Sec. 475 mark-to-market election: what every tax practitioner should know.

• Author: Harmon, Michael R.

Hidden among the countless rules of the Internal Revenue Code lies a provision that extends huge advantages to certain taxpayers, yet many practitioners are apparently unfamiliar with it. The provision offering these underused advantages is Sec. 475(f), which allows taxpayers to make what is known as the mark-to-market election. In short, if an individual qualifies and makes the election, he or she is allowed to treat losses from the sales of stocks and other securities as ordinary losses rather than capital losses--a tremendous opportunity for those who are eligible. While this provision normally applies only to traders (e.g., day traders of stocks and bonds), in those cases in which a taxpayer is eligible it is an election that cannot be overlooked. This recently became all too apparent to one CPA when he was found negligent and required to pay $2.5 million to a former client for not informing the client of the election. (1)

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That the Sec. 475(f) election for traders could escape seasoned practitioners is not surprising. The enactment of the mark-to-market rules in 1993 and the Sec. 475(f) election in 1997 are relatively recent developments. Moreover, at the time of their creation, the day trading phenomenon was in its infancy. While day trading is not new, historically its practice was limited due to the high cost of commissions. But with the advent of the internet, electronic trading, and discount brokerage firms, individuals can now trade online 24 hours a day, 7 days a week with low commissions. (2) This has revolutionized trading, enabling anyone to trade whenever and wherever at the click of a mouse. In short, day trading has become increasingly popular among even casual investors. For this reason, practitioners must be aware of the benefits of Sec. 475 and whether their clients' stock trading activities may qualify. This article focuses on the operation of Sec. 475 and recent developments.

Taxation of Dealers, Investors, and Traders

The tax treatment of those who buy and sell stocks and other securities is not the same for all taxpayers. It can vary depending on whether a taxpayer is considered a dealer, an investor, or a trader. In addition, taxpayers who are considered traders (and only traders) are entitled to make the Sec. 475(f) election to use the mark-to-market rules. Thus, there are four different types of tax treatment for taxpayers who buy and sell securities. Because the treatments differ so dramatically, it is incumbent on practitioners to distinguish among them. (3)

Under the mark-to-market rules, dealers and eligible traders are treated as having sold all their securities on the last day of the tax year at their fair market value (FMV), causing gain or loss to be taken into account for the year. Any gain or loss recognized under this rule is taxed as ordinary income or ordinary loss. Dealers' and traders' expenses are considered business expenses and are deductible subject to any special rule or limitation.

Dealers

If the taxpayer is considered a dealer, Sec. 1236 governs the treatment of the taxpayer's gains or losses from sales of securities. Under Sec. 1236, the gains and losses of a dealer that arise from sales of securities are not considered gains or losses resulting from the sale or exchange of a capital asset. (4) Instead, the dealer's gains and losses from sales of securities are treated as ordinary income or ordinary loss from business transactions (i.e., the sales of inventory). However, under Sec. 1236, a dealer can obtain capital gain and capital loss treatment if the dealer clearly identifies the securities in his or her records as securities held for investment. Importantly, Sec. 475 requires dealers to report using the mark-to-market method of accounting.

The mark-to-market rules are generally applicable only to dealers. Historically, Sec. 475 has defined a "dealer in securities" as a taxpayer who regularly purchases securities from or sells securities to customers in the ordinary course of a trade or business. In this regard, the securities owned by a dealer represent inventory held primarily for resale. Congress expanded this original definition to include those who regularly offer to enter into, assume, offset, assign, or otherwise terminate positions in securities with customers in the ordinary course of a trade or business. (5) These changes extended the historical definition significantly by including those who offer or hold themselves out to terminate security positions. The examples in the regulations indicate that this covers more exotic securities such as interest rate swaps and foreign currency transactions,(6) situations in which things are not bought and sold but contracts are entered into.

