The Internal Revenue Service has seen an increase in tax return errors related to reporting securities transactions. To assist taxpayers in avoiding the most common reporting errors and omissions, the IRS is offering some helpful tips.  These errors are generally uncovered during routine audits.

Day Traders
Error: Day traders (those who seek to profit from daily price changes in the securities market) are reporting transactions and expenses on the wrong tax form.   

Tip: If the trading activity is considered a business, the taxpayer’s trading expenses would be reported on Form 1040, Schedule C, Profit or Loss From Business (Sole Proprietorship), not Form 1040, Schedule A, Itemized Deductions.  Day traders should not use Schedule C to report income or loss from the sales of securities — these transactions belong on Form 1040, Schedule D or Form 4797, Sales of Business Property.

For stocks, bonds or exchange traded options on individual company stocks, the trades are generally reported on Form 1040, Schedule D, Capital Gains and Losses, with each trade recorded separately.  However, if the taxpayer previously made the “mark to market” election, each transaction is reported on Form 4797 instead of Schedule D.

Error: Day traders who elect to use the “mark-to-market” method of accounting are forgetting to use Form 4797, Sales of Business Property, when reporting gains or losses from transactions.

Tip: Once the “mark-to-market” election is made, gains or losses from day trading should be reported as ordinary gains and losses in Part II, Form 4797, Sales of Business Property. 

http://www.irs.gov/businesses/small/article/0,,id=127292,00.html


Figuring Gains and Losses
Error: Taxpayers aren’t properly classifying their capital gains/losses as either short-term or long-term when reporting them on Form 1040, Schedule D.

Tip: When investments are sold or traded, taxpayers must first determine the “holding period” for the property. The holding period is how long the investment was owned before it was sold or exchanged. To determine how long the investment was held, taxpayers should begin counting on the date after the day the property was acquired and include the day the property was disposed as part of the holding period.

Generally, if a capital asset is held one year or less, the gain or loss from its disposition is “short term” and is reported in Part I of Form 1040, Schedule D. If a capital asset is held longer than a year, the gain or loss from its sale or exchange is “long term” and is reported in Part II of Schedule D.

It is essential that taxpayers include the “date acquired” and “date sold” for each securities sale to document that the property qualifies for short or long term treatment.

Error: Taxpayers neglect to show the purchase and sale amounts for securities on Form 1040, Schedule D. Instead, they show only the net amount of gain/loss.

Tip: Often taxpayers can’t complete Form 1040, Schedule D sections for “sales price” and “cost or other basis” due to inadequate record keeping. However, individuals may be able to reconstruct this information through their broker, or research at a business library, or on the Internet.

The sales price can be determined from the Form 1099-B (or substitute statement), which is issued by the broker after the sale. This provides the gross sales price, or a net amount if commissions and option premiums have been used to reduce the gross price. If the net amount is used on Schedule D, taxpayers should not include the commissions or option premiums as an adjustment to basis.

To determine the original price or “cost basis” of stocks or bonds, taxpayers should start with their purchase price, then add any costs of purchase — such as commissions and recording or transfer fees. If the stocks or bonds were acquired other than by purchase, then the basis is usually determined by fair market value or the previous owners adjusted basis.

The basis of stock must be adjusted for certain events that can occur after purchase. For example, if more stock was received from nontaxable stock dividends or stock splits, the basis of the original stock must be reduced. Taxpayers must also reduce their basis when nontaxable distributions are received, because these are considered a return of capital. See Basis of Investment Property in Chapter 4 of Publication 550, Investment Income and Expenses, for more information on calculating basis.

If taxpayers sell mutual fund shares that were acquired at different times and prices, they can choose to use an average basis. For more information, see Average Basis in Publication 564, Mutual Fund Distributions.

It’s important to note that taxpayers have the burden of proving the basis of their securities. Failure to prove this when required can result in a basis determined by the IRS, or even a basis of zero.

Error: When reporting 1099-B sales on Form 1040, Schedule D, taxpayers are listing the payer or broker’s name as the description of the property.

Tip: When reporting securities sales shown on Form 1099-B, taxpayers should list the stock ticker symbol or abbreviation to describe the property on Form 1040, Schedule D, not the name of the stock payer (ABC Brokerage, Inc.) involved in the transaction.

Error: Taxpayers don’t list all their transactions, omitting those that resulted in no net gain or loss.

Tip: The sale of all stocks, bonds, mutual funds and stock options need to be reported on Form 1040, Schedule D, regardless of whether there was no gain or loss.

There can be subtle differences in reporting these transactions, so taxpayers are well advised to review the information in these free IRS publications. These are available for download on the IRS.gov website or by calling 1-800-829-3676:

Publication 550, Investment Income and Expenses – Covers the sale of stocks, bonds and exchange traded stock options.

Publication 564, Mutual Fund Distributions – Covers the sale of mutual fund shares.

Publication 525, Taxable and Nontaxable Income – Covers income from employee stock options.

Notice — Clarification of the 2005 Instructions for Schedule D (Form 1040)

The IRS has received many inquiries about a new instruction that was added on page D-6 of the 2005 Schedule D instructions for completing lines 1 and 8. The new instruction states:

"You must enter the details of each transaction on a separate line. If you have more than five transactions to report on line 1 or line 8, report the additional transactions on Schedule D-1. Use as many Schedules D-1 as you need. Enter on Schedule D, lines 2 and 9, the combined totals from all your Schedules D-1. Do not enter "see attached" and summary totals from an attachment in lieu of reporting the details of each transaction directly on Schedule D or D-1."

However, on page D-3 of the 2005 Schedule D instructions, the instructions for "Traders in Securities" state:

"Like an investor, a trader must report each sale of securities (taking into account commissions and any other costs of acquiring or disposing of the securities) on Schedule D or D-1 or on an attached statement containing all the same information for each sale in a similar format."

The instructions on page D-3 for traders (and investors) have been unchanged since the year 2000. The new instructions on page D-6 were meant to highlight and clarify these rules, not to change them. Therefore, taxpayers may continue to use a substitute statement to provide all of the same information and in a similar format to lines 1 and 8 of Schedules D and D-1. They are not required to use the official version of Schedules D and D-1 to provide the details on each transaction. However, the details of each transaction still must be provided with the tax return and not just upon request.

The 2005 Instructions for Schedule D (Form 1040) is now available for download ( PDF version) or for viewing online ( HTML version). -- 09-JAN-2006

http://www.irs.gov/formspubs/article/0,,id=109875,00.html

 A Traders Tax Responsibilities



Colin M. Cody, CPA, CMA
TraderStatus.com LLC
6004 Main Street
Trumbull, Connecticut 06611-2400

(203) 268-7000