KROST Industry: The Financial Services Issue - Volume 5, Issue 1

KROST INDUSTRY

THE FINANCIAL SERVICES ISSUE

FEDERAL DEPOSIT INSURANCE, CORPORATION INSURANCE, AND THE SILICON VALLEY BANK COLLAPSE

SECTION 1244 STOCK DEMYSTIFIED: MAXIMIZING BENEFITS FOR SMALL BUSINESS INVESTORS

SECTION 1256

CONTRACTS AND STRADDLES: A GUIDE TO TAX PLANNING AND RISK MANAGEMENT

ARE YOUR PASSIVE INVESTMENTS COSTING YOU MORE IN TAX?

A COMPREHENSIVE LOOK AT VIRTUAL CURRENCY TAXATION UNDER IRS GUIDELINES

Fax:

By Christopher Kochiyama, CPA

Jason C. Melillo, CPA CEO

Gregory A. Kniss, CPA

Lou Guerrero, CPA, MBT

Jean Hagan

So Sum Lee, CPA

Richard Umanoff, CPA, MBA

Douglas A. Venturelli, Esq.

Evelyn Fernandez, CPA, MST

Stacey R. Korman, CPA, MST

Keith Hamasaki, CPA

Paren Knadjian

Brad Pauley, CPA

Grant K. Miller, CPA, EA

Randall Poe

By Matthew Weber, CPA, MAcc

By Erik Cassarubias

Chen, Editor-in-Chief

Mayra Silva, Graphic Designer

Kelley Lau, Assistant Editor

Christopher Kochiyama, CPA

INTRODUCING

KROST’S FINANCIAL SERVICES TEAM

Our team, led by industry expert Matthew Weber, CPA, MAcc, offers specialized niche services in a narrow band of industries including financial services. Our focus is on management companies and their investment vehicles. We have assisted the management companies of Hedge Funds, Money Managers, Private Equity Firms and their principals with a wide range of accounting and tax services for the last 15 years. We are prepared to address the implications of specific financial industry issues.

Our team produces regular KROST Insights posted to our website. This issue will highlight some of the hot topics in the Financial Services industry including the Silicon Valley Bank collapse, Section 1244, Section 1256, virtual currency, and more.

Jason Melillo, CPA CEO

FINANCIAL SERVICES

Team at KROST

360° Service Model

• Carried interest

• Qualified Small Business Stock (QSBS)

• Special allocations of incentive fees

• Mark-to-market treatment and elections (Section 475)

• Regulated futures contracts (Section 1256)

• Wash sale rules

• Specialized profit and loss allocations for syndicators and investors

• Unrelated business income for tax-exempt investors

• Federal withholding issues for foreign investors

• Self-employment tax issues for traders and management fee income

• Cryptocurrency transactions

Experience You Can TrustOur Sector Expertise

• Hedge Funds

• Money Managers

• Private Equity Firms

• Venture Capitalists

• Family Offices

“The experienced, multi-disciplined teams at KROST can provide services for very specific needs relating to financial services, as well as a holistic approach to tackling multiple challenges as a true partner in the development of your business.”

Greg Kniss, CPA Chairperson

Christopher Kochiyama, CPA Manager - Tax

Matthew Weber, CPA, MAcc Director - Tax

Lou Guerrero, CPA, MBT Principal - Tax

FEDERAL DEPOSIT INSURANCE, CORPORATION INSURANCE, AND THE SILICON VALLEY BANK COLLAPSE

By Christopher Kochiyama, CPA | Manager - Tax

The Silicon Valley Bank (SVB) collapse on March 10th spread concern among many high-net-worth individuals and businesses owners leading them to question the safety of their cash reserves. One of the glaring revelations of this event was the high volume of deposits held with the bank that were not insured by the Federal Deposit Insurance Corporation (FDIC). According to the Federal Reserve Board, only about 6% of SVB Financial Group’s deposits were insured as of December 31, 2022. Although regulators quickly stepped in to guarantee that depositors would have full access to their funds, it is important to remember that this was the exception, not the rule.

HOW MUCH OF MY ACCOUNT IS INSURED?

