Tag Archives: court

IRS And State Exam Controversy For Traders (Recording)

October 14, 2014 | By: Robert A. Green, CPA

Join Green NFH’s Robert A. Green CPA and Mark Feldman, tax attorney in this Webinar.

There’s been an increase in tax exams over trader tax status, cost-basis reporting and related issues. Recently, our CPA firm successfully represented a trader in tax court. State tax authorities are also challenging trader tax status and related Section 475 MTM ordinary loss treatment, trying to avoid issuance of large tax refunds. Learn the latest arguments raised by IRS and state tax authorities on the exam and appeals level, and how to mount a successful defense. In this Webinar, we will cover:

  • Highlights of our recent “small claims” petition filed in federal tax court with favorable outcome.
  • Highlights of recent state tax controversy over trader tax status.
  • IRS cost-basis reporting controversy including tax notices.
  • IRS attacks on weak segregation of investment positions vs. trading business positions and related implications for trader tax status and use of Section 475 MTM ordinary gain or loss treatment.
  • Review of trader tax status requirements.
  • Common mistakes traders and local tax preparers make that invite IRS and state controversy.
  • Questions and answers.

For traders involved with IRS or state tax controversy, we recommend our IRS & State Tax Exam Representation Service.

IRS & State Tax Representation

September 4, 2014 | By: Robert A. Green, CPA

The heat has been turned up on traders, wealthy taxpayers, offshore accounts, cryptocurrencies, and more in IRS and state tax exams. Our CPAs and tax attorneys are the best people to have in your corner. Start with a 45-minute consultation with our IRS and state tax experts. If we agree to represent you in a notice, exam, appeal, or tax court petition, then purchase our IRS or state representation service.

Learn more and purchase now.

Traders open the door to IRS and state exams by messing up cost-basis reporting, trader tax compliance, and international matters. Start off by reading our Trader Tax Center page: Dealing with the IRS & States. We have the fewest traders examined, and the best record in dealing with the IRS. A minuscule number of our trader tax compliance clients have been audited by the IRS since Congress enacted new trader tax laws in 1997. To date, we’ve had very favorable results.

Many traders who don’t use our tax compliance services have engaged us for tax representation services after they messed up their tax return filings. We can’t believe all the poor work we have seen. Watch These Tax Errors Will Cost Professional Traders Dearly.

Non-Traders: We’ve successfully defended all sorts of clients before the IRS and state since our founding in 1983.

If you have any questions about our IRS and state tax controversy services, please contact us.

We look forward to working with you soon.

Managing Members Robert A. Green, CPA and Darren L. Neuschwander, CPA

 

Dealing With The IRS And States

September 1, 2014 | By: Robert A. Green, CPA

The IRS has several initiatives underway that affects traders and investors.

1099-B matching to Form 8949

We expect issues over IRS cost-basis reporting on securities, including cost-basis, wash sales and short or long-term holding periods. With 1099-B computer matching to align broker 1099-Bs with taxpayer Form 8949s, traders should expect to receive tax notices with questions about the differences. The IRS indicated they would hold off on these reconciliations for a few years, and 2016 could be the year the IRS starts sending tax notices.

Attacks on trader tax status (TTS)

Sole proprietor business traders may receive IRS questions on Schedule Cs, as only trading business expenses are reported there which causes it to look like a losing business since trading-related income is reported on other tax forms. Sole proprietor business traders with large ordinary losses from trading expenses and Section 475 MTM losses should expect to hear from the IRS, since such losses will likely generate huge net operating loss (NOL) carryback refunds. Other attention grabbers are perennial money-losing traders and messed up tax return filings on TTS, Section 475, tax treatment and omitted footnotes. Although the IRS is underfunded and the number of agents is down, the slack is being taken up by computer matching and computer-generated tax notices.

