Definition of “Trader”

There is no definition of trader in the Internal Revenue Code or in the regulations. Instead, the definition has evolved through a number of court cases over the years. Under the definition that has evolved, you have to satisfy the following two tests to be a trader:

Trading Activity Test

The first test distinguishes between the activity of investing and the activity of trading. Your activity is investing if it’s designed to benefit from long-term appreciation in securities, or to produce a significant amount of dividend or interest income. Investors are likely to be interested in a company’s balance sheet, market share, industry trends and other indicators of long-term viability. They typically ignore short-term price fluctuations — or try to, anyway.

Trading activity, for purposes of this test, consists of trying to capture short-term price swings. Many traders have little interest in the long-term prospects of the companies they trade. They may know little about the company other than the way the price of its stock has moved in the recent past. If a trader happens to capture a dividend, that’s likely to be merely coincidental. Traders seek their profits in the market’s zigs and zags.

The precise limits of this test have never been established. It’s reasonably clear that you don’t have to be a day trader to be a trader. People who hold positions overnight, or for a few days at a time, are still engaged in trading activity. The point where your average holding period indicates you’re an investor rather than a trader is almost surely more than a few days, and probably less than six months. There isn’t a lot to go on if you’re looking for a more refined answer than that. If your typical holding period is 60 days, you’re in no man’s land.

Substantial Activity Test

Even if you engage in trading activity, you have to do enough of it, regularly enough, over a long enough period of time, to be considered a trader. I call this the substantial activity test.

Different words have been used to express this test. The Supreme Court said the taxpayer must be “involved in the activity with continuity and regularity.” The Tax Court has used the words “frequent, regular and continuous.” The basic point is that you aren’t a trader unless you do a lot of trading, and keep at it on a regular basis over an extended period of time.

Here again there is no bright line. Are 10 trades a week enough? 20? No one can say for certain. My feeling about the way the courts should decide the question is to look at whether the activity was carried on the way someone would if they treated it as a serious business. If you have a good business reason for executing only a few trades, or none at all, for a period of time, then your absence from the market should not disqualify you from trader status. But if your spotty trading activity, or low volume, indicates a lack of commitment to trading as a business, then you aren’t a trader. It remains to be seen whether the courts will take the approach I advocate.

Both Are Required

You need to pass both tests to be a trader. There are cases where the taxpayer was not a trader even though his activity was substantial, because the activity was investing. And there are cases where the taxpayer was not a trader because he failed the substantial activity test, even though his activity was trading, not investing. If you fail either test, you are not a trader, do not pass “Go,” do not collect $200.