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Strategies & Market Trends : IRS, Tax related strategies--Traders -- Ignore unavailable to you. Want to Upgrade?

To: Colin Cody who wrote (51)	2/18/1998 3:53:00 PM
From: Robert A. Green, CPA	Read Replies (6) \| Respond to of 1383

Correction of misstatements made by others about "trader tax rules." In our professional opinion, Colin Cody is incorrect in many of his comments (tax advice) made on "trader tax status." We base this statement (and prior statements made by us on this thread) on our tax research (excerpted below), and our experience as a proven tax accountant who has taken this position for clients. There is a lot of confusion on bulletin boards on this tax issue. All active traders should learn the rules and follow them whether you think it is in your interest or not. You can search my prior posts on this subject as well. Colin Cody claims that the definition of a "trader in securities" is limited, hard to qualify for and the time factor is a key-determining factor. He points out that CPAs don't know these rules, but that he does, and goes on to answer questions through out this thread giving conflicting incorrect statements about the tax laws. Question for Colin, are you giving professional tax advice on this thread and are you prepared to be responsible to users for it. Also, are you a qualified practicing tax professional? In one post (#50) Colin states that there is no definition for trader in securities in the tax code. This is clearly wrong. Then in a later post (#56) Colin admits that there are such definitions in the federal tax code and he concedes that the tax code does not require time factors or other objective tests. In his posts (#50 and #46 he bases his limiting (and hurtful to bona-fide "traders in securities") opinions on some old tax court case (Liang v. Comr from 1955). According to our tax research excerpted below, the Liang case in no way refutes the positive conclusions drawn in our research. In our opinion, the Liang court case is also not relevant because it was for a nonresident alien who claimed trade or business activity for his trading account in the U.S. The court ruled against Liang because he was never present in the U.S. to qualify for a trade or business. As you can see from an excerpt of our tax research guide "Trader Tax Rules", there are no such objective tests. Just read the below summary and tax site references and see for yourself. If you would like to get more information and consult with us, send an email to rgreen@greencompany.com Our postings are subject to the following disclaimer. We are only responsible to clients who pay us for tax advice, which we give to them after reviewing all their specific facts and circumstances. Here are a few other incorrect statements made by Colin Cody on this thread. Our corrections are based on our tax research and the same conclusions were printed in a recent Barron's article ("Who's a trader"). So either the tax research and Barron's are wrong or Colin is wrong. One thing I agree with Colin on is his biased towards not trying to classify yourself as a trader unless you really qualify as one. Also, I agree with him that one should carefully learn the rules. The important point to debate at this thread is the issue of a part-time trader who has a full-time job. This is a judgement call that we are prepared to make with new clients who contact us to discuss their situation. Other Colin Cody and others misstatements in our opinion. Colin please correct us were you disagree. I do not wish to fight with Colin Cody or anyone else, but I do want to address misinformation and scare tactics. 1. Colin stated in post #66 that "a trader holds stocks as capital assets in an active trade or business." This is wrong, a trader's stock positions are ordinary assets not capital assets. 2. Colin stated in post #56 that "Virtually BY DEFINITION, a Stock trader's Trade or Business will ALWAYS show just expenses on Schedule C, and will likely show little or NO INCOME on schedule C. This is because BY DESIGN, all the TRADER'S SECURITIES ACTIVITY goes on Schedule D, leaving basically ONLY THE EXPENSES on the Schedule C." Correction - This is wrong, a trader's trading gains are ordinary and are reported on Schedule D. Net Schedule C income is considered earned income subject to self-employment taxes and one may make Keogh retirement plan contributions in connection with this net income. Excerpt from our "Trader Tax Status Rules guide." Tax Law - Whether taxpayer is a trader or an investor. Whether a taxpayer's investment activities are sufficient to constitute carrying on a trade or business requires an examination of the facts in each case. In determining whether a taxpayer who manages his own investments is a trader, who is engaged in a trade or business, or an investor, who is not, courts consider the following factors: . . . the taxpayer's investment intent; . . . the nature of the income to be derived from the activity; and . . . the frequency, extent, and regularity of the taxpayer's securities transactions An individual whose sole source of income in the tax year was derived from dividends and interest was held not to be engaged in any trade or business. According to the Tax Court, the distinction between a trader