Section 475 improper identification

The IRS and some states have been playing havoc with traders in exams, claiming traders did not properly comply with Section 475 rules for segregation of investment positions from trading positions. Noncompliance gives the agent license to drag misidentified investment positions into Section 475 mark-to-market (MTM), or to boot misidentified trading losses out of Section 475 into capital loss treatment subject to the $3,000 capital loss limitation. Both of these types of exam changes cause huge tax bills, penalties and interest. Traders don’t want to lose capital gains deferral and lower long-term capital gains rates on investment positions in securities. With misidentified investments, the IRS has the power to drag positions into Section 475, subjecting them to MTM and ordinary income tax rates.

Tax notices and exams

When a tax notice arrives, don’t panic and gush out everything to an IRS agent. Consult with a trader tax expert. Understand where the IRS is coming from; it may just be a computer-generated notice asking for a few simple open items. If the IRS is getting ready to challenge TTS and Section 475 MTM, it’s important to step back and make sure you have a strong case. Don’t expect the IRS to get it right the first time around. The IRS notice may have a hobby-loss business or passive-loss activity questionnaire and a trading business is exempt from those rules. Agents often calculate volume, frequency and other metrics on your trading activity to determine TTS qualification in ways that are favorable to them and wrong in our view, so do the calculations right. The big issue is TTS, not a few hundred dollars of trading expenses. 

Appeals

Expect the IRS agent to deny TTS unless you have a clear-cut case. Agree to disagree with the agent and go to the appeals level. Show the appeals officer how you are prepared to go to tax court to win based on application of trader tax court cases. It’s best to have a trader tax expert CPA or tax attorney in your corner to present your TTS qualification, explain trader tax law and prepare the appeals letter. 

Transfer the exam or appeals

If you work with a CPA firm with expertise and experience on trader tax clients and IRS exams, it’s probably a good idea to transfer the exam to your CPA’s office and local IRS office. If your CPA has worked on many prior exams with local IRS agents, they probably have educated the agents on trader tax status, trader tax treatment and Section 475 elections. This helps avoid problems with less informed agents on trader tax. That’s been our experience at Green, Neuschwander & Manning, LLC.

Tax Court

If appeals deny TTS and Section 475 MTM, and your trader tax expert thinks you have a good case, then file a petition in tax court. We generally suggest a “small case” filing. Engage the trader tax expert to write the tax court petition — preferably a tax attorney well versed in trader tax law. 

States also send tax notices and initiate exams

We’ve noticed more states challenging TTS and related tax breaks on their own, without the IRS taking the lead.

For more in-depth information on dealing with the IRS and states, read Green’s 2018 Trader Tax Guide.

Consider our IRS & State Tax Representation Service.

 

IRS Warns Section 475 Traders

August 13, 2014 | By: Robert A. Green, CPA

The IRS Chief Counsel (ICC) recently gave auditors advice on challenging Section 475 mark-to-market (MTM) traders trying to game the system with segregated investment positions. Section 475 MTM means ordinary gain or business loss treatment, whereas investment positions are capital gain or loss treatment. It’s important not to mix up the two on tax return filings. If you are unclear on your situation, check with one of our CPAs.

In new IRS Chief Counsel Advice 201432016, the IRS focuses on options created on “basket transactions,” which I feel are rarely used tax avoidance schemes. During the past decade, some very large hedge funds parked their trading activity inside of banks and arranged option transactions with the banks to reclaim their trading profits after year-end. These hedge funds avoided application of Section 475 MTM income on their trading gains during the tax year, and replaced it with an option allowing them tax deferral and long-term capital gains tax rates in the following year(s). They converted 40% ordinary tax rates to 20% capital gains rates and received a tax deferral to boot. Their tax savings from these transactions was in the billions of dollars and it attracted the attention of Congress and the IRS. The hedge funds’ arguments about “economic substance” sound pretty hollow to me in relation to tax savings from this tax avoidance scheme. The IRS wants to treat these segregated option transactions as part of the trader’s Section 475 MTM ordinary income trading activities, since they see a connection to those activities (see rules below). To learn more about these schemes, read Hedge Fund Chief Testifies at Senate Tax-Avoidance Hearing (New York Times, July 22, 2014).

