Definition of a Securities Trader

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The Taxpayer Relief Act of 1997 summarized that “traders in securities generally are taxpayers who engage in a trade or business involving active sales or exchanges of securities on the market. rather than to customers.”

The IRS FAQ site has said that: “Investors trade solely for their own account and do not carry on a trade or business. Their securities sales result in capital gain or loss and their deductible expenses are itemized deductions. Dealers sell securities to customers in the ordinary course of trade or business. Their sales result in ordinary gain or loss [generally subject to self-employment tax] and their deductible expenses are trade or business expenses. Traders buy and sell securities frequently but have no customers. Their purchases and sales result in capital gain and loss [generally not subject to self-employment tax, and optionally converted to ordinary gains and losses via electing to use the mark-to-market method of accounting], and their deductible expenses are trade or business expenses.”

“Even if you engage in extensive securities activities, you are an investor, not a dealer or trader, if you do not seek profit primarily in swings in daily market movements, and [sic OR you] do not personally engage in or direct the purchases or sales. An investor trades for profit-motivated reasons such as long-term appreciation, dividends and interest. Whether the activities of an individual constitute trade or business or investment is determined from the facts in each case. These distinctions have been established through court cases.”


Definition of a Securities Trader – Tax Court
“…in order to qualify as a Schedule C trader in securities, a taxpayer is generally required to rely on trading activity as a primary source of income and meet meticulous recordkeeping standards.”

“Petitioner did not qualify as a Schedule C trader in securities because he had substantial Form W-2 income for some of the years in issue and failed to present any of the required mark-to-market accounting.”

T.C. Memo. 2009-11
EDWARD R. VOCCOLA, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent


What the Court thought of an internet based tax advisor’s recommendation to retroactively have a client make his so-called “internal” M2M election:

“The Form 1065 was signed by petitioner’s accountant … At the conference petitioner claimed that as partners he and his wife made an ‘internal’ election in 2000 to use the mark-to-market method of accounting.”

“We disagree. ..petitioner’s Form 1065 was never filed with respondent, was not signed by petitioner and his wife, and was not submitted to respondent’s counsel until over 5 years after it was due. Additionally, petitioner did not attach to petitioners’ tax returns for 2000, 2001, or for any other year, a statement making the mark-to-market election, identifying the first taxable year for which the election was to be effective, and describing the business to which the election was to relate. Courts have consistently held that a securities trader did not make an election under section 475 where the trader did not follow the election requirements of Rev. Proc. 99-17, supra.”

T.C. Memo. 2008-297
MARK N. KANTOR AND MARLA R. KANTOR, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent


What a typical Trader in Securities looks like (per the Courts):

  • A trader purchases and sells securities frequently to catch the daily market movements and to profit on a short-term basis. (C.H. Liang v Commr)
  • A trader’s profits are derived through direct management of purchasing and selling. (R.E. Purvis v Commr)
  • A trader does not perform merchandising functions or any services that need be compensated, and does not have any customers. (G.R. Kemon v Commr)
  • A trader engages in a continuous volume and magnitude of purchases and sales. (J.M. Ferguson, Sr. v Commr)
  • The amount of time spent on trading is important to trader status. (Chemical Bank & Trust Co. v US)
  • A trader’s activities are directed to short-term trading, not the long-term holding of investments, and income principally is derived from the sale of securities rather than from dividends and interest paid on those securities. Relevant considerations in determining whether a taxpayer is a trader or investor are the taxpayer’s investment intent, the nature of the income to be derived from the activity, and the frequency, extent, and regularity of the taxpayer’s securities transactions. (R.E. Purvis v Commr)
  • Consider the subjectivity of what in particular is meant by the frequency, extent and regularity of transactions that identify the person entering into them as a trader rather than an investor.
  • A trader engages in transactions almost daily for a continuous period that exceeds a single tax year. (F.Chen v Commr)
  • Traders ordinarily engage in trading activity as a sole or primary source of income. (F.Chen v Commr)


The tests for Trader Status as outlined in detail by the Court in 2015:

In determining whether a taxpayer in a securities activity is engaged in a trade or business, courts have distinguished between “traders”, who are in a trade or business, and “investors”, who are not. Mayer v. Commissioner, T.C. Memo. 1994-209 (citing Moller v. United States, 721 F.2d 810, 813 (Fed. Cir. 1983)). Management of securities investments, whatever the extent and scope of such activity, is seen as the work of a mere investor, “not the trade or business of a trader.” Id. (quoting Estate of Yaeger v. Commissioner, 889 F.2d at 34); see also Whipple v. Commissioner, 373 U.S. 193, 202 (1963); Higgins v. Commissioner, 312 U.S. at 217; Paoli v. Commissioner, T.C. Memo. 1991-351. This result is the same notwithstanding the amount of time the individual devotes to the activity. Mayer v. Commissioner, T.C. Memo. 1994-209.

