Sec. 475 mark-to-market election: what every tax practitioner should know.
That the Sec. 475(f) election for traders could escape seasoned practitioners is not surprising. The enactment of the mark-to-market rules in 1993 and the Sec. 475(f) election in 1997 are relatively recent developments. Moreover, at the time of their creation, the day trading phenomenon was in its infancy. While day trading is not new, historically its practice was limited due to the high cost of commissions. But with the advent of the internet, electronic trading, and discount brokerage firms, individuals can now trade online 24 hours a day, 7 days a week with low commissions. (2) This has revolutionized trading, enabling anyone to trade whenever and wherever at the click of a mouse. In short, day trading has become increasingly popular among even casual investors. For this reason, practitioners must be aware of the benefits of Sec. 475 and whether their clients' stock trading activities may qualify. This article focuses on the operation of Sec. 475 and recent developments.
Taxation of Dealers, Investors, and Traders
The tax treatment of those who buy and sell stocks and other securities is not the same for all taxpayers. It can vary depending on whether a taxpayer is considered a dealer, an investor, or a trader. In addition, taxpayers who are considered traders (and only traders) are entitled to make the Sec. 475(f) election to use the mark-to-market rules. Thus, there are four different types of tax treatment for taxpayers who buy and sell securities. Because the treatments differ so dramatically, it is incumbent on practitioners to distinguish among them. (3)
Under the mark-to-market rules, dealers and eligible traders are treated as having sold all their securities on the last day of the tax year at their fair market value (FMV), causing gain or loss to be taken into account for the year. Any gain or loss recognized under this rule is taxed as ordinary income or ordinary loss. Dealers' and traders' expenses are considered business expenses and are deductible subject to any special rule or limitation.
If the taxpayer is considered a dealer, Sec. 1236 governs the treatment of the taxpayer's gains or losses from sales of securities. Under Sec. 1236, the gains and losses of a dealer that arise from sales of securities are not considered gains or losses resulting from the sale or exchange of a capital asset. (4) Instead, the dealer's gains and losses from sales of securities are treated as ordinary income or ordinary loss from business transactions (i.e., the sales of inventory). However, under Sec. 1236, a dealer can obtain capital gain and capital loss treatment if the dealer clearly identifies the securities in his or her records as securities held for investment. Importantly, Sec. 475 requires dealers to report using the mark-to-market method of accounting.
The mark-to-market rules are generally applicable only to dealers. Historically, Sec. 475 has defined a "dealer in securities" as a taxpayer who regularly purchases securities from or sells securities to customers in the ordinary course of a trade or business. In this regard, the securities owned by a dealer represent inventory held primarily for resale. Congress expanded this original definition to include those who regularly offer to enter into, assume, offset, assign, or otherwise terminate positions in securities with customers in the ordinary course of a trade or business. (5) These changes extended the historical definition significantly by including those who offer or hold themselves out to terminate security positions. The examples in the regulations indicate that this covers more exotic securities such as interest rate swaps and foreign currency transactions,(6) situations in which things are not bought and sold but contracts are entered into.
Distinguishing a dealer from a trader or investor is normally not difficult. A dealer makes money by serving as a middleman--a market maker--holding securities as inventory and buying and reselling securities to customers. A dealer's income is derived from the services provided, charging a markup on buying and reselling rather than obtaining profit from price fluctuations in the securities. A stockbroker who owns shares that he or she sells to customers at a market price plus a commission would be a bona fide dealer. Floor brokers and specialists at a stock exchange are people whose business it is to put investors together and who properly receive ordinary income treatment as dealers.
