You may have a trader in your midst.

Ever since the Revenue Act of 1934, it has been well-settled that there are three types of individuals or entities that have transactions with respect to stock or securities: dealers, investors and traders.

By far the largest number of taxpayers are considered investors. For these taxpayers, gains and losses on transactions in stock and securities are treated as capital gains or losses. Individual taxpayers who are investors may deduct portfolio and investment management expenses only as 2% floor itemized deductions. Thus, many of these expenses become nondeductible. In addition, the deductibility of investment interest expense incurred by an investor may be limited, particularly in years of low investment income.

Dealers such as the Wail Street brokerage houses are individuals or entities that hold stock or securities primarily for sale to customers in the ordinary course of business. These taxpayers recognize ordinary gain and loss on transactions in securities and are able to deduct in ,full all costs relative to these investments as ordinary business expenses.

A trader is an investor who speculates and trades securities on his own account. He does not hold securities for resale to customers. However, the trader's stock activity is of the nature that rises to a level of being a trade or business. If a taxpayer is classified as a trader, gains or losses on securities transactions give rise to capital gains or losses under Sec. 1221. However, portfolio and investment management expenses and investment interest expense become deductible without limitation under Sec. 162 in arriving at adjusted gross income. This can be a significant benefit to many taxpayers who have lost deductions as a result of severe limitations imposed by recent tax law changes.

To qualify as a trader, the taxpayer must trade in stock or securities on a relatively frequent basis. A preponderance of shortterm trades relative to long-term positions is indicative of trader status. The taxpayer must be involved in tracking daily market movements in order to be in a position to profit on a short-term basis. While the number of trades is not controlling, certainly a taxpayer with a large number of short-term transactions will be in a good position to show that he qualifies as a trader. The trader also must be able to show that he spends significant time directly managing the buying and selling of his stock. Case law discussing how these factors are viewed includes Kemon, 16 TC 1026 {1951), Huebschman, TCMemo 1980537, and King, 89 TC 445 11987).

While dealer status would be beneficial when losses are taken on transactions in stock, few individuals or entities will be able to qualify. However, there are probably a great many taxpayers who qualify for trader status; in some cases this can be as beneficial or even more beneficial than being a dealer. Practitioners should review their client lists to see who might benefit from being reclassified and take steps to be sure that they meet the requirements for that classification.

From Scott P. Murphy, CPA, Cohen & Company, Akron, Ohio