The release of formula weighted portfolios were a huge step in the right direction. Position size should be proportional to confidence.
However, it has been my experience that the use of formula weighting in portfolios results in highly tax inefficient behavior.
For example, formula weighting often results in frequent buying and selling of a position in the same security which invokes the wash sale rule. Basically, the IRS will not allow us to realize many of the capital losses while forcing us to realize all gains of securities bought and sold within 31 days. Unless the IRS allows me make election 475(f), there is really no way around this unless I give up frequent rebalancing – which I am reluctant to do because of its awesomeness.
So, to my questions:
Are there any good ways to better control rebalancing transactions in a formula weighted portfolio so as to prevent buying shares which have been sold at a loss in the last 31 days?
If not, then what developments are required to the P123 platform to make this a possibility?
Also, if you guys/gals have any further ideas on how to mechanically implement tax efficient portfolios, I would love to hear them.
I’m also not a tax lawyer, but I think the rules is that if the “replacement” stock is bought within 30 before or after a loss, the loss can’t be immediately recognized and is used to adjust the cost basis instead. The edge cases can be confusing. Hence, services like http://www.tradelogsoftware.com .
I have a model that I expect won’t have wash sales but it keeps holdings for a least one year, has a buy rule ‘LastSellDaysLT(30)=False’ and sets ‘Allow Immediate Buyback’ to No. It may be sufficient to AND each sell rule a guard rule like ‘NoDays>=30’ to make a portfolio wash rule safe.
I’m intrigued by Walter’s tax smart portfolio. Assuming that my short-term capital gains tax rate is 30%, I need to outperform buy-and-hold by ~43% annually just to break-even (because (1-.3)(1+r)=1; r = .428571). So if the market does 10% this year, I need to gross 14.3% (after commissions, before taxes), to justify active management. Doing that consistently would put a manager in the top 1% of peers, so obviously it can’t be that easy.
…which is why I am drawn to tax efficient portfolios. If I can lower my taxable basis to somewhere between ST and LT gains, that greatly lowers the hurdle rate and requires zero stock picking skill.
Another alternative would be to incorporate… from what I can tell this would lower your short-term capital gains rate to ~20% under the new tax law. You will have to pay an additional Personal Holding Company Tax on Dividends, but for frequent traders this should represent a small percentage of total gains. I’m curious if anyone else has explored this possibility.
what the article fails to mention is that private holding companies are exempt from the accumulated earnings tax. If you live in Texas or another tax-free state I have a hard time making it not be a great idea.
Sure, had my accountant look at this briefly, although I think I will need to hire someone a little more high powered to actually feel comfortable pulling the trigger. In short, we are hit with 4 different taxes on investing income: short-term capital gains, long-term capital gains, dividends, and interest. Top marginal individual rates on these items are roughly as follows
Effective rates will of course vary from person to person depending on income level. However, if we switch that same income stream to a C-Corp the following changes happen
ST Cap Gains ~ 20%
LT Cap Gain ~ 20%
Dividends ~ 10.5% (Dividends Received Deduction)
Interest ~ 20%
This seems wonderful, especially if your income is made up of a significant portion of ST Cap Gains. There are (of course) some catches to this
1.) You will have to pay additional tax on distributions of this income to the shareholders of ~20%, so this really only works if you are able to retain most of the earnings inside the C-Corp.
2.) Closely held corporations are hit with an additional tax named the Personal Holding Company Tax of 20% on undistributed PHC income (dividends & interest not capital gains). This raises the C-Corp tax rate on dividends to ~28% and to on interest to ~36%. However, if most of your income is coming from Capital Gains the higher rate on Dividends (20% to 28%) is offset by the much lower rate on ST Capital Gains (40% to 20%).
3.) Accumulated Earnings Tax - A potential levy against retained earnings of 20%, however this tax does not apply to Personal Holding Companies
4.) State Taxes - This will vary from state to state… in Texas (where I live) it is a non-issue.
Clearly the value of converting to a C-Corp structure will vary from person to person. For me it is currently looking very attractive. I’m still concerned that there is a gotcha out there that I haven’t come across yet, and for that reason I will probably try and find a decent tax lawyer for advice before pulling the trigger.
How do you get around double taxation? C Corp gets taxed at corporate level, then shareholder gets taxed on individulal level.
As I understand it, most closely held corps want to AVOID Personal Holding Company status, as it implies another tax on top of the regular corporate tax. I don’t see how it does anything help with the double taxation issue. What am I missing?
Another article about business structures for trading.
Both of those things are true, but let’s run through one scenario.
Before Tax Total Rate of Return = 15%
Dividend Yield = 2%
Dividends as % Total Return = 13%
% Capital Gains (assume all Short-Term) = 87%
Amount Invested in Year 0 = $100
Annual “Consumption” Requirements = $0
Assume Other Income Puts Investment Income in Highest Marginal Tax Bracket
State of Residence = Texas
The above assumptions yield the following tax rates
Admittedly I selected this scenario as one very favorable to the C-Corp structure, and it would need to be adjusted to fit an individual investment profile. When money is withdrawn from the C-Corp it would be taxed as a dividend at ~20%, but if your consumption requirements are significantly less than your assets then this impact will not outweigh the impact of having your assets compound at a 2.5% higher rate.
Definitely interested in people throwing stones at this, but for certain investors, it looks very attractive.
If I had enough money would I want to incorporate the trading for my “Prop Shop”, and perhaps have my daughter manage the fund and use the carried interest deduction for her salary?
I have thought of this in the past but do not know enough to be sure whether this is a serious consideration.
Thanks all for the ideas and references. This is definitely one of the more helpful threads for me.
I will have to think on this a little bit longer. Given that the tax benefits of incorporation are not that appealing as a Californian, I am still most interested in “tips and tricks” to add my investing style which minimize taxable gains and maximize deductibjes.