Controversies over whether a taxpayer is a dealer typically arise when taxpayers and the IRS disagree on the character of gains and losses from the sales of securities. The parties usually are at odds as to whether gains should qualify for favorable capital gain treatment or losses should be treated as ordinary losses. In settling these disputes, the courts have looked to the definition of a capital asset. (7) Under Sec. 1221 and its predecessor, Sec. 117, property is not a capital asset if the taxpayer holds it primarily for sale to customers in the ordinary course of a trade or business. The crucial words in the definition are "to customers." Congress specifically added this phrase and the word "ordinary" to the definition of capital assets as part of the Revenue Act of 1934. (8)
The additions were designed to ensure that speculators could not claim that the securities they sold were ordinary assets, presumably to obtain ordinary loss treatment. The rationale for the amendment was that those who sell securities on an exchange for their own account have no customers, and thus the property held by such taxpayers is a capital asset. Consequently, in those cases in which the courts have been required to differentiate between dealers and traders or investors, they have consistently focused on whether the taxpayer had customers. Taxpayers that have customers are normally treated as dealers, while taxpayers that do not have customers but trade for their own account are normally treated as investors or traders.
In Archarya, (9) a finance professor at the University of Illinois-Chicago tried to characterize himself as a dealer in order to convert a net capital loss of $117,000 into an ordinary loss. Professor Archarya argued that he was in the business of buying and selling stock. He, like a broker-dealer, had suppliers (i.e., the people in the market who sold him securities) and customers (the people in the market who bought the securities he sold). The court noted that while Archarya's theory may have had some economic merit, it was not relevant for legal analysis, and the court rejected the argument. Interestingly, the Tax Court rejected the government's proposal to add a negligence penalty, observing that Archarya had approached the matter as an economist would rather than as the Code requires.
The IRS seems to accept the courts' method of distinguishing dealers from traders and investors. In Rev. Rul. 97-39, (10) the IRS provided instructions on how to make the mark-to-market election, using a question and answer format (i.e., issues and holdings). Issue 3 asks, "If a taxpayer's sole business consists of trading in securities (that is, the taxpayer does not purchase from, sell to, or otherwise enter into transactions with customers), is the taxpayer a dealer in securities within the meaning of section 475(c)?" The holding is, "No. A taxpayer whose sole business consists of trading in securities is not a dealer in securities within the meaning of section 475(c) because that taxpayer does not purchase from, sell to, or enter into transactions with, customers in the ordinary course of a trade or business." Although the IRS offers nothing new, it is useful to know that its position is completely consistent with case law.
Practitioners are most familiar with the taxation of investors. The basic rules concerning capital gains and losses apply to investors, who report their gains and losses on Schedule D. The mark-to-market rules and the possibility for ordinary loss treatment are not available if the taxpayer is considered an investor. In addition, the wash sale rules apply to investors. (11)
On the expense side, investors are not carrying on a trade or business, and for this reason their deductions may be restricted in some way. For example, the investment interest provisions of Sec. 163(d) limit the deduction of investment interest to investment income. Similarly, the home office deduction is not extended to investors because it is allowed only for those carrying on a trade or business. Likewise, the Sec. 179 expense deduction is allowed only for property used in a business. Moreover, any investor expenses that are deductible are treated as investment expenses and characterized as miscellaneous itemized deductions subject to the 2% of adjusted gross income (AGI) limitation of Sec. 67 as well as the phase-out of deductions under Sec. 68. (12) Perhaps the most significant problem for investors is the elimination of the deduction of these expenses for purposes of the alternative minimum tax (AMT).
Practitioners generally have no trouble distinguishing investors from dealers. Investors do not hold securities in inventory and are not in the business of buying and selling securities. In addition, investors do not make their money through commissions like dealers but derive it from the price movement of the securities as well as dividends and interest. Above all, unlike dealers, investors do not have customers but buy and sell on their own behalf.
While it is usually easy to separate investors from dealers, distinguishing investors from traders can be extremely challenging. The difficulties in making this determination are discussed below, after considering why making the distinction is so important.
In general: The tax treatment of a trader's transactions is similar to that for an investor but varies in several important respects. First and foremost, a taxpayer who is considered a trader is treated as carrying on a trade or business. Even though traders are treated as conducting a business, unlike dealers they do not have inventory or customers. Therefore, their gains and losses on the sales of securities are still treated as capital gains and capital losses and--assuming the taxpayer is an individual--they are reported on Schedule D, the same as an investor. Similarly, dividend and interest income is still treated as investment income, reported on Schedule B.
