Securities Trader Reporting Requirements

Is a client who trades securities a trader or investor? How can a tax adviser tell? Why is the distinction important? Are there benefits to be gained from qualifying for one status or another? This article's many examples illustrate the different tax treatment of taxpayers in the two categories; it also explains why trader status may be advantageous, how to qualify and the special "mark-to-market" election available.

Thomas Rolfe Pudner, MST, CPA
Manager
Washington National Tax
KPMG LLP
Washington, DC

For more information about this article, contact Mr. Pudner at tpudner@kpmg.com .

Executive Summary

• An individual who buys and sells securities may be classified as a dealer, trader or investor for tax purposes.

• To be a trader, a taxpayer's trading activity must be substantial; he must seek to exploit short-term market swings, rather than merely profit from long-term appreciation.

• The ability to convert capital losses into ordinary losses is the main benefit of making a Sec. 475(f) election.

     

An individual who buys and sells securities may be classified as a "dealer," "trader" or "investor" for tax purposes. Determining a taxpayer's status requires consideration of case law, statutory authority and all the facts and circumstances. Most individuals are not dealers, because they do not purchase securities for resale to customers; rather, they are classified as investors, because they buy securities with the primary intent of holding them to profit from their long-term appreciation and/or interest or dividends. However, some taxpayers are neither investors nor dealers and, instead, qualify for trader status.

There is considerable case law addressing the definition of a trader for tax purposes and how to achieve that status. Generally, a trader is one who trades significantly and continuously in an effort to profit from short-term changes in the price of a security (or securities). While it is debatable whether such a market-timing approach to investing is wise from a wealth-management perspective, the tax treatment traders receive is often preferential to that of investors. In any event, proper tax planning and reporting are essential for taxpayers who seek to be taxed as traders.

Once a practitioner has determined that a taxpayer is a trader, his job has just begun. The practitioner should advise the client about his reporting options and ensure that all returns and elections have been filed in accordance with planning and that the relevant facts and circumstances have been considered. Improper planning or compliance in this area can lead to adverse tax consequences.

This article provides an overview of the factors most relevant to determining whether a taxpayer is a trader, then considers the reporting requirements. It describes the reporting requirements for a trader who has not made a Sec. 475(f) "mark-to-market" election. Because a Sec. 475(f) election has a profound effect on a trader's tax treatment, this article analyzes the relatively complex procedures and tax ramifications of making the election, and the reporting requirements for a trader who has made a Sec. 475(f) election. Finally, it provides practical examples comparing the tax consequences of an investor and a trader under various facts, and illustrates the circumstances under which a Sec. 475(f) election will enhance a trader's tax situation.

Trader or Investor?

An individual who buys and sells securities may be classified as a dealer, trader or investor for tax purposes. Typically, such an individual is not a dealer, because he does not buy and sell securities for customers.¹ Because neither the Code nor the IRS (in regulations or rulings) has defined "trader," the facts and circumstances must be considered when determining whether an individual's investment activity rises to the level of a trader. There is significant case law differentiating traders from investors.

While the courts continue to look at the facts and circumstances, it appears that there are two minimum requirements they deem necessary to attain trader status. First, the individual's trading must be substantial; second, the taxpayer must seek to profit from short-term market swings. The cases below illustrate how courts have applied these requirements (and other factors) in distinguishing traders from investors.

Supreme Court Cases

In Higgins,² a taxpayer owned real estate and substantial stock and bond investments. The Supreme Court held that whether a taxpayer is "carrying on a business" as to his investment activities hinges on an examination of the facts and circumstances. The Court held that merely keeping records of, and collecting interest and dividends on, investments is not sufficient to establish trader status; rather, such activity is insufficient no matter how large the estate or how continuous the work required to carry on such investment activity.

In Groetzinger,³ the Supreme Court considered whether a full-time gambler's activities rose to the level of a trade or business. The Court stated that, while Higgins held that merely collecting portfolio income would not give rise to trader status, it did not indicate that a trader must buy and sell for customers. The Groetzinger Court held that the taxpayer's continuous full-time devotion and intent to sustain his livelihood through gambling, even in the absence of placing bets for third parties, demonstrated that his activity rose to the level of a trade or business. The Court stated that a trader of securities operating in a manner similar to the gambler would have qualified for trader status. Further, "trade or business" and similar terms appear throughout the Code, but are not defined there or in regulations. The Court declined to provide a formula or universal test for trade or business status, observing that it would be counterproductive to apply a general test to the broad applications throughout the Code; it instead concluded that all relevant facts and circumstances must be considered when determining trader status.

