30.17 Mark-to-Market Election for Traders

A trader in securities may elect to have his gains and losses treated as ordinary gains and losses by making a mark-to-market election. As explained below, it is too late to make an election for 2012. In the absence of an election, gains and losses of a trader are treated as capital gains and losses on Form 8949 andSchedule D.

If the mark-to-market election is made, you report trading gains and losses on closed transactions plus unrealized gains and losses on securities held in your trading business at the end of your taxable year as ordinary gains and losses on Form 4797. Trader profits are not subject to self-employment tax (45.1), whether or not the mark-to-market election is made. The unrealized gain or loss on a security that is reported on Form 4797 increases or reduces the basis of the security. For example, if you report an unrealized gain of $50 on stock with a cost of $100, you increase the basis of the stock to $150. If you later sell the stock for $90, you report a loss of $60 in the year of the sale. The requirement to report unrealized gains and losses at the end of the year and to adjust basis of shares is a change in accounting method that requires you to file Form 3115 with the IRS National Office and report required adjustments; see IRS Publication 550 for details.

Once the mark-to-market election is made, it applies to all future years unless the IRS agrees to a revocation.

Making the election is not proof that you are actually a trader in securities. If you are audited by the IRS, you must be able to prove that your activities are such that you are in the business of making money by buying and selling over short periods of time. As mentioned in 30.16, there are no hard and fast rules that specify how many daily or short-term trades qualify you as a trader.

When to make the mark-to-market election.

The IRS requires you to make the election by the due date (without extensions) of the tax return for the year prior to the year for which the election is to be effective. Under this due date rule, it is too late to make an election for 2012, as this had to be done by April 17, 2012, the due date for your 2011 return. The election for 2013 must be filed by April 15, 2013.

A regulation gives the IRS authority to grant an extension of time to file the mark-to-market election if the taxpayer has acted reasonably and in good faith and allowing relief does not prejudice the interests of the government. However, the IRS has refused to allow such extensions, claiming that a late election invariably results in prejudice to the interests of the government.

The Tax Court has supported the IRS in cases where the taxpayers, in filing their elections several years late, were relying on hindsight to try to gain a tax advantage from ordinary loss treatment.

The Ninth Circuit Court of Appeals has also refused to allow a late election where the taxpayer was relying on hindsight to try to gain a tax advantage. On his 1999 return, Acar reported over $950,000 in losses from trading securities, treating them as capital losses. In early 2002, he filed an amended return and tried to make a retroactive mark-to-market election beginning with 1999 so he could treat his 1999 losses as ordinary losses and claim a refund. The IRS disallowed the late election and a federal district court and the Ninth Circuit affirmed. Allowing the late election would give Acar an advantage that was not available on April 15, 1999, the due date for making the election for 1999 under Revenue Procedure 99-17. When the late election was made, Acar knew that he had incurred losses and, with that hindsight, was trying to convert what had been capital losses on his original return into ordinary losses. It does not matter that any advantage from a late election for 1999 could be outweighed if Acar in later years realized trading gains that under the irrevocable election would have to be treated as ordinary rather than capital gains. That a taxpayer might come to regret an election in later years does not mean that hindsight was not used to gain an advantage at the time of the retroactive election.

In another case, the Tax Court was more sympathetic, allowing an extension to a taxpayer who filed his election for 2000 on July 21, 2000, three months after the IRS deadline of April 17, 2000. He had left his law practice and became a trader in January 2000. The accountant who prepared his 1999 return did not know about the mark-to-mark election but a friend told him about it in June 2000 and in July the taxpayer hired a law firm, which filed the election for him and asked the IRS to allow the extension. The taxpayer did not conduct any trading activities between the date he should have filed the election and the date he actually filed it. Over IRS objection, the Tax Court allowed the late election on the grounds that the taxpayer had acted reasonably and in good faith by promptly employing the law firm after learning about the availability of the election. Since the taxpayer did not realize any further gains or losses between the date he should have filed the election and when he actually did so, the Court held that the interests of the government were not prejudiced.

How to make the mark-to-market election.

An election for 2013 must be made by April 15, 2013, on a statement attached to your original 2012 return or on a request for an extension to file that return. The statement should specify that effective for the taxable year starting January 1, 2013, you are electing to report gains and losses from your trading business under the mark-to-market rules of Section 475(f). However, in the case of a new taxpayer, a different rule applies. A new taxpayer is defined as a taxpayer for which no federal tax return was required to be filed for the taxable year immediately preceding the election year. A new taxpayer, such as a newly organized partnership, would make the election by placing a statement of election in its books and records no later than two months and 15 days after the first day of the election year. A copy of the statement also must be attached to the original tax return filed for the election year.

One of the conditions of the election is that you must clearly distinguish between securities held for investment and trading purposes. The election applies only to the securities held in your trading business, not to the securities held for investment. Holding investment securities in a separate account is advisable.

An election may not be revoked in a later year except with IRS permission.

In light of the accounting requirements and the overall effect of reporting unrealized gains and losses, before making the election you should consult a professional experienced in the use of mark-to-market accounting.

See IRS Revenue Procedure 99-17 for details on making the mark-to-market election.