There’s a lesson for retail traders using Section 475
We haven’t seen retail traders attempt these complex schemes with bank counterparties. Yet it’s a good time to revisit the segregation rules in Section 475 MTM. It’s a nuanced area of the law and it can have significant consequences on tax returns for business traders who have investments.

All business traders using or considering Section 475 MTM should learn its segregation of investment rules. (One way to prevent this problem is to conduct your business trading activity in an entity separate from individual and IRA investment accounts. The entity has a different taxpayer identification number, so there is no connection in the activity.)

We’ve recommended Section 475 MTM since 1997 when Congress expanded it for traders. The biggest tax benefit is unrestricted business ordinary loss treatment, with taxpayers escaping the onerous rules for wash-sale loss deferrals and the capital loss limitation ($3,000 against ordinary income per year on individual tax returns). Section 475 MTM can be the ticket to receiving huge tax refunds, often on NOL carryback returns.

An example of investments vs. business trades
Many traders want to make long-term investments as well in order to benefit from deferral on taxable income (until sale) and to hold investment securities 12 months for lower long-term capital gains tax rates (currently up to 20% vs. 39.6% the ordinary tax rate on short-term capital gains).

Each year we run into a handful of confusing situations on what’s considered a trading position vs. an investment position. Here’s a common example: A trader may want to house his investment portfolio inside a business trading account for portfolio margining purposes and hyperactively trade stock options around his core investment stock positions.

Suppose a trader holds Apple stock as an investment and trades Apple options for business around it to manage risk. Apple stock and Apple stock options are substantially identical positions for purposes of wash sales and Section 475 MTM. By doing this type of commingling activity, the trader may inadvertently subject his Apple stock investment to Section 475 MTM treatment at year-end, thereby losing deferral on the stock and subjecting his gains to ordinary rates rather than lower long-term capital gains rates.

There are all sorts of scenarios that can come up and in some cases it appears to benefit the taxpayer. It’s important to keep in mind that the IRS is entitled to apply the rules in a way that does not prejudice the government’s position. In the previous example, if the trader had a material loss in the Apple stock held for investment, the IRS is entitled to bar the application of Section 475 on that losing investment position. The IRS can have its cake and can eat it too.

Segregation of investment position rules
Per Thomson Reuters/Tax & Accounting, “Any securities held by the trader are subject to marking unless they fall within the exception to marking under Code Sec. 475(f)(1)(B). In the case of traders, there is only one exception to marking. Under that exception, two requirements must be met. First, it must be established to IRS’s satisfaction that the security has no connection to the activities of such person as a trader. (Code Sec. 475(f)(1)(B)(i)) Second, any such security must be clearly identified in such person’s records as being described in Code Sec. 475(f)(1)(B)(i) before the close of the day on which it was acquired, originated or entered into (or such other time as IRS may by regs prescribe). (Code Sec. 475(f)(1)(B)(ii)) An identification that a security is held for investment for financial reporting purposes is not sufficient for Code Sec. 475 purposes. (Rev Rul 97-39, 1997-2 CB 62).

Generally, gains and losses recognized under Code Sec. 475 are ordinary income or loss to a trader that has made an election under Code Sec. 475(f). (Code Sec. 475(d)(3)(A)(i) and Code Sec. 475(f)(1)(D)) However, Code Sec. 475(d)(3)(B) provides exceptions to the automatically ordinary rule under Code Sec. 475(d)(3)(A). If a taxpayer can establish that it held securities as hedges, or that the securities were not held in connection with its trading business, or that a security is improperly identified (see Code Sec. 475(d)(2) ), then gains and losses are not automatically ordinary. (Code Sec. 475(d)(3)(B)(i), Code Sec. 475(d)(3)(B)(ii) and Code Sec. 475(d)(3)(B)(iii)) Character must then be determined by other relevant Code sections.”

Many hedge funds and some traders skip a Section 475 election because they don’t want to be burdened with identifying investments on the time and date of purchase. They establish a trade and may let their profits run and morph the position into an investment position for long-term capital gain and deferral.

How Section 475 MTM and the segregation rules work
A business trader using Section 475 MTM has ordinary gain or loss treatment, plus open business positions are marked-to-market as imputed sales at year-end. On the first day of the subsequent year, the trader imputes a purchase of that same position at the same year-end price.