Substantial Trading Activity

In Fuld,⁴ a married couple engaged in approximately 665 sales transactions during a year. They devoted substantial time to studying and charting securities prices, reading annual reports, attending corporate meetings and consulting with corporate executives. The main source of the taxpayers' livelihood derived from their securities transactions. The court agreed that the taxpayers were traders.

In King,⁵ the taxpayer engaged in commodity futures trading for his own account. He entered into 11,040 contracts in one year and 6,711 contracts in another year at issue. The court held that the taxpayer's trades were both frequent and substantial and that his activity rose to that of trader.⁶

Recently, in Hart,⁷ a taxpayer made fewer than 100 purchases and 100 sales over three years of activity. The Tax Court held that his trading was not substantial or frequent, regular or continuous; thus, he was not a trader.

Frequent Trading Based on Daily Market Swings

In Liang,⁸ the average holding period of securities sold was 5.8 years. More than 90% of the gains were derived from securities held for more than two years; more than 40% of gains were derived from securities held for more than five years. The Tax Court held that such infrequent turnover demonstrated that the taxpayer was an investor, not a trader.

In Moller,⁹ the court noted that while the taxpayers' investment activities were continuous, regular and extensive, the vast majority of their income derived from dividends, interest and the long-term holding of securities,¹⁰ not from short-term profits and market swings. The court held that the type of income, not the amount of time and effort required to obtain it, determines whether a taxpayer attains trader status. The average holding periods of stocks sold during the periods at issue were 31/2 and 8 years, which demonstrated to the court that the taxpayer was an investor, not a trader.

In Mayer,¹¹ the court noted that the weighted-average holding periods of securities sold ranged from 317–545 days for the years at issue. The court also considered that the percentage of stocks sold after being held for 30 days or less ranged from 0.01%–5.41% of total sales during the years at issue. The court held that these and other factors indicated that the taxpayer did not operate his trades to catch daily swings in market movement, and to profit from these short-term changes. The activity was thus deemed investing, not trading.

Summary

Thus, to be a trader, a taxpayer's activity must be substantial, and he must seek to exploit short-term market swings, rather than merely profit from long-term appreciation. Once these threshold requirements are met, all facts and circumstances must be considered to determine whether his activity rises to trader status.

Reporting Requirements

Investors

Because most individuals are investors, not traders, it is helpful to briefly address the investor reporting requirements.

Typically, an investor reports gains and losses on Form 1040, Schedule D. Long-term gains are generally taxed at 20%; net long-term and short-term losses are generally limited to $3,000 per year, with the remainder carried forward indefinitely.¹² Miscellaneous investment expenses are deductible on Schedule A, subject to the Sec. 67(a) 2%-of-adjusted-gross-income (AGI) limit. Any such deductions allowable for regular tax purposes are added back for alternative minimum tax (AMT) purposes under Sec. 56(b). If an investor pays margin interest on his investments, it will be deductible in the current year under Sec. 163(d) only to the extent the taxpayer has investment income.

Traders

The tax ramifications and compliance requirements vary considerably, depending on whether a trader has made a Sec. 475(f) mark-to-market election. However, certain compliance aspects are the same whether or not a trader makes the election.

Expenses incurred by a trader are reported "above the line" on Schedule C, under Sec. 162. This allows a trader to deduct expenses without the Sec. 67(a) 2%-of-AGI limit. Trader expenses also will not be added back under Sec. 56(b) for AMT purposes. If the trader paid margin interest associated with the trading activity, it is fully deductible and not subject to the Sec. 163(d) interest expense deduction limits. Further, expenses incurred by a trader will reduce AGI for purposes of phasing out itemized deductions under Sec. 68. By qualifying for trader status, a trader fully benefits from trading expenses; an investor's expenses are typically partially or fully disallowed and, even when allowed, do not reduce AGI for phaseout computation purposes.

Whether or not a trader makes a Sec. 475(f) election, the earnings from the activity will not be subject to self-employment (SE) tax, as is typically the case with Schedule C income.¹³ Also, because a trader's income is earned from a trade or business, he may elect to expense certain depreciable assets (such as a computer used predominately in the trading activity) under Sec. 179.¹⁴

Thus, the primary benefit of qualifying for trader (instead of investor) status is the preferential tax treatment of expenditures available to traders.

If No Sec. 475(f) Election

The tax treatment of a trader who has not made a Sec. 475(f) election is "between" that of an investor and that of a trader who has made a Sec. 475(f) election. Under Sec. 1221, trader gains and losses realized from the sale of securities generally will be reported on Schedule D as short-term capital gains and losses. Normally, gains will be taxed at a taxpayer's top marginal rate, unless there are offsetting losses. Losses are deductible only to the extent of gains, plus $3,000; the excess is carried forward indefinitely.¹⁵ Under Sec. 172(d)(2), a loss generally will not be allowed as part of a net operating loss (NOL) carryback.