Even “full-time market activity in managing and preserving one’s own estate is not embraced within the phrase ‘carrying on a business,’ and * * * salaries and other expenses incident to the operation are not deductible as having been paid or incurred in a trade or business.” Commissioner v. Groetzinger, 480 U.S. at 30; Mayer v. Commissioner, T.C. Memo. 1994-209. Instead, an investor’s expenses are deductible under section 212 as incurred in the production of income.

In determining whether a taxpayer who manages his own investments is a trader, nonexclusive factors to consider are:
MY COMMENT: the court has said here that one who “manages” his “investments” can be a trader.  This differs from other court decisions.

  1. the taxpayer’s investment intent,
  2. the nature of the income to be derived from the activity, and
  3. the frequency, extent, and regularity of the taxpayer’s securities transactions.

Moller, 721 F.2d at 813.

Thus, a taxpayer’s activities constitute the trade or business of trading only where both of the following are true:

  1. the taxpayer’s trading is substantial and
  2. the taxpayer seeks to catch the swings in the daily market movements and to profit from these short-term changes, rather than to profit from the long-term holding of investments.

Mayer v. Commissioner, T.C. Memo. 1994-209.

As to the first requirement, “substantial” means frequent, regular, and continuous enough to constitute a trade or business. Holsinger v. Commissioner, T.C. Memo. 2008-191. Sporadic trading does not constitute a trade or business. Commissioner v. Groetzinger, 480 U.S. at 35; Mayer v. Commissioner, T.C. Memo. 1994-209. The number of trades executed in a year and the amount of money traded are helpful in determining whether a taxpayer’s trading activity was “substantial”. Holsinger v. Commissioner, T.C. Memo. 2008-191.

As to the second requirement, a trader’s activities must seek profit from short-term market swings, unlike those of an investor who seeks capital appreciation and income and who is usually not concerned with short-term market developments that would influence prices on the daily market. Paoli v. Commissioner, T.C. Memo. 1991-351. Courts also look at whether the taxpayer’s securities income is principally derived from frequent sales of securities, rather than from dividends, interest, or long-term appreciation. Moller, 721 F.2d at 813; King v. Commissioner, 89 T.C. 445, 458-489 (1987); Liang v. Commissioner, 23 T.C. 1040, 1043 (1955); Mayer v. Commissioner, T.C. Memo. 1994-209.

Petitioner meets the first prong of the two-part test outlined above. In 2003 petitioner executed about 60 trades each month, for a total of approximately 720 trades per year. Petitioner’s trading was not sporadic. …We find petitioner’s trading was sufficiently frequent, regular, and continuous to constitute a trade or business.

In addition to petitioner’s intent, we look to the two fundamental criteria that distinguish traders from investors: the length of the holding period of the securities and the source of the profit. Estate of Yaeger v. Commissioner, 889 F.2d at 33; Mayer v. Commissioner, T.C. Memo. 1994-209.

T.C. Memo. 2015-205
WILLIAM F. POPPE, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent


Definition of a Securities Trader
Since 2000 the instructions for Form 1040, Schedule D state: “To be engaged in business as a trader in securities (all of the following statements must be true):

  • 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.
  • You must carry on the activity with continuity and regularity

.

The following facts and circumstances should be considered in determining if your activity is a business:

  • Typical holding periods for securities bought and sold.
  • The frequency and dollar amount of your trades during the year.
  • The extent to which you pursue the activity to produce income for a livelihood.
  • The amount of time you devote to the activity.”

You are considered an investor, and not a trader, if your activity does not meet the above definition of a business. It does not matter whether you call yourself a trader or a “day trader.”


IRC §864(b)(2) Trading in securities or commodities

(A) Stocks and securities
(i) In general
Trading in stocks or securities through a resident broker, commission agent, custodian, or other independent agent.

(ii) Trading for taxpayer’s own account
Trading in stocks or securities for the taxpayer’s own account, whether by the taxpayer or his employees or through a resident broker, commission agent, custodian, or other agent, and whether or not any such employee or agent has discretionary authority to make decisions in effecting the transactions. This clause shall not apply in the case of a dealer in stocks or securities.

(B) Commodities
(i) In general
Trading in commodities through a resident broker, commission agent, custodian, or other independent agent.

(ii) Trading for taxpayer’s own account
Trading in commodities for the taxpayer’s own account, whether by the taxpayer or his employees or through a resident broker, commission agent, custodian, or other agent, and whether or not any such employee or agent has discretionary authority to make decisions in effecting the transactions. This clause shall not apply in the case of a dealer in commodities.

