Am I a Trader?

Trader's Office
For IRS tax purposes a Trader might operate as a “trade or business” if the intent is to profit from market price swings as the primary source of income for the year. With this as the intent, then once the taxpayer’s activity rises to a sufficient level it may be taxed under trader status rather than, by default, as an investor (investor status).

For the trade or business to gain Securities Trader Status or Financial Instruments Trader Status or Commodities Trader Status with the IRS it might buy and sell Stocks, Stock options, Bonds, Futures, Commodities, E-mini’s, QQQQ options, §1256 contracts, foreign currency contracts and so on.

Generally speaking to have Trader Status your frequent trading activity must be substantial and you must carry on the activity with continuity and regularity.

Per an IRS audit/examination guide, you must not have any interest in “capital appreciation” or even in “conservation of capital.” While it is true that generally a knowledgeable business person should probably have money management as a major concern, it is a fact that IRS agents have these instructions in their audit guides.

Avoid tax return preparation “errors” that the IRS is wise to. Some preparation firms make extra money handling the IRS inquiries and examinations resulting from such “unintentional” oversights. We feel that it is best to do it right the first time and avoid questions from the IRS.


As a very general and over-simplified “set of rules” for a newbie to start with and gain a relative understanding applicable to your IRS taxes:

  1. Without having BOTH Trader Status & M2M (Mark-to-Market) your overall net Securities Trading losses are limited to a deduction of $3,000, per year.

  2. Forex and Futures (including Options on futures, Commodities and many Index trading instruments) have different tax rules.

  3. To use (to have) M2M for your Securities Trading you MUST have Trader Status and you MUST have made a timely, written, automatically approved M2M election and in some cases, also filed an IRS Form 3115 in duplicate.

  4. Generally, to have Trader Status you SHOULD absolutely trade:     actively.     frequently.     with continuity (meaning have relatively few periods of inactivity).    and be using a reasonably substantial amount of liquid assets.

  5. Furthermore, you are BETTER OFF with:    no interest income.     no dividend income.    more margin interest.    shorter holding periods.    fewer long-term holding periods.     few, if any, investments or other sources of income (such as long-term stock holdings, family business S-corp or LLC, W-2 wages, 1099-NEC self-employment income, rental property, trust-fund baby income, etc).


 

Beware of these common misconceptions:
Please note that obtaining “trader status” alone results in no change from the norm for reporting your gains and losses – which is to say, they remain being taxed under a Schedule D and Form 8949 “realization method” for capital gains and losses. If you wish to obtain Form 4797 ordinary gains and losses tax treatment you must further elect “mark-to-market” under stringent rules (see Rev. Proc. 99-17). And if you wish the later change back to a realization method, there are additional stringent rules (see Rev. Proc. 2015-14) to be followed right down to the nth degree.

Please note further that once obtaining “trader status” with or without having elected “mark-to-market” that the security trades generally must still be accounted for by matching purchases and sales on a FIFO basis (unless “versus purchase” or other method is stated at the time of sale) and listing each matched transaction in a format similar to what is found on IRS Schedule D and Form 8949. This reporting format does not change whether the trader is an individual person, a LLC, or a corporation.  Starting with 2013, there is a limited exception allowing for the use of an aggregated total on Schedule D, lines 1a and 8a.    And for certain separately filing trader entities (Forms 1120S or 1065) and rarely for certain individuals, summary totals on Form 8949 are allowed.

 

Individuals and most Individually owned SMLLCs:

  • Under audit, it should be evidenced that the taxpayer had a substantial portion of his liquid net worth trading the market. Ideally even using margin.
  • There should be monthly sells. preferably weekly sells, even more preferably daily sells.
  • There should probably be at least 200 to 500 significant sells per year with a minimum of maybe 1/36th of the year’s number of sells occurring in each month. Ideally, each week should see some selling.
    • ○ Traders with 1,000 or more significant sells per year usually clearly qualify for trader status.
    • ○ Traders with less than 100 or 200 sells may have a tougher time substantiating trader status.
      • ◙ Mostafavi, California State Board of Equalization, July 1, 2005, The taxpayer was not in the business of being a day trader and was not entitled to related business expense deductions, because he did not trade frequently, regularly, and continuously throughout the year and his trading activity was not the primary source of his income during the year. The taxpayer conducted only 238 trades on 83 days during the year, and he had a full-time job as a field sales engineer.
    • ○ Traders with significant sells numbering between 200 and 500 or 1,000 often can qualify for trader status but they might be under more scrutiny during an audit than would someone with more significant volume.
  • The typical holding period for most sells should be four months or less, preferably one month or less, even more preferably one week or even daily.
  • The taxpayer should spend a good part of most every day watching and trading the markets during trading hours.
  • The taxpayer should be looking for this activity to be the primary way to provide his livelihood. i.e. he should avoid having a “regular day job.”
  • The taxpayer should maintain a business-like operation: good books and records, continuing education books and seminars and so on.
  • It can be said that a better rule of thumb is to only claim trader status as an individual reporting income on tax Form 1040 whenever the activity is your only job and you have no other funds available to support yourself with. Otherwise form a separately filing entity that will not use Form 1040