Although the securities gains and losses of a trader are--absent the Sec. 475(f) election--considered capital gains and losses like those of an investor, the treatment of expenses differs because traders are viewed as carrying on a trade or business. (13) For example, a trader's margin account interest is no longer investment interest subject to limitation under Sec. 163(d) but rather business interest deductible without limitation. This may enable the taxpayer to deduct significant amounts of interest that otherwise might be limited. In addition, a trader can take the Sec. 179 expense deduction because the trader meets the active trade or business requirement. Likewise, the trader may qualify for the home office deduction in that the home qualifies for one of the exceptions under Sec. 280A for business use. A trader is also entitled to set up a qualified retirement plan while investors are not. Management fees, investment advice, investment newsletters, courses on investing, travel to education and investment seminars, and related expenses are no longer subject to the 2% of AGI floor of Sec. 67 for miscellaneous itemized deductions because they are business expenses deductible under Sec. 162 rather than production of income expenses deductible under Sec. 212.
Moreover, all these expenses are deductions for adjusted gross income on Schedule C (even though the trader reports the income on Schedules B and D). This approach avoids not only the limitations imposed on miscellaneous itemized deductions but also the deduction cutback rule of Sec. 68. Significantly, the deductions are not eliminated in computing the AMT. Notwithstanding that traders are in a trade or business, they are not subject to self-employment tax owing to the rule that dividends, interest from securities, and gain or loss from the sale of capital assets are not considered self-employment income.
Traders making Sec. 475 election: Traders have an important option unavailable to investors. As indicated above, taxpayers who are considered traders (but not investors) may take advantage of the mark-to-market rules of Sec. 475. Under those rules, traders who make the Sec. 475(f) election are deemed to have sold all their stocks and securities for their FMV on the last business day of the tax year. In other words, every position in the trader's trading account is marked to market and is deemed to be sold at that price at the end of each year. As a result, traders must recognize all gains and losses on the constructive sales as of that date.
Note: This may be a major drawback to making the initial election. Electing mark-to-market accelerates recognition of all gains or losses that had been deferred. The election, also eliminates the opportunity to time the recognition of gain or loss in future years as well. However, this is usually insignificant because traders rarely defer income.
The net income or loss from the deemed sale is added to the actual trading activity during the year and results in ordinary income or ordinary loss. In contrast to traders that do not make the mark-to-market election, traders who so elect report their gains and losses on Schedule C. Due to the deemed sale, the basis of the securities is increased to FMV and is used as the basis for subsequent transactions.
Making the Sec. 475(f) election offers at least one monumental advantage. Sec. 475(d)(3) provides that the gains and losses recognized on the deemed sales are treated as ordinary income or ordinary losses. This rule is extremely valuable because it allows traders (who make the election) to avoid the limitation on the deduction of capital losses. By making the election, traders can use losses to offset all other taxable income without limitation. Moreover, because these are business losses, traders can add to or create a net operating loss that they can carry back two years and forward 20 years. (14) The wash sales rules do not apply. (15)
While the mark-to-market election converts capital losses to ordinary losses, it also converts capital gains to ordinary income. As a practical matter, this presents little concern because the capital gains of most traders would be short term, which are treated as ordinary income. However, traders who want to preserve the possibility of long-term capital gain treatment for certain securities may do so by taking advantage of another special rule. Under Sec. 475(f)(1)(B), any security that is acquired is deemed to be acquired for trading purposes, unless the security is clearly identified in the dealer's records as being held for investment or other purposes. An individual can easily segregate trader transactions from investor transactions by simply using separate accounts for each. An individual may be a trader using the mark-to-market method while at the same time being an investor for the segregated investments.
The election's conversion of capital gains to ordinary income may be a stumbling block for those who have capital loss carryovers. These taxpayers would have neither short-term nor long-term capital gains to absorb the losses. However, taxpayers concerned about this issue might be able to solve the problem by using the segregation rule.
