Short-Term Cap Gains Taxes and Compounding

[contango_and_cash]

Why not just move to PR and enjoy life?



I have been planning this for myself in the coming years.



I think a separate interesting question is at what AUM is this actionable/sustainable at your toy 50% ROI.

[EspressoLover]

Bump...



1) Anyone aware of new opportunities from Trump's plan?



From what I've seen, the lower corporate rate might offer a petit opportunity. When corporate rates were 35%, it almost always made sense to structure investments as a passthrough. But at 21%, you might get more juice out of compounding than you pay in double taxation.



In the toy example from my original post, structuring the strategy as a non-passthrough corporate would produce a post-(corporate-)tax annual ROI of 39.5%. If the initial $1 million grew inside the corporate structure for fifteen years, it would hold $147 million. Assuming dividends are taxed at a personal rate of 23%, you'd get paid out $113 million. More than double the straight pass-through option.



The passthrough deductions don't seem like anything great for traders. Even if you fully utilize the 20% deduction, it lowers the top marginal rate from 40% to 32%. And getting that deduction is no easy feat. You either have to 50X the deduction in real capital expenditures, or 4X the deduction in payroll. Obviously neither of those really apply to a trading operation. Best I can think of is finding some corporate with a lot of people on payroll, who's not utilizing the deduction. Then cut some deal to "employ" all their employees as a sort of middleman "service provider".



Finally there's the 100% CapEx deduction. Maybe there's some interesting games to play here. What I can think of is deferring trading-related taxes with offsetting CapEx. E.g. if you make $1 million in 2018 from trading, spend $1 million on some long-lived asset with steady cash flow. Like a commercial building or something, which you can lever up. That sets your tax liability to zero for the year. Assume you can borrow 90% against the asset, you're only taking $100 thousand out of the trading operation. It defers most of the trading related taxes, so you avoid most of the tax-compounding drag.



Anything else interesting in this front?



2) Related to plain old pre-Trump tax law... Anyone have any color on using the Active Financing Exception to Subpart F? Normally a majority-American owned offshore company is "collapsed" into a passthrough entity for tax treatment purposes. But as I recently learned the law requiring this, Subpart F, has an exception related to "active financing".



The classic example is a bank engaged in genuinely offshore activities. But at the very least it seems like a securities brokerage is also covered (as long as it only touches non-American securities). Assume you're running a quant trading operation that covers international markets. I would think you segment off the non-domestic trading into an offshore company, and use this to shield income under the active financing exception. Particularly if you're closer to the HFT end of the spectrum, where the operations do seem quite similar to what a securities brokerage does. However I couldn't find any specific guidance on this topic, so curious if anyone has looked into this?

[NeroTulip]

Not an expert in US matters, but the IRA route is interesting. Could you license some software to a e.g. Dubai-based company that does the trading? The money compounds tax free inside the Dubai company, and if you hold it in your IRA I suppose your exit would be tax free too.



I suppose it can't be that easy, but then you see what Romney did...

[EspressoLover]

@nerotulip



That's a great idea, and you piqued my curiosity. The good news is that it seems like Roth IRAs are exempt from Subpart F. So you setup an offshore C-corp in a jurisdiction without corporate taxes, and avoid both US income and corporate taxes. This way you also get around the leverage and settlement restrictions. As long as the corporate entity is limited liability, you're not pledging IRA assets as collateral.



The hitch comes from avoiding "prohibited transaction". Basically the IRA cannot engage in any transactions with the IRA holder, immediate family or their fiduciaries. The logic here is to prevent someone from transferring value into/out of the IRA by doing something like selling an expensive asset to the IRA for $1 or having the IRA pay themselves a salary.



So you definitely cannot receive management or incentive fees on the investments. And even leasing the software from yourself or an associated entity also doesn't smell kosher. However, I think there may be a couple of workarounds. One is to "release" the software under the MIT license or some other copyleft. Just don't publish it anywhere. In this way, there's no actual transaction. The IRA entity is simply utilizing an open-source piece of software, that just so happened to be created by the disqualified party.



Another would be to do something akin to Romney. He put his interest in the partnership inside the IRA. Since there was no actual revenue streams associated with the partnership at the time of formation, the tax rules allowed him to value his interest at $1, well under the contribution limit. I think you could also do something with the software license itself. As long as it's not being actively used at the time. The downside is that it limits you from using the software in any context outside the IRA, because that would be a prohibited transaction.



However I should say once you get this far out, with this or any of the other more out there proposals, there isn't really so much "law" in the classical sense. The statutes are ambiguous, case precedence is sparse, and the underlying concepts don't really map on to these scenarios. (It's not even really clear if capital gains from quant trading qualifies as "active" or "passive" incomes.) You can run through the wording of the law umpteen times with tax accountants and lawyers, but it's going to basically come down to the subjective opinion of the tax court judge.

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