(iii) Limitation
Clauses (i) and (ii) shall apply only if the commodities are of a kind customarily dealt in on an organized commodity exchange and if the transaction is of a kind customarily consummated at such place.

(C) Limitation
Subparagraphs (A)(i) and (B)(i) shall apply only if, at no time during the taxable year, the taxpayer has an office or other fixed place of business in the United States through which or by the direction of which the transactions in stocks or securities, or in commodities, as the case may be, are effected.


Definition of a Securities Trader per proposed REG-130507-11 December 5, 2012
(C)(i) Distinguishing between dealers, traders, and investors

Determining whether trading in financial instruments or commodities rises to the level of a section 162 trade or business is a question of fact. Higgins v. Comm’r, 312 U.S. 212, 217 (1941); Estate of Yaeger v. Comm’r, 889 F.2nd 29,33 (2nd Cir. 1989). In general, section 475(c)(1) provides that the term dealer in securities means a taxpayer who (A) regularly purchases securities from or sell securities to customers in the ordinary course of a trade or business, of (B) regularly offers to enter into, assume, offset, assign, or otherwise terminate positions in securities with customers in the ordinary course of a trade or business. In contrast, a trader seeks profit from short-term market swings and receives income principally from selling on an exchange rather than from dividends, interest, or long-term appreciation. Groetzinger v. Comm’r, 771 F,2nd 269,274-275 (7th Cir. 1985), aff’d 480 U.S. 23 (1978); Moller v. United States, 721 F.2nd 810, 813 (Fed. Cir. 1983). A person will be a trader, and therefore engaged in a section 162 trade or business, if his or her trading is frequent and substantial, which has been rephrased as “frequent, regular, and continuous.” Boatner v. Comm’r T.C. Memo. 1997-379, aff’d in unpublished opinion 164 F.3d 629 (9th Cir. 1998).

An Investor is a person who purchases and sells securities with the principal purpose of realizing investment income in the form of interest, dividends, and gains from appreciation in value over a relatively long period of time (that is long-term appreciation). The management of one’s own investments is not considered a section 162 trade or business no matter how extensive or substantial the investments might be. See Higgins v. Comm’r, 312 U.S. 212, 217 (1941); King v. Comm’r, 89 T.C. 445 (1987). Therefore, as investor is not considered to be engaged in a section 162 trade or business of investing.

For purposes of section 1411(c)(2)(B), in order to determine whether gross income is derived from a section 162 trade or business of trading in financial instruments or commodities, the gross income must be derived from an activity that would constitute trading for purposes of chapter 1. Therefore, a person that is a trader in commodities or a trader in financial instruments is engaged in a trade or business for purposes of section 1411(c)(2)(B). The Treasury Department and the IRS emphasize that the proposed regulations do not change the state of the law with respect to classification of traders, dealers, or investors for purposes of chapter 1.


Definition of a Securities Trader per proposed reg §1.199A-5(b)(2)(xii) August 8, 2018
For purposes of section 199A(d)(2) and paragraph (b)(1)(xi) of this section only, the performance
of services that consist of trading means a trade or business of trading in securities (as defined in
section 475(c)(2)), commodities (as defined in section 475(e)(2)), or partnership interests. Whether a
person is a trader in securities, commodities, or partnership interests is determined by taking into
account all relevant facts and circumstances, including the source and type of profit that is associated
with engaging in the activity regardless of whether that person trades for the person’s own account, for
the account of others, or any combination thereof.


Definition of a person engaged in the business of dealing in firearms
Just for comparison purposes, this is a federal definition: A person who devotes time, attention, and labor to dealing in firearms as a regular course of trade or business with the principal objective of livelihood and profit through the repetitive purchase and resale of firearms, but such term shall not include a person who makes occasional sales, exchanges, or purchases of firearms for the enhancement of a personal collection or for a hobby, or who sells all or part of his personal collection of firearms.


Definition of a Part-Time Trader
The Internal Revenue Service recently took a quasi-position regarding “part-time traders” which is discussed at this link: Part-time traders and other special situations. Part-time traders should strongly consider forming a separate entity to trade through to avoid, as much as possible, negative IRS issues.


Definition of a business determined from per IRS Summertime Tax Tip 2009-18:
Here are eight questions that will help determine if your activity is a business:

  1. Is the purpose of your activity to make a profit? Generally, your activity is considered a business if it is carried on with the reasonable expectation of earning a profit.
  2. Do you participate in your activity just for fun? Playing the market for enjoyment of it and not pursued for significant profit.
  3. Do you depend on income from the activity? If so, your activity is likely considered a business.
  4. Have you changed methods of operation to improve profitability? If so, your activity may actually be a business.
  5. Do you have the knowledge needed to carry on the activity as a successful business? People who carry out the activity without obtaining the training, books and studies often don’t have the business acumen to turn their not-for-profit activity into a profitable business venture.
  6. Have you made a profit in similar activities in the past? This may indicate your activity is a business rather than not-for-profit. An activity is presumed carried on for profit if it makes a profit in at least three of the last five tax years, including the current year – or at least two of the last seven years for activities that consist primarily of breeding, showing, training or racing horses.
  7. Does the activity make a profit in some years? Even if your activity does not make a profit every year, it still may be considered a business.
  8. Do you expect to make a profit in the future from the appreciation of assets used in the activity? This indicates your activity may be a business rather than a hobby.


