Last weekend, a subscriber wrote and suggested I address record keeping for tax preparation purposes. Clearly, taxes are an important part of any trader's life so I'll offer some comments concerning approaches to record keeping and tax preparation. I do so with the specific disclaimer that I am not a tax expert and personally use a very accomplished tax adviser to advise me and prepare my returns.
Since I trade for my living, I want a tax professional who is familiar to the rules related to trading. Not all CPAs, accountants, and tax preparers have expertise in taxes and tax planning as they relate to trading so the first thing I would suggest is that the active trader find a tax professional who is knowledgeable in the area. I would also suggest that one not wait until April to seek out an adviser with the requisite expertise. Now is the time to make contacts and speak with potential advisers to see whether they are familiar with the rules relating to traders. For example, would they recommend that the trader create a corporation to trade, or should an individual seek trader status with the IRS, and, if so, is it likely that he will be able to meet the necessary criteria? These issues and many others can only be addressed by an expert in the field and the answers will differ for each individual.
I remember all too well my first tax return after I began active trading. I had made well over 100 trades during the year and it was not until tax time came that I learned I had to file Schedule D-1 with my return. The D-1s literally list every trade including date of entry, date of exit, profit or loss, and whether the trade was long term or short term. Specific rules apply to straddles, for example, and covered calls may be handled in different ways. It literally took me days just to get the D-1 together because I had not prepared for that requirement. I had previously used an accountant who had no familiarity with traders. The whole episode was a nightmare.
Brokerage statements do provide much of the needed information, but they, like anyone, can and do make errors. I would suggest, therefore, that the trader also keep records of each trade themselves. That can be done with an Excel spreadsheet, individual sheets for each trade, and/or various software programs available to traders. It is important to keep records of at least the entry and exit dates, type of trade (e.g. straddle, covered call, spread, etc.), entry price, exit price, dividends received, and confirmations. There have been numerous times when I have been glad to be able to get my hands on a confirmation to answer my tax professional's questions. Of course, you may very well be able to get those online from your broker. I guess I may engage in overkill since I keep 3-ring binders with a page devoted to each trade and I then place the confirmations in the back of the binder. I have a binder for each year and for each brokerage account so that I can go back and quickly find any given trade even if it was made a number of years before.
The better the records you keep, the easier and less expensive the cost of preparation will be whether it be in terms of your own time or the fees charged by the professional preparer.
Remember, too, that some costs related to your investing or trading may be deductible. Seminars, books, perhaps even a computer or software may be deductible expenses for the trader (sometimes subject to limitations). Once again, keep receipts and records of those expenditures so that you may discuss them with a professional to determine whether they may be a deduction. If you are incorporated for your trading, the rules for deductions may well be even more liberal than for the individual so consideration of incorporation is a subject worthy of discussion with a knowledgeable professional.
I have heard people say they would prefer to do their own taxes or have their neighbor do them for a very modest fee and that is fine as long as the person or neighbor knows what they are doing. In the long run, it may be much more cost effective to pay a professional a little more in order to gain significant benefits. Taxes are a major cost of living so the better the preparation, the more likely some of the impact can be avoided. Remember that tax avoidance is appropriate and legal; tax evasion is a ticket to the federal penitentiary.
Bill Kraft, Editor
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