A Call From Chuck

I was speaking with a client this week. He told me that he recently retired and his financial advisor recommended he discuss a matter with me.

Me:              So, what are we going to talk about?”

Chuck:         I worked for Costco for many years.”

Me:              OK.”

Chuck:         I bought their stock all along.”

Me:              Not sure where this is going. Are you diversifying?”

Chuck:         Have you heard of Net Unrealized Appreciation?”

Me:              Sure have, but how does that apply to you?”

That was not my finest moment. I did not immediately register that Chuck had – for many years – bought Costco stock inside of his 401(k).

Take a look at this stock chart: 

Costco stock was at $313 on February 7, 2020. Five years later it is at $1,043.

It has appreciated – a lot.

I missed the boat on that one.

The appreciation is unrealized because Chuck has not sold the stock.

The difference between the total value of the Costco stock in his 401(k) and his cost in the stock (that is, the amount he paid over the years buying Costco) is the net unrealized appreciation, abbreviated “NUA” and commonly pronounced (NEW-AHH).

And Chuck has a tax option that I was not expecting. His financial advisor did a good job of spotting it.

Let’s make up a few numbers as we talk about the opportunity here.

Say Chuck has 800 shares. At a price of $1,043, the stock is worth $834,400.

Say his average cost is 20 cents on the dollar: $834,400 times 20% = cost of $166,880.

Chuck also owns stocks other than Costco in his 401(k). We will say those stocks are worth $165,600, bring the total value of his 401(k) to an even $1 million.

Chuck retires. What is the likely thing he will do with that 401(k)?

He will rollover the 401(k) to an IRA with Fidelity, T Rowe, Vanguard, or someone like that.

He may wait or not, but eventually he will start taking distributions from the IRA. If he delays long enough the government will force him via required minimum distributions (RMDs).

How is the money taxed when distributed from the IRA?

It is taxed as ordinary income, meaning one can potentially run through all the ordinary tax rates.

It was not that long ago (1980) that the maximum tax rate was 70%. Granted, one would need a lot of income to climb through the rates and get to 70%. But people did. Can you imagine the government forcing you to take a distribution and then taking seventy cents on the dollar as its cut?

Hey, you say. What about those capital gains in the 401(k)?  Is there no tax pop there?

Think of a 401(k) as Las Vegas. What happens in Las Vegas stays in Las Vegas. What leaves Las Vegas is ordinary income.

And that gets us to net unrealized appreciation. Congress saw the possible unfairness of someone owning stock in a regular, ordinary taxable brokerage account rather than a tax-deferred retirement account. The ordinary taxable account can have long-term capital gains. The retirement account cannot.

Back to NEW-AHH.

How much is in that 401(k)?

A million dollars.

How much of that is Costco?

$834,400.

Let’s roll the Costco stock to a taxable brokerage account. Let’s roll the balance ($165,600) to an IRA.

This would normally be financial suicide, as stock going to a taxable account is considered a distribution. Distributions from an IRA are ordinary income. How much is ordinary income tax on $834,400? I can assure you it exceeds my ATM withdrawal limit.

Here is the NUA option:

You pay ordinary tax on your cost - not the value - in that Costco stock.

OK, that knocks it down to tax on $166,880.

It still a lot, but it is substantially less than the general rule.

Does that mean you never pay tax on the appreciation – the $667,520?

Please. Of course you will, eventually. But you now have two potentially huge tax planning options.

First, hold the stock for at least a year and a day and you will pay long-term capital gains (rather than ordinary income tax) rates on the gain.

QUIZ: Let’s say that the above numbers stayed static for a year and a day. You then sold all the stock. How much is your gain? It is $667,520 (that is, $834,400 minus $166,880). You get credit (called “basis” in this context) for the income you previously reported.

What is the second option?

You control when you sell the stock. If you want to sell a bit every year, you can delay paying taxes for years, maybe decades. Contrast this with MRDs, where the government forces you to distribute money from the account.

So why wouldn’t everybody go NUA?

Well, one reason is that (in our example) you pony up cash equal to the tax on the $166,880. I suppose you could sell some of the Costco stock to provide the cash, but that would create another gain triggering another round of tax.