On July 21, 2010, the standard insured amount was permanently raised from $100,000 to $250,000 per depositor, per FDIC-insured bank, for each account ownership category. For example, jointly held accounts with two co-owners have up to $500,000 of eligible coverage, while a revocable trust’s coverage will depend on the number of trust beneficiaries. For further information related to a depositor’s individual situation, they may visit the FDIC website’s “Electronic Deposit Insurance Estimator" (EDIE) at edie.fdic.gov/index.html.

WILL ANY CHANGES TO FDIC RULES COME FROM THE BANK RUNS IN MARCH 2023?

To better understand recent bank failures and how they can be protected against in future, the FDIC performed a comprehensive review of the deposit insurance system.

The report, released on May 1, 2023, concludes with three primary potential options for reform:

1. Limited Coverage, maintaining the current system of deposit insurance, potentially increasing the deposit insurance limit;

2. Unlimited Coverage, fully insuring all deposits; and

3. Targeted Coverage, substantially increasing coverage to business payment accounts, without significantly changing the limit for other deposits.1

While bringing challenges of its own, the report finds that the most promising option is to transition to Targeted Coverage. Whether or not this opinion will influence legislative change remains to be seen.

While there is potential for significant reform to FDIC coverage limitations, depositors must work within the existing rules to ensure they are mitigating the risk of financial loss due to bank failure. For many, this may mean opening additional FDIC-insured accounts, joining a credit union, utilizing sweep vehicles, or simply retitling a personal account in the name of a living trust with multiple beneficiaries. Please contact Christopher, if you would like to further discuss your financial, tax, or accounting needs. 

1 fdic.gov/analysis/options-deposit-insurance-reforms/report/options-depositinsurance-reform-full.pdf

CONTACT CHRISTOPHER

SECTION 1244 STOCK DEMYSTIFIED: MAXIMIZING BENEFITS FOR SMALL BUSINESS INVESTORS

By Randall Poe | Senior - Tax

Understanding the various provisions of the tax code can provide valuable insights to investors. One of which is Section 1244 of the Internal Revenue Code, which offers unique benefits to small business investors.

WHAT IS SECTION 1244 STOCK?

Section 1244 stock refers to shares issued by a domestic small business corporation that meet specific requirements outlined in Section 1244 of the Internal Revenue Code. The purpose of this provision is to incentivize investments in small businesses by offering potential tax advantages to shareholders in the case of loss.

TAX BENEFITS OF SECTION 1244 STOCK

The primary benefit of Section 1244 stock is in the tax treatment of losses. If an investor incurs a loss from the sale or worthlessness of Section 1244 stock, they can treat the loss as an ordinary loss rather than a capital loss. This is significant because ordinary losses can be deducted against ordinary income, resulting in potentially higher tax savings. In comparison of capital gain losses, only $3,000 can be deducted as an ordinary loss each year.

While the ordinary loss treatment under Section 1244 is subject to certain limitations, the deductions significantly outweigh capital gain losses. The maximum amount of ordinary loss an individual can claim in a single year is $50,000, $100,000 for joint returns. Additionally, the stock must have been acquired directly from the corporation in exchange for money or other property. The stock cannot be acquired via another shareholder.

HOW TO QUALIFY FOR SECTION 1244 STOCK

These several conditions must be met:

Domestic Small Business Corporation: The issuing corporation must be a domestic small business corporation at the time of stock issuance. Small businesses are defined as corporations with aggregate capitalization (including stock and debt) of $1 million or less when the stock is issued.

Stock Issued for Money or Property: The stock must have been acquired directly from the corporation in exchange for money or property. It cannot be acquired through stock options or other forms of compensation.

Original Issuance: The stock must be issued directly by the corporation as an original issuance. It cannot be acquired from another shareholder in a secondary market transaction.

The corporation's assets must consist primarily of assets used in an active trade or business. This requirement ensures that the corporation is engaged in active business operations rather than being primarily an investment company.

CONSIDERATIONS FOR INVESTORS

While Section 1244 stock offers potential tax benefits, investors should be wary of potential risks. Here are some key considerations:

Investment Risks: Investing in small businesses inherently carries higher risks compared to established companies like blue chip stocks. Investors should thoroughly research the company, its management, financials, and growth potential before investing.