MY COMMENT: Though tax court cases have differed from this IRS position when it comes to the business of a “securities trader.”


Definition of a Securities Trader from IRS Auditors’ guide book:
What Is a Securities Trader?

“Although the Supreme Court has yet to find a taxpayer properly characterized as a ‘securities trader,’ it is clear that such a ‘businessman’ exists, given the proper facts.” (Levin v. United States, 79-1 U.S.T.C. 9331) The standard applied by the lower courts to distinguish between an investor and a trader was first enunciated by the Tax Court in Liang v. Commissioner (23 T.C. 1040): “In the former, securities are purchased to be held for capital appreciation and income, usually without regard to short-term developments that would influence the price of securities on the daily market. In a trading account, securities are bought and sold with reasonable frequency in an endeavor to catch the swings in the daily market movements and profit thereby on a short-term basis. There is general agreement amongst the courts (Moeller v. United States, 83-2 U.S.T.C. 9698 and Purvis v. Commissioner, 76-1 U.S.T.C. 9270) that the following factors are to be considered in determining whether a taxpayer is an investor or engaged in the trade or business of securities trading:

  1. The taxpayer’s intent – investment negates trader status.
  2. Nature of the income from the activity – only short term gains qualify as trading income.
  3. Frequency, extent and regularity of transaction- holding period can be critical.


Items 2 and 3 are objective (and quantitative) indicators of intent which are principally relied on. Taxpayers who mention “capital appreciation” or even “conservation of capital” do not prevail. Significant long term capital gains, and even dividends and interest, are strong indications of an investor and not a trader.

In one instance, the Court of Claims (Mayer v. United States, 94-2 U.S.T.C. 50,509) took the position that a taxpayer who carefully selected money managers and farmed out a portion of his funds to each could not be considered a securities trader since he did not actually make any purchase or sale decisions himself; – To claim a trade or business deduction, taxpayer must himself perform the activity characterizing the ‘trade or business’ citing Groetzinger (87-1 U.S.T.C. 9191). The Tax Court considered the same taxpayer for subsequent years and came to the same result based on holding period and frequency of trading. (Mayer v. Commissioner, TCM 1994-209)

The Supreme Court provided in Higgins that expenses related to real estate rental were deductible and that office and salary expenses could reasonably be allocated between investment and trade or business. Accordingly, even where it has been determined that a partnership is engaged in the trade or business of securities trading, care must taken to ensure that any portion of the partnership’s activity or expenses that are properly allocable to investment should be separately stated.

See Chapter 12 here:
http://www.irs.gov/Businesses/Partnerships/Partnership—Audit-Techniques-Guide-%28ATG%29

Back-up site:
http://www.irstaxattorney.com/tax-topics/irs-audit-techniques/Partnership%20-%20Audit%20Technique%20Guide%20-%20Chapter%2012%20-%20Syndicated%20Investment%20Partnerships.asp#5

 


Typical analysis made during an IRS examination (Form 886A):

The Internal Revenue Code does not define the term “trade or business” for purposes of I.R.C. §162. Whether activities constitute a trade or business is a question of fact.

In determining whether a taxpayer is a trader, nonexclusive factors to consider are:

  1. the taxpayer’s intent,
  2. the nature of the income to be derived from the activity, and
  3. the frequency, extent and regularity of the taxpayer’s securities transactions. (Moller v. United States, 721 F.2d 810,813 (Fed.Cir.1983))


For a taxpayer to be a trader the trading activity must be substantial, which means “frequent, regular and continuous enough to constitute a trade or business” as opposed to sporadic trading. (Ball v. Comr, T.C. Memo 2000-245 {quoting Hart c. Comr, T.C. Memo 1997-11}) A taxpayer’s activities constitute a trade or business where both of the following requirements are met:

  1. the taxpayer’s trading is substantial, and
  2. the taxpayer seeks to catch the swings in the daily market movements and to profit from these short-term changes rather than to profit from the long-term holdings of investments. (Mayer c. Comr, T.C. Memo 1994-209)


Typical analysis made for qualifying as a Trade or Business in another business area:

Citations – Here are court cases related to the issue of rental real estate as a trade or business (note the liberal leaning toward trade of business, except for limited exceptions and cases in the 2nd Circuit):

