Commodity traders can be taxed according to two different methodologies. One that I refer to as the “Default Rule” and the other to the “Market Price Choice Rule”.
THE DEFAULT RULE
Under section 1256 of the Internal Revenue Code (“IRC”), commodity traders receive two important tax breaks:
Tax exemption n. 1
60% of commodity earnings are taxed at the long-term earnings tax rate and 40% of earnings are taxed as short-term earnings. This is known as the “60/40 rule.”
Tax exemption n. 2
Losses in commodity trading can be carried forward three years to offset gains in commodity trading from previous years.
To meet the definition of a commodity trader, for the purposes of the favorable tax breaks above, a person must be a member of a national trading board designated as a contract market by the Commodity Futures Trading Commission (also known as as “regulated exchange”). . The definition of a commodity under IRC section 1256 includes any regulated futures contract, any foreign currency contract, any non-share option, any broker share option, and any securities futures contract. intermediation. If you trade on a regulated exchange, you are a “commodity trader” under IRC section 1256 and qualify for the 60/40 preferential rule.
When such commodity traders file their tax returns for the year in which they report their commodity gains and losses on Form 6781, which is attached to Form 1040 (Federal Income Tax Return for Individuals). The gains and losses reported on Form 6781 are divided into two groups: 60% long-term gains and 40% short-term gains. The next step is to carry over these two groups of gains / (losses) to Schedule D and are taxed accordingly (long-term gains / losses are offset by short-term gains / losses). If there is a long-term net gain, it is taxed at the current favorable capital gains tax rate of 15%.
What I just described is the general taxation rule for commodity traders and most commodity traders pay taxes under this rule. Any expense you incurred (such as margin interest expense) can only be deducted as an itemized deduction and therefore limited.
BRAND TO MARKET CHOICE RULE
However, there is another tax option available to commodity traders. If a commodity trader meets the definition of a “professional trader,” they are eligible to make the IRC Mark-to-Market section 475 election. This new optional rule went into effect in 1997 under the Taxpayer Relief Act of 1997, which gave commodity merchants the ability to make the Internal Revenue Code (“IRC”) election, section 475, mark to market. . When making this choice, commodity traders can do two things:
# 1 Treat commodity gains and losses as ordinary income (losses). When you make the IRC section 475 brand-to-market election, you are eligible to file a Schedule C and list your commodity business expenses. Under this choice, commodity business expenses have more value as they are no longer considered itemized deductions but instead ordinary business expenses. These expenses can be used to offset other reported income, such as wages. When making the Mark-To-Market choice, a commodity trader chooses outside of the 60/40 rule and instead treats all gains and losses as normal. The 60/40 rule is the default rule that is available to commodity traders who have not made the IRC choice of section 475 Mark-to-Market. Most commodity traders do not make the IRC section 475 brand-to-market choice to preserve favorable commodity taxation (long-term profit treatment of 60% and short-term profit treatment of 40%). %).
# 2 Allow commodity traders to deduct on Schedule C for business expenses associated with your commodity trading business. You can only take deductions on a Schedule C where you have a valid IRC choice of section 475 Mark-To-Market instead.
To be eligible for the IRC section 475 Mark-to-Market election, a commodity trader must meet the strict definition of a trader’s tax. The definition of “trader”, for the purposes of the Mark-To-Market election, requires that a person seek to benefit from short-term changes in the market. This business activity must be substantial, frequent and continuous. You must be a full time trader who is trying to capitalize on the momentary changes in the market each day. If you meet the definition of “merchant,” then you are eligible to hold the Mark-To Market election, which must be held by April 15 of the current year if you want the election to be effective for the current year. Example: You make the election before April 15, 2012 for fiscal year 2012. Once in place, the election allows you to treat all gains and losses as ordinary (reported on Form 4797, which is attached to your income tax return). individual income tax Form 1040).
Commodity traders cannot take advantage of the 60/40 rule and make Schedule C deductions at the same time. It is one or the other. The 60/40 rule is only available to commodity traders who DID NOT make the IRC Mark-to-Market section 475 choice. The ability to take Schedule C deductions is only available to commodity traders.