Is Your Client an INVESTOR? a TRADER? or a MARK-TO-MARKET TRADER?
~ by Nancy E Goedecke, EA ~
The Internet has spawned a new breed of investors who use their computers to execute stock trades on a daily basis. Suddenly everyone and their cousin is either an online day trader or thinking about becoming one. Even the more laid back investors who used to buy and hold are racing to open online trading accounts so they can get in on the action.
It’s fun, it can be profitable and it is interactive. Day trading is rapidly becoming a potential new national pastime. Seeking to meet their customer needs, a large discount department store recently announced that they are providing space for e-trade centers and/or brokers to operate.
Most day traders hold their positions just a few hours or days, looking for a quick profit on minor price fluctuations. At the end of the year they may have scores or even hundreds of stock market transactions to report on their tax returns. Our practice saw a dramatic increase in the number of clients who had embraced online trading and, in turn, created EA angst by the exponential increase in the number of Schedule D line entries required to report their activity.
Active investors may find some special strategies to reduce their tax bills if they can qualify as traders, who are taxed differently from investors and dealers.
Traders can deduct 100% of their investment related expenses on Schedule C, while investors are limited and subject to the 2% of AGI haircut as miscellaneous itemized deductions on Schedule A.
The tax issue is whether the person is actually in the business of trading stocks —
between the two. Most individuals, even those who trade several times a week, are, by the IRS’ interpretation, investors.
IRS regulations are yet to be promulgated and the court cases dealing with this issue are pre-Internet online trading activities. Nonetheless, the only way we have to define the status is to go by the guidelines laid out in several court cases that have addressed the question.
The courts have required evidence of:
- Frequent, regular, and continuous trading activity (Preferably, daily and year round)
- Substantial time and energy devoted to trading activity (Preferably, a full-time job)
- Goal is to profit from short-term market fluctuations rather than from long-term gains or dividend income
Other considerations include:
- Overall profitability of the activity after expenses
- No other regular full-time job or profession
- Eligible for trader status year after year
Additionally, the IRS will look for:
- Daily record keeping activity
- Independence in decision making and research activity
- Minimal dividend or interest income from trading activity
- High volume of transactions, i.e., number of shares traded, not dollar costs
- Positions held for less than thirty days
In contrast, Investors focus on long-term capital appreciation and usually have another occupation or line of work. In general, a taxpayer who works a full-time job then trades stock before or after work will be classified as an Investor.[See citations: Investor vs Trader References & Court Cases].
Carefully consider the circumstances of your client. To be treated as a trader, a taxpayer’s trading activity must be regular, continuous, extensive and intended for short-swing gain. Certainly if the taxpayer’s primary goal is holding investments for long-term appreciation, trader status does not apply. Unless taxpayers clearly meet the tests, they probably should be treated as investors. You might also discuss the hobby loss rules with your trader-client.
Note: Day Traders are allowed to hold stocks for the long term if they are held in a separate account and not day traded. The trader must tell the IRS these long term positions exist and they are not assets of a day-trading business.
WHAT’S THE REWARD FOR QUALIFYING AS A TRADER?
According to tax law, traders are in the business of buying and selling securities. This means the trader is self-employed and may deduct all of his (her) trading expenses on Schedule C, like any other sole proprietor. These would include margin account interest, computer expenses, Section 179 expensing for equipment used in the trading business, and perhaps even home office expenses. Here, unlike the Investor who is subject to limitations and phase-outs on Schedule A, 100% of the expenses are deductible and could even create a net operating loss.
The trader still reports all transactions on Schedule D, and any profits from the sale of capital assets are exempted from self-employment taxes. Deductible net losses are limited to the statutory maximum of $3,000 per year, with the excess being carried forward. Since all the trading activity is reported on Schedule D and all expenses on Schedule C, we recommend attaching a statement to the return to explain and reconcile the odd appearance.
Any gains are short term, and thus are taxed at ordinary income rates. Unfortunately, if there is a net loss, STCL rules limit the deduction to $3,000 ($1,500 for married filing separately) in any single tax year. The balance can only be carried forward and will offset future capital gains and the remaining excess deducted at the maximum $3,000 per year.
Sam has a $100,000 STCG with a $40,000 STCL in 2000. The net gain of $60,000 is taxed at ordinary income rates. However, in 2001, Sam has a $40,000 STCG and $100,000 STCL, producing loss of $60,000. Sam cannot carryback his 2001 loss to 2000 to offset the taxable gain that year. Instead, he receives a $3,000 ordinary loss in 2001 and must carry forward the $57,000 balance to future years. If Sam does not have gains in future years, he would exhaust his STCL in 19 years. ($3,000 x 19 = $57,000).
