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A big way promoters target traders inappropriately is by promising full business-tax deduction treatment for trading education, seminars and travel expenses incurred up to 18 months before as well as after traders enter a trading entity, even if the entity doesn’t qualify for trader tax status.
This promise is very attractive to traders since many pay $5,000 to $25,000 or more for education, training and seminars before they qualify for trader tax status business treatment.
Unfortunately, the promoters are wrong on a number of levels. We wish they were right as it would save traders lots in taxes. But, by following this incorrect advice, traders can wind up owing the IRS significant back taxes, interest and substantial understatement (higher) tax penalties.
“Dangerous entity scams targeting traders, part 1” explained that only a trading entity that qualifies for trader tax status may have business expense treatment. Business expenses may only include items incurred after the commencement of a business activity. Despite these tax rules, the promoters promise business expense treatment for pre-business education, seminar and travel costs up to 18 months back to those who don’t qualify for trader tax status.
Under limited conditions, some pre-business education expenses can be treated as Section 195 start-up costs amortized at far lower amounts than full business deductions – providing the trader qualifies for trader tax status as a sole proprietor trader or within an entity soon thereafter. This is explained in detail below.
When a pass-through trading entity doesn’t qualify for trader tax status, the IRS considers it an “investment company.” Tax law dictates that an investment company entity or individual investor use the more restrictive Section 212 investment income and expense tax treatment.
The education, convention, seminar and travel tax rules
Unfortunately, most trading education, convention, seminar and travel expenses are generally not allowed as Section 212 investment expenses because of IRS rules to prevent abuse on travel and entertainment-related expenses (Section 274(h)(7)). This tax fact was confirmed for traders in a recent landmark tax court case, Carl H. Jones, III, et al. v. Commissioner. The tax court ruled that Jones, who conceded he was not a business trader, was not entitled to claim Section 212 investment expense treatment for day trading educational courses, seminars and travel expenses because those courses qualified under Section 274(h)(7). Jones wound up with no tax deduction for these items.
Here’s a little more background information about Section 274(h)(7).
§ 274 Disallowance of certain entertainment, etc., expenses.
(h)(7) Seminars, etc. for section 212 purposes. No deduction shall be allowed under section 212 for expenses allocable to a convention, seminar, or similar meeting.
Jones traveled to a destination to take a one-time course that lasted a week or more and that deduction was denied due to Section 274(h)(7). Here’s our interpretation of Section 274(h)(7) in light of the Jones decision. In-person courses lasting many weeks (rather than one-shot “seminars”), as well as online courses of any format may be considered Section 212 investment expenses – and not denied under Section 274(h)(7).
The above non-Section 274(h)(7) courses don’t require travel to any location, and therefore ipso facto should not be governed by Section 274(h). Jones v. Comr states, “Thereafter in 1986 Congress. .. ., enacted section 274(h)(7) to curb taxpayers from claiming deductions under section 212 for expenses related to conventions, seminars, or other meetings related to financial planning. The accompanying House and Senate committee reports observed that individuals had claimed deductions for attending seminars about investments in securities or tax shelters, and that in many cases those seminars were held in locations that were attractive for vacation purposes and scheduled in ways to allow substantial recreation time. The disallowance of expenses is intended to extend to registration fees, travel, and transportation costs, and meal and lodging expenses among other costs attributable to attending a convention, seminar, similar meeting.”
If Jones had taken classes not snagged under Section 274(h)(7), he could have taken a Section 212 expense deduction because he was already an active investor and the classes helped him managed and produce investment income.
Does the education qualify a taxpayer for a new trade or business? If so, it’s not deductible.
It’s important to note new traders may not deduct trading courses under Section 212, because they fail its main requirement: They are not already involved in Section 212 investment income generation activities before taking the trading courses. This was the problem for the Woody case discussed later: He wasn’t a real-estate investor when he took real-estate investment classes. Woody commenced a real-estate investment business activity the year after he took his non-deductible education classes, which the court said qualified him for a new trade or business.
Traders established in the business of trading under Section 162 before they take trading courses are not snagged by Section 274(h)(7), because that section limits Section 212 expenses only.
If the education qualifies for Section 162 treatment, the business trader may take a business deduction. When an established business trader travels to attend trading courses, seminars and conventions, the travel expenses partially or fully qualify for business deduction treatment. Traders should reference specific IRS rules on travel and entertainment deductions and be aware of strict requirements on personal travel, including extending stays for personal benefit and expenses for family members.
