How To Become Eligible For Trader Tax Status Benefits

June 5, 2017 | By: Robert A. Green, CPA


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Trader tax status (TTS) drives many key business tax breaks like business expenses, business ordinary trading losses with the Section 475 election and through an S-Corp, employee benefit deductions for retirement plans and health-insurance premiums. These items are deducted from gross income without restriction, whereas investment expenses are subject to itemized deductions, AMT preferences, and Pease limitations, and there are limitations on capital losses and wash sale loss deferral adjustments. Unfortunately, only a small fraction of active traders qualify for TTS, and the rules are vague and confusing to understand. In this blog post, learn how to be eligible for TTS.

TTS is good before and after tax reform:
Congress and President Trump are working on tax reform in 2017, and considering delays; I expect changes won’t be effective until 2018. Don’t wait for concrete plans, get started on 2017 tax planning based on current law, and hopefully, tax reform will favor your planning.

TTS is a case in point: It works perfectly for 2017, and tax reform should be the icing on the cake offering a lower tax rate on business income, hopefully, available to a TTS company. Tax reform may also repeal investment expense deductions, thereby making TTS even more attractive. (Read Consider Smart Tax Moves Now That Work With Possible Reform).

The first step is to determine if you qualify for TTS. If you do, you can claim some tax breaks such as business expense treatment after the fact, and make an election and set up other breaks — like Section 475 MTM and employee-benefit plans — on a timely basis.

There’s no election for TTS:
There’s no election for TTS; it’s an optional tax status based on facts and circumstances. A trader may qualify for TTS one year but not the next. It’s analogous to taking bread out of the oven each year to see if it rose to the level of bread (TTS) or if it’s flat bread (investor tax status). If you elected Section 475 and later don’t qualify for TTS, you must suspend use of Section 475 treatment until you requalify since Section 475 is conditional on qualification for TTS.

You can also qualify for TTS for part of a year. Perhaps you qualified for TTS in 2016 and quit or suspended active trading on June 30, 2017. Or you began active trading on July 1, 2017. Include the period of qualification on Schedule C or the pass-through entity tax return and deduct business expenses during that part-year period. If elected, use Section 475 for the TTS time, too.

TTS uses business expenses:
Qualifying for TTS means you can use business treatment for trading expenses as opposed to the default investment treatment. Business expense treatment under Section 162 gives full ordinary deductions, including home-office, education, Section 195 start-up expenses, Section 248 organization expenses, margin interest, tangible property expensing, Section 179 (100%) depreciation, amortization on software, seminars, market data, stock borrow fees and much more. (Watch my Webinar recording Top 11 Tax Deductions For Active Traders and see how a TTS trader has tax savings of $38,500 vs. an investor with no savings.)

Conversely, investment expenses don’t allow home-office, education, start-up, and organization costs, and they are only allowed as a miscellaneous itemized deduction in excess of 2% of adjusted gross income (AGI), and not deductible against the alternative minimum tax (AMT). The IRS further restricts investment expenses with the “Pease” itemized deduction limitation for taxpayers with AGI’s over $313,800 (married) and $261,500 (single), based on 2017 thresholds. Many states limit itemized deductions too. The bottom line is business expense treatment is much better.

You can claim TTS after year-end; you don’t need to make an election in advance like Section 475 MTM and the forex election to opt out of Section 988. You can claim TTS for the tax year that just ended and even for the prior three tax years with amended returns by including a Schedule C as a sole proprietor on individual accounts or for entities by changing the character of expenses on Schedule K-1s. (Note: Filing amended tax returns may increase your odds of IRS questions or exam so be sure of your status.)

Full-time traders often qualify for TTS, but it’s harder for part-time traders. The bar is raised in the eyes of the IRS — especially if you have significant trading losses with business ordinary loss treatment (Section 475) rather than capital loss limitations.