The taxpayer in Jamie (16) became well acquainted with how different the tax treatment can be, depending on whether the Sec. 475(f) election is made. In this case, Dr. Jamie, a licensed physician, and the IRS stipulated that Jamie was a trader and not a dealer. On its face, this might suggest that the taxpayer was in a trade or business and could deduct his security losses as ordinary losses. In fact, that was the approach Jamie took. For the years at issue, he reported on Schedule C about $2.5 million in losses from sales of stock on the theory that he was carrying on a trade or business. The losses created a net operating loss carryover that he used to offset his income from his medical practice. However, Jamie did not elect to use the mark-to-market method of accounting for his trading activity. As a result, the Tax Court agreed with the IRS that his $2.5 million in losses should be recharacterized as capital losses subject to the $3,000 limitation. To make matters worse, the Tax Court sustained the 20% accuracy-related penalty of Sec. 6662(a).
Exhibit 1 on p. 127 shows the various tax treatments of traders, investors, and dealers.
Exhibit 1: Tax treatment of investors, traders, and dealers Investor Trader No Trader Dealer mark-to-market Mark-to-market election election Income Capital gain Yes Yes No (ordinary No treatment income) Capital loss Yes Yes No (ordinary No limits loss) Reporting Schedule D Schedule D Form 4797 Form 4797 Wash sales Yes Yes No No rules Dividends and Schedule B Schedule C Schedule C Schedule interest C Deductions Authority Sec. 212 Sec. 162 Sec. 162 Sec. 162 Type Investment Business Business Business Reporting Schedule A Schedule C Schedule C Schedule C Sec. 67 misc. Yes No No No itemized Sec. 68 Yes No No No phaseout Sec. 179 No Yes Yes Yes expensing Home office No Yes Yes Yes Investment Yes No No No interest AMT expense Yes No No No limitations SE tax No No No Yes Qualified No Yes Yes Yes retirement plan Health No Yes Yes Yes insurance premiums
Investor or Trader
Due to the significant differences in the tax treatment of traders and investors, determining how the taxpayer is classified is crucial. Unfortunately, the Code and the regulations do not define "trader." In that absence, the courts have made the distinction between a trader and an investor. In this regard, the critical question is one that taxpayers frequently litigate with respect to not only buying and selling securities but other areas as well: Do the activities of the taxpayer constitute a trade or business? As one court lamented,
Neither the Internal Revenue Code nor the regulations define "trade or business." However, the concept of engaging in a trade or business, as distinguished from other activities pursued for profit, has been in the Internal Revenue Code since its inception and has generated much case law. (17)
The leading case to address the issue is the Supreme Court's 1941 landmark decision in Higgins. (18) Mr. Higgins lived in Paris but conducted his extensive financial affairs through a New York office that followed his detailed personal instructions. According to the court, he kept a "watchful eye" over his securities by cable, telephone, and mail. The staff of the New York office kept records, bought and sold securities, received interest and dividend checks, made deposits, forwarded reports, and generally took care of the investments as instructed by Higgins. Higgins primarily sought long-term investments but did make changes in his portfolio as needed. Despite the fact that the taxpayer devoted a considerable amount of time and expense overseeing his securities and did so in a businesslike manner, the Court held that the activities did not constitute a trade or business. In so doing, it indicated:
The petitioner merely kept records and collected interest and dividends from his securities, through managerial attention for his investments. No matter how large the estate or how continuous or extended the work required may be, such facts are not sufficient as a matter of law to permit the courts to [hold that the activities constituted a trade or business].
The decision in Higgins clearly suggests that management of securities investments is not considered a trade or business, regardless of the extent and scope of the activity. Management is viewed as the work of an investor. (19) Under this view, the amount of time spent on the activity is irrelevant, even if the taxpayer is involved on a full-time basis and pays salaries and other expenses incident to the management function. (20)
Although most decisions have adopted this approach, there are exceptions. In the 1979 Levin decision, (21) the taxpayer devoted virtually all his working time to buying and selling securities. He routinely visited the corporations in which he was interested and talked to company officers. He also ate lunch with brokers and attended lectures sponsored by securities analysts if the topic was relevant. The Court of Claims also noted that in the year in question, Levin conducted 332 transactions, which represented the transfer of 112,400 shares with a total value of $3,452,125. After considering all the facts, the court believed that Levin's activities placed him "close to the trader end of the spectrum." In reaching its decision, the court emphasized that in contrast to the distant management of a portfolio in Higgins, Levin made judgments about purchases and sales directly based on his personal investigation of the companies. In addition, the court apparently believed that "the sheer quantity of transactions he conducted" suggested trader status.