While the Schedules C and D instructions do not address how to report a trader's gains and losses, the following seems reasonable: A taxpayer reports the gross proceeds from Form(s) 1099B on Line 1, "gross receipts or sales" of Schedule C. Both the basis and the gain or loss reported on Schedule D are backed out on Schedule C as Line 27 "other expenses," with a statement indicating that these amounts have been reported elsewhere on the return.¹⁶ This allows a taxpayer to report all transactions from the trading activity on one schedule (Schedule C), which helps to avoid the mistaken impression that an activity is less profitable than it actually is.¹⁷ Because Schedule C reflects a business's income statement, presenting all income and expenses from the activity (including items reported elsewhere on the return) helps to present an accurate picture of the activity's overall profitability.

If Sec. 475(f) Election

Benefits: A trader may make a Sec. 475(f) "mark-to-market" election that can dramatically change his reporting requirements and tax consequences. Generally, according to Sec. 475(f)(1)(D) and (d)(3)(A)(i), a Sec. 475(f) election converts short-term capital gains or losses into ordinary income or loss. The ability to convert capital losses into ordinary losses is the primary benefit of making a Sec. 475(f) election. In addition, losses that otherwise would have been limited to $3,000 by Sec. 1211(b) are fully deductible against ordinary income in the current year. Even if trading losses offset gains from other activities and, thus, are not limited under Sec. 1211(b), to the extent such gains are long-term, the losses prevent the gains from being taxed at the preferential capital gain rates. A Sec. 475(f) election often allows a trader to deduct losses earlier and to offset ordinary income instead of capital gains.

A mark-to-market election also relieves a trader of the significant administrative burden of complying with the Sec. 1091 wash sale rules.¹⁸ The Sec. 1091 wash sale rules generally prevent a deduction for a loss on the sale of securities if a taxpayer purchases "substantially identical" securities within 30 days before or after the sale. Those rules pose a particularly troublesome burden for traders, because they typically trade heavily in substantially identical securities.

Because traders typically buy and sell in very short cycles, the Sec. 1091 wash sale restrictions are generally much more relevant to investors from a tax planning perspective. A trader normally sells shares immediately when he perceives their short-term outlook is not good, and it is not likely he will sell shares at the end of a year solely to lock in tax losses. In fact, most traders buy and sell continuously, and pay relatively little attention to the tax consequences of such trades. However, traders often purchase and sell shares in the same companies, because they believe they can forecast the ebb and flow of their share prices. Thus, the Sec. 1091 loss limits may cause an unintended administrative nightmare to many traders (and their tax advisers). For example, a taxpayer who bought and sold shares of one company in 75 separate transactions throughout a year would need to apply the Sec. 1091 provisions to each of these transactions, even though the tax consequences might well be insignificant. However (and as noted), a taxpayer with a Sec. 475(f) election is not subject to the Sec. 1091 loss limits. This administrative burden alone may be reason enough to consider making a Sec. 475(f) election.

Making the election: Sec. 475(f)(3) provides that a trader may make an election to mark securities to market if held at year-end. Once made, this election is revocable only with IRS consent. Rev. Proc. 99-17¹⁹ provides procedures for making this election.

Making a mark-to-market election requires two important steps. First, to elect Sec. 475(f) treatment for a tax year beginning after 1998, a taxpayer must attach an election by the due date of the previous year's return. Thus, planning for and communication about the election with a client are critical, because the election must be made before the majority of trades are likely even to have occurred. For example, an election for 2000 must have been filed by April 17, 2000. The statement should describe that the election is being made, the first tax year for which the election is effective and the trade or business for which the election is being made. The election should be attached to the taxpayer's Form 1040 (or to Form 4868, Application for Automatic Extension of Time to File U.S. Individual Tax Return, if an extension was filed). If a return was not required for the year preceding the election year, a Sec. 475(f) election should be made by March 15 of the election year. This election should be attached to the taxpayer's initial tax return.

The taxpayer must generally file Form 3115, Application for Change in Accounting Method, with his tax return, by the due date (including extensions) for filing the election-year return; a copy must be mailed to the IRS National Office. Form 3115 is required because a taxpayer's elected use of the mark-to-market method of accounting is a change in accounting method from cash-basis reporting.

