In this article we take a look at what the IRS requires for you to be called a trader and what forms are required to be completed with your yearly tax returns.
Just because you call yourself a securities trader doesn’t make you one in the eyes of the Internal Revenue Service. In fact, Uncle Sam is predisposed to consider you merely an investor, and thus deny you more favorable tax status, unless you meet a number of tests that are frustratingly open to interpretation.
That’s right: the tax code contains no actual definition of trader status. Instead, the IRS has issued guidelines that the courts have further delineated by case law, most of which denied taxpayer appeals. What we’re left with is a blurred image, like a photograph of a trader taken from a speeding car.
According to the IRS, to qualify as a trader:
- 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.
- To help determine if you meet these three tests, the IRS considers these qualifiers:
Typical holding periods for securities bought and sold;
- Frequency and dollar amount of trades during the year;
- Extent to which you pursue trading to produce income for a livelihood, and
- Amount of time you devote to the activity.
Swoosh, right? What is “substantial” activity? “Continuity and regularity?” And what’s an acceptable holding period? Is a week too long? A month?
We know who investors are: They’re our hardworking neighbors who buy securities and hold them for such long-term goals as a college fund or retirement.
Traders, on the other hand, buy and sell securities solely to take advantage of short-term market changes. Your profits come from price swings, not dividends and interests. Since your holding period is brief, often a day at most (hence the term “day trader”), there’s no need to perform due diligence on the companies you trade.
Who cares how the IRS classifies you? You do! Investors are subject to the 2% threshold for deductible investment expenses (and hence cannot write off most of their expenses) and are limited to a $3,000 capital loss deduction. But as a trader, you write off 100% of your expenses, and if you elect the mark to market accounting option, can offset all of your losses against income.
Here’s how to claim and protect your trader status:
Step one: Prove beyond doubt that you are a bona fide trader; that is, you “seek to profit from daily market movements.” The best way to accomplish this is by showing a pattern of high trading volume and short holding periods. Keep your personal investments well separated from your trading business. The IRS is looking for “earnest intent;” that is, you work diligently to manage transactions, conduct strategy sessions and make frequent trades.
Step two: Clear the “substantial activity” hurdle. The hallmarks the feds are looking for here are “frequent, regular and continuous” trading. That means volume. One court case ruled that 75 trades a year was insufficient to warrant trader status. The feds need to know that you approach this as a business, not a hobby. Fail to convince them of that and you’re back in investor-land.
Step three: Trade with “continuity and regularity.” If you want business status, it only stands to reason that you must actually be in and remain in business. Here’s where the IRS is looking for a healthy flow of trades, significant dollar amounts, short holding periods, all the signs that your are at least attempting to make a living as a trader. If you take the summer off or show other gaps in your trading, the IRS will be disinclined to grant you trader status. If you’re a newbie and flame out after nine months, while it seems unfair, the IRS has made it clear: no trader status for you.
Once you obtain trader status, you’re not entirely in the clear. Owing to the capricious nature of appellate rulings and the ever-evolving tax code, there are no guarantees that the trader status you enjoy today might not be gone tomorrow.
One good way to claim and protect your trader status is to trade under the umbrella of a business. Not only is that where the biggest tax advantages reside, but a legal entity such as a C corporation or Limited Liability Company sends a strong message to the IRS that yours is an earnest and legitimate business enterprise worthy of trader tax status.
Trader income tax preparation can be overwhelming for the first-time filer. Even many experienced traders prefer to entrust their federal income tax return to tax professionals rather than battle it alone. You know trading; we know trader taxes. It’s just common sense.
But all traders can benefit from a general familiarity with these key Internal Revenue forms and procedures that comprise a typical trader’s tax return:
Mark-to-market (MTM) accounting enables a trading business to change the tax status of their earnings from capital gains/losses to ordinary income/losses, thereby avoiding the $3,000 capital loss limitation and the wash sale rule.
To elect mark-to-market as your accounting method, you must enclose a statement of intent with your personal tax return (if you are going to file as a trader in securities) or extension request and file by the appropriate tax deadline (March 15 or April 15) the year prior to beginning MTM accounting. For example, to use MTM on your 2006 return, you would have to have elected mark-to-market by April 15, 2006.
