New blog post: Traders: Good and Troubling News in Poppe Ruling Excerpts on prop trading: (Is anyone on Elite having problems with the IRS over these issues?) The Poppe court construed Poppe’s proprietary trading firm arrangement to be a disguised retail customer account. This ruling should be a huge concern for the proprietary trading firm industry, especially since regulators warned clearing firms about disguised customer accounts in the past. By agreement, prop traders do not trade their own capital in a retail customer account. They trade a firm sub-account with firm capital and far higher inter-firm leverage than is available with a retail customer account. Proprietary trading account or disguised customer account? In 2007 (the IRS exam year), Poppe lost $1 million trading with a proprietary trading firm that cleared through Goldman Sachs Execution & Clearing (GSEC). This is the tax loss at the center of this case. On his original tax return filing, Poppe reported this loss (assumed) on Schedule E page 2, as an ordinary loss flowing through to him as a partner in a partnership. If the proprietary trading firm qualified for TTS and filed a timely Section 475 election on the firm level, then trading losses allocated to partners would have ordinary loss treatment. Poppe attached a partner Schedule K-1 to his tax return even though it is not required. But during the exam, the IRS was unable to find Poppe’s K-1 in the partnership tax return filings where it is required to be attached. This begs the question: Did Poppe fabricate his own Schedule K-1? That would be illegal. Or did the firm present Poppe with a Schedule K-1 only to retract it in their partnership tax filing later on? (IRS computers match K-1s reported on partner’s individual tax returns with partnership tax filings looking for incorrect reporting.) Prop trading firm arrangements, agreements, tax treatment and regulatory issues are murky. Perhaps Poppe never formally signed the prop trading firm’s LLC Operating Agreement. The case states Poppe couldn’t satisfy the IRS that he was a partner in the firm. If not an LLC member, perhaps he was an independent contractor, which is the second business model for proprietary trading firms. Poppe claimed he was a Class B member of the firm. Generally, the main owners (Class A members) are allocated firm-wide trading losses on their K-1s since they own the firm’s capital in their capital accounts, which provide tax basis for deducting trading losses. Generally, Class B members don’t have capital accounts so they aren’t allocated losses since they wouldn’t have tax basis to deduct losses, which would then be suspended to subsequent years when they might have capital. Instead of paying into firm capital, Class B members pay “deposits” to the firm. This is where the confusion mainly lies. The firm applies these deposits to cover the prop trader’s trading losses incurred in a firm sub-account. Prop traders are entitled to deduct lost deposits as business bad debts, which are ordinary business losses. Perhaps Poppe should have considered lost deposit bad debt tax treatment instead of using an incorrect K-1 and later relying on an alleged Section 475 election as a retail individual trader. I’ve been covering the proprietary trading industry since the late 1990s. Around 2000, some people questioned whether proprietary trading firm arrangements were really “disguised” retail customer accounts. Reg T margin rules allow 4:1 margin on pattern day trader (PDT) customer accounts requiring a $25,000 minimum account size. Otherwise, retail investors are limited to 2:1 margin on securities. The big attraction of proprietary trading firms is they offer proprietary traders (LLC members or independent contractors) far greater leverage (greater than 10:1 in some cases) on their deposits made with the firm. Some proprietary trading firms have minimum deposit amounts as low as $2,000. If the firm’s profit sharing arrangement is more than 80% sharing to the prop trader, FINRA’s Regulatory Notice 10-18 issued to clearing firms stated it’s one of several signs it may be a disguised retail customer account. Read my June 2010 blog post FINRA’s notice to prop traders. Poppe had 90% profit sharing and perhaps that led the IRS to conclude it was a disguised retail customer account. GSEC is a popular clearing firm for proprietary trading firms and I don’t believe it services individual retail customers. Goldman Sachs brokerage firm has high standards for opening individual retail customer accounts. The Poppe opinion states: “The parties stipulated that all transactions and capital in the GSEC account belonged to petitioner (Poppe).” Perhaps the parties preferred this tact so they could ague the case over Poppe’s alleged Section 475 election as a retail trader. In my view, the word “stipulate” means the parties agreed on facts as a pre-condition to negotiating a settlement. But it’s not necessarily the true facts. Should prop traders file Section 475 elections as a backup position in case the IRS later considers them a disguised retail customer account? I imagine plenty proprietary trading firms and prop traders are in tax controversy (exams, appeals or tax court) now and I suggest they consider contacting our CPA firm for help soon.
If prop trading is found to be a disguised customer account, does that mean the account gets SIPC coverage? Is the trader entitled to Finra/SEC assistance in getting his deposit back?
I've only traded with 1 prop firm and I was hired as an independent contractor, taxed under ordinary income. Capital gains or anything related to that sort of stuff didn't apply to me. I'm wondering how in the hell does a prop trader lose $1M?