A second reason is your specific tax situation. If you just leave it alone, distributions from a normal retirement account would be taxable as ordinary income. If you NUA, you are paying tax now for the possibility of paying reduced tax in the future. Take two people with differing incomes and taxes and whatnot and you might arrive at two different answers.

Here are high-profile points to remember about net unrealized appreciation:

(1)  There must exist a retirement account at work.

(2)  There must be company stock in that retirement account.

(3)  There is a qualified triggering event. The likely one is that you retired.

(4)  There must be a lump-sum distribution out of that retirement account. At the end of the day, the retirement account must be empty.

(5)  The stock part of the retirement account goes one way (to a taxable account), and the balance goes another way (probably to an IRA).

(6)  The stock must be distributed in kind. Selling the stock and rolling the cash will not work.

BTW taking advantage of NUA does not have to be all or nothing. We used $834,400 as the value of the Costco stock in the above example. You can NUA all of that – or just a portion. Let’s say that you want to NUA $400,000 of the $834,400. Can you do that? Of course you can.

Chuck has a tax decision that I will never have.

Why is that?

CPA firms do not have traded stock.

An S Corporation Nightmare

Over my career the preferred entities for small and entrepreneurial businesses have been either an S corporation or a limited liability company (LLC). The C corporation has become a rarity in this space. A principal reason is the double taxation of a C corporation. The C pays its own taxes, but there is a second tax when those profits are returned to its shareholders. A common example is dividends. The corporation has already paid taxes on its profits, but when it shares its profits via dividends (with some exception if the shareholder is another corporation) there is another round of taxation for its shareholders. This might make sense if the corporation is a Fortune 500 with broad ownership and itself near immortal, but it makes less sense with a corporation founded, funded, and  grown by the efforts of a select few individuals – or perhaps just one person.

The advantage to an S corporation or LLC is one (usually - this is tax, after all) level of tax. The shareholder/owner can withdraw accumulated profits without being taxed again.

Today let’s talk about the S corporation.

Not every corporation can be an S. There are requirements, such as:

·       It cannot be a foreign corporation.

·       Only certain types of shareholders are allowed.

·       Even then, there can be no more than 100 shareholders.

·       There can be only one class of stock.

Practitioners used to be spooked about that last one.

Here is an example:

The S corporation has two 50% shareholders. One shareholder has a life event coming up and receives a distribution to help with expenses. The other shareholder is not in that situation and does not take a distribution.

Question: does this create a second class of stock?

It is not an academic question. A stock is a bundle of rights, one of which is the right to a distribution. If we own the same number of shares, do we each own the same class of stock if you receive $500 while I receive $10? If not, have we blown the S corporation election?

These situations happen repetitively in practice: maybe it is insurance premiums or a car or a personal tax. The issue was heightened when the states moved almost in concert to something called “passthrough taxes.” The states were frustrated in their tax collection efforts, so they mandated passthroughs (such as an S) to withhold state taxes on profits attributable to their state. It is common to exempt state residents from withholding, so the tax is withheld and remitted solely for nonresidents. This means that one shareholder might have passthrough withholding (because he/she is a nonresident) while another has no withholding (because he/she is a resident).

Yeah, unequal distributions by an S corporation were about to explode.

Let’s look at the Maggard case.

James Maggard was a 50% owner of a Silicon Valley company (Schricker). Schricker elected S corporation status in 2002 and maintained it up to the years in question.

Maggard bought out his 50% partner (making him 100%) and then sold 60% to two other individuals (leaving him at 40%). Maggard wanted to work primarily on the engineering side, and the other two owners would assume the executive and administrative functions.

The goodwill dissipated almost immediately.

One of the new owners started inflating his expense accounts. The two joined forces to take disproportionate distributions. Apparently emboldened and picking up momentum, the two also stopped filing S corporation tax returns with the IRS.

Maggard realized that something was up when he stopped receiving Schedules K-1 to prepare his personal taxes.

He hired a CPA. The CPA found stuff.

