Investor vs Trader
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.
Keep in mind one thing - there is no such thing as "Trader Status" promulgated by IRS. Qualifying as a "Trader" or "Trader in Securities" is a facts and circumstances determination.
The determination, however, is important since it can dictate how gains and losses are recognized and under which [Internal Revenue] Code Section your expenses can be deducted:
Investors - Code Sec 212
Traders - Code Sec 162
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If you qualify as a "Trader" your gains and losses are recognized the same as those of an "Investor". However, as a "Trader" you may qualify as a "Mark-to-Market" Trader.
Regardless of which section you qualify under, your income is not subject to self-employment tax.
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 Form 8949/Schedule D. Net capital losses are limited to $3,000 in any one year. Stock losses are also subject to the wash sale rules detailed under Wash Sales.
As noted above, an investor’s investment expenses are deducted under IRC Section 212, which means, on Form 1040 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 or Trader in Securities
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, hour-by-hour.
Gains and losses are reported on Form 8949/Schedule D. Net capital losses are limited to $3,000 in any one year. Stock losses are also subject to the wash sale rules, again, detailed under Wash Sales.
A trader’s expenses, however, 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
Even though investment expenses are deducted on Schedule C, any gains from trading are not subject to self-employment tax.
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” [Emphasis mine] and should review his motives for covered calls. (page 65).
Maybe not according to IRS definition but possibly useful in chipping away at their position …
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” qualifying 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 minimal amounts at risk.
However, keep in mind, with two or more accounts and one designated as a trading account and meeting trader 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.
Court Cases Related to Investor vs Trader
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.
Keep in mind, most of the delineation between Investor or Trader is facts and circumstances related, as evidenced by these court cases.
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
Endicott (TC Memo 2013-199) - Taxpayer made a substantial number of trades one year, attested to by Tax Court, but still did not rise to level of trader status Result: Investor
Nelson (TC Memo 2013-259) - Again, taxpayer’s dollar volume substantiates trader status but Tax Court determined that days trading were not regular and consistent Result: Investor
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? The decision in Jamie was 252 trades ... 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 - but you will have to convince IRS of that!!
To delve deeper into these and additional court cases to see if your situation differs from theirs, click here.
If you have determined you are indeed a trader, there are still some disadvantages you will face, namely:
the annual 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 qualifications.
Summary, Discussion and Conclusions from Court Cases
Everybody wants to achieve “trader status” - because of the tax benefits - in similar fashion to everybody wanting to go to heaven but not wanting to die ... there is a cost to achieve this.
Based on the above cases, a lot of taxpayers meet the time threshold in that they spend a substantial amount of time researching stocks, developing a watch list and monitoring overall stock market movement.
So why did these investors not qualify as traders?
The two major criteria illustrated in Holsinger are:
Substantial amount of trading, either measured in dollar or trade volume, and
Attempting to profit from short-term stock market movement as opposed to long-term capital appreciation and collecting dividends.
Cited above is Liang v Commissioner, 23 TC 1040 (1955), that provides the defining language used by subsequent courts in distinguishing between investor activities and trader activities:
In the former [investing], securities are purchased to be held for capital appreciation and income, usually without regard to short-term developments that would influence the price of securities on the daily market. In a trading account, securities are bought and sold with reasonable frequency in an endeavor to catch the swings in the daily market movements and profit thereby on a short-term basis.
Most of courts agree on the following criteria:
The taxpayer’s intent - profit from short-term volatility
Nature of the income from the activity - not interest, dividends or long-term appreciation
Frequency, extent and regularity must be substantial
When capital appreciation or even conservation of capital are mentioned, especially in light of the possibility of dividend income, taxpayer’s rarely prevail as a trader. However, as options traders, conservation of capital is easily maintained with the purchase of a put close to one’s cost basis until the impending specter of a sudden downturn fades. Even a covered call or a collar relies on “capital appreciation” when the goal is to be called out of the stock while also protecting your position - as in the collar trade.
With regard to the first criterion, Holsinger mentioned $9 million in dollar volume and 1,100 trades. So would $7.5 million qualify? Or what about $5 million? Or what about $2.5 million? And how is it measured? Would churning the same shares over and over so that one’s Form 1099-B showed gross proceeds of over $2.5 million qualify? So your portfolio, for example, could only be $275,000 and you purchase 1,000 shares of Apple at $250 per share and sell 10 calls and they are exercised each month for twelve months. Your gross proceeds would approximate $3 million but your portfolio started at less than $300,000.
