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by Dave Fleck Traders Accounting

Trader Taxation Secrets That You Won't Hear From Your Local CPA

Many traders began as investors. That is, they started out holding securities long-term, with the intention of capital appreciation and favorable long-term capital gain rates. Over the last few years of market decline, many investors have seen the wisdom in taking a short-term approach to their investing. For most, this included frequent trades held for a shorter duration.

From a tax perspective, these traders are very much in business - for example, just like any other business, they are looking for short-term profits and positive monthly cash flow (that is, any business other than amazon.com). The challenge for these traders has been a lack of information from the IRS as to the exact demarcation point between the activities of a trader (as a business) vs. the activities of an investor.

What is a Trader in Securities?
An interesting facet of trader taxation is that no real definition of a "trader" exists in the tax code. The data we have now is gleaned from tax court cases, the results of which add to a surprising lack of information available on the topic. Lack of clarity and research makes for a very ambiguous and fluid definition, so a clear understanding of past court cases is mandatory.

Before we discuss pertinent court cases, a better explanation of trader is warranted. A trader buys and sells a position to take advantage of short-term market changes. Profit comes from price changes, not from dividends and interest. Short-term holding periods mark the trader, with the majority of periods being a day or a few weeks at most. And since long-term growth is neither expected nor desired, many traders aren't concerned about which company issues the securities, and therefore forego due diligence research common among investors. A trader's single concern is the profit they make from holding a position for a very short time.

Another telltale sign of a trader is his or her ability to devote substantial amounts of time to their business. According to the IRS, traders need to show an earnest intent to be a trader. A trader spends a significant amount of time in trading activities, from managing transactions and conducting strategy sessions, to making frequent trades on a consistent and regular basis. These defining points come from case law, and the IRS will diligently fight what it feels is an unsubstantiated trader election. It's been proven in case after case after case.

What do the Courts Have to Say? Two early cases speak directly to establishing trader status. In Higgins v. the Commissioner (1941), the Supreme Court denied the deductibility of Higgins' investment expenses. Higgins ran a vast operation, which included offices and employees, who recorded and managed all aspects of his trading activity. Even so, the court concluded that business function did not exist related to Higgins' trading. According to the court, Higgins' business existed solely to record his investments.

Estate of Yaeger v. the Commissioner (1989) is a similar case. Yaeger, according to definition, was the very picture of a trader. Trading was his full-time job, and he made substantial profits buying and selling securities. He equipped himself with offices and a staff, and continuously educated himself regarding financial matters. Yet this was not enough to convince the IRS or the Supreme Court that he was a trader. At issue was the fact that Yaeger held his securities for long periods of time, so the court ruled that Yeager conducted investing activity, and did not run a trading business.

In a more recent case, Fredrick R. Mayer (1994), the court established that even if a trader devotes substantial time to trading activities, trader status would still be denied unless other factors are met. Mayer, like Higgins, ran a vast operation and hired eight money managers to handle his funds. Mayer set the company's goals and monitored his managers closely. He did everything a good businessperson should do to increase profits, yet the IRS and the Tax Court denied him trader status, and disallowed his business deductions. Like Yaeger, Mayer profited from long-term holding periods. Buying frequently negated selling infrequently.

The case of Rudolph Steffler (1995) differs from others because the court denied trader status based on trade infrequency. Steffler conducted a very small number of trades each year, and the Tax Court denied trader status on that ground alone.

Compare Steffler to Higgins, Yaeger and Mayer, where trade frequency was not at issue. In those cases, the court denied trader status due to lengthy holding periods. It's an important distinction, and a significant feature of IRS and court-approved trader status: your intention must be to hold securities for short-term periods, and you must conduct a large number of transactions.

The Tax Court, in the case of Stephen A. Paoli (1991), established a preface to the frequency test. In Paoli, the court focused on the consistency of trading activities. Paoli conducted numerous trades, but most during one particular time of the year. Throughout the remainder of the tax year, Paoli engaged in little to no trading activities. The court ruled that although both the transaction and frequency tests were met, Paoli's activity should have been conducted continuously over the course of the year, just as a business does business all year long.

As we've mentioned, you won't find one specific part of the IRS code that deals with securities traders. However, due to the exponential growth in online trading in the last few years, and the overwhelming advantages conferred upon traders, the IRS has been forced to issue statements regarding the definition. Recently in Tax Topic 429, the IRS says that to qualify as a trader in securities:

• 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.

As we've mentioned, you won't find one specific part of the In addition, the IRS says that the following circumstances must 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.
• The amount of time you devote to the activity.

What does that really tell us? Not much, forcing lawyers and CPAs representing traders to rely on court cases that more clearly define who is eligible for the trader classification. The bottom line is that without adequate definition by the IRS, an individual who files as a trader in securities will always be in jeopardy of losing their privileged status based on a new, overriding court case that raises the bar on required qualifications. The answer to this problem is to establish a legal entity for your trading business.

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Dave's practice centers around tax reduction strategies for businesses and individuals. He has a wealth of experience serving hundreds of tax clients from around the United States.

He has been invited to speak at many prestigious events where he has helped educate thousands of traders. He is currently working on his first book on trader taxation, tentatively scheduled for release in the fall of 2004.