Trader Tax Management

1. Trader Tax Management Spread Trade Systems Chicago Student Summit March 28, 2009

2. Disclaimer Options Any strategies used as examples and discussed, using actual securities and price data, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation or solicitation to buy or sell securities. Taxation Any US tax advice contained in this presentation is not intended to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions, or (ii) providing, marketing or recommending to another party any transaction or matter addressed herein. The information presented provides only a general discussion of the tax law affecting the taxation of options and is not intended to be applicable to any individual investment and tax situation. You are strongly advised to contact your own tax professional in considering the tax consequences of your own specific set of facts and circumstances.

3. Before We Begin! • What are we going to do? • Talk about some of the tax aspects of options trading • You will understand more about tax return preparation • You should be able to talk more intelligently with your CPA or tax preparer • Questions fielded at the end • What we are not going to do? • Teach you to prepare your own tax return • Cover options taxation exhaustively

4. Investment / Options Taxation

5. Agenda • Securities taxation in general • Trader vs Investor • How to spot the difference • Mark to Market • Wash sale rules • What it is • Attempting to avoid it • Section 1256 Contracts • Reporting

6. Securities Taxation Overview

7. What Triggers Tax? • Completed transaction – generally • Acquisition Sale • Stock • Purchase Sale • Short Sale Cover • Options • BTO STC/Expiration • STO BTC/Expiration

8. What is Taxed? • Sales of stock/securities determined on a: • First In First Out (FIFO) basis (IRS presumption) • First shares purchased are the first shares sold • Used when cannot or does not identify which shares sold [Reg 1.1012-1(c)(1)] • Specific Lot Identification basis • Shares must be identified to broker • Broker must confirm in writing [Reg 1.1012-1(c)(3)]

9. How is it Taxed? • Stocks/securities are capital assets • Closing transaction generates capital gain/loss • Mark-to-market deems sale/repurchase but character is changed to ordinary gain/loss • Holding periods • Short-term – one year or shorter • Long-term – longer than one year • Generally begins on day after acquisition • Generally ends on day of disposition • Pass-through entities – retain character

10. Ordering Rules • Short-term capital losses • Reduce short-term capital gains • Reduce net long-term capital gains (28% > 25% > 15%) • Long-term capital losses (28%) • Reduce long-term capital gains (28% > 25% > 15%) • Long-term capital losses (15%) • Reduce long-term capital gains (28% > 25%) • Net LTCL can offset net STCG

11. Basis for Gain or Loss

12. Investor vs Trader

13. Investor vs Trader • Why? – Subject to differenttaxrules • Definitions: • Investor – • Stock purchase for capital appreciation/dividends • Little regard for short-term fluctuations; buy and hold • Trader – • Regularly and continuously trade stock/securities • Trade in own account • Profit from short-term fluctuations • Can be BOTH trader and investor • IRS presumption Investor

14. Investor vs Trader • Taxation of Investors • Stocks/securities considered capital assets • Gains and losses considered capital • Reported on Schedule D / D-1 • Subject to $3000 net capital loss limit • Subject to IRC Sec 1091 wash sale rules • Investment expenses (except interest) • Schedule A miscellaneous itemized deductions • Subject to 2% AGI threshold • Not deductible for AMT purposes • Interest – deductible up to net investment income • Net investment income does not include • Long-term capital gains • Qualified dividends

15. Investor vs Trader • Taxation of Traders • Stocks/securities considered capital assets • Gains and losses considered capital • Reported on Schedule D / D-1 • Subject to $3000 net capital loss limit • Subject to IRC Sec 1091 wash sale rules • Investment expenses • Schedule C/E* deductions • Interest deductible (for material participation) • Home office deduction eligibility • Gains NOT subject to self-employment tax • Mark-to-Market (MTM) election eligibility _____________________________________________________________________________________________________ * Flow-through entity, such as partnership, LLC, S-Corp

16. Investor vs Trader – Expenses • Deductible – BOTH Investor and Trader • Investment counsel/advice • Subscription services • OptionsAnimal • OptionsMonster • OptionsAnimal Mentor? – Possibly (see below) • STS tuition? – No? • Office expenses – administrative, supplies • Pro-rata portion of computer/software used to determine/manage investments – must be able to substantiate • Reg 1.212-1(g) – paid or incurred by the taxpayer … for the management, conservation, or maintenance of investments held by the taxpayer for the production of income

17. Investor vs Trader – Expenses • Non-Deductible for Investor • Shareholder meeting/transportation expense • Expenses to produce tax-exempt income • Investment-related seminars – THIS EVENT! • IRC Sec 274(h)(7) – “No deduction shall be allowed under [IRC] Sec 212 for expenses allocable to a convention, seminar or similar meeting” • IRC Sec 212 – “… there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred … (1) for the production … of income”

18. Investor vs Trader – Expenses • Investor expenses – Summary • All expenses for the production of income (Sec 212) • Deducted on Sch A as Miscellaneous Deductions • Subject to 2% AGI threshold • Interest expense deductible to the extent of net investment income – does not include LTCG / Div • No Sec 179 expensing election • No home office deduction

