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
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 $5,000 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.”
Important new tax court case for options traders:
Read our blog
dated Aug. 30, 2013 "The Tax Court Was Right To Deny Endicott
Trader Tax Status." See the more current Nelson
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 (on an
• Has proceeds in the millions of dollars per year on
securities and less is okay on options and futures.
• Makes mostly day trades or swing trades.
• Has the full intention to run a business and make a
• 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.
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.
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.
are not sure if you qualify for trader tax status, first read
Chapter 1 "Trader Tax Status" of Green’s
2014 Trader Tax Guide.
Next, consider a 30-minute
consultation with Robert A. Green, CPA or Darren
Neuschwander, CPA, co-managing members of Green NFH, LLC.
Consider our Trader Tax Status Determination Service
from Green NFH, LLC on your qualification for trader tax status.
here to learn more.