Perhaps it is unfortunate that the vast majority of the cases since Higgins have given little attention to the taxpayer's involvement in the trading activity even if it resembles a businesslike endeavor. Instead, subsequent decisions have fashioned other criteria that arguably are more relevant in determining whether the taxpayer's activities rise to the level of a trade or business. According to these cases, the critical factors are the individual's investment intent, the frequency or regularity of trades, and the nature of the income derived from the activity. (22)
From a broad perspective, it seems that, regardless of the strategy, the intent of anyone who buys, holds, and sells securities is to make a profit. While this may be true, in distinguishing between investors and traders the courts have placed great significance on the differing strategies used to make a profit. In other words, how the taxpayer intends to derive a profit from the investments can determine whether the taxpayer is a trader or an investor. As the Tax Court stated in its 1955 Liang decision and many courts have since echoed: (23)
The distinction between an investment account and a trading account is that 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.
The courts seem to be saying that in order to be a trader, the taxpayer must direct his or her activities primarily to a short-term trading strategy designed to capture profits from the volatility of the market rather than a buy and hold strategy with a hope for long-term growth.
Nature of Income Derived from Activity
Another factor critical to the distinction between investors and traders is the type of income derived from the investment activity. Case law consistently focuses on whether the taxpayer principally derives his or her income from securities activities from the frequent sale of securities or from dividends, interest, or long-term appreciation. According to this view, taxpayers looking for capital appreciation and income such as dividends and interest are investors. The very nature of trading tends to make dividend income, interest income, and long-term growth very unlikely because the taxpayer holds a security for such a short time. The courts often combine this factor with the taxpayer's investment intent. (24) If the primary source of income is long-term gains, dividends, or interest, this tends to confirm that the taxpayer is an investor and not a trader who tries to profit from the daily ups and downs of the market.
Substantial Trading Activity
The factor upon which many cases are decided concerns the frequency, extent, and regularity of the taxpayer's trading. In addition, the courts place considerable emphasis on the holding period of the securities to determine whether the taxpayer is trying to gain from short-term fluctuations in the market.
As one might expect, there are no specific guidelines regarding any of these variables, the number of trades per year, the length of the holding period, or the total activity during the year. However, a review of the relevant cases does provide some insight into the standards a taxpayer must meet to achieve trader status.
Investors vs. Traders: The Rules Applied
Mayer: One of the more telling cases is Mayer. (25) In this case, the taxpayer sold an oil drilling company and invested his share of the proceeds of about $80 million in securities. To manage the investments, Mayer hired a professor of finance at the University of Denver. He also hired an individual who handled the operating side of the business. Mayer met with the two individuals three times a year to determine the allocation of the funds among various money managers, who had sole discretion as to how to invest the assets on his behalf. Notwithstanding the flexibility given the money managers, Mayer made it clear in written communication that the overriding goal should be wealth maximization through capital appreciation.
In determining whether Mayer was a trader or an investor, the Tax Court focused on his trading activities. Mayer averaged about 1,280 trades per year over a three-year period, and the net gains were in the millions of dollars. The amount of income from net gains vastly exceeded the interest and dividend income. At first glance, it seems that this level of trading and business formality would constitute a trade or business. In fact, the Tax Court believed that Mayer's trading was substantial in both dollar amount and number of trades.
Indeed, without looking at whether the trades were bunched in a few months or spread throughout the year--as courts in general have tended to do--the Tax Court held that the taxpayer had met the frequency requirement. However, it also considered what it believed to be the "two fundamental criteria that distinguish traders from investors: the length of the holding period of the securities and the source of profit." Unfortunately for Mayer, the weighted average of the holding period for the stocks sold in each year at issue was 317 days, 439 days, and 415 days, respectively. Similarly, the percentage of stock sold with holding periods of one year or more ranged from about 32% to 44%, and he held approximately two-thirds of the stocks he sold for longer than six months. According to the Tax Court, the lengthy holding periods of the stocks sold belied "any effort to capitalize on daily or short-term swings in the market." Consequently, the Tax Court held that Mayer should be treated as an investor.