and an investor is that a trader buys and sells securities with frequently in an effort to catch the swings in the daily market movements and thus profit on a short-term basis. On the other hand, an investor purchases securities to be held for capital appreciation and income, usually without regard to short-term developments that would influence the price of the securities on the daily market. The Second Circuit similarly says that the two fundamental criteria that distinguish traders from investors are the length of the holding period of the securities and the source of the profit. Traders buy and sell securities to profit on a short-term basis, while investors derive profit from the interest, dividends and capital appreciation. The Federal Circuit also says that in order to be a trader, a taxpayer's activities must be directed to short-term trading, not the long-term holding of investments, and income must be principally derived from the sale of securities rather than from dividends and interest paid on those securities. In Kales, the Sixth Circuit held that a taxpayer was engaged in the trade or business of managing her own investments because her management activities were extensive, varied, continuous and regular. However, in a later case, the Sixth Circuit recognized that Kales was disapproved by the Supreme Court in Higgins (see 25,609) where a private investor engaged in comparable activities was held not to be carrying on a business. Considering the extensive case law on the issue of whether a taxpayer who manages his own investments is a trader, the Tax Court has developed a two-part test that must be satisfied in order for a taxpayer to be a trader. It holds that a taxpayer's activities constitute the trade or business of trading only where both of the following are true: 1 the taxpayer's trading is substantial (i.e., sporadic trading will not constitute a trade or business), and 2 the taxpayer seeks to catch the swings in the daily market movements, and to profit from these short-term changes, rather than to profit from long-term holding of investments. 8 observation: A trader's investment related expenses are deductible in arriving at adjusted gross income, whereas an investor's expenses are deductible only as miscellaneous itemized deductions as Code Sec. 212 expenses for the production or collection of income, and thus are subject to the 2% floor on miscellaneous itemized deductions ( 56,163). In addition, the investment interest limitation rules of Code Sec. 163(d) don't apply in the case of interest on debt incurred by a trader where the proceeds are used to purchase or carry investments used in the trade or business. Tax Law - Traders in securities -- a business or investment activity? While the Supreme Court has cast doubt on the deductibility of expenses incurred by a trader in securities as business expenses, later decisions by the Tax Court indicate that traders may be entitled to business expense deductions. In any case, traders are entitled to investment-related deductions for expenses incurred in the production and collection of income, as well as for the management and conservation of income producing property. Tax Law - Whether a taxpayer managing his own investments is in a trade or business. Individual investors are not engaged in a trade or business merely because they manage their investments, no matter how large the investments or how continuous or extended the work required may be. Investors who aren't in a trade or business can't deduct expenses connected with their investments as business expenses Courts often examine whether the taxpayer is a "trader" (and, thus, is in a trade or business) as opposed to an "investor"; for discussion of cases on that subject. Our opinion about why there is confusion among Taxpayers - What Taxpayers are most confused about and why they don't take this attractive position Many Taxpayers are confused about their rights as Taxpayers in connection with their stock trading activities. Confused Taxpayers incorrectly think that although they think of themselves as traders rather than investors, they don't qualify for trader tax status. Most accountants and lawyers are not very familiar with the specifics of the tax law in this regard and make some of the below mistakes explaining it to Taxpayers. The first misconception is that either a Taxpayer is an "investor" or a "dealer." Many professionals and some media omit the classification of "trader." The below paragraph of tax law contributes to this first round of misunderstanding. You can see in the next paragraph that the tax law distinguishes between "traders" and "dealers". Traders are penalized versus dealers and dealer status is hard to qualify for. This is not the important point and the new tax law of 1997 mutes it. Many professionals tell their clients that they must be dealers to get the tax advantages of a trader. This is clearly not true as stated above and also below. Traders in stocks and securities. A "trader" purchases and resells property for his own account. He purchases stocks and securities with the expectation of selling them after their market price has risen. He holds the stocks and securities for investment and not for sale to customers. Unlike a dealer, he performs no merchandising function for which he