Traders are defined as taxpayers who are in the business of buying and selling securities, options, commodities, futures and foreign exchange currencies for their own accounts. To be considered an active trader for income tax purposes an individual must meet special rules established by the IRS. Since the Internal Revenue Code does not define the term “trader” or “investor”, taxpayers must rely on facts and circumstances described in previous IRS court decisions. The facts and circumstances of these cases are all different and the decisions are very subjective. Without clear definitions to help guide taxpayers and tax advisors, traders are left with uncertainty as to how best categorize themselves and their trading businesses on their tax return.
Individuals who buy and sell securities for their own accounts, including equities, options, futures, commodities and foreign currencies fall into one of three categories: (a) investor; (b) trader, and; (c) mark-to-market trader. These categories are determined by comparing a taxpayer’s trading activity to the special rules outlined in IRS Publication 550, the IRS website (Tax Topic 429) and previous court cases effecting traders. The special active trader IRS rules are as follows:
- An active trader must seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation.In this first test, the IRS is concerned with the length of a taxpayer’s holding period for securities bought and sold and the frequency of transactions. Day traders who buy and sell securities all day long and close out their positions at the end of the day, definately pass this first test. Swing traders who hold positions from a couple days to several weeks to catch short-term price swings in prices based on technical analysis, i.e, momentum, pass this test as well. In Purvis [37 AFTR2d 76-968, 530 F2d 1332 (1976, CA-9)], the Ninth Circuit Court of Appeals upheld a prior tax court decision [Purvis, TC Memo 1974-164 (1974)] and agreed with the Tax Court that in order to be classified as an active trader, the activity should be performed with sufficient frequency to “catch the swings in the daily market movements and profit thereby on a short-term basis.”
- An active trader’s activity must be substantial. For this test, the IRS is again focused on the frequency of trades and the financial committment made by the taxpayer to his trading business. What does “substantial” mean? This is a very subjective test. Substantial can mean something different for every trader. The definition of substantial includes words such as material, significant, fairly large, considerably, belonging to substance, strong, firm, solid, corporeal, etc. A full-time trader must be trading daily or almost daily and have a sufficient amount of equity in a direct-access or online brokerage account to have an opportunity to earn enough profits to pay his or her expenses and support ones lifestyle. It’s tough to justify substantial activity with an account of $25,000 or less. Most active traders have have at least $50,000 – $100,000 in a trading acount and have invested significant sums of money on trading books, charting software, seminars and computer equipment. if you haven’t then you have not yet demonstrated that you have a legitimate trading business.
- An active trader must carry on the activity with continuity and regularity. In this final test, the IRS is concerned with the extent to which a taxpayer pursues their trading activity to produce income for their livelihood and the amount of time devoted to the activity. There must be continuous, repititious, and regular activity spent in one”s trading business. In Holsinger v. Commissioner, TC Memo 2008-191, one of the reasons that the IRS ruled against the taxpayers was because their trading activity was not sufficiently substantial. Holsinger’s trades were less than 40% of the trading days in one year and 45% in the second year. Unfortunately, their are different styles of trading that require different percentage of days in the market. For example, I have clients that qualify as active traders that have substantial trading activities that are not in the markets every day. They are waiting for certain short-term technical chart patterns to form before they strike. I don’t think there is a “one size fits all” percentage of days in the market that all traders can rely on for this IRS test. If you are monitoring the markets every day and waiting for your particular technical setup to ocurr, you are actively in the business of trading. There is still a lot of work to be done to educate the IRS in this area.
In addition, detailed records must be maintained indicating that trading activities were performed in a business-like manner. Since brokerage firms are required to send out monthly statements and year-end 1099-B’s (and soon to be required cost basis), record keeping should not be an issue for anyone. Option traders have it a little more difficult. Test #3 is the toughest hurdle for most traders to overcome and the area where the IRS is most likely to attack, especially part-time traders. In this day and age, it’s quite possible and quite common to own several businesses and have a full-time or part-time job to boot. With the advances in communications, transportation, computer technology and the Internet, its relatively easy to be in two places at once or be multi-tasking on several activities at once. Though, it’s very difficult to be succesful when your focus is scattered across many different activities. Part-time traders need to be prepared to fight back against the IRS’s claim that a part-time trading activity does not constitute an active business.
One of the main tax benefits afforded Pro Traders, traders that qualify as being in the business of trading, is the ability to deduct trading losses as ordinary losses and not capital (IRC Sec. 475(f)). This means that there is no $3,000 limitiation when deducting losses from trading. This is a huge benefit to traders. The other benefits include the ability to deduct trading related expenses on your Schedule C, partnership or corporation tax return. These expenses include margin interest, seminars, software, journals, newsletters, books and computer equipment. If you are business trader that works out of your home, you are eligible to deduct home office expenses. The home office deduction is only available for the expenses that are attributable to a portion of the home used exclusively on a regular basis. Traders tend to trade in one place where they have their computer equipment (multiple monitors) and their trading library in the same room. Income from trading (and investing) is not subject to self-employment tax.
In December, 1997, the Joint Commitee on Taxation published what is referred to as the Blue Book (which is a general explanation of a particular year’s enacted tax legislation), stating for the first time that trading income is not subject to self-employment tax. The Blue Book clearly states that….” The Congress intended that gain or loss that is treated as ordinary solely by reason of the election would not be treated as other than gain or loss from a capital asset, for purposes of determining an individual’s net earnings from self-employment under the Self-Employment Contributions Act (sec. 1402) or determining whether the passive-type exception to the publicly-traded partnership rules is met (sec. 7704(c)).”