Day traders: investors, traders or self-employed dealers?

On a global scale, the Internet has changed the investing landscape forever. The low cost of on-line stock trading has created a new type of securities trader. Individuals can now buy and sell securities on-line at costs of as low as $7 per trade and receive executions at speeds close to those of Wall Street professionals. Many of this new breed of securities trader consider this activity their trade or business. They spend considerable amounts of time and resources on their new career, often earning more trading securities than they might have from their former professions. From the IRS's viewpoint, are these day traders investors, traders or self-employed dealers in securities? Are day traders subject to self-employment (SE) tax? The distinction may have a significant financial effect for today's Internet day trader.

The Code treats investors and traders differently from dealers in securities. Investors and traders receive capital gain or loss treatment on sales. On the other hand, dealers in securities receive ordinary gain or loss treatment on security sales, unless (under Sec. 1236(a)):

* The security was, before the close of the day on which it was acquired, clearly identified in the dealer's records as a security held for investment; and

* The security was not, at any time after the close of that day, held by the dealer primarily for sale to customers in the ordinary course of his trade or business.

Dealers in securities also must maintain an inventory of securities held for resale; see Regs. Sec. 1.471-1 and Stern Bros. & Co., 16 TC 295 (1951), acq., 1951-2 CB 4.

A dealer in securities, as a self-employed individual, is subject to SE tax. For 2000, SE net earnings up to $76,200 are taxed at 15.3%; additional SE earnings are taxed at 2.9%. Therefore, if an individual is considered a dealer in securities and has net gains for a tax year, not only would these gains be taxed at ordinary rates but, in addition, they would be subject to SE tax.

However, Sec. 1402(a) (3) (A) excludes capital gains or losses from SE net earnings. Sec. 1402(a)(3)(C) also excludes gains or losses from sales of property that are neither:

* Stock in trade or other property of a kind that would properly be includible in inventory if on hand at the close of the tax year; nor

* Property held primarily for sale to customers in the ordinary course of business.

On the other hand, dealers in securities receive more favorable treatment in the case of a net loss. Under Sec. 1211(b), net losses from sales or exchanges of capital assets by noncorporate taxpayers are allowed against ordinary income only up to the lower of $3,000 (generally) or the net loss. Conversely, under Sec. 165, a dealer in securities can deduct all ordinary losses against ordinary income. Therefore, characterization as capital rather than ordinary gain could have severe tax consequences for net securities losses. If an individual has such net losses and cannot establish dealer status, his deduction against ordinary income cannot exceed $3,000 a year.

Through the years, the courts have developed a distinction between dealers, traders and investors. A dealer is a person who purchases securities with the expectation of realizing a profit "not because of a rise in value ... but merely because they have or hope to find a market of buyers who will purchase from them at a price in excess of their cost. This excess or mark-up represents remuneration for their labors as a middle man bringing together buyer and seller, ... Dealers have customers for purposes of [sections] 1221" (Steven M. Wood, 943 F2d 1048 (9th Cir. 1991)). The determination of whether an individual has "customers" is essential in determining dealer versus trader or investor status. Only dealers have customers. In contrast, traders and investors transact business with brokers.

A dealer can have "brokers" as customers (although typically, this is not the case). In William D. Stevens, 78 F2d 713 (2d Cir. 1935), the court found that a broker could be regarded as a customer of a securities dealer when he:

* Had an established place of business;

* Held himself out to the general public as a securities dealer; and

* Dealt primarily in the securities trade for his livelihood.

"Generally, when a taxpayer trades on his own account and sells securities to persons he does not know, the purchasers are `not his customers, but customers of the brokers who bought of him'" (Marrin, 147 F3d 147 (2d Cir. 1998), citing Seely, 77 F2d 323 (2d Cir. 1935)). "Management of securities investments, whatever the extent and scope of such activity, is seen as the work of a mere investor, not the trade or business of a trader" (Frederick R. Mayer, TC Memo 1994-209, for 1986-1988 and 32 Fed C1 149 (1994) for 1983-1985). If an individual merely trades for his own benefit, without holding himself out to the public as a securities dealer, without an established location and does not deal primarily in the securities trade for his livelihood, the taxpayer cannot be a dealer.

The establishment of the Internet as a means of business communication has permanently changed the way business is conducted. A virtual business can exist in the basement of a private individual's home as easily as it can in a brick and mortar commercial building. The establishment of a "place of business" will increasingly become a meaningless concept as virtual business takes its foothold. Further, the electronic stock market has reduced the need for broker-middlemen. Consequently, it is conceivable that the tax authorities might reconsider the tax treatment of frequent stock traders.

Under existing case law, the typical day trader should be considered a trader or an investor and, thus, should receive capital gain or loss treatment on securities transactions. Also, day traders, except in unusual circumstances, should not be subject to SE tax on their net trading gains. In characterizing an individual as a "dealer in securities" the courts have placed little emphasis on the number of trades or the amount of time an individual devotes to trading. In Martin, the court concluded that the "... securities were capital assets, and their losses were capital losses, despite the size, frequency, or nature of the trades." The requirement for "customers" distinguishes a dealer from a trader or investor. Therefore, in most circumstances, day traders should not be considered dealers in securities.

FROM JOSEPH G. STAPF, CPA, GRAND RAPIDS, MI