Because a Sec. 475(f) election is irrevocable in the absence of IRS consent, it is crucial that proper consideration be given before an election is made. If a taxpayer is making a Sec. 475(f) election, it is critical that investments (particularly those being held for the long-term) be identified as such. Sec. 475(f)(1)(B) allows a taxpayer to clearly establish, by the close of the purchase date, that an asset is unrelated to his trading activity. Once established, such an asset is not subject to the mark-to-market requirements.

If a taxpayer fails to properly identify an investment as unrelated to his trading activity, the investment must be marked to market and any related gain must be treated as ordinary income.²⁰ The results could be costly for a taxpayer who intends to hold significant highly appreciating investments for the long-term. Unless these assets are properly identified as investment assets, the taxpayer may not only convert capital gains into ordinary income, but will accelerate income recognition into the election year. The consequences could be severe for taxpayers with millions of dollars in appreciated securities.

Prop. Regs. Sec. 1.475(f)-2(a)(3) indicates that a taxpayer who does not specifically identify individual investments as separate from his trading activity will be allowed to treat them separately if the assets are held in a separate, nontrading account maintained by a third party. If a trader holds appreciated property or intends to hold any portion of his portfolio for the long-term, such assets should be held in separate accounts, each of which are specifically identified as investment accounts unrelated to his trading activity. An ancillary benefit of separating such investments is that it may help bolster a taxpayer's argument that the securities held separately in the trading account are traded with the frequency necessary for trader status, even though the investment securities are not.²¹ However, the negative ramifications of failing to identify "investment assets," including the acceleration of income and conversion of capital gains to ordinary income, will likely far exceed the otherwise generally preferential treatment afforded under a Sec. 475(f) election.²²

Reporting requirements: Under Prop. Regs. Sec. 1.475(f)-2(b), a trader who makes a Sec. 475(f) election can report gains and losses from sales directly on Schedule C as ordinary. It is recommended that a taxpayer report the proceeds on Schedule D, to match the amount reported on Form 1099B and avoid IRS audit. These amounts should then be backed off on the next line on Schedule D, with a note that the proceeds are included elsewhere on the return. Generally, a nonelecting trader's gains are taxed at his top marginal tax bracket, because they are short-term. Therefore, losing the benefit of capital gain rates on trader gains generally is not a significant concern to a trader who has made a Sec. 475(f) election. If a trader has significant loss carryovers, however, he will not be able to use them against trading gains if he has made the election.

To summarize, making a Sec. 475(f) mark-to-market election presents significant benefits, with little down-side—if properly executed. A trader can deduct expenses above the line and can deduct unlimited losses from sales as ordinary in the current year. These losses may be carried back under Sec. 172 as an NOL deduction and the taxpayer is relieved of the significant administrative burden of complying with the Sec. 1091 was sale rules. The fact that a Sec. 475(f) election is generally irrevocable—and must be elected before trading results can be tallied—should be considered. Perhaps most important is the consideration and proper planning necessary so that, once an election is made, any long-term holdings are properly identified (and, preferably, held in accounts specifically identified as not related to the individual's trading activity).

Examples

The following six examples illustrate the tax computations for individual A, who is, alternatively, an investor (Investor), a trader (Trader 1) and a trader with a Sec. 475(f) election in effect (Trader 2). In each case, A is married filing jointly. A has long-term capital gains or losses from an investment activity, separate from a trading activity that has generated short-term capital gains or losses in the current year. Under each example, Investor, Trader 1 and Trader 2 each have identical earnings and expenditures; however, the Investor's "trading" activity is deemed an investing activity for income tax purposes. Trader 2 has properly identified the investing activity as a separate investment activity, unless otherwise noted.

Example 1: Individual A has $1,000,000 in wages and $100,000 in long-term gains from a separate investing activity. His trading activity has produced $200,000 of short-term capital gains and $20,000 in related expenses. A paid $50,000 in state income taxes and $10,000 in tax preparation fees. If A is an Investor, his tax liability is $460,917; if Trader 1 or Trader 2, $454,343. Investor's liability is higher primarily because only $4,000 of the trading expenses are deductible due to the Sec. 67(a) 2%-of-AGI limit. For Trader 1 and Trader 2, the full $20,000 is deductible from AGI, which also reduces the Sec. 68 phaseout of itemized deductions.

Example 2: The facts are the same as in Example 1, except that A had $100,000 in long-term capital losses instead of gains from the investing activity. The Investor's tax liability is $397,357, Trader 1's liability is $392,367 and Trader 2's liability is $431,932. The Investor pays more taxes than Trader 1, because the trading expenses are (1) partially phased out under Sec. 67(a) and (2) deducted from AGI instead of above the line (increasing the overall Sec. 68 phaseout of itemized deductions). Because Trader 2's trading gains are treated as ordinary income, they cannot offset his short-term capital losses for purposes of the Sec. 1211(b) overall capital loss limit. This leads to an increase in the Sec. 68 phaseout of itemized deductions for Trader 2. This difference is somewhat mitigated by the fact that these losses may be carried forward to offset investment capital gains in future years.