HOW IS A DEALER DIFFERENT FROM A TRADER?
A trader, even one who makes trading his career, isn’t a dealer.
A dealer is a merchant, a middleman whose business, licensed in the securities industry, is to buy securities in quantity and resell them to his customers, usually at a markup. He looks to his markup or fees, rather than to the changes in the market, for his profits.
Traders, on the other hand, depend on fluctuations in the market for their profits. Traders do not hold inventories of securities, and those who buy what a trader sells are not his “customers”. As the courts have stated, while “both dealers and traders may be engaged in a trade or business, only a dealer has customers.”
By definition, all securities, except those held for sale to customers, are capital assets. Thus, transactions as a trader result in capital gain or loss, while sales by a dealer out of his inventory generate ordinary income or loss. The dealer is subject to self-employment tax on his Schedule C profit, but the trader is not subject to SE tax on the sale of his capital assets on Schedule D.
Another striking difference is the way in which losses are treated. Dealers are exempt from the wash sale rules which bar traders and investors from deducting losses on sales of securities if they buy substantially identical securities within 30 days before or after the sale. A dealer’s current net losses may create a net operating loss which can be carried back to offset earlier years’ taxable income, but an investor or trader’s losses are limited to $3,000 in the current year with any excess being carried forward to future years.
MARK-TO-MARKET TRADERS — RRA97 & Rev
Those who qualify as Traders may take advantage of a recent tax law change that allows Traders to elect “mark-to-market” accounting. Two important tax benefits result:
- First, the wash sale rules do not apply, and
- Secondly, the trading profit or loss is considered “ordinary” and is therefore exempt from the $3,000 annual deduction limit on net capital losses.
Here’s how it happens:
On the last trading day of the year, the mark-to market trader must for accounting purposes “sell” all holdings at fair market value to book the imaginary gains and losses as of that day for tax purposes. This means (s)he begins the new tax year with no unrealized gains or losses and the new basis of the retained securities is year-end fair market value. The net gains or losses on the transactions are reported as ordinary income or loss and as such are not subject to the capital loss restrictions.
Net earnings from self-employment does not include gain or loss of a securities or commodities trader that is treated as ordinary income solely by reason of the mark-to-market election (IRC §475 (f) (1)(D)).
During the tax year 2000, Sam as trader, had $200,000 of STCG and $300,000 of STCL. If Sam failed to elect mark-to-market accounting, he would report his gains and losses on Schedule D. His net STCL would be $100,000. Sam could deduct $3,000 in 2000 as an ordinary loss and carry forward $97,000 in losses to future years.
In contrast, if Sam had elected the mark-to-market treatment, he would report his year 2000 transactions in Part II of Form 4797 netting $100,000 in short term ordinary loss. This loss flows to Form 1040 and is applied to other income, perhaps creating an net operating loss.
Furthermore, under the net operating loss rules, Sam could carry forward the unused loss for 20 years, or carry it back for 2 years, then forward from that point (subject to the 20-year carryforward limitation).
The 2000 Form 4797 Instructions provide guidance for the trader in securities with a mark-to-market election under IRC §475(f) in effect for the tax year.
A summary follows:
Gains and losses from all securities or commodities held in connection with your trading business (including those marked to market) are treated as ordinary income and losses. As a result, the lower capital gain tax rates and the limitation on capital losses do not apply. The gain or loss from each security or commodity held in connection with your trade or business (including those marked to market at the end of the trading year) is reported on Form 4797, line 10. The wash sale rule does not apply.
Attach to your tax return a statement, using the same format as line 10, showing the details of each transaction. Separately show and identify securities or commodities held and marked to market at the end of the year. On line 10, enter “Trader – see attached” in column (a) and the totals from the statement in columns (d), (f), and (g). Also enter on line 1 the total gross proceeds from sales of securities or commodities reported to you on Forms 1099-B (or substitute statements) that you are including on line 10 as a mark-to-market trader.
Revenue Procedure 99-17
This revenue procedure provides the exclusive procedure for dealers in commodities and traders in securities or commodities to make an election to use the mark-to-market method of accounting under §475(e) or (f) of the Internal Revenue Code.
Unfortunately, most traders already missed the chance to make the mark-to-market election for 1999 and 2000 and will have to wait until 2001 for it to be effective.
The election requires some planning and must be filed with the previous year’s return or timely filed extension request for that previous year (i.e, by April 15th usually). Make a note to attach the election to the year 2000 return filed before April 16, 2001 or to the extension filed by that date. Then the election would be effective for tax year 2001.
