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Taxation of Investors Versus Traders & Dealers

Many individuals (and businesses) buy stock and securities with the hopes and intent of the securities appreciating and perhaps paying interest or dividends.  What determines when an individual is treated as an investor, dealer or trader?  Furthermore, what is the tax treatment and proper way to report income and expenses when one is classified as an investor, dealer or trader?  The article below has been prepared by a tax attorney to provide information related to the above issues and questions.  Please remember to always discuss your specific facts and circumstances with your tax attorney and tax advisors, as this article is for informational purposes only.

The Internal Revenue Service applies different definitions and meanings to the terms investors, dealers and traders.  Thus, we will begin with an explanation as to these terms.  An investor would typically buy and sell securities in anticipation of the securities appreciating, as well as producing other returns such as interest or dividends.  In short, the investor would buy a security and hold the security for personal investment as opposed to conducting these activities in a trade or business.  Generally, the investor would hold the securities for themselves and for a substantial period of time.  When an investor sells or disposes of the securities, the transactions are reported as capital gain or capital loss on the investors 1040 via a Schedule D.  As an investor, capital loss limitations under IRC Section 1211(b) would apply as well as wash sale rules under IRC 1091.  Investors may be able to deduct expenses associated with creating the taxable income on their Schedule A itemized deductions.  Further, interest paid for money to buy investment property that generated taxable income may be deducted.  The cost of commissions and other related fees to dispose of the stock are not deductible but should be accounted for in calculating the gain or loss from the sale or disposition of the securities.

A dealer will differ from an investor in that a dealer will purchase and hold securities for their customers and conduct these activities in the ordinary course of the dealer’s business.  The dealer may hold an inventory of securities.  The dealer will make their money and income by marketing securities to their clients.  A dealer will report gains and losses from the disposition of securities by applying and using market-to-market rules.

Apart from being designated as an investor or dealer, special rules can apply when you are determined to be a trader in securities.  In short, a trader would be considered to be in the business of buying and selling securities for your own account.  Under certain circumstances you could be considered to be a business even if you do not hold an inventory and maintain customers.  The IRS could consider you to be in business as a trader in securities if you meet the following conditions:

 

  • The activity is substantial;
  • You are attempting to profit from daily market movements if the pricing of securities and not so much from appreciation, interest or dividends; and,
  • The activity is practiced with continuity and regularity.

If you are a trader in securities you can report your income and expenses on a Schedule C with your 1040 and thus Schedule A limitations would not apply, and further, the gains and losses from selling securities are not subject to self-employment tax.

The article above has been prepared by John McGuire of The McGuire Law FirmJohn is a tax attorney and business attorney with the firm and can be reached at John@jmtaxlaw.com

 

Can the IRS Take my Passport?

Can the Internal Revenue Service really impact my ability to travel?  If you owe taxes to the Internal Revenue Service, especially “seriously delinquent tax debts” the answer is yes, the IRS can impact your travel plans by impacting your passport as discussed below.

In January of 2018, the Internal Revenue Service announced it will implement new procedures that could impact an individuals ability to obtain or maintain a passport.  The IRS stated these new procedures will impact those individuals that have “seriously delinquent tax debts.”  Under the Fixing America’s Surface Transportation (FAST) Act, the IRS is required to notify the State Department of certain taxpayers owing seriously delinquent tax debts.  The FAST Act also requires the denial of passport applications, renewals of passports and in some cases even the revocation of an individual’s passport.

So what constitutes a seriously delinquent tax debt?  Generally, the IRS has defined a seriously delinquent tax debt as someone who has a tax debt to the IRS of more than $51,000.  The $51,000 threshold would include tax, penalty and interest for periods whereby the IRS has filed a Notice of Federal Tax Lien or issued a levy, and the taxpayer can no longer properly challenge the lien or levy action.

If you are taxpayer with a seriously delinquent debt to the IRS, you can likely avoid the IRS contacting the State Department by taking the following action(s).

 

  • Pay the debt in full;
  • Paying a settlement amount through a tax settlement or offer in compromise with the IRS;
  • Paying the tax debt under a formal installment agreement with the IRS;
  • Paying the tax debt through a formal settlement with the Department of Justice;
  • Suspending collection action by the IRS through an innocent spouse claim; or
  • Requesting a Collection Due Process Hearing with a levy.