seeks to be compensated, since his source of supply is generally the same as that of his eventual transferee. He must treat his commission expenses as capital expenditures, increasing his costs on purchase and decreasing his gain on sale. The volume of sales made by the trader is not a material factor. The question of whether an individual is a trader or dealer is a question of fact. The following clearly demonstrated that the taxpayer was a trader and not a dealer: All of the transactions involved were done on behalf of his private account. He had no customers. All of his transactions were handled through a broker. Further, he was not licensed to sell securities nor did he have a seat on any of the exchanges. A taxpayer was a trader where he wasn't licensed as a securities dealer, didn't hold himself our to be one, and didn't perform a merchandising function in selling his stocks. The taxpayer traded on his own account and depended upon a rise in the market value of his portfolio for a profit. 25,003 Traders in stocks and securities. A "trader" purchases and resells property for his own account. He purchases stocks and securities with the expectation of selling them after their market price has risen. He holds the stocks and securities for investment and not for sale to customers. 13 Unlike a dealer, he performs no merchandising function for which he seeks to be compensated, since his source of supply is generally the same as that of his eventual transferee. 14 He must treat his commission expenses as capital expenditures, increasing his costs on purchase and decreasing his gain on sale. 15 13 Nehring, Paul, (1957) TC Memo 1957-51, PH TCM 57051, 16 CCH TCM 224. 14 Kemon, George, (1951) 16 TC 1026, acq. 15 Jordan, Glen v. U.S., (1972, DC AR) 29 AFTR 2d 72-1418, 344 F Supp 87, 72-2 USTC 9501. The volume of sales made by the trader is not a material factor. 16 16 Com. v. Burnett, O.L., (1941, CA5) 26 AFTR 893, 118 F2d 659, 41-1 USTC 9347; Mirro-Dynamics Corp v. U.S., (1967, CA9) 19 AFTR 2d 1029, 374 F2d 14, 67-1 USTC 9324, affg(1965, DC CA) 16 AFTR 2d 5671, 247 F Supp 214, 65-2 USTC 9713, cert den(1967, S Ct) 389 US 896, 19 L Ed 2d 214; Adnee, Harry, (1963) 41 TC 40. The question of whether an individual is a trader or dealer is a question of fact. The following clearly demonstrated that the taxpayer was a trader and not a dealer: All of the transactions involved were done on behalf of his private account. He had no customers. All of his transactions were handled through a broker. Further, he was not licensed to sell securities nor did he have a seat on any of the exchanges. 17 17 Huebschman, Eugene, (1980) TC Memo 1980-537, PH TCM 80537, 41 CCH TCM 474. Another factor to be considered is whether the taxpayer uses the product in question in normal business operations. Thus, where the taxpayer engaged in investments through a partnership, it was held that he was not a trader in silver futures where neither he nor the partnership used the silver in normal business operations. 18 18 Kozikowski, Arnold, (1986) TC Memo 1986-364, PH TCM 86364, 52 CCH TCM 148. Where a syndicate is formed to take a large position in a stock, it is treated as a trader and not as a dealer. It is not material that one or more members of the group is a dealer, or that the syndicate ultimately disposes of the stock to underwriters who are dealers. 19 19 Currie, Frances, (1969) 53 TC 185, acq1970-2 CB xix; Lahman, Harry, (1969) TC Memo 1969-239, PH TCM 69239, 28 CCH TCM 1244; Turner, Joseph, (1969) TC Memo 1969-240, PH TCM 69240, 28 CCH TCM 1252. A corporation that purchased stocks and securities for resale on the open market, buying and selling for speculation and investment on its own account through a broker was not a "regular dealer in stock or securities." 20 20 Trading Associates Corp v. Magruder, (1940, CA4) 25 AFTR 290, 112 F2d 779, 40-2 USTC 9519. A taxpayer was a trader in GNMA futures contracts where he bought from, and sold to, the same primary dealer and did not act as a middleman bringing the buyer and seller together. 21 21 Frankel, Russell, (1989) TC Memo 1989-39, PH TCM 89039, 56 CCH TCM 1156. The taxpayer was a scalper, that is a commodities trader who purchased and sold futures of T-Bonds for his own account for immediate resale or repurchase at a profit. In deciding that he was a trader, the court found that the taxpayer didn't perform any service that required compensation by way of a markup of the commodity futures he traded. 22 22 MacAdam, Robert, (1991) TC Memo 91410, 62 CCH TCM 565, TC Memo 1991-410. A person may be a dealer as to some securities and at the same time hold other securities as a trader or investor on his own account and not for resale to customers, see 25,004 A taxpayer was a trader where he wasn't licensed as a securities dealer, didn't hold himself our to be one, and didn't perform a merchandising function in selling his stocks. The taxpayer traded on his own account and depended upon a rise in the market value of his portfolio for a profit. 23 23 Furer, Lewis v. Com., (1994, CA9) 74 AFTR 2d 94-6019 (unpublished), affg(1993) TC Memo 1993-165, RIA TC Memo 93165, 65 CCH TCM 2420. 