Distinguishing a dealer from a trader or investor is normally not difficult. A dealer makes money by serving as a middleman--a market maker--holding securities as inventory and buying and reselling securities to customers. A dealer's income is derived from the services provided, charging a markup on buying and reselling rather than obtaining profit from price fluctuations in the securities. A stockbroker who owns shares that he or she sells to customers at a market price plus a commission would be a bona fide dealer. Floor brokers and specialists at a stock exchange are people whose business it is to put investors together and who properly receive ordinary income treatment as dealers.

Controversies over whether a taxpayer is a dealer typically arise when taxpayers and the IRS disagree on the character of gains and losses from the sales of securities. The parties usually are at odds as to whether gains should qualify for favorable capital gain treatment or losses should be treated as ordinary losses. In settling these disputes, the courts have looked to the definition of a capital asset. (7) Under Sec. 1221 and its predecessor, Sec. 117, property is not a capital asset if the taxpayer holds it primarily for sale to customers in the ordinary course of a trade or business. The crucial words in the definition are "to customers." Congress specifically added this phrase and the word "ordinary" to the definition of capital assets as part of the Revenue Act of 1934. (8)

The additions were designed to ensure that speculators could not claim that the securities they sold were ordinary assets, presumably to obtain ordinary loss treatment. The rationale for the amendment was that those who sell securities on an exchange for their own account have no customers, and thus the property held by such taxpayers is a capital asset. Consequently, in those cases in which the courts have been required to differentiate between dealers and traders or investors, they have consistently focused on whether the taxpayer had customers. Taxpayers that have customers are normally treated as dealers, while taxpayers that do not have customers but trade for their own account are normally treated as investors or traders.

In Archarya, (9) a finance professor at the University of Illinois-Chicago tried to characterize himself as a dealer in order to convert a net capital loss of $117,000 into an ordinary loss. Professor Archarya argued that he was in the business of buying and selling stock. He, like a broker-dealer, had suppliers (i.e., the people in the market who sold him securities) and customers (the people in the market who bought the securities he sold). The court noted that while Archarya's theory may have had some economic merit, it was not relevant for legal analysis, and the court rejected the argument. Interestingly, the Tax Court rejected the government's proposal to add a negligence penalty, observing that Archarya had approached the matter as an economist would rather than as the Code requires.

The IRS seems to accept the courts' method of distinguishing dealers from traders and investors. In Rev. Rul. 97-39, (10) the IRS provided instructions on how to make the mark-to-market election, using a question and answer format (i.e., issues and holdings). Issue 3 asks, "If a taxpayer's sole business consists of trading in securities (that is, the taxpayer does not purchase from, sell to, or otherwise enter into transactions with customers), is the taxpayer a dealer in securities within the meaning of section 475(c)?" The holding is, "No. A taxpayer whose sole business consists of trading in securities is not a dealer in securities within the meaning of section 475(c) because that taxpayer does not purchase from, sell to, or enter into transactions with, customers in the ordinary course of a trade or business." Although the IRS offers nothing new, it is useful to know that its position is completely consistent with case law.

Investors

Practitioners are most familiar with the taxation of investors. The basic rules concerning capital gains and losses apply to investors, who report their gains and losses on Schedule D. The mark-to-market rules and the possibility for ordinary loss treatment are not available if the taxpayer is considered an investor. In addition, the wash sale rules apply to investors. (11)

On the expense side, investors are not carrying on a trade or business, and for this reason their deductions may be restricted in some way. For example, the investment interest provisions of Sec. 163(d) limit the deduction of investment interest to investment income. Similarly, the home office deduction is not extended to investors because it is allowed only for those carrying on a trade or business. Likewise, the Sec. 179 expense deduction is allowed only for property used in a business. Moreover, any investor expenses that are deductible are treated as investment expenses and characterized as miscellaneous itemized deductions subject to the 2% of adjusted gross income (AGI) limitation of Sec. 67 as well as the phase-out of deductions under Sec. 68. (12) Perhaps the most significant problem for investors is the elimination of the deduction of these expenses for...