IRS case law and Publication 550:
It’s not easy to be eligible for TTS. Currently, there’s no statutory law with objective tests. Subjective case law applies. Leading tax publishers have interpreted case law to show a two-part test:

1. Taxpayers’ trading activity must be substantial, regular, frequent and continuous.

2. The taxpayer must seek to catch the swings in the daily market movements and profit from these short-term changes rather than profiting from the long-term holding of investments.

IRS agents often refer to Chapter 4 in IRS Publication 550, “Special Rules for Traders.” Here’s an excerpt: The following facts and circumstances should be considered in determining if your activity is a securities trading business.

– Typical holding periods for securities bought and sold.
– The frequency and dollar amount of your trades during the year.
– The extent to which you pursue the activity to produce income for a livelihood
– The amount of time you devote to the activity.

The IRS does not define the words “substantial, regular, frequent, and continuous” and case law also doesn’t give a bright-line test with exact numbers.

My Golden Rules on how to qualify for TTS:
I base my Golden Rules on trader tax court cases and our CPA firm’s vast experience with IRS and state controversy for traders. The trader:

Trades full time or part time, all day, every day. Part-time and money-losing traders face more IRS scrutiny and individuals face more scrutiny than entities. Full-time options traders actively trading significant portfolios may not qualify because they don’t have enough volume and frequency and their average holding period is over 31 days. On the other hand, a part-time trader with a full-time job may qualify as a day and swing trader in securities meeting all my golden rules.

Hours: Spends more than four hours per day, almost every market day working on his trading business. All time counts, including execution of trade orders, research, administration, accounting, education, travel, meetings, and more. Most active business traders spend more than 40 hours per week in their trading business. Part-time traders usually spend more than four hours per day. In one tax exam our firm handled, the IRS agent brought up “material participation” rules (Section 469), which require 500 hours of work per year (as a general rule). Most business traders easily surpass 500 hours of work. However, Section 469 doesn’t apply to trading activities, under its “trading rule” exemption. Without this exemption, taxpayers could generate passive activity income by investing in hedge funds and the IRS did not want that.

Few to no occasional lapses: The IRS has successfully denied TTS in a few tax court cases by arguing the trader had too many breaks in trading, such as taking several months off during the year. Traders can take vacations, sick time, and personal time off just like everyone else. Some traders take a break from active trading to recover from recent losses and learn new methods and markets. Explain these breaks to the IRS in tax-return footnotes. Retooling and education during an occasional break may be acceptable. Keep good records of your time spent.

Frequency: Executes trades on close to four days per week, every week. It’s wise to prevent an IRS challenge by trading close to four days per week or 75% of available trading days — even if you need to make smaller executions with reduced risk on otherwise non-trading days. It’s not a good idea to have the tax tail wag the dog, and any trading you do for TTS should have an actual economic risk.

Holsinger, Assaderaghi, Endicott and Nelson, options traders with less activity than equity or futures traders, only traded around 40% of available trading days, which is two days per week. Three days per week may be cutting it too close, so try to get closer to four. While we feel the IRS should also count working days when you don’t have an execution, it currently does not as evidenced by the Assaderaghi, Endicott and Nelson cases.

Volume: Makes 720 total trades per year (Poppe court) on an annualized basis. If you start July 1, then you need 360 executions, half of the 720. The court mentioned Poppe having 60 trades per month as being sufficient volume. Count the buy and sell, or open and close, as two total trades.

The markets are open approximately 250 days per year, and with personal days and holidays, you might be able to trade on 240 days. With a 75% frequency, you would trade on 180 days per year, so 720 total trades divided by 180 trading days equals four trades per trading day.

Some traders scale into trades and executions are broken down into smaller lot sizes. Options traders have multi-legged positions on complex trades. We believe you may count each trade confirmation of a complex trade, providing you make the executions separately, although this has not come up in tax court cases. If you initiate a trade and the broker breaks down the lot sizes without your involvement, the IRS may reject counting the extra volume of trades in this case.

Forex and futures trades aren’t listed line by line on tax returns (unlike securities trades), so the IRS doesn’t see those numbers. Report an actual number in your tax return footnotes about TTS.

