Burgess J.W. Raby, Esq., and William L. Raby, CPA, of the Raby Law Office, Tempe, Ariz., discuss issues arising out of the mark-to- mark election such as late filing and highlight potential problems.

Date: May 21, 2002
 

Burgess J.W. Raby, Esq., and William L. Raby, CPA, associated with the Raby Law Office in Tempe, Ariz., and contributing authors to Tax Notes' column Tax Practice and Accounting News, discuss issues arising out of the mark-to-mark election such as late filing and highlight potential problems.

In "The Security Trader: Ordinary Deductions and Capital Gains," Tax Notes, June 20, 1994, p. 1603, we explored the definitions and tax consequences of being classified as a security trader circa 1994. To somewhat paraphrase our conclusions, we noted that, "The trader can get all of the deductions to which the dealer is entitled, while still retaining the investor's ability to realize capital gains (or suffer the capital loss limitations). The classification of a given taxpayer as a security investor or security trader for a given year is a matter of facts and circumstances. Generally, traders have frequent transactions, short holding periods, and lack customers." The lines separating the categories of investor, trader, and dealer are not always clear, we suggested, not least so because a given taxpayer may, for a given year, be one or another or all three, with different transactions falling into different classifications.

Relatively few people had the frequency of short-term transactions qualifying them as traders before 1994. The advent of Internet trading coupled with a burgeoning NASDAQ market resulted in an explosion in the number of security and commodity traders. Many of these were day traders, whose normal modus operandi is to close out all positions by the end of the day. These people clearly were not investors. The Internet also made possible new ways of executing security and commodity transactions, including direct matching of buy and sell orders, a point to which we will return again later. Then, in 1997, in the midst of this explosion in the number of traders, these traders received what many have hailed as a tax bonanza.

Mark-to-Market Election

The Taxpayer Relief Act of 1997 introduced section 475(f), which allowed both security and commodity traders -- as well as commodity dealers -- to elect to calculate their taxable income under the mark- to-market rules of section 475. Previously, mark-to-market had been mandatory under section 475(a) for security dealers as well as mandatory for certain contracts covered by section 1256, including regulated futures contracts and foreign currency contracts.

Prior to the 1997 change, the primary tax advantage of being a trader as opposed to being an investor was that the trader took Schedule C deductions for the business expenses, including margin interest, incurred in the trade or business of being a trader. In fact, the trader had an odd-looking Schedule C, reporting little or no income because gains and losses were all capital (albeit short- term), but substantial expenses. Section 475(f) allowed security and commodity traders to elect to calculate their taxable income under the mark-to-market rules of section 475. Traders who make a mark-to- market election convert their security or commodity trades from capital to ordinary, whether there is gain or loss. Thus the Schedule C for an electing trader shows gross receipts and cost of sales as well as expenses, and looks more conventional. For a true trader, there is normally no downside to the election unless there are existing capital loss carryovers otherwise soaking up short-term capital gains. The upside of the election is the ability to use losses against other income, not just against capital gains plus $3,000 of other income per year, and the ability to carry net operating losses in excess of current income back and receive refunds from prior years.

After the stock market trauma of 2000 and 2001, many traders looked longingly at the section 475(f) election when preparing returns showing large trading losses. They saw the election as a way of getting the government to refund them a part of the income taxes they had paid in prior years. But those who had sustained losses and then sought to make the section 475(f) election were in for a shock, as were some of the tax practitioners who handled their work.

Section 475(f) Election

A LIFO inventory election can be made with the first tax return to which it is applicable, thus providing an opportunity for a look- back before electing. Other automatic changes of accounting method usually can also be made on the return. The section 475(f) election is different. The statute is actually silent on the question of when the election is to be made, but Rev. Proc. 99-17, 1999-1 C.B. 503, Doc 1999-5430 (10 original pages), 1999 TNT 26-20 , fills the void. Sec. 5.03 of that procedure requires, for tax years beginning after 1998, that "[t]he statement [required by section 5.03(2)] must be filed not later than the due date (without regard to extensions) of the original federal income tax return for the taxable year immediately preceding the election year and must be attached either to that return or, if applicable, to a request for an extension of time to file that return."

