Features of Trader Status
(see Mark-to-Market Trader for different features)
Some features of Trader Status are:
- Filing with Trader Status allows you to optionally elect the §475(f) mark-to-market method of accounting.
- Effective for years 2011 and thereafter, there is a complicated reconciliation of IRS Form 8949 and the broker issued Form 1099-B that is required.
- The year’s net trading losses are “capital losses” and are therefore limited to the annual $3,000 “capital loss” limitation. The year’s net trading losses in excess of $3,000 get added to any existing balance of your prior years’ capital loss carryforwards.
- The year’s net trading gains are “capital gains” and are therefore offset against any old prior years’ “capital loss” carryforwards.
- The year’s net trading gains, while part of a trade or business, are nonetheless not subject to Self-Employment tax under IR Code §1402(a)(3)(A) as further clarified by IR Code §1402(i) because they are taxed as “capital gains” (and they are of course subject to the capital gain tax rates).
- Since net trading gains are not subject to Self-Employment tax no deduction for an IRA or other Retirement plan or Health Insurance plan may be directly based on them. (but by forming a separately filing trading entity self-employment income can be created)
- The year’s net trading gains remaining after any offsetting capital loss carryforwards are usually taxed at the short-term (held less than twelve months) capital gains rates. Additionally, it is possible that some securities, if inherited or if held in excess of twelve months, may be taxed at the lower long-term capital gains rates.
- The year’s net trading gains in §1256 contracts (futures) are usually taxed 40% at the short-term (held less than twelve months) capital gains rate and 60% at the long-term (held more than twelve months) capital gains rate.
- The year’s trading gains and losses in each specific §988 transaction (FOREX) are usually taxed at the regular ordinary income rates as interest income or deducted as interest expense.
- The year’s trading gains and losses in each specific §988 transaction (FOREX) are usually taxed as a regular §1256 contract if you elected under §988(a)(1)(B) by the end of the day that the position was opened, pursuant to §988(c)(1)(B)(iii).
- Stocks are identified as either being subject to trader status or as held for investment. Expenses associated with the investment securities are not allowed to be full deductible as business expenses, but rather are itemized deductions subject to limitations.
- The Wash Sales rule is applicable for these securities.
- The activity is not treated as a passive activity, even if held passively through a trader entity.
- The income is not treated as portfolio income.
- A wife may have a trader status business separate and apart from her husband’s.
- Any paper gains or losses on securities held overnight on December 31st are usually deferred until they are actually sold and are not shown on the current year’s tax return.
- Sole proprietors report expenses (which generally includes margin interest) on Schedule C and trading activity (which generally includes the commissions thereon) on Schedule D.
- Sole proprietors may report each individual trade on IRS Schedule D & Form 8949. At times the IRS may restrict the old “see statement attached” along with summary totals and they may prohibit the old “details provided upon request” as well.
- Partners, LLC members and S-Corp shareholders report passthru amounts on Schedule E and other tax forms.
- Partners, LLC members and S-Corp shareholders deduction for margin interest may be limited if they are not active managers.
- Partners’, LLC members’ and S-Corp shareholders’ gains and losses reported on Schedule K-1 Form 1065, box 11F and Form 1120S, box 10E are not, as is commonly thought, ordinary gains or losses, but they are short-term and/or long-term capital gains and losses. (unless a M2M election was made by an upper tier passthru entity)
- Partners, LLC members, S-Corp shareholders and C-Corp shareholders may be subject to Self-Employment tax and therefore may be able to have a deduction for a Retirement plan or Health Insurance plan.
A securities trader is someone engaged primarily in speculative activity from which he or she derives most of his or her income, seeking to profit from short-term market swings. (Liang v. Comr.)
A trader will not be looking for interest income or dividends from the stocks he buys. The stocks held by a trader are usually characterized by high price volatility rather than a dividend yield or long-term growth potential.
But what if an individual is not primarily engaged as a trader? In other words, what if trading, while very active, is only a part-time or seasonal activity? What if the individual has full employment elsewhere? What if the individual has significant interest income or dividends from non-trading investments? There’s still an answer! Look into A Trader’s Choice of Entities.
Strange as it may seem, the IRS Code does not define who or what a securities trader is (but starting in 2000 the IRS Form 1040 instructions do). To further guide us there are a number of Tax Court decisions which decided whether a taxpayer’s transactions in securities constituted a bona-fide trade or business. Among the most important court decisions were those regarding whether a full-time professional gambler’s wagering activity constituted a trade or business for income tax purposes. (Groetzinger v. Comr. 1985) “there is an equitable basis for according a high-volume short-term trader different tax treatment than the taxpayer who occasionally engages in a short-term trade.”
In (Comr. v Groetzinger 1987), the Supreme Court concluded “to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer’s primary purpose in engaging in the activity must be for income or profit.” This landmark decision confirmed the availability of trader status for income tax purposes. (IRC §162(a) and §62(a)(1)).
Example: An individual’s trader status was approved where his entire income was derived from his securities trading (a good argument for setting up your own pure-play trading entity), he devoted his whole working day to his stock transactions (having W-2 wage employment is not helpful here, again an argument for establishing an entity), and judgments regarding purchases and sales were made directly by him, based on his personal investigation of the assets, operation, and management of various corporations. In addition, the sheer quantity of transactions he conducted supported a reasonable conclusion that his business was trading on his own account. In the year in question, he conducted 332 transactions representing the transfer of 112,400 shares with a total value of over $3,000,000. Furthermore, it was his practice to buy to the maximum extent of allowable margin. (Levin, Samuel)
To substantiate your stock, option and futures trading activity, it is a good idea each day for some traders to print out their activity, including the unexecuted limit orders. This can then be given to IRS in the case of an audit. These print-outs will show more activity than mere executed orders that are reported on Schedule D, Form 6781 and Form 4797.
Taxpayers who qualify to file as Trader Status may optionally “elect” to do so simply by filing with the IRS a tax return reflecting this procedure for the “election” year and then optionally “elect” again for each ensuing year.
Note: do not confuse “electing” TraderStatus with electing market-to-market.
This “election” treats what might otherwise be Schedule A “itemized deductions” instead as Schedule C “ordinary and necessary business expenses.” Generally a trader must make the “election” by filing a tax return or amended or superseding tax return that reflects this procedure (if not using efile, then we suggest traders use certified mail with return-receipt-requested) with the IRS office where the trader normally mails his or her tax filings (1040, 1040X, 1065, 1065X, 1120S, etc.) within the prescribed statute of limitation period. That normally means within three years after the due date of the original tax return. The IRS has seen tens of thousands of taxpayers who have made the decision to file this way.