Investor
An investor purchases stock/securities for capital appreciation and/or dividends. It is typically a “buy-and–hold” strategy, or as option traders quip, “buy-and-hope” strategy. There are no “trade adjustments” based on the new trend for the stock, just maintaining a position and providing cocktail party conversation.
Gains and losses are reported on Schedule D/D-1. Net capital losses are limited to $3000 in any one year. Stock losses are also subject to the wash sale rules detailed under Taxation.
As noted above, an investor’s investment expenses are deducted under IRC Section 212, which means, on Schedule A as Miscellaneous Itemized Deductions subject to a 2% of Adjusted Gross Income threshold.
Interest (margin/investment interest) is deductible up to net investment income which includes interest, dividends and short-term capital gains but does not include qualified dividends or long-term capital gains. This deduction is made on Form 4952 and Schedule A in the Interest You Paid section.
As you can see, your ability to deduct a substantial amount of expenses is substantially reduced when “trading” as an investor.
An investor purchases stock/securities for capital appreciation and/or dividends. It is typically a “buy-and–hold” strategy, or as option traders quip, “buy-and-hope” strategy. There are no “trade adjustments” based on the new trend for the stock, just maintaining a position and providing cocktail party conversation.
Gains and losses are reported on Schedule D/D-1. Net capital losses are limited to $3000 in any one year. Stock losses are also subject to the wash sale rules detailed under Taxation.
As noted above, an investor’s investment expenses are deducted under IRC Section 212, which means, on Schedule A as Miscellaneous Itemized Deductions subject to a 2% of Adjusted Gross Income threshold.
Interest (margin/investment interest) is deductible up to net investment income which includes interest, dividends and short-term capital gains but does not include qualified dividends or long-term capital gains. This deduction is made on Form 4952 and Schedule A in the Interest You Paid section.
As you can see, your ability to deduct a substantial amount of expenses is substantially reduced when “trading” as an investor.
Trader
A trader, on the other hand, regularly and continuously attempts to profit from short-term fluctuations in the price of securities. A trader will adjust trade positions based on the new trend of the underlying security and market sentiment, which can change day-by-day, or, as we have seen lately, hour-by-hour.
Gains and losses are reported on Schedule D/D-1. Net capital losses are limited to $3000 in any one year. Stock losses are also subject to the wash sale rules, again, detailed under Taxation.
A trader’s expenses are deducted under IRC Section 162 as “ordinary and necessary” expenses of a trade or business. If trading as a Sole Proprietor or in an entity, such as a single member LLC, a Schedule C is filed for investment expenses. If trading in a flow-through entity, such as a partnership, multi-member LLC or S Corporation, expenses will be reported on a Schedule K-1 from the flow-through entity and be reflected on page 2 of Schedule E.
Interest is deductible on Schedule C for material participation in the trading activity, otherwise reported on Form 4952 which flows to Schedule A.
As a trader, one is also potentially eligible for other tax benefits:
• Home office deduction
• Automobile deductions
• Retirement benefits
• Mark-to-Market election
Even though investment expenses are deducted on Schedule C, any gains from trading are not subject to self-employment tax.
A trader, on the other hand, regularly and continuously attempts to profit from short-term fluctuations in the price of securities. A trader will adjust trade positions based on the new trend of the underlying security and market sentiment, which can change day-by-day, or, as we have seen lately, hour-by-hour.
Gains and losses are reported on Schedule D/D-1. Net capital losses are limited to $3000 in any one year. Stock losses are also subject to the wash sale rules, again, detailed under Taxation.
A trader’s expenses are deducted under IRC Section 162 as “ordinary and necessary” expenses of a trade or business. If trading as a Sole Proprietor or in an entity, such as a single member LLC, a Schedule C is filed for investment expenses. If trading in a flow-through entity, such as a partnership, multi-member LLC or S Corporation, expenses will be reported on a Schedule K-1 from the flow-through entity and be reflected on page 2 of Schedule E.
Interest is deductible on Schedule C for material participation in the trading activity, otherwise reported on Form 4952 which flows to Schedule A.
As a trader, one is also potentially eligible for other tax benefits:
• Home office deduction
• Automobile deductions
• Retirement benefits
• Mark-to-Market election
Even though investment expenses are deducted on Schedule C, any gains from trading are not subject to self-employment tax.
Trader with Mark-To-Market
If you have determined you are indeed a trader, there are still some disadvantages you will face, namely:
• the Capital loss limitation of $3000, and
• the Wash sale rule
By electing Mark-To-Market, you can eliminate these two restrictions. Please refer to the discussion on Mark-To-Market trader status.