The one exception: if you’re filing as a new business entity,
such as a limited liability company or C corporation, you have two months from opening to note your accounting preference in your meeting minutes; you need not notify the IRS until the next tax deadline.
We highly recommend that anyone confer with their tax professional prior to making the MTM election. While it seems like a panacea for a trader, that is not always the case, and an extra set of eyes that understands the code could help you not make a huge mistake.
Form 3115: Application for Change in Accounting Methods
Your first year using MTM, you will file IRS Form 3115, Application for Change in Accounting Methods, and submit it with your tax return. This form contains a one-time adjustment, Section 481(a), which captures duplications and omissions resulting from the change in accounting methods. If the adjustment is $25,000 or less, you may deduct the full amount on your return; if it exceeds $25,000, you may deduct 25% each year for the next four years.
Schedule C: Profit or Loss from Business
Traders who file as sole proprietors and do not elect the mark-to-market accounting method report their expenses on Schedule C, Profit or Loss from Business, but their trades on Schedule D, Capital Gains and Losses. This unfortunately can lead to an audit since you are only showing expenses on Schedule C with no income (it goes on Schedule D. Most businesses that file a schedule C also show their income on the same form, but for a trader this is not possible. If this seems somewhat odd, it is; the discrepancy appears suspect to the IRS, too.
One way to avoid this awkward tax position is to trade under a more formal business entity (limited partnership, LLC or C corporation). Tax treatment of business entities is both more favorable and more routine.
Schedule D: Capital Gains and Losses
Traders in stocks, options and single-stock futures who do not elect mark-to-market accounting report their trading activity on Schedule D, Capital Gains and Losses.
Schedule D contains two parts: short-term capital gains/losses for assets held less than one year, and long-term capital gains/losses for assets held more than one year. This also is the form on which wash sale adjustments are recorded. Because trading activity often involves buys and sells of unequal shares, calculations of gain or loss must be broken down into the smallest number of shares on either the buy or sell side, which can be a time-consuming and tedious process.
If your trading activity is significant enough to warrant trader tax status, chances are Schedule D will appear an overwhelmingly difficult form to complete without an experienced trader tax professional.
Traders Accounting will soon introduce an electronic trader’s log that will greatly simplify the process of reporting trading activity on your IRS returns.
Form 4797: Sales of Business Property
Traders in stocks, options and single-stock futures who elect mark-to-market accounting report their trading activity on Form 4797, Sales of Business Property (Also Involuntary Conversions and Recapture Amounts Under Sections 179 and 280F(b)(2)).
Under the mark-to-market method, all securities that you hold at the end of the year are treated as if they were sold and repurchased on the last day of the year; they are “marked to market” for tax purposes. All trading activity should be entered under Section II of Form 4797, Ordinary Gains and Losses.
Note: long-term investments that are not part of your trading business should be entered on Schedule D, Capital Gains and Losses, and not marked to market on Form 4797.
Form 6781: Gains and Losses from Section 1256 Contracts and Straddles
Traders in commodities, including such Section 1256 contracts as futures, foreign exchange and nonequity options, report their trading activity on Form 6781, Gains and Losses from Section 1256 Contracts and Straddles. You enter the gross amount of your Section 1256 proceeds from your 1099 on Part 1, Line 2 (Net Gain or Loss) of Section 1, Contracts Marked to Market.
The IRS cuts commodities traders a break by allowing them to split their Capital gains and losses, 60% long-term and 40% short-term. This is such an attractive deal that many commodities traders choose not to elect mark-to-market accounting, thereby retaining their profitable 60/40 split on gains. An added plus: losses on Form 6781 may be carried back three years against gains.
Form 4868: Application for Automatic Extension of Time
Tax time can be confusing, especially for the first-time active trader. But there is relief in Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Return. When filed by April 15, the extension automatically moves your tax deadline three months ahead, to Aug. 15. A second extension, to Oct. 15, affords you a full six months to file, but it is not automatic; you must receive the form marked “granted” back from the IRS.
Bear in mind that an extension only buys you time to file, not pay – if you don’t remit more than 90% of your estimated tax due by the original April 15 deadline, your extension will be deemed invalid.
Take it from experienced traders: don’t go it alone when it comes to filing with the IRS. One false move can cost you plenty, possibly even your trader tax status. We strongly recommend you seek the assistance of a trader tax professional at Traders Accounting this tax season.