This page provides more detail into the court cases presented on the Trader page and includes some other important “Trader vs Investor” decisions. Click the cases below to read the summary or on the case title to download and read the full case. Full cases will download as a pdf file. Some contain highlighted text denoting the important points of the case.
Court cases presented
Cameron v Commissioner (TC Memo 2007-260)
Mayer v Commissioner (TC Memo 1994-209)
Paoli v Commissioner (TC Memo 1991-351)
Steffler v Commissioner (TC Memo 1995-271)
Chen v Commissioner (TC Memo 2004-132)
Moller v Commissioner, 721 F2d 810, 83-2 USTC ¶ 9698
Estate of Yaeger v Commissioner, 64 AFTR 2d 89-5801, 89-2 USTC ¶ 9633
Holsinger v Commissioner, TC Memo 2008-191
Higgins v Commissioner (312 US 212)
Levin v US (597 F2d 760)
Vines v Commissioner, 126 TC 479 (2006)
Arberg v Commissioner, TC Memo 2007-159
Jamie v Commissioner, TC Memo 2007-22
Kay v Commissioner, TC Memo 2011-234
Van der Lee v Commissioner, TC Memo 2011-244
Endicott v Commissioner, TC Memo 2013-199
Nelson v Commissioner, TC Memo 2013-259
Summary, Discussion and Conclusions - Tax Blog
Note: In the following cases, the taxpayer is referred to as the “petitioner” and IRS as “respondent.”
Taxpayer made 46 purchases and 14 sales in 2002 with holding periods of less than 61 days for 11 of the trades and 31 days for the other 3.
During 2003 taxpayer made 109 purchases and 103 sales of which 65 sales were reported on Schedule D and the others reported on Form 6781 as Section 1256 Contracts.
Cameron did not trade five days per week and for only two months during 2002 and for 2003 he did not trade more than 10 days per month.
Of the expenses noted on Schedule C, the majority represented attendance at seminars, subscriptions, software, travel and meals, totaling $12,211 (98% of total) for 2002 and $6,043 (69% of total) for 2003.
The Tax Court recognized some “nonexclusive factors to consider [in determining trader status] are: (1) the taxpayer’s investment intent, (2) the nature of the income to be derived from the activity, and (3) the frequency, extent, and regularity of the taxpayer’s securities transactions.” citing Moller v US.
The Tax Court went on to say that:
A taxpayer’s activities constitute a trade or business where both of the following requirements are met: (1) The taxpayer’s trading is substantial, and (2) the taxpayer seeks to catch the swings in the daily market movements and to profit from these short-term changes rather than to profit from the long-term holding of investments. In Mayer v. Commissioner Respondent concedes that petitioner meets the second requirement.
The last statement made by the Tax Court is significant. Even with a lack of substantial trading the taxpayer met the short-term profit motive.
Cameron lost because his trading was not deemed to be substantial in terms of both the amount of money involved and the number of trades.
Mayer averaged over 1,000 trades per year but focused on capital appreciation, interest and dividends instead of attempting to profit from short-term swings in the market.
Mayer’s weighted average holding period for stocks were 317, 439 and 415 days for the years at issue. In fact, the securities held for less than 30 days comprised less than 5% of his sales.
Further, Mayer did not trade himself. He delegated his trading to no less than eight portfolio managers and employed two professionals two assist him in “managing the managers” through an investment corporation. They communicated their objectives to the managers who were given three years to achieve the investment objectives dictated to them.
In determining whether Mayer met the criteria as stated in Cameron above, the Tax Court concluded that Mayer met the substantial trading criteria, even though he did not personally trade his portfolio, but did not meet the short-term profit threshold.
At issue here is whether the taxpayer could deduct interest paid to several brokerages with which he maintained accounts on Schedule C instead of as interest on investment indebtedness.
On his 1982 tax return, Paoli reported over $9.8 million in gross proceeds coupled with almost $10.8 million in cost. The Schedule D was 22 pages of stock transactions and expiring options.
