Trader Tax Status
The first step to tax savings is qualifying for “trader tax status,”
which signifies business treatment of trading gains, losses and expenses
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% of
adjusted gross income (AGI), and not deductible against the nasty alternative
minimum tax (AMT). Starting in 2013, investment expenses are further restricted
with “Pease” itemized-deduction limitations for taxpayers
with AGI over $300,000 (married) and $250,000 (single). Business expense
treatment is much better.
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 with business ordinary-loss treatment (Section 475) rather
than capital-loss limitations.
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).
This lack of guidance isn’t unusual; the IRS doesn’t provide
objective tests for other types of businesses either. Business traders
face more scrutiny from the IRS, similar to hobby-loss businesses. But
hobby-loss rules can’t be successfully applied against a trading
business (more on this topic later). Arizona tried to apply hobby-loss
rules to a trader and we blocked them from doing so.
Currently, there’s no statutory law with objective tests for how
to qualify for trader tax status. Subjective case law applies. Leading
tax publishers have interpreted case law to show a two-part test to qualify
for trader tax status:
• “Taxpayers’ trading activity must be substantial,
regular, frequent, and continuous.
• 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: We’ve
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. Learn more about continuous
business activity in Chapter 11.
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
• 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
1. Automated trading without much involvement by the trader.
2. Engaging a money manager.
3. Trading retirement funds.
Trader tax status drives many key business tax breaks like business expenses,
business ordinary trading losses with the Section 475 election and AGI
deductions for retirement plans and health-insurance premiums. These items
are deducted from gross income without restriction, whereas investment
expenses are subject to itemized deductions and AMT preferences, and there
are capital-loss limitations and wash-sale loss deferrals to contend with
as investors. Unfortunately, only a small fraction of active traders qualify
for trader tax status, and the rules are vague and difficult to understand.
If you’re not sure, consult Robert A. Green, CPA.
Excerpt from "Entities For Traders."
If you’re thinking about creating an entity for your trading business,
you have options — LLCs, general partnerships or S-Corps. Before
we take a closer look, it’s critical to note that entities don’t
guarantee trader tax status. Your trading must rise to the qualification
level of a business trader before you should consider forming an entity.
If you are not sure if you qualify for trader tax status, first read Chapter
1 "Trader Tax Status" of Green’s
2013 Trader Tax Guide. Next, consider a 30-minute
consultation with Robert A. Green, CPA.
This is an excerpt from Green’s
2013 Trader Tax Guide • Copyright © 2013