You Say You’re a Trader? Be Prepared to Prove It to the IRS!

The first and perhaps biggest hurdle that every new trader faces come tax time is to convince the Internal Revenue Service that you are, in fact, a professional trader and not merely an overactive investor. Fail to do so and the tax consequences could severely affect how much of your earnings Uncle Sam will allow you to keep.

The first and perhaps biggest hurdle that every new trader faces come tax time is to convince the Internal Revenue Service that you are, in fact, a professional trader and not merely an overactive investor. Fail to do so and the tax consequences could severely affect how much of your earnings Uncle Sam will allow you to keep.

The IRS well knows that most traders begin as investors looking to hold securities long-term for capital appreciation and favorable long-term capital gains rates. But during the past few years as market declines made short-term investing more attractive, the IRS has held fast to the line by which it sorts out the traders from the investors.

Does it really matter which camp you fall into for tax purposes? Absolutely. Investors, who file on Schedule A, 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 who files on Schedule C, you write off 100% of your business expenses, and if you elected the mark-to-market accounting method, can offset all of your losses against income in the same year.

As a result, traders who ended the year with a profit could save thousands thanks to their unique tax status, while those who wound up in the red could realize a windfall of $20,000 or more in same-year tax write-offs they wouldn’t be able to take as an investor.

Clearing the Trader Bar

Not surprisingly, the IRS keeps a close watch on individuals who claim the advantageous “trader in securities” tax status. Although the guidelines that separate traders from investors are far from clear, relying as they do more on appellate court rulings than IRS definition, there are certain activity profiles that the IRS is looking for before it grants trader tax status.

To qualify for trader status:

* 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.

Admittedly, there’s plenty of gray area in these guidelines. For instance, what exactly constitutes “substantial” activity? What are the perimeters on holding periods? Can a part-time trader claim trader tax status?

So far, the IRS has left further delineation in the hands of the tax courts, which have been inclined to uphold the denial of trader status without shedding much light on how individuals might qualify for trader status in the first place.

Three Steps to Trader Tax Status

Follow these three steps to claim and protect your trader tax status:

1. Trade: The first step to convince the IRS that you are a trader is to “seek to profit from daily market movements.” They’re looking for a pattern of high trading volume and short holding periods. Keep your personal investments well separated from your trading business. The IRS also is looking for “earnest intent;” that is, you work diligently to manage transactions, conduct strategy sessions and make frequent trades.

2. Turn: Although no exact number of transactions has been established, one tax court case found that 75 trades a year was insufficient to warrant trader tax status. The IRS is not only looking for “substantial activity,” but “frequent, regular and continuous” trading as well. That means volume. 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.

3. Endure. If you want to reap the benefits of the trader business status, it stands to reason that you must actually be in business and remain that way for the entire tax year. Of course, you’ll also need to convince the IRS you deserve this advantageous business status by showing a healthy flow of trades, significant dollar amounts and short holding periods, all the signs that you’re attempting to make your living as a trader. This is what constitutes “continuity and regularity.” While it may seem unfair, if you suspend business for any reason, say by taking the summer off, or you flame out as a trader after nine months, the IRS has made it very clear that they will deny your claim for trader tax status.

Best Defense: A Business Entity

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 that the trader status you enjoy today will still be there tomorrow.

Take Frank Chen for example, he lost his Trader Status because he did not trade consistently. Furthermore the IRS determined that if his trades were consistent he would of still lost is status because he held a second job.

One good way to avoid the Mr. Chen stumble and protect your trader tax status is to trade under a business entity. Not only is that where the biggest tax advantages reside, but a legal entity such as a C corporation or Limited Liability Company sends a strong message to the IRS that yours is an earnest and legitimate business enterprise worthy of trader tax status.

At Traders Accounting, we are both traders and accountants. Our tax professionals can help you choose the, Limited Liability Company or C Corporation that best suits your business and provides the best hedge against loss of trader tax status in the future.

To view Frank Chen’s U.S. Tax Court case click here (http://www.tradersaccounting.com/frank-chen-tax-court-case.asp)

Michelle Boyer, CPA, is the nation’s authority on trader taxation and the Vice President of taxation for TradersAccounting.com, Inc – A nationwide tax and accounting firm for active traders. Michelle and our staff of professionals are dedicated on helping you correctly report your trading activity and legally lower your taxes.