Thus, an individual trader's election for the year 2000 had to be filed by April 15, 2000, and for 2001 by April 15, 2001. The trader who decided on March 27, 2002, that a section 475(f) election should be made for that person's 2001 income tax return was almost a year too late. But do not tax practitioners know how to deal with late elections, such as late S corporation elections? Of course. The taxpayer asks the IRS for an extension, lays the blame on the terribly complicated tax law and the stupid tax preparer who missed the timely filing date, and in due course the extension is granted and the taxpayer goes on without any problem. See, for example, LTR 200220013, Doc 2002-12033 (4 original pages) [PDF], 2002 TNT 97-17 (late section 338 election allowed), and LTR 200220016, Doc 2002-12036 (6 original pages) [PDF], 2002 TNT 97-21 (granting an extension of time to file a "closing of the books election" under reg. section 1.382- 6(b)).

This approach does not work with the section 475(f) election, however, a fact underscored with the release earlier this year of three private letter rulings. LTRs 200209052, Doc 2002-5152 (4 original pages) [PDF], 2002 TNT 42-48 , 200209053, Doc 2002-5153 (4 original pages) [PDF], 2002 TNT 42-50 , and 200209054, Doc 2002-5154 (5 original pages) [PDF], 2002 TNT 42-49 , were all similar. The taxpayer in each was reciting what might generally be considered good and sufficient reasons for the government to grant a reg. section 301.9100 extension of time for filing an election. Nevertheless, the extensions were denied.

Permission to File a Late Election

Reg. section 301.9100 sets the rules for extensions of time to make elections. Reg. section 301.9100-3(b)(3) provides, in part, that a taxpayer is generally not deemed to have acted reasonably and in good faith if the taxpayer uses hindsight in requesting relief. The taxpayer must provide strong proof that, in fact, the decision to make the late election did not involve hindsight. Such proof may be a practical impossibility for the securities or commodities trader with a 2002 loss who is seeking to make an election for 2002 in early 2003. The effect of the election would be to allow what otherwise would be a net capital loss from trading activities for 2002 -- the first year under the election -- to be converted to an NOL; the timing of the election is such that the losses already have been sustained when the extension is being requested. The NOL resulting from the election either offsets other income currently or becomes part of a NOL which can be carried back three years (for which the 2002 Job Creation and Worker Assistance Act substitutes five years for losses in 2001 and 2002) or forward for 20. All of the situations we have encountered where taxpayers were thinking of late elections involved losses in the election year. Traders do not contemplate at the start of a year that they will be sustaining losses in excess of gains. If they did, they probably would stop trading.

Because of the hindsight element discussed above, and the section 481(a) adjustment aspect of the election, to be discussed later, the LTRs each conclude that, "Taxpayer has failed to demonstrate unusual and compelling circumstances regarding his failure to make a timely election sufficient to overcome the presumption of prejudice to the Government's interests." Since the revenue procedure is the "exclusive procedure" for traders to make the mark-to-market election, we do not anticipate seeing many taxpayers being granted extensions of time for late elections.

Election Does Not Make A Person A Trader

The election itself is not what makes the taxpayer a trader. The taxpayer's activity must qualify him, her, or it as a security or commodity trader or commodity dealer. The section 475(f) election has no impact on that qualification. Contrary to some descriptions of the election, a person who makes a 475(f) election but is not actually a trader is not really converted into a trader by virtue of the election. On audit, the IRS can deny trader classification just as readily as it routinely uses denial of "trade or business" classification to take loss deductions from taxpayers who raise horses, sell Amway products, or travel as research for books they never get around to writing. For a discussion of what constitutes a trade or business for tax purposes, see Commissioner v. Groetzinger, 480 U.S. 23 (1987), 1987 TNT 37-7 , dealing with a gambler. For a discussion of the distinction between a trader and an investor, see Eugene Higgins v. Commissioner, 312 U.S. 212 (1941); and Nathan Boatner v. Commissioner, T.C. Memo. 1997-379, Doc 97-24124 (13 pages), 97 TNT 162-4 .

