Taxes and Option Trading

When I first started selling options I had a lot of questions about how the taxes worked with it.  At the end of my first year of selling options I asked a neighbor who was a financial advisor how I should account for options that had not expired yet.  He said he’d have to check and get back to me.  At some point after I asked him it dawned on me that until I bought it back or it expired I didn’t have a cost basis for my transaction so the gain or loss would roll into the next year.  It sounds simple now, but confused me when I first pondered it.  I’m sure others have wondered before the light went on for them too.

Earlier this year I asked a CPA about creating a business for this blog to have a way to write off expenses.  She was cool and said she’d charge me more than I’d save by coming to her and I could just list my blog income and expenses on a schedule C and not have to incorporate.  She also asked how much I was trading to see if I’d qualify as a “Trader”.  I don’t.  She also asked my current income and was happy to see that my FICA was covered by my current W-2 job.  I left the phone call happy with my new knowledge.  I mentioned this FICA part in a post earlier this week and a new commentor, Bill, corrected me.  He said FICA does not apply to investment income. (FICA is the Federal Insurance Contributions Act tax that funds Social Security and Medicare.)

This is the part where I start getting in over my head… 

I had the time today to check to get the details.  Check page 72 for the longer version, but here’s the snipet that mattered:

Self-employment tax. Gains and losses from selling securities as part of a trading business are not subject to self-employment tax. This is true whether the election is made or not.

The part that stuck out to me was “as part of a trading business”.  I don’t have a trading business, but could not find any answer in this 80 page document stated exactly how it should work for those of us who are not “part of a trading business”.  It’s probably in there, but after reading this pdf for a while I was reminded why I am not an accountant.  I skimmed a lot and skipped even more.  If anyone finds the paragraph that explains it for non-businesses, please post a comment.  I won’t be surprised if it’s in another document.  The closest I can find that seems fairly clear is from the Internal Revenue bulletin number 2004-50.  It states on page six at the bottom in the middle, “FICA taxes on ‘wages'”.  Since capital gains are not wages, I think Bill is right.  I stand corrected and am happy I didn’t use that CPA in the end.

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  1. Comment by MELVIN

    Alex, http://WWW.FAIRMARK.COM (Tax Guide for Investors), has a simple explanation of qualifications/benefits of a “trader” that I have ever found. Hope this helps anyone who has an interest.

  2. Comment by Alex Fotopoulos

    Cool, thanks Melvin. in particular is worth a read. I’m not going to file as a “trader”, but it’s still interesting, because if nothing else I didn’t know how traders were able to avoid the wash rule. Apparently it doesn’t apply to them.

  3. Comment by Teamrivers

    You DONT want to pay FICA, on any income that you don’t have to. The inefficiencies of the US govt associated with the management of your hard earned income are outrageous! You should only be paying FICA on W-2. Ideally you should be incorporated, at least as an LLC for all related business activities. It gives you the opportunity for expanded expenditures and planning, as well as taxation “avoidation”.

  4. Comment by options trading

    Excellent post Alex! I wasn’t sure if the self employment tax was applicable to traders, that link really sheds some light on the answer.

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