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.

Exceptions to Early Distribution Penalties

 

What caught my eye about the case was the reference to an “oral opinion.”

Something new, methought.

Better known as a “bench opinion.’

Nothing new, methinks.

What happened is that the Tax Court judge rendered his/her opinion orally at the close of the trial.

Consider that a tax case will almost certainly include Code section and case citations, and I find the feat impressive.

Let’s talk about the case, though, as there is a tax gotcha worth discussing.

Molly Wold is a licensed attorney. She was laid-off in 2017. Upon separation, she pulled approximately $86 grand from her 401(k) for the following reasons:

(1)  Pay back a 401(k) loan

(2)  Medical expenses

(3)  Student loans

(4)  Mortgage and other household expenses

You probably know that pulling money from a 401(k) is a taxable event (set aside a Roth 401(k), or we are going to drive ourselves nuts with the “except-fors”).

Alright, she will have income tax.

Here is the question: will she have an early distribution penalty?

This is the 10% penalty for taking money out from a retirement account, whether a company plan (401(k), 403(b), etc) or IRA and IRA-based plans (SIMPLE, SEP, etc). Following are some exceptions to the penalty:

·      Total and permanent disability

·      Death of the account owner

·      Payments over life expectancy; these are sometimes referred to as “Section 72(t)” payments.

·      Unreimbursed medical expenses (up to a point)

·      IRS levy

·      Reservist on active duty

Then it gets messy, as some exceptions apply only to company-based plans:

·      Leaving your job on reaching age 55 (age 50 if a public safety employee)

Is there a similar rule for an IRA?

·      Withdrawals after attaining age 59 ½.

Why age 55 for a 401(k) but 59 ½ for an IRA?

Who knows.

Molly was, by the way, younger than age 55.

There are exceptions that apply only to a company-based plan:

·      A qualified domestic relations order (that is, a divorce)

·      Dividends from an ESOP

There are exceptions that apply only to an IRA and IRA-based plans:

·      Higher education expenses

·      First-time homebuyer (with a maximum of $10,000)

Yes, Congress should align the rules for both company, IRA and IRA-based plans, as this is a disaster waiting to happen.

However, there is one category that all of them exclude.

Ms Wold might have gotten some pop out of the exception for medical expenses, but that exclusion is lame. The excluded amount is one’s medical expenses exceeding 7.5% of adjusted gross income (AGI). I suppose it might amount to something if you are hit by the proverbial bus.

The rest of the $86 grand would have been for general hardship.

Someone falls on hard times. They turn to their retirement account to help them out. They take a distribution. The plan issues a 1099-R at year-end. Said someone says to himself/herself: “surely, there is an exception.”

Nope.

There is no exception for general hardship.

10% penalty.

Let’s go next to the bayonet-the-dead substantial underpayment penalty. This penalty kicks-in when the additional tax is the greater of $5,000 or 10% of the tax that should have been shown on the return.

Folks, considering the years that penalty has been around, you would think Congress could cut us some slack and at least increase the $5 grand to $10 grand, or whatever the inflation-adjusted equivalent would be.

Ms Wold requested abatement of the penalty for reasonable cause.

Reasonable cause would be that this area of the Code is a mess.

You know who doesn’t get reasonable cause?

An attorney.

Here is the Court:

So I will hold her as a lawyer and as a highly intelligent person with a good education to what IRS instructions that year showed.”

Our case this time was Woll v Commissioner, TC Oral Order.

IRS Rejects A Religious Organization’s Tax-Exempt Application

 

We have a nonprofit application for exempt status that has gone off the rails.  

The reviewing (IRS) officer wanted them, for example, to recharter under a different category of nonprofit status.

I considered it arbitrary, but if it made him happy….

He called this week threatening to terminate his review altogether. I called him back immediately.

What happened, I asked

You have not forwarded all the information I asked for, he explained.

I faxed you several documents in early June. I said. I am unaware of having omitted anything.

I need state certification of the amendment to the charter, he replied.

Which he had not requested previously.

Fine. I called the secretary of state’s office, explaining my situation. They were very helpful and by the end of the day I received a verification that I could forward to the IRS.

