IRS Guidance on Trader Taxation

What you need to know about what the IRS says about trader taxation.

For many years there was no guidance available from the IRS on the subject of trader taxation. In 2000 the tax agency recognized the explosion of interest in the subject and published a limited amount of guidance in three forms:

  • Instructions for Schedule D and Form 4797 now cover the bare outline of tax rules for traders. (Acrobat Reader required for these links.)
  • IRS Publication 550 now includes a short section on traders, with essentially the same information you’ll find in the tax return instructions.

I applaud the IRS for recognizing the need for guidance in this area and making the effort to answer these questions. Still, I have a few complaints about statements that appear in their guidance.

Factors Indicating Trader Status

In both Publication 550 and the instructions for Schedule D, the IRS provides a list of facts and circumstances that should be considered in determining whether your trading activity is a 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.

My complaint about this list is perhaps a little subtle, but still an important one. In the tax law, whenever there is a list of facts and circumstances like this, it should be true that being strong on one of them can make up for being weak on another one. That’s true for the last three items in the list above. For example, if you seem to be a borderline case when we look at your trading volume, you might strengthen your case by showing that you devote a great deal of time to your trading activity.

The first item, your typical holding period, is important in determining trader status. Still, it doesn’t belong on this list because it’s part of an entirely separate test for trader status. The length of your holding periods for securities bought and sold is used to determine whether you pass the trading activity test. If you fail that test, the other three factors on the list won’t save you.

The best case to illustrate this is Estate of Yaeger (889 F.2d 29, 2d Cir. 1989). In that case, the last three factors on the list were as strong as possible: the taxpayer made over a thousand trades per year; this was his sole livelihood; and he spent all his time on the activity. Yet he wasn’t a trader because his typical holding period was long, indicating that he pursued this activity for capital appreciation rather than to capture short-term market swings. In other words, he failed the trading activity test.

The IRS guidance would be clearer and more accurate if it indicated that your typical holding period is a factor in determining whether you pass the trading activity test, and the other three factors in their list apply in determining whether you pass the substantial activity test.

Part-Time Traders

The IRS’s Frequently Asked Questions about trader status includes the following statement:

“Basically, if your day trading activity goal is to profit from short-term swings in the market rather than from long-term capital appreciation of investments, and is expected to be your primary income for meeting your personal living expenses, i.e. you do not have another regular job, your trading activity might be a business.”

That seems to imply that you can’t be a trader if you have another regular job, which is plainly incorrect. It’s firmly established that you can have a part-time activity that’s recognized as a “trade or business” under the tax law, and there’s no reason to suppose that the business of trading securities is different from all other businesses in this regard. Naturally, if your activity is part-time you will have a greater burden in showing that it was substantial enough to qualify as a business, but having a different full-time job doesn’t prevent you from qualifying as a trader.

Consent to Change Accounting Method

This point is a quibble. The FAQ says you need the consent of the Commissioner to change to the mark-to-market method of accounting. The law plainly states that consent is not required. (Internal Revenue Code section 475(f)(3)). That’s merely a technicality because the law also gives the IRS authority to determine the time and manner of making the election, and the IRS automatically grants consent when you follow those procedures.