30.16 Trader, Dealer, or Investor?

The tax law recognizes three types of individuals who may sell and buy securities. They are:

Investor. You are an investor if you buy and sell securities for long-term capital gains and to earn dividends and interest.
Trader. You may be a trader if you buy and sell securities to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation. Your buy and sell orders must be frequent, continuous, and substantial. There are at present no clearcut tests to determine the amount of sales volume that qualifies a person as a trader. The term “trader” is not defined in the Internal Revenue Code or Treasury regulations. The IRS has not issued rulings for determining trader status. The Tax Court has held that sporadic trading does not qualify; see the Examples below.
Dealer. You are a dealer if you hold an inventory of securities to sell to others. Dealers report their profits and losses as business income and losses under special tax rules not discussed in this book.
EXAMPLES
1. After he retired, Holsinger began buying and selling stocks. In 2001, he made 289 trades over 63 days, and had losses of almost $179,000, which he reported as ordinary losses. In 2002, he made 372 trades over 110 days, and reported trading losses of just over $11,000 as an ordinary loss.
The Tax Court held that Holsinger was an investor, not a trader. His trading losses were capital losses, and as such they could be deducted only to the extent of capital gains and then $3,000 of ordinary income. The Court held that the level of Holsinger’s trading activities was not substantial enough to constitute a business. In addition, his trades were not aimed at catching the swings in daily market movements and profiting from these short-term changes, as evidenced by the fact that a significant amount of his positions were held more than 31 days. Since Holsinger failed to establish that he was in business as a trader, he could not make a mark-to-market election.
2. While holding a full-time job as a computer chip engineer in 1999, Chen made 323 transactions, 94 percent of which occurred in February, March, and April; he did no trading in June or August through December. Most of the securities were held for less than a month. He had losses of nearly $85,000, which he reported as ordinary losses.
The Tax Court held that Chen was not a trader in securities and was limited to deducting $3,000 of his net 1999 loss against ordinary income. To be considered a trader, the purchases and sales of securities must amount to a trade or business. There is no exact number of trades or other clear standard used to make this determination. Rather, it is based on the taxpayer’s intent, the nature of the income derived from trading, and the frequency, extent, and regularity of the transactions. During three months of the year, Chen bought and sold with frequency, but he failed to achieve trader status because, overall, his activities were not frequent, regular, and continuous. In prior cases, trader status has been found where such activities usually were frequent, regular, and continuous for a period of more than a single year. Because Chen could not claim trader status, he was ineligible to make a mark-to-market election.

Tax treatment of traders.

The tax rules applied to traders are a hybrid of tax rules applied to investors and business persons, as discussed in the following paragraphs.

Reporting trader gains and losses.

Unless a trader previously made a mark-to-market election, gains and losses are reported as capital gains and losses on Form 8949 and Schedule D. As almost all or substantially all of a trader’s sales are short-term, such gains are reported as short-term gains and losses as short-term losses. A net profit from Schedule D is not subject to self-employment tax (45.1). Substantial losses subject to capital loss treatment are a tax disadvantage because capital losses in excess of capital gains are deductible only up to $3,000 of ordinary income in one tax year. True, carryover capital losses may offset capital gains in the next year, but your inability to deduct them immediately may subject you to paying a tax liability that might have been reduced or eliminated if the losses had been deductible for the year of the sale. If you are concerned about incurring substantial short-term capital losses that would be limited by capital loss treatment, you may consider a mark-to-market election (30.17), which would allow you to treat your security gains and losses as ordinary income and loss.

Deducting trader expenses.

Although a trader does not sell to customers but for his or her own account, a trader is considered to be in business. Expenses such as subscriptions and margin interest may be deducted as ordinary business losses on Schedule C of Form 1040. Home office expenses are deductible if the office is regularly and exclusively used as the principal place of conducting the trading business (40.12); the deduction is computed on Form 8829 and entered on Schedule C.

An investor, on the other hand, may deduct margin interest only as an itemized deduction to the extent of net investment income (15.10). Other investment expenses are allowed only as miscellaneous itemized deductions and only to the extent that, when added to other miscellaneous costs such as fees for tax preparation, they exceed 2% of adjusted gross income (19.1). An investor may not deduct home office expenses since investment activities, no matter how extensive, are not considered a business; see the Moller decision discussed in 40.16.

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