25,610 Whether taxpayer is a trader or an investor. Whether a taxpayer's investment activities are sufficient to constitute carrying on a trade or business requires an examination of the facts in each case. 49 49 Higgins, Eugene v. Com., (1941, S Ct) 25 AFTR 1160, 312 US 212, 85 L Ed 783, 41-1 USTC 9233. In determining whether a taxpayer who manages his own investments is a trader, who is engaged in a trade or business, or an investor, who is not, courts consider the following factors: . . . the taxpayer's investment intent; . . . the nature of the income to be derived from the activity; and . . . the frequency, extent, and regularity of the taxpayer's securities transactions. 50 50 Mayer, Frederick, (1994) TC Memo 1994-209, RIA TC Memo 94209, 67 CCH TCM 2949; Moller, Joseph v. Com., (1983, CA Fed Cir) 52 AFTR 2d 83-6333, 721 F2d 810, 83-2 USTC 9698, revg(1982, Cl Ct) 51 AFTR 2d 83-369, 1 Cl Ct 25, 553 F Supp 1071, 82-2 USTC 9694, cert den(1984, S Ct) 467 US 1251, 82 L Ed 2d 839; Yaeger, Louis Est, (1989, CA2) 64 AFTR 2d 89-5801, 889 F2d 29, 89-2 USTC 9633, affg on this issue(1988) TC Memo 1988-264, PH TCM 88264, 55 CCH TCM 1101. An individual whose sole source of income in the tax year was derived from dividends and interest was held not to be engaged in any trade or business. 1 1 Klawa, John v. Com., (1968) TC Memo 1968-85, PH TCM 68085, 27 CCH TCM 403. According to the Tax Court, the distinction between a trader and an investor is that a trader buys and sells securities with frequently in an effort to catch the swings in the daily market movements and thus profit on a short-term basis. On the other hand, an investor purchases securities to be held for capital appreciation and income, usually without regard to short-term developments that would influence the price of the securities on the daily market. 2 The Ninth Circuit has adopted the same test. 3 2 Chjang Hsiao Liang, (1955) 23 TC 1040, acq1955-2 CB 4; King, Marlowe, (1987) 89 TC 445, acq1988-2 CB 1. 3 Purvis, Ralph v. Com., (1976, CA9) 37 AFTR 2d 76-968, 530 F2d 1332, 76-1 USTC 9270, affg(1974) TC Memo 1974-164, PH TCM 74164, 33 CCH TCM 702. The Second Circuit similarly says that the two fundamental criteria that distinguish traders from investors are the length of the holding period of the securities and the source of the profit. Traders buy and sell securities to profit on a short-term basis, while investors derive profit from the interest, dividends and capital appreciation. 4 4 Yaeger, Louis Est, (1989, CA2) 64 AFTR 2d 89-5801, 889 F2d 29, 89-2 USTC 9633, affg on this issue(1988) TC Memo 1988-264, PH TCM 88264, 55 CCH TCM 1101. The Federal Circuit also says that in order to be a trader, a taxpayer's activities must be directed to short-term trading, not the long-term holding of investments, and income must be principally derived from the sale of securities rather than from dividends and interest paid on those securities. 5 5 Moller, Joseph v. Com., (1983, CA Fed Cir) 52 AFTR 2d 83-6333, 721 F2d 810, 83-2 USTC 9698, revg(1982, Cl Ct) 51 AFTR 2d 83-369, 1 Cl Ct 25, 553 F Supp 1071, 82-2 USTC 9694, cert den(1984, S Ct) 467 US 1251, 82 L Ed 2d 839. In Kales , the Sixth Circuit held that a taxpayer was engaged in the trade or business of managing her own investments because her management activities were extensive, varied, continuous and regular. 6 However, in a later case, the Sixth Circuit recognized that Kales was disapproved by the Supreme Court in Higgins (see 25,609) where a private investor engaged in comparable activities was held not to be carrying on a business. 7 6 Kales, Alice v. Com., (1939, CA6) 22 AFTR 411, 101 F2d 35, 39-1 USTC 9255. 7 Goodyear Investment Corp v. Campbell, (1943, CA6) 31 AFTR 1024, 139 F2d 188, 43-2 USTC 9668, revg(1942, DC OH) 30 AFTR 1688, 42-2 USTC 9643. Considering the extensive case law on the issue of whether a taxpayer who manages his own investments is a trader, the Tax Court has developed a two-part test that must be satisfied in order for a taxpayer to be a trader. It holds that a taxpayer's activities constitute the trade or business of trading only where both of the following are true: 1 the taxpayer's trading is substantial (i.e., sporadic trading will not constitute a trade or business), and 2 the taxpayer seeks to catch the swings in the daily market movements, and to profit from these short-term changes, rather than to profit from long-term holding of investments. 8 8 Mayer, Frederick, (1994) TC Memo 1994-209, RIA TC Memo 94209, 67 CCH TCM 2949 observation: Most taxpayers who manage their own investments will be treated as investors rather than traders. Proving that one's investment activities rise to the level of carrying on a trade or business is a difficult task. observation: A trader's investment related expenses are deductible in arriving at adjusted gross income, whereas an investor's expenses are deductible only as miscellaneous itemized deductions as Code Sec. 212 expenses for the production or collection of income, and thus are subject to the 2% floor on miscellaneous itemized deductions ( 56,163). In addition, the investment interest limitation rules of Code Sec. 163(d) don't apply in the case of interest on debt incurred by a trader where the proceeds are used to purchase or carry investments used in the trade or business. --------------- We had to cut-off the excerpt here because the post does not allow more words. If you want the rest, email us at rgreen@greencompany.com