IRS Proposes Tougher Rules for Traders

The Internal Revenue Service has issued proposed regulations that would impose new accounting and reporting standards on traders and require them to make a key tax-filing decision as early as March.

The regulations could take months, even years, to become final. But the odds are pretty good that they'll ultimately be adopted, says Jim Calvin, an investment-management tax partner at Deloitte & Touche in Boston and the editor-in-chief of the Journal of Taxation of Investments. Prudent taxpayers should treat them as if they're final.

The IRS will release a revenue procedure, a document that should help to clear up some ambiguities in the proposed regulations, as early as today, says Steve Rosenthal, a financial products tax partner at KPMG.

Among the 17 pages of regulations regarding Section 475 (the part of the tax code that addresses mark-to-market accounting) are requirements that traders:

• Elect to mark to market gains within the first two-and-a-half months of the tax year. Mark to market is a paper transaction that allows qualified traders to recognize the value of their securities as if they were sold for their fair market value on the last business day of the year. Currently, the mark-to-market election can be made at any time. (For more information, see our Taxes for Traders series.)
  
  
• Keep a separate account for long-term holdings or risk not qualifying for trader status. Currently, there's no such requirement, although traders should do it anyway because it will help solidify their trader status in the eyes of the IRS, says Ted Tesser, CPA and author of The Trader's Tax Survival Guide.
  
  
• Have bulletproof documentation to show the rationale behind investment purchases. The IRS wants a higher standard of proof that trades are being made for a trader's business, not his or her personal account. The documentation requirements have not yet been spelled out, though.

Mark to Market by March

The proposed regulations say the mark-to-market election must be made "not later than [two-and-a-half] months after the beginning of the taxable year for which the election is made." Although the time period is tentative, the idea of making the declaration is not.

The IRS' goal is to prevent first-year traders and traders who had bad years from waiting until the very last moment to make this election. The IRS believes that if traders are serious about their trading business, they should be able to make advance decisions about its accounting practices.

So assuming a calendar tax year, traders will have to file a form by March 15 stating their election. Technically, this regulation is effective as of Jan. 28, but we're still waiting for more details from the IRS.

Separate Accounts Now Required

Because of the "fungible" nature of some securities, the proposed regulations now require separate accounts for long-term and short-term trading. The IRS' concern is that if traders are trading the same security for both long-term and short-term accounts, it's hard to determine whether they're trading for their investment accounts or for their businesses.

The proposed regulations would require long-term securities to be "held in a separate, nontrading account maintained with a third party."

Tougher Documentation Requirements

The IRS believes it's hard to distinguish between a transaction that's part of a trader's business and one that's a personal investment. So traders would be required to show "clear and convincing evidence" that the two are separate.

This is clearly a higher standard of proof than what is required of a nontrader taxpayer. But what exactly this will require still is unclear. The IRS has not yet defined "clear and convincing." Instead, it is requesting comments and suggestions for examples of what good documentation would be.

These stringent documentation rules would affect securities acquired on or after March 1. So it's wise to start documenting now. And that means more than identifying which account a security is purchased for. The IRS wants to know a trader's thought process, says Calvin. In our Taxes for Traders series, Calvin suggested traders email themselves to document each purchase of a security for an investment account. But that may not be enough now. The IRS will want to know why a trader bought it.

How do traders document their thought processes? It's still unclear, but a serious trader most likely follows a specific strategy or discipline. So technically, a purchase should fall within that strategy. For purchases made outside a discipline, traders should keep the report or release -- whatever convinced them to buy the stock -- along with the trade ticket and any notes made.

Tesser suggests that traders keep a log and have it "notarized on a monthly basis with a statement that says it was kept on a current basis and actively reflects my trading [or investment] activity."

This regulation would be particularly tough on traders who buy and sell off tips or are unsophisticated, says Calvin.

Traders with comments on these regulations can send them to the IRS via the service's Web site.

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