of Melvin in Ballantyne Brothers Partnership. Russell handled farming in North Dakota and his son’s Orlyn and Gary helped out. Melvin was an oil and gas explorer in Canada. His two sons Stephen and Kab helped out. In 1993 Melvin was diagnosed with cancer and died March 4, 1994. Partnership tax returns form 1065 were filed each year from 1980 to 1994 by CPA Jules Feldman showing Russell and Melvin as 50-50 partners. After Melvin’s death Jean sued Russell asking for proper accounting of the partnership. The Estate tax return form 1041 filed in 1995 and then amended. The IRS audited 1994 and 1995 returns disallowing various estate deductions. Jean representing the estate appealed to US Tax Court in Ballantyne v IRS claiming that Russell owed additional tax not the estate. The IRS then sent Russell and his wife Clarice a whipsaw audit notice for 1993 and 1994 claiming Russell was liable instead of Jean. Russell then appealed to US Tax Court and both US Tax Court cases were consolidated for one trial in Ballantyne v IRS. Judge Ruwe eventually sided with the US Government and Jean Ballantyne. IRS and Jean win Russell loses.

So you all out there with whipsaw situations, what can you do now to avoid litigation with your partners, ex-wives or ex-husbands, and family after your loved one passes? First and most important, in every divorce, partnership and estate plan and settlement agreement make certain you have a tax attorney involved with your divorce, partnership, or estate attorney in some capacity prior to finalizing a property settlement agreement and operating agreement or a family estate plan. Second, make sure you ask your attorney this question: What are the whipsaw implications if the IRS audits my tax return in my divorce, partnership or estate? Get your lawyers’s response to this question in writing before you sign anything. Finally, take notes in your discussions with your ex-spouse, your partners, and your family regarding whipsaw issues that are bound to surface perhaps years later during an IRS audit. Have your tax attorney witness these meetings and include her notes in your annual 1040, 1065 and 1041 tax returns. Remember, the IRS will be looking for opportunities to whipsaw you. Have your tax attorney bulletproof your tax returns each year with anti-whipsaw attachments and documents to make sure you are protected. Many years later during a possible whipsaw IRS audit you will be glad you did. Thanks for joining us on TaxView with Chris Moss CPA.

See you next time on TaxView

Kindest regards

Chris Moss CPA