Well the easiest way to prevent these kinds of problems is to ensure that you aren't trading your own money (via depositing your money into the company). Prop trading, by definition is trading the firm's money. Why is there a need to deposit your own money in, which can be mistakenly (intentionally?) treated as a retail customer account? I can't tell if I am missing something simple or what? I just came from a thread where someone lost money because a prop firm refused to return his/her deposit.
The magic question is this: what was Poppe's capital contribution with the prop firm? Also, you mentioned in the article that prop firms accept "deposits" however my understanding is it's not a "deposit" but rather "firm capital" that gets allocated directly to the firm. The operating agreement usually states that losses are "pooled" which means your "at risk" capital contribution could be attributed to another trader's loss, once the Class A members' (owners) funds are exhausted. However, a Class B member is not liable for losses beyond his/her own capital contribution. If Poppe's capital contribution was over $1 million and he lost ALL of it, then it would show up on his K-1.
The capital the person brings is the loss limits for the trader. The prop provides the fund for the rest. For instance, if the trader's deposit is say 20k, then he can negociate with the prop the maximum sizes allowed, but whenever his losses reach 20k, the trader is booted out. So, effectively, here this trader is like trading a retail customer account. What most of these firms do, is charge a "training fee" to cover for the trader's potential losses.
Yes, he is only limited by losses of his "capital contribution" (deposit is not really the correct term for a registered firm). And you're right, at 20k in losses for example, he would be "booted out" close to that level, probably well before it even drops that low, since his total BP would be reduced severely. In other words, he'd have to replenish his account or cease trading. However, he's not trading his own retail account, since according to SEC focus report filings of registered prop firms, firms clearly state that it has no customer accounts. For example, Chimera Securities, a registered broker-dealer, which had over $15 million in total members' equity in 2014 according to SEC filings, has the following statement: As per SEC rule 15c3-3: "The company did not handle any customer cash or securities during the year ending December 31, 2014 and does not have any customer accounts." This is the standard language used by prop firms in their SEC filings, it's the same for T-3, Avatar, Hold, Quasar, etc. Anyone can check SEC.gov and read the focus reports. So I'm not sure how the IRS considered him a "retail customer" when SEC rules regarding control requirements of customer cash for the broker-dealer model of a prop are different than say TD Ameritrade, which obviously has retail accounts. Also, he was allocated 90% of his profits, clearly not the 100% as in a retail account. There was a lot of hoopla surrounding this when firms were requiring traders to be registered with the series 56 exam. The CBOE posted various alerts regarding payout rules. It's baffling for any IRS representative to think someone who SPLITS profits with a firm, signs an agreement that he's a "Class B" member, gets a K-1 statement (unlike a 1099 from TD Ameritrade), and trades with a firm that does NOT handle retail accounts is actually a retail customer! I think the issue with Poppe is regarding his K-1, and unless one reads the statement of facts in the court case, it's difficult to make a conclusion on his particular situation. The firms that charge "training fees" are usually not registered broker dealers. They mask their deposit as a "training fee" since they sell education/training, which makes the trader believe he's making a deposit when it fact it's only a training fee.
Here is the summary of the ruling, courtesy of Google: http://www.ustaxcourt.gov/USTCInOP/OpinionViewer.aspx?ID=10583 If you look at the SEC filings for Madison, they clearly state the SEC 15c3-3 exemption! This of course implies they do NOT have any customer accounts, so why would Poppe agree to stipulate that he owned the account at Goldman as a customer? Given that the ruling stated that Poppe satisfied the burden of being a trader as a business, I don't think he would have had this issue if the respondent found a true and correct copy of his K-1 in Madison's records. (As you suggested, either Poppe allegedly fabricated the K-1, or Madison had it and withdrew it). Unless the parties gave depositions under oath, there is no way to really know. If Poppe simply had an operating agreement (instead of a "side letter") showing he was a registered Class B member, AND if Madison had a copy of his K-1, then isn't it reasonable for Poppe to claim the $1 million of losses? This case is not indicative of the Series 56 prop firms. It is standard procedure to have operating agreements with their Class B members, AND to send out K-1 statements at the end of each year. So I don't think there is any issue of traders having to second-guess whether or not they are retail customers. This case is an anomaly. Prop traders clearly are not "retail customers" for the reasons I posted above.
Why is the K-1 loss a "business bad debt?" The trader makes a capital contribution, which becomes his "at risk basis" for income in the partnership. If the K-1 results from actual activity (in this case, proprietary day trading), then isn't it considered "active" since he would be materially participating in the course of making the income? The IRS would be hard pressed to find him being a "passive" member of the partnership, given the fact they even admitted that the bulk of his income came from trading! If the K-1 is considered active income, then why wouldn't he be allowed to offset losses from this K-1 against other active income such as his wages? If the IRS found a proper K-1 in Madison's records, then it would have clearly showed what Poppe's capital contribution was at the beginning of the year, if there were any additions/withdrawals to his capital contributions, and it would have showed he lost over a million dollars in the partnership. Then, couldn't he carry forward those ordinary losses in subsequent years? Similarly, if he had gains in the partnership, those gains would be treated as ordinary income (instead of capital gains).