Day-trader deja vu.

In January the JofA ran a second article by Marc I. Lebow, P. Michael McLain and Wayne Schell regarding the taxation of day traders (see "Day Trading and Self-Employment Taxes," page 80). This was in response to a number of queries about two articles in the October 2000 issue ("Paying the Piper: Some Tax Rules for Day Traders" page 115, and "Being a Trader in Securities," page 118) on the same subject. The following is further commentary on the January article; The first is by Lebow and McLain, and the second is from the IRS.

Tax Rules for Day Traders Revisited

In the October 2000 JofA, we explained how day traders could report their gains and losses on schedule C ("Paying the Piper: Some Tax Rules for Day Traders," page 115). The gains and losses would be ordinary income and not subject to the $3,000 capital loss limitation. Our position was based on various court rulings that equated gambling on the security markets with other forms of gambling. A taxpayer following our recommendation would have to pay self-employment taxes on his or her gains.

The "From the Tax Adviser" column in the same issue ("Being a Trader in Securities," page 118), said day traders could report their gains and losses on form 4797 and their expenses on Schedule C if they elected "mark-to-market" accounting. The gains and losses would be ordinary income and not subject to the $3,000 capital loss limitation. The taxpayer also could avoid paying self-employment taxes on his or her net gains.

In an attempt to clarify the differing positions, we explained the various court rulings supporting our position in a January 2001 JofA article ("Day Trading and Self-Employment Taxes," page 80). Since that position was based on court rulings, it is not free from potential challenge by the IRS. We also cited several rulings that did not support our position.

Unfortunately, in that article, we failed to adequately address all the relevant IRC sections and, therefore, made a misleading statement. We stated that the "mark-to-market" election only covered the yearend adjustment from cost to market for the investment portfolio and failed to address several related code sections. IRC section 475(d)(3)(A)(ii)(II) explains that all dispositions of securities for taxpayers taking the mark-to-market election are treated as ordinary gains and losses, and section 475(f)(D) says all income from security transactions for taxpayers electing the mark-to-market position is not subject to self-employment tax.

The difference between the various articles, therefore, is whether the taxpayer uses the "mark-to-market" election. By using it, the taxpayer can achieve the same results we advocate for others not electing "mark-to-market" and still not be subject to IRS challenge. If the election is not made, then both our October 2000 and January 2001 articles are correct without further explanation.

--Marc I. Lebow, CPA, PhD, associate professor of accounting at Christopher Newport University in Newport News, Virginia, and P. Michael McLain, CPA, DBA, assistant professor of accounting at Hampton University, Hampton, Virginia.

IRS Weighs in on Day Traders

I am the technical reviewer for many of the forms and instructions issued by the IRS, including schedules C, D and SE (form 1040) and form 4797. There appear to be many inconsistencies and incorrect statements [in the January JofA article on page 80] regarding traders (including day traders). Please see the instructions for schedule D and form 4797 for the correct treatment and proper reporting by traders. Expenses of traders always go on schedule C. Gain or loss from securities never does. Security transactions are reported on schedule D, unless the mark-to-market election applies, in which case each transaction is reported on form 4797. In neither case is the income subject to self-employment tax, nor can a taxpayer "choose" to pay the tax.

The JofA article stated: "The code then explains that gains and losses from applying the mark-to-market provision, while they may be ordinary income or loss, are not subject to self-employment taxes (IRC section 475(f)(1)(D)). That is, the ability to avoid self-employment taxes from this section does not apply to realized gains or losses; it merely applies to the revaluation of a portfolio of securities from cost to market value occurring at the end of a tax year."

The excerpt [above] is incorrect because it does not correctly take into account section 475(f) (1)(D), which requires section 475(d) to apply. Section 475(d)(3)(A)(ii) applies subsection (a)(2) to all gain or loss recognized on securities during the year. This affords ordinary gain or loss treatment and exclusion from self-employment tax to all such gains and losses during the year."

--Curt Freeman, IRS Review Section, Tax Forms Development Branch, Tax Forms and Publications Division.

AIG on the Rise

On 1998 individual income tax returns, adjusted gross income (AGI) reached $5.4 trillion, an increase of 9% from 1997.

AGI (trillions)

1997     $4.95

1998     $5.40

Note: Table made from a bar graph.

Source: IRS, www.irs.gov.