The two did not like this, and they froze out Maggard. They cut him off from the company’s books, left him out of meetings, and made his life miserable. To highlight their magnanimity, though, they increased their own salaries, expanded their vacation time, and authorized retroactive pay to themselves for being such swell people.

You know this went to state court.

The court noted that Maggard received no profit distributions for years, although the other two were treating the company as an ATM. The Court ordered the two to pay restitution to Maggard. The two refused. They instead offered to buy Maggard’s interest in Schricker for $1.26 million. Maggard accepted. He wanted out.

The two then filed S corporation returns for the 2011 – 2017 tax years.

They of course did not send Maggard Schedules K-1 so he could prepare his personal return.

Why would they?

Maggard’s attorney contacted the two. They verbally gave the attorney – piecemeal and over time – a single number for each year.

Which numbers had nothing to do with the return and its Schedules K-1 filed with the IRS.

The IRS took no time flagging Maggard’s personal returns.

Off to Tax Court Maggard and the IRS went.

Maggard’s argument was straightforward: Schricker had long ago ceased operating as an S corporation. The two had bent the concept of proportionate anything past the breaking point. You can forget the one class of stock matter; they had treated him as owning no class of  stock, a pariah in the company he himself had founded years before.

Let’s introduce the law of unintended consequences:

Reg 1.1361-1(l)(2):

Although a corporation is not treated as having more than one class of stock so long as the governing provisions provide for identical distribution and liquidation rights, any distributions (including actual, constructive, or deemed distributions) that differ in timing or amount are to be given appropriate tax effect in accordance with the facts and circumstances.

Here is the Tax Court:

… the regulation tells the IRS to focus on shareholder rights under a corporation’s governing documents, not what the shareholders actually do.”

That makes sense if we were talking about insurance premiums or a car, but here … really?

We recognize that thus can create a serious problem for a taxpayer who winds up on the hook for taxes owed on an S corporation’s income without actually receiving his just share of distributions.”

You think?

This especially problematic when the taxpayer relies on the S corporation distributions to pay these taxes.”

Most do, in my experience.

Worse yet is when a shareholder fails to receive information from the corporation to accurately report his income.”

The Court decided that Maggard was a shareholder in an S corporation and thereby taxable on his share of company profits.

Back to the Court:

The unauthorized distributions in this case were hidden from Maggard, but they were certainly not memorialized by … formal amendments to Schricker’s governing documents. Without that formal memorialization there was no formal change to Schricker’s having only class of stock.”

I get it, but I don’t get it. This reasoning seems soap, smoke, and sophistry to me. Is the Court saying that – if you don’t write it down – you can get away with anything?      

Our case this time was Haggard and Szu-Yi Chang v Commissioner, T.C. Memo 2024-77.

 

What Is Your Tax Basis When There Are No Records?

 

Since I started practice, there have been repetitive proposals to change the step-up basis rules upon death. With some exceptions, the general rule is that assets at one’s death take fair market value as their tax basis.

EXAMPLE: A decedent purchased his principal residence in 1975 for $56,000. The house is in Brentwood, Tennessee, and upon death the property is worth $1 million. The property’s tax basis is reset from $56 thousand to $1 million. Sell it for $1 million shortly after death and there is no gain or loss.

The common exception are retirement accounts: 401(k)s, 403(b)s, traditional IRAs and so on. These assets do not reset to fair market value (the tax nerds call this the “mark”), as the Code wants distributions from these accounts to be taxed as ordinary income.

There is a downside to the mark, of course. If the asset has gone down in value, then that lower value becomes the new basis.

The proposals I to which I refer would require carryover basis for the asset, meaning that tax basis will be acquisition cost plus improvements with no reference to market value at death.

I get it, I really do.

Why should income tax basis for an asset be marked just because someone died?

To continue that line of argument, why should there be a mark if one did not even have to file an estate tax return, much less pay estate taxes? The lifetime exemption in 2024 is $13.61 million. That is rarified air. So few estate tax returns are being filed that the IRS has been reassigning estate examiners to other functions.

The flip side asks how many times an asset is going to be taxed. To require carryover basis is to extend taxation on someone even beyond their death, which – I admit – seems macabre.