If you have determined you are indeed a trader, there are still some disadvantages you will face, namely:
• the Capital loss limitation of $3000, and
• the Wash sale rule
By electing Mark-To-Market, you can eliminate these two restrictions. Please refer to the discussion on Mark-To-Market trader status.
Dual Status - Trader & Investor
Basically, you can have both trader and investor status simultaneously, but it will be in two separate brokerage accounts.
One account, probably designated as your primary source of income or as a part-time yet substantial income activity, would be your “trader” status account and would meet all trader criteria.
Another account(s) could be those designated as a college fund for your children or simply a “mad money” account where you would take small positions and test trade strategies with not a lot at risk.
However, keep in mind, with two or more accounts and one designated as a trading account and meeting trader status criteria, you could possibly draw increased IRS scrutiny. The IRS presumption is that all accounts carry investor status and it will be your responsibility to prove otherwise.
Basically, you can have both trader and investor status simultaneously, but it will be in two separate brokerage accounts.
One account, probably designated as your primary source of income or as a part-time yet substantial income activity, would be your “trader” status account and would meet all trader criteria.
Another account(s) could be those designated as a college fund for your children or simply a “mad money” account where you would take small positions and test trade strategies with not a lot at risk.
However, keep in mind, with two or more accounts and one designated as a trading account and meeting trader status criteria, you could possibly draw increased IRS scrutiny. The IRS presumption is that all accounts carry investor status and it will be your responsibility to prove otherwise.
Trader vs Investor - Which Are You?
In this section we will assist you in determining your status as an investor or trader. The results can have a significant impact on your tax liability.
The determination dictates how gains and losses are recognized and under which [Internal Revenue] Code Section your expenses are deducted:
• Investors - Code Sec 212
• Traders - Code Sec 162
Regardless of which section you qualify under, your income is not subject to self-employment tax.
The determination dictates how gains and losses are recognized and under which [Internal Revenue] Code Section your expenses are deducted:
• Investors - Code Sec 212
• Traders - Code Sec 162
Regardless of which section you qualify under, your income is not subject to self-employment tax.
Cases Relating to Trader vs Investor
Following are a few of the more significant tax and appellate court decisions regarding the determination of trader versus investor. Unfortunately, most of them were decided against the taxpayer and therefore the activity was deemed to be investor related.
Estate of Yeager (2nd Cir, 1989) - Over 2000 transactions in 2 years; Shortest holding period for stock was 3 months, most (90%) over 1 year. Taxpayer attempted to deduct substantial amount of margin interest on Schedule C Result: Investor
Paoli (TC Memo 1991-351) - Made 326 sales of which 205 were stocks held less that 31 days; Mostly 3 months out of the year and not regularly and continuously Result: Investor
Steffler (TC Memo 1995-271) - Taxpayer had a firm name, business cards, separate bank account, computerized investment analysis system; Traded 5-12 days during each of 3 years buying only 16-44 contracts per year Result: Investor
Chen (TC Memo 2004-132) - Made 323 trades, of which 303 were made in Feb, Mar and Apr. The other 20 in three other months and none for 6 months. The case at bench stemmed from Chen attempting retroactively to elect mark-to-market trader status Result: Investor, MTM denied
Cameron (TC Memo 2007-260) - Made 46 purchases and 16 sales in the first year; 109 purchases and 103 sales in the second year; Rarely spent more than 10 days per month and never 5 days per week trading Result: Investor
Holsinger (TC Memo 2008-191) - Taxpayer traded through an individual brokerage account; Created an LLC and made a MTM election; Did not transfer stock to LLC name or new taxpayer identification number of LLC; Traded less than 40% of trading days on individual account and 45% with LLC Result: Investor
Levin (Ct Cl, 1979) - Taxpayer spent most of working day engaged in research on companies to identify attractive trades and making stock transactions Result: Trader
Arberg (TC Memo 2007-244) - Concludes that a husband cannot qualify as a mark-to-market trader on an account owned by his spouse, presumably because of non-community property state residence Result: Investor
Jamie (TC Memo 2007-22) - Only made 252 trades over 3-year period but IRS agreed that taxpayer was a ‘trader in securities’ apparently based on dollar volume of trades. Taxpayer lost on MTM status Result: Trader
Kay (TC Memo 2011-159) - Taxpayer made a mark-to-market election but it was determined that his level of trading did not meet the criteria for trader status Result: Investor, MTM denied
Van der Lee (TC Memo 2011-234) - Taxpayer again attempted to qualify for trader status but the frequency of trades did not meet the judicial threshold Result: Investor
Summary
Several characteristics may be gleaned from the above cases in order to position yourself as a trader:
• Your trading activity must be substantial but “substantial” is never defined. In Holsinger, the judge mentioned 1100 trades as being substantial ... so would 1000 suffice?, what about 850? At best, it is a facts and circumstances issue.
