Those who trade stocks can take advantage of the mark-to-market election to convert capital losses into ordinary losses. This election is only available to “traders.”
There are often questions as to when a taxpayers trading activities are sufficient to warrant being treated as a “trader” for tax purposes. By the time the taxpayer discovers that they qualify, it is often too late to make the election.
Taxpayers then have to make a late election by seeking 9100 relief. This relief has resulted in a number of tax disputes. The recent PLR 202009013 provides an example. It also provides an opportunity to consider the late mark-to-market election rules.
Facts & Procedural History
The taxpayers who submitted the ruling request were husband and wife. The wife is a school teacher. The husband is a treasurer at a trust fund company.
The husband traded volatility-based futures contracts outside of his job. He incurred significant losses for two years.
The taxpayers filed an extension to ask for additional time to file their income tax return for year two.
In year three, when the taxpayer-husband was preparing his year two tax return, he discovered that the mark-to-market election had to be made on a timely-filed return for year one. He did not know that the election could not be made on a return filed after the unextended due date, yet alone one filed on the year two tax return.
The taxpayers submitted a ruling request asking for the IRS’s permission to make a late mark-to-market election.
The Mark-to-Market Election
At a high level, mark-to-market accounting refers to recording assets on financial statements at their current fair market value. Compare this to cost accounting in which assets are recorded based on the cost or price paid for the asset.
Our income tax system operates off of cost accounting. Meaning, assets are recorded for tax purposes based on the cost or purchase price.The mark-to-market election is an exception.
The mark-to-market election applies to those who trade securities. If elected, it requires the trader to report gain or loss based as if the securities held by the trader on the last day of the year were sold on the last day of the year. The gain or loss is taxed at ordinary income tax rates.
There is currently a significant rate difference between the ordinary and capital gains tax rates. The highest ordinary tax rate is 37%. The highest long term capital gains tax rate is 20% (plus a 3.8% net investment income tax). If the trader lives in a high income tax state, the state income tax can add to this ordinary vs. capital gain tax rate.
Many traders prefer the mark-to-market election as it allows them to take any trading losses as ordinary losses. The losses can either offset other items of ordinary income (such as Form W-2 wages) rather than offsetting capital gains. They can also produce net operating losses that can be carried forward to future tax years.
In addition, the trader is able to treat his or her expenses as business expenses. This often allows quite a few tax deductions that would otherwise not be deductible.
The drawback of selling securities at the end of the year may mean little to traders, as they generally do not hold securities for long periods of time. And the drawback is really limited for gains, as most traders have short term capital gains which are taxed at higher rates anyway.
Timing of the Mark-to-Market Election
For those who trade securities, they often fail to make the mark-to-market election timely. This is often due to the trader not knowing about the
election or that the election for year two has to be made on the year one tax return. It may also be due to the trader not expecting to have losses.
This brings us to the trader in PLR 202009013. The trader asked for the IRS’s permission to make a late mark-to-market election. This request is submitted as 9100 relief as it is a request to change an accounting method.
The IRS concludes that the taxpayers are not entitled to make a late election because they did not act reasonably and in good faith and granting relief would prejudice the interests of the government.
Acting Reasonably & in Good Faith
To be granted the ability to make a late election, taxpayers generally have to show that they acted reasonably and in good faith.
The trader argued that he didn’t know of the requirement to make the election. The IRS has accepted this argument in other cases, but not in cases where hindsight was involved.
According to the IRS, the taxpayers did not act reasonably or in good faith in requesting the late election. The IRS noted that the taxpayers did not make the election on their year one tax return (before the extended due date). Yet the taxpayer-husband continued to trade securities in year 2. This afforded the taxpayers the benefit of hindsight, as they knew that they suffered additional trading losses in year 2.
According to the IRS, this hindsight means that the taxpayers did not act reasonably or in good faith in requesting an extension to make a late election. It was not fair to allow the taxpayers to use this hindsight to make a late election that would reduce their tax liability for year 2.
This is consistent with prior case law which generally says that there is no hindsight if the trader makes no trades between the time he should have filed the election and the time he filed the request for relief. This lack of trading shows that there is no advantage from the time of the return to the time the election is requested. The Vines v. Commissioner, T.C. Memo. 2006-258 case provides a prime example of this.
Prejudice to the Government
To be granted the ability to make a late election, taxpayers generally have to show that the interests of the government are not prejudiced. The government’s interest is deemed to be prejudiced if the election requires a Sec. 481 adjustment (this is a catch up adjustment in year 2 for a tax benefit or detriment in year 1).
The trader here argued that a Sec. 481 adjustment wasn’t required for this election.
they … argue that their accounting method regulatory election is not one that requires an adjustment under § 481(a) because their § 481(a) adjustment amount is zero. The § 481(a) adjustment is reported by Taxpayers to be zero because they disposed of all their securities prior to their Year 1 taxable year end.
The IRS noted that a Sec. 481 adjustment was required:
a § 475(f)(1) election requires a change in method of accounting that requires a § 481(a) adjustment. The change is not permitted to be implemented on a cut-off method.
The government’s interest was prejudiced here as the election would lower the trader’s tax liability.
To avoid this argument, taxpayers generally have to show that they relied on an experienced tax advisor who did not know of the need to make an election. This can also be shown by establishing that there was no hindsight, as discussed above.
Those wishing to making mark-to-market elections should consult with an experienced tax attorney. They can analyze the past rulings and advise on the probability of getting a ruling request approved by the IRS. They can also assist in litigating requests that are denied.