I prefer the mark over carryover basis for a different reason:

I am a practitioner and have been for decades. The argument for carryover basis may sound reasonable in the insulated confines of academe or expense account restaurants in corridors of power, but one should make a reality check with practitioners who have to work with these rules.

I expect that many if not most practitioners have encountered assets that are nearly impossible to cost or – if possible – possible only with extraordinary effort.

We had an example during busy season. A client and his siblings sold undeveloped land inherited from their grandfather and great aunt. The property had been owned separately, then as tenants in common, had survived two deaths and eventually found its way into a trust. The trust had terminated, and the siblings had formed a partnership in its place. One of the siblings was convinced that the basis for the land was incorrect. It was possible, as we had assumed the tax work from another accountant. We had not previously questioned the basis for the land. No one had.   

It took weeks and multiple people investigating and researching the provenance of the land. Even so, we were fortunate to research only back to the dates of the two deaths, as those would be the trigger dates for any potential mark.   

This is but one asset. One taxpayer. One practitioner. Who knows how many times the story repeats?

There is also a dark side to establishing tax basis that should be said out loud.

Let’s look at the Youngquist case.

Dean Youngquist (DY) did not file a tax return for 1996. He in fact had not filed a tax return since the late 1980s, which is a story for another day.

DY started day trading in 1996. He opened an account with Protrade. He closed that account in December 1996 and opened an account with Datek, another brokerage.

Do you remember the 1099-Bs that brokerages send you and the IRS? The Protrade and Datek 1099-Bs totaled $2,052,688 in sales proceeds.

COMMENT: I expect to see net trading losses, as net gains from day trading are uncommon.

The IRS send DY a tax assessment of $791,200, with another $796,726 in penalties and interest.

DY had been space-tripping, I guess. He did not file a tax return. He did not remember receiving notice(s) from the IRS. He had no idea that liens were filed on his property. He was shocked to learn that the IRS wanted to sell stuff to collect his taxes.

COMMENT: DY needs to tighten his game.

DY asked how the IRS got to the $791 grand in tax, much less the penalties and interest.

Easy, said the IRS. Since you did not provide records, we used zero (-0-) as your basis in the trades.

Folks, we all know there is zero chance that DY had no cost in his trades. The world does not work that way. How then did the IRS assert its position with a straight face?

Here is the Court:

The fact that basis may be difficult to establish does not relieve a taxpayer from his burden.”

DY did not even file a tax return, so it appears he put zero effort into discharging his burden.

If the taxpayer fails to satisfy the burden, the basis is deemed to be zero.”

Harsh, but that is the Coloman decision and extant tax law.

What did DY do next?

Believe it or not, he found – way, way after the fact – records for his Datek account.

The United States will abate the assessments by the portion of the assessments, penalties, and interest that were based upon the $601,612.50 in stock sales through Datek in 1996.”

Datek, BTW, was not his major trading account. Protrade was.

… there is no evidence documenting Youngquist’s actual stock transactions in the Protrade account. There are no statements from Protrade. There are no letters or emails from Protrade. Youngquist did not keep any notes about the stocks he purchased and sold, and he is unable to testify from memory about the specific stocks he bought and sold.”

DY had waited too long. Protrade was out of business.

DY had an idea:

·      He started his Protrade account with $73,000.

·      He closed his account with $67,333.

·      There was an aggregate loss of $5,677.

Seems reasonable.

Here is the Court:

First, I can find no authority to support his aggregate theory of proving basis in stock.”

This is technically correct, as each sale is its own event. Still, I would urge the Court to pull back the camera and use common sense. In legal-speak, we would call this an equity argument.

His only evidence is his own uncorroborated testimony. Youngquist’s bank account records do not reveal the November 5, 1996 withdrawal went to Protrade. There is no wire transfer record. There is no cancelled check evidencing payment to Protrade. Youngquist relies solely on his own testimony to suggest these facts.”

Personally, I believe that DY lost money overall in his Protrade account, but that is not the issue. The issue is that he needed to retain (some) records and file a return, responsibilities which he ignored. He then wanted the Court to do his work for him, and the Court was having none of that.

A taxpayer’s self-serving declaration is generally not a sufficient substitute for records.”

