Trader or Investor? The IRS Wants to Know

Trader or investor?

It's an important distinction. The Internal Revenue Service considers investing to be a kind of hobby. But trading is a business, eligible for tax breaks and 100% deduction of legitimate business expenses. Plus, a trader has the option of using trading losses to offset an unlimited amount of income.

Day trading may seem like a recent phenomenon, but individuals who consider it their profession have been around for years. Until the Taxpayers' Relief Act of 1997, the tax code never acknowledged them, says Ted Tesser, trader tax specialist and author of the Trader's Tax Survival Guide.

Now it does -- Section 475(f) is the applicable portion of the tax code -- but the IRS still hasn't offered taxpayers any detailed guidance on who is and who isn't a trader. Instead, they must look to case law dating back to the 1940s for guidance, says Robert Willens, a CPA and managing director of Lehman Brothers in New York.

You might be a trader if: You're not a trader if: The only thing you do all day is trade for your own personal account You sneak trades at your desk when your boss is out to lunch You take advantage of the swings in the market and don't hold anything long term You're in it for the long haul Your family's next meal comes from your trading activities Your family's next trip to Disney World depends on your trading activities You invest based on the technicals You invest based on fundamentals

From the case law, experts have fashioned some guidelines. To be considered a trader, you must:

• Trade for your own personal account. And you must do the trading yourself. You can't hire someone to do it for you, nor can you trade for someone else. If you have clients or customers, then you're a dealer, and we're not going there today.
• Make your living off your trading. It's not just something you do at lunch or in your spare time.
• Trade to take advantage of market swings. A trader holds securities for a very short period of time, around 30 days.
• Trade based on technical, rather than fundamental, factors.

It's important to note that if only one or two of these criteria apply to you, you are not a trader, says Richard Shapiro, an Ernst & Young securities tax partner. All must apply, and even then, it's not a sure thing. The devil is in the details, so take a closer look at the requirements.

Weekend Warriors Don't Count

If your trading is a hobby, forget about qualifying. To be considered a trader, your trades must be "frequent, regular and continuous," and you must spend a substantial amount of time doing them, says Tesser. The doctor who does a lot of trades between patients doesn't count, says Shapiro. But beyond that, it gets fuzzy. The IRS doesn't define "frequent" or "substantial." So we resort to case law.

In Stephen A. Paoli (1991), the court rejected the taxpayer's testimony that he spent four hours trading daily throughout the year and found that most transactions occurred in one month. "His trading was deemed not to be frequent, regular and continuous," says Tesser.

The court also concluded that the Paoli didn't depend on income from his trading. He actually received substantial pay from his solely owned corporation.

Don't Have a Long-Term Outlook

A trader shouldn't hold onto securities much beyond 30 days, says Jim Calvin, an investment management tax partner at Deloitte & Touche in Boston and editor-in-chief of the Journal of Taxation of Investments.

The reason: A trader buys with the expectation of reselling after a rise in value and thereby "takes advantage of short-term swings in market," says Willens. If you hold securities for long periods, the tax courts most likely will conclude that you're an investor.

He points to the case of Fredrick R. Mayer (1994). "The court concluded that Mayer was an investor because his investment activity was intended to achieve capital appreciation and virtually none involved trading based in daily market price swings," says Willens. The fact that Mayer had more than 22,000 trades executed in his accounts within a three-year period didn't impress the court, especially since it was determined that he had advisers making trades in those accounts on his behalf.

In Estate of Yaeger vs. Commissioner (1989) the tax court held that the taxpayer was not a trader because most of his sales were of securities held for more than a year. The taxpayer's emphasis on capital growth and profit from resale also indicated long-term investment activity, not short-term trading. And in Purvis vs. Commissioner (1976), the tax court ruled against the taxpayer, who admitted that some of his shares were held for periods exceeding three years. In attempting to distinguish investing from trading, the court said:

"In the former, securities are purchased to be held for capital appreciation and income, usually without regard to short-term developments that would influence the price of securities on the daily market. In a trading account, securities are bought and sold with reasonable frequency in an endeavor to catch the swings in the daily market movements and profit thereby on a short-term basis."

Don't Live Off Your Yields

Is your income mostly from gains and losses? Or do you have a substantial amount of interest and dividends? A full-time trader should be living off gains and losses.

The courts are pretty stalwart on this, says Willens. He's seen people with thousands of trades disqualify because they had too much income from interest, dividends and long-term appreciation. How much income from interest and dividends is too much? "They don't tell you that either," notes Tesser. It's on a case-by-case basis.

The IRS does tell you that trading must be your "trade or business." That means your family's next meal must depend on your trading business. Here's a good definition from the Research Institute of America: "A trade or business is a pursuit or occupation carried on for profit, whether or not profit actually results. An isolated transaction isn't a business. Merely investing in corporations, however actively, isn't a business."

You must file Schedule C Profit or Loss from Business to prove that this is your business. (We'll get into those tax-reporting details tomorrow.)

Can You Go Both Ways?

Absolutely. You can be both a trader and an investor. Let's say you qualify as a trader but you have a retirement account. The income and expenses associated with your retirement account would be treated as a regular investor's, but trader activities would be treated as part of business income and expense.

Naturally, it is important to keep the accounts separate and compile adequate documentation in case the IRS comes knocking.

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If you're still unsure whether or not you're a trader, drop me a line at [e-mail]. Or email trader tax specialist Ted Tesser at [e-mail] and get a copy of his "Trader Evaluation Questionnaire."