The Internet has spawned a burgeoning class of investors who use their computers to execute stock trades on a daily basis for their own personal gain ("day traders"). Most day traders hold their positions just a few hours or days, looking for a quick profit on minor price fluctuations. The tax issue is whether the person is actually in a full-time business trading stocks -- a "trader in securities" ("Trader") – or an investor who purchases and holds stocks for appreciation ("Investor").
To attain Trader status, the courts have required proof of full-time business activity where the taxpayer buys and sells securities for his own account as a continuous and frequent occupation. Traders must actively and continuously purchase and sell securities, devoting the same time and energy as to a full-time job while concentrating on short-term swings in stock prices.
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 and trades stock before or after work will be classified as an Investor.
Note: A Trader may engage in long-term stock purchases and sales, provided he segregates those activities from his daily trading. This becomes a critically important aspect of day-trading.
The determination of whether a taxpayer is a trader or an investor is made on a case-by-case basis, upon an examination of all the facts and circumstances. There is no statutorily prescribed litmus test for this determination.
The courts have traditionally focused on two requirements: (1) the taxpayer’s trading activities must be substantial (i.e. the number of trades during the year must be large) and (2) the taxpayer must be seeking profits from short-term market swings (usually buying and selling within 30 days) rather than concentrating on holding securities for long-term appreciation.
For instance, in Leoland F. Fuld, 139 F2d 465 (2nd Cir. 1943), a taxpayer who engaged in 665 sales transactions during the year and whose main source of income came from securities’ purchases and sales, was considered a trader.
In contrast, a taxpayer who made 100 trades (purchases and sales) over a 3-year period was not considered a trader. Hart, TC Memo 1997-11.
The court in Joseph A. Moller, 721 F2d 810 (Fed Cir 1983) focused on the type of income (profits from short-term market swings), not the amount of time and effort put forth by the taxpayer in the activity as determinative of trader status. The court noted that even though the taxpayer’s security purchases and sales were extensive and continuous, the income he received came mostly from interest, dividends, and the sale of securities held for a long period. Thus, the income received was in the nature of investment activity and the taxpayer was not a trader.
In summary, a trader engages in continuous trading, probably at least two hundred trades a year at a minimum, concentrates on short-term swings in price, and holds securities for less than 30 days on average.
Stock purchased and sold for a profit within 12 months is subject to short-term capital gains ("STCG") rules; profit is taxed as ordinary income. Similarly, stock sold for a loss is subject to short-term capital loss ("STCL") rules. At year’s end, STCG and STCL stocks are netted and gains are taxed at ordinary-income rates.
Unfortunately, if there is a net loss, STCL rules limit it to a maximum of $3,000 ($1,500 for married filing separately) in any single tax year; the balance is then carried forward. Because capital losses greater than $3,000 per year can only be carried forward, the taxpayer must make profits in future years to off-set the losses greater than $3,000 per year
Example: Joe Smith has $100,000 STCG with $40,000 of STCL in 1998. The net gain of $60,000 is taxed as ordinary income. However, in 1999, Joe has $40,000 STCG and $100,000 STCL, producing a loss of $60,000. Joe cannot carryback his 1999 loss to 1998 to offset the taxable gain in that year. Instead, he receives a $3,000 ordinary loss in 1999 and must carry forward the $57,000 balance to future years. If Joe does not have gains in future years, he would exhaust his STCL in 19 years ($3,000 year x 19 = $57,000).
Both Traders and Investors may deduct expenses associated with their investment activities (computers, Internet-access costs, library expenses and investment advice). However, an Investor deducts these losses as itemized miscellaneous deductions on Form 1040, Schedule B, which means (1) he must itemize deductions and (2) the deduction amount is only for expenses exceeding 2% of the taxpayer’s adjusted gross income ("AGI").
