Holsinger case: IRS denies trader tax status and MTM

September 3, 2008 | By: Robert A. Green, CPA

A trend is not your friend. The IRS won a few tax court cases over the past few years; disallowing trader tax status and IRC Section 475(f) mark-to-market accounting (MTM, ordinary loss treatment) for “close call” traders. 

Unfortunately for all business traders, a few of these tax court cases had weak factors for qualification for trader tax status, plus botched MTM elections. Plus, the cases were argued poorly in court; often by the traders without a trader tax expert’s help, or by an expert who was not sufficiently strong enough on trader tax law. 

A very recent IRS tax court case victory (denying trader tax status and MTM) has caused a stir in the media and among traders. It’s Holsinger vs. IRS. This case was written up in today’s Wall Street Journal by Tom Herman, an excellent WSJ columnist on tax matters. 

See the below links for that article and the links in that article:
Think You’re A Trader? IRS May Disagree

Note that one expert’s quote in the article is wrong. A trader can segregate investment positions and still benefit from lower long-term capital gains tax rates, while benefiting from IRC 475 MTM ordinary loss (or gain) treatment on business positions. Otherwise, it’s an excellent article. 

As another example, in Chen vs. IRS, a part-time trader lost both trader tax status and MTM ordinary trading loss treatment; where he should have only lost MTM on technical grounds (and he represented himself poorly on all fronts).

Like the Chen case above, I believe the Holsinger decision is also controversial, in that the IRS easily won denial of MTM ordinary loss treatment on technical grounds, and this taxpayer also conceded trader tax status qualification too easily. 

Both of these cases should serve as precedent for MTM technical issues, yet they will gain ground as settled law for trader tax status and they should not – because they were argued incorrectly and without good enough legal counsel. That’s bad precedent for business traders and it needs to be corrected soon! 

Denial of MTM converts ordinary trading losses into capital loss limitations (which are carryovers instead), which is the biggest type of loss in these cases. However, winning trader tax status – a different but connected point – can keep business ordinary loss treatment for expenses; versus reclassifying them as restricted and limited investment expenses. 

See my full comments on the Holsinger vs. IRS tax court case below. 

These poorly handled cases are becoming an increasing problem for business traders; who are entitled to all trader tax status related benefits (business expenses, MTM treatment and more). 

Judges have made remarks in some of these cases that are not settled tax law and then IRS agents later on cite these court cases as settled law precedent in exams and other proceedings. Traders are hurting themselves by botching trader tax returns, getting examined and then bringing losing cases to tax court; plus often handling those poorly in tax court too boot. 

This tax court case trend coupled with new IRS exam proliferation (see my November 2008 article in Active Trader does not bode well for business traders. 

In the current environment, it’s wise to form a separate trading business entity (for a separate tax filing) and to be more conservative on trader tax status qualification decisions. Plus, do not invite the IRS into your tax return with undue red flags either.

Comments on the Holsinger vs. IRS tax court case: 

Holsinger (H) was a “close call” at best on trader tax status, and GreenTraderTax (GTT) would probably have challenged and maybe not allowed his trader tax status as a tax preparer. 

GTT would not have filed the tax returns this taxpayer filed; which contained important errors. H was not entitled to use his LLC or the LLC’s internal MTM election; because taxpayer conducted most trading in his individual name and therefore did not have trader tax status on the LLC level. No mention was made of an external sole proprietor MTM election by 4/15/01. 

The “agent” argument is a problem in this context (of MTM). I wonder why H didn’t just trade in the name of the LLC, thereby doing himself a disservice in this regard. The case did not mention anything about prior capital loss carryovers either; so we don’t know any other factors that may be important in this context. 

It’s different with a defacto husband and wife general partnership; which can include individual joint trading accounts during the defacto period (in the initial year). Defacto GPs must open GP trading accounts when they are formalized. 

