The terms “investor” and “professional broker-dealer” are clearly defined in the Internal Revenue Code (IRC).  Unfortunately, the terms “trader”, “active trader”, or “trader status” are not.  Traders and tax professionals have had to rely on various Tax Court cases for facts and rulings to provide sufficient guidance, as to what constitutes someone in the business of trading securities.  Regrettably, these court decisions have not been consistent over the years, and have left much to be desired in the way of clear, precise guidelines for taxpayers wanting to claim active business trader status.

One of the first distinctions made by the courts is the difference between an investor and a trader.  The activities of both are generally classified as investment activity, but beyond this point, the lines blur, and are open for interpretation.  Existing case law defines an individual who holds stocks on a long-term basis, and who collects dividends, interest and capital gains as an investor.

In contrast, much more is required of someone to reach the level of trader status.  Merely calling oneself a “trader” is not enough.  In reviewing many court decisions over the past several years, a trader might conclude that it is very difficult, if not impossible, to obtain trader status.  I am here to tell you that it is possible.  As recently as Cameron v. Commissioner (2007), the court confirmed that it is possible for a person, who manages his/her own investments, to be engaged in the “trade or business” of being a trader in securities.  Let us look at some of the existing case law to determine what the court requires of someone to qualify for trader status.

Guidance from the Courts

There are numerous court cases, dating back many years, suggesting how trading securities can meet the definition of a “trade or business,” as defined under IRC Sec. 162.  For example, in Fuld v. Commissioner (1943), the court concluded, “Persons who buy and sell securities on their own account are engaged in a trade or business.”  Additionally, in Snyder v. Commissioner of Internal Revenue (1935), the court determined that a taxpayer could be “regularly engaged in the business of buying and selling corporate stocks.”

The problem is that many of these court decisions are outdated, and do not reflect the current environment we now live in of high-speed Internet, fast and powerful PCs, and low online commission rates.  The PC and the Internet have dramatically leveled the playing field between the so-called “professional” and the average person.  I am not suggesting that intelligence, skill, proper temperament, and determination do not factor into the potential success of a trader.  I am merely pointing out that many people began trading stocks and futures in the 1990s, and the IRC, IRS, and our tax courts have still failed to respond to the growing online trading phenomenon.

Nearly anyone owning a computer with access to the Internet can trade securities online.  However, does this constitute an active trade or business pursuant to IRC Section 162?  The Court said no in Cameron v. Commissioner (2007), finding that the taxpayer’s online trading activities did not rise to the level of a “trade or business.”  The Court stated that an individual who manages his/her own investments online, “regardless of the extent and scope” of such activity is just an investor, and not engaged in a “trade or business.”  This position is consistent with the decision handed down in the Supreme Court case of Higgins v. Commissioner (1943).  In this case, the Court held that the taxpayer’s activities of collecting interest on his various investment holdings, and keeping detailed records did not meet the definition of a trade or business as outlined in IRC Sec. 162.

One of the earliest cases to deliberate on the term “trade or business” was Snyder v. Commissioner (1935).  The Snyder case involved a taxpayer who traded securities in addition to having other business activities.  The income he made from trading supplemented his other income.  The Court determined, based on the facts of the case, that the taxpayer was not properly characterized as a “trader on an exchange who makes a living buying and selling securities.”  The Court did however; acknowledge that a taxpayer could be engaged in more than one trade or business and that “one may be regularly engaged in the business of buying and selling corporate stocks.”

There have been several other tax cases in the past involving taxpayers trying to claim trader status with varying success (see Chapter 6).  In these cases the courts have established the principle that traders may be engaged in a “trade or business” while investors may not.  The Tax Court has developed a two-part test for determining active trader status:

  1. Taxpayers must conduct their trading with reasonable frequency and it must be continuous and substantial in nature.
  2. Taxpayers must seek to profit from short-term swings in the daily market movements rather than from capital appreciation and income, such as dividends and interest, from long term holdings.

For a trader to qualify for active trader status, both tests must be passed.  These trader tests were first implemented in the landmark case of Purvis v. Commissioner (1976), after being introduced in Liang v. Commissioner (1955).  In other words, this two-part test dates back for many years and provides the basis of our current understanding of the definition of trader status for tax purposes.

The problem with this two-part test is that the courts have often proven contradictory and shortsighted in applying these tests.  For example, in Moller v. United States (1983), the court based their decision on the duration of time that the taxpayers owned the securities, instead of the time spent monitoring their securities, or the quantity of trades made.  The taxpayers claimed that they worked in their trading business more than 40 hours per week studying the markets, making trades, plotting their positions, and managing their trades, that is, applying stop loss orders.  The court decided that the taxpayers were investors and not engaged in a “trade or business” because the duration of their holding periods was considered long-term, and they were trying to receive income from long-term positions rather than catching short-term swings in the market.

In the Cameron case, the court ruled that the taxpayer was not a trader because he only executed 75 sales during the course of the year, of which 31 were held for more than six months.  I agree, 75 sales do not sound like much of a trading business, but I have to say, there are many very successful swing traders out there that trade less than the average 1.5 numbers of trades per week that Cameron made.  I think the number of trades per year should not have as great a bearing on trader status as the tax courts and IRS seem to think it does.  Nevertheless, beyond that, the problem is the inconsistency in which the courts have defined the number of trades to equate to “substantial.”

Table 1.1 depicts the number of trades in various trader cases, and how they were interpreted by the courts.  There is somewhat of a conclusion that can be drawn in reviewing this data.  Annual trades of 300 or more generally were viewed as substantial activity, except for the anomaly that occurred in the Holsinger and Mickler v. Commissioner (2008) case.  In the Holsinger case, the taxpayers made 289 trades in 2001 and 372 trades in 2002.  The Court ruled that the taxpayers trading did not reach the level of “substantial trading activity.”  This ruling is contrary to the determination made in Fuld (1941), where 318 trades were deemed substantial.  Granted, Fuld was nearly 70 years ago, but the inconsistency in the classification of the trading activity, and the lack of real guidance from the IRC, IRS publications, and regulations highlights the fact that traders and tax professionals are shooting somewhat blindly when it comes determining tax status.

Table: 1.1: How Many Trades Does It Take to Qualify as a Trader in Business?

Tax Court Case

Year

Annual Transactions

Determined Trading Level*

Tax Court Determination

Reason for Denied Business Trader Status

      Ball

2000

7 – 8

Insubstantial

    No Trader Status     Activities not substantial
     Hart

1997

75, 53, 30

Insubstantial

    No Trader Status     Activities not substantial
    Moller

1983

124

Insubstantial

    No Trader Status     Activities not substantial
    Cameron

2007

212

Insubstantial

    No Trader Status     Activities not substantial
    Holsinger

2008

289, 372

Insubstantial

    No Trader Status     Activities not substantial
    Fuld

1941

318

Substantial

    Trader Status     N/A
    Chen

2004

323

Substantial

    No Trader Status     Activities not continuous
    Paoli

1991

326

Substantial

    No Trader Status     Activities not continuous
    Levin

1979

332

Substantial

    Trader Status     N/A
    Mayer

1994

1,136

Substantial

    No Trader Status     Long-term holdings

*This chart illustrates how the Court categorized taxpayers’ trading activity level for various trader/investor tax court cases.