During the year, the taxpayer reflected 326 sales of stocks and options. However, 38% of those transactions were made during a one month period between Jan 12 and Feb 11. Further, the proceeds from stock sales during this period accounted for over 54% of the total proceeds for the year.
Paoli testified that he spent 4-5 hours per day engaged in the activity of trading securities. However, the Tax Court was unconvinced of his alleged diligence since only 1 sale and no purchases were made from October through December.
Petitioner received substantial compensation from his solely owned manufacturing corporation.
Paoli apparently lost because he could not substantiate his trading activity during periods of low transactions, ie, managing a watch list where some watched stocks eventually became traded stocks.
The pertinent portion of Steffler involved the taxpayer’s commodity trading.
Steffler taught himself the commodity trading business. Taxpayer’s spouse, a former math teacher, wrote computer programs that extensively analyze a large amount of historical commodity data that they had purchased.
Taxpayer conducted his activities through an assumed name, purchased stationary and business cards and had a separate bank account in the business name. The amount of $100,000 was deposited at a commodities brokerage in order to fund his trades.
During the years in question, Steffler purchased 16, 18 and 47 contracts in each of three years. Each contract was offset within two months. Trades were made on 7 days one year, 8 days the next and 12 days in the last year.
Although the taxpayer testified, and the Tax Court conceded, as to the arduous nature of programming software for the commodity markets and studying various market theories, such as Elliott Wave, regression theory, moving averages and momentum indicators, the Court also concluded that Steffler’s trading activity was not “frequent, regular and continuous enough to constitute a trade or business.”
This case deals, in pertinent point, with the distinction between trader and investor but also illustrates two further important issues: (1) the mark-to-market (MTM) election cannot be retroactively elected and (2) ignorance of the law is no defense.
The taxpayer was actually employed full-time as a chip design engineer while he was “trying his hand” at trading. During the year in question he maintained two brokerage accounts and made 323 trades. He held most of the securities for less than a month and any short sales were covered within a month.
Chen lost almost $85,000 in his brief foray into trading and attempted to make a retroactive mark-to-market election on an amended tax return. Unfortunately for Chen, he made 303 of those trades during only three consecutive months, the remaining 20 during three more months and none the other six months.
Qualifying for trader status involves qualifying for a unique and highly scrutinized position, as discussed in King v Commissioner. In Chen, the court clearly states that “investors purchase and hold securities for capital appreciation and income [dividends] whereas traders buy and sell ‘with reasonable frequency in an endeavor to catch the swings in the daily market movements and profit thereby on a short-term basis.’” Liang v Commissioner, 23 TC 1040, 1043 (1955) Other relevant considerations stated are the investment intent and nature of the income to be derived from the activity.
The court actually agreed that for Feb-Apr (Apr only had 25 trades) Chen satisfied the criteria it set forth but went on to say that he failed in the second criteria, that his purchases and sales of securities must be “frequent, regular, and continuous.” The court saw Chen’s trading activity as sporadic and therefore insufficient to qualify for trader status.
If Chen does not qualify as a trader then his retroactive MTM election is void since non-traders are precluded from electing MTM. See the MTM page for election requirements.
One observation regarding Chen: Could he not have qualified as a trader for part of the year, as the court conceded that he met the criteria? He could not have elected MTM, but his expenses would qualify as “ordinary and necessary” and deductible on Schedule C. He simply started a new business and it failed. Just a thought ...
Yaeger was an active trader for his own account as well as providing investment consulting services. He subsequently ceased his consulting services and focused solely on trading his own accounts. He worked every day of the week and was trading the day before he died.
During the years in question, he made 1,176 purchases and 86 sales and 1,088 purchases and 39 sales the following year.
His investment philosophy was to buy the stock of undervalued companies and hold them until their price reflected the underlying value of the company. This approach required him to research each company extensively including contacting company management and attempting to orchestrate a merger or acquisition.
Yaeger used an extensive amount of leverage in his investing activities. In this case, his portfolio margin reached 47 and 42 percent, respectively.
