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Traders in Tax Court

Unfortunately for traders and their tax advisors, trader tax status remains vague in statutory law, leaving it open to interpretation in tax court. Recently, tax-court judges have complicated matters by adopting varying definitions, creating a checkerboard of relevant case law. Due to these court cases, many traders expecting to qualify for trader tax status have been denied. Some had unreasonable expectations.

CHEN VS. COMMISSIONER (2004)
Chen was a part-time trader with a full-time job who entered and exited his trading business in three months after losing almost all his money in hyperactive trading. Chen botched many things in this case. First and foremost, he lied to the IRS about electing Section 475(f) MTM on time, and then used MTM when he wasn’t eligible. Second, he brought a losing case to tax court and made the mistake of representing himself. Once Chen realized he was busted on the phony MTM election, he caved in on all points, including trader tax status.

Even though Chen only traded for three months while keeping his full-time job, it doesn’t mean he didn’t start a new business — with every intention of changing careers to business trading — and make a full investment of time, money, and activity. Tax code or case law doesn’t state that a business must be carried on for a full year’s time or as the primary means of making a living. Countless businesses start up and fail in a few short months. Chen probably could have won trader tax status had he been up front with the IRS and engaged a tax attorney or trader tax expert to represent him in court.

HOLSINGER VS. COMMISSIONER (2008)
Holsinger was a close call at best on trader tax status. (Our CPA firm would not have allowed his trader tax status if we had been preparing his tax returns, as he fell short of our golden rules based on the facts we learned in his sub-par presentation to the court.)

Holsinger also made several errors on his tax return, which rightfully drew IRS attention and an exam. Holsinger formed an LLC for his trading business and he correctly filed an internal MTM election. (New taxpayers are permitted to elect MTM internally within 75 days of inception.) The problem: Holsinger never traded in the LLC’s name and instead traded in a joint individual account with his wife. Holsinger didn’t elect MTM on the individual level and the IRS easily won this denial of MTM in tax court.

Holsinger has similarities to Chen. Holsinger wasn’t entitled to use MTM, yet used it anyway and tried to defend it in tax court. Like Chen, Holsinger got off on the wrong foot and lost credibility with the IRS.

Holsinger’s number of round-turn trades was less than 160 — well below our golden rule, which generally requires 500 round-turn trades at a minimum. Business traders can have fewer, but other factors need to be strong. Business traders should have an average holding period of days to a week (not months), and Holsinger’s average holding period was more than one month. This can be a problem for option traders who trade monthly expirations and Holsinger didn’t raise this point in court.

One IRS argument in this case seems to be that Holsinger traded on only 40 percent of available trading days in 2001 and 45 percent in 2002.

The biggest problem with the Holsinger decision in my view is the court seems to give credit only to days traded and not days spent on business activity where no transactions were consummated. The decision doesn’t mention if Holsinger raised the idea that a business trader spends significant amounts of time on trading business activity, even if he or she doesn’t execute trades on every available day.

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