EDUCATION CENTER
Trader Tax Status

The first step to tax savings is qualifying for “trader tax status,” which signifies business treatment of trading gains and losses, as opposed to the default investment treatment.

Business treatment gives full ordinary-loss deductions, including home-office, education, start-up expenses, margin interest, and much more, whereas investment expenses are very limited, only allowed in excess of 2 percent of adjusted gross income (AGI), and not deductible against the nasty alternative minimum tax (AMT). The average trader saves more than $8,000 per tax year with trader tax status, and hedge funds also save taxes for their investors. You can claim trader tax status after year-end; it doesn’t need to be elected in advance like Section 475 MTM (mark-to-market) and the forex election to opt out of Section 988. You can claim trader tax status for the tax year that just ended and even for the prior three tax years with amended returns by including a Schedule C as a sole proprietor. (Note: Filing amended tax returns may increase your odds of IRS questions or exam.)

Full-time active traders generally qualify for trader tax status quite easily. Part-time traders can also qualify, but it’s more difficult. The bar is raised in the eyes of the IRS — especially if you have trading losses.

QUALIFYING FOR TRADER TAX STATUS
Unfortunately, the IRS hasn’t issued specific rules with objective criteria for how a trader qualifies for trader tax status (business treatment).

Leading tax publishers have interpreted case law to show a two-part test to qualify for trader tax status:
1. “Taxpayers’ trading activity must be substantial, regular, frequent, and continuous.
2. The taxpayer must seek to catch the swings in the daily market movements and profit from these short-term changes rather than profiting from long-term holding of investments.”

Continuous business standard update: Last year we made headway in establishing the importance of the “continuous business standard” vs. the frequency of trades. Plenty of traders meet the continuous business standard, but some fall short of the required frequency of trades. Over the past few years, more day traders have moved to swing trading and trading options, thereby reducing their frequency of trades and lengthening their holding period. There’s new hope for these traders to retain or achieve trader tax status. This past year, we did not have the opportunity to raise this argument again in an IRS appeals case. It’s good that we haven’t needed to, but we welcome the opportunity to battle-test the argument more and to set a precedent for future cases.

GOLDEN RULES
Our golden rules for trader tax status qualification are based on years of experience. The trader:
• Trades full time or part time, all day, every day.
• Spends more than four hours per day, every market day working on his trading business.
• Has few to no sporadic lapses in the trading business during the year.
• Executes trades on more than 75 percent of available trading days.
• Makes close to 500 round-turn trades per year.
• Has proceeds in the millions of dollars per year.
• Makes mostly day trades or swing trades.
• Has the full intention to run a business and make a living.
• Has significant business tools, education, business expenses, and a home office.
• Has a material account size.

WHAT DOESN'T QUALIFY?
There are three factors that automatically don’t qualify for trader tax status:
1. Automated trading without much involvement by the trader.
2. Engaging a money manager.
3. Trading retirement funds.

This is an excerpt from Green’s 2012 Trader Tax Guide • Copyright © 2012