Day traders: investors, traders or self-employed dealers?

• Author: Stapf, Joseph G.

On a global scale, the Internet has changed the investing landscape forever. The low cost of on-line stock trading has created a new type of securities trader. Individuals can now buy and sell securities on-line at costs of as low as $7 per trade and receive executions at speeds close to those of Wall Street professionals. Many of this new breed of securities trader consider this activity their trade or business. They spend considerable amounts of time and resources on their new career, often earning more trading securities than they might have from their former professions. From the IRS's viewpoint, are these day traders investors, traders or self-employed dealers in securities? Are day traders subject to self-employment (SE) tax? The distinction may have a significant financial effect for today's Internet day trader.

The Code treats investors and traders differently from dealers in securities. Investors and traders receive capital gain or loss treatment on sales. On the other hand, dealers in securities receive ordinary gain or loss treatment on security sales, unless (under Sec. 1236(a)):

* The security was, before the close of the day on which it was acquired, clearly identified in the dealer's records as a security held for investment; and

* The security was not, at any time after the close of that day, held by the dealer primarily for sale to customers in the ordinary course of his trade or business.

Dealers in securities also must maintain an inventory of securities held for resale; see Regs. Sec. 1.471-1 and Stern Bros. & Co., 16 TC 295 (1951), acq., 1951-2 CB 4.

A dealer in securities, as a self-employed individual, is subject to SE tax. For 2000, SE net earnings up to $76,200 are taxed at 15.3%; additional SE earnings are taxed at 2.9%. Therefore, if an individual is considered a dealer in securities and has net gains for a tax year, not only would these gains be taxed at ordinary rates but, in addition, they would be subject to SE tax.

However, Sec. 1402(a) (3) (A) excludes capital gains or losses from SE net earnings. Sec. 1402(a)(3)(C) also excludes gains or losses from sales of property that are neither:

* Stock in trade or other property of a kind that would properly be includible in inventory if on hand at the close of the tax year; nor

* Property held primarily for sale to customers in the ordinary course of business.

On the other hand, dealers in securities receive more favorable treatment in the case of a net loss. Under...