Therefore, the issue in this case was the deductibility of interest as an ordinary and necessary expense on Schedule C or as investment interest expense subject to the limitation of IRC Sec 163(d). Further, the deductibility of that interest turned on whether Yaeger’s investment activity rose to the level of a trade or business.
Although the sheer number of Yaeger’s security transactions and the fact that he pursued them vigorously and extensively bore great weight in the eyes of the court, coupled with the amount of debt used to fund those activities, ultimately their conclusion turned on the fact that simply managing securities investments is not the trade or business of a trader.
Moller, a husband and wife trading team, sought to deduct home office expense for two residences and in so doing, assumed that their securities transaction activity rose to the level of a trader in securities.
The home office deduction is available to a taxpayer who conducts an activity which is a trade of business where the principal office of that trade or business is in the taxpayer’s home. As further cases describe, that office must be for “regular and exclusive” purposes.
The Mollers spent 40-42 hours each week in research, kept regular office hours and monitored the stock market daily. However, they engaged in only 83 purchases and 41 sales in one year and 76 purchases and 30 sales in the next.
By their own admission, the Mollers did not purchase stock for speculative purposes but for long-term growth potential and the payment of dividends. They also invested in Treasury Bills for interest income.
The Appeals Court concluded that the Mollers were not traders but were active investors and were not entitled to the home office deduction since that is only available when the taxpayer carries on a trade or business.
In my opinion, Holsinger is an example of what can go wrong when one simply does not know what they are doing. This case could have been won by the taxpayer.
Holsinger incorporated an entity - Alpha Trading Co of Sarasota LLC - and flowed his income from that entity through to his individual income tax return, Schedule E. Holsinger then claimed trading deductions on Schedule C.
Taxpayer had five brokerage accounts in which he engaged in investment activity. After incorporating Alpha, taxpayer did not change the name on his trading accounts and continued to use his social security number as the taxpayer identification number for all accounts. He also used a room in his home that was regularly and exclusively used for his investment activity containing computers, multiple monitors and Internet access. None of the equipment was transferred to Alpha.
Alpha made a timely mark-to-market election but the effectiveness of that election turns on the validity of whether Alpha would be classified as a trader in securities.
As summarized from various Tax Court cases, a taxpayer’s activities constitute a trade or business where both of the following requirements are met: (1) the taxpayer’s trading is substantial and (2) the taxpayer seeks to catch swings in the daily market movements and to profit from these short-term changes rather than from long-term holding of investments.
In this case, the court found that taxpayer’s trading was not substantial. Holsinger executed 289 trades one year and 372 trades the next year which constituted 40% of the trading days for the first year and 45% for the second.
Although Holsinger testified that he attempted to capture short-term swings in the market an analysis of his trading activity reveals that a significant number of his holdings were held more than 31 days and that he rarely bought and sold on the same day.
Therefore, the court found that Holsinger did not meet the trader in security threshold either individually or through Alpha and that the expenses deducted on Schedule C as ordinary business expenses were more properly deductible on Schedule A as Miscellaneous Itemized Deductions.
This is a very important case. Read my comments in the Tax Blog.
The case that “got the ball rolling” so to speak. Appealed all the way to the Supreme Court in 1941, the taxpayer, Higgins, lost in his attempt to deduct expenses associated with his substantial investment holdings in stocks and bonds.
Higgins also managed substantial holdings in real estate and the expenses were allowed by the Commissioner of Internal Revenue stating that “the claimed deductions are ordinary and necessary expenses.”
The interesting thing about the allowance of deductions pertaining to the real estate is that they were still carried on from a distance. Higgins lived in Paris and managed his investment holdings via telephone, cable and mail. Higgins argued that his real estate and security holdings constituted a unified business. However, the Commissioner was able to identify and segregate expenses pertaining to each, and so he did.
