Planning for Active Trader Status and Mark-to-Market Rules in a Volatile Market

Author:

Robert K. Doyle, CPA, PFS
Managing Partner & Principal
Doyle, Riley & Spoor, P.A.
St. Petersburg, FL

Editor's note: Mr. Doyle is the vice chairman of the AICPA Personal Financial Planning Executive Committee. If you would like additional information about this article, contact Mr. Doyle at rkd@spoordoyle.com.

With the incredible volatility in the stock market over the past few years, many investors have become short-term investors, unwilling or unable to keep a long-term perspective in the stock market. Millions of people have opened online trading accounts, while many others have become "day traders" in the market. Many of these investors have achieved a trading level that may qualify them for greater benefits under the Code.

As part of the Taxpayer Relief Act of 1997, Congress amended Sec. 475 to allow active traders in securities to elect the mark-to-market (MTM) rules of accounting. Prior to this law, it was difficult for traders in securities to escape treatment as investors, under which their gains and losses were considered capital in nature rather than ordinary.

Investor vs. Active Trader

Most individuals fall into the investor category. An investor is a person who buys and sells securities with the intention of capturing investment income (such as dividends and interest), and with the intention of realizing appreciation of the underlying investment over a relatively long period of time. The income generated from an investor's activities will usually not be his primary source of income.

A trader, on the other hand, is engaged primarily in the speculative activity of seeking to profit from short-term swings in the market or individual securities. Accordingly, the trader is uninterested in the securities' dividend yields, except to the extent that they may affect short-term stock movements. Nor is a trader interested in the long-term appreciation potential of a security.

A trader will buy and sell securities with such frequency and attention that the activity will rise to the level of a trade or business. As noted by the Supreme Court in Groetzinger, 480 US 23 (1987), "to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity," and, "the taxpayer's primary purpose in engaging in the activity must be for income or profit."

Capital Gain Treatment vs. MTM

With the maximum tax rate on long-term capital gains at 20%, long-term investors are in a better tax position than short-term investors (who are taxed at ordinary income tax rates). The advantage the active trader has in electing MTM treatment under Sec. 475 is that short-term losses are treated as ordinary losses.

The basic premise of MTM accounting is that every position in a trader's trading account is priced, or marked to market, and treated as though it had been closed out at the end of each year. The net unrealized gain or loss on the position is then added to the actual trading activity for the year and taxed as ordinary income. The marked-to-market price at which the security is deemed to have been sold becomes the new basis in the position. An "active trader" in securities therefore can elect to recognize gain or loss on any security held in connection with his trade or business as a trader at the close of the tax year, as if that security was sold for its fair market value on the last business day of that tax year, and thus take into account the gain or loss for the year.

If the net gains and losses and trading expenses result in a loss, that loss can be deducted as an ordinary loss (i.e., loss from a trade or business). This is much more favorable treatment than the limited deduction allowed for capital losses.

Because the active trader is conducting a trade or business, presumably the profits generated would be subject to self-employment (SE) tax. However, under Sec. 475(f) these profits are exempt from such tax. This exemption can be a blessing or a curse. The blessing is clear in that the active trader would not be liable for the SE tax; the curse would be that because the profits would not be considered earned income, the active trader would not be eligible to contribute to a retirement plan.

As an alternative, the active trader could create a trading entity in which to conduct the business. He could draw a salary from the trading entity, thereby generating earned income (and paying the equivalent of SE taxes). The trader could then be eligible for contributions to a retirement plan. In light of the fact that contribution limits to retirement plans are greater than employment tax rates, a viable planning alternative would be to consider establishing a trading entity to take advantage of this benefit.

Additional Benefits of MTM and Active Trader Status

Wash sales. A common problem for many short-term traders is the Sec. 1091 wash-sale rules, which generally disallow the loss on the sale of a security if the trader buys substantially identical securities within 30 days before or 30 days after the sale that generated a loss. The wash-sale rules are not an issue under MTM; at the end of the year, all positions are deemed sold.