As the Mayer decision makes clear, the volume of trades is not necessarily conclusive evidence of trader status, particularly in light of other factors that suggest the taxpayer's intent was not to earn income through short-term changes of the market. It is also worth noting that the Tax Court, referring to Higgins, believed the fact that Mayer had handled his securities investments in a businesslike manner was irrelevant to the determination.
Interestingly, Mayer argued in the alternative that if he was not a trader but an investor, he should be entitled to capitalize the security-related expenses as part of basis. While the argument seemed like an ingenious route to the desired result, the Tax Court thought otherwise. It noted that such expenses were not part of the acquisition cost and he could capitalize them; consequently, he could deduct them only as production of income expenses under Sec. 212.
Paoli: Another case in which the taxpayer appeared to meet the requirements was Paoli. (26) Reminiscent of the taxpayer in Levin, Paoli approached his trading activities in a businesslike manner. He had a private telephone line with a stock brokerage house, had frequent conversations with brokers, and even had a Quotron machine in his home to obtain current stock prices. He also collected information about stocks from periodicals, reports on the companies, and the issuing companies themselves. During 1982, Paoli reported 326 sales of stocks or options, involving approximately $9 million worth of stocks or options that he had purchased for approximately $10 million.
Many of Paoli's transactions involved stocks that he had held for less than one day. Of the 326 sales made, 205 (62.88%) involved stocks he held for fewer than 31 days. The proceeds Paoli realized from these sales were $7,713,025.69, or 78.49% of the total proceeds. Nevertheless, the Tax Court believed that the pattern of buying and selling stocks was not sufficiently regular and continuous throughout the entire year to constitute a trade or business. The Tax Court noted that of the 326 sales, he made 40% of them during a one-month period. Moreover, the Tax Court pointed out that buying and selling stock was not the only activity in which Paoli engaged; he also provided substantial services to an engineering company he owned.
The Paoli decision once again demonstrates the importance of meeting all the criteria. A large number of trades by itself will not cause the trading activity to rise to the level of a trade or business. The trading activity must not only be substantial but also be ongoing throughout the year. Finally, in Paoli, as in Levin, the Tax Court was not influenced by the businesslike manner used in Paoli's trading activities.
Chen: In Chen, (27) the taxpayer seemed to fail for the same reason as Paoli. Chen argued that the volume and short-term nature of his securities trading during 1999, along with his substantial investment in software used to provide timely information about market conditions, qualified him as a trader. Chen had 323 trades during the year. However, 86% of the trades occurred in February and March, and Chen made none after July. Chen asserted that for parts of the year his daily transactions evidenced that he was trying to catch the swings in the daily market movements. Unfortunately, the Tax Court held that this pattern of trading was better described as "sporadic" rather than "frequent, regular and continuous" and thus held that Chen was not a trader. The Tax Court also noted in dicta that in the cases in which the taxpayer was found to be a trader, the trades were usually daily, and trading was the primary income-producing activity. Chen worked the entire year as a computer chip engineer.
Yaeger: Estate of Yaeger (28) was yet another case in which the taxpayer's volume of trades seemed representative of a trade or business. In this situation, the taxpayer averaged over 1,100 trades per year for two years. However, he failed the investment intent test. The court found that he was not a trader because his strategy was to buy undervalued stocks and hold them until they regained value, which is a long-term view. Thus, the taxpayer's method of deriving a profit was inconsistent with that of a trader. In addition, his income was disproportionately from long-term capital gains and dividends. In this case, the Second Circuit largely ignored the number of transactions and focused on the method used to derive his income.