DY won on Datek but lost on Protrade. This was going to be expensive.

Back to the carryover basis proposal.

DY could not find records in 2013 going back to 1996. Granted, that is a long time, but that is nothing compared to requiring records from other people, possibly from other states and likely from decades earlier.  There should be a concession in tax administration that ordinary people pursuing ordinary goals are not going to maintain (and retain) records to the standards of the National Archive, at least not in overwhelming numbers. Combine that with a possible Youngquist body slam to zero, and the carryover basis proposal strikes as economically inefficient, financially brutish, possibly condescending, and an administrative nightmare. Why are we discussing a tax policy that cannot survive exposure to the real world?

Our case this time was U.S. v Youngquist, 3:11-cv-06113-PK, District Oregon.

Qualifying For Stock Loss Under Section 1244

 

I am looking at a case having to do with Section 1244 stock.

And I am thinking: it has been a while since I have seen a Section 1244.

Mind you; that is not a bad thing, as Section 1244 requires losses. The most recent corporate exit I have seen was a very sweet rollup of a professional practice for approximately $10 million. No loss = no Section 1244.

Let’s set up the issue.

We are talking about corporations. They can be either C or S corporations, but this is a corporate tax thing. BTW there is a technical issue with Section 1244 and S corporations, but let’s skip it for this discussion.

The corporation has gone out of business.

A corporation has stock. When the corporation goes out of business, that stock is worthless. This means that the shareholder has incurred a loss on that stock. If he/she acquired the stock for $5,000, then there is a loss of $5,000 when the corporation closes.

Next: that loss is – unless something else kicks-in – a capital loss.

Capital losses offset capital gains dollar-for-dollar.

Let’s say taxpayer has no capital gains.

Capital losses are then allowed to offset (up to) $3,000 of other income.

It will take this person a couple of years to use up that $5,000 loss.

Section 1244 is a pressure valve, of sorts, in this situation.

A shareholder can claim up to $50,000 of ordinary loss ($100,000 if married filing joint) upon the sale, liquidation or worthlessness of stock if:

 

(1)  The stock is be either common or preferred, voting or nonvoting, but stock acquired via convertible securities will not qualify;

(2)  The stock was initially issued to an individual or partnership;

(3)  The initial capitalization of the corporation did not exceed $1 million;

(4)  The initial capitalization was done with stock and property (other than stock and securities);

(5)  Only persons acquiring stock directly from the corporation will qualify; and

(6)  For the five tax years preceding the loss, the corporation received more than 50% of its aggregate gross receipts from sources other than interest, dividends, rents, royalties, and the sale or exchange of stocks or securities.

The advantage is that the ordinary loss can offset other income and will probably be used right away, as opposed to that $3,000 year-by-year capital loss thing.

Mind you, there can also be part Section 1244/part capital loss.

Say a married couple lost $130,000 on the bankruptcy of their corporation.

Seems to me you have:

                      Section 1244                     100,000

                      Capital loss                         30,000

Let’s look at the Ushio case.

Mr Ushio acquired the stock of PCHG, a South Carolina corporation, for $50,000.

PCHG intended to was looking to get involved with alternative energy. It made agreements with a Nevada company and other efforts, but nothing ever came of it. PCHG folded in 2012.

Ushio claimed a $50,000 Section 1244 loss.

The IRS denied it.

There were a couple of reasons:

(1)  Mr. Ushio still had to prove that $1 million limit.

 

The issue here was the number at the corporate level: was the corporation initially capitalized (for cash and property other than stock and securities) for $1 million or less? If yes, then all the issued stock qualified. If no, the corporation must identify which shares qualified and which shares did not.

        

It is possible that PCHG was not even close to $1 million in capitalization, in which a copy of its initial tax return might be sufficient. Alternatively, PCHG’s attorney or accountant might/should have records to document this requirement.        

 

(2)  PCHG never had gross receipts.

 

This means that PHGC could not meet the 50% of gross receipts requirement, as it had no gross receipts at all.

 

Note that opening a savings or money market account would not have helped. PCHG might then have had gross receipts, but 100% of its gross receipts would have been interest income – the wrong kind of income.

