Monitor JAN-FEB 12: Main Article

Mysteries of Trader Tax Status

Contributed by Jim Crimmins

Just because you call yourself a securities trader doesn’t make you one in the eyes of the Internal Revenue Service.

In fact, Uncle Sam is predisposed to consider you merely a hyperactive investor—and thus deny you a more favorable tax status—unless you meet a number of criteria that are frustratingly open to interpretation.

You read that right: the tax code contains no actual definition of trader tax status.

Instead, the IRS has issued guidelines the tax courts have expanded upon with case law, most of which denied tax appeals by traders.

What we’re left with is a blurred image, like a photograph of a trader taken from a speeding car.

According to the IRS, to qualify as a trader:

• You must seek to profit from daily market movements in the prices of securities and not from dividends, interest or capital appreciation;
• Your activity must be substantial, and
• You must carry on the activity with continuity and regularity.

To help determine if you meet these three tests, the IRS considers these qualifiers:

• Typical holding periods for securities bought and sold;
• Frequency and dollar amount of trades during the year;
• Extent to which you pursue trading to produce income for a livelihood, and
• Amount of time you devote to the activity.

Swoosh, right? What is “substantial” activity? “Continuity and regularity?” And what’s an acceptable holding period? Is a week too long? A month?

We know who investors are: They’re our hardworking neighbors who buy securities and hold them for such long-term goals as a college fund or retirement.

Traders, on the other hand, buy and sell securities solely to take advantage of short-term market changes. Your profits come from price swings, not dividends and interests. Since your holding period is brief, often a day at most—hence the term “day trader”—there’s no need to perform due diligence on the companies you trade.

Who cares how the IRS classifies you? You do!

Investors are subject to the 2% threshold for deductible investment expenses — and hence cannot write off most of their expenses—and are limited to a $3,000 capital loss deduction.

But as a trader, you write off 100% of your expenses, and if you elect the mark-to-market accounting option, you can offset all of your losses against your earned income.

Three Steps to Claim and Protect Your Trader Tax Status

Step 1: Prove beyond doubt you are a bona fide trader — that is, you “seek to profit from daily market movements.”

The best way to accomplish this is by showing a pattern of high trading volume and short holding periods. Keep your personal investments well separated from your trading business. The IRS is looking for “earnest intent;” that is, you work diligently to manage transactions, conduct strategy sessions and make frequent trades.

Step 2: Clear the “substantial activity” hurdle.

The hallmarks the feds are looking for here are “frequent, regular and continuous” trading. That means volume. One court case ruled that 330 trades a year was sufficient to warrant trader status. The feds need to know that you approach this as a business, not a hobby. Fail to convince them of that and you’re back in investor-land.

Step 3: Trade with “continuity and regularity.”

If you want trader tax treatment, it only stands to reason that you must actually be in — and remain in — the business of trading.

Here’s where the IRS is looking for a healthy flow of trades, significant dollar amounts, short holding periods — all the signs that you are at least attempting to make a living as a trader.

If you take the summer off or show other gaps in your trading, the IRS will be disinclined to grant you trader status. If you’re a newbie and flame out after nine months, while it seems unfair, the IRS has made it clear: no trader status for you.

Once you obtain trader tax status, you’re not entirely in the clear. Owing to the capricious nature of appellate rulings and the ever - evolving tax code, there are no guarantees the trader status you enjoy today might not be gone tomorrow.

One good way to secure your trader status is to trade under the umbrella of a business. That’s not only where the most lucrative tax advantages reside, but a legal entity such as a general partnership, Limited Liability Company or C corporation sends a strong message to the IRS that yours is an earnest and legitimate business enterprise worthy of trader tax status.

My recommendation is for you to maintain a day timer devoted completely to tracking the amount of time you spend each day on your trading activities. If you are audited by the IRS chances are it will be two or three years after you have filed your taxes. The day timer will service as proof of how many hours you spend each week on your trading activities.

About Jim Crimmins

Jim has become a nationally known speaker on tax strategies, entity structuring, and lifestyle change. He delivers over 30 talks a year throughout America as well as speaking in several chat rooms each month. You can learn more at TradersAccounting.com.