This week in Tax Forum we'll cover a few questions prompted by our recent TSC Does Mike Bauer's Taxes series. We'll also tackle a mutual fund issue for a nonresident alien and a few hairy issues for traders.
A special thanks to all of you who joined Martin Nissenbaum, national director of personal income tax planning at
Ernst & Young
, and me for a Yahoo! chat on Tuesday. In case you weren't able to attend, check out the
Send any other questions along to
email@example.com. Please remember to include your full name.
Trading on the Side
I have been investing for a few years and never reported more than a $3,000 loss or $6,000 gain. Lately I began trading heavily in my investment account and made substantial capital gains in 1998. I know I'm not a trader, since I still have my day job, but I am not sure about the tax implications of this. My current job is actually one where I am considered self-employed, so I have to pay self-employment taxes. Does this mean my capital gains taxes are also subject to self-employment taxes? -- Mike Chettle
"Capital gains are not subject to self-employment tax unless the person trades from the floor or owns a seat on an exchange," says Ted Tesser, a certified public accountant in Boca Raton, Fla., and author of
The Trader's Tax Survival Guide
So as long as your self-employed job has nothing to do with your trading activity, you should just report your trades on
- Capital Gains and Losses
. Just be sure to keep your job expenses and activities separate from your trading expenses and activities.
Dividends for a Nonresident Alien
I am a nonresident alien. I bought a mutual fund from PBHG last year. I received Form 1099-DIV yesterday for 1998. From my understanding, I also should receive Form 1042-S. Can I download a 1042-S and fill in the information from my 1099-DIV? -- Yan Gao
You already should have gotten your
- Foreign Person's U.S. Source Income Subject to Withholding
, the equivalent of
- Dividends and Distributions
, but for foreign folks.
"If you haven't, you're probably not getting it at this point," says Nick Morrow, foreign tax specialist at
, a New York accounting firm. Your fund company, PBHG, might not realize you're a nonresident alien. Don't get nervous. It happens fairly frequently, notes Morrow. (Of course it is always possible that the fund company has your foreign address on file, and that's where it sent the form.)
If the company knows you are a nonresident alien, it would send a Form 1042-S and withhold taxes on the dividends. Depending on the treaty the U.S. has with your home country, the withholding would range from 15% to 30%.
As a nonresident alien you have to file
- U.S. Nonresident Alien Income Tax Return
instead of Form 1040. When you fill in your 1040NR, just include the gross dividend number from your 1099-DIV. The form will help you calculate the tax on your dividend income based on the treaty's rate.
There's no need for you to fill out Form 1042-S yourself. But you should inform your mutual fund company that you're a nonresident alien for 1999, says Morrow.
Former Broker on Her Own
I recently retired as a broker with Morgan Stanley Dean Witter retail and have been asked by a former client to trade his account for him with full power of attorney. He wants me to handle all trading in return for a percentage of profits. I will receive nothing if the account's ending monthly balance is not greater than the opening balance. I also will not share in any losses. How can I set up this account for tax purposes, and should I incorporate to take advantage of write-offs, limited liability and the ability to fund my retirement plan at a higher rate? -- Kelly Dolan
Sounds like you've got yourself a pretty good deal, especially if you don't have to share in the losses.
But because you are getting a percentage of the profits, you are being paid a kind of incentive fee, notes Jim Calvin, an investment management tax partner at
Deloitte & Touche
in Boston and the editor-in-chief of the
Journal of Taxation of Investments
Your fee would be reported on
- Profit or Loss from Business
as income from a trade or business. It will be subject to self-employment tax. You can deduct any related expenses against that income. But that money should not be considered capital gains.
To avoid this self-employment tax, you can set up a partnership with the person who owns the account. The only glitch is that you'll need to invest some type of capital interest into the partnership for it to truly be considered as such, says Calvin. But even 1% is enough. Then the partnership's bylaws can include your special profit allocation.
Let's say you're supposed to receive 20% of the net profits. "That 20% will have a tax flavor to it," says Calvin. That means you'll get 20% of everything. That includes net gains, dividends, interest and expenses. (Your losses would be limited to the amount you invested in the partnership.)
These numbers will be reported in
- Supplemental Income and Loss
, and those numbers will flow through to your Schedule D. So you'll get the long-term treatment if the gain qualifies.
This doesn't have to cost you a fortune. You can find "dummy documents" -- generic legal documents -- on the Internet or at an office supply store. Then just have an attorney review them, says Calvin.
If you will be actively trading and generating primarily short-term gains and (hopefully not) losses, you probably do not need to set up a partnership. Just make sure you have a contract, and get everything in writing.
You also can consider setting up a limited liability company, but the costs are higher. For some of the nitty-gritty on LLCs, see this previous
If you sign up more than 15 clients, you'll have to register as an investment adviser. Then the
Securities and Exchange Commission
gets involved, and that's "no picnic," says Calvin.
Converting an IRA to a Roth
week we answered reader
question about converting a $2,000 nondeductible contribution from his traditional IRA to a Roth. Since David had already paid taxes on the money before he invested it in the IRA -- and it had not yet earned any returns -- the conversion to a Roth was not taxable.
But a few readers asked, "What if the account did have earnings?"
In that case, David would owe tax on the earnings. Let's assume his traditional IRA is now worth $2,500. On line 14a of
- Nondeductible IRAs (Contributions, Distributions and Basis
), he'd enter the full $2,500 -- the amount that he's converting to the Roth.
Line 15 asks for his basis in that amount. In this case, his basis is his original contribution of $2,000. So David would report $500 on line 16 and would owe tax on that amount. For 1998, he'd have the option of paying the tax over a four-year period.
Child Care Follow-up
Also last week, reader
said he was sending his child to India for the summer to stay with his parents. He asked if he could deduct the cost of the plane ticket as part of his child-care costs. Unfortunately for Paresh, transportation to and from day care is not deductible. That prompted reader
Harry L. Roberts
What if the grandparents pay for the flight and any other expenses associated with the child's stay? Could the parents pay the grandparents enough to cover these costs and then deduct them as child-care expenses?
Paresh could pay his parents to take care of their child and take a deduction for that as part of his overall child-care expenses. That's not a problem. But the transportation costs are not deductible, as we reported.
But should Paresh beef up the grandparents' pay to include the cost of the airplane ticket?
Realistically, the IRS has no way of knowing whether the grandparents' fees are padded. But our tax system is an honor system, and that means if you commit fraud, you'll go to jail. "I would not advise anyone to willfully inflate a cost or expense," says tax specialist Morrow. Nor would he ever advise anyone to pay more than the going rate for the child care, he says.