Entities (including SMLLCs) filing separate tax returns:

  • Under audit, it should be evidenced that the trading entity had all it’s capital in the market and was actively trading it. Ideally even using margin.
  • There should be monthly sells. preferably weekly sells, even more preferably daily sells.
  • There should probably be at least 100 to 300 significant sells per year with a minimum of maybe 1/36th of the year’s number of sells occurring in each month. Ideally, each week should see some selling.
  • Traders with 750 or more significant sells per year usually clearly qualify for trader status.
  • Traders with less than 100 or 200 sells may have a tougher time substantiating trader status.
  • Traders with significant sells numbering between 100 and 500 or 750 often can qualify for trader status but they might be under more scrutiny during an audit than would someone with more significant volume.
  • The typical holding period for most sells should be four months or less, preferably one month or less, even more preferably one week or even daily.
  • The entity should spend a good part of most every day watching and trading the markets during trading hours.
  • The entity especially should maintain a business-like operation: good books and records, continuing education books and seminars and so on.


U.S. Tax Court cases with taxpayers who screwed up their trader status and M2M election one way or another (learn from their mistakes)

  • June 1, 2004. Taxpayer went up against the IRS alone as a “pro se” in Tax Court.
    • ○ 303 of the year’s 323 transactions occurred in February through April, meaning only 20 transactions were made during the rest of the year. 🙁
    • ○ Taxpayer was employed full-time as a computer chip engineer (and did not set his trading up within a separate entity) and therefore the trading was not the “sole or even primary activity in which the taxpayer engaged for the production of income.” 🙁
    • ○ Taxpayer failed to timely file a §475(f) M2M election before filing his tax return. 🙁
    • ○ Taxpayer even failed to file his tax return on time. 🙁
    • ○ Taxpayer filed his tax return only after it was already two years late and he was contacted by the IRS looking for $611,357 tax based on the gross amount of his sales of securities. 🙁
    • ○ Taxpayer then filed an amended tax return with a “retroactive M2M election” seven weeks later. 🙁
    • ○ The “retroactive M2M election” was prepared using “fractured English,” rather than the more specific language required by the IRS Rev. Proc. 🙁

See Frank Chen, TC Memo. 2004-132. The IRS walked all over the taxpayer, though quite frankly the taxpayer had a weak argument that he was a trader rather than an investor and in any event, he was not entitled to use the M2M method of accounting. He apparently filed his tax returns on his own, 🙁 and he went up against the IRS and the Tax Court alone rather than with a trader status tax advisor and a lawyer familiar with the Tax Court procedures. 🙁

 

  • August 11, 2008. Taxpayers using a husband-wife LLC lose mightily against IRS attack on their trader status. Deemed to be investors rather than traders, the Court primarily looked to the evidence of the reported trading operations:
    • ○ Their trading station, using a four computer monitor set-up, was in a dedicated room in their residence. 🙂 But the equipment was not reported on the LLC tax return. 🙁
    • ○ M2M election was documented as being timely made on May 17, 2001 (probably on their internal books and records). 🙂
    • ○ The brokerage accounts apparently were held in the bare legal title name of the individual with the individual’s social security number (rather than held in the name of the LLC with the LLC’s taxpayer ID#) 😐 and they were used by the individual, as his own, prior to the formation of the LLC. 😐
    • ○ 2001 – 289 trades were executed (no definition if a trade is a buy&sell or if a buy alone is a trade and a sell alone is a trade). Gross sales $754,277. Margin interest of $7,660. 🙂 They traded on 63 different days (40% of total possible days) 😐
    • ○ 2002 – 372 trades were executed. Apparently there was zero margin interest. 🙁 They traded on 110 different days (45% of total possible days) 😐
    • ○ Most positions were held open more than 31 days. Very few were one-day flips. 😐
    • ○ Form 1040 was prepared using a (likely) pre-LLC trader status Schedule C (it is possible that this and other basic errors and oversights are what initiated the IRS inquiry to begin with). 🙁
    • ○ Taxpayer was (probably) greedy and after losing $180,174 in 2001 from their LLC trading business, they took another $80,100 of additional trading “business expenses” on the Schedule C. 🙁
    • ○ Continuing the (probable) greed in 2002 the taxpayer avoided the use of Schedule C, but took $34,294 of trading “business expenses” via the LLC on top of losing $11,227 from their trades. 🙁
    • ○ The taxpayer’s defense failed to show “that they sought to catch the swings in the daily market movements and to profit from these short-term changes.” 🙁

