Last month, Senate Finance Chairman Ron Wyden (D-Ore.) introduced legislation that would severely increase the tax burden on the multi-trillion-dollar derivatives market. There is a chance that the looming $3.5 trillion budget reconciliation bill could include this tax hike on derivatives contracts, which would harm everyday investors trading on platforms such as Robinhood, SoFi, FTX, and CME Group.
Individuals who trade derivatives on brokerage apps will be negatively affected by this tax change. This is especially concerning since retail investing in equity options is on the rise. According to data from the Options Clearing Corporation, and reported by Reuters, in January U.S. equity options increased by 70%. Additionally, Robinhood alone has 18 million user accounts. In the second quarter of 2021, Robinhood made $180 million in order flow revenue. Out of that, $111 million was from options trading. That is over 60% of revenue from options.
It is safe to say that derivatives trading is not just for the rich. Anyone with a smart phone can buy or sell derivatives contracts. This is just another example of how technological advances are allowing retail investors to breach the traditionally closed off world of finance.
Senator Wyden’s legislation, the Modernization of Derivatives Tax Act of 2021 (S. 2621), imposes a tax burden that is two-fold.
First, the bill taxes derivatives transactions at ordinary income rates and applies the tax to unrealized gains for derivative transactions prior to completion of the contract. Thus, taxes will be required to be paid annually even if the derivatives contract has not been settled. This is incredibly alarming. Individuals will be required to pay taxes even when there has been no real gain from the derivative. What incentive do individuals have to invest in derivatives if they will constantly have to pay taxes for holding the asset even when no actual gains are being made? There will be very little incentive to invest at all.
Second, the bill could require investors who execute derivatives with respect to a stock position they hold, to recognize built-in gain on the stock, and potentially pay tax annually on the current market value (mark-to-market) of the stock position in perpetuity. Again, another provision that will certainly stymie private investment.
The provisions of this bill will only add to investors’ compliance burden.
The derivatives impacted by Wyden’s bill include certain futures contracts, swaps, and options.
Certain derivatives are currently taxed at a top rate of 23.8%. But changing statute to tax these transactions as ordinary income opens the tax burden to increase to upwards of 43.4% if the budget reconciliation bill raises the top rate to 39.6%. Not to mention additional state taxes.
Specifically, passage of Sen. Wyden’s bill could severely hamper any growth for the nascent cryptocurrency derivatives market in the United States. Overburdensome government regulation across the globe has already stymied Binance’s crypto derivatives services. The last thing the U.S. should do is follow suit and implement a tax regime that will raise taxes on individuals who participate in the derivatives markets through free online brokerage accounts.
Democrats falsely claim this measure will close tax loopholes for the super-rich. But make no mistake, this tax-grab will harm all individuals who trade futures, options, and swaps.
The Joint Committee on Taxation estimated that this bill would raise $16.5 billion over 10 years. However, raising $1.65 billion in revenue annually pales in comparison to the subsequent decline of derivatives trading overall that will likely occur in the $15.8 trillion derivatives market because of the increased tax burden. Enactment of Wyden’s bill will chill derivatives trading activity and may lower revenue for the federal government.
Members of Congress should oppose this tax increase and its potential inclusion in the budget reconciliation bill. “Closing loopholes” and cracking down on “tax avoidance” have become a recent clarion call of the Democratic party to raise taxes on middle-class Americans. But all retail investors should be aware that this new tax regime is not only going to affect the wealthy, it will affect you too.