Form K-1 and Section 475(f)

September 23, 2014

Schedule K-1 presents interesting challenges for individual taxpayers. Where they were once invested in mutual funds, many people now own a piece of investment vehicles that operate as an LLC or a partnership. A mutual fund issues a 1099-DIV and the tax reporting is usually a simple matter.  An LLC issues a K-1 and the tax reporting can be very complicated.  A K-1 is a detailed listing of the investor’s share of the fund’s activity and that activity is reported in various locations on an individual tax return.  In the next several posts we will attempt to explain some of the more confusing items.

DISCLAIMER – what follows is a discussion of general rules.  There are many tax provisions that interact and impact your particular situation.  The following is not a substitute for professional tax advice.

Form K-1, Box 11, Code F — Section 475(f) Gain

Q — What is a 475(f) gain?

A — A 475(f) gain is an ordinary gain.

Where to report:  Part II of form 4797.

Explanation and background: The general rules on gains and losses from the sale of securities are written for investors.  An “investor” is someone who does not make their living from buying and selling securities.  Therefore, the vast majority of taxpayers fall into this category.  An investor recognizes a gain or loss when a security is sold.

  • The good news — net gains on securities held for more than one year are taxed at the lower capital gains rates rather than the higher ordinary rates.
  • The bad news — net losses can be limited by the capital loss rules and the wash sale rules.

Congress has recognized that not every person or entity is an investor.  There are some people who make their living buying and selling securities.  These people can be dealers, who sell securities to their customers, or traders, who buy and sell securities for their own benefit.  Congress does not like the idea of giving dealers the benefit of lower rates, and dealers do not like the idea of being subject to restrictions of the loss rules.  As a result, we get section 475. 475 says that if you are a dealer in securities and you hold securities at the end of the tax year, you have to do two things:

  1. Pretend you sold them at fair market value.
  2. Pick up the gain or loss in taxable income for that tax year.

So a dealer does not have to sell in order to have a taxable event.  A dealer’s gains are taxed at ordinary rates, but net losses are fully deductible. This treatment is not mandatory for traders and 475(f) was written for them.  Under this section a trader can elect to use the dealer rules described above.  Once elected, the trader has to continue to use these rules in the future unless the IRS gives them permission to stop.

For more information, contact our office.

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