The IRS probably examined (audited) H because he filed a large loss on Schedule C (sole proprietorship before the entity was started) and Schedule E (for the LLC). Expenses were also fairly large by most business trader standards. I doubt H used proper trader tax footnotes and he probably botched his tax reporting too.

H is a retired person and that raises the bar on trader tax status qualification in our view; like for a part-time trader. We have reason to believe that the IRS is prejudiced against retirees, part-time and money losing traders. 

H’s number of round trip trades was well below our published golden rule numbers of 500 round trip trades. Some business traders can have fewer trades, but their other factors need to be strong. See Green’s 2008 Trader Tax Guide for our golden rules. We always say/write that we want to see one or more trades per day; every possible trading day. H had fewer than 160 round trip trades in 2002 and even less in 2001. If all of H’s other factors were very strong, maybe he could have won trader tax status business expense treatment. H’s low number of trades coupled with an average holding period over 31 days was troubling. 

H’s total cost basis on trades was well under 1 million per year and that’s very low for our golden rules as well. We usually see several million for proceeds and cost basis on securities. 

The IRS cited all the normal tax court cases on trader tax status and the range of total trades was very broad. From the denial of trader tax status on less than 50 round trip trades to agreeing to trader tax status on 1,100 total trades (assume 550 round trip trades). H fell in the middle and probably closer to a winning position. 

One of the biggest IRS’s arguments in this H case seems to be that H traded on only 40% of available trading days in 2001 and 45% in 2002. I wonder what’s happened since 2002, as subsequent events add credibility as well. 

Here’s a very important concept to interject into these arguments about number of business days. I don’t see that taxpayer raised the idea that a business trader spends significant amounts of time in their trading business activity; on perhaps all or most available trading days, even if they don’t execute trades on every available day (sometimes for very good market reason). 

There are many examples of other types of valid business activities where a person is devoted to their business activities/duties almost every business day, but they don’t execute transactions every available business day. For example, real estate and other commissioned salesman may work every day but not generate a transaction commission (a sale) every day (and most don’t). 

This is a point that I feel we should get involved with in defending traders with the IRS; before this number of trading day’s argument adds up in tax court cases as hurtful precedent. 

I think the IRS focuses most on number of trades, and actual trading days because these are the most objective factors which the IRS can verify. It’s going to be hard for business traders to prove their time spent in their trading business on a daily basis (unless they have daily trades), since they are not punching a clock controlled by the IRS. 

We have recommended that business traders use all available means to document their time spent on a daily basis; like using business plans, saving login sessions, using calendars, emailing significant memos to themselves on a daily basis and more. 

After all, numbers of trades and trading days alone can not serve as the most important factors. Many traders use automated trading programs now to generate lots of trades on a daily basis and some of them fail qualification for trader tax status for other good reasons – of equal importance in our view. 

Several other factors show business intent and business activity levels as well. For example, H obviously had large business expenses and many business tools and these points were not sufficiently addressed in his favor in the tax court memo. 

H had the typical serious business trader’s set up with multiple monitors, computers, home-office and more and these points were not commented on in the court’s decision; other than as large items for denial as business expenses. It should have been noted that these serious tools and expenses are indicative of a serious trading business activity and not casual investing.

Another big point by the IRS in H is the concept of “daily market movements rather than long-term price appreciation” This brings up the point of average and mean holding periods. 

“Daily market movements” does not mean that day trading only is required; as certainly swing trading is allowed too. H is weak in having an average holding period over one month in stocks. We have seen one month holding periods being okay for trader tax status, usually in connection with stock options (with monthly expirations) only; but usually not for stocks. 

H did himself a disservice by claiming he was often closing positions daily when in fact he rarely did. But, I don’t see any effort in the memo (which is just a snap shot of this case) to segregate out investment positions; which can reduce the average holding period calculation. H first botched MTM with the LLC versus individual accounts and this second misstatement helped him lose credibility with the IRS on the agent level (I presume). 

Hopefully, this case has a lot more analysis and facts behind it, than what is summarized in this brief tax court memorandum.