Mr Ushio did not have a Section 1244 loss, as PCHG did not qualify due to the gross-receipts requirement. You cannot do percentages off a denominator of zero.

My first thought when reviewing the case was the long odds of the IRS even looking at the return, much less disallowing a Section 1244 loss on said return. That is not what happened. The IRS was initially looking at other areas of the Ushio return. In fact, Ushio had not even claimed a capital loss – much less a Section 1244 loss – on the original return. The issue came up during the examination, making it easy for the IRS to say “prove it.”

How would a tax advisor deal with this gross-receipts hurdle in practice?

Well, the initial and planned activity of PCHG failed to produce any revenues. It seems to me that an advisor would look to parachute-in another activity that would produce some – any – revenues, in order to meet the Section 1244 requirement. The tax Code wants to see an operating business, and it uses gross receipts as its screen for operations.

Could the IRS challenge such effort as failing to rise to the level of a trade or business or otherwise lacking economic substance? Well, yes, but consider the alternative: a slam-dunk failure to qualify under Section 1244.

Our case this time was Ushio v Commissioner, TC Summary Opinion 2021-27.

Section 1202 Stock And A House Tax Proposal

I am not a fan of fickleness and caprice in the tax law.

I am seeing a tax proposal in the House Ways and Means Committee that represents one.

It has been several years since we spoke about qualified small business stock (QSBS). Tax practice is acronym rich, and one of the reasons is to shortcut who qualifies – and does not qualify – for a certain tax provision. Section 1202 defines QSBS as stock:

·      issued by a C corporation,

·      with less than $50 million in assets at time of stock issuance,

·      engaged in an active trade or business,

·      acquired at original issuance by an eligible shareholder in exchange for either cash or services provided, and

·      held for at least five years.

The purpose of this provision is to encourage – supposedly – business start-ups.

How?

A portion of the gain is not taxed when one sells the stock.

This provision has been out there for approximately 30 years, and the portion not taxed has changed over time. Early on, one excluded 50% (up to a point); it then became 75% and is now 100% (again, up to a point).

What is that point?

The amount of gain that can be excluded is the greater of:

·      $10 million, or

·      10 times the taxpayer’s basis in the stock disposed

Sweet.

Does that mean I sell my tax practice for megabucks, all the while excluding $10 million of gain?

Well, no. Accounting practices do not qualify for Section 1202. Not to feel singled- out, law and medical practices do not qualify either.

I have seen very few Section 1202 transactions over the years. I believe there are two primary reasons for this:

                 

(a)  I came into the profession near the time of the 1986 Tax Reform Act, which single-handedly tilted choice-of-entity for entrepreneurial companies from C to S corporations. Without going into details, the issue with a C corporation is getting money out without paying double tax. It is not an issue if one is talking about paying salary or rent, as one side deducts and the other side reports income. It is however an issue when the business is sold. The S corporation allows one to mitigate (or altogether avoid) the double tax in this situation. Overnight the S corporation became the entity of choice for entrepreneurial and closely-held companies. There has been some change in recent years as LLCs have gained popularity, but the C corporation continues to be out-of-favor for non-Wall Street companies. 

 

(b)  The sale of entrepreneurial and closely-held companies is rarely done as a stock purchase, a requirement for Section 1202 stock. These companies sell their assets, not their stock. Stock acquisitions are more a Wall Street phenomenon.

So, who benefits from Section 1202?

A company that would be acquired via a stock purchase. Someone like … a tech start-up, for example. How sweet it would have been to be an early investor in Uber or Ring, for example. And remember: the $10 million cap is per investor. Take hundreds of qualifying investors and you can multiply that $10 million by hundreds.

You can see the loss to the Treasury.

Is it worth it?

There has been criticism that perhaps the real-world beneficiaries of Section 1202 are not what was intended many years ago when this provision entered the tax Code.

I get it.

So what is the House Ways and Means Committee proposing concerning Section 1202?

They propose to cut the exclusion to 50% from 100% for taxpayers with adjusted gross income (AGI) over $400 grand and for sales after September 13, 2021.