19. Investor vs Trader – Expenses • Trader expenses - Summary • All ordinary and necessary expenses (Sec 162) • Interest expense on margin accounts – if material participation, otherwise, for a limited partner, to extent of net investment income • Sec 179 expensing of computers, software • Eligible for home office deduction • Automobile expenses from principal place of business (home) deductible – if for business purpose

20. Investor vs Trader • So what’s the difference? • IRC Sec 212 – Investor “… there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred … (1) for the production … of income” • IRC Sec 162 – Trader “There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred … in carrying on any trade or business …” • As an Investor you are producing income • As a Trader you are in a trade or business

21. Investor vs Trader – Cases • Firm name, business cards, separate bank account, computerized investment analysis system; Traded 5-12 days during each of 3 years buying only 16-44 contracts per year Investor, Steffler (TC Memo 1995-271) • Over 2,000 transactions in 2 years, shortest holding period for stock was 3 months, some over 1 year Investor, Estate of Yeager (2nd Cir, 1989)

22. Investor vs Trader – Cases • Made 46 purchases and 16 sales in 1st year; 109 purchases and 103 sales in 2nd year; Rarely spent more than 10 days/month and never 5 days/wk trading Investor, Cameron (TC Memo 2007-260) • Made 326 sales of which 205 were stocks held less than 31 days; Mostly 3 months of year and not regular and continuous Investor, Paoli (TC Memo 1991-351)

23. Investor vs Trader – Cases • Traded through individual brokerage account; Created LLC, made MTM election; Did not transfer stock to LLC name or Tax ID; Traded less than 40% of trading days on individual account and 45% with LLC Investor, Holsinger (TC Memo 2008-191) • Most of working day engaged in research on companies to identify attractive trades and making stock transactions Trader, Levin (Ct Cl, 1979)

24. Investor vs Trader – Cases • Summary • In Holsinger, Tax Court remarked in its opinion that trading activity of over 1,100 trades or the value of securities traded over $9 million was deemed substantial • Levin – most of working days; substantial time • Regular and continuous • Short holding periods • Substantial number of trades

25. Investor vs Trader Mark-to-Market

26. Investor vs Trader – MTM Election • What is Mark-to-Market (MTM)? • Traders can elect to mark their stock holdings to market value at the end of the tax year IRC Sec 475(f) – “… In the case of a person who is engaged in a trade or business as a trader in securities …” • Gains and losses treated as ordinary gain/loss • Adjustment to stock basis for unrealized gain/loss • Not subject to self-employment tax • Reported on Form 4797, Part II

27. Investor vs Trader – MTM Election Benefits Two restrictions no longer apply: $3,000 net capital loss limit Wash sale rule

28. Investor vs Trader – MTM Election • Election is effective for the year for which it is made and all subsequent years unless revoked with IRS permission (mandatory) • Must make the election by the unextended due date for the tax return for the year … before the year … the election is to be effective • We need an example

29. Investor vs Trader – MTM Election • Eric is actively trading stocks and believes he can generate significant income by trading, on a regular and continuous basis, the short-term fluctuations in the stock market. In July 2008 he begins trading full-time. • Does Eric qualify as a trader? Yes Why?

30. Investor vs Trader – MTM Election • Eric is actively trading stocks and believes he can generate significant income by trading, on a regular and continuous basis, the short-term fluctuations in the stock market. In July 2008 he begins trading full-time. • Does Eric qualify as a trader? • Can he elect MTM for 2008? Yes No

31. Investor vs Trader – MTM Election • Eric would have had to file an election by: • April 15, 2008, or, • Attach the election to his extension (Form 4868) • Eric can make a MTM election for 2009 anytime before April 15, 2009, however, • If this is not the first year as a trader (it is not) then Eric will be required to file Form 3115, Application for Change in Accounting Method • A Sec 481(a) adjustment is also required

32. Investor vs Trader – Making the MTM Election • Attach the following statement to the timely filed Form 1040 or extension Form 4868 Trader in Securities Election to Mark to Market Taxpayer hereby elects under IRC Sec 475(f) to use the mark-to-market method of accounting for securities. The election will first be effective for the tax year ended [20##]. The election is made for the following trade or business: [trade or business name, EIN] • There is relief for late elections – PLR request • New pass-through entity for late election • New taxpayer – elect by 15th day of third month

33. Investor vs Trader - Summary

34. Wash Sale Rules

35. Wash Sale Rules • Loss on wash sale of stock is not currently deductible • What is a wash sale? – • Loss on sale of stock – does not apply to gains • Within 30 days BEFORE/AFTER the loss sale: • Acquire stock* • Buy* call – Reg 1.1091-1(a) “option to acquire” • Sell* ITM put – Rev Rul 85-87 • Impact • Basis – disallowed loss added to cost of newly acquired stock • Holding period – newly acquired stock now has holding period of the stock for which the loss was disallowed _______________________________________ * substantially identical