See William G. Holsinger, TC Memo. 2008-191, Dec. 57,512(M). The taxpayers apparently retained well-qualified estate planner tax attorney’s to represent themselves in this IRS controversy. They also apparently retained a well-qualified estate planning attorney as the registered agent for the LLC. But we have seen no indication that any tax professional having extensive experience with the unique characteristics of trader status was ever retained or consulted with by the taxpayers.



  • July 6, 2011. Taxpayer defending himself as a “pro se” goes down in flames with $200,000 income taxes due, plus $40,000 in negligence penalties. Some of the facts in this case:
    • ○ Taxpayer was earning his living from operating a ball bearing manufacturing and distribution business (rather than from trading). 🙁
    • ○ M2M election was documented as being timely made in 1999. 🙂
    • ○ Over three years taxpayer had only 313, 72 and 84 buys or sells. 🙁
    • ○ Over three years taxpayer had activity (a buy or a sell) on only 29% 7% and 8% of the days that the stock market was open. 🙁
    • ○ Over three years taxpayer had only 6, 4 and 3 same day trades. 😐


See Richard Kay Jr., TC Memo. 2011-159. [alternative link]



  • August 28, 2013. Taxpayer defending himself as a “pro se” loses it all – owes income taxes and penalties.
    • ○ Taxpayer held too many common stock positions long-term, earning dividends and writing call options to reduce risk and enhance returns. 🙁
    • ○ Heavy use of margin. 🙂
    • ○ Over three years taxpayer had only 204 🙁 303 🙁 and 1,543 🙂 buys or sells.
    • ○ Over three years taxpayer had activity (a buy or a sell) on 75, 99 and 112 days. 😐
    • ○ Over three years taxpayer had 10 months where he executed less than 4 trades. 🙁
    • ○ Not only did the taxpayer fail to have a CPA and Lawyer involved in his representation, his home-brewed “research” was mostly limited to information gleaned from the IRS web site. 🙁
    • ○ The taxpayer’s “average holding period of 35 days demonstrates that he was not attempting to catch and profit from the swings in the daily market.” 🙁


See Thomas Endicott, TC Memo. 2013-199.



  • October 19, 2015. Taxpayer is denied M2M treatment.
    • ○ Taxpayer held funds earning interest, he was not trading using margin. 🙁
    • ○ The taxpayer reported gross income was $370,235, and 43% on this was interest income, 🙁 but this was unusual for the taxpayer. 😐
    • ○ Taxpayer had a full-time job as a high school teacher. 🙁
    • ○ But the reported wages were only $38,462 vs. $142,278 trading income. 🙂
    • ○ Taxpayer devoted four to five hours a day researching his trades. 🙂
    • ○ Dividends received on open positions were merely incidental. 🙂
    • ○ Taxpayer’s intent was for short-term trading profits. 🙂
    • ○ Taxpayer averaged 60 trades per month in 2003 and the court agreed that this volume and frequency, along with other factors, reached trader status. 🙂
    • ○ Taxpayer averaged 400 trades per month in 2007, the loss year. 🙂
    • ○ Taxpayer consulted with his accountant and he intended to elect section 475(f) M2M election for 2003. 🙂
    • ○ Taxpayer’s accountant, as one of those busy so-called experts, failed to result in a M2M election that would stand up to IRS scrutiny, possibly due to failing to provide the necessary personal attention that was needed. 🙁
    • ○ Taxpayer did not retain a signed copy of his M2M election, nor any evidence of mailing it. 🙁 🙁
    • ○ Taxpayer filed his 2003 tax return one year late. 🙁
    • ○ Taxpayer failed to attach Form 3115 to the 2003 tax return. 🙁 🙁
    • ○ Taxpayer reported the 2003 trades on his Schedule C, rather than on Schedule D or From 4797. 🙁
    • ○ For the loss year, 2007, the taxpayer failed to file his tax return. 🙁 🙁
    • ○ Nine months after the IRS prepared an SFR and issued a deficiency, the taxpayer filed his 2007 tax return using a realization method for short-term and long-term capital gains on Schedule D. 🙁
    • ○ One year later the taxpayer amended his 2007 tax return, claiming M2M losses. 🙁
    • ○ Taxpayer attached a Schedule K-1 to his 2007 tax return, showing those M2M losses thereon. 🙁
    • ○ No evidence was provided to show that the entity that purportedly issued the Schedule K-1 had itself elected M2M. 🙁
    • ○ The validity of the actual Schedule K-1 itself was questionable (fraudulent). 🙁 🙁 🙁
    • ○ Taxpayer made an unallowable election to carry forward his 2007 trading losses (because refunds from carrying them back would have been denied under RSED. 🙁


