Trader Tax Issues

1. Trader Tax Issues OptionsAnimal Dallas Student Summit April 2, 2011

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 consultant in considering the tax consequences of your own specific set of facts and circumstances.

3. Agenda • Securities & options taxation in general • A Primer on OSI • New basis reporting • aka “Pin the tail on the correct basis” • The Roadmap – www.optionstaxguy.com • Trader vs Investor • Mark to Market • Entity selection • Reporting

4. Goal Understand how to get from the Trade to the Tax Return

5. Securities Taxation General Concepts Taxation of Strategies Options Symbology Initiative New Broker Reporting Requirements

6. What Triggers Tax? • Completed transaction • Open followed by Close • Stock • Purchase Sale • Short Sale Cover • Options • BTO STC/Expiration • STO BTC/Expiration • Which transaction establishes basis for gain/(loss)? • The debit/non-credit side of the transaction

7. What is Taxed? • Gains and losses • Determined on a: • First In – First Out (FIFO) basis • First shares purchased are the first shares sold • Used when cannot or does not identify which shares sold [Reg 1.1012-1(c)(1)] • IRS presumption • Specific Lot Identification basis • Shares must be identified to broker • Broker must confirm in writing [Reg 1.1012-1(c)(3)] Online Trading

8. How is it Taxed? • Stocks/securities are generally capital assets • Closing transaction generates gain/loss – generally • Mark to market deems sale/repurchase but character is still capital – generally • 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

9. Amount of the Tax? • Short-term capital gains • Ordinary income rates – 10% to 35% • Long-term capital gains • Marginal rate bracket up to 15% 0% • Marginal rate bracket 25%+ 15%

10. Securities Taxation General Concepts Taxation of Strategies Options Symbology Initiative New Broker Reporting Requirements

11. How are Strategies Taxed? They’re NOT!! What did he say? Individual Trades ARE

12. How are Strategies Taxed? • Initiate a Put Calendar on SPY in Jan 2011 • BTO May 11 130 • STO Jan 11 130 • BTC/Expire Jan 11 130 • STO Feb 11 130 • BTC/Expire Feb 11 130 • STO Mar 11 130 • BTC/ExpireMar 11 130 • STC May 11 130* • Four lines on Sch D/D-1 Taxable Transaction #1 Taxable Transaction #2 Taxable Transaction #3 *Taxable Transaction #4

13. How are Strategies Taxed?

14. How are Strategies Taxed? • Initiate a Covered Call/Collar on Apple: • Buy AAPL on 7/20/2010 • STO Sep 10 280 Call • BTC/Expired Sep 10 280 Call • STO Oct 10 320 Call • BTO Nov 10 290 Put • BTC/Expired Oct 10 320 Call • STO Nov 10 300 Call • STC Nov 10 290 Put • Expired Nov 10 300 Call • AAPL* called at Nov 10 expiration Taxable Transaction # 1 Taxable Transaction # 2 Taxable Transaction # 3 Taxable Transaction # 4 *Taxable Transaction # 5

15. How to keep it straight ... • That was a lot of trades!!! • The OCC – and others – helped us out here with the ... Options Symbology Initiative

16. Options Symbology Initiative • The ‘Do-It-Yourselfers’ best friend • No more OPRA symbols • OPRA: Apple Dec 2009 210 Call – AAQLB • OSI: AAPL091219C00210000 (what it would have been)

17. Options Symbology Initiative • Excel function to build OSI Symbol • osisymbol(open,ticker,expiry,weekly,type,strike) • open – 0=closed, 1=open • ticker – stock symbol, ie, AAPL, SPY • expiry – expiration date in ‘mmm yyyy’ format • weekly – weekly expiration day (numeric) • type – Put (P) or Call (C) • strike – strike price • Good for sorting option symbols

18. Securities Taxation General Concepts Taxation of Strategies Options Symbology Initiative New Broker Reporting Requirements

19. New Basis Reporting • Brokers now required to report cost basis and holding period • Both will be reported to IRS • Implementation timeframe • Stock purchases – January 1, 2011 • Mutual funds – January 1, 2012 • Options & debt instruments – January 1, 2013 • Why? • Close tax gap $6.7B over 10 years

20. Basis Reporting Problems • Community property laws • Inheritance • Stepped-up basis • All long-term • Wash sale rules • Loss add back • Holding period adjustment • Assigned puts • Decrease basis of assigned shares • Broker transfers

21. Basis Reporting ... so far so • Good • Purchased and sold/same broker – sometimes • Bad • Purchased and sold/different broker • Cost basis – Wrong • Cost basis – “UNKNOWN” • Examples from 2010 tax year