Above-the-line expenses. An active trader deducts all ordinary and necessary expenses of the trade or business on Schedule C. If the trader qualifies as an active trader, he can deduct home office expenses. This is more favorable tax treatment than the miscellaneous itemized deduction that investors are allowed on Schedule A. It is important to note that qualifying traders can deduct expenses on Schedule C whether or not they elect MTM treatment.

The best of both worlds—active trader and investor. There is no prohibition against an active trader using MTM while still maintaining investor status for other investments. Segregation of an active trader's positions from investments held for long-term is crucial to protecting these long-term assets from MTM treatment. Under Sec. 475(f)(1)(B), any security that is acquired is for trading purposes, unless there is clear and convincing evidence that it is not connected with the trading business. The identification of a security as an investment must be done before the close of business on the day acquired. It is possible that an active trader may have a trading position in a stock, as well as a long-term investment. This highlights the importance to traders of keeping separate accounts for trading and investing. Further, if the active trader uses margin loans, he should never use these loans to finance other investments. Doing so would blur the lines separating the two activities.

How to Elect MTM

The MTM election under Sec. 475(f) may be made without IRS consent, but, once made, may not be revoked without such consent. Perhaps the most important element of the election is the timing of the election filing itself. The election for claiming MTM status must be attached to the return or the extension for the return. Under no circumstances may the election be filed after April 15 for the year it is to take effect. Thus, for a taxpayer to be eligible for MTM for tax-year 2002, the election must be attached to the 2001 return filed on (or before) April 15, 2002 or attached to the extension filed on (or before) April 15, 2002. Not filing a timely election is likely the single largest mistake made by active traders when claiming MTM treatment.

Now is the time for active traders and practitioners to be planning for tax year 2002. The primary factor to consider will be the existence of capital losses that are carried forward. Once MTM is elected, only $3,000 of these losses will be available to offset ordinary income from the active trading account.

The election must:

• Include a statement that it is an election under Sec. 475(f) claiming MTM accounting treatment;
• State the first tax year for which the election is effective; and
• State the trade or business for which the election is made.

Change in Accounting Method

If an active trader is changing from the cash method of accounting for securities transactions to the MTM method, he is making a change in accounting method and must file Form 3115, Application for Change in Accounting Method. In addition, the active trader must calculate a Sec. 481 adjustment to reflect the effects of the change in method.

If a new trader, who qualifies as an active trader in securities, elects MTM accounting treatment, Form 3115 and a Sec. 481 adjustment are not required. The new active trader is simply adopting MTM accounting for the new business. A new trader would be someone who filed as an investor in the prior year and did not report expenses for trading activity on Schedule C in the prior year.

Reporting Trading Activity

For those who qualify as active traders and properly elect MTM accounting, they must report all gains and losses from the trading activity on Form 4797, Sales of Business Property, not on Schedule C. This change is effective for tax year 2000 and subsequent years. When reporting trading activity, most Forms 1099-B are prepared based on the trade date, while monthly brokerage position statements are prepared on the settlement date. The Service requires all transactions to be reported as of the trade date. Therefore, the active trader must reconcile his monthly position report to his Form 1099-B to mark to market any pending trades that have not settled.

Before an active trader changes to the MTM method of accounting, he should first examine his trading account for any unrealized gains that would become income when marked to market. Traders also must consider the extent of any short-term capital losses being carried forward as a result of the trading losses incurred in 2000 (and so far in 2001). If large capital loss carryforwards exist, the adoption of MTM accounting should be closely examined; these capital losses carried forward would not offset the new ordinary income that might be generated in an active trader's business.

If a trader qualifies for active trader status and is considered as having a trade or business, more often than not electing MTM accounting and reporting expenses on Schedule C will be more advantageous. This will allow the active trader a full deduction for trading expenses and losses that he can use to offset other income. The trader would still be permitted to hold investments for the long term in segregated accounts, and his activity will not be subject to SE taxes or wash-sale rules.