One more thing: Since marking-to-market is a change in accounting methods, Form 3115 must be filed for the effective tax year (here, 2001).
What might the election look like? Here’s one possible format for the 2001 tax year election:
Sam MM Trader
Attachment to 2000 Form 1040 (or Form 4868)
I hereby elect to use the mark-to-market method of accounting under IRC §475(f) for my trade or business of trading securities. The first year for which the election is effective is the taxable year beginning January 1, 2001.
Sam MM Trader
Section 5, Paragraph .03 – Elections effective for a taxable year beginning on or after
January 1, 1999.
“…the taxpayer must file a statement that satisfies the requirements in section 5.04 … not later than the due date (without regard to extensions) of the original federal income tax return for the taxable year immediately preceding the election year and must be attached either to that return, or if applicable, to a request for an extension of time to file that return.”
Section 5, Paragraph (2) New taxpayers.
“A new taxpayer is a taxpayer for which no federal income tax return was required to be filed for the taxable year immediately preceding the election year. A new taxpayer makes the election by placing in its books and records no later than 2 months and 15 days after the first day of the election year a statement that satisfies the requirements in section 5.04 of this revenue procedure. To notify the Service that the election was made, the new taxpayer must attach a copy of the statement to its original federal income tax return for the election year.”
Section 6, Change in Method of Accounting – Paragraph (2)
“…The original Form 3115 must be attached to the taxpayer’s timely filed (including extensions) original federal income tax return for the year of change, and a copy of the Form 3115 must be filed with the national office no later than when the original Form 3115 is filed with the federal income tax return for the year of change.”
There is no fee for filing Form 3115 in this case because it is being filed under an automatic procedure provision. Write “Filed under Rev. Proc. 99-17 & IRC §475(f)” at the top of the form.
FILING AS AN INVESTOR, TRADER, or MARK-TO-MARKET TRADER
Advantages, Disadvantages, and Reporting Requirements Summary
|Anyone qualifies||Special rules||Special rules plus positive election / IRS approval needed to reverse|
|Gains are capital
LTCG rates available
|Gains are STCG taxed at ordinary rates Segregate LT holdings||Gains are STCG taxed at ordinary rates Segregate LT holdings|
|Losses limited to $3K/yr||Losses limited to $3K/yr||Unlimited losses allowed
Potential NOL treatment
|No SE tax||No SE tax||No SE tax|
|Expenses go to Sch A
Limited by 2% AGI &
Income phaseout rules
|Expenses go to Sch C
|Expenses go to Sch C
|Margin Interest limited
by Form 4952 & Sch A
|Margin interest on Sch C||Margin interest on Sch C|
|No office-in-home||May be office-in-home||May be office-in-home|
|Wash sale rules apply||Wash sale rules apply||No wash sale rules apply|
|Transactions on Sch D||Transactions on Sch D||Transactions on Form 4797, Part II, Line 10 (Ordinary Income & Loss)|
|Expenses on Sch A||Expenses on Sch C
|Expenses on Sch C
|No special elections||No special elections||Affirmative election required in the Year previous to effective year. Form 3115 also required (no fee). Automatic approval, but IRS permission required to change.|
CFS Income Tax 1996 to 2000 Research CD-Rom
CCH Federal Tax Service
BNA Portfolio Plus
“Tax Tips for Day Traders” by Bill Bischoff, email@example.com
Tax Guide for Traders, Kaye A Thomas, Fairmark Press Inc, www.fairmark.com
Form 4797 Instructions (2000), Curt Freeman, Tax Forms Development Branch
Copyright © 2001, NANCY E GOEDECKE, EA Reprinted with permission.
If you want to copy or reprint this article, please contact Nancy Goedecke
About the author: NANCY E GOEDECKE, EA
Nancy E Goedecke, EA is a full-time practicing Enrolled Agent specializing in individual and small business taxation. She is an experienced teacher and a frequent presenter of income tax seminars for professionals across the country. Nancy is known for her ability to make comprehensive tax issues understandable and applicable in daily practice of attendees. Nancy became an EA and joined NAEA in 1986, is a Fellow of the National Tax Practice Institute and currently serves as Secretary of NAEA. She is also a member of the Internal Revenue Service Advisory Council (IRSAC) which meets at the national office of IRS with Commissioner Rossotti and his staff. Nancy is a Past President of the Massachusetts Society of Enrolled Agents and recipient of the 1989 “Enrolled Agent of the Year” award. As owner of Taxes & Money Management in Hudson, MA, Nancy is also a Registered Representative/Advisory Representative orchestrating comprehensive financial solutions to her clients.