Duly segregated investment positions are not subject to Section 475 MTM. For example, a business trader organized as a sole proprietor may have a business trading account at Interactive Brokers and a segregated investment account held jointly with his spouse at Fidelity for making long-term investments. Like all professionals, it’s expected that a business trader would have investments, too.

It’s important for the business trader to contemporaneously segregate investment positions from business positions in “form and substance.” Form means a separate account and substance means don’t trade substantially identical positions with business trading positions. While proposed IRS regulations required a separate account, that rule never became final law, so a trader can have investment positions within a business trading account. Just make sure to email yourself contemporaneously when purchasing an investment position. Don’t trade around investment positions with your business positions, as that runs afoul of the substance rule. The lines of distinction can be blurred in some cases and you should consult a trader tax expert about it.

Read Green’s 2014 Trader Tax Guide Chapter 2 on Section 475 MTM to learn more.

Recent trader tax court cases
In recent trader tax court cases covered on our blog, Assaderaghi, Nelson and Endicott, the IRS won denial of trader tax status partially because these option traders did not segregate active option trading from investing in stocks (similar to the example above). However, even if these traders did follow segregation rules and our above guidance, I still don’t think they traded options enough to qualify for trader tax status. They also sought Section 475 MTM ordinary loss treatment on stock investments, which is not possible.

Bottom line
Section 475 MTM is fantastic for most business traders — we call it “tax loss insurance.” But the fine print requires discipline on dealing with investments. It’s best to trade in a separate entity to skip these handcuffs.

 

IRS Exams: How To Defend Trader Tax Breaks And Win (Recording)

August 11, 2014 | By: jparasole

Join CPAs Robert A. Green and Amanda Smitson, and tax attorney Mark Feldman.

IRS tax notices often question trader tax status (TTS) and the right to deduct trading business expenses on a Schedule C for individuals or pass-through entity tax returns. The IRS figures it can force limited investment expense treatment on Schedule A and a capital loss limitation instead of unlimited Section 475 MTM ordinary business losses which are conditional on qualifying for TTS.  The IRS has recently been victorious against traders Assaderaghi, Nelson and Endicott in tax court, so we prepared some tips for other traders facing an exam. In this Webinar, we will cover:

* How to file a trader tax return without red flags.

* How to reply to tax notices.

* How to keep an IRS exam limited in scope and under control for winning. 

* Big issues like trader tax status, a Section 475 election, cost-basis accounting and IRS matching tax returns with 1099Bs from brokers.   

* How to stay in bounds on tax filings so you don’t invite scrutiny. 

* When to “agree to disagree” with your IRS agent and move on to appeals, where you may have a much better chance of success.   

* How to write a winning appeals letter. 

* The pros and cons of tax court. 

* Learn how to file a petition for a tax court “small case”, and attempt to negotiate a settlement back in appeals. 

* Who should represent you in tax court. 

* The consequences of not filing tax returns, filing late, installment payment agreements and not dealing with IRS collections. 

Handling tax compliance right significantly reduces your chances of having problems with the IRS. 

Questions and Answers.

Another trader tax court loss

February 27, 2014 | By: Robert A. Green, CPA

The IRS is piling up victories in tax court against individual traders who inappropriately use Section 475 MTM business ordinary loss treatment for deducting large trading losses. Fariborz Assaderaghi & Miao-Fen Lin v. Commissioner is yet another IRS win that can be added to the list. According to Tax Analysts, “The Tax Court held that a husband’s trading activity in securities didn’t constitute a trade or business and, thus, he wasn’t eligible for a mark-to-market accounting method election under section 475(f) and the couple was limited to a $3,000 deduction of losses from the purchase and sale of securities under section 1211(b) for each year at issue.”

Only traders who qualify for trader tax status (Schedule C business expenses) may elect and use Section 475. Lots is at stake since without trader tax status or a timely Section 475 MTM election, traders are forced to use a puny $3,000 capital loss limitation against other income.