The nonprofit, by the way, is a high school booster club. The IRS is treating them like they were Amazon. Folks, these are parents selling pop and snacks at high school games. All they are trying to do is buy bleachers and build restrooms nearer the athletic fields. The IRS overkill here is ridiculous.

My previous exempt application, on the other hand, went smoothly. I had one conversation with the reviewing officer and that was it.

Yes, one’s experience with the IRS can vary greatly depending on whom one is working with.

I am looking at IRS response to an application by an organization called Christians Engaged. It caught my attention for two reasons: first, the response came out of Cincinnati; second, the organization got turned down. I get curious when an application is rejected. I remember, for example, an application rejected for being little more than a masquerade for sending family members to college on a tax-deductible basis.

Let’s set this up:

(1)  The organization was organized in Texas in 2019.

(2)  The founder and president is a former Republican Congressional candidate and a preacher.

(3)  The vice president is a former Promise Keepers prayer coordinator and a homeschool mom.

(4)  The secretary is a millennial managing Republican field teams in Collins county, Texas.

Sounds 2021-ish.

The organization’s mission statement includes the following:

a.    Regular prayer for the nation

b.    Impact culture by voting every election

c.    Encourage political education and activism

d.    Educate Christians on the importance of prayer, voting and nonpartisan political engagement

Got it. There is noticeable call-to-action here.

So what are the activities of Christians Engaged?

(1)  Hold weekly prayer meetings for state and federal leaders, including distribution of program outlines to participating churches.

(2)  Maintain a website and social media providing educational materials and connections for Christians to become politically active.

(3)  Educate believers on issues central to biblical faith, such as the sanctity of life, the meaning of marriage, private versus governmental ethics, religious liberty, and so on.

(4)  Conduct educational activities, including a course in political activism, with a basis in Biblical and Christian value systems.

(5)  Educate on how to select between imperfect candidates as well as political party impact on elected officials.

Tax-exempts have to be careful when they approach political activities.  The type of exempt we are discussing here is the (c)(3) - the most favorable tax status, as contributions to a (c)(3) are tax-deductible.

As a generalization, a tax-exempt is permitted to advocate on issues affecting them, the community, society and the nation. Think environmental protection or domestic abuse, for example, and you will get a feel for it.

What it cannot do is lobby (at least, not to any significant extent).

What is lobbying?

An obvious example is direct lobbying: contacting an elected or government official with the intent of influencing new or existing legislation.

Less obvious is indirect lobbying, sometimes referred to as grassroots lobbying. Rather than contacting an elected or government official directly, the goal is to influence and motivate the public to do so.

To me this definition is soapy water. A tax exempt is allowed to advocate, and obviously it will advocate on behalf of its mission statement. An early education (c)(3) will, for example, advocate with the goal of getting someone to leave the couch and take action on early education matters.  

We have to tighten-up the definition of grassroots lobbying to make it workable.

How about this:

Attempt to influence the general public through communications that:

·      Refer to specific legislation

·      Reflect a point of view on said legislation, and

·      Include a call to action

Better. It seems that a general education or exhortation mission – and leaving specific legislation or candidates alone - will fit into this definition.

What did the IRS reviewing officer see in the Christians Engaged application?

(1)  The activities approach that of an action organization, involving itself with political campaigns and candidates.

How, me asks?

The organization involves itself on issues prominent in political campaigns, instructing what the Bible says about the issue and how the public should vote.

(2)  The issues discussed are more commonly affiliated with certain candidates of one political party rather than candidates of another party, meaning the organization’s activities are not neutral.

(3)  The organization itself is not neutral, as it instructs people on using and voting the Bible. 

(4)  The organization serves the interest of the Republican party more than incidentally, meaning it serves a substantial nonexempt purpose.

 Huh?

Let’s just quote the IRS: 

Specifically, you educate Christians on what the Bible says in areas where they can be instrumental including the areas of sanctity of life, the definition of marriage, biblical justice, freedom of speech, defense, and borders and immigration, U.S. and Israel relations. The bible teachings are typically affiliated with the [Republican] party and candidates.”

