Mark-to-Market Accounting Decision
The MTM method of accounting is not a decision to be taken lightly.
It can provide a tremendous tax benefit in certain circumstances but may also result in a devastating tax burden as well. Click here to see examples of both.
Under the MTM method of accounting:
Gains and losses are treated as ordinary gains or losses - NOT capital gains or losses
There is an adjustment required to the stock basis of the recognized but unrealized gain or loss on stock
Gain/income is not subject to self-employment tax
Reported on Form 4797 Part II
Two major restrictions now disappear:
The $3,000 net capital loss limitation
The wash sale rule
So much for the overview, now for the details.
In order to elect MTM accounting, an option trader must actually be classified as a “trader” as opposed to an “investor.” See the Investor vs Trader page for further information on this delineation.
Section 475 of the Internal Revenue Code (IRC) is entitled “Mark to market accounting methods for dealers in securities.”
Under IRC Sec 475(f), MTM is for a person who is engaged in a trade or business as a trader in securities who elects ...
So three distinct criteria exist:
A trade or business must exist (see Entities for more on this topic)
One must be classified as a trader in securities (see Investor vs Trader for more information), and,
One must make an election to use MTM accounting
Sec 475(f) continues ...
[an electing person] shall recognize gain or loss on any security held in connection with such trade or business at the close of any taxable year as if such security were sold for its fair market value on the last business day of such taxable year, and
any gain or loss shall be taken into account for such taxable year.
Thus, if the trader in securities elects to do so, he will be:
deemed to have sold any security held at year end,
gain or loss will be determined based on the difference between the fair market value at the close of business on the last day of the tax year and the trader’s cost basis, and
that gain or loss will be recognized and reported on the trader’s tax return.
Making the MTM Election
The election is effective for the year in which it is made and all subsequent years unless revoked. The revocation request must be made to the IRS and is only valid if approved. We will discuss the revocation procedure below.
The election must be made by the unextended due date of the tax return for the year before the year the election is to be effective.
Let’s look at an example which will hopefully make this clear.
Hal is actively trading stocks and believes he can generate significant income by trading, on a regular and continuous basis, the short-term fluctuations in the stock market, either by using stock or option strategies. In May 2023 he begins trading full-time.
Hal qualifies as a trader in securities but can he make an election to use the MTM method of accounting for 2023?
The answer is NO! Hal would have had to:
File an election by April 15, 2023 with his 2022 tax return (Form 1040), or,
Attach the election to his 2022 extension (Form 4868)
What can Hal do?
Make an election for 2024 anytime until April 15, 2024
Form a new entity, transfer the securities into the newly formed entity and make a MTM election for the newly formed entity by the 15th day of the third month the newly formed entity is in existence
Request a private letter ruling (PLR) from the IRS - very expensive and probably unsuccessful
So what does the election actually state? Here is some sample language:
TRADER IN SECURITIES ELECTION TO MARK-TO-MARKET
Taxpayer hereby elects under IRC Sec 475(f) to use the mark-to-market method of accounting for securities. The election will first be effective for the tax year ended [20##]. The election is made for the following trade or business: [name of trade or business, EIN of trade or business]
Taxpayer does/does not have an Applicable Financial Statement as that term is described in Regs Sec 1.475(a)-4(h).
Taxpayer agrees to provide all information, records and schedules pursuant to Regs Sec 1.475(a)-4(k).
This election is attached to the tax return or extension for the tax return year before the year for which the election is to be effective, per the above example. SSN is formatted ###-##-####; EIN ##-#######.
So the election for 2023 is attached to the tax return or extension for 2022.
But Wait, There's More ...
In the above example, Hal has been a trader for a while. Since this is not Hal’s first year as a trader, he will need to file Form 3115 Application for Change in Accounting Method.
Also, a Section 481(a) adjustment is necessary. A Sec 481(a) adjustment is the accumulation of all adjustments arising from a particular change in accounting method in order that items of income or expense are not omitted or duplicated.
Sec 481(a) adjustments, if positive, and so elected on Form 3115, may be spread out over four years. If negative, the entire amount may be taken in the year of change.
Section 481(a) is a technical code section and a complete and thorough discussion is beyond the scope of this website. You would be prudent to seek professional tax advice.
