How Traders Can Keep More of their Gains
We live in an age of specialization for good reason. Family doctors don’t perform heart surgery. Lube shops don’t replace transmissions. Diners don’t cater weddings. It’s simply outside their areas of expertise.
The same holds true when it comes to accounting for traders and investors. Unfortunately, unlike doctors, lube shops and diners, every accountant worthy of their CPA will gladly accept trader or investor clients – and often wind up costing those more in unnecessary taxes and missed savings than the fee for their services.
That’s because trading involves a unique tax code that is well outside the expertise of most CPAs. Fortunately, a new breed of trader-accountants has emerged that combine their expertise in two very different disciplines, trading and accounting, into a specialized accounting practice that unlocks the little-known, lucrative tax loopholes only available to traders.
This article will take a look at how these trader-accountants help clients navigate the unique trader tax landscape, from securing the coveted trader tax status to choosing their most advantageous tax accounting method to forming the business entity that best suits their trading discipline and lifestyle.
What is Trader Tax Status?
The Internal Revenue Service, quite understandably, has a very special interest in traders; so special in fact that they’ve developed a unique tax code that can be either exceedingly generous or cruelly onerous depending on how an individual’s tax return is prepared.
Improper filing or failure to qualify for so-called trader tax status, in this exclusive trader tax universe, can lead to dire consequences indeed, including the potential loss of a trader’s livelihood.
What is trader tax status? In a nutshell, it’s a unique filing category that enables traders to write off 100% of their business-related expenses and, if they choose the mark-to-market accounting method, offset all of their losses against income. They can even apply the loss to taxable income from past years and generate a tax refund!
Investors, meanwhile, are subject to the 2% threshold for deductible investment expenses (and hence cannot write off most of their expenses) and have a maximum allowable net capital loss of $3,000 in any tax year. That means if they lose more than $3,000, their only recourse is to carry over the remaining balance until it’s used up – but again, only to a maximum of $3,000 per year.
How do traders stack up against investors come tax time? If a trader ended the year in the black, their trader tax status could save them thousands. If they ended the year with a substantial loss however, the ability to write off that loss in the year it occurred could result in a windfall of $20,000 or more.
Qualify for Trader Tax Status
Given the disparity of the tax benefits, it comes as no surprise that the IRS does not allow just any investor into the coveted trader tax club. In fact, Uncle Sam is predisposed to consider everyone a mere investor unless they meet a number of criteria that are unfortunately open to interpretation.
That’s right: the tax code contains no actual definition of trader tax status. Instead, the IRS has issued guidelines that the courts have further delineated by case law, most of which denied taxpayer appeals. What we’re left with is a blurred image, somewhat like a photograph of a trader taken from a speeding car.
According to the IRS, to qualify as a trader:
- You must seek to profit from daily market movements in the prices of securities and not from dividends, interest or capital appreciation;
- Your activity must be substantial, and
- You must carry on the activity with continuity and regularity.
To help determine if you meet these three tests, the IRS considers these qualifiers:
- Typical holding periods for securities bought and sold;
- Frequency and dollar amount of trades during the year;
- Extent to which you pursue trading to produce income for a livelihood, and
- Amount of time you devote to the activity.
Swoosh, right? What exactly constitutes “substantial” activity? “Continuity and regularity?” And what’s an acceptable holding period? Is a week too long? A month?
Informally, we know who investors are: they buy securities and hold them for such long-term goals as a college fund or retirement. Traders, on the other hand, buy and sell securities solely to take advantage of short-term market changes. Their profits come from price swings, not dividends and interests, and their holding period is brief, often a day at most (hence the term “day trader”).
Here are the three steps trader-accountants use to help newcomers claim and protect their trader tax status:
1. Prove beyond doubt that you are a bona fide trader; that is, you “seek to profit from daily market movements.” – The best way to accomplish this is by showing a pattern of high trading volume and short holding periods. Keep personal investments well separated from trading business. The IRS is looking for “earnest intent;” that is, you work diligently to manage transactions, conduct strategy sessions and make frequent trades.
