Most of you all have invested in stocks and bonds or other publicly traded securities with the help of a “securities dealer” or stock broker. But if you are “trading” in securities on a regular basis for yourself and family, IRS Topic 429 says you may be upgraded to a “trader”. Why is this important? If you “substantially” trade to profit “from daily movement in the prices of securities” the Government gives you valuable tax benefits as provided in Section 162(a) and Section 475(f) of the IRS Code. More specifically, you can deduct “ordinary losses” not subject to the $3000 per year capital loss limitation by electing the “mark to market” method of accounting. This could be a huge tax saver if your husband or wife has substantial W2 income. But beware, IRS has set multiple Trader Traps (TTs) to trip up “traders” right in their investment tracks. So if you are a trader or are thinking about becoming one, stay tuned on TaxView with Chris Moss CPA to find out how to avoid TTs and to successfully defend your preferred “Trader” status to save you taxes in the event of an IRS audit years later.
Section 475(f) of the Taxpayer Relief Act of 1997 allows a “trader in securities” to elect under Rev Proc. 99-17 to “mark to market” stocks held in connection with your trading business. According to the Joint Committee on Taxation 12/17/1997 Report, “mark-to-market accounting imposes few burdens and offers few opportunities for manipulation”. So what exactly is “mark to market” for a trader? If you are a trader an elect mark to market you compute taxable income based on the market value rather than cost and you get the entire loss as a deduction not subject to the $3000 capital loss limitation.
So where are the TTs? The vast majority of TTs are set by the IRS to keep you from ever breaking out your “investor” chains to “trader” freedom. The first of the TTs is simply to make the election. But it is shocking how many of you miss a timely election to mark to market including Knish v IRS (2006). The facts are simple: Knish began trading securities in 1999 to 2001 and did not elect the mark to market method of accounting on his tax return until 2001. Knish then carried back losses from 1999 and 2000 to 1996. The IRS audited and disallowed all the losses claiming the election was 18 months too late. Knish appealed to US Tax Court in Knish v IRS. The Court found for the Government. There are no exceptions here folks, you must make the election or get downgraded to investor and pay large amounts of tax. IRS wins, Knish loses. See also Kantor v IRS (2008) and Assaderaghi and Lin v IRS (2014)
The second of the TTs focus us on the “frequency of the trades” and takes us to Van Der Lee v IRS (2011). Van Der Lee filed a 2002 tax return claiming to be a trader with gross receipts of almost $4.4 Million and expenses of $5 Million resulting in a $1.4 Million loss. Van Der Lee offset this loss against W2 income. The IRS audited and disallowed all losses claiming even if an election was made which it was not, Van Der Lee was still not a trader because his trades were not substantial. Van Der Lee appealed to US Tax Court Van Der Lee v IRS (2011) Judge Marvel notes that Van Der Lee did not trade with sufficient frequency to qualify as a trader. Brokerage statements show that between April 15 and Dec 31 2002 Van Der Lee executed 148 trades through Merrill Lynch and 11 trades through Prudential. Trading was sporadic with trades averaging 3 or 4 trading days per month citing Kay v IRS (2011). IRS wins Van Der Lee loses.
This brings us to the third and fourth final of the TTs, the time a trader spends on trading and the way the trader profits from short term swings in the market. Kay reported on his 2000 tax return a “trader” loss of over $2 Million from sales of securities. Kay also owned a business with large profits which he offset by his trader losses. The IRS audited and disallowed all losses. Kay appealed to US Tax Court in Kay v IRS (2011). The Court concluded that Kay’s trading activity was insubstantial citing Chen v IRS (2004) and his stock positions were more of a long term nature rather than seeking profit from short term swings in the market citing Mayer v IRS (1994). The Court also noted that Kay’s trading activity was infrequent. Kay traded 29% 7% and 8% in 2000, 2001 and 2002 citing Holsinger and Mickler v IRS (2008). Finally, the Court concluded that Kay’s income from his profitable business was his primary source of income and therefore concluded that based on all the facts presented to the Court that Kay was not a trader. IRS wins Kay loses.
What does all this mean us? First and most important, make the "Mark to Market" election on the first year of trading with the assistance of your tax attorney and document the election appropriately as you file your tax return before signing and filing you return. Your tax attorney should be prepared to sign the return and act as a witness years later if needed during an IRS audit. Second, keep track of your trades and time spent on the trading business. Remember, your trading must be substantial. You should be able to easily prove to the IRS that you spent the majority of each working day trading stocks and bonds and other securities. Third keep track of daily profit taking. You will need to prove you focused each day on short term daily profits, not long term positions or appreciation. Finally if you plan on offsetting W2 or 1099 income either from a separate business you own or from your husband or wife’s W2 income, be prepared if audited for the Government to allege you were being supported by your spouse if the pattern of losses persists year after year. In conclusion, if you are a trader you get amazing tax benefits that justify the risk of IRS audit. Be prepared and be ready to bullet proof your tax return from the TTs before filing, Happy trading and see you next time on TaxView! Thank you for joining us on TaxView with Chris Moss CPA
Chris Moss CPA