Case — Capital vs. Ordinary Treatment of Stock Trades

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TL Case Summ

THE QUESTION

Is taxpayer a securities trader or an investor?

THE DISPUTE

Taxpayer Says: Trading activity was conducted as a business, so losses on stock sales are ordinary income and deductible in full, as are expenses related to the trading.

Internal Revenue Service Says: Taxpayer is an investor, not a trader. Losses on stock sales are subject to capital gains rules and limitations, and expenses are not deductible as business expenses.

THE LAW

From Internal Revenue Code Section 475(f): Provides that a taxpayer engaged in a trade or business as a trader in securities may elect to apply the mark-to-market accounting method to securities held in connection with such trade or business.

From Internal Revenue Code Section 475(f)(1)(A)(i): A taxpayer engaged in a trade or business as a trader in securities is eligible to elect to recognize gain or loss on any security held in connection with his trade or business at the close of the taxable year as if the security were sold for its fair market value at year end.

From Internal Revenue Code Section 475(d)(3)(A)(i): In general, any gains or losses resulting from the mark-to-market election shall be treated as ordinary income or loss.

From Moller v. United States, 721 F.2d 810, 813 (Fed. Cir. 1983): In determining whether a taxpayer is a trader, nonexclusive factors to consider are: (1) The taxpayer’s intent, (2) the nature of the income to be derived from the activity, and (3) the frequency, extent, and regularity of the taxpayer’s securities transactions.

From Mayer v. Commissioner, T.C. Memo 1994-209: A taxpayer’s activities constitute a trade or business where both of the following requirements are met: (1) The taxpayer’s trading is substantial, and (2) the taxpayer seeks to catch the swings in daily market movements and to profit from these short-term changes rather than to profit from the long-term holding of investments.

THE CAUSE OF THE DISPUTE

For federal tax purposes, your activities in buying and selling securities can generally be classified into one of three categories: Dealer, trader, or investor.

You’re a dealer when you’re engaged in the trade or business of buying and selling securities, which means you make sales to customers in the ordinary course of your business. Your sales are not considered capital asset sales. Instead, they’re subject to ordinary income tax treatment.

To be considered a trader (in the business of trading), your stock trading activity must be substantial, frequent, regular, continuous and extensive. In addition, you must try to profit from daily short-term market changes rather than long-term capital gains. Your sales can be taxed under capital gains rules or ordinary income rules, and your expenses are deductible as business expenses.

You’re an investor if your goal is capital appreciation or conservation of capital. Your sales are taxed as capital gains, and deductible expenses and losses are limited. (The IRS generally assumes you’re an investor, unless your actions demonstrate you’re carrying on a business of stock trading.)

Disputes in this area arise because the term ‘trader’ is not clearly defined in Internal Revenue Code Section 475, or in the related federal tax regulations, and achieving this status results in a more favorable tax outcome.

In this case, the taxpayer set up a corporation with a stated goal of trading stocks in order to profit from short-term swings in the market. In addition, the taxpayer made a timely Section 475(f) mark-to-market election, which applies only to those engaged in a trade or business as traders in securities, and which allows ordinary income tax treatment of gains or losses from investment sales.

The IRS says the number of executed trades (289 in 2001 and 372 in 2002) was not substantial, and that a significant amount of stocks were held for more than 31 days. Both factors lead to the classification of the taxpayer as an investor, not a trader.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 13KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Right answer!
For the IRS. The trading pattern was consistent with that of an investor, not of a trader. Activity did not rise to the level of a business. Expenses are not deductible as business expenses.
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