What if the same trades as above were executed only on the S&P 500 Index (SPX)? Yaeger’s trading reached this threshold but he was deemed to be an active investor engaged in security management and not a trader. But Yaeger invested for long-term appreciation in purchasing what he perceived to be undervalued stock and then letting it rise to its proper valuation. So he was denied because his trading was not substantial on a round-trip basis.
So, back to our AAPL/SPX example. Holsinger noted that a substantial number of trades were more than 31 days. If one’s covered calls are called each month, that represents a holding period of less than 31 days and profit has been captured based on this “short-term” movement.
Here’s another example, exploring the same principles.
A pool service company owner examines a homeowner’s green pool and determines that the chemicals are drastically out of balance. The pool service company owner determines the right amount of chemicals to apply to the pool, applies them and then waits to see the outcome. During the waiting period he telephones or emails the homeowner as to the current condition of his pool.
Now, the pool service has fifty homeowners for whom he provides this service. Once the initial chemicals are applied he leaves and simply calls the homeowners and/or comes by periodically to monitor the pools.
How is the pool service treated for tax purposes? He initially treats a pool (the trade) and then monitors the application of the chemicals (watching the trade). He may do this for twenty to over sixty homeowners during “pool season” and then just monitors their pools during non-pool season.
The pool service company owner operates a trade or business just like a trader. What differentiates them? Number of trades versus number of pools served or the frequency with which the pools are monitored?
The point is, the standards are higher for a trader in securities to be classified as a trade or business versus other businesses.
The classic example is the real estate agent who may work a tremendous amount of hours obtaining real estate listings, showing homes, preparing marketing and advertising media and preparing paperwork for the sale and only sell a few homes in a year. IRS classifies that as a trade or business. If the agent sells $1.625 million in real estate and averages 4.5% commissions, that is over $73 thousand in income for the sale of as few as 5 homes - one home every 2½ months.
The IRS, based in large part on the court cases presented, now defines in Publication 550 a number of conditions necessary to qualify as a trader.
You must seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation.
Your activity must be substantial
You must carry on the activity with continuity and regularity.
So, does that mean a trader cannot receive interest, dividends and hold a particular stock for over one year? What if you had held Apple for one year ... you would have a nice long-term profit. What if you had day-traded or swing-traded Research in Motion (Blackberry) or GoPro? You'd be licking your wounds and finding something else to fill your time.
Just what does “substantial” mean? In Levin, who prevailed, it was 332 trades but Holsinger lost with 372 trades.
The carrying on of the activity with continuity and regularity would seem to mean that most of one’s day is spent on trading activities.
IRS Publication 550 goes on to say that:
The following facts and circumstances should be considered in determining if your activity is a securities trading business:
Typical holding periods for securities bought and sold.
The frequency and dollar amount of your trades during the year.
The extent to which you pursue the activity to produce income for a livelihood.
The amount of time you devote to the activity. [emphasis mine]
Here again, we are left with a facts and circumstances decision on the part of the taxpayer.
The holding period issue would encompass the short-term aspect of seeking profit. But the court cases do not define short-term. For capital gain purposes, short-term is less than one year. However, the cases seem to present that even a 30-day holding period is not “short-term” enough, see Holsinger [(372 trades ÷ 2) ÷ (251 trading days per year × 45%) = around 1.6 round-trip trades per day.]
The extent to which one pursues the activity to produce income is, in and of itself, easy to achieve. If one shows a nice profit and spends some time researching stocks and options, this threshold is met. However, IRS added, which is in none of the court cases, nor is it contained in the Internal Revenue Code or Regulations, “for a livelihood.” Therefore, if you have another source of income, and that income is substantial, ie, retirement pension, IRA, or a spouse is earning a meaningful salary, this could be a substantial hurdle to overcome.
Time devoted to the activity seems to have little or no bearing if one does not initiate a “substantial” number of “short-term” trades.
So there you have it! Probably more than you wanted but at least it will give you criteria to ponder before deciding if you are indeed a trader in securities.