What the election does do is to permit a taxpayer who is a trader as to a specific year to write off net trading losses against other income without worrying about the limitations on using net capital losses. While the election is irrevocable without the IRS's consent, the requirement of "mark-to-market" should not apply, in our opinion, to any subsequent year in which the electing taxpayer fails to qualify as a "trader." For many traders, especially those who are or who border on being day traders, the actual impact of "mark-to- market" is nominal since few or no positions are carried over from one year to the next, while those electing traders who shift from trading to investing need not worry about "mark-to-market" if they properly identify their investment securities.

Section 481 Adjustment

One of the consequences of the section 475(f) election is to require all positions to be marked to market as of both the beginning and the end of the year. Section 6.03 of Rev. Proc. 99-17 then provides that a net positive difference between the beginning value of the positions and the amount at which they were carried is to be treated as income spread over the year of change and the subsequent three tax years. A net negative adjustment would be entirely deducted in the year of change pursuant to Rev. Proc. 2002-19, 2002-13 I.R.B. 1 (14 May 2002), Doc 2002-6514 (17 original pages) [PDF], 2002 TNT 51-9 .

One ambiguity in the election year calculations arises when a trader is also an investor. As of the first day of the first election year, that person's investment portfolio may be quite large and may contain substantial unrealized appreciation. The dealer rules -- applicable to traders electing under section 475(f) -- require that investment positions be identified as such before the end of the day they are acquired. As to all existing investment positions as of the date the election is actually made, that requirement is impossible for the electing trader to meet. Does that mean that the price for making the section 475(f) election is to recognize as ordinary income all of the appreciation in the trader's investment portfolio? We think not. We think that the securities held for investment as of the first day of the election year fall outside of the section 475(f) regime unless their status changes. Reg. section 1.475(d)-1 provides that "[i]f a security is never held in connection with the taxpayer's activities as a dealer in securities, section 475(d)(3)(A) does not affect the character of gain or loss from the security, even if the taxpayer fails to identify the security under section 475(b)(2)." The same rule should apply to electing traders once regulations are issued. This eliminates the ordinary income consequence but not necessarily the immediate recognition of the unrealized appreciation. However, when the taxpayer was not an electing trader at the time the securities were acquired, the identification requirements of section 475(b), which would be the applicable requirements under section 475(f)(1)(B), would seem inapplicable so long as the taxpayer could establish that the security was never a part of the taxpayer's trading business.

Since the taxpayer becomes an electing trader as to the entire election year even if the election is not made until part of the year (for example, January 1 -- April 15) has already passed, the rules would seem to require same day identification of investment securities acquired during that period. We would hope that regulations would clarify that identification of existing investment securities on or before the date of the election would avoid any controversy over their status, with same-day identification applying, of course, to all investment securities subsequently acquired. The practitioner might well advise any client who is a trader and also an investor, and who contemplates even the possibility of making a section 475(f) election, that identifying investment securities on the date of their acquisition in accordance with section 475(b)(2) would be a prudent step to take. The easiest way to do that is probably to maintain different accounts for investment securities and for trading activities. See Rev. Rul. 93-76, 1993-2 C.B. 235, as modified by Rev. Rul. 97-39, 1997-2 C.B. 62.

Using an Entity

One possible solution to the late election and investment security problems is to carry on the trading activities in a new entity. A new passthrough entity, for example, makes its section 475(f) election "by placing in its books and records no later than 2 months and 15 days after the first day of the election year a statement that satisfies the requirements in section 5.04 of this revenue procedure," according to section 5.03 of Rev. Proc. 99-17. "To notify the Service that the election was made, the new taxpayer must attach a copy of the statement to its original federal income tax return for the election year." The new entity has no investment securities, either, and no problems of a section 481(a) adjustment.

FSA 200111001, Doc 2001-7641 (8 original pages) [PDF], 2001 TNT 53-62 , [ http://www.irs.ustreas.gov/pub/irs-wd/0111001.pdf ]while not dealing with the section 475(f) election, makes it clear that the tax consequences of being a trader passes through to the partner from the partnership for those partners who are active participants in the trading activity. Those who do not materially participate in the trading activity will find the interest expense attributable to that activity treated as investment interest expense under section 163(d)(5)(A)(ii) rather than being treated as business interest. However, the general rule that would subject the losses of those partners to the passive activity loss rules does not apply. This is because of a special exception for the activity of trading personal property for the account of owners of interests in the activity. Reg. section 1.469-1T(e)(6) declares that such an activity is not a passive activity regardless of whether it is a trade or business activity.

