Offering Advice & Services to Traders | Investors | Funds
Hedge Fund Mark to Market Election
Mark-to-Market Tax Treatment Section 475(f) of the tax code allows an active securities trader to treat all securities as: generating ordinary income or loss, and if held at year-end, marked to market (treated as sold for fair market value on 12/31 and then repurchased at that value on 1/1). Mark-to-market refers to the procedure followed at year end when all open positions are marked to market value. In effect a sale of all open positions (long and short) is triggered for tax purposes at year end using the year end market prices. On the first day of the following year those positions are bought back for the same market value. This tax treatment flushes out all realized and unrealized gains and losses for U.S. tax reporting purposes. Confused? Only if you have to file a U.S. tax return. MTM applies only to trading gains and losses and not to business expenses. An active trader may elect MTM for trading gains and losses and use the accrual or cash method of accounting for business expenses.
Should I Consider a MTM Election? Only someone who qualifies as an active securities trader can elect MTM treatment. Although the MTM election can be made in a year in which you qualify as an active trader, the MTM election once made applies to subsequent years whether or not you are an active trader in later years. Before Electing Mark-to-Market Tax Treatment The decision making process is influenced by the fact that this election is a permanent election that can be revoked only with the consent of the IRS. However you could still establish an investment securities account or an investment company whose positions are outside the scope of the election. Trades in these other accounts generate capital gain or loss. Futures contracts (such as most index options) in mark-to-market accounts are still entitled to special tax treatment. MTM is not a preferred accounting method for profitable commodities and futures traders as the default tax rates favor them: 60% long term and 40% short term capital gain. The current maximum blended tax rate on commodities and futures is 23% versus 35% on securities. Electing MTM converts commodities and futures trading capital gains and losses (60/40 treatment) to ordinary gain and loss treatment (a 12% tax rate increase). But if you have large commodity trading losses before April 15 of the current year, electing MTM will allow the losses to be treated as ordinary.
Some Strategies for Making the Election 1. As the election is specific to the active trader, it is best made by an entity, rather than an individual taxpayer. An S corporation is easier to liquidate than an individual. The individual unhappy with his or her election needs to cease trading activities and become inactive (trading in the interim should be conducted through an entity) so that trading status lapses.
2. Make sure you (or your entity) are an active securities trader. There is no bright line test for trader versus investor status based on what little legal precedent exist. Make sure you have significant portfolio turnover on an annualized basis. Other factors (use of a margin account, options, futures, and short selling) can support active trader status.
3. The election for an active trader must be made by the original due date of his tax return for the current year with no exceptions. For a new trading entity, you must elect within 75 days of the start of trading activities, and then include the election in the entity's first tax return.
4. If your mix of positions includes both active trading and buying some positions (or taking some shorts), for the longer term you should establish an investment securities account. This account can be at the same brokerage where your active trading account is maintained.
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Customer Testimonial It was indeed a pleasure working with you and your team at Capital Management Services Group to set up our investment management firm and its associated hedge fund. As someone with deep analytical and trading expertise who is unfamiliar with the complex regulatory environment surrounding hedge funds, I greatly appreciate the advice and clarity you brought to the process of establishing the firm. Your breadth of expertise was invaluable in navigating the plethora of choices to be made and more importantly, it was reflected in your ability to make the necessary filings and obtain approvals from all the regulatory agencies. I am also impressed that your estimate for how long the entire process would take was remarkably accurate. As a new business entity, it was a benefit to our firm that you were able to provide your knowledgeable and comprehensive services at extremely reasonable terms. I would not hesitate to recommend your firm to others seeking to launch or expand investment advisory businesses and hedge funds. Best regards, Dr. Sid Valluri Managing Director Odessa Capital Management LLC Sent December 01, 2008
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