The MTM Election template may be used in order to calculate the amount of the 481(a) adjustment as well as year-end and subsequent year-end MTM adjustments.
Relief for a Late Election
The MTM election is fairly straightforward, especially when an example of a timely election is provided. However, missing the election can have disastrous results.
But help has arrived ...
An extension of time to make the MTM election is explained under Reg Sec 301.9100-3 as one of those “any other” elections that are not specifically addressed in other sections.
Under this Regulation, two conditions must be met:
The taxpayer acted reasonably and in good faith, and
If the position of the government will not be prejudiced by the granting of relief.
There are several interesting points regarding the two conditions.
The taxpayer is specifically prevented from using hindsight as a justification for making the election, which makes sense given the procedures for making the election. So, are the procedures actually fair in light of a rapidly moving market?
The government’s interest is prejudiced if the election is made for a closed period, which again makes sense, but also if the election results in a lower tax liability, and, isn’t that the whole point?!
Therefore, given these conditions and restrictions, relief is available, but it is an uphill battle. Preparing the application for relief is a detailed effort and, as always, must be signed under penalties of perjury.
My recommendation ... let a tax professional prepare this for you. The IRS scrutinizes MTM elections carefully, so you are already “behind the eight ball” in that you are assuming you qualify as a ‘Trader in Security’ plus making a MTM election to reflect substantial losses and you have missed the election … Not exactly a good start.
It has been successfully argued. Take a look at the Vines case.
One More Option (no pun intended)
If you want to elect MTM treatment, setup another trading entity and make a timely election for it. For a new entity, you must make the election by the 15th day of the third month - or basically within 2½ months.
No formal statement must be made to IRS in order to make the election. The election is made during a board of directors meeting and placed into the minutes of the meeting. Then the entity marks to market all securities at year-end.
It would be a good idea to attach the election/board meeting minutes to the timely filed tax return for the first year. Make sure the election is dated before the 15th day of the third month of the new entity’s existence.
Revoking the MTM Election
The revocation process is exactly the opposite of the election process, except you do not have to express your desire to revoke with a timely filed election.
However, you must request permission from the IRS to revoke the election. If granted, another Form 3115 must be filed and another 481(A) adjustment made.
Once the MTM election is made on a timely filed tax return or timely filed extension, you are proverbially “stuck with it.” You cannot simply fail to file Form 3115 or use other non-compliance techniques to cry “Kings X.” You can be charged penalties for willful failure to comply.
Implementing the MTM Election
So you have made the MTM election according to the procedures detailed above. Now what?
Let’s say you made the election timely with your 2022 tax return filed on April 15, 2023. The election is therefore effective for the 2023 tax year.
Jan 1, 2023 - Calculate the adjustment for the beginning of the year by completing the 481(a) adjustment spreadsheet. If the adjustment is negative, it must be taken in 2023; if the adjustment is positive but less than $25,000 it must be taken entirely in 2023; if the adjustment is $25,000 or greater, then the adjustment may be spread over the next four years, including 2023.
During 2023 - Trade the account as a “MTM Trader in Securities” making note of the new basis in the shares open as of Jan 1, 2023.
Dec 31, 2023 - Use the MTM spreadsheet to calculate the market value of the open securities in your account. Any differences in the market value and your cost basis results in a taxable transaction.
April 15, 2024 - File 2023 tax return with MTM status as a “MTM Trader in Securities.” Do not report gains and losses on Form 8949/Schedule D nor investment expenses on Schedule C. Report trading gains and losses, including the gains and losses resulting from the MTM year-end adjustment on Form 4797, Part II (possibly Form 6781 as well) and the trading expenses on Schedule C and possibly Form 8829. You will also need to file Form 3115 Change in Accounting Method showing the Sec 481(a) adjustment which is the mark to market of the prior year (2022 in this case) open positions.
Download an example Form 3115 here.
Note: The difference between “MTM Trader in Securities” and “Trader in Securities” is simply for reporting purposes. A “Trader in Securities” is subject to the same trading criteria described in the Investor vs Trader section of this website.
If during this period you decide not to continue as a “MTM Trader in Securities” you have two alternatives open to you:
Request revocation from IRS, or
Setup a new entity and transfer your entire trading account into the new entity (most practical method of revocation)