36. Wash Sale Example 1 • Tim buys 500 shares of C for $23 on 10/1/08 • Tim sells 300 shares for $4 on 11/21/08 • Tim buys 300 shares for $8.50 on 12/10/08 • Is there a loss? • Yes, $19 per share on 11/21/08 ($4.00 - $23.00) • Any repurchase within 30 days either side of 11/21? • Yes, on 12/10/08 • Loss is Not Deductible • Basis of 12/10/08 shs – $27.50 ($8.50 + $19.00)

37. Wash Sale Example 2 • Tim buys 500 shares of C for $23 on 10/1/08 • Tim buys 300 shares for $4 on 11/21/08 • Tim sells 300 shares for $8.50 on 12/10/08 • Is there a loss? • Yes, $14.50 per share on 12/10 ($8.50 – $23.00) • Any repurchase within 30 days either side of 12/10? • Yes, on 11/21/08 • Loss is Not Deductible • Basis of 11/21/08 shs – $18.50 ($4.00 + $14.50)

38. Wash Sale Example 3 • Tim buys 500 shares of C for $23 on 10/1/08 • Tim sells500 shares for $4 on 11/21/08 • Tim buys 300 shares for $8.50 on 12/10/08 • Is there a loss? • Yes, $19 per share on 11/21/08 ($4.00 - $23.00) • Any repurchase within 30 days either side of 11/21? • Yes, on 12/10/08, but • Loss on 300 shs is not deductible • Loss on 200 shs is deductible • Basis of 12/10/08 shs – $27.50 ($8.50 + $19.00)

39. Wash Sale Strategy • Definition of security • IRC Sec 1091 limits the wash sale rules to stocks or securities BUT defines options as a security • Related parties • Sale and purchase collapsed • 61-day window (IRC Sec 267) • IRA is a related party • Does not apply if sale made in connection with the taxpayer’s trade or business (if MTM)

40. Wash Sale Strategy • Reduction in holdings (Rev Rul 56-602) • Bona fide sales in order to reduce holdings of a security • Maybe: Naked put assigned unintentionally and then sold • Puts • Rev Rul 85-87 Facts:Phil sustained a loss on the sale of stock. The next day he sold a put two months out. The put was substantially ITM at the time of sale. Analysis: In light of the spread between the value of the underlying stock and the exercise price of the put, the term of the put, the premium paid, the historic volatility in the value of the stock, and other objective factors, there was at the time the put was sold no substantial likelihood that the put would not be exercised

41. Wash Sale Strategy • Criteria for an ITM naked put • Distance ITM • Term of the put • Historic volatility of underlying stock • Substantial likelihood of exercise • Wait 31 days to repurchase stock • Bull call entered 31 days before sale • Bull put entered 31 days before sale

42. Sec 1256 Contracts Index Options

43. Section 1256 Contracts A Section 1256 Contract is any: • Regulated futures contract – daily MTM • Foreign currency contract • Dealer equity option – market maker/specialist • Dealer securities futures contract • Non-equity option • Broad-based stock index option (SEC determined) • Cash-settled options • Examples – DJX, SPX, OEX, NDX (not ETFs)

44. Sec 1256 Contracts – Mark-to-Market • At the end of the tax year (last business day) • Treat contract as sold • At FMV on the last business day of year • Gain or loss recognized • Recognized gain/loss taken into consideration upon ultimate disposition of contract • 60/40 rule – • 60% of recognized gain/loss is long-term • 40% of recognized gain/loss is short-term • No matter what the actual holding period • A net loss can be carried back 3 years • Report on Form 6781 • We need an example

45. Sec 1256 Contracts – Mark to Market Example

46. Sec 1256 Contracts – Mark to Market Example • 100 SPX Jun 08 1250 calls bought for 145 on 7/17/06 • SPX Jun 08 1250 call at 252 on last business day of 2006 • Mark-to-Market requirements: • SPX LC deemed SOLD on 12/29/06 at 252 • SPX LC deemed REPURCHASED on 12/29/06 for 252 • Gain 107 (252 – 145) • Long-term 64.20 (60% x 107); 15% max tax rate • Short-term 42.80 (40% x 107); 35% max tax rate

47. Sec 1256 Contracts – Mark to Market Example • SPX Jun 08 1250 LC declines to 228 by 3/12/2007 and is sold • What is the gain/loss? • How is it taxed? Deemed repurchase at 252 on 12/29/06 Sale 228 Basis 252 Loss <24> LTCL <14.40> - 60% STCL <9.60> - 40% • Loss may be carried back three years

48. Cow Options Investor at Her Wits End … Is this a put straddle constructive sale, unrecognized wash sale or mocha cappuccino latte???

49. Reporting

50. Reporting • Schedule D/Schedule D-1 • Used by both investor and trader • Name, dates, sale, cost, gain/loss • Use of “VARIOUS” designation for dates of block purchases or sales; still separate ST and LT