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Traders Tax - Mark to Market Accounting

June 2004
by Joe Wishcamper, Esq.

www.tradersaccounting.com
 

 

One significant feature of being a trader in securities is the ability to elect the Mark-to-Market (“MTM”) method of accounting.

The MTM accounting method is not an automatic event for a trader; it is an election that the trader must affirmatively make.

Nor is it an election that can be made by an investor. It is only available for a trader.

What is the Tax Impact of the MTM Election?

If the MTM election is made, then the result is that a constructive sale of the trader’s securities occurs on the last business day of the taxable year. The expression is that all positions are “marked to market,” hence the name of the election. All open positions held on the last business day of the taxable year are treated as if they were sold on that day. If a trader who has made the election has a security that has gone down in value and is in the portfolio at year-end, that trader will recognize a loss on that security. The inverse is also true if there is a gain. The basis of that security is then adjusted to reflect the gain or loss that the trader recognized on his or her individual tax return.

Consequences of the MTM Election

The Mark-to-Market method of accounting has a number of significant tax impacts. Let’s look at each of these consequences in turn.

  1. Change in Character of Gain/Loss. The MTM election changes the character of a trader’s gains or losses from capital gain or loss to ordinary income or loss. The immediate consequence of that statement is that for a trader who has taken the election, the $3,000 capital loss limitation no longer applies. Note that a person trading mainly in 1256 contracts typically would not want to make the MTM election because that person would lose the 60% long-term capital gain treatment on futures subject to the 1256 rule.
  2. Wash Sale Rule No Longer Applies. Once the MTM election is made, the wash sale rule no longer applies. That could be a huge benefit for a trader with a large number of repetitive trades in the same securities.
  3. The Election is Permanent. For all intents and purposes, the MTM election is a permanent choice. Once it is made, it cannot be retracted absent advance consent of the IRS.
  4. No SE Tax Impact. The MTM election does not result in the imposition of the self-employment tax on the trader’s income, even though that income is no longer considered to be capital gain. This is great news for traders since this tax is 15.3%.
  5. Potential Adverse Impact if there are Pre-election Trading Losses. The fact that one will no longer have capital gains or losses (rather the gains or losses will be characterized as ordinary) could have significant adverse impact under certain circumstances. If a trader had a large capital loss carryforward on his or her individual return, that person typically would not want to elect the MTM method of accounting. That’s because if the trader has gains the next year, those gains would be ordinary income because of this accounting method. That ordinary income cannot be used to offset the capital loss carryforward, except to the extent of $3,000.

Obviously there are a lot of factors to consider, both pro and con, in deciding whether to take the MTM election. The decision ought to be made in consultation with a knowledgeable, experienced, competent tax advisor. Don’t make this decision at home in the closet by yourself.

Mechanics of the Election

The mechanics of taking the election involve both the timing and certain required paperwork. The election needs to be made by the due date (without regard to extensions) of the original federal tax return for the taxable year immediately preceding the year in which the election is to be effective (the “election year”). Hence if a taxpayer wants the MTM to be effective for tax year 2004 (the election year), then the election needs to be made by the due date of the 2003 tax return—April 15, 2004. The election must either be attached to that return or to a timely-filed request for an extension of time to file that return.

If a taxpayer blows the timing requirement, then the MTM is not available for that desired election year. One way around the timing problem is to form a legal entity from which to trade, such as a LLC. That would create a “new taxpayer.” A new taxpayer can make the MTM election within the first two months and 15 days of its election year.

Required Paperwork for the MTM Election

In making the election, the taxpayer attaches a written statement to the tax return that provides the following information: the election being made, the first taxable year for which the election is effective, and the trade or business for which the election is made. Here’s a sample statement:

I hereby elect to use the Mark-to-Market method of accounting under Section 475(f)(1) of the Internal Revenue Code for my trade or business of trading securities. The first year for which the election is effective is the taxable year beginning January 1, (insert applicable year).

This election applies only my securities trading business per Section 475(f)(1). It does not apply to any business I have now or in the future for trading commodities and Section 1256 contracts per Section 475(f)(2).

The second step for an existing taxpayer (as distinct from a “new taxpayer”) is to file a Form 3115, Application for Change in Accounting Method. This Form 3115 must be attached to the taxpayer’s timely filing (including extensions) return for the year of change, and a copy must be sent to the national office. The Form 3115 is an 8 page, complicated form and is best left to a competent CPA to prepare.

Identification of Securities Not Subject to the Election

While a trader generally holds securities to capture short term market swings, a trader may nevertheless hold some securities for long term appreciation as an investment. In that circumstance, there is an exception to the MTM treatment if the taxpayer has “clearly identified” the investment securities in the trader’s records before the close of the day on which the investment security was acquired or the date the MTM election was made.

Under proposed IRS regulations, the exemption is not effective unless the taxpayer can demonstrate by “clear and convincing evidence” that the securities have no connection with his or her trading business.

If the electing trader holds an investment security and is also trading in the same or substantially similar security, the identification is not effective unless the investment securities are held in a separate nontrading account maintained with a third party.

A trader has two ways to make the exemption identification.

 

The first (and safest) way is to establish a separate brokerage account for investment securities. The second way is to clearly indicate on your own records which securities are not part of your trading business. The obvious problem with the second way is that it may be difficult, if not impossible, for the trader to carry his or her burden of proof by “clear and convincing evidence” that this self-generated record was not made up after the fact when the winners and losers were known.

Reporting MTM Gains and Losses

Prior to the MTM election, gains and losses would have gone on Schedule D, Capital Gains and Losses. Now such gains and losses are not longer “capital.” Rather they are ordinary. Hence the IRS requires MTM gains and losses to be reported on Form 4797, Sales of Business Property. Each trade is listed under Part II, Ordinary Gains and Losses. Expenses are going to be reported on Schedule C, Profit or Loss From Business.

In conclusion, the MTM election is a very important issue for every trader to consider—whether one chooses to take the election or not. This article has discussed the major considerations involved, so hopefully you are in a much better position now to discuss this topic with your tax advisor in advance of making the decision for your trading business.

by Joe Wishcamper, Esq.

www.tradersaccounting.com

Information, charts or examples contained in this lesson are for illustration and educational purposes only. It should not be considered as advice or a recommendation to buy or sell any security or financial instrument. We do not and cannot offer investment advice. For further information please read our disclaimer.

 




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