I Want Out! - Revoking Your Section 475 (e) or (f) Election
In a regulatory environment where taxpayers may feel that compliance with constantly evolving tax reporting requirements is unreasonably difficult, surprises sometimes do happen. In fact, there are instances where the IRS announces changes that make adhering to reporting requirements significantly less burdensome. One area of significance to the alternative investment community is the procedures by which mark to market elections can be revoked.
What type of reaction could taxpayers be expected to have if they were presented with a requirement that said, “We’re going to charge you a fee of up to $7,000, and the outcome you are seeking is not guaranteed”? Previously, taxpayers who made a mark to market election under Section 475(e) or 475(f) were faced with that very situation. However, under the provisions of Rev. Proc. 2015-14, that provision is no longer on the table. The IRS has implemented new procedures to streamline the steps needed to revoke the mark to market election and the associated fee.
Similar to the timeline for making a mark to market election, a revocation of the mark to market election must also occur by the due date of the return for the year immediately preceding the year of change. Thus, if a taxpayer wishes to revoke an election beginning in calendar year 2016, the revocation request must be made before the due date, not including extensions, of the 2015 tax return.
A taxpayer requesting the revocation is permitted only to change to the realization method of accounting. A Form 3115, Application for Change in Accounting Method, must be filed. In addition, Section 23.02(5) of Rev. Proc. 2015-14 calls for a taxpayer to make a final mark of all Section 475 securities, Section 475 commodities, or both, that are being marked to market and that are the subject of the accounting method change being requested. Section 23.02(6) of Rev. Proc. 2015-14 requires the taxpayer to attach a notification statement.
The notification is required to include the following:
- The name of the taxpayer that will change its method of accounting (i.e., the applicant), and if applicable, the filer
- A statement that the taxpayer is requesting to change its method of accounting from the mark to market method, described in € 475, to a realization method
- The year of change (both the beginning and ending dates)
- The types of instruments subject to the method change, e.g., Section 475 Securities, Section 475 Commodities, or both
If a taxpayer has made an election under € 475(e), (f)(1) or (f)(2), the taxpayer must also include a statement revoking the section 475 election or elections for Section 475 Securities, Section 475 Commodities, or both, for which the change in accounting method is sought
It should be noted that taxpayers cannot freely elect in and out of mark to market treatment. A waiting period of five taxable years is required before an automatic change can be requested in order to resume using mark to market treatment.
Much like any election a taxpayer can make, there are advantages and disadvantages. It is important that taxpayers understand the consequences of making and/or revoking a mark to market election. One significant disadvantage of having a mark-to market election in place is the taxpayer loses their ability to retain capital gain characteristics. Whether an appreciated investment is held for three months (short-term) or 12 months (long-term), at the end of the tax year this investment will be treated as an ordinary gain. With the current top federal ordinary income tax rate at 39.6% and the current top federal capital gain rate on long-term investments at 20%, having a mark to market election in place can cut potential tax savings significantly.
Another disadvantage that may not be as clear with respect to a mark to market election has to do with Section 1256. Managers whose strategies either involve or evolve into investments in regulated futures contracts, foreign currency contracts, or non-equity options that are used and identified as hedges against securities in their trading portfolios will concede the potential benefit of having gains and losses taxed at 60% long-term on gains or losses and 40% short-term on gains or losses that they would otherwise receive under Section 1256.
As with any decision, tax planning managers and their tax advisors would be wise to analyze their portfolios and gain an understanding of the pros and cons of a Section 475 mark to market election.