 

A taxpayer under the following situations should not be at risk for having their passport rights impacted.

 

  • The taxpayer has filed and is in bankruptcy;
  • Is an identity theft victim;
  • The taxpayer’s account has been determined non-collectible by the IRS;
  • The taxpayer is located in a federally declared disaster area;
  • The taxpayer has a pending installment agreement with the IRS;
  • The taxpayer has a pending offer in compromise with the IRS; or,
  • The taxpayer has an adjustment that with satisfy the IRS debt in full.

 

In short, to prevent any passport issues if you owe taxes to the IRS, if the tax debt is being addressed, your likelihood of having  a passport application denied or a passport revoked is severely lessened.

The above article has been prepared by John McGuire of The McGuire Law Firm.  John is a tax attorney and business attorney and can be reached through www.jmtaxlaw.com

Please remember this article is for informational purposes only and you should consult directly with your tax attorney regarding any tax matters or questions.

Tax Attorney

Denver Tax Attorney

What is an Abusive or Illegal Tax Scheme

What is an abusive tax scheme?  You may have heard of a program or scheme that promises to eliminate or substantially lessen your tax burden and taxes due to the Internal Revenue Service.  A promoter of such a scheme is likely to use financial instruments such as a trust and/or pass through entities such as a limited liability company or limited partnership.  When these programs and schemes are used improperly and to facilitate tax evasion, IRS may criminally investigate the scheme and prosecute the promoters as well as investors.  You should remember that if something sounds too good to be true, it could be, and could lead investigation by the Internal Revenue Service and potential criminal tax charges.  It is recommended that you discuss any potential tax scheme or program with a tax attorney.  The article below will provide more information regarding abusive tax schemes, but this article is for informational purposes only, and please always discuss your specific issues with a tax attorney.

Overtime tax schemes have developed from relatively simple single structure arrangements into more complex and sophisticated overall schemes and strategies that take advantage of foreign jurisdictions and financial secrecy laws.  The Internal Revenue Service Criminal Investigation has a national program to fight these illegal tax schemes and programs and prosecute violators with criminal tax charges.  Our government has and will continue to criminally prosecute the promoters of illegal tax schemes and those who play substantial roles in aiding or assisting the tax scheme, which could include investors into the tax scheme.  The biggest question when initially looking at these issues is, what constitutes an abusive or illegal tax scheme and could lead to criminal tax evasion and criminal tax charges?  In short, an abusive tax scheme that could lead to criminal matters would violate the Internal Revenue Code and related federal statutes.  Furthermore, generally the violations of the federal tax law and related statutes would use domestic or foreign trusts as well as pass through entities such as partnerships as vehicles in violating the federal tax laws.  In recent years, foreign bank accounts and other financial accounts have been used more frequently to accomplish tax evasion because of reporting issues (one may refer to FATCA for further information).  Many foreign banks and financial institutions do not report income such as interest and dividends, and thus there is no record of the income to the trust, entity and individuals.  With no reporting to the federal government, and no reporting on applicable tax returns, the income goes unreported.

As stated above, foreign accounts or trusts may be used frequently in illegal tax schemes.  A common scheme that may have many variations may flow as follows.  A United States citizen has a business in the United States and also forms a foreign corporation and foreign bank account in the same name of their US business.  When checks are received, the checks are processed through the foreign business and foreign bank account.  The foreign account will likely be in a foreign jurisdiction that does not report income and related items to the US government.  Thus, the income goes unreported on the taxpayer’s tax return and there are no 1099s issued to the US government to have any knowledge of the account and thus income going into the account.  Some schemes will involve a foreign business that issues invoices to a United States business.  The invoices are paid to the foreign business and a deduction taken by the US business, but the income of the foreign business is not claimed.  The business are commonly owned and the US citizens involved are not claiming the income of the foreign business.  Again, we have unreported income into a foreign account, and likely interest and/or dividends in a foreign account that would not be reported.  The above examples could go many more layers deep, but provide good examples as to how an illegal tax shelter or abusive tax scheme could be established.

The above article has been prepared by John McGuire of the McGuire Law Firm for informational purposes, and should not be relied on as legal advice.  Mr. McGuire is a tax attorney, representing individuals and businesses before the Internal Revenue Service and can be contacted directly through the McGuire Law Firm.