In my opinion, one of the most damaging issues in this case was the fact that Higgins “sought permanent investments” and that “changes, redemptions, maturities and accumulations caused limited shiftings in his portfolio.” He did not, as what would in the coming years come to be called, “attempt to profit from short-term swings in the market.”
Therefore, the principle that the management of one’s securities was not deemed to rise to the level of a trade or business was born - a threshold that has become increasingly difficult to clear.
In the extensive list of cases presented, this is the only one in which the taxpayer prevailed. There are several nuances to this case that I believe make it a winner for the taxpayer.
Levin began trading after World War II and apparently had some initial success. He concentrated on one corporation at a time but traded other securities concurrently.
He spent his working day researching companies, traveling and talking to the officers of target companies. He attended seminars, ate with NYSE traders and generally immersed himself in the stock market.
He used margin extensively and at the end of one year owned stocks worth $8 million with margin debt of $3 million. Also during the year in question, he made 332 trades of 112,400 shares totaling $3,452,125.
As mentioned above, one nuance that I believe weighed heavily on the mind of the court was that Levin had only one other source of income, a $5,000 per year fee from sitting on the board of directors of a small oil company.
Almost all of Levin’s substantial income derived from trading. Further, in the words of the court, “In contrast to the distant management of a portfolio portrayed in Higgins, judgments regarding purchases and sales were made directly by taxpayer, based on his personal investigation of the assets, operation and management of various corporations. In addition, the sheer quantity of transactions he conducted also supports a reasonable conclusion that this taxpayer's business was trading on his own account.”
Thus, Levin was deemed to be a trader in securities.
This case deals primarily with a taxpayer’s ability to receive relief for a late filed mark-to-market election but concedes trader in securities status on the following basis:
Based on the volume and frequency of petitioner’s [Vine’s] trading, the parties have stipulated that petitioner become engaged in the trade or business of trading securities ...
The petitioners were married and lived in a non-community property state, in fact they lived in separate states. One spouse was a trader at Salomon Smith Barney and opened a permissible retail trading account at E*Trade. The other spouse was a financial professional and traded in his own account as a mark-to-market trader, having never made a MTM election.
The first year in question, they filed separate returns and the wife reported short-term gains on her timely Form 1040. The next year they filed jointly and attempted to reflect her trading account as his account, along with his trades, and to report all trading transactions as MTM trades.
A considerable amount of expenses were attributable to the MTM trading activities and were at risk if MTM trader status was not upheld, which it was not.
The Tax Court stated that the taxpayer’s trading activity was not attributed to the taxpayer, ie, trading his spouse’s account, and, as such, trader status could not attach to that activity. Further, and most importantly in this case for tax purposes, if there is no trader status, there is no MTM trader status.
This is an involved case, with many convoluted trails. Never specifically addressed was the consideration of a spouse trading another spouse’s account within a community property state, which would presumably overcome this result, as long as the trading frequency rose to the level of a trader.
Petitioner filed his tax return as a “Trader” and attempted to reflect MTM tax treatment without making a MTM election. The petitioner lost this case but, in some regards, it was a win for traders.
Jamie conducted 118, 81 and 53 trades in 2000, 2001 and 2002, respectively. The dollar volume of those trades were $14.8 million, $656 thousand and $1.8 million for the respective years.
IRS agreed that Jamie attempted to profit “from short-term fluctuations in the market price of securities” and did not attempt to earn interest or dividends on the securities he traded.
However, IRS agreed that Jamie was a “trader in securities” apparently not based on the number of trades but on the dollar volume of the trades.
This conclusion is not expressly stated in the decision so it may not be prudent to rely on it, but consistently trading the same stock on a daily/weekly basis may meet the trader threshold due to the dollar volume of activity, especially AAPL or GOOGL.
The taxpayer in this case was an employee of his solely-owned S corporation. The taxpayer specifically made a mark-to-market election which continued in place during the years in question.
Taxpayer attempted to profit on short-term movements of the stock he traded but only traded sporadically - 313 trades over 73 days, 72 trades over 18 days and 84 trades over 21 days - during a three year period.
