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The Marcum Advisor - March 2011

 

Trader vs. Investor in Securities and Mark to Market Elections

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Overview

The Tax Ramifications of Nonqualified Stock OptionsTaxpayers buying and selling securities for their own account generally will qualify as either an investor or trader for tax purposes. The distinction between trader and investor is important because tax rules are generally more favorable for traders. As a general rule, most taxpayers are categorized as investors. However, in today's setting of online trading and discount brokers, some taxpayers are spending considerable time trading stocks on a regular basis, which may qualify them for trader status.

The tax treatment of online and day trading for federal income tax purposes depends on the individual's classification: Investor, Trader, or Mark-to-Market Trader (see discussions below). To qualify as a trader, an individual must be active in the securities markets on a daily basis and attempt to profit from short term swings in security prices. Most taxpayers who manage their own investments will be treated as investors rather than traders. Proving that one's investment activities rise to the level of carrying on a trade or business is a difficult hill to climb. In determining whether a taxpayer is a trader or an investor, courts consider the following factors:

  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.

There are three different classifications for tax treatment for taxpayers who trade securities; Investors, Traders and Traders subject to mark-to market accounting under Internal Revenue Code §475(f). In general, the main distinction in tax treatment between traders and investors relate to how to categorize the deduction of the related investment expenses. Investors' expenses are deductible only as itemized deductions and are subject to deductibility limitations based adjusted gross income. Traders' expenses are deductible in arriving at adjusted gross income as ordinary business expenses and are not are not subject to further adjusted gross income limitations. Traders subject to mark-to-market under IRC§ 475(f) must treat all securities related to trading activities as inventory and all income and losses (realized and unrealized) are treated as ordinary income instead of capital.

Taxation of Investors

Investors treat stock holdings as capital assets and report gain or losses as capital, depending on whether shares were held for more than one year. The expenses incurred in connection with investing activity are treated as expenses incurred for the production of income. These expenses are deductible as miscellaneous itemized subject to the two percent of adjusted gross income limitation. In addition, these expenses are not deductible in computing the taxpayer's alternative minimum tax (AMT). Any commissions paid in purchasing the securities are capitalized as a part of its cost basis while commissions paid at the time of sale reduce the sales proceeds. Any interest expense incurred in the activity is deductable only to the extent of the taxpayer's net investment income. Many investors receive little or no benefit from their investment expenses because of the two percent AGI limitation on miscellaneous itemized deductions and the add-back for AMT purposes. Perhaps the single worst tax result from investor status is the treatment of notional principal contract (SWAP) losses. Investors who incur losses from SWAPS must deduct those losses as "Expenses for Production of Income” compared to traders who will deduct the losses as ordinary portfolio loss. This can be crippling to investors because of the potential large dollars of gain and loss that result from dealing in SWAPS.

Taxation of Traders

The classification of a taxpayer as a trader is a purely judicial phenomenon, but it carries with it a number of tax advantages and few, if any, disadvantages. Unlike investors, securities traders are deemed to be conducting a “trade or business”, so trading expenses are deductible as ordinary and necessary expenses. A trader's business expenses include interest paid on margin accounts used in connection with the trading activity. However, if the taxpayer does not materially participate in the trading activity (e.g., a limited partner in a trader partnership), interest incurred in the activity is subject to the investment interest expense limitation. Individuals who are traders report trading expenses on Schedule C and, therefore, eligible for a greater benefit by being able to deduct these costs when computing AGI. Despite all these tax advantages resulting from being a self-employed trader, the taxpayer still generates capital gains and losses and is exempt from self-employment (SE) taxes.

Taxation of Traders subject to Mark-to-Market under IRC §475(f)

As an alternative to capital asset treatment, IRC §475(f) allows traders to elect to mark their stock holdings to market at the end of the tax year. If the election is made, any gains or losses with respect to such securities, whether deemed sold at year-end under the mark-to-market method of accounting or actually sold during the taxable year, shall be treated as ordinary income or loss. All security gains and losses are treated as ordinary income or loss. A primary benefit of making the election to be treated as subject to mark to market is that the annual $3,000 limitation on net capital losses will not apply. Conversely, the trader is not allowed to treat trading activity gains and losses as capital asset transactions, but this should have minimal negative impact since traders by definition should have few, if any, long term capital gains.

Traders who choose to make the mark-to-market election must follow the rules set forth in Revenue Procedures 99-17, 2008-52 and 2009-39 which include attaching certain elections and specific forms choosing this method of accounting.

Because capital gains and losses are specifically excluded from the definition of net earnings from SE, earnings from a trading activity are not subject to the SE tax. A §475 mark-to-market election converting the gains and losses to ordinary income does not change their status for SE purposes. However, since a trader's net earnings are not SE income, he cannot contribute to a retirement plan (e.g., SEP or IRA) based on such income. Although a trader's security gains and losses are excluded from SE earnings, there is no guidance as to how the trading expenses reported on Schedule C impact SE earnings. Presumably, a trader who has SE earnings from other sources can reduce those earnings by the SE loss generated from the trading expenses.

A big advantage, not often mentioned when discussing mark-to-market elections, is the absence of a requirement for securities testing. Since these taxpayers elect to treat all their income (realized and unrealized) as ordinary income, there is no need to test at year end for wash sales, constructive sales, and straddles. The absence of this requirement not only significantly reduces an administrative burden on the taxpayer, but also can potentially reduce taxpayer's professional fees.

Conclusions

Every securities investor who could possibly qualify as a trader should try to do so, since only tax advantages follow. Unfortunately, being a trader is not a tax election. The general presumption is that individuals hold stocks and securities as investors unless their actions demonstrate that they are carrying on a business of securities trading. A trader is, in effect, an unusually active investor in terms of volume and frequency of securities transactions. The concept of a "trade or business" is not defined in the Internal Revenue Code, but is judicially developed.

The battle between trader and investor has evolved over time. Early on, trader status was easily attained and simply measured by the amount of time devoted to the activity. Today, according to the Tax Court, the distinction between a trader and an investor is that a trader buys and sells securities with reasonable frequency in an effort to catch the swings in the daily market movements, and profits on a short-term basis. On the other hand, an investor purchases securities to be held for capital appreciation and income, usually without regard to short-term developments that would influence the price of the securities on the daily market.

Taxpayers whose time and effort are devoted to securities transactions and are substantial should always consider attempting to achieve trader status. Most investors cannot qualify as traders, but many can. Please refer to the chart below which is a summary of factors from case law that have been used to determine whether an individual is a trader or investor.

Characteristics of Traders and Investors

TRADER

INVESTOR

Criteria for buying and selling stocks

Expected short-term swings in the market and stock price; stock selection based on technical factors.

Long-term perspective; considers stock’s income (dividends) and potential for long term capital appreciation; stock selection based on fundamental factors.

Involvement

Substantial personal involvement; frequent, regular and continuous; devotes considerable time to activity; a primary source of individual’s income for meeting personal living expenses.

Active primarily on weekends or after work hours; may rely on a broker or agent; has other primary sources of income for meeting personal living expenses. Relatively short periods of high-volume trading may occur.

Stock holding periods

Generally 30 days or fewer; few, if any, stocks held more than a year.

A mixture of long-term and short-term holding periods.

Frequency of trades

Daily or almost daily trading; average one or more trades each day; few periods without any activity. Portfolio turnover of at least 3x annually.

Sporadic trading; no particular pattern to activity; may go for long periods without any activity.

Source of Income

Short-term gains

Interest, dividends, long-term gains.

 
 
 
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