1. Facts and circumstances of each case must be examined – Higgins Sup Ct 312 U.S. at 217.

2. Two definitional requirements:

  • Profit motive;
  • The second is in relation to the scope of the activities, which must be “beyond the scope of mere ownership of property” and must be considerable, regular, and continuous activity. See generally Commissioner v. Groetzinger, 480 U.S. 23 (1987) for “regular and continuous” requirements. (See also GCM 38779 which says only a “relatively small amount of activity” is required;

i. “Considerable” rather than minimal
ii. Regular as opposed to irregular
iii. Continuous – not “sporadic” – “The property was continuously rented.” No deviation throughout ownership of its “planned use”. Good v. Commissioner, 16 T.C. 906 (4/26/51)

3. Activities that are considered: Even though an agent or manager “negotiated or renewed leases, arranged for repairs, collected rents, paid taxes and assessments, and remitted net proceeds to landlord, local agent paid principal and interest on the mortgages, insurance premiums, and taxes. Agent retained commissions and amounts to be applied on landlord’s income taxes and the remainder was sent to landlord. These activities were beyond the scope of mere ownership of property and the receipt of income”. They were considerable, continuous, and regular. De Amodio v. Commissioner, 34 T.C. 894

To the same conclusion: executing leases and renting the properties, collecting the rents, keeping books of account, supervising any necessary repairs to the properties, paying taxes and mortgage interest, insuring the properties, executing an option to purchase property, and executing the sale of the property. In addition, the agent conducted a regular correspondence with the landlord; he submitted monthly reports; and he advised him of prospective and advantageous sales or purchases of property.

These activities are beyond the scope of mere ownership of real property, or the receipt of income from real property. The activities were considerable, continuous, and regular.

4. One rental with minimal activity was a trade or business – Hazard v Comm.’r, 7 T.C. 372 (1946), LaGreide, 23 T.C. 508 -taxpayer inherited a single residence which she then rented out. Tax Court found it to be a trade or business. “It is clear from the facts that the real estate was devoted to rental purposes, and we repeatedly held that such use constitutes use of the property in trade or business, regardless of whether or not it is the only property so used.”

5. Other cases with level of activity that definitely should put you over the top even in the 2nd circuit mentioned in Grier was Pinchot v. C. I. R., 2 Cir., 1940, 113 2d 718 (eleven commercial buildings in New York), Gilford v. C. I. R., 2 Cir., 1953, 201 F.2d 735, (eight buildings in New York), Fackler v. C. I. R., 6 Cir., 1943, 133 F.2d 509 (a six-story commercial building), Rogers v. U.S., D.C.Conn.1946, 69 F. Supp. 8 (sixty-one properties).

6. 25% interest in two timeshare units rented were a trade or business – James B. and Joan E. Murtaugh v. Commissioner [74TCM75][1997-319] Timeshare units in a resort lodging facility were trade or business even though they lost money for two years and then were sold.

7. But a triple net lease does not qualify since it is specifically not allowed per Section 3.05 of Notice 2019-07. The Rev Proc defines a triple net lease as one where a lease agreement requires the tenant or lessee to pay taxes, fees, and insurance, and to be responsible for maintenance.

  • Land leased where the landlord pays taxes, insurance, fees and is responsible for and does repairs is arguably a trade or business.
  • Land leased where the landlord pays taxes, insurance, fees and is responsible for, but the lessee does, repairs…not so sure.
  • Land leased where the landlord pays taxes, insurance, fees and lessee/tenant is responsible for and does repairs…doubtful.

8. Other situations that may or may not qualify as trade or business:

  • Not rented at fair rental value – It is not uncommon for landlords to rent a property to a relative or friend at less than the fair rental value. Therefore the property owner is not engaging in the activity for income or profit.
  • A vacation home rented and used personally will generally not qualify because the personal use violates the continuity and regularity of the activity.


IRC Sec. 469. Passive Activity Rules show consistency in the requirements for regular, continuous and substantial.

  • §469(h) Material Participation Defined
    For purposes of this section–
    §469(h)(1) In General
    A taxpayer shall be treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a basis which is–
  • §469(h)(1)(A) regular,
  • §469(h)(1)(B) continuous, and
  • §469(h)(1)(C) substantial.

 

Passive Activity Loss ATG – Exhibit 4.1: Material Participation and Temp. Regs. Sec. 1.469-5T and Determining a Member’s Participation in LLC Activities

To determine material participation in an activity, the taxpayer must meet ONE of the following:

1.____ Does taxpayer and/or spouse work more than 500 hours a year in the business?

2.____ Does taxpayer do most of the work?  Even if taxpayer does not meet 500 hour test, but his participation is the only activity in the business,  he materially participates.  Example:  sole proprietor with no employees.

