<% Response.Redirect "http://www.fool.com/how-to-invest/personal-finance/taxes/index.aspx" %>
Fool.com: Tax Issues for "Traders"
Tax Issues for "Traders", Part I
Who's a Trader?
By Roy Lewis
What!? Why in the world are the folks at The Motley Fool talking about stock traders?
Well, as much as we believe in the idea of investing in solid companies for as long as they remain solid companies, we know some folks out there do "trade" on a daily or weekly basis. We realize it's not you of course, but there may be someone you know... friend or family... who is addicted to trading. And, since it is a reality, I thought you should be made aware of the tax differences between traders and investors.
Why? Because, if you can classify yourself as a trader, a completely different tax-reporting world will open up to you. Not only that, there are a number of inaccuracies and half-truths out there about traders and taxes. Since the Fool is about education, a lesson in trading and taxes appears to be in order.
Who Is a Trader?
Before we can talk about the tax treatment for traders, we have to try defining what a trader actually is. We know what the typical investor looks like: He or she holds stocks and securities for income and long-term capital appreciation. Traders, on the other hand, generally hold stock positions for only a short period of time -- many times for less than a few days (or a few hours). But let's see what the IRS has to say about who might be a trader.
Well... ummm... uhhhh... gee... there are no IRS guidelines about who is a trader. So, you really have to review the various court cases to make a determination. It would be lovely if the IRS provided us with some type of "bright line" determination of what makes a trader, but they have not done so to date and will likely not do so in the future. I won't bore you with legal citations and other technical jargon here. Instead, if you summarize all of the court cases, you arrive at the following outline for the traits of a stock trader:
- The trader generally holds positions 30 days or less. Virtually none of the trader's positions are held for more than a year.
- The trader's goal is to profit from short-term swings in the market and the associated stock price. In addition, stock selection is generally based on technical factors (such as charting) that relate purely to stock price, as opposed to an evaluation of the merits of the company whose stock is being purchased.
- The trader spends a lot of time doing just that... trading! The trader has substantial, frequent, regular, and continuous involvement in the activity of trading. Additionally, the courts tend to identify a trader as someone without another regular job; the trading activity is expected to be the primary income for meeting the trader's personal living expenses. The trader will make daily (or almost daily) trades -- at least one or more -- and there will be few (if any) periods without trading activity.
So don't be confused. The sheer number of trades does not a trader make. There are other attributes to being a trader than simply doing a large number of trades over the course of a month or year. In reality, it seems to me that very few people would really be able to meet the standards of a trader as illustrated above, but you (or someone you know) might just qualify.
Trader AND Investor?
Many times, the question that immediately springs to mind after reading about trader status is: "Can I be both a trader and an investor?" There is nothing in the tax code or court cases that specifically prohibits someone who might qualify as a trader from also holding stocks and securities for investment purposes.
But, a trader who makes investments should clearly designate which stocks are held for trading and which are held for investment. In fact, if a trader makes the Code Section 475 Mark to Market election (that we'll discuss in Part II), he must clearly identify a stock as "not held for trading" before the close of the day on which it was acquired. When the same stocks are held for both trading and investment, the trader must hold the investment stock in a separate account from the trading account or accounts.
So, while there is nothing specifically prohibiting the purchase of stock for both trading and investing, careful consideration must be given to the identification, allocation, and record keeping of the investment shares.
Finally, while doing the research for this article, I ran across a court decision primarily dealing with gambling activities that also made a statement about stock trading. See if you agree. The court said:
"We are unable to discern any meaningful distinction between the so-called 'active trader' of securities and the full-time gambler. The essential nature of these activities is identical; to state it simply, one gambles on stocks, the other on dogs. Both bet, or trade, solely for their own account and do not enter into any transactions with specific individuals; rather, their profits or losses depend solely on their ability to predict outcomes in an impersonal and (presumably) non-manipulatable market or pari-mutuel event."
Tax Reporting Differences
If you're an investor, you already know how to report your income and related investment expenses. You report your gains and losses on Schedule D. You report any margin interest expense paid on Schedule A as an interest expense deduction (subject to the investment interest expense rules). You also report any related investment expenses (such as investment newspapers and publications, stock analysis computer programs, etc.) on Schedule A as an itemized deduction, subject to the 2% Adjusted Gross Income (AGI) limitation.
The unfortunate fact is, if you don't itemize your deductions or your AGI is high relative to your investment expenses, your investment expenses could be rendered useless.
Example #1: Sally has $1,200 of investment expenses related to her stock portfolio. Sally also has paid $1,000 in margin interest. Sally doesn't itemize her deductions. Therefore, the $2,200 of expenses will not reduce Sally's taxes.
Example #2: Sally has $1,200 of investment expenses related to her stock portfolio and no other miscellaneous itemized deductions. Sally is able to itemize her deductions. Sally's AGI is $75,000. To be beneficial as a miscellaneous itemized deduction, Sally's investment expenses must exceed $1,500 ($75,000 x 2%). Since Sally's investment expenses only amounted to $1,200, she'll receive no tax benefit from these expenses.
If you qualify for trader status, your stock gains or losses are still reported on Schedule D, but your trading expenses are reported on Schedule C, and there are no AGI restrictions or limitations thwarting the deduction of these expenses.
Additionally, since you are deemed to be conducting a trade or business, you are also eligible for the "office in home" deduction. Not only that, any margin interest generated would also be reported on Schedule C as an expense (and not as a Schedule A itemized deduction subject to the "investment interest" rules). This can be a very significant tax benefit.
Example #3: Trader Tim has $1,200 in trading expenses and $1,000 in margin interest paid. Tim doesn't itemize his deductions. No matter -- because Tim qualifies for trader status, he will be able to deduct these $2,200 of trading expenses on his Schedule C. If Tim is in the 28% tax bracket, this will allow Tim to reduce his tax liability by $616.
Common Misconceptions
The ability to use Schedule C is the main difference between a trader and investor, if that's as far as the trader status goes. There are really two classes of traders: a regular trader and a Mark-to-Market (MTM) trader.
The MTM election allows for even more unusual tax differences between traders and investors. We'll discuss the MTM rules in greater detail in Part II... but, to close out this week's article, understand that regular traders are still subject to many of the same rules as the investor:
- The regular trader and investor are both subject to the $3,000 capital loss rules.
- The regular trader and investor are both subject to the wash sale rules.
- The regular trader and the investor are not subject to Self-Employment (SE) taxes on stock gains.
The last point requires a bit more discussion. Many people (including, sadly, some tax preparers) think that, if you are a trader and report your trading activities as such, you are required to report your stock sales on Schedule C and any net income from such stock sales are subject to Self-Employment (Social Security) taxes.
This is simply not true. The law is very clear that regular traders will report their stock transactions on Schedule D. And, even if the gains on those stock sales are greater than the trading expenses reported on Schedule C, none of that net income is subject to SE taxes. Because capital gains and losses are specifically excluded from the definition of "net earnings from self-employment," net earnings from a trading activity are not subject to the SE tax (IRC Section 1402(a)(3)(A)).
While an MTM election will require reporting net stock gains on Schedule C, it does not change the status of these stock gains for SE tax purposes (IRC Section 475(f)(1)(D)). So, if you (or one of your friends) meet the trader standards and are paying SE taxes on stock profits, you are paying too much in taxes and should consider amended tax returns for all years still considered "open" under the statute of limitations (generally three years).
Well, hopefully I've demystified at least some of the tax issues regarding trader status. Next we'll focus on the Mark-to-Market trader and the tax rules and requirements associated with that type of trader.