Distributions of Stock and Stock Options

Many corporations may provide or distribute stock or stock rights to employees. When a corporation distributes it’s own stock, this would be referred to as a stock dividend and when a corporation grants stock rights, these are typically referred to as stock options. When individuals receive stock dividends and stock options, they generally will ask or inquire as to whether or not these dividends or stock options are taxable. Generally, the answer is no, stock dividends and stock options are not taxable, and thus not reported on an income tax return. However, under certain circumstances, the stock dividends or stock options can be taxable. These circumstances are discussed below, and please remember to always consult directly with your tax advisors regarding your specific circumstances.

A distribution of stock dividends and stock rights or stock options are taxable if any of the following apply:

1) The corporation distributes cash or other property to certain shareholders of the corporation and provides other shareholders with an increase in their percentage of interest in the assets and earnings and profits of the corporation.
2) The distribution can be converted by the shareholder into preferred shares.
3) Any shareholder has the ability to choose cash or other property be received as opposed to the stock or stock rights.
4) The distribution is a distribution of preferred stock. It should be noted, however, that such a distribution would not be taxable if it is solely an increase in a conversion ratio of convertible preferred stock, which has been made solely due to a stock dividend, stock splitting or similar action that would result in reducing the overall conversion rate.
5) The distribution allows for preferred stock to be issued to some common stock shareholders and common stock of the corporation to be issued to other shareholders.

When a taxpayer does receive a taxable stock dividend or stock rights, the taxpayer would include the fair market value at the time of the distribution in their income. It is also important for shareholders to be aware of constructive distributions. A shareholder may have to treat certain transactions that increase their proportionate share or interest in the earnings and profits or assets of the corporation as if stock or stock options were distributed if the result is the same as items 1, 2, 4 or 5 above. This treatment would apply to a change in a shareholder’s conversion ratio or redemption price, a difference between the stock’s redemption price and issue price, a redemption that is not treated as the sale or exchange of the applicable stock and other transactions whereby the similar effect is realized on the shareholder’s interest in the corporation. An example of a taxable distribution would be the receipt of preferred stock that holds a redemption price higher than the price the stock was issued for. This difference is considered the redemption premium, and generally the redemption premium would be considered a constructive distribution and taxable.

The above article has been prepared by John McGuire of the McGuire Law Firm for informational purposes and should not be considered tax or legal advice. John is a tax attorney and business attorney in Denver, Colorado and Golden, Colorado serving clients in Colorado and nationwide on certain tax matters.
Denver Tax Lawyer

Gain, Loss & Realization Events in Property Transactions

When must I realize gain?  For the most part, it is easy to recognize when gain or loss has been realized, but at other times it may be hard to ascertain.  The article below has been prepared by a tax attorney to discuss gain or loss on certain property transaction and certain realization events.  Please remember this article is for informational purposes and specific facts and circumstances should be discussed specifically with your tax attorney and other tax advisors.

When an asset is sold, disposed of or transferred it may go without saying that a realization event has occurred.  Gain on the sale or disposition of the asset will be the amount received (realized) in excess of the adjusted basis of the property.  Loss, on the other hand would be the amount the adjusted basis exceeded the amount realized.  It is important to remember that not all transactions would require one to recognize the gain or loss in their income at the time of the transaction.  The word recognize in the previous sentence would mean to include the gain or loss in your current income.  A requirement to include gain or loss in your income is the occurrence of some realization event.  Once a realization event has occurred, then you must ascertain and determine the proper tax treatment of the transaction such as:

 

  • The adjusted basis in the property that was sold, transferred or disposed of;
  • The amount realized from the transaction as a whole;
  • Was gain or loss recognized from the transaction;
  • The character of the gain. For example, was the gain short term capital gain or long term capital gain.  Or perhaps, is the gain subject to recapture rules.
  • If there was a loss, is the loss allowed in whole or in part.