3.____ Does taxpayer work more than l00 hours and no one (including non-owners or employees) works more hours?    Example:  If owner puts in l75 hours a year and an employee works 190 hours a year, taxpayer would not meet material participation test.

4.____ Does taxpayer have several passive activities in which he participates between 100-500 hours each, and the total time is more than  500 hours?  The following activities should not be included in the above test: rental activities: activities involving portfolio or investment income, and activities in which the taxpayer does most of the work.

5.____ Did taxpayer materially participate in activity for any 5 out of l0 preceding years (need not be consecutive)?  Example:  taxpayer who retired and his children now run business, but he stills owns part of partnership.

6.____ Did taxpayer materially participate in a personal service activity for any 3 prior years (need not be consecutive)?  Personal service activity includes fields of health, law, engineering, architecture, accounting, actuarial science, performing arts and consulting.

7.____ Do the facts and circumstances indicate taxpayer is materially participating?  Test does not apply unless taxpayer worked more than 100 hours a year.  Furthermore, it does not apply if:

  1. any person, other than the taxpayer, received compensation for managing the activity; or,
  2. if any person spent more hours than taxpayer managing the activity.

 


IRS ATG on Passive Activity Losses

There are two major exceptions to the passive loss rules:

  1. Working interests in oil and gas activities; [IRC § 469(c)(3), Reg. §1.469-1T(e)(4)(v)] and,
  2. Traders in stocks and bonds [Reg. §1.469-1T(e)(6) ].


Publicly Traded Partnerships (PTP) have a special Passive Activity Rule:

Income from commodities and commodity futures, forwards, and options with respect to commodities (including options) if the partnership’s principal activity is buying and selling commodities are considered passive activity income for PTP’s §7704(d)(1).

The IRS issued final regulations under Regs. §1.7704-3, which generally expanded the types of qualifying income to include certain investment income such as capital gain from the sale of stock, income from holding annuities, income from national principal contracts (as defined in Regs. §1.446-3), and other substantially similar income from ordinary and routine investments to the extent determined by the IRS.

However, under Regs. §1.7704-3(a)(2), qualifying income does not include income derived in the ordinary course of a trade or business. Regs. §1.7704-3(b)(2) clarifies that gain recognized with respect to a marked to market position will not fail to be qualifying income solely because there is no sale or disposition. Regs. §1.7704-3(b)(3) also clarifies that certain ordinary income may be qualifying income. Regs. §1.7704-3(b)(4) provides rules for computing qualifying and gross income of a partnership that makes a mixed straddle account election under Regs. §1.1092(b)-4T. Also, Regs. §1.7704-3(b)(1) clarifies that, in general, all losses will be ignored in determining partnership gross income for purposes of §7704(c)(2).


Definition of a Commodities Trader
§1258(d)(5)(B) Definitions. —
For purposes of this paragraph —
1258(d)(5)(B)(i) Options Dealer. —
The term ‘options dealer’ has the meaning given such term by section 1256(g)(8).
1258(d)(5)(B)(ii) Commodities Trader. —
The term ‘commodities trader’ means any person who is a member (or, except as otherwise provided in regulations, is entitled to trade as a member) of a domestic board of trade which is designated as a contract market by the Commodity Futures Trading Commission.

1256(g)(8) Options Dealer
1256(g)(8)(A) In General
The term “options dealer” means any person registered with an appropriate national securities exchange as a market maker or specialist in listed options.

1256(g)(8)(B) Persons Trading In Other Markets
In any case in which the Secretary makes a determination under subparagraph (C) of paragraph (7), the term “options dealer” also includes any person whom the Secretary determines performs functions similar to the persons described in subparagraph (A). Such determinations shall be made to the extent appropriate to carry out the purposes of this section.


Definition of Commodities-Futures Dealers (Traders) from H.R. Conf. Rep. No. 106 – 1033, at 1036 (2000):

The determination of who is a dealer in securities futures contracts is to be made in a manner that is appropriate to carry out the purposes of the provision, which generally is to provide comparable tax treatment between dealers in securities futures contracts, on the one hand, and dealers in equity options, on the other.

Although traders in securities futures contracts (and options on such contracts) may not have the same market-making obligations as market makers or specialists in equity options, many traders are expected to perform analogous functions to such market makers or specialists by providing market liquidity for securities futures contracts (and options) even in the absence of a legal obligation to do so.

Accordingly, the absence of market-making obligations is not inconsistent with a determination that a class of traders are dealers in securities futures contracts (and options), if the relevant factors, including providing market liquidity for such contracts (and options), indicate that the market functions of the traders is comparable to that of equity options dealers.