Trade or Business and Self-Employment Income

Unlike the gambler who is determined to be in a trade or business, a taxpayer in the trade or business of trading securities or commodities does not realize self-employment income. This is because section 1402(a)(3) excludes any gain or loss from the sale or exchange of capital assets and section 475(f)(1)(D) provides that the ordinary income or loss treatment afforded an electing trader "shall not apply" for purposes of section 1402.

This rule is different for the electing commodity futures dealer, however. Keith M. Rudman v. Commissioner, 118 T.C. No. 21 (2002), Doc 2002-10457 (7 original pages) [PDF], 2002 TNT 83-9 , illustrates how the self-employment rules apply to commodity future dealers with or without the section 475(f) election. Rudman argued that, although he was a member of the Chicago Board of Trade (CBOT), his trading activities during the tax year 1994 were actually conducted through a floor broker rather than being handled directly by himself on the trading floor. Thus, he contended, his $1,541,926 of net gains in 1994 from trading commodity futures contracts subject to section 1256 should not be subject to self-employment tax despite the section 1402(i) provision that gains realized by options or commodity dealers from trading in section 1256 contracts are subject to such tax. The Tax Court held that Rudman remained a dealer for tax purposes inasmuch as he remained a member of the CBOT, and that his use of a floor broker instead of handling his trades himself did not change the result.

Trader vs. Dealer

Rudman was held to be a dealer even though he wanted to be classified as a trader. He wanted to be a trader so as to avoid the self-employment tax. Most of the tax cases on the question of trader vs. dealer have involved taxpayers who sought to be classified as dealers in order to avoid the capital loss limitations being imposed on the use of their losses. A recent case dealing with that issue in the context of government securities was Gary K. Bielfeldt v. Commissioner, 86 AFTR2d Par. 2000-5505 (7th Cir. 2000), Doc 2000- 28883 (4 original pages), 2000 TNT 218-14 , cert. denied Doc 2001- 25191 (5 original pages) [PDF], 2001 TNT 191-3 , in which the taxpayer was trading literally billions of dollars a year. For a discussion of the same issue in the context of a commodities trader vs. commodities dealer see Marlowe King v. Commissioner, 89 T.C. 445 (1987), acq. 1988-2 C.B. 1. Both of these cases emphasized heavily the fact that a dealer has customers, whereas a trader sells to or through dealers, and plays a vital role in providing liquidity to the marketplace.

The advent of new order handling rules from the Securities and Exchange Commission in January 1997 revolutionized trading in NASDAQ securities and created confusion as to what it meant to be selling to customers. Each market maker was required to display those customer limit orders priced at or better than the market maker's current quote if they were not immediately executed. Alternatively, the market maker could place an order into an eligible Electronic Communications Network (ECN) that would then display the order to the entire market. Following that, there came into existence ECNs designed to match bids and offers, such as Island (ISLD) and REDI. This then raised the question -- still unresolved -- whether persons who trade substantial amounts of securities directly with buyers and sellers using Island or REDI are now dealers for federal tax purposes. Security dealers must mark-to-market and the section 475(f) election is irrelevant to them. Thus, taxpayers who sustained substantial losses in 1999, 2000, or 2001, and who primarily traded through Island, REDI, or a similar ECN, but who failed to make a timely section 475(f) election, might have a basis for a refund claim on the ground that they were actually dealers and not traders during those years. They bought and sold directly and not through dealers.

Conclusion

The section 475(f) election can make the government an insurer of sorts against losses in the taxpayer's trading activities. In the typical trader scenario, there is little downside to making the election since trading activities will not, by definition, produce long-term capital gain and the short-term capital losses that may be sustained are of limited tax benefit. Making the election will not result in self-employment income. It will eliminate the need to worry about the wash sale rules of section 1091, as to which see section 475(d)(1). The problems arising with making the election involve attempts to make late elections and the absence of clear guidance as to the transitional handling of the existing investment portfolios of traders who are also investors.