We agree with the IRS that Assaderaghi did not qualify for trader tax status in any of the years examined. Assaderaghi had many day trades, and he used professional trading equipment and charts. But he had a demanding full-time career as an engineer/executive and the IRS is more skeptical toward part-time traders claiming trader tax status. Assaderaghi was unable to prove his hours spent in trading and his evidence lacked credibility in the eyes of the IRS and tax court.

Most importantly, Assaderaghi came up short on meeting our golden rules for 2008, the one year he had a chance to qualify for trader tax status. He had 535 trades and our golden rules call for 1,000 total trades. He traded just over 60% of available trading days and our golden rules call for trade executions on 75% of available trading days. In the other years examined, he came up far short of trader tax status and when you view the years together it’s especially weak.

Perhaps Assaderaghi could have fought harder to win trader tax status in 2008, and concede the other years, but that is generally not the main issue. A bigger issue is filing a timely Section 475 MTM election and Assaderaghi and his accountant did not do that. It’s significant since Assaderaghi’s CPA deducted $374,000 in trading losses for his 2008 Schedule C, but the IRS forced them to use a puny $3,000 capital loss limitation instead. Once again, a trader and professional go to tax court with a clear losing case on technical grounds, missing or botching a Section 475 MTM election, and there is nothing that can be done about it. They wasted their money and effort in tax court.

Assaderaghi made some tragic rookie tax mistakes which sealed his fate as a loser with the IRS. He made the common mistake of asking his local CPA tax preparer to elect trader tax status and Section 475 MTM, but after not getting an answer from his CPA, he didn’t do anything about it. His accountant was clueless about trader tax benefits and rules — which is sadly still often the case. When it comes to timely Section 475 elections, there is no excuse allowed for relying on an accountant, and there is no IRS relief. The IRS is lenient on many things, but not Section 475.

His accountant grasped the idea of trading as a business — filing a Schedule C — but he jumped to the tragic conclusion that he could simply report trading gains and losses on schedule C like other types of businesses. He should have filed a timely election for Section 475 and reported trading gains and losses on Form 4797 Part II with ordinary gain and loss treatment. It’s clear the accountant did not know that Section 475 MTM had to be elected by April 15, 2008 for 2008 or perfected with a 2008 Form 3115 change of accounting filed in 2009 with the 2008 tax returns. Had Assaderaghi known the golden rules, perhaps he would have traded more to meet them.

Assaderaghi’s tax return screamed for an IRS beat down. The IRS computers see trades on Schedule C and issue a tax notice because trades don’t belong on Schedule C. The IRS tries to match broker 1099-Bs to Schedule D (in 2008 and Form 8949 after 2010), Form 4797 Part II (section 475 MTM) and Form 6781 (Section 1256). The IRS agent asked the CPA preparer about his filing of a Section 475 MTM election and the CPA did not even know what the agent was talking about. Case closed — it’s a loser! You can never file a Section 475 MTM election late (or with hindsight).

Lessons learned: Learn trader tax benefits and rules with our content and hire a proven trader tax CPA like our firm Green NFH, LLC to assist you with the election, Form 3115, Form 4797 and tax return footnotes.

It’s important to note that 2014 Section 475 MTM elections are due by April 15, 2014 for individuals and existing partnerships, and March 15, 2014 for existing S-Corps. “New taxpayers” (new entities) file a Section 475 MTM election in their own books and records (internally) within 75 days of inception of the new entity formation. We recommend Section 475 MTM on securities only, so you retain lower 60/40 capital gains rates on Section 1256 contracts like futures. Section 475 MTM does not apply to segregated investment positions. If you have capital loss carryovers, you may want to wait until you generate more capital gains to use them up first.

Make sure you meet our golden rules for trader tax status based on tax court cases. The Assaderaghi case does not change our golden rules. The Assaderaghi court reinforced the notion that business traders must be consistent in trading volume and frequency and avoid sporadic lapses in active trading. The tax law requires “regular, frequent and continuous trading based on daily market movements and not long-term appreciation.”