That took a turn I did not expect.

I expected an analysis of applying soapy-water standards of grassroots lobbying to societal reality in the 21^st century.  

We got something … else.

The matter is being appealed, of course.

Downside Of Not Issuing 1099s

Let’s be honest: no one likes 1099s.

I get it. The government has conscripted us – business owners and their advisors – into unpaid volunteers for the IRS. Perhaps it started innocently enough, but with the passage of years and the accretion of reporting demands, information reporting has become a significant indirect tax on businesses.

It’s not going to get better. There is a proposal in the White House’s Green Book, for example, mandating banks to report gross deposit and disbursement account information to the Treasury.

Back to 1099s.

You see it all the time: one person pays another in cash with no intention – or ability – to issue a 1099 at year-end.

What can go wrong?

Plenty.

Let’s look at Adler v Commissioner as an example.

Peter Adler owned a consulting company. He had a significant client. He would travel for that client and be reimbursed for his expenses.

The accounting is simple: offset the travel expenses with the reimbursements. Common sense, as the travel expenses were passed-on to the client.

However, in one of the years Peter incurred expenses of approximately $44 thousand for construction work.

The Court wondered how a consultant could incur construction expenses.

Frankly, so do I.

For one reason or another Peter could not provide 1099s to the IRS.

One possible reason is that Peter made his checks out to a corporation. One is not required to issue 1099s to an incorporated business. Peter could present copies of the cancelled checks. He could then verify the corporate status of the payee on the secretary of state’s website.

Nah, I doubt that was the reason.

Another possibility is that Peter got caught deducting personal expenses. Let’s assume this was not the reason and continue our discussion.

A third possibility is that Peter went to the bank, got cash and paid whoever in cash. Paying someone in cash does not necessarily mean that you will not or cannot issue a 1099 at year-end, but the odds of this happening drop radically.

Peter had nothing he could give the Court. I suppose he could track down the person he paid cash and get a written statement to present the Court.

Rigghhhtttt ….

The Court did the short and sweet: they disallowed the deduction.

Could it get worse?

Fortunately for Peter, it ended there, but – yes – it can get worse.

What if the IRS said that you had an employee instead of a contractor? You are now responsible for withholdings, employer matching, W-2s and so on.

COMMENT: You can substitute “gig worker” for contractor, if you wish. The tax issues are the same.

Folks, depending upon the number of people and dollars involved, this could be a bankrupting experience.

Hold on CTG, say you. Isn’t there a relief provision when the IRS flips a contractor on you?

There are two.

I suspect you are referring to Section 530 relief.

It provides protection from an IRS flip (that is, contractor to employee) if three requirements are met:

1.    You filed the appropriate paperwork for the relationship you are claiming exists with the service provider.

2.    You must be consistent. If Joe and Harry do the same work, then you have to report Joe and Harry the same way.

3.    You have to have a reasonable basis for taking not treating the service provider as an employee. The construction industry is populated with contractors, for example.

You might be thinking that (3) above could have saved Peter.

Maybe.

But (1) above doomed him.

Why?

Because Peter should have issued a 1099. He had a business. A business is supposed to issue a 1099 to a service provider once payments exceed $600.

There was no Section 530 relief for Peter.

I will give you a second relief provision if the IRS flips a contractor on you. 

Think about the consequences of this for a second.

(1)  You were supposed to withhold federal income tax.

(2)  You were supposed to withhold social security.

(3)  You were supposed to match the social security.

(4)  You were supposed to remit those withholdings and your match to the IRS on a timely basis.

(5)  You were supposed to file quarterly employment reports accounting for the above.

(6)  You were supposed to issue W-2s to the employee at year-end.

(7)  You were supposed to send a copy of the W-2 to the Social Security Administration at year-end.

(8)  Payroll has some of the nastiest penalties in the tax Code.

This could be a business-shuttering event. I had a client several years ago who was faced with this scenario. The situation was complicated by fact that the IRS considered one of the owners to be a tax protestor. I personally did not think the owner merited protestor status, as he was not filing nonsense appeals with the IRS or filing delaying motions with the Tax Court. He was more …  not filing tax returns.  Nonetheless, I can vouch that the IRS was not humored.