   

Example 3: The facts are the same in Example 1, except that the trading activity produced $200,000 of short-term capital losses instead of gains. The Investor's tax liability is $354,530; Trader 1's liability is $350,356 and Trader 2's liability is $291,191. The Investor fares slightly worse than Trader 1, because his trading expenses are partially phased out and are deductible below instead of above the line. Trader 2 fares much better than Trader 1, because his trading losses are fully deductible against ordinary income; Trader 1's losses are limited under Sec. 1211(b) to $3,000. Also, Trader 2's short-term losses offset ordinary income and his $100,000 capital gain is taxed at 20% under Sec. 1(h). Because long-term capital gains are fully offset by short-term capital losses, neither Investor nor Trader 1 receives a benefit from the preferential capital gain rate.

   

Example 4: The facts are the same as in Example 3, except that A had $100,000 of long-term capital losses instead of gains. The Investor's tax liability is $354,530, Trader 1's liability is $350,356 and Trader 2's liability is $268,780. The Investor fares slightly worse than Trader 1, because the trading expenses are partially phased out and deductible below the line. Each taxpayer's losses are limited to $3,000 under Sec. 1211(b). However, Trader 2 can deduct the entire amount of short-term capital losses ($200,000), resulting in a significant reduction in AGI and greater use of itemized deductions, because of a reduction in the Sec. 68 phaseout.

In Examples 1–4 above, the Traders have typically done better than the Investor; Trader 2 has done significantly better when he has suffered short-term capital losses from his trading activity. In each of these examples, it is assumed that Trader 2 has separated and adequately identified his nontrading investment activity. Examples 5 and 6 below demonstrate the results when separate investment activities are not adequately identified and, thus, are included as part of the trading activity.

Example 5: The facts are the same as in Example 1, except that A holds a separate investment in stock of a company that will go public during the current year. The stock was purchased toward the end of the prior year; at the beginning of the current year, the fair market value (FMV) equaled basis. After the initial public offering, the investment's FMV increased sharply; by year-end, it had appreciated by $10,000,000. After a planning meeting with his tax adviser, Trader 2 intended to keep this investment in a separate account that would be specifically identified as unrelated to his trading activity. Although he forgot to separate this activity, he did not sell any of the highly appreciating securities. (The gain of $100,000 from the separate portfolio also resulted from appreciation during the current year; Trader 2 failed to specifically identify this portfolio as unrelated to his trading activity.) In this case, the Investor's tax liability is $460,917, Trader 1's liability is $454,343 and Trader 2's liability is $4,436,081. Unfortunately for Trader 2, not only are his $100,000 long-term sales converted from capital gain to ordinary income in the current year, but the entire amount of the $10,000,000 built-in gain is marked to market in the current year, reported as ordinary income and taxed at 39.6%. No tax adviser would want to explain to Trader 2 that his failure to precisely follow advice has led to these unintended consequences. At return filing time, it is too late to revoke the Sec. 475(f) election without IRS consent.

   

Example 6: The facts are the same as in Example 5, except that A sold the highly appreciating securities at year-end. The Investor's tax liability is $2,464,401, Trader 1's liability is $2,456,481 and Trader 2's liability is $4,436,081. The acceleration of income into the current year is not an issue, because the highly appreciated securities were actually sold. The problem is that Trader 2's long-term capital gains are taxed at 39.6%, instead of 20% under Sec. 1(h). This problem most likely would result from execution (rather than planning) errors, but the reason for the problem will be small consolation at filing time.

Conclusion

Today, securities traders are much more capable of meeting the stringent requirements for trader status. The primary tax benefit of qualifying for such status is that deductions are allowed above the line without AGI limits or Sec. 163(d) investment income requirements. Taxpayers should carefully consider whether attaining such status makes economic sense based on their own unique financial circumstances. As soon as possible after such a determination has been made, the taxpayer should consider making a Sec. 475(f) mark-to-market election. Perhaps more importantly, once such election is made, traders should be very careful to properly designate investment holdings as separate and unrelated to the trading activity. Generally, creating separate accounts for investment portfolios is the most practical way to accomplish this. Because the Sec. 475(f) election and designation requirements must be made well before the related tax returns are filed, and the consequences of improper execution can be severe, proper guidance and extreme care are particularly critical for a securities trader contemplating a Sec. 475(f) election.