Qualification Criteria: Investors should ensure that the stock they are purchasing qualifies for Section 1244 status. Failure to meet any of the qualifying conditions may result in the disallowance of ordinary loss treatment.

Tax Planning: Investors should consult with tax professionals to understand the implications of Section 1244 stock on their individual tax situations. Proper tax planning can maximize the benefits of the provision while complying with the necessary requirements.

Diversification: It is generally prudent to diversify investments across different asset classes and sectors. Investors shouldn’t solely rely on Section 1244 stock investments which may expose investors to concentrated risks.

Section 1244 stock provides an opportunity for investors to potentially receive favorable tax treatment in the event of losses incurred from small business investments. However, it is essential to understand the qualifying criteria, investment risks, and engage in appropriate tax planning. Contact Randall at randall.poe@krostcpas.com, he can help investors make informed decisions and leverage the benefits of Section 1244. 

law.cornell.edu/wex/section_1244_stock#: investopedia.com/terms/s/section-1244-stock.asp

thetaxadviser.com/issues/2009/mar/claimingordinarylossesforsec1244stock.html

LEARN MORE 

SECTION 1256 CONTRACTS AND STRADDLES: A GUIDE TO TAX PLANNING AND RISK MANAGEMENT

By Matthew Weber, CPA, MAcc | Director - Tax

Investing and trading in the financial markets can be a complex endeavor, and it is essential to consider several factors, including tax implications. Section 1256 of the Internal Revenue Code (IRC) addresses the taxation of certain derivative contracts, commonly known as Section 1256 contracts. Additionally, straddles, which involve offsetting positions in different securities or contracts, can have unique tax consequences. In this article, we will explore Section 1256 contracts and straddles, their definitions, and the tax treatment associated with them.

SECTION 1256 CONTRACTS

Section 1256 of the IRC defines specific types of derivative contracts that are subject to special tax rules. These contracts include regulated futures contracts, foreign currency contracts, non-equity options, and dealer equity options.

Let us delve into each of these contract types:

REGULATED FUTURES CONTRACTS 1

These are standardized contracts traded on exchanges, such as futures contracts on commodities, stock indices, and interest rates. Taxation of regulated futures contracts is straightforward, as they are markedto-market at the end of each tax year. This means that gains and losses are treated as if the contracts were sold and repurchased at fair market value on the last trading day of the year.

FOREIGN CURRENCY CONTRACTS 2

Currency contracts, commonly known as forex contracts, are also included under Section 1256. Similar to regulated futures contracts, gains and losses on foreign currency contracts are treated as if they were sold and repurchased at fair market value at the end of the tax year.

NON-EQUITY OPTIONS 3

Non-equity options, such as options on commodities or indexes, are another category of Section 1256 contracts. These options are subject to the mark-to-market treatment, where gains and losses are realized annually, regardless of whether the option is exercised.

DEALER EQUITY OPTIONS 4

Dealer equity options refer to options on individual stocks that are actively traded. The tax treatment of dealer equity options differs from the other Section 1256 contracts. Gains and losses on dealer equity options are not marked-to-market annually but are treated as capital gains or losses when the options are closed or expire.

TAX TREATMENT OF SECTION 1256 CONTRACTS

The unique tax treatment of Section 1256 contracts offers several advantages to traders and investors. The gains and losses from these contracts are treated as 60% long-term capital gains and 40% short-term capital gains, regardless of the holding period. This blended tax rate, known as the 60/40 rule, provides more favorable tax treatment for traders compared to ordinary income tax rates.

One notable benefit of 1256 contracts are the ability to carry back net losses up to three years. This provision allows traders to offset gains from previous years, potentially resulting in significant tax savings. It is important to note that this carryback feature is not available for straddle losses.

Moreover, traders in Section 1256 contracts have the option to elect out of the mark-to-market treatment. By doing so, they can defer recognition of gains and losses until the contracts are closed or expired. This flexibility allows traders to align their tax liabilities with their trading strategies and optimize their tax positions.

STRADDLES AND TAX IMPLICATIONS

A straddle is an investment strategy involving offsetting positions in different securities or contracts to profit from price volatility. While straddles can be used in various markets, including stocks and options, their tax implications are primarily associated with options.