It’s wise to stop trading as an individual and form an entity that qualifies for trader tax status and files an entity business tax return that resembles many active trading hedge funds. As pointed out in Green’s 2014 Trader Tax Guide, a high ranking IRS person in the trader tax status and Section 475 area recently warned at a tax conference that the IRS is going after individual traders inappropriately using trader tax status and Section 475 MTM ordinary loss treatment. Get the help you need to be a winner.

See the Tax Analysts PDF file on this case with our yellow highlights.

Another non-business trader busted in tax court

November 15, 2013 | By: Robert A. Green, CPA

Chalk up another win for the IRS on denying trader tax status. But it’s not a result of IRS excellence. Rather, it’s another case of a taxpayer filing a huge red-flag tax return with crazy unsupportable positions.

See the latest tax court case decision denying trader tax status: Nelson, TC Memo 2013-259. Here is an RIA summary with my highlights in yellow.

First off, the taxpayer seems to have been a tax cheat and that never bodes well in an exam. What trader in his or her right mind files a Schedule C for trader tax status deducting $800,000 of trading business expenses over two years? Nelson did, and when pressed, she conceded most of these expenses early on (see footnote 8 in the case). Most of those Schedule C expenses were probably unsubstantiated even as investment expenses on Schedule A. The IRS did not allow a Schedule C, since Nelson did not qualify for trader tax status.

Our firm has always pointed out that a sole proprietor trading business Schedule C is a red flag as it only shows expenses. We prefer a pass-through entity tax return for reporting a trading business. Traders generally have business expenses of $5,000 to $25,000. If the trader has trading gains, we use our income-transfer strategy to zero out Schedule C.

In another recent IRS tax court win denying trader tax status, Endicott reported $300,000 of margin interest on his trading business Schedule C and that triggered his tax exam. The IRS was correct; it should have been reported as investment interest expense on Schedule A.

As with Endicott, we agree with the Tax Court and IRS that Nelson did not qualify for trader tax status in 2005 and 2006. First, it sounds like Nelson’s live-in boyfriend, perhaps a trader himself, made many of the trades on her trading account. Nelson seemed focused on her active and successful mortgage business. We’ve always pointed out that trades made by an outside manager do not qualify for trader tax status. This can be a problem even with married couples, when one spouse trades the other spouse’s individual account. This is why we recommend a general partnership or LLC filing a partnership tax return for married couples — or significant others — so the trader/partner can bring trader tax status to the entity level for the benefit of all partners, even passive owners.

The tax court is right to point out that even if Nelson was credited with making all the trades — which clearly she did not — the activity did not rise to the level of trader tax status. The account failed our golden rules for trader tax status. Our rules call for 1,000 total trades and the Nelson account had half that in one year and one-quarter of that in the other year. Even considering a partial year, it was too few trades. Our golden rules call for executions on 75% of available trading days, and the Nelson account had executions of less than 50% one year and less than 30% the other year. The IRS was not clear about the average holding periods; they may have been under 31 days, which could be okay. But there were far too many sporadic lapses in trading, which is against the tax law requiring “regular, frequent and continuous” trading.

“I appreciate the break down of trading within this case,” says Green NFH co-managing member Darren Neuschwander, CPA. “This will be good to show clients how the IRS is clearly reviewing trader tax status.”

Notice Nelson couldn’t get relief from significant accuracy-related penalties. According to the RIA summary, “Nelson’s claim that she spoke with a friend who is an accountant was insufficient to show what advice the accountant provided and whether her reliance on same was reasonable.”

Bottom line
Get educated on trader tax status before you claim it. Conservatively assess it at year-end before deploying it on your annual tax returns. Consider an entity going forward. If you’re examined by the IRS, consult with a trader tax status expert and consider their representation. Don’t bring a losing case to tax court and argue it on your own.

Tax court was right to deny Endicott TTS

August 30, 2013 | By: Robert A. Green, CPA

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.

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
United States Tax Court: WILLIAM G. HOLSINGER AND JOANN MICKLER, v. COMMISSIONER OF INTERNAL REVENUE
http://www.irs.gov/taxtopics/tc429.html 

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.