Internal Revenue Bulletin: 2004-38


Definition of a Trader from the preamble to proposed Reg. 1.1411(6)(C)(i)
A person will be a trader, and therefore engaged in a section 162 trade or business, if his or her trading is frequent and substantial, which has been rephrased as “frequent, regular, and continuous.” Boatner v. Comm’r, T.C. Memo. 1997-379, aff’d in unpublished opinion 164 F.3d 629 (9th Cir. 1998).

Further, the text in proposed Reg. 1.1411-9 implies that a reasonable level of trader expenses is in the range of 25% to 37.5% of the amount of the net gain from the year’s trading.   Reg. 1.1411-9 implies 3.75% and 13.3%. And T.D. 9644 implies various other levels in the examples. And proposed Reg. 1.1411(5)(E) imply 20%.


IRS web site Tax Topic 429
http://www.irs.gov/taxtopics/tc429.html

Topic 429 – Traders in Securities (Information for Form 1040 Filers)

This topic explains if an individual who buys and sells securities qualifies as a trader in securities for tax purposes and how traders must report the income and expenses resulting from the trading business. The term security is defined in Internal Revenue Code section 475(c)(2). In general, the term security includes a share of stock, beneficial ownership interests in certain partnerships and trusts, evidence of indebtedness, and certain notional principal contracts, as well as evidence of an interest in, or a derivative financial instrument in, any of these items and certain identified hedges of these items. Please refer to section 475(c)(2) for a complete list of items that qualify as a security. To better understand the special rules that apply to traders in securities, it is helpful to review the meaning of the terms investor, dealer, and trader, and the different manner in which they report the income and expenses relating to their activities.

Investors
Investors typically buy and sell securities and expect income from dividends, interest, or capital appreciation. They buy and sell these securities and hold them for personal investment; they are not conducting a trade or business. Most investors are individuals and hold these securities for a substantial period of time. Sales of these securities result in capital gains and losses that must be reported on Form 1040 or 1040-SR, Schedule D (PDF), Capital Gains and Losses and on Form 8949 (PDF), Sales and Other Dispositions of Capital Assets, as appropriate. Investors are subject to the capital loss limitations described in section 1211(b), in addition to the section 1091 wash sales rules. Investors may be able to benefit from a deduction for the expenses of producing taxable investment income. These include expenses for investment counseling and advice, legal and accounting fees, and investment newsletters. They report these expenses on Form 1040, Schedule A (PDF), Itemized Deductions, as miscellaneous deductions allowable to the extent that they exceed 2% of adjusted gross income. They can also deduct interest paid for money to buy or carry investment property that produces taxable income on Schedule A, but under section 163(d), the deduction cannot exceed the net investment income. Commissions and other costs of acquiring or disposing of securities are not deductible but must be used to figure gain or loss upon disposition of the securities. Review Topic 703, Basis of Assets for additional information. Commissions and other costs of acquiring or disposing of securities aren’t deductible but must be used to figure gain or loss upon disposition of the securities. Review Topic No. 703, Basis of Assets for additional information. Investment income isn’t subject to self-employment tax. For more information on investors, refer to Publication 550, Investment Income and Expenses (PDF).   (Updated 14-Feb-2020)

Dealers
Dealers in securities may be individuals or business entities. Dealers purchase, hold, and sell securities to their customers in the ordinary course of their trade or business. Sometimes they maintain an inventory. Dealers are distinguished from investors and traders because they have customers and derive their income from marketing securities for sale to customers. Section 475 requires dealers to keep and maintain records that clearly identify securities held for personal gain versus those held for use in their business activity. Dealers must report gains and losses associated with dispositions of securities by using the mark-to-market rules discussed below.

Traders
Special rules apply if you are a trader in securities, in the business of buying and selling securities for your own account. The law considers this to be a business, even though a trader does not maintain an inventory and does not have customers. To be engaged in business as a trader in securities, you must meet all of the following conditions:

  • 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.

 

The following facts and circumstances should be considered in determining if your activity is a securities trading business:

  • Typical holding periods for securities bought and sold;
  • The frequency and dollar amount of your trades during the year;
  • The extent to which you pursue the activity to produce income for a livelihood; and
  • The amount of time you devote to the activity.

 

If the nature of your trading activities does not qualify as a business, you are considered an investor, and not a trader. It does not matter whether you call yourself a trader or a day trader, you are an investor. A taxpayer may be a trader in some securities and may hold other securities for investment. The special rules for traders do not apply to the securities held for investment. A trader must keep detailed records to distinguish the securities held for investment from the securities in the trading business. The securities held for investment must be identified as such in the trader’s records on the day he or she acquires them (for example, by holding them in a separate brokerage account).

Traders report their business expenses on Form 1040, Schedule C (PDF), Profit or Loss From Business. The Schedule A limitations on investment interest expense, which apply to investors, do not apply to interest paid or incurred in a trading business. Commissions and other costs of acquiring or disposing of securities are not deductible but must be used to figure gain or loss upon disposition of the securities. See Topic 703, Basis of Assets. Gains and losses from selling securities from being a trader are not subject to self-employment tax.