For tax purposes, a straddle occurs when an individual holds offsetting positions in identical or similar positions. A straddle can be either a long straddle, involving the purchase of both a call option and a put option, or a short straddle, where both options are sold.

The IRS has specific rules regarding the taxation of straddles. If a taxpayer holds a straddle, any loss on the position is deferred until the straddle is closed or expires. The deferred loss is added to the basis of the position that remains open. This rule prevents taxpayers from recognizing a loss in one year while deferring the gain to a subsequent year. In other words, a taxpayer must defer the loss into a gain recognition year.

TAX PLANNING

Traders and investors can strategically incorporate Section 1256 contracts and straddles into their portfolios to optimize tax outcomes. By understanding the blended tax rate and loss carryback provisions of Section 1256 contracts, traders can structure their investments to maximize long-term capital gains treatment and potentially offset gains from previous years. It is also important to carefully manage straddle positions to navigate the tax implications effectively.

RISK MANAGEMENT

Straddles offers a way to manage risk and volatility in a portfolio. By holding offsetting positions, investors can hedge against adverse price movements or take advantage of anticipated market fluctuations. Careful consideration of the tax implications and regulations surrounding straddles is essential for effective risk management.

Navigating the world of Section 1256 contracts and straddles requires a solid understanding of their tax implications and the regulatory landscape. These financial instruments offer opportunities for tax planning, risk management, and potentially enhanced returns. However, it is crucial for traders and investors to carefully comply with tax rules and consult with experienced tax advisors, like the professionals at KROST. 

ARE YOUR PASSIVE INVESTMENTS COSTING YOU MORE IN TAX?

By Erik Casarrubias | Senior - Tax

In the realm of taxation, the Net Investment Income Tax (NIIT) stands as a critical component of the Affordable Care Act (ACA), commonly referred to as Obamacare. Designed to aid in funding the Affordable Care Act (ACA), the Net Investment Income Tax (NIIT) was created to add additional tax on investment income earned by individuals, estates, and trusts. Since 2013, typically, NIIT applies to high earners with significant investment income. As a result, taxpayers who surpass the income threshold must carefully evaluate their tax planning strategies and consider the implications of the additional 3.8% tax on investment income. In this article, we dive into the potential impact of passive investments on your overall tax liabilities, providing insights and guidance for individuals, estates, and trusts with significant amounts of investment income.

The net investment income tax applies a rate of 3.8% to certain taxpayers with passive sources of investment income, typically high-net-worth individuals with sizable amounts of assets. NIIT is defined as income earned from investments such as interest, dividends, and capital gains. In addition, rental, and royalty income as well as some types of annuity payments may be subject to this tax. Lastly, income from businesses involved in trading financial instruments or commodities may fall under this tax situation.

Types of income sources that are not subject to the NIIT are income from wages, unemployment compensation, social security, alimony, self-employment income, and distributions from qualified accounts.

Taxpayers may be subject to net investment income tax if their passive investment income and modified adjusted gross income (MAGI) is above a certain threshold. The threshold amount is based on the taxpayer’s filing status and applies to the amount of net investment income that exceeds that threshold.

For example, a couple’s filing status is married filing jointly with a $300,000 modified adjusted gross income and their NIIT threshold is $250,000 per the above grid. $300,000 less $250,000 equals a $50,000 excess. The couple’s total passive investment income for the tax year is $75,000. The taxpayer would then be paying 3.8% on the lesser of either the excess amount or their total passive investment income. Thus, the couple will be paying an additional $1,900 in taxes ($50,000 x 0.038).

Net Investment income tax could also be a concern for those who are in retirement and rely on living off their passive investment income. Although social security, pensions, IRAs, and tax-deferred retirement account distributions are not subject to NIIT, those income sources may increase your MAGI which in return may make you subject to NIIT. Therefore, it is important for retirees to be aware of the potential impact NIIT may have before making any considerable investment sales or conversion.

Taxpayers who think they may be subject to net investment income tax should seek various strategies to avoid or mitigate this tax. The most notable way to avoid this tax would be through keeping income below the threshold. As mentioned previously, NIIT only applies when the taxpayer’s modified adjusted gross income is above a certain threshold, therefore, by keeping income below these thresholds, one may be able to avoid NIIT entirely. Taxpayers may also consider reducing their NIIT through tax-loss harvesting.

