The IRS is piling up victories in tax court against individual traders who inappropriately use Section 475 MTM business ordinary loss treatment for deducting large trading losses. Fariborz Assaderaghi & Miao-Fen Lin v. Commissioner is yet another IRS win that can be added to the list. According to Tax Analysts, “The Tax Court held that a husband’s trading activity in securities didn’t constitute a trade or business and, thus, he wasn’t eligible for a mark-to-market accounting method election under section 475(f) and the couple was limited to a $3,000 deduction of losses from the purchase and sale of securities under section 1211(b) for each year at issue.”
Only traders who qualify for trader tax status (Schedule C business expenses) may elect and use Section 475. Lots is at stake since without trader tax status or a timely Section 475 MTM election, traders are forced to use a puny $3,000 capital loss limitation against other income.
We agree with the IRS that Assaderaghi did not qualify for trader tax status in any of the years examined. Assaderaghi had many day trades, and he used professional trading equipment and charts. But he had a demanding full-time career as an engineer/executive and the IRS is more skeptical toward part-time traders claiming trader tax status. Assaderaghi was unable to prove his hours spent in trading and his evidence lacked credibility in the eyes of the IRS and tax court.
Most importantly, Assaderaghi came up short on meeting our golden rules for 2008, the one year he had a chance to qualify for trader tax status. He had 535 trades and our golden rules call for 1,000 total trades. He traded just over 60% of available trading days and our golden rules call for trade executions on 75% of available trading days. In the other years examined, he came up far short of trader tax status and when you view the years together it’s especially weak.
Perhaps Assaderaghi could have fought harder to win trader tax status in 2008, and concede the other years, but that is generally not the main issue. A bigger issue is filing a timely Section 475 MTM election and Assaderaghi and his accountant did not do that. It’s significant since Assaderaghi’s CPA deducted $374,000 in trading losses for his 2008 Schedule C, but the IRS forced them to use a puny $3,000 capital loss limitation instead. Once again, a trader and professional go to tax court with a clear losing case on technical grounds, missing or botching a Section 475 MTM election, and there is nothing that can be done about it. They wasted their money and effort in tax court.
Assaderaghi made some tragic rookie tax mistakes which sealed his fate as a loser with the IRS. He made the common mistake of asking his local CPA tax preparer to elect trader tax status and Section 475 MTM, but after not getting an answer from his CPA, he didn’t do anything about it. His accountant was clueless about trader tax benefits and rules — which is sadly still often the case. When it comes to timely Section 475 elections, there is no excuse allowed for relying on an accountant, and there is no IRS relief. The IRS is lenient on many things, but not Section 475.
His accountant grasped the idea of trading as a business — filing a Schedule C — but he jumped to the tragic conclusion that he could simply report trading gains and losses on schedule C like other types of businesses. He should have filed a timely election for Section 475 and reported trading gains and losses on Form 4797 Part II with ordinary gain and loss treatment. It’s clear the accountant did not know that Section 475 MTM had to be elected by April 15, 2008 for 2008 or perfected with a 2008 Form 3115 change of accounting filed in 2009 with the 2008 tax returns. Had Assaderaghi known the golden rules, perhaps he would have traded more to meet them.
Assaderaghi’s tax return screamed for an IRS beat down. The IRS computers see trades on Schedule C and issue a tax notice because trades don’t belong on Schedule C. The IRS tries to match broker 1099-Bs to Schedule D (in 2008 and Form 8949 after 2010), Form 4797 Part II (section 475 MTM) and Form 6781 (Section 1256). The IRS agent asked the CPA preparer about his filing of a Section 475 MTM election and the CPA did not even know what the agent was talking about. Case closed — it’s a loser! You can never file a Section 475 MTM election late (or with hindsight).
Lessons learned: Learn trader tax benefits and rules with our content and hire a proven trader tax CPA like our firm Green NFH, LLC to assist you with the election, Form 3115, Form 4797 and tax return footnotes.
It’s important to note that 2014 Section 475 MTM elections are due by April 15, 2014 for individuals and existing partnerships, and March 15, 2014 for existing S-Corps. “New taxpayers” (new entities) file a Section 475 MTM election in their own books and records (internally) within 75 days of inception of the new entity formation. We recommend Section 475 MTM on securities only, so you retain lower 60/40 capital gains rates on Section 1256 contracts like futures. Section 475 MTM does not apply to segregated investment positions. If you have capital loss carryovers, you may want to wait until you generate more capital gains to use them up first.
Make sure you meet our golden rules for trader tax status based on tax court cases. The Assaderaghi case does not change our golden rules. The Assaderaghi court reinforced the notion that business traders must be consistent in trading volume and frequency and avoid sporadic lapses in active trading. The tax law requires “regular, frequent and continuous trading based on daily market movements and not long-term appreciation.”
It’s wise to stop trading as an individual and form an entity that qualifies for trader tax status and files an entity business tax return that resembles many active trading hedge funds. As pointed out in Green’s 2014 Trader Tax Guide, a high ranking IRS person in the trader tax status and Section 475 area recently warned at a tax conference that the IRS is going after individual traders inappropriately using trader tax status and Section 475 MTM ordinary loss treatment. Get the help you need to be a winner.