22. Basis Reporting Examples

23. Basis Reporting Examples

24. Basis Reporting Examples

25. What is the Point? Keep track of: COST BASIS YOURSELF!

26. The Roadmap Investor vs Trader Mark to Market Entity Selection Reporting

27. Entity Selection Complete Roadmap with associated links at: www.optionstaxguy.com/roadmap

28. 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

29. Investor vs Trader • Taxation of Investors • Stocks/securities considered capital assets • Gains and losses considered capital • Reported on Schedule D • Subject to IRC Sec 1091 wash sale rules • Subject to $3000 loss limit • Investment expenses (except interest) • Schedule A deductions • Subject to 2% AGI threshold • Not deductible for AMT purposes • Interest – deductible up to net investment income

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

31. Investor vs Trader – MTM Election • What is Mark-to-Market (MTM)? • Traders can elect to mark their security 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

32. Investor vs Trader – MTM Election Benefits Two restrictions no longer apply: $3,000 net capital loss limit Wash sale rule However ... Election is IRREVOCABLE without IRS consent

33. Wash Sales • Wash sale definition: • Loss transaction • Buy substantially identical stock – OR – • Option to acquire substantially identical stock • Within 30 days before or after loss transaction • Are options subject to wash sale treatment? • Does AAPL Apr 11 350 SP = AAPL Apr 11 340 SP? • If AAPL at Apr expiration = $330 Yes • If AAPL at Apr expiration = $345 No

34. Mark to Market Example

35. Mark to Market Example • Purchase 100 SPX at 105 on 11/8/2009 • Make MTM election on 2/4/2010 • SPX closes at 126 on 12/31/2010 • Mark-to-Market requirements: • SPX deemed SOLD on 12/31/2010 at 126 • SPX deemed REPURCHASED on 12/31/2010 for 126 – new basis going forward • Gain 21 (126 – 105) • Long-term 12.6 (60% x 21); 15% max tax rate • Short-term 8.4 (40% x 21); 35% max tax rate

36. Mark to Market Example • SPX declines to 110 by 4/10/2011 and is sold • What is the gain/loss? • How is it taxed? Deemed repurchase at 126 on 12/31/2010 Sale 110 Less: Basis 126 (from deemed repurchase) Loss <16> LTCL <9.6> (60%) STCL <6.4> (40%) • Loss may be carried back three years

37. Investor vs Trader – Making the MTM Election Section 481(a) Adjustment spreadsheet – available at www.optionstaxguy.com

38. Investor vs Trader – Living with the MTM Election Also available at www.optionstaxguy.com

39. Investor vs Trader - Summary

40. The Roadmap Investor vs Trader Mark to Market Entity Selection Reporting

41. Entity Selection

42. Entity Selection

43. Entities – Types • Types of entities for Traders • Sole proprietor – Sch C/Sch D/Form 4797 (default) • General Partnership – Form 1065 • Limited Liability Company (LLC) – Form 1065 • Single member LLC – Sch C/Sch D/Form 4797 • Multiple member LLC* • Corporation • C Corporation – Default; Form 1120 • S Corporation – Election; Form 2553 Form 1120S • * LLC with election: Form 8823 Form 2553 (S Corp)

44. Entities – Setup • State law prevails – name, articles, etc. • Separate bank account styled identically to entity name (Patriot Act) • Brokerage account name identical to entity • Business activity code: 523110, 523900 • Source: www.naicscode.com; keyword: securities trader • Employer Identification Number (EIN) • Setup: www.irs.gov • Walk-through of IRS site at optionstaxguy.com

45. Entities – Taxation • Sole proprietorships (SMLLC) • Flows to page 1 of Form 1040 • Subject to self-employment tax – except traders • May be subject to state business/franchise tax • Partnership (LLC default for 2+) • Flows through to Form 1040 via Schedule E page 2 • Flows to Sch B/Sch D/Sch 4797 via K-1 • Subject to self-employment tax – except traders

46. Entities – Taxation • C Corporation • Separate perpetual entity • Subject to double taxation • Benefits more compliant/straightforward • S Corporation • Separate perpetual entity • Flows through to Form 1040 via Schedule E page 2 • Flows to Sch B/Sch D/Form 4797 via K-1 • Benefits available same as C but less flexible • Not subject to self-employment

47. Entities – Benefits • General benefits • Employer-reimbursement for education • Dependent Care Assistance • Adoption Assistance • Home office • Principal place of business as a trader • Regular use – continuing basis • Exclusive use – no personal, television, exercise

48. Entities – Benefits • Employer-provided transportation • Substantiation for business use Log • Personal use includible in income (W-2) • 100% depreciation for employer • Various valuation methods but limited if owner • Reimbursement at federal rates • Vehicle should be titled in business name • Insurance rates may be higher • May be subject to property tax

49. Entities – Benefits • Health & Medical plans • Entity-dependent treatment • Health reimbursement accounts (Sec 105 plans) • Section 125 plans – cafeteria plans • Retirement plans • Simplified Employee Pension – super-IRA • SIMPLE • Profit-sharing • Pensions – defined benefit or contribution

50. Entities – What are we missing? • Most benefits based on compensation • You need to be an employee Wages • Forms 941, 940, W-2, W-3, State • Form 5500 possibly • Form 1120/1120S/1065