As always, along with losses, a substantial amount of expenses were deducted on taxpayer’s Schedule C.
Within the text of the Tax Court decision were three identical statements that provide insight, I believe, to Treasury’s position on investor vs trader/MTM trader status:
Taxpayer “bought and sold the same stock on the same day” only X number of times in 20XX.
IRS differentiates investing from trading based primarily on frequency of trading activity. One of their criteria is that the taxpayer is attempting to capture short-term swings in the stock market.
As discussed below, I believe this is short-sighted on the part of IRS because from a frequency standpoint, a trader does not have to buy and sell the same stock on the same day in order to attempt to profit from short-term swings in the stock market.
Again, taxpayer was found to be an investor because his trading was too in frequent and sporadic. Thus, for tax purposes, even though a mark-to-market election was in place, IRS ignored that election and looked at the frequency and nature of the trades to determine trader status - which in this case was found lacking.
Taxpayer had been a trader at several large brokerage houses and decided to trade his own account. However, during the year in question he only conducted 148 transactions in one brokerage account and 11 in another.
As usual, a large amount of expenses accompanied the trading activity.
No mark-to-market election was made and no reporting of unrealized gains or losses were reported.
Taxpayer had only 76 sales of stock from April to December and of those, 35 had been held prior to beginning the trading activity. Further, his source of profit was from capital appreciation and not short-term price variations.
The Tax Court therefore determined that the taxpayer’s trading activity did not rise to the level of a trader.
The taxpayer had been the president of a medium-sized - and now defunct - tool and stamping company. Recently retired, he decided to try his hand at trading, employing a singular covered call strategy for several years.
Endicott never purchased shares without selling corresponding calls against the position and conversely, never sold calls without owning the underlying stock. The term of the short calls was one to five months. If the options expired, additional calls were sold.
Employing this strategy led to the holding of stock for a longer period than the options were held. However, on average, the stocks were held 35 days with some being held over one year and others for over four years.
Endicott testified that “Although [he] did not execute trades on every business day, he … devoted every business day to monitoring his portfolio as well as performing research to find new positions” - a watch list - “to take once his current positions were closed.”
Taxpayer traded entirely (100%) on margin, so the most significant expense was margin interest.
He executed 204 trades in 2006, 303 trades in 2007 and 1,543 trades in 2008 with the dollar volumes at $7 million, $15 million and $16 million, respectively.
The Tax Court determined that the trading for 2006 and 2007 was not substantial enough to deem trader status, even though those years were accompanied by high volumes of trades.
Unfortunately, and correctly, the Tax Court, even though they found that the 2008 trading was substantial, it did not reach a level of frequency, continuity or regularity necessary to constitute a trade or business.
Just in case you thought only men trade securities, challenge the IRS and lose, here is the case of a woman who traded stock and was quite successful, racking up over $470 thousand in short-term gains one year followed by $37 thousand the next.
During 2005 she traded 121 days out of a possible 250 trading days and executed 535 trades. However, there were eight periods during the year in which over spans of at least seven days that no trades were made. The holding periods ranged from 1 to 48 days.
During 2006 her trading slowed to 66 days out of 250 trading days with 235 trades executed. During 2006, her holding period ranged from 1 to 101 days. There again spans of time where no trades were made.
I believe one significant issue led to this taxpayer’s demise. The Court found her testimony vague, self-serving, uncorroborated and generally not credible. When I see “uncorroborated” I read “unsubstantiated.” She did not have the requisite documentation or third-party substantiation to support her expenses.
The Tax Court concluded that even though the dollar volume of trades was considerable ($32.9 million sales and $32.5 million purchases in 2005 and $24.3 million sales and $23.2 million purchases in 2006), those volumes were not determinative that the trading was substantial, citing Moller.
During 2005, 95 of her 535 trades occurred during a one-week period.
As such, the Tax Court concluded that her overall trading was neither substantial nor frequent, regular or continuous enough to rise to the level of a trader in securities.