Planning for active trader status and mark-to-market rules in a volatile market.

• Author: Doyle, Robert K.

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...