As an example, through this strategy, taxpayers should sell poorly performing investments that have decreased in value which can offset gains from other investments. Doing so will help reduce overall investment income and potentially keep the taxpayer below the threshold. Due to the complexity of NIIT and the tax code, there is no blanket strategy, and it is important to consult with our tax professional or CPA before making any investment or tax-related decisions.

Contact Erik at erik.casarrubias@krostcpas.com to schedule a meeting to review your investments and learn more about how you can save more in taxes. 

https://www.irs.gov/newsroom/questions-and-answers-on-the-net-investment-income-tax

https://www.youtube.com/watch?v=q9WpkT2Sjws

https://www.forbes.com/advisor/investing/net-investment-income-tax

https://asenaadvisors.com/blog/how-to-avoid-the-net-investment-income-tax

A COMPREHENSIVE LOOK AT VIRTUAL CURRENCY TAXATION UNDER IRS GUIDELINES

By Christopher Kochiyama, CPA | Manager - Tax

Virtual Currency (Cryptocurrency) taxation is a relatively new topic with many unanswered questions. There are parts on which the IRS has not provided guidance that can be open to interpretation. However, the purpose of this article is to review what the IRS has already answered or established as law. Their official Q&A below can answer most questions asked by investors and traders. If you still have a question, please feel free to reach out to us, and we would be happy to answer.

How is virtual currency treated for Federal income tax purposes?

Virtual currency is treated as property and general tax principles applicable to property transactions apply to transactions using virtual currency.

Will I recognize a gain or loss when I sell my virtual currency in real currency?

Yes. When you sell virtual currency, you must recognize any capital gain or loss on the sale, subject to any limitations on the deductibility of capital losses.

The Form 1040 asks whether at any time during the year, I received, sold, sent, exchanged, or otherwise acquired any financial interest in any virtual currency. If I purchased virtual currency with real currency and had no other virtual currency transactions during the year. Must I answer yes to the Form 1040 question?

No. If your only transactions involving virtual currency during 2020 were purchases of virtual currency with real currency, you are not required to answer yes to the Form 1040 question.

How do I determine my basis in virtual currency I purchased with real currency?

Your basis (also known as your “cost basis”) is the amount you spent to acquire the virtual currency, including fees, commissions and other acquisition costs in U.S. dollars. Your adjusted basis is your basis increased by certain expenditures and decreased by certain deductions or credits in U.S. dollars.

Do I have income if I provide someone with a service and that person pays me with virtual currency?

Yes. When you receive property, including virtual currency, in exchange for performing services, whether or not you perform the services as an employee, you recognize ordinary income.

How do I determine my basis in virtual currency I receive for services I’ve provided?

If, as part of an arm’s length transaction, you provided someone with services and received virtual currency in exchange, your basis in that virtual currency is the fair market value of the virtual currency, in U.S. dollars, when the virtual currency is received.

Will I recognize a gain or loss if I pay someone with virtual currency for providing me with a service?

Yes. If you pay for a service using virtual currency that you hold as a capital asset, then you have exchanged a capital asset for that service and will have a capital gain or loss.

Will I recognize a gain or loss if I exchange my virtual currency for other property (including another virtual currency)?

Yes. If you exchange virtual currency held as a capital asset for other property, including for goods or for another virtual currency, you will recognize a capital gain or loss.

How do I determine my basis in property I’ve received in exchange for virtual currency?

If, as part of an arm’s length transaction, you transferred virtual currency to someone and received other property in exchange, your basis in that property is its fair market value at the time of the exchange.

One of my cryptocurrencies went through a hard fork but I did not receive any new cryptocurrency. Do I have income?

A hard fork occurs when a cryptocurrency undergoes a protocol change resulting in a permanent diversion from the legacy distributed ledger. This may result in the creation of a new cryptocurrency on a new distributed ledger in addition to the legacy cryptocurrency on the legacy distributed ledger. If your cryptocurrency went through a hard fork, but you did not receive any new cryptocurrency, whether through an airdrop (a distribution of cryptocurrency to multiple taxpayers’ distributed ledger addresses) or some other kind of transfer, you don’t have taxable income.

