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December 2001 Are you an investor ... or a trader? The tax laws treat you differently when you make the transition from one to the other With the explosion in inexpensive online trading opportunities, many individuals are devoting significant time to stock trading. So what happens if, in the eyes of the tax law, you move from being a traditional investor to a stock trader? Perhaps the greatest distinction is in the treatment of expenses. An investor can claim investment-related expenses only as miscellaneous itemized deductions. For most taxpayers this categorization means nondeductibility, as expenses must exceed 2% of Federal Adjusted Gross Income. Conversely, a stock trader is considered to be conducting a business activity, and that allows expenses to be fully deductible. This business status can also allow home office deductibility and an improved location in the tax return for deductibility of any margin interest expense. And yet stock gains are reported in the same manner by a trader as an investor: Capital gain or loss treatment is allowed, without any exposure to the self-employed social security tax. Note, however, that if a net stock loss occurs, the $3,000 limitation continues to apply to a stock trader as well. Trader status also allows the taxpayer to elect “mark-to-market” status. This election results in all security gains and losses reported as ordinary income rather than capital gain, with open transactions at year-end adjusted to market value (resulting in recognition of any unrealized gain or loss). The ordinary treatment of stock gains is probably inconsequential, as a true trader would only have short-term gains that are also taxed as ordinary income. The big benefit is on the loss side, where the $3,000 limitation no longer applies if the transactions are given ordinary status. The impact of adjusting to market value at year-end, of course, depends on whether the open positions are at a net profit or net loss. Given that the mark-to-market election is optional, moving to trader status is clearly advantageous. But will the tax law allow you to be considered a trader? Unfortunately, the definition of “stock trader” is somewhat subjective. It has evolved through a series of court cases and never been clarified by any definitive IRS rulings or regulations. The courts have tended to focus on three factors: (1) holding period of securities, (2) trading activity, and (3) regular personal involvement. The individual’s typical holding period, of course, should be very short, as a trader is focusing on short-term or even daily swings in price. The trading activity should be conducted on nearly a daily basis, and should include significant personal involvement by the taxpayer. While trader status can bring an improved tax-reporting situation, it must be recognized that the barrier is high, at least in the view of some courts. In the Yaeger case, trading status was denied – despite over 2,000 transactions in a two-year period – because many securities were held for more than a year and the shortest holding period was three months. In the Steffler case, the individual claimed to have worked full-time in trading activities but could document trades on fewer than 15 days each year. It appears the courts look for nearly daily personal activity, as well as nearly daily trading, to achieve trader benefits. Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market. |