In regards to a realization event, generally speaking, a transaction with property will be considered a realization event if the taxpayer’s relationship, or control of the property is terminated, or the interest is significantly or materially reduced.  The lack of any transaction would tend to show a lack of a realization event.  Further, it should be noted that the mere increase or decrease in the fair market value of property does not, by its self, create a realization event.  For example, you may purchase Microsoft stock.  As the stock increase, you do not recognize gain, but rather, when you sell the stock, if the sale price of the stock is in excess of your adjusted basis, gain would likely be realized, and need to be recognized by reporting the gain on your income tax return.  Furthermore, transferring or disposing of property through a gift is generally not a realization event.  While the gift may have many tax implications, the gift alone may not be enough for a realization event whereby income or loss would be recognized on an income tax return.

There are multiple issues to consider relating to realizing gain and loss, and recognizing gain and loss.  Further, there are many situations whereby a loss may be disallowed in whole or part, or the loss can only be recognized in certain amounts or over certain times.

This article has been prepared by John McGuire at The McGuire Law Firm.  John is a tax attorney and business attorney working with individuals and businesses before the IRS and assisting clients with other tax and business matters.  John can be reached at 720-833-7705.

Original Issue Discount and Debt Instruments

What is original issue discount?  Original issue discount (OID) is a form of interest that you may not realize you have earned, received or need to report.  The article below has been prepared by a tax attorney to provide information regarding (OID), but please consult directly with your tax advisors regarding your specific facts and circumstances.

Generally, you should (or will) report OID as income as it accrues over the term of any debt instruments even if you do not received any payment(s) of the actual interest from the party paying the debt and/or interest.  A debt instrument could be a promissory note, bond, debenture or any other evidence of indebtedness based upon the facts and circumstances.  You may typically see a debt instrument have OID when the debt instrument was issued for less than the stated redemption price.  A debt instrument that pays no interest before the instrument matures would likely be considered issued at a discount.  The following are examples of discounted debt instruments.

 

  • Municipal Bonds (interest may not be taxable)
  • Notes between individuals or private parties
  • United States Treasury Bonds
  • Stripped Bonds
  • Certificates of Deposit (CODs)

An example may help illustrate the discount and interest amount.  If a bank issues a bond with a maturity price of $1,000 for $900, the original issue discount is $100, and the discount would be included in income as it accrues over the term of the bond.  Please note, if the discount is less than one-quarter of an interest percentage (.0025) the discount may be considered de minimis discount and treated as zero.

 

All of the above being said, many people will ask if there are any exceptions to reporting OID income. The OID may not apply to the debt instruments below, but please always check current law and regulations with your tax attorney or tax advisors.

 

  • United Savings Bond
  • Tax Exempt Obligations
  • Debt instruments with a fixed maturity date less than one-year from the date of issuance (short-term debt instruments)
  • Obligations issued by an individual prior to March 2, 1984
  • A loan between individuals if the loan and any other prior loans between the same individuals is less than $10,000 (USD), the individual lending the money is not in the business or regularly lending money; and, a primary purpose of the loan is not to avoid federal income tax.

Is a 1099 issued?  If the total of the OID is $10 or greater, the party issuing the debt instrument should issue a 1099-OID.

You can speak with a tax attorney or business attorney with questions related to interest and OID by contacting The McGuire Law Firm.   Call 720-833-7705 to discuss your matters with a tax attorney.

Tax Attorney

Denver Tax Attorney

 

 

Operating Agreement Invalidating S Corporation Election

Limited Liability Companies (LLC) are a very popular entity choice and structure for new businesses and closely held entities.  An LLC can be formed quickly and has a lot of flexibility regarding members, operations and taxation structure.  It is not rare for an LLC to eventually consider and perhaps decide to be taxed as an S corporation.  Although, an LLC converting to a Subchapter S corporation has benefits, such as potentially reducing self-employment taxes, these benefits may be mistakenly lost if the Subchapter S corporation status is invalidated.  A means by which to invalidate the S corporation status, which is many business owners may not consider is the LLC operating agreement.  Abiding by the LLC operating agreement may cause the entity to operate in a manner than invalidates the S corporation election.  The article below has been prepared by a tax attorney and business attorney to further discuss the risk of losing S corporation status by abiding by an operating agreement.  Please remember this article is for information purposes only, and is not intended to be legal or tax advice.