Back to relief 2. Take a look at this bad boy:

§ 3509 Determination of employer's liability for certain employment taxes.

(a)  In general.

If any employer fails to deduct and withhold any tax under chapter 24 or subchapter A of chapter 21 with respect to any employee by reason of treating such employee as not being an employee for purposes of such chapter or subchapter, the amount of the employer's liability for-

(1)  Withholding taxes.

Tax under chapter 24 for such year with respect to such employee shall be determined as if the amount required to be deducted and withheld were equal to 1.5 percent of the wages (as defined in section 3401 ) paid to such employee.

(2)  Employee social security tax.

Taxes under subchapter A of chapter 21 with respect to such employee shall be determined as if the taxes imposed under such subchapter were 20 percent of the amount imposed under such subchapter without regard to this subparagraph .

Yes, you still owe federal income and social security, but it is a fraction of what it might have been. For example, you should have withheld 7.65% from the employee for social security. Section 3509(a)(2) gives you a break: the IRS will accept 20% of 7.65%, or 1.53%.

Is it great?

Well, no.

Might it be the difference between staying in business and closing your doors?

Well, yes.

Literacy And Tax Penalties

I am looking at a Tax Court case.

It does not break any new ground, but there is a twist I do not remember seeing before.

Michael Torres and Elizabeth Ruzendall founded an S corporation (Water Warehouse).

In 2016 Michael found himself in a bad way health-wise. Elizabeth was around, though, even though she was no longer an owner. She ran the company in Michael’s absence.

It must have been a sweet gig, as Water Warehouse issued her a $166,494 Form 1099 for 2016.

Here is the oddball fact: Michael could not read or write. He was sick for so long, however, that he had time to learn.

Good for him.

In 2017 he came across the Form 1099. He could now read.

In 2018 he filed civil suit against Elizabeth.

Both the company’s and Michael’s personal 2016 tax returns were due in 2017. That did not happen, and both returns were filed in 2018.

Remember that an S corporation normally does not pay its own taxes. Instead, the S income would be included on Michael’s personal return, and he would pay tax on the sum.

Michael amended the 2016 S corporation return to subtract the $166,494 paid Elizabeth. Amended returns take an explanation, and it appears that the word “theft” may have come up.

As the corporate income went down, Michael’s personal income would simultaneously go down. Michael was now expecting a refund for 2016.

The IRS told him to pound sand.

And off to Court they went.

Embezzlement or theft are maddening topics in the tax Code.

A key question was whether a theft even occurred. When Elizabeth was running the show in 2016, Michael told her to take “what she felt was her pay.”

Be fair: Elizabeth could easily argue that she had done that.

Except she testified to taking the funds without Michael’s authorization.

And then you have the hurdles of the tax law itself.

The Code says that a theft is deductible when discovered.

Matthew discovered the theft in 2017.

He amended the 2016 corporate and personal tax returns.

That were due in 2017.

But filed late in 2018.

When was the theft discovered?

That would be 2017.

It cannot go on a 2016 return. It could go on a 2017 return, though.

Michael struck out. He claimed the theft a year early.

COMMENT: Once tax year 2016 became an issue with the IRS, he should have filed a protective claim for 2017. The purpose of the claim would be to keep the 2017 tax year open if the theft deduction in 2016 went against him.

The IRS however marched on: it wanted penalties.

I get it: he failed to file those 2016 returns on time.

However, the penalty can be abated for reasonable cause.

The Court said the IRS had reached too far. Michael had been sick for an extended period of time. He hired a new accountant upon learning of the 2016 issues. He taught himself to read and write. e taught himself to read and writeHe could now review his own accounting records rather than having to rely on others.

 

It sounded reasonable to the Court.

To me too.

This is the first time I can remember somebody receiving penalty abatement citing illiteracy.

However, it is probably more correct to say that Michael received abatement for becoming literate. I would say the Court liked him.

Our case this time was Torres v Commissioner, T.C. Memo 2021-66.