The Disturbing State of the Law

It’s hard to find guidance on tax rules for traders.

It would be nice to look up in a book somewhere a clear, detailed definition of trader that applies for purpose of the tax law. Unfortunately that isn’t possible. The term isn’t defined in the Internal Revenue Code or in the tax regulations. The IRS has never given us a ruling or other guidance that delineates where trader status begins and ends. Instead, the definition has evolved over a period of many years through dozens of court decisions.

This fact doesn’t make the definition any less real. Yet it makes it much more difficult to bring the definition into sharp focus.

It Gets Worse

Consider the following, based on my review of numerous trader cases. In the last fifty years:

  • Number of cases dealing with electronic day traders: zero.
  • Number of cases where someone other than a conventional professional trader was declared to be a trader: one.
  • Number of cases where there was a reasonably close question as to whether the taxpayer was a trader: one.
  • Number of cases where a taxpayer claimed trader status and won: zero.

That last item isn’t as bad as it looks. There aren’t all that many cases where a taxpayer claimed trader status and lost, either, if you eliminate the cases where the claim was so weak as to be nearly frivolous.

Trader Economics

Why weren’t there any helpful cases in the past? Simple economics. To be considered a trader, you have to be constantly engaging in a large number of short-term trades. Before cheap, fast online trading became available, it was virtually impossible to do this as a customer of a brokerage house. If you tried, you were all but certain to go broke in no time. Commissions were too high, spreads too large, execution too iffy, and good, current information too hard to come by. In fact, the only case I’ve found where someone other than a floor trader was declared to be a trader for tax purposes involved a compulsive gambler who lost millions in the stock market.

Until a few years ago, virtually the only people who could realistically sustain the kind of activity that would qualify for trader status were people with access to the floor of a stock exchange. Floor traders have lower transaction costs and control over execution — and of course, current price information is right in front of them.

Times Have Changed

The Internet changes all that. Trading commissions are way down. Spreads are smaller, too, and current price information is a mouse click away. Just in the last couple of years it has become possible as a practical matter to engage in the kind of activity that qualifies for trader status without being on the floor of an exchange.

It’s still hard — really hard — to make money as an electronic day trader. Most people who try it lose their shirt. But it’s no longer impossible. And that means for the first time we’re going to see tax cases dealing with trader status for this type of trader. But don’t hold your breath waiting for them. It takes at least a few years, and often ten or more, for an issue to find its way from someone’s tax return into a decided case. It will be a long time before we know how the courts apply these rules to today’s online day traders.

Until then, all we can do is extrapolate from the principles laid down by the courts in the cases decided under yesterday’s economics. When the courts get around to deciding cases involving electronic day traders, they’ll do the same thing: examine the principles of the previous cases and try to apply them to the present circumstances. Inevitably there will be situations where previous cases provide no definitive guidance, but in many cases it should be relatively clear whether the taxpayer is a trader.