We agree with the IRS and tax court on denying trader tax status (TTS) — otherwise known as business treatment — to Endicott (TC Memo 2013-199, Aug. 28, 2013) for 2006 and 2007 since he clearly was a long-term stock investor managing risk in his long portfolio with call options held on average one to five months and a number of stock positions held for over a year, with some over four years.
Many investors use options in this manner. They hold significant long positions in stock and are exposed to bearish headlines, so during “risk off” periods they may sell calls or buy puts on their underlying stock. When they expect little movement they may “write premium” to enhance their income.
Management of an investment portfolio is a far cry from being a business trader with an entity, day and swing trading weekly and monthly options full-time with executions almost every day of the week, average holding periods of less than seven days, and no connection to management of risk in an investment portfolio.
Endicott failed all our golden rules for TTS qualification in 2006 and 2007. Our rules call for 500 round trip trades and Endicott had 204 trades in 2006 on 75 days and 303 trades on 99 days in 2007. Our rules call for executions on 75% of available trading days and Endicott had well under 40%. Additionally, there were seven months in 2006 in which he executed less than three trades in a given month.
Endicott was even less frequent than Holsinger, another landmark trader tax court case we covered on our blog dated 9/3/08. Holsinger executed 372 options trades on 45% of trading days. Holsinger was at least trading and not managing his investments like Endicott.
We have some questions about Endicott’s 2008 trading activity since his numbers —1,543 trades on 112 days, including investments — exceeded our 500 round trip requirement. But, he still was stuck at 45% of day executions, well below our 75% requirement. He started trading ETFs instead of options in 2008, perhaps in connection with his portfolio of investments, although we don’t know for sure. The court clearly focused on the big picture over three years (2006 to 2008) and couldn’t get past the fact that Endicott was a significant investor managing his portfolio and was not running a separate and distinct trading business.
Endicott begged for a beat down from the IRS. He deducted $300,000 on a trading business Schedule C, including huge margin interest on his long stock investment portfolio. Investors deduct investment interest expense on Schedule A (itemized deductions) and it’s limited to investment income.
There are some interesting precedents that come out of the Endicott court.
We’ve written about presenting the “hotel analogy” for options traders to the IRS and this ruling seems to deny one pillar of that argument. Although we would have presented the argument better, Endicott did not deserve to make this case. It’s only for a very close call on TTS.
Endicott argued his number of trading days should include days his option investments were actually open — not just the execution days for buys and sells. He said he did not trade options on a daily basis because commissions made it unprofitable. That’s bogus. Option traders can trade enough to surpass our golden rules if they are running a business. The court agreed and said counting days that investments are open doesn’t hold muster for counting trading days. We don’t consider this a denial of our hotel analogy, but it’s certainly a shot across the bow on that argument.
There are some interesting technicalities in the Endicott ruling. The court broke down qualification for TTS into two sub-part tests, although we think they are basically one test. The first test was “substantial” for size and number of trades. The court erred in viewing Endicott’s significant stock portfolio as part of the TTS test, as although it was large, it doesn’t count in a TTS analysis.
The second test was for “frequency” and it focused on trading execution days as a percentage of available trading days. Endicott knew he came up far short and he tried to claim days for options being open.
We agree with the tax court that Endicott was not attempting to catch the swings in the daily market because his overall holding period of the call options. Holding periods of one to five months are definitely not, as the tax court implies, “indicative” for a trader seeking such swings in the daily market.
(Note: Upon our complete reading of the Endicott case, we found a footnote by the tax court of what is deemed as an “executed trade.” The tax court appears to take the position that the expiration of an option in itself does not count within a trader’s number of “executed trade” for TTS qualification due to lack of any required action of the trader himself. The following example was given: If a taxpayer “purchased stock, sold a call option that expired unexercised, and subsequently sold the stock,” only three trades were deemed executed. This is contrary to our position that the expiration of an option is a trade itself.)
The lesson in the Endicott court case is it’s very important to ring fence investments vs. business trading. If you have material investments, it’s wise to use a trading business entity for that separation. When trader tax status is analyzed, don’t let investments infect your analysis. Don’t count investments in the numerator or denominator for the percentage of days traded, number of trades or average holding period.
Had Endicott had a consultation with our firm in the years in question, we would have certainly told him he did not qualify for TTS. As we have said for several years, it’s more challenging for an options trader to qualify for TTS. Especially when they have a full-time job and trade monthly options on the side a few days per week, bunching trades around explorations.
There is plenty of good news in the Endicott court ruling, too. It affirms TTS and reinforces what does qualify.
What should options traders do to qualify for TTS?
We advise setting up a separate trading business entity that disconnects trading from an individual’s investment portfolio. Don’t manage your investments with options and other “risk on and risk off” instruments like ETFs and indexes. Rather, day and swing trade options, ETFs and indexes on a stand-alone business-trading-program basis. Make sure you meet our golden rules.
Side note: The Edicott Court raised a concern about Endicott’s other Schedule C for consulting income. Endicott retired in 2002 and received income on a yearly basis as part of a non-compete agreement as the president of his former company. He reported this income on a separate “Consulting” Schedule C for each respective tax year. There appears to be no actual daily work requirement for Endicott in association with the receipt of this income and therefore it had no interference on his attempt to trade. The tax court pointed out that a taxpayer that qualifies for TTS “generally” should have the business of trading as his/her “sole or primary source of income.” The key term is “generally.” Just because a taxpayer has another source of income and net trading losses in a given tax year does not in itself deny a taxpayer from qualifying as TTS. In Endicott’s case, this other income was for past services and it should not have been a contributing reason for denial of TTS.
Watch our Sept. 10, 2013 Webinar recording on this subject.