Chalk up another win for the IRS on denying trader tax status. But it’s not a result of IRS excellence. Rather, it’s another case of a taxpayer filing a huge red-flag tax return with crazy unsupportable positions.
See the latest tax court case decision denying trader tax status: Nelson, TC Memo 2013-259. Here is an RIA summary with my highlights in yellow.
First off, the taxpayer seems to have been a tax cheat and that never bodes well in an exam. What trader in his or her right mind files a Schedule C for trader tax status deducting $800,000 of trading business expenses over two years? Nelson did, and when pressed, she conceded most of these expenses early on (see footnote 8 in the case). Most of those Schedule C expenses were probably unsubstantiated even as investment expenses on Schedule A. The IRS did not allow a Schedule C, since Nelson did not qualify for trader tax status.
Our firm has always pointed out that a sole proprietor trading business Schedule C is a red flag as it only shows expenses. We prefer a pass-through entity tax return for reporting a trading business. Traders generally have business expenses of $5,000 to $25,000. If the trader has trading gains, we use our income-transfer strategy to zero out Schedule C.
In another recent IRS tax court win denying trader tax status, Endicott reported $300,000 of margin interest on his trading business Schedule C and that triggered his tax exam. The IRS was correct; it should have been reported as investment interest expense on Schedule A.
As with Endicott, we agree with the Tax Court and IRS that Nelson did not qualify for trader tax status in 2005 and 2006. First, it sounds like Nelson’s live-in boyfriend, perhaps a trader himself, made many of the trades on her trading account. Nelson seemed focused on her active and successful mortgage business. We’ve always pointed out that trades made by an outside manager do not qualify for trader tax status. This can be a problem even with married couples, when one spouse trades the other spouse’s individual account. This is why we recommend a general partnership or LLC filing a partnership tax return for married couples — or significant others — so the trader/partner can bring trader tax status to the entity level for the benefit of all partners, even passive owners.
The tax court is right to point out that even if Nelson was credited with making all the trades — which clearly she did not — the activity did not rise to the level of trader tax status. The account failed our golden rules for trader tax status. Our rules call for 1,000 total trades and the Nelson account had half that in one year and one-quarter of that in the other year. Even considering a partial year, it was too few trades. Our golden rules call for executions on 75% of available trading days, and the Nelson account had executions of less than 50% one year and less than 30% the other year. The IRS was not clear about the average holding periods; they may have been under 31 days, which could be okay. But there were far too many sporadic lapses in trading, which is against the tax law requiring “regular, frequent and continuous” trading.
“I appreciate the break down of trading within this case,” says Green NFH co-managing member Darren Neuschwander, CPA. “This will be good to show clients how the IRS is clearly reviewing trader tax status.”
Notice Nelson couldn’t get relief from significant accuracy-related penalties. According to the RIA summary, “Nelson’s claim that she spoke with a friend who is an accountant was insufficient to show what advice the accountant provided and whether her reliance on same was reasonable.”
Get educated on trader tax status before you claim it. Conservatively assess it at year-end before deploying it on your annual tax returns. Consider an entity going forward. If you’re examined by the IRS, consult with a trader tax status expert and consider their representation. Don’t bring a losing case to tax court and argue it on your own.