Until a few years ago there was very little guidance available from the IRS or elsewhere on how to file as a trader. Late in 2000 the IRS began to offer at least a limited amount of guidance on what a trader’s tax return should look like.
Do You Elect Trader Status?
Strictly speaking, trader status isn’t an election. Either you are a trader, or you are not. Traders are eligible to make the mark-to-market election, but you can be a trader without making this election or any other election.
Yet the IRS is never going to audit a non-trader return and say you should have filed as a trader. In theory there could be a reason for the IRS to do that, but as a practical matter it’s almost never a disadvantage to be a trader.
That means you don’t have to file as a trader if you don’t want to do so. You may feel that the tax benefits are too small to justify the risk that filing as a trader may provoke an audit of your tax return. Or you may just want to keep things simple. The bottom line: filing as a trader isn’t an election, but it is effectively elective.
Preparing the Return
Before filing as a trader, you should carefully consider whether you qualify as a trader, and whether the benefits of trader filing justify the audit risk. Then, if you want to file as a trader and have not made the mark-to-market election, you should file as follows:
- Report your trading gains and losses on Schedule D, just as you would if you were filing as an investor. Note that you are subject to the wash sale rule.
- Report the allowable deductions associated with your trading business on Schedule C. In Box A on this schedule you will describe yourself as “securities trader.”
- Schedule C generally doesn’t have any income on it because your income is capital gain on Schedule D. The total of your trading deductions shows as a loss, which carries to line 12 of Form 1040, reducing the amount of tax you pay on trading gains or other income.
Tax professionals who are not familiar with trader tax returns are likely to react to this description by saying, “That can’t be right.” It goes against everything a tax pro learns to put the income from a business on Schedule D — or to file a Schedule C when there’s no operating profit, and no possibility of operating profit. Yet this is the way traders file, and IRS guidance described on the next page of this guide now makes it clear this is the case.
The mark-to-market election turns the trader’s gains and losses into ordinary income. Instead of appearing on Schedule D, the trading profits and losses appear on Form 4797. Prior to the 2000 filing year, many mark-to-market traders reported trading profits and losses directly on Schedule C, but form instructions for 2000 clarify that the IRS wants them to appear on Form 4797. Most traders will have at least one year when they file without this election, though, because the election has to be made by April 15 of the year for which it is effective. You can’t make the election for a year that’s already completed.