See William F Poppe, TC Memo. 2015-205.

The IRS Tax Elections

Trader Status

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, 1040-X, 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.

Mark-to-Market

Taxpayers who qualify to file as Trader Status may optionally elect, by a filing a Rev. Proc. 99-17 election statement with the IRS, to use as their accounting system one or both of the §475(f) “Mark-to-Market” methods. These accounting methods treat what would normally be Schedule D “capital gains and losses” as Form 4797 “ordinary gains and losses” and also exempts these “ordinary gains and losses” from the wash sale rule.  Accordingly, those taxpayers who qualify may elect to adopt the “Mark-to-Market” method, or they may elect to change to the “Mark-to-Market” method.  The designated Form 3115 automatic accounting method change number is “64.”  (see Rev. Proc. 99-17)

Click here for some other features of a Mark-to-Market Trader.

Revoking Mark-to-Market

Taxpayers who qualify may optionally request permission, by filing the Rev. Proc. 2015-14 Notification Statement with the IRS, to change their method of accounting from “Mark-to-Market” to a realization method and when applicable, including a statement revoking their §475(f) election or elections. The designated Form 3115 automatic accounting method change number is “218.” (see Rev. Proc. 2015-14)

FOREX & Futures §988 and §1256

Taxpayers (not necessarily traders) generally may elect as provided in §988(a)(1)(B) and elsewhere, to have certain §988 forward contracts, etc. taxed under §1256.

Taxpayers (not necessarily traders) generally may elect as provided in §1.988-1(a)(7)(ii) and elsewhere, to have certain §1256 futures contracts and non-equity options, etc. taxed under §988.

Doctrine of Election

Taxpayers who have elected are bound by the election. The doctrine of election as it applies to federal tax law consists of two elements:

  1. There must be a free choice between two or more alternatives; and
  2. there must be an overt act by the taxpayer communicating the choice to the Commissioner, i.e., a manifestation of the choice.


See Grynberg, 83 T.C. at 261. See also Bayley v. Commissioner, 35 T.C. 288, 298 (1960), acq., 1961-2 C.B. 4; Burke & Herbert Bank & Trust Co. v. Commissioner, 10 T.C. 1007, 1009 (1948). Pursuant to the doctrine of election, a taxpayer that makes a conscious election under the tax laws may not, without the consent of the Commissioner, revoke or amend its election merely because events do not unfold as planned. See, e.g., J.E. Riley Inv. Co. v. Commissioner, 311 U.S. 55 (1940); Pacific Nat’l Co. v. Welch, 304 U.S. 191 (1938).

Duty of Consistency

Taxpayers who have elected are bound by the election. The duty of consistency as it applies to federal tax law is sometimes referred to as quasi-estoppel,  It is an equitable doctrine that Federal courts historically have applied in appropriate cases to prevent unfair tax gamesmanship. Beltzer v. United States [Dec. 50,969 ], 105 T.C. 324 (1995); LeFever v. Commissioner [96-2 USTC ¶60,250 ] 100 F.3d 778 (10th Cir. 1996).

The duty of consistency doctrine “is based on the theory that the taxpayer owes the Commissioner the duty to be consistent in the tax treatment of items and will not be permitted to benefit from the taxpayer’s own prior error or omission.” Cluck v. Commissioner, supra at 331.

It prevents a taxpayer from taking one position on one tax return and a contrary position on a subsequent return after the limitations period has run for the earlier year. If the duty of consistency applies, a taxpayer who is gaining Federal tax benefits on the basis of a representation is estopped from taking a contrary return position in order to avoid taxes.

Michael C. Hollen and Joan L. Hollen v. CommissionerDocket No. 5586-97., TC Memo. 2000-99, 79 TCM 1719, Filed March 24, 2000.