Set aside the $400 grand AGI. That sale might be the only time in life that someone ever got close to or exceeded $400 grand of income.

The issue is sales after September 13, 2021.

It takes at least five years to even qualify for Section 1202. This means that the tax planning for a 2021 sale was done on or before 2016, and now the House wants to retroactively nullify tax law that people relied upon years ago.

Nonsense like this is damaging to normal business. I have made a career representing entrepreneurs and their closely-held businesses. I have been there – first person singular - where business decisions have been modified or scrapped because of tax disincentives. Taxing someone to death clearly qualifies as a business disincentive. So does retroactively changing the rules on a decision that takes years to play out. Mind you – I say that not as a fan of Section 1202.

To me it would make more sense to change the rules only for stock issued after a certain date – say September 13, 2021 – and not for sales after that date. One at least would be forewarned.   

Should bad-faith tax proposals like this concern you?

Well, yes. If our current kakistocracy can do this, what keeps them from retroactively revoking the current tax benefits of your Roth IRA?  How would you feel if you have been following the rules for 20 years, contributing to your Roth, paying taxes currently, all with the understanding that future withdrawals would be tax-free, and meanwhile a future Congress decides to revoke that rule - retroactively?

I can tell you how I would feel.

A Day Trader and Wash Losses

 

We have had a difficult time with the tax return of someone who dove into the deep end of the day-trading pool last year. The year-end Fidelity statement reported the trades, but the calculation of gain and losses was way off. The draft return landed on my desk showing a wash loss of about $2.5 million. Problem: the client was trading approximately $250 grand in capital. She would have known if she lost $2.5 million as either she (1) would have had a capital call, (2) used margin, or (3) done a bit of both.

Let’s talk about wash sales.

The rule was created in 1921 because of a too-favorable tax strategy.

Let’s say that you own a stock. You really believe in it and have no intention of parting with it. You get near the end of the year and you are reviewing your to-date capital gains and losses with your advisor. You have $5 thousand in capital gains so far. That stock you like, however, took a dip and would show a $4 thousand loss … if you sold it. The broker hatches a plan.

“This is what we will do” says the broker. We will sell the stock on December 30 and buy it back on January 2. You will be out of the stock for a few days, but it should not move too much. What it will do is allow us to use that $4 thousand loss to offset the $5 thousand gain.”

It is a great plan.

Too great, in fact. Congress caught wind and changed the rules. If you sell a stock at a loss AND buy the same or substantially identical stock either

·      30 days before or

·      30 days after …

… the sale creating the loss, you will have a wash sale. What the tax law does is grab the loss ($4 thousand in our example) and add it to the basis of the stock that you bought during the 30 day before-and-after period. The loss is not permanently lost, but it is delayed.

Mind you, it only kicks-in if you sell at a loss. Sell at a gain and the government will always take your money.

Let’s go through an example:

·      On June 8 you sell 100 shares at a loss of $600.

·      On July 3 you buy 100 shares of the same stock.

You sold at a loss. You replaced the stock within the 61-day period. You have a wash loss. The tax Code will disallow the $600 loss on the June 8 trade and increase your basis in the July 3 trade by $600. The $600 loss did not disappear, but it is waiting until you sell that July 3 position.

Problem: you day trade. You cannot go 48 hours without trading in-and-out of your preferred group of stocks.

You will probably have a lot of wash sales. If you didn’t, you might want to consider quitting your day job and launching a hedge fund.

Problem: do this and you can blow-up the year-end tax statement Fidelity sends you. That is how I have a return on my desk showing $2.5 million of losses when the client had “only” $250 grand in the game.

I want to point something out.

Let’s return to our example and change the dates.

·      You already own 100 shares of a stock

·      On June 8 you buy another 100 shares

·      On July 3 you sell 100 shares at a loss

This too is a wash. Remember: 30 days BEFORE and after. It is a common mistake.

The “substantially identical” stock requirement can be difficult to address in practice. Much of the available guidance comes from Revenue Rulings and case law, leaving room for interpretation. Let’s go through a few examples.

·      You sell and buy 100 shares of Apple. That is easy: wash sale.

·      You sell 100 shares of Apple and buy 100 shares of Microsoft. That is not a wash as the stocks are not the same.