If education courses qualifies a taxpayer for a new trade or business activity – perhaps money management for trading other people’s money which often requires various professional licenses and registrations (series 7, 3, 63, registered investment advisor, CTA or CPO) – education to achieve that professional status may be viewed by the IRS as non-deductible. The IRS usually determines the education qualifies the existing business person for a distinct, new, and different trade or business activity; in this case, professional money management vs. trader tax status for one’s own account (which doesn’t require licenses, special training, or education in advance).
Back to the important question
Can some pre-business education, seminar, and travel costs incurred just before a trader qualifies for trader tax status be squeezed into Section 195 business start-up costs? Start-up costs are defined as investigating and inquiring about a new business, and we believe educational classes and seminars can fall in this category.
If the answer is yes, then it’s a partial solution to the issue at hand. Section 195 start-up costs may be amortized – a tax-deduction similar to a business expenses, but far less. A maximum $5,000 first year “expense election” plus the balance can be amortized over 15 years on a straight-line basis. That’s a stretched out deduction vs. an upfront business deduction promised by promoters.
Woody vs. Commissioner
In Woody vs. Commissioner, the court reinforced the notion that the IRS and courts will probably deem pre-business education non-deductible for the following alternative reasons:
1. Because the education qualifies a taxpayer for a new trade or business, which is non-deductible education.
2. Because it’s not allowed under Section 212 since the taxpayer wasn’t an existing investor at the time.
3. Because it’s allowed as Section 212 in general, but denied under Section 274(h)(7) because it involved travel.
In post-trial briefs, Mr. Woody acknowledged that he would be precluded from the special treatment afforded under Section 195 because he failed to make the requisite election required by section 195(b). Can we infer that had Woody made the Section 195 election on time, he might have been able to use Section 195 treatment? Doubtful, since again, the court ruled that the education was non-business, and it qualified him for a new trade or business.
The Woody case states: “A taxpayer is not carrying on a trade or business under section 162(a) until the business is functioning as a going concern and performing the activities for which it was organized.” Glotv v. Commissioner, supra. Until that time, expenses related to that activity are not “ordinary and necessary” expenses currently deductible under section 162 (nor are they deductible under section 212) but are considered “start-up” or “pre-opening” expenses.
Nonetheless, in order to resolve the matter before us, we don’t need to decide whether Mr. Woody’s business started at the time he purchased the Randolph Street property or at the time he held it out for rent, because, in any event, the expenses in question all occurred before the purchase date, i.e., before Dec. 30, 2004. 9 If the earliest possible date Mr. Woody was actively carrying on a trade or business was Dec. 30, 2004, then [*16] any expenses incurred “before the day on which the active trade or business” began, sec. 195(c)(1)(A)(iii) – i.e., all the expenses incurred from Jan. 1 through Dec. 29, 2004 – would be, by definition, start-up expenses whose deductibility, and possible amortization, is expressly dealt with by section 195. Since all the expenses at issue fall between those dates, 10 they would not be deductible for 2004 under section 162 because their timing makes them subject to the provisions of section 195. (Remember, section 195 start-up expenditures are not deductible under section 162.) See Hardy v. Commissioner, 93 T.C. 684 (1989). Mr. Woody’s largest expenditure in 2004 – $ 21,515 for workshops and training – was an educational expense incurred to prepare for a new career (real estate investor and renter), rather than to maintain or improve skills in an ongoing business or career. It was therefore not deductible under section 162.”
Can Woody be interpreted in a more beneficial light for traders?
In my view, the Woody court is saying the following: Section 162 treatment starts in 2005 and 2004 expenses may be eligible for Section 195 start-up business tax treatment. Yet, because Woody’s classes qualified him for a new trade or business (in the court’s view), the court concluded Woody couldn’t use Section 195 treatment because the business hadn’t already been in operation.
Online traders
For online traders, typical trading education courses aren’t taken to qualify a trader for a new trade or business. Traders don’t need licenses, as is generally the case for money managers.
Online trading is a business for which trading courses aren’t needed at all. Courses may improve a person’s skills, but many people trade without ever taking a course. This is a crucial test to get past, to avoid the Woody outcome and have a chance for including the classes in Section 195. I imagine Woody would have tried to say that his real estate classes weren’t needed for owning a rental property business. It’s a fine line of distinction.
Comparing Jones to Woody
Jones was a day trader, but didn’t achieve trader tax status, before, during, and after he took his trading classes. Jones never entered a trade or business as Woody did.