The Mark-to-Market Election
Traders can choose to use the mark-to-market rules, investors cannot. If a trader does not make a valid mark-to-market election under section 475(f), then he or she must treat the gains and losses from sales of securities as capital gains and losses and report the sales on Form 1040 or 1040-SR, Schedule D (PDF), Capital Gains and Losses and on Form 8949 (PDF), Sales and Other Dispositions of Capital Assets, as appropriate. When reporting on Schedule D, both the limitations on capital losses and the wash sales rules continue to apply. However, if a trader makes a timely mark-to-market election, then he or she can treat the gains and losses from sales of securities as ordinary gains and losses (except for securities held for investment – see above) that must be reported on Part II of Form 4797 (PDF), Sales of Business Property. Neither the limitations on capital losses nor the wash sale rules apply to traders using the mark-to-market method of accounting.

In general, a trader must make the mark-to-market election by the due date (not including extensions) of the tax return for the year prior to the year for which the election becomes effective. You can make the election by attaching a statement either to your income tax return or to a request for an extension of time to file your return. The statement should include the following information:

  1. That you are making an election under section 475(f);
  2. The first tax year for which the election is effective; and
  3. The trade or business for which you are making the election.

 

Refer to the Form 1040, Schedule D Instructions (PDF), Capital Gains and Losses, for more information on how to make the mark-to-market election. It’s important to note that in general, late section 475(f) elections aren’t allowed.

After making the election to change to the mark-to-market method of accounting, you must change your method of accounting for securities under Revenue Procedure 2015-14 (revenue procedures are available on IRS.gov). In addition to making the election, you will also be required to file a Form 3115 (PDF), Application for Change in Accounting Method (see Revenue Procedure 2015-13). Publication 550 describes the procedures for making an election under the section called “Special Rules for Traders in Securities.”

After making the election to change to the mark-to-market method of accounting, you must change your method of accounting for securities under Revenue Procedure 2018-31 (PDF), Section 24.01. In addition to making the election, you’ll also be required to file a Form 3115, Application for Change in Accounting Method (PDF). Publication 550 (PDF) describes the procedures for making an election under the section called “Special Rules for Traders in Securities.” Non-filing of the Form 3115 mentioned above won’t invalidate a timely and valid election.

If you have made a valid election under section 475(f), the only way to stop using mark-to-market accounting for securities is to request and receive written permission from the Service to revoke the election. Non-filing of the Form 3115 mentioned above will not invalidate a timely and valid election. To request permission to revoke your election under section 475(f), you must file a second Form 3115 and pay a fee.

If you’ve made a valid election under section 475(f), the only way to stop using mark-to-market accounting for securities is to file an automatic request for revocation under Revenue Procedure 2018-31, Section 24.02. Under that revenue procedure, the request for revocation must be filed by the original due date of the return (without regard to extensions) for the taxable year preceding the year of change (the year of change is the first taxable year the revocation is to be effective). This revocation notification statement must be attached to either that return or if applicable, to a request for extension of time to file that return. Late revocations won’t generally be allowed except in unusual and compelling circumstances.

Comment: The above website paragraph fails to reflect the “exclusive method,” that has been in effect since January 16, 2015, for revoking valid or invalid M2M elections . See Rev. Proc. 2015-14 section 23.02(2) (PDF).

Comment: Also, the above paragraph was added to the IRS website in 2011 and is still there as of its August 31, 2015 revision. Apparently, this is an IRS interpretation that apparently runs contrary to a long-standing position of TraderStatus.com and Section 6 of Rev. Proc. 99-17, that a taxpayer who is changing his method of accounting to M2M must timely file both the election statement (in advance) and the Form 3115 in duplicate one year later in order to receive automatic consent from the IRS Commissioner to make the change. With the obvious potential loophole being that a taxpayer might file a protective advance election statement (year-after-year if desired) and then using hindsight either perfect that year’s election by filing Form 3115, or fail to file Form 3115 and thereby cancel out their protective election statement.

How the Courts will decide this odd complication is yet to be seen. Particularly the conundrum of saying that not filing a Form 3115 will not invalidate a “valid election” when by definition, the taxpayer does not have the required consent from the IRS Commissioner for a “valid election” unless Form 3115 is filed.

Update 2015: Rev. Proc. 2015-14 Section 23.02(6)(b) addresses Form 3115 in a similar manner.  Although the filing of Form 3115 is required pursuant to Rev. Proc. 2015-14 Section 23.02(7)(b), it is not necessary to actually file Form 3115 to effectuate the change in accounting method from M2M to a realization method.