·      You sell 30-year Apple bonds and buy 10-year Apple bonds. This is not a wash, as bonds of different maturities are not considered substantially identical, even if issued by the same company.

·      You sell Goldman Sachs common stock and buy Goldman Sachs preferred. This is not a wash, as a company’s common and preferred stock are not considered substantially identical.

·      You sell 100 shares of American Funds Growth Fund and buy 100 shares of Fidelity Growth Company. The tax law gets murky here. There are all kinds of articles about portfolio overlap and whatnot trying to interpret the “substantially identical” language in the area of mutual funds.  Fortunately, the IRS has not beat the drums over the years when dealing with funds. I, for example, would consider the management team to be a significant factor when buying an actively-managed mutual fund. I would hesitate to consider two actively-managed funds as substantially identical when they are run by different teams. I would consider two passively-managed index funds, by contrast, as substantially identical if they tracked the same index.  

·      You sell 100 shares of iShares S&P 500 ETF and buy the Vanguard S&P 500 ETF.  I view this the same as two index mutual funds tracking the same index: the ETFs are substantially identical.

·      Let’s talk options. Say that you sell 100 shares of a stock and buy a call on the same stock (a call is the option to buy a stock at a set price within a set period of time). The tax Code considers a stock sale followed by the purchase of a call to be substantially identical.

·      Let’s continue with the stock/call combo. What if you reverse the order: sell the call for a loss and then buy the stock? You have a different answer: the IRS does not consider this a wash.

·      Staying with options, let’s say that you sell 100 shares of stock and sell a put on the same stock (a put is the option to sell a stock at a set price within a set period of time). The tax consequence of a put option is not as bright-line as a call option. The IRS looks at whether the put is “likely to be exercised,” generally interpreted as being “in the money.”

Puts can be confusing, so let’s walk through an example. Selling means that somebody pays me money. Somebody does that for the option of requiring me to buy their stock at a set price for a set period. Say they pay me $4 a share for the option of selling to me at $55 a share. Say the stock goes to $49 a share. Their breakeven is $51 a share ($55 minus $4). They can sell to me at net $51 or sell at the market for $49.  Folks, they are selling the stock to me. That put is “in-the-money.”  

Therefore, if I sell a put when it is in-the-money, I very likely have something substantially identical.

There are other rules out there concerning wash sales.

·      You sell the stock and your spouse buys the stock. That will be a wash.

·      You sell a stock in your Fidelity account and buy it in your Vanguard account. That will be a wash.

·      You sell a stock and your IRA buys the stock. All right, that one is not as obvious, but the IRS considers that a wash. I get it: one is taxable and the other is tax-deferred. But the IRS says it is a wash. I am not the one making the rules here.

·      There is a proportional rule. If you sell 100 shares at a loss and buy only 40 shares during the relevant 61-day period, then 40% (40/100) of the total loss will be disallowed as a wash.

Let’s circle back to our day trader. The term “trader” has a specific meaning in the tax Code. You might consider someone a trader because they buy and sell like a madman. Even so, the tax Code has a bias to NOT consider one a trader. There are numerous cases where someone trades on a regular, continuous and substantial basis – maybe keeping an office and perhaps even staff - but the IRS does not consider them a trader. Maybe there is a magic number that will persuade the IRS - 200 trading days a year, $10 million dollars in annual trades, a bazillion individual trades – but no one knows.

There is however one sure way to have the IRS recognize someone as a trader. It is the mark-to-market election. The wash loss rule will not apply, but one will pay tax on all open positions at year-end. Tax nerds refer to this as a “mark,” hence the name of the election.

The mark pretends that you sold everything at the end of the year, whether you actually did or did not. It plays pretend but with your wallet. This tax treatment is different from the general rule, the one where you actually have to sell (or constructively sell) something before the IRS can tax you.

Also, the election is permanent; one can only get out of it with IRS permission.

A word of caution: read up and possibly seek professional advice if you are considering a mark election. This is nonroutine stuff – even for a tax pro. I have been in practice for over 35 years, and I doubt I have seen a mark election a half-dozen times.