To properly evaluate how an S corporation could lose or invalidate the S corporation election, it is important to remember how a business qualifies and the requirements for an S corporation.  The qualify as an S corporation, the corporation must:

 

  • Have only allowable shareholders (no partnership, corporate or non-resident alien shareholders)
  • Have only 100 shareholders or less
  • Have only one class of stock
  • Be a domestic corporation
  • Not be an ineligible corporation (insurance companies and other disallowed companies)

Our focus will be on the one class of stock requirement.  The one class of stock requirement requires that all shareholders receive distributions and liquidation preferences pro-rata per their stock ownership.  An S corporation can have a different class of stock for voting rights, but the economic benefits and distributions to the shareholders must follow the ownership percentage, which is directly related to the number of shares each shareholder owns.  Many LLC operating agreements will contain clauses and language that actually require unequal or disproportionate distributions to the LLC members.  Thus, if the distributions are in accordance with the operating agreement, the issuance of disproportionate distributions could lead to the IRS claiming the corporation has multiple classes of stock, and therefore, the S corporation election is invalid.  Treasury Regulation Section 301.7701-(3)(c)(1)(v)(c) states that the S corporation election is valid only if ALL requirements are met.  Thus, an LLC electing be to be taxed as an S corporation should consider removal of certain clauses within the operating agreement relating to substantial economic effect, IRC Section 704 and any other clause that could create disproportionate distributions.  If the S corporation election was lost, the owners may be subject to additional self-employment tax, or the business, if taxed as a C corporation would be subject to tax at the corporate level, and the shareholder level, thus double taxation.

If you have questions related to your choice of entity, taxation matters and internal business documents, it is recommended you speak with a tax attorney and/or business attorney to review the documents, taxation matters and intended tax treatment.

Denver Tax Attorney Denver Tax Lawyer IRS Tax Attorney

 

Denver Business Attorney

The Cohan Rule

Individuals or business who have been audited by the Internal Revenue Service may be familiar with the Cohan rule.  The Cohan rule is based upon a court case that may allow a taxpayer an allowance for certain business deductions even if the taxpayer is unable to verify or substantiate certain expenses.  This article has been prepared by a tax attorney at the The McGuire Law Firm to provide additional information related to the Cohan Rule and IRS tax audits.  It is recommended you use this article for informational purposes only and discuss your facts and circumstances specifically with your tax attorney and other advisors.

The Internal Revenue Code requires that a taxpayer maintain certain records for the IRS to allow an expense or deductions.  When a taxpayer is being audited by the IRS, generally the taxpayer must show a receipt, invoice, cancelled check or like item for the IRS to allow the expense that is under audit.  If the taxpayer is unable to provide the necessary documentation, the IRS may disallow the expense or item.  Under the Cohn rule, the IRS or a court may allow a taxpayer reasonable amount of the deductions.  The key issue is, what is reasonable?

The Cohan rule was established through a Court of Appeals case in the Second Circuit in 1930.  Although, the court stated the taxpayer did not have adequate substantiation to verify expenses, the court held the board (IRS) should make an approximation.  In short, the court felt that it was reasonable for the taxpayer to have some reasonable business expenses, and should not be disallowed all deductions due to lack of records.  Thus, under the Cohan rule, a taxpayer can make an argument for an expense deduction to be allowed without proper documentation.

It is important to remember that the Cohan rule does not apply to all expenses.  For example, the Cohan rule does not apply to items whereby Internal Revenue Code Section 274(d) applies.  IRC 274(d) applies to travel expenses, entertainment expenses, gifts and other listed property, and taxpayer must comply with very strict verification rules for the IRS to allow a deduction.

One question that is often asked is, who has the burden of proof in a tax audit?  Generally, the taxpayer will have the burden of proof that they are entitled to the deduction and the additional tax proposed by the IRS is incorrect.  However, under Internal Revenue Code Section 7491(a), the burden of proof can switch to the IRS when the taxpayer produces credible evidence relating to factual issues, complies with requirements and verifies deductions, cooperates with reasonable requests by the IRS relating information, documents, interviews, meetings and maintains records under the Internal Revenue Code.

If you are being audited by the IRS, you may consider representation by a tax attorney.  You can speak with a tax attorney by contacting The McGuire Law Firm.

Deductible or a Capital Expense?

