Securities trader reporting requirements.

• Author: Pudner, Thomas Rolfe

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.

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 3 1/2 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...