More importantly, itemized miscellaneous deductions are disallowed for Alternative Minimum Tax (AMT) purposes. Thus, Traders who pay state income taxes and who are subject to AMT (because state taxes are not deducted for AMT purposes), deducting expenses under the itemized miscellaneous deduction does not benefit them.
In contrast, Traders are permitted to deduct expenses on Schedule “C” and the AMT will not limit these deductions. Traders may also expense depreciable equipment under IRC Sec. 179, such as computers and office equipment used in their trade or business. Because the securities are capital assets, gains are not subject to self-employment tax. This is a big advantage, but it also precludes Traders from sheltering their trading income with retirement plans, since those plans require that taxpayers earn self-employment income subject to social security taxes.
Gains and losses from the sale of stock and securities should be reported on Schedule D. Trading expenses are listed on Schedule C. There are no instructions on how to report the Schedule D activities as income on Schedule “C.”
A simple approach would be to report just the net amount from Schedule D as gross income on Schedule “C.” Because the income is derived from the purchase and sale of capital assets under IRC Sec. 61(a)(3) [gains derived from dealings in property], use of Schedule D is proper.
This approach, however, could cause a distortion, because if the Trader engaged in $10,000,000 of trades and made a profit of $100,000, Schedule “C” would merely show the $100,000 in profit, rather than the extensive trading that was really part of the Trader’s business.
The Trader could report the gross proceeds from Schedule “D” on line 1 of Schedule “C,” then back out his costs (losses and the adjusted basis in each stock) as other expenses on line 27. A statement on the return should indicate that these “other expenses” were reported on Schedule “D.” This would provide Schedule “C” with a true and accurate picture of the trading activities, and the amounts reported on Form 1099B would match the activities on Schedule D.
Finally, if the taxpayer makes a mark-to-market election (discussed below), the amount listed on line 27 could be listed on line 36 as costs of goods sold, since the mark-to-market election treats the stock and securities as inventory. However, this approach is contrary to the notion of gross income under IRC Sec. 61 (a)(3), dealing with gains derived from dealings with property. Traders are engaged in the purchase and sale of capital assets. Trading income is not considered self-employment income and no social security taxes are paid
Gains derived from the purchase and sale of assets are determined by subtracting the adjusted basis under IRC Sec.1001(a) from the amount realized. In contrast, gross income derived from business under IRC Sec. 61(a)(2) is determined by taking the gross sales and subtracting the costs of goods sold. Thus, treating the stock as inventory and using the cost of goods sold method is contrary to Congressional intent (see IRC Sec. 475 (f)(1)).
The distinction between business income and gain derived from the purchase and sale of assets becomes very important if the trading activity occurs in a California Limited Liability Company and the mark-to-market election under IRC 475 (f) is made. California charges LLCs an annual fee based on “total income” plus costs of goods sold (in other words, costs of goods sold is added back to gross income). Consequently, if the income from trading were considered gross income derived from business under IRC Sec. 61(a)(2), then the concept of total income would include the gross selling price of stocks, without reduction for costs of goods sold.
This would mean that an LLC engaged in trading activity which made a mark-to-market election with $10,000,000 in gross income, but with $9,990,000 in cost of goods sold (a net profit of $10,000) would pay an annual fee of $9,377, the highest annual fee under California law, based on its total income.
However, because trading activity is supposed to be treated as the purchase and sale of capital assets under IRC Sec. 61(a)(3) (gains derived from dealings with property) the cost of goods sold concept is not involved and the LLC computes its annual fee based on net income of $10,000. The annual fee is determined in the same manner as gross income for income tax purposes, the amount realized of $10,000,000, less the adjusted basis in the assets of $9,990,000 produces a gross income under IRC Sec. 61 (a)(3) of $10,000. Under California law, the LLC would pay the minimum annual fee of $800, a savings of $8,500 in California taxes.
A recent tax change allows Traders to elect "mark-to-market" accounting under IRC Sec. 475(f) so that securities may be taxed as follows: (1) the Trader recognizes gains and losses on securities at year’s end; and (2) gain or loss is determined and reported as though the security were sold at the fair market value on the last day of the tax year. In short, gains and losses are netted, whether or not the stock is actually sold, and the difference is reported as ordinary income or loss.