Proceeds: Have proceeds in the millions of dollars per year on equities. More traders are using options and futures, which have lower proceed values. Explain this well in footnotes since proceeds for futures and forex are not reported on 1099s, and the IRS won’t see the proceeds amount. Proceeds on a Form 1099-B provide the IRS with a quick indication about qualification for TTS.

Holding period: Over the years, the IRS stated that holding period is the most important factor, and in the Endicott court, the IRS said average holding period must be 31 days or less. That’s a bright-line test and the only one.

Active traders usually make day trades or swing trades. Don’t hold many trading positions over a month, unless you segregate them as investments. Exclude investments from average holding period calculations. Investment positions are also not subjected to MTM in Section 475 (if elected), which then allows for deferral at year-end and perhaps lower long-term capital gains tax rates if held 12 months.

Options traders may have average holding periods of over one month if they trade monthly options and keep them open for one or more months. (Note: Holsinger was an options trader and his holding periods averaged between one to two months.)

Many options traders qualify for TTS by trading weekly options, thereby shortening their average holding periods to under 31 days. Their other challenge is frequency, as many still only execute trades on two to three days per week, rather than the requirement closer to four days per week. It’s a challenge for options traders to be that frequent. Some fill in the blanks by trading securities, futures and or forex.

Intention: Has the plan to run a business and make a living. You must have the intention to run a separate trading business — trading your money — but it doesn’t have to be your exclusive or primary means of making a living. The key word is “a” living, which means it can be supplemental income for your livelihood.

Many traders enter an active trading activity while still performing their full-time job. It’s possible to carry on both activities simultaneously using advances in technology and flexible job schedules.

It’s not a good idea to try to achieve TTS within a business entity already principally conducting a different type of business activity. It’s better to form a new trading entity. Trading an existing business’s available working capital seems like a treasury function and sideline, which can undermine trader tax status.

While filing as a sole proprietor on a Schedule C is allowed and used by many, it’s not the best tax filing strategy. Your tax return shows your job and other business activities or retirement, and that may undermine TTS in the eyes of the IRS. The IRS tends to think trading is a secondary activity, and they may seek to deny TTS. It’s best to form a new, separate entity dedicated to trading only.

Operations: Has significant business equipment, education, business services and a home office. Most business traders have multiple monitors, computers, mobile devices, trading services and subscriptions, education expenses, high-speed broadband, wireless and a home office. Some have staff. The IRS needs to see that you have a serious trading business operation. How can you run a business without an office? Casual investors rarely have as elaborate an office set up as business traders do. Why would a long-term investor need multiple monitors? If you use the office exclusively for business rather than personal use, don’t skip reporting a valid home-office deduction.

Account size: Securities traders need to have $25,000 on deposit with a U.S.-based broker to achieve “pattern day trader” (PDT) status. With this status, they can day trade using up to 4:1 margin rather than 2:1. Without PDT status, securities traders, which include equities and equity options, can’t day trade and they will have a hard time qualifying for TTS. The $25,000 amount seems substantial enough to impress the IRS.

Many new traders don’t want to risk $25,000 on day trading securities; they prefer to trade futures or forex, all allowing mini-account sizes of $5,000 or less. A small account size won’t impress the IRS — you probably need more capital to qualify. We like to see over $15,000 for futures or forex accounts.

What doesn’t qualify for TTS:
Three factors don’t qualify for TTS: Automated trading without much involvement by the trader (but creating your program qualifies); engaging a professional outside investment manager; and trading in retirement funds. Don’t include these trades in the golden rule calculations.

This blog post is a partial excerpt from Green’s 2017 Trader Tax Guide. There’s more to learn about TTS in the guide.

Consider a 30-minute paid consultation with Robert A. Green, CPA to discuss: Whether you qualify for trader tax status; if you should elect mark-to-market accounting; if you benefit from an entity and which type of company; and more trader tax benefits.