• It must be regular and continuous, not sporadic throughout the year. Even if you do not “pull the trigger” on a trade, keep notes or a log of why you did NOT buy or sell. That is trading too!
To delve deeper into these and additional court cases to see if
Following are a few of the more significant tax and appellate court decisions regarding the determination of trader versus investor. Unfortunately, most of them were decided against the taxpayer and therefore the activity was deemed to be investor related.
Estate of Yeager (2nd Cir, 1989) - Over 2000 transactions in 2 years; Shortest holding period for stock was 3 months, most (90%) over 1 year. Taxpayer attempted to deduct substantial amount of margin interest on Schedule C Result: Investor
Paoli (TC Memo 1991-351) - Made 326 sales of which 205 were stocks held less that 31 days; Mostly 3 months out of the year and not regularly and continuously Result: Investor
Steffler (TC Memo 1995-271) - Taxpayer had a firm name, business cards, separate bank account, computerized investment analysis system; Traded 5-12 days during each of 3 years buying only 16-44 contracts per year Result: Investor
Chen (TC Memo 2004-132) - Made 323 trades, of which 303 were made in Feb, Mar and Apr. The other 20 in three other months and none for 6 months. The case at bench stemmed from Chen attempting retroactively to elect mark-to-market trader status Result: Investor, MTM denied
Cameron (TC Memo 2007-260) - Made 46 purchases and 16 sales in the first year; 109 purchases and 103 sales in the second year; Rarely spent more than 10 days per month and never 5 days per week trading Result: Investor
Holsinger (TC Memo 2008-191) - Taxpayer traded through an individual brokerage account; Created an LLC and made a MTM election; Did not transfer stock to LLC name or new taxpayer identification number of LLC; Traded less than 40% of trading days on individual account and 45% with LLC Result: Investor
Levin (Ct Cl, 1979) - Taxpayer spent most of working day engaged in research on companies to identify attractive trades and making stock transactions Result: Trader
Arberg (TC Memo 2007-244) - Concludes that a husband cannot qualify as a mark-to-market trader on an account owned by his spouse, presumably because of non-community property state residence Result: Investor
Jamie (TC Memo 2007-22) - Only made 252 trades over 3-year period but IRS agreed that taxpayer was a ‘trader in securities’ apparently based on dollar volume of trades. Taxpayer lost on MTM status Result: Trader
Kay (TC Memo 2011-159) - Taxpayer made a mark-to-market election but it was determined that his level of trading did not meet the criteria for trader status Result: Investor, MTM denied
Van der Lee (TC Memo 2011-234) - Taxpayer again attempted to qualify for trader status but the frequency of trades did not meet the judicial threshold Result: Investor
Summary
Several characteristics may be gleaned from the above cases in order to position yourself as a trader:
• Your trading activity must be substantial but “substantial” is never defined. In Holsinger, the judge mentioned 1100 trades as being substantial ... so would 1000 suffice?, what about 850? At best, it is a facts and circumstances issue.
• It must be regular and continuous, not sporadic throughout the year. Even if you do not “pull the trigger” on a trade, keep notes or a log of why you did NOT buy or sell. That is trading too!
To delve deeper into these and additional court cases to see if
More extensive coverage is provided for each of these cases and more on the “Court Cases” page. You can even download the actual cases themselves from there.
Probably the most well-respected authority on options trading, Lawrence McMillan, in his treatise on options, Options as a Strategic Investment, emphasizes that in trading covered calls using his total return concept, the investor who sells a call in anticipation of a stock decline in price is “really becoming a trader” and should review his motives for covered calls. (page 65)
Maybe not according to IRS definition but chipping away at their position.
| Roadmap |
| Assignment |
| Trader |
| Mark-to-Market |
| Entities |
| Trade to Return |
| OSI |
| Software |
| Indexes |
| Court Cases |
| Wash Sales |
| MTM Example |
| MTM Mechanics |
| Getting an EIN |
| Start Up Expenses |
| Benefits |
| Reporting |
| Option Trading Software |
| Option Pricing |
| Presentations |