Trader Status: Lessons from a Recent Case

Weaknesses produce IRS victory

By Kaye A. Thomas
Posted September 12, 2008

Is day trading necessary?

A recent Tax Court memorandum decision (Holsinger v. Commissioner) agreed with the IRS in finding that the taxpayers were investors, not traders. The ruling was not especially notable, but it received some attention, including a writeup by Tom Herman in the Wall Street Journal, so let’s see what we can learn from this outcome.

The business entity

You don’t have to form a business entity to qualify as a trader. In my experience most true traders don’t use a business entity unless their trading business is also a true partnership. They simply trade using an account in their own name.

In this case, the taxpayers, husband and wife, formed a limited liability company (LLC) jointly owned by the two of them. Perhaps they did this as a way to specify their ownership percentages (67/33), or they may have wanted to take advantage of the rule that allows a newly formed entity to make the mark-to-market election for a particular year after April 15. In any event, they did form the entity and file the mark-to-market election shortly thereafter.

Unfortunately, they didn’t transfer their trading business to this entity. They continued to trade with the same accounts they previously used, under their own names and their own social security numbers. (They had multiple accounts with different brokers.) They didn’t transfer their computers or other equipment used in their trading activity to the LLC, either.

The taxpayers argued that they were trading as agents of their LLC, and the judge offered no comment on the argument, proceeding to decide the case without regard to this issue. That’s a pretty lame argument, though, particularly as this case involved the mark-to-market election. One of the main considerations in connection with this election is to be as clear as possible as to what accounts (and what holdings within those accounts) are affected by the election. Otherwise the taxpayer can claim that the accounts that showed profits were personal (and produced capital gain) while the accounts that showed losses were covered by the election (and produced ordinary loss). I suppose the judge felt it wasn’t necessary to rule on that issue because the decision was in favor of the IRS anyway, but here’s a word to the wise: if you set up an entity for your trading activity, you should transfer your trading activity to the entity.

Substantial activity test

One of the requirements to qualify as a trader is to pass what I call the substantial activity test. Basically, you need to be doing enough trading on a regular, sustained basis to show that this is a serious business activity.

For detailed discussion of trader taxation get our book, Capital Gains, Minimal Taxes.

In this case, the judge found that the volume of trading activity wasn’t enough to establish the taxpayers as traders. They had a few hundred trades in each of the two years that were contested. This is a low number for anyone seriously pursuing a trading business. The total dollar amount was also quite low: under a million dollars in one of the years. The kind of active buying and selling normally associated with a trading business usually produces many millions of dollars in purchases and sales. What’s more, the taxpayers traded on fewer than half the days the market was open. These facts undercut the notion that the taxpayers were pursuing trading as a business.

These taxpayers were certainly more active than the typical investor, but their activity fell short of what we would expect of someone carrying on trading as a business. At best they put themselves in a gray area on this issue. If you want to qualify as a trader, you should be devoting time to the activity nearly every business day. Sporadic activity indicates your trading is an avocation rather than a business.

Trading activity test

You don't automatically qualify as a trader if you pass the substantial activity test. You also have to pass what I call the trading activity test. The issue here is that the main thrust of your activity is trying to capture short-term swings in market prices rather than profit from dividends and share appreciation.

In this case, the taxpayer testified that he sought to capture short-term swings in the market and tried to avoid holding stocks and options overnight. According to the court, though, trading records showed that the taxpayer rarely bought and sold on the same day, and held "a significant amount" of the holdings for more than 31 days.

The courts have never spelled out a clear standard for this test. Other cases make it reasonably clear, though, that you can qualify as a trader without being a day trader, that is, someone who normally avoids holding a position overnight. They sometimes speak informally of traders trying to capture "daily" swings in the market, but that isn't the same as saying the only people who qualify as traders for tax purposes are day traders. To the extent this decision suggests otherwise, it's out of line with the main body of law on this issue.

What would be a good standard for this test? I would look at the turnover rate of the trading portfolio, rather than the holding period of specific positions. You can't possibly make money as an investor if your portfolio turns over, say, 12 or more times per year, because your trading expenses will greatly exceed any reasonable investment gains, and the only hope for success is to generate trading profits. This is my own opinion of how the courts should look at this, however, not a test that has been articulated by the courts.

It isn't clear that the court applied the correct standard on this point, but it appears that the taxpayer damaged his own case by offering testimony that was refuted by the documentary evidence. In any event, the court's conclusion on the substantial activity test was enough to give victory to the IRS.

Snowball's chance?

A recent article in Tax Notes Today offered a gloomy assessment for anyone seeking to claim trader status:

Many individual investors . . . want to take the position that they are full-time traders for tax purposes so that they can deduct their expenses and elect section 475(f). . . . In court, these people have a snowball's chance in hell of prevailing. Numerous cases hold that individual day traders do not have a trade or business of trading securities.

I had previously published an article on trader status in that publication, and I responded to this statement with a letter to the editor stating in part:

Without reviewing the criteria laid out in my previous discussion it can be observed that the courts have wasted a great deal of time and effort in reviewing and applying those criteria if it were simply the case that trader status is not available to persons other than full-time trading professionals.

I don't recommend trading as a way to make money, because nearly all people who try it end up with painful losses, occasionally spectacular losses. Yet the conventional wisdom about how hard it is to qualify as a trader for tax purposes is misleading. The reason most of the cases involving trader status end up as victories for the IRS is that these cases involve people who claimed that status based on questionable facts. If you're one of those rare few who can make a go at trading, and you pass the relevant tests, you should not be intimidated into passing up tax benefits to which you are entitled.