How To Qualify For Substantial Tax Savings As A Trader

Trader tax status (TTS) constitutes business expense treatment and unlocks an assortment of meaningful tax benefits for those who qualify. The first step is to determine eligibility. If you do qualify for TTS, you can claim some tax breaks such as business expense treatment after the fact and elect and set up other breaks — like Section 475 MTM and employee-benefit plans — on a timely basis.

Business expenses include home-office, education, startup expenses, organization expenses, margin interest, tangible property expense, Section 179 (100%) or 100% bonus depreciation, amortization on software, self-created automated trading systems, seminars, market data, stock borrow fees, and much more. The Tax Cuts & Jobs Act suspended “certain miscellaneous itemized deductions subject to the 2% floor,” including investment fees and expenses, commencing in 2018.

Securities traders with TTS should consider electing Section 475 ordinary gain or loss treatment by April 15 (individuals) and March 16, 2020 (existing partnerships or S-Corps). I call it tax-loss insurance: It exempts securities trades from wash sale loss adjustments and the $3,000 capital loss limitation. Profitable 475 traders are eligible for the 20% qualified business income (QBI) deduction. QBI excludes capital gains and losses.

A TTS S-Corp unlocks deductions for health insurance premiums and high-deductible retirement plan contributions.

Traders who do not qualify for TTS aren’t eligible for any of these tax benefits.

How to qualify
It’s not easy to be eligible for TTS. Currently, there’s no statutory law with objective tests for eligibility. Subjective case law applies a two-part test:

1. Taxpayers’ trading activity must be substantial, regular, frequent, and continuous.
2. A taxpayer must seek to catch swings in daily market movements and profit from these short-term changes rather than profiting from long-term holding of investments.

Golden rules
Volume, frequency, and average holding period are the “big three” because they are more accessible for the IRS to verify.

Volume: The 2015 tax court case Poppe vs. Commission is a useful reference. Poppe made 720 total trades per year/60 per month. We recommend an average of four trades per day, four days per week, 16 trades per week, 60 a month, and 720 per year on an annualized basis. Count each open and closing trade separately, not round trip. Scaling in and out counts, too.

Frequency: Executes trades on close to four days per week, around a 75% frequency rate.

Holding period: In the Endicott court, the IRS said the average holding period must be 31 days or less. That’s a bright-line test.

Trades full time or part-time, for a good portion of the day, almost every day the markets are open. Part-time and money-losing traders face more IRS scrutiny, and individuals face more scrutiny than entity traders.

Hours: Spends more than four hours per day, almost every market day working on the trading business — all time counts.

Avoid sporadic lapses: Has few to no intermittent lapses in the trading business during the year.

Intention: Has the intention to run a business and make a living. It doesn’t have to be a primary living.

Operations: Has significant business equipment, education, business services, and a home office.

Account size: Has a material account size. Securities traders need to have $25,000 on deposit with a U.S.-based broker to achieve pattern day trader (PDT) status. For the minimum account size, we like to see more than $15,000.

What doesn’t qualify?
These four types of trading activity do not count for TTS qualification.

1. Outside-developed automated trading systems (ATS). A computerized trading service with little to no human involvement doesn’t qualify for TTS. On the other hand, if the trader can show he’s very involved with the creation of the ATS — perhaps by writing the code or algorithms, setting the entry and exit signals, and turning over only execution to the program — the IRS may count those trades.
2. Trade copying service. Some traders use trade copying software. Trade copying is similar to using a canned ATS or outside adviser, where the copycat trader might not qualify for TTS on those trades.
3. Engaging a money manager. Hiring a registered investment adviser or commodity trading adviser — whether they are duly registered or exempt from registration — to trade one’s account doesn’t count toward TTS qualification.
4. Trading retirement funds. Achieve TTS through trading in taxable accounts. Trading activity in non-taxable retirement accounts doesn’t count for purposes of TTS qualification.

For more in-depth information on TTS, see Green’s 2020 Trader Tax Guide Chapter 1 “Trader Tax Status.”