Is an amount paid by a business an expense that is currently deductible, or is it a capital expenditure that should be depreciated,, amortized or depleted?  This issue is one of the most common issues in a tax audit with the Internal Revenue Service, as well as one of the most litigated issues in United States Tax Court.  The article below has been prepared by a tax attorney to provide additional information related to this common issue.  Please remember that this article is for informational purposes, and you should consult directly with your tax attorney and advisors related to your specific issues.

A currently deductible expense is an ordinary and necessary expense that is paid or incurred by the business during the taxable year in the ordinary course of operating the trade or business.  Please reference Internal Revenue Code Section 162.  In comparison, a capital expenditure would be the cost to acquire, improve or restore an asset that is expected to last more than one year.  These capital expenditures are not allowed a deduction, but rather are subject to amortization, depreciation or depletion over the useful life of the property. See Internal Revenue Code Section 263.

That being said, how does one determine whether an expenditure is an expense to be deducted or a capital expenditure?  The answer is, it is a question of fact.  The Courts have applied the principles of deductibility versus capitalization on a case by case basis, and the facts and circumstances of each case will likely determine the outcome.

An example may help illustrate the difference between an expense that would be deductible versus one that would be capitalized.  If a business owner bought certain office supplies such as pens and paper, they would be deductible.  If the same business owner, purchased a building to operate the business, the building would be capitalized.  Let’s look at a different example that might not be as obvious.  Assume a business owns and rents property.  In one property a hole was placed in the wall when a tenant moved.  In another property, the owner decided to replace the walls with new drywall and paint.  It is likely the fixing of the hole in the wall would be deductible as a repair or maintenance, whereas the cost to replace the walls would be capitalized by the business.

One further issue to consider beyond the matters discussed above is that the Internal Revenue Code requires books and records to be maintained to verify and substantiate the expense whether it be a deduction or capital expense.  If the item or amount of the expense cannot be verified and substantiated by the taxpayer, the IRS may disallow the deduction or the capital expense.

If you have questions related to a deduction or capital expense, you can speak with a tax attorney by contacting The McGuire Law Firm.   The McGuire Law Firm offers a free consultation with a tax attorney to discuss your questions and issues.

Denver Tax Attorney

Identifying Tax Related Identity Theft

Identity theft has become a very common crime and can impact individuals in many ways.  Apart from an identity thief stealing your identity and obtaining credit cards or bank account information, an identity thief may use your personal information and steal your identity for tax purposes and tax related theft.  Although, the Internal Revenue Service and state taxing authorities work hard to prevent identity theft, you can assist your assist by being aware of common signs of tax related identity theft.  The article below has been prepared by a tax attorney to provide information and what you may consider as warnings or red flags that your identity has been compromised, and the thief using your identity for a tax related purpose.

  • When you go to file your tax return electronically, the return is rejected. The message may state that a return with a duplicate social security number or tax identification number has already been filed.  This may mean that someone has used your social security number to file a tax return.  You may want to check the social security number you used, but if the social security number you are using is correct, your identity may have stolen.  The Internal Revenue Service has an identity theft affidavit (Form 14039) that can be filed with the IRS.  Please see the instructions for Form 14039, and any related form.
  • The Internal Revenue Service may forward you a letter requesting that you verify whether you have filed a return with your name and social security number. When the IRS receives a suspicious return, the IRS may hold the return and mail a letter to the taxpayer to verify certain information.  If you did not file the return, it is likely someone is attempting to steal your identify for a tax related purpose.
  • If you receive a W-2 or a 1099 (or other items) reported to you for income you did not receive or from third parties you did not work for, or perform services for, someone may have compromised your identity and reported income under your social security number.
  • You receive a check from the United States Department of Treasury as a refund that you did not claim. If the refund is incorrect, you likely do not want to deposit the check, and should contact the IRS or a tax attorney.
  • You receive a wage and income transcript, account transcript, tax return transcript or other tax return transcript from the Internal Revenue Service that you did not request. A identity theft may be attempting to test or receive information via transcript.

The Internal Revenue Service has information available regarding identity theft, including Publication 4524.  The article above has been prepared for informational purposes by John McGuire, a tax attorney at The McGuire Law Firm.  Please consult with your tax attorney, tax advisor or other parties regarding our specific questions.

Tax Identity Theft by Denver Tax Attorney