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Karl, it is still an unfortunate fact of life that many front line IRS
auditors who get to handle tax examinations probably have had as much
experience with Trader Status as the person who serves you up a "Whopper",
Coke and fries at the Burger King. As a CPA, and professional tax
practitioner, as well as a Trader who has made my living doing both for the
past twenty years, I have had the unpleasant experience of dealing with this
ignorance more than a few times in my career.
Not knowing your situation, I can't comment on whether or not I think you
do or do not qualify to file as a Trader, but I will tell you that someone
with 500 trades should be in a pretty good position. If you want, I will
discuss it with you further, as I am profoundly offended by the position
taken by some IRS auditors.
The Internal Revenue Code clearly defines an investor, as well as a
professional broker/dealer. It also defines what a business is, and allows
for the deduction of ordinary business expense under Code Section 162.
It is the Supreme Court and the various District Tax Courts which have
defined "Trader Status" and have given the right to the investor to claim it
under certain circumstances. There have been hundreds of such court cases
since the 1930's starting with Snyder vs. The Commissioner, 1935, in which
the Supreme Court stated that a taxpayer "can be involved in the business of
trading securities".
The problem with interpreting these court cases is that the courts have
reserved the right to make a final determination whether someone is or is not
qualified to claim "Trader Status." Also the rulings have been
contradictory, and in fact may be somewhat outdated now due to changes in the
tax law, and the changes in technology that have transpired over the past few
years. Nonetheless each Trader is evaluated on a case-by-case basis and the
IRS should handle it this way, as the Courts have mandated. They take into
consideration factors such as:
1. Frequency of trades
2. Duration of trades (long or short term)
3. Quantity of trades, and several other equally important factors.
The courts have basically stated that a Trader is "one who trades his own
account on a frequent, regular and continuous basis, with a substantial
number of short-term trades." Unfortunately, they never quantify the amount
they consider substantial, nor do they tell us what will qualify as being
frequent, regular and continuous. They also never elaborate on the time
period that is considered short term (be it a day, a week, a month or a
year), although for tax treatment it is a year or less.
Oftentimes the front line IRS tax examiner is not familiar with any of
these cases, nor with the investors' right to claim he is trading as a
business. Most of the time the auditor confuses "Trader Status" with a
professional floor trader (having customers).
It was just in The 1997 Tax Act that the Internal Revenue Code
specifically mentioned the Trader. It was under Code Sections 475 E and F(1)
and (2) where Congress granted Traders the right to mark to market their
positions in the same manner a floor trader.
Code Section 475 used to just apply to floor traders, as the definition
of a Market Maker and Broker Dealer states which was posted to this list by
"tagteam@xxxxxxxxxxxxxx This came from the part of Section 475 A and B,
which was introduced into the law in the Revenue Reconciliation Act of 1993.
It mandated then that "Market Makers or Dealers in Securities" use this mark
to market accounting method for valuing their positions at year end - to
prevent them from carrying unrealized gains into the new year. Congress
expanded this section in 1997 and included Traders of their own accounts, who
do not have outside customers with subsections E and F(1) and (2). But
Traders are not required to do so, they have the right to elect to do so.
On December 17, 1997 the Joint Committee on Taxation issued its report
(aka the Blue Book). This publication is 549 pages long and explains the new
tax law. Although they did not tell us what specifics a Trader must meet to
qualify as a business, they did define what a Trader does.
On page 180 of this report, Title X, Section A (Financial Products),
Subsection 1001(b), they stated:
"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. Under prior law, the mark-to-market treatment
applicable to securities dealers did not apply to traders . . ." (Securities
is a generic term which applies equally to commodities, futures contracts,
options, etc.)
If the IRS auditor in question has an issue with whether or not a Trader
"trading his own account" is to be considered a business, perhaps he should
have a word with Congressmen Bill Archer of Texas or William Roth of Delaware
who wrote the report. In it, both these Congressmen, as well as the other
eight on the committee, interpreted the law similar to how you did.
Usually referencing the auditor to the court cases will be enough to
convince them, and I have listed a few of my favorites at the end of this
post. However, sometimes the issue must be taken above the head of the
front-line auditor to his or her supervisor or even to Appeals, in order to
find someone familiar with this aspect of the law.
My firm has filed thousands of tax returns under the distinction of
"Trader Status" over the past ten years. We have also turned down thousands
of potential "Trader Status" tax returns because we felt that they did not
meet the criteria for claiming this designation.
I must tell you that if I evaluate someone as a Trader, I am 99%
confident that I can defend that determination in an audit or an appeals
hearing. Over the years we have only had a handful of audits that have been
disallowed, and the only reason we have not been successful in defending them
is that the cost of doing so would have outweighed the benefits in terms of
billable hours. I must also say that the audit rate involved in filing as a
Trader is no more so than the rate of audit we have with our ordinary tax
clients.