Although there is no specific form that is filed to elect mark-to-market accounting, the election should include the following language:
Election to Use Mark-to-Market Method of Accounting
Pursuant to Revenue Procedure 99-17, Sections 5.04 and .04, I hereby elect to use the mark-to-market
method of accounting under section 475(f) of
the Internal Revenue Code for my business of trading securities as a sole proprietor which
business commenced on [date]. The first year for which the election is effective is the
taxable year beginning January 1, 2002.
Dated:
_________________________
[name of taxpayer
In addition, taxpayers may have to file an application for change in accounting (Form 3115) with the tax return, by the due date (including extensions) if the activity has been previously accounted for by the cash or accrual methods of accounting.
Once elected, mark-to-market accounting can be revoked only with IRS permission. The election must be made timely, by the due date of the previous year’s tax return, without regard to extensions. Thus, if a taxpayer wants to elect mark-to-market accounting in the year 2002, the election must be attached to his 2001 tax return if it is filed on or before April 15, 2002 or the election must be attached to the extension filed for the 2001 tax return. In either case, the election must be filed by April 15, 2002.
A major benefit from electing mark-to-market accounting is that the wash sales rules of IRC Sec. 1091 no longer apply. The wash-sales rules can create administrative difficulties since under these rules, losses cannot be deducted if the taxpayer purchases substantially identical securities within 30 days before or after a sale. A Trader who purchases and sells a select number of stocks multiple times throughout the year will have to apply the wash sales rule to each transaction.
Under mark-to-market accounting, all gains and losses are taxed as ordinary income and reported by individuals on Form 1040, Schedule C as a business activity; thus, the STCL rule limiting the loss to $3,000 per year does not apply.
Example: During tax year 1998, Joe Smith, as a Trader, had $200,000 of STCG and $300,000 of STCL. If Joe failed to elect mark-to-market accounting, he would report his gains and losses on Schedule D. His net STCL would be $100,000. Joe could deduct $3,000 in 1998 as an ordinary loss and carry forward $97,000 in losses to future years.
In contrast, if Joe elects mark-to-market treatment, his 1998 $100,000 STCL is reported on Schedule C as an ordinary loss and applied to other income earned in 1998. Furthermore, under the net operating loss rules, Joe could carry forward the unused loss for 20 years, or carry it back 2 years, then forward from that point (subject to the 20-year carryforward limitation).
Note: This is usually an advantage, however, Traders with significant loss carryovers will not be allowed to apply them to subsequent trading gains under the mark-to-market rules.
Note: While mark-to-market accounting is a huge benefit if the Trader has losses, the preferential tax treatment for long-term capital gains is also lost under the mark-to-market election. Therefore, it is critical for Traders to segregate their long-term investments from Trading activities.
IRC Sec. 475(f)(1)(B) allows the segregation of long-term investments. This can be accomplished by designating a separate investment account with a broker that will hold only long-term investments.
With day trading, tax status is everything. Traders enjoy the full deduction of expenses and ability to elect mark-to-market accounting. Trader status, however, requires a full-time commitment to trading stocks for short-term gains.
The lesson: Unless you trade stocks full-time, pay strict attention to your stock losses, particularly if you’re assuming those losses are fully deductible. Otherwise, you may need to work even harder at your other day job just to break even.
Use of a California LLC, coupled with an election to use mark-to-market accounting, could cause an unnecessarily high annual fee if the tax preparer is not vigilant and improperly uses the cost of goods sold concept to compute gross income under IRC Sec. 61(a) (2).
Also, those who elect mark-to-market accounting must vigilantly maintain their long-term investment assets in a separate account unrelated to the trading activity; otherwise, long-term gains that should receive the favorable capital gains tax treatment, will be taxed at ordinary income rates.
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