Here's my new blog on the subject.
Post fiscal cliff tax planning for traders
While most traders generally came out okay in the fiscal cliff deal, upper-income traders should consider a C-corporation and/or S-corporation in 2013 to avoid Obama-era tax hikes.
By Robert A. Green, CPA
The fiscal cliff deal was a nail biter: We went over the fiscal cliff on Dec. 31 but Congress forged a last minute decision before the lame-duck session expired on Jan. 3. Unfortunately, no one could plan his or her taxes with certainty before year-end. Now that the deal has been reached, hopefully we can make better tax planning moves in 2013.
Fiscal cliff news dissected
The good news is Congress and the President made the Bush-era tax cuts and rates permanent for all taxpayers, except the top 2% with incomes over $300,000 (joint filers) and $250,000 (single filers). (To get a good handle on the amounts due, use calculators like this one at http://calculator.taxpolicycenter.org/ .)
If you thought the thresholds were $450,000/$400,000, youâre not alone. Congress and the media focused on the top tax rate returning to the Clinton-era rate of 39.6% only on incomes over $450,000 for couples and $400,000 for individuals. Many Republicans applauded and Democrats lamented, thinking President Obama waivered from his campaign promise to raise taxes on people making over $250,000/$200,000.
But besides adding a new top tax rate of 39.6%, The American Taxpayer Relief Act included Speaker Boehnerâs original offer to raise tax revenues through reducing tax expenditures. Starting with incomes over $300,000 (joint filers) and $250,000 (single), the act brings back old tax law for Personal Exemption Phaseout (PEP) and Pease provisions. The Pease provision eliminates itemized deductions up to 80% on incomes over those levels, and PEP eliminates exemptions. For families in high-tax states, it can raise their official 33% tax rate to an effective rate of 38%.
In effect, President Obama got what he wanted with tax hikes on the two top tax brackets, using a combination of official tax rate hikes and reductions of tax expenditures. After you factor in ObamaCare 3.8% Medicare tax hikes which went into effect Jan. 1 on incomes over $250,000 (joint filers) and $200,000 (single), Obama-era taxes on the rich are higher than Clinton-era taxes.
The fiscal-cliff deal made the qualifying dividends and long-term capital gains tax rates permanent. It raised the Bush-era 15% qualifying dividends and long-term capital gains tax rate to 20% when incomes exceed $450,000/$400,000. (The higher 20% tax rate only applies to qualifying dividends and long-term capital gains income that exceed the threshold.)
Taxes were raised on the middle class, too. The temporary 2% payroll tax cut expired, reducing the net pay in every paycheck. Traders are not affected by the payroll tax, as trading gains are not subject to payroll taxes. However, when traders pay themselves a small fee to unlock AGI deductions for retirement plans and health insurance premiums, they do owe payroll taxes on salaries or self-employment taxes on administration fees.
The good news is that many traders have incomes under the new tax hike thresholds, so they will continue to benefit from Bush-era tax cuts, which the act makes permanent â if you believe in such fantasies. Most traders wonât see their taxes hiked, unless they have a very good year in the markets or they are married to a high-income earner.
More tax reform is on the way
Donât get too comfortable with tax planning certainty for 2013. Before signing the fiscal cliff legislation, President Obama promised he will try to raise more tax revenue as part of a grand bargain to reform taxes, spending and entitlement programs.
Will tax reform discussions focus on further limiting itemized tax deductions and credits for the upper income, rather than hiking more tax rates? With the PEP and Pease provisions already added back, how much more can Congress raise in taxes from limiting tax expenditures?
Tax reform shouldnât hurt business traders much
The good news for business traders is 2013 tax reform will probably not undermine our trader tax strategies and related tax breaks. First, consider trader tax status. If you qualify, you are able to use âabove the lineâ business expense deduction treatment, rather than âbelow the lineâ itemized deductions for investment expenses. Investors stand to lose a lot in tax reform, but business traders should be saved any damage on their expensing. The fiscal cliff deal extended bonus depreciation for one year and favorable Section 179 depreciation.
Qualifying business traders may elect Section 475 MTM accounting (ordinary gain or loss treatment), which we call âtax loss insuranceâ because it exempts business traders from onerous wash sale loss deferral rules and the dreaded $3,000 capital loss limitation against ordinary income. We havenât heard any discussion in Congress or the administration about reversing these tax breaks for business traders. In 1997, Congress expanded Section 475 MTM from dealers to qualifying business traders. Economic and marked-to-market (MTM) reporting makes more sense and its good public policy.
We also havenât heard any discussion about denying forex trading gains into Section 1256(g) treatment, after a duly filed Section 988 opt-out âcapital gains election.â
If Congress raises revenue from disallowing corporate tax deductions for employer-provided health insurance, then we expect it to carry through across the board, disallowing health insurance premium AGI deductions for everyone. AGI deduction strategies using an entity for attractive retirement plan deductions will still make sense.
Is the 60/40 tax break on futures in jeopardy?
While some in Congress called Section 1256 and its lower 60/40 tax rates a tax loophole, others defended it. I defend the rates and Warren Buffett calls them a loophole in the New York Times article âAn Addition to the List of Loopholesâ by Andrew Ross Sorkin.
As long as there are two rates there should be a blended (long-term and ordinary) tax rate for Section 1256. With MTM baked into Section 1256 by default, traders and investors may not defer capital gains to get the lower long-term capital gains tax rate or enjoy tax deferral over years, but investors in securities (Mr. Buffet) can. Hopefully Congress and the President wonât try to change the blended mix of rates from 60/40 to 40/60 or some other mix.
The Bowles Simpson Deficit Commission advocated one tax rate to simplify the tax code and do away with income conversion strategies from ordinary to capital gains, like carried interest. Bowles Simpson suggested one tax rate of 23%, which happens to be the Bush-era top 60/40 blended tax rate. The problem is that Democrats want tax reform with one rate of 30% or higher. That matches Obamaâs Buffett Rule minimum tax proposal for million dollar incomes taxed at a minimum rate of 30%. I doubt Republicans will ever agree to one rate if that rate is above 23%, so the parties are worlds apart over tax reform (see prior blogs on this subject). Starting in 2013, the Obama-era top 60/40 blended rate is 28%.
Top individual rates are 10% higher than the corporate rate......(cut off here - see the full blog above)......
It goes on to show how high-income traders can avoid many of the Obama-era tax hikes on upper-income taxpayers
If we ignore the reductions from PEP and Pease for a second, it looks like futures and index option traders have a 38% increase in the max tax rate from 2012 to 2013, if you are successful.
In 2012 we had 40% long term and 60% short term treatment for Section 1256 contracts. That means we had a max 23% tax rate:
60%*(max long term rate of 15%) + 40%*(max short term rate of 35%) = 23%
Now in 2013 both short and long term rates have gone up if you are profitable enough so:
60%*(max long term rate of 20%) + 40%*(max short term rate of 39.6%) = 27.84%
Then the kicker is we have to pay 3.8% on net investment income thanks to Obamacare. I can't find any distinction for this rate with regard to short or long term, so it appears Section 1256 traders just have to pay that on top of the standard rate:
27.84% + 3.8% = 31.64%
Obviously this is just the marginal rate for successful traders, but a 38% increase seems a bit excessive. Am I missing anything there?