The benefits of filing as a Trader far and above outweigh the downside
risk if the taxpayer qualifies. Those benefits have now been increased to
include the ability to writeoff losses beyond $3000 per year with a Section
475 election. Traders do not give up the right to section 1256 treatment of
their gains on futures contracts (60% long term) . It is only when the
Section 475 election is made that the income becomes ordinary and the 60/40
treatment is waived. The way around this is simply to start a new entity to
trade from once you make the 475 election (a Sub S Corp or LLC). Then you
don't even have to ask the IRS for permission to revert back to a non 475
entity -- you become one. (By the way Trader Status is a fully revocable
election. You can be a Trader one year, and an investor the next without
anyone's permission.)
If a Trader has large expenses, or large losses in any one year, Trader
Status often saves thousands of dollars, and it is one of the last remaining
tax breaks available for Traders. I have had cases where the difference
between filing as a Trader and as an investor has been worth over a hundred
thousand dollars on a single tax return.
As I mentioned, some of the court cases you may want to reference the
auditor to are:
1) Snyder v. Commissioner (1935): Supreme court stated that taxpayer can be
involved in the "business" of trading securities.
2) Higgins v. Commissioner (1941): Supreme court ruled that whether or not
the trading activities of a taxpayer constitute carrying on a business, an
examination of the facts is required in each case.
3) Fuld v. Comm (1943): Taxpayers held to be Traders because of a large
number of trades, none of which were held for as long as two years.
4) Commissioner v. Nubar (1951): It was held that the extensive trading of
stocks and futures constituted engaging in a trade or business.
5) Kemon v. Commissioner (1953): Court determined that Traders are sellers
who take advantage of short term price fluctuations to sell at a gain over
cost.
6) Liang v. Commissioner (1955): Relevant considerations to Trader status is
intent of Trader to derive profits from a frequent trading.
7) Reinach v. Commissioner (1967): Option writer did not have to prove this
activity was a trade or business due to nature of instrument (options).
8) Marlowe King v. Commissioner (1978): Futures Trader allowed to deduct all
expenses incurred with business of trading futures, even though some gains
were long term. Trader's business of trading futures was upheld because of
the nature of futures contracts.
9) Levin v. United States (1979): A Trader is an active investor because he
does not passively accumulate earnings, but rather manipulates his holdings.
A Trader's profits are derived through trading.
10) Ropfogel v. United States (1992): US District Court (Kansas) determined
criteria for Trader Status is comprised of six factors.
These next few are cases in which trader status was disallowed, however the
guidelines for what the requirements are were established. Note the issue of
Trader Status and the category itself was not denied, but rather its
existence was reinforced, even though these specific cases were denied. The
courts just gave us more guidelines to follow:
1) Purvis v. Commissioner (1976): Attorney denied status for failure to file
Schedule C.
2) Moeller v. United States (1983): Despite full time management of
securities and large investments, taxpayers were not Traders because their
investments were long term.
3) Frederick R. Mayer (1994): Trading advisors were objected to by IRS in
determination of Trader status — courts never ruled on this issue. Trader
status denied because advisors were investors.
4) Rudolph Steffler (1995): Distinction made between "business" and "activity
entered into for profit." Substantial number of trades was key issue - the
man had only 27 futures trades in 3 years!
There are hundreds more. You just need to do a search on Kleinrocks, BNA,
RIA, CCH, or some other tax reference library.
Good luck on the audit. If you qualify as a Trader, don't give up. I will
give you something. It is the magic word that makes auditors shrivel up like
vampires to a cross ( and because they don't often hear it, they will be
somewhat surprised). That magic word is "NO". If they tell you they are
moving your deductions to a Schedule A, tell them "NO YOU'RE NOT". I am a
Trader, and I'm entitled to take them on my schedule C. Keep repeating it
like a mantra. "NO...NO...NO". It works.
Also, remember, the auditor has no right to change your tax return. He
or she can only propose changes. You have to sign the form allowing them to
do it. If you don't agree with the proposed changes, tell them you don't and
ask to speak to their supervisor. If the supervisor doesn't know what you are
talking about, and you don't agree, go to appeals. If what's at stake is less
than $10,000, you can go all the way to small claims tax court - by yourself.
It is your right as a taxpayer.
Also, at each higher level, you have a greater chance of winning. The
front line auditor's job is to make problems for you, their supervisor's job
is to resolve them. And, 66% of all cases that go to appeals get resolved in
the taxpayer's favor. You may want to consider having someone who is
knowledgeable in this area represent you. It all depends what is at stake in
terms of money for you.
Again I don't know what your situation is, so I am not telling you that
you qualify as a Trader, but, if you want me to email a Trader questionnaire
to help you evaluate your situation, email me a tbtesser@xxxxxxxx
And most of all...
"Keep the IRS out of your pockets, and away from your trading
profits!"
Ted Tesser, CPA
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