One of my cryptocurrencies went through a hard fork followed by an airdrop and I received new cryptocurrency. Do I have income?

If a hard fork is followed by an airdrop and you receive new cryptocurrency, you will have taxable income in the taxable year you receive that cryptocurrency.

How do I calculate my income from cryptocurrency I received following a hard fork?

When you receive cryptocurrency from an airdrop following a hard fork, you will have ordinary income equal to the fair market value of the new cryptocurrency when it is received, which is when the transaction is recorded on the distributed ledger, provided you have dominion and control over the cryptocurrency so that you can transfer, sell, exchange, or otherwise dispose of the cryptocurrency.

How do I determine my basis in cryptocurrency I received following a hard fork?

If you receive cryptocurrency from an airdrop following a hard fork, your basis in that cryptocurrency is equal to the amount you included in income on your federal income tax return. The amount included in income is the fair market value of the cryptocurrency when you receive it. You have received the cryptocurrency when you can transfer, sell, exchange, or otherwise dispose of it, which is generally the date and time the airdrop is recorded on the distributed ledger.

I received cryptocurrency through a platform for trading cryptocurrency; that is, through a cryptocurrency exchange. How do I determine the cryptocurrency’s fair market value at the time of receipt?

If you receive cryptocurrency in a transaction facilitated by a cryptocurrency exchange, the value of the cryptocurrency is the amount that is recorded by the cryptocurrency exchange for that transaction in U.S. dollars. If the transaction is facilitated by a centralized or decentralized cryptocurrency exchange but is not recorded on a distributed ledger or is otherwise an off-chain transaction, then the fair market value is the amount the cryptocurrency was trading for on the exchange at the date and time the transaction would have been recorded on the ledger if it had been an on-chain transaction.

Do I have income when a soft fork of cryptocurrency I own occurs?

No. A soft fork occurs when a distributed ledger undergoes a protocol change that does not result in a diversion of the ledger and thus does not result in the creation of a new cryptocurrency. Because soft forks do not result in you receiving new cryptocurrency, you will be in the same position you were in prior to the soft fork, meaning that the soft fork will not result in any income to you.

I received virtual currency as a bona fide gift. Do I have income?

No. If you receive virtual currency as a bona fide gift, you will not recognize income until you sell, exchange, or otherwise dispose of that virtual currency.

How do I determine my basis in virtual currency that I received as a bona fide gift?

Your basis in virtual currency received as a bona fide gift differs depending on whether you will have a gain or a loss when you sell or dispose of it. For purposes of determining whether you have a gain, your basis is equal to the donor’s basis, plus any gift tax the donor paid on the gift. For purposes of determining whether you have a loss, your basis is equal to the lesser of the donor’s basis or the fair market value of the virtual currency at the time you received the gift. If you do not have any documentation to substantiate the donor’s basis, then your basis is zero.

What is my holding period for virtual currency that I received as a gift?

Your holding period in virtual currency received as a gift includes the time that the virtual currency was held by the person from whom you received the gift. However, if you do not have documentation substantiating that person’s holding period, then your holding period begins the day after you receive the gift.

If I donate virtual currency to a charity, will I have to recognize income, gain, or loss?

If you donate virtual currency to a charitable organization described in Internal Revenue Code Section 170(c), you will not recognize income, gain, or loss from the donation.

I own multiple units of one kind of virtual currency, some of which were acquired at different times and have different basis amounts. If I sell, exchange, or otherwise dispose of some units of that virtual currency, can I choose which units are deemed sold, exchanged, or otherwise disposed of?

Yes. You may choose which units of virtual currency are deemed to be sold, exchanged, or otherwise disposed of if you can specifically identify which unit or units of virtual currency are involved in the transaction and substantiate your basis in those units.

If I engage in a transaction involving virtual currency but do not receive a payee statement or information return such as a Form W-2 or Form 1099, when must I report my income, gain, or loss on my federal income tax return?

You must report income, gain, or loss from all taxable transactions involving virtual currency on your federal income tax return for the taxable year of the transaction, regardless of the amount or whether you receive a payee statement or information return. 