The court claimed Jones was stuck with Section 212 and 274(h)(7) treatment, and Section 195 was not an option because he never qualified for trader tax status soon after taking his classes. Once stuck in Section 212, Jones was disallowed a deduction for the classes because the classes were snagged with Section 274(h)(7).
Woody, on the other hand, eventually formed a new rental property business soon after taking his classes, and the court invited him to consider Section 195 for classes taken beforehand. Yet, the court ruled that Woody’s classes failed the Section 162 business test, because the education qualified Woody for a new trade or business. Jones wouldn’t have had that same problem because he was already established as an active investor; Woody was not.
Had Jones qualified for trader tax status soon after taking his classes, he could have considered Section 195 treatment. He was already established in day trading – just not enough to qualify for trader tax status yet – and his classes in our view didn’t qualify him for a new trade or business; they continued his ongoing maintenance of trading education.
The possible opening for traders
Traders will need to show the IRS that their courses aren’t for a new trade or business activity. Traders don’t have clients and courses don’t enhance their value to the public in anyway. As investors, traders were already engaged in short-term trading, and reaching “trader tax status,” meant they engaged in trading more frequently. This isn’t qualifying for a new trade or business for purposes of education deductions (even though it’s a new trade or business for purposes of Section 195). There is a fine line of distinction on these points, and traders should consult an expert.
Here’s the counter argument
The IRS may consider trading courses just like it viewed Woody’s real estate courses, concluding the trader is taking courses to be qualified for a new trade or business. After all, everyone agrees the trader has entered into a new trade or business by obtaining trader tax status (and thus qualifying under Section 195). The IRS would say the education puts an investor in the new trade or business of being a trader, and that you can’t distinguish between a new trade or business for purposes of education deductions vs. Section 195.
Alternatively, the IRS could argue the education isn’t a Section 195 expense because it helps the trader with his current investing (and is a Section 212 deduction) even if he never qualifies for trader tax status.
Potential inconsistencies and the fine line
Since most traders take courses that wouldn’t be deductible under Section 274(h)(7), their best shot at a tax deduction is Section 195. Better yet, qualify as a business trader before taking classes to have Section 162 expenses, unaffected entirely by Section 274(h)(7)
Traders should be careful. Some of these arguments appear to have it both ways, which could undermine a trader’s case in view of the IRS. If a trader seeks Section 212 expense treatment for continuing online classes (not travel courses), it’s hard to also argue the classes were intended to be part of Section 195 for starting up a trading business activity.
If a trader knows his courses will be disqualified under Section 274(h)(7), or that he won’t benefit from Section 212 expenses, then it would be wiser to squeeze those courses into Section 195 start up costs. If the IRS bounces the 195 approach during an exam, it may be more difficult to claim Section 212 treatment (if not denied under Section 274(h)(7)).
Golden rules for using Section 195
Our golden rules for Section 195 start up expense treatment for some pre-business education:
1. The amount should be reasonable and probably limited to $5,000, which happens to be the Section 195 “expense election” deduction amount, or perhaps up to $10,000.
2. We think the look-back period should be no longer than six months and hopefully much closer to the date the trader commences his trading business with trader tax status. The business commencement date is important and the IRS rules aren’t very clear about it, so that determination is important to discuss with our professionals too.
3. The trading education, seminars, and travel should be in connection with the trader’s original business plan.
4. Try to apportion some of the classes to investigating and inquiring (Section 195) and some to non-deductible amounts to be more conservative.
Back to the promoters promising full deductions
If you fell prey to their promises and schemes, and used business expense treatment for pre-business education, seminars, and travel expenses, you may want to consider filing amended tax returns. That may reduce IRS penalties if they catch up with you later on.
Traders and their trader tax experts should review their files to determine if they can include any pre-business education, seminars and travel expenses as part of Section 195 start-up costs, or as part of Section 212 investment expenses.
Bottom line
By default, pre-business education, seminars and travel are not deductible and claiming Section 195 start-up expense treatment may invite challenges from the IRS.
Established investors may claim Section 212 investment expense treatment for online courses which aren’t otherwise denied Section 212 deduction treatment under Section 274(h)(7) ¬– otherwise known as travel seminars.
Trader tax status is an absolute requirement (don’t be fooled by the promoters saying otherwise) for new trading businesses; there may be a narrow opportunity to squeeze some pre-business education into Section 195 start up expenses.
When it comes to deducting pre-business education expenses, there’s still too much unknown. Our tax attorneys may be able to build a “reasonable-basis” position for your account. Perhaps they can even reach “substantial-authority” positions too. Contact us for help.