2. Clear the “substantial activity” hurdle. – The hallmarks the feds are looking for here are “frequent, regular and continuous” trading. That means volume. One court case ruled that 75 trades a year was insufficient to warrant trader status. The feds need to know that you approach this as a business, not a hobby. Failure to convince them of that, and you’re back in investor-land.
3. Trade with “continuity and regularity.” – If you want business status, it only stands to reason that you must actually be in and remain in business. Here’s where the IRS is looking for a healthy flow of trades, significant dollar amounts, short holding periods – all the signs that your are at least attempting to make a living as a trader. If you take the summer off or show other gaps in your trading, the IRS will be disinclined to grant you trader status. If you’re a newbie and flame out after nine months, while it seems unfair, the IRS has made it clear: no trader status for you.
Choose the Best Accounting Method
After securing a trader tax status, the most important tax move a trader can make is to elect the mark-to-market accounting method, or MTM. The mark-to-market method not only carries with it considerable tax advantages, it also exempts traders from the confusing and tedious “wash sale” rule.
Under MTM, all holdings are tallied at year’s end (or “marked to market”), thereby eliminating the need to account for gains or losses that might occur within the 30-day “wash sale” restrictions. Because all income/losses under MTM are treated as ordinary and not capital gains/losses, they are taxed at a more favorable rate. In addition, traders are not bound by the $3,000 capital loss limitation and therefore can deduct all losses in the year they occur, providing tax relief when it’s needed most.
While mark-to-market is a boon for most traders, it can be a costly mistake for some. Those carrying forward a substantial capital loss, for example, may want to avoid MTM. Why? Since capital losses can only be offset by capital gains, if they elected MTM, their future gains would automatically convert to ordinary income. As a result, only $3,000 per year could be used to offset their capital loss.
Traders who deal primarily in commodity futures and 1256 contracts also tend to steer clear of mark-to-market, preferring the favorable 60-40 tax split associated with 1256 contracts to the “loss insurance” of mark-to-market accounting.
The IRS is crystal clear on its deadline to elect mark-to-market: the statement of intent must be filed with the individual’s tax return by April 15 of the tax year in which it will take effect, i.e. a year before the accounting method may be used.
Although the mark-to-market election is a one-time, irreversible election, those who miss the mid-April deadline may still elect MTM by forming a new business entity and noting their election in meeting minutes within two months of opening. It’s just one of the many benefits of trading under a business entity.
Form the Right Business Entity
From a tax perspective, one of the best moves a trader can make is to form a “flow-through” business entity such as a limited or general partnership, Limited Liability Company (LLC) or an S corporation.
The IRS has two tax codes: one for businesses, the other for individuals. Because businesses grow money both by paying taxes and employing other taxpayers, they are rewarded and encouraged through a benevolent tax code. Individuals, however, are treated far more harshly by routine tax hikes and diminishing deductions. In addition, self-employed individuals run a greater risk of an IRS audit.
A trader’s livelihood could hinge upon their ability to prove to the IRS that their trading enterprise is a legitimate business. Fail that and they risk a domino effect whereby their trader tax status is denied, their mark-to-market accounting method is disallowed, and their ordinary losses suddenly loom catastrophic thanks to the $3,000 capital loss limit.
In addition to enjoying the relative security of being recognized as a business for tax purposes, a formal business entity also can open the door to starting a 401(k) program, reaping health care savings, employing family members and finding tax-effective ways to plow earnings back into the company.
Unfortunately, too many traders wait unnecessarily to form a business entity until after they’re up and running and lose the often considerable startup tax savings. If you file as a sole proprietor, few of your start-up expenses would be deductible against ordinary income. However, if you file as an LLC and select mark-to-market, your losses become business-related expenses that are fully deductible against ordinary income.
Considering the myriad of important decisions that must be made early and well to unlock a treasure trove of tax savings – securing trader tax status, electing an accounting method and forming the proper business entity – traders and investors alike would do well to have a professional trader-accountant at their side from day one to avoid costly missteps.
Jim Crimmins is the founder and President of TradersAccounting.com, a company in the fast growing market of specialized accounting with a consortium of tax professionals and traders familiar with all financial markets.