Holsinger: More recently, in the 2008 Holsinger decision, (29) a retired Eli Lilly employee created an LLC to buy and sell stocks. The LLC made a timely filed election under Sec. 475(f) and reported ordinary losses from trading activities of $178,870 in 2001 and $11,227 in 2002. In addition, the taxpayer deducted related expenses on Schedule C. Holsinger made 289 trades during the year, all of which occurred on only 63 trading days, or less than 40% of the trading days available. After considering these facts, the Tax Court concluded that it was doubtful that Holsinger conducted the trades with the frequency, continuity, and regularity indicative of a business. Adding to the Tax Court's doubt was the taxpayer's claim that he was trying to catch the short-term changes in the market. Even though the taxpayer testified that he was after gains from daily swings, the Tax Court noted that he held a significant--but undefined--amount of his holdings for more than 31 days, which appeared to be long term. The Tax Court concluded that his trading pattern was consistent with that of an investor and not a trader.
The IRS has borrowed from these cases and created its own set of tests that a taxpayer must meet in order to be a trader. (30) According to the publication, "[t]o be engaged in business as a trader in securities" the taxpayer must meet all of the following tests:
* The taxpayer must seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation;
* The activity must be substantial; and
* The activity must be carried on with continuity and regularity.
The following facts and circumstances must be considered in determining whether the activity is a securities trading business:
* Typical holding periods for securities bought and sold;
* The frequency and dollar amount of trades during the year;
* The extent to which the taxpayer pursues the activity to produce income for his or her livelihood; and
* The amount of time devoted to the activity.
Exhibit 2 summarizes the process of determining whether a taxpayer is an investor, a dealer, or a trader.
Assuming trader status is desirable, there are a number of steps that individuals can take to help them qualify as traders and for the mark-to-market election. However, securing it may be an uphill battle. Based on the number of recent court decisions, the IRS is closely watching mark-to-market elections. The cases make it clear that the IRS is very reluctant to grant trader status, and the courts seem to agree. In virtually all the recent cases, it would appear--at least at first glance--that the taxpayer's facts adequately supported trader status. However, there was always something lacking.
Recall that in Paoli, the taxpayer had 326 trades during the year, and about 63% involved stock held for less than a month. Nevertheless, Paoli lost because (1) his trading was not sufficiently regular and continuous (40% of the trades in one month) and (2) he performed substantial services in activities other than trading. As this decision and the others demonstrate, there is no single bright-line test that distinguishes a trader from an investor. For this reason, those seeking trader status must be careful to satisfy all the amorphous indicia set forth for traders and avoid those for investors.
In evaluating the recent decisions, there appears to be little doubt that absent some substantial level of trading activity that is continuous and regular throughout the year, it will be difficult to achieve trader status. Courts give little weight to the amount of time an individual spends on unexecuted trades, placing trades, evaluating opportunities, or any other activity associated with trading. Rather, the emphasis is on the number of trades, the number of days traded, and the length of the holding period. Consequently, traders would be wise to execute at least one trade every day of the year, if not more, and also to avoid long holding periods.
However, using numerical tests is not a foolproof formula; in practice, such tests would be easy to meet. In fact, automated programs--robots--are now available that allow individuals to produce whatever number of transactions they choose. Thus, taxpayers and practitioners can expect that the tests might change. Nevertheless, it is still wise to trade regularly throughout the year.
Traders can also help their case by demonstrating that their time spent in all trading activities is substantial. In other situations involving whether a taxpayer is in a trade or business, time spent is a critical factor (e.g., determining whether an activity is passive under Sec. 469). For this reason, traders should maintain contemporaneous records that document how they spend their time. At a minimum, taxpayers should keep calendars and records showing how they were working and whether they were placing trades or analyzing opportunities. Time spent on related activities could be important. There are many other situations in which taxpayers are treated as being in a trade or business even though they do not execute a transaction every day. The classic example is a real estate salesperson or someone in commissioned sales who is fully engaged in his or her activity but does not have a sale every day.
Outside activities can be detrimental. In most cases in which a court found the taxpayer to be a trader, trading was the primary income-producing activity. If trading is not a full-time endeavor--the taxpayer does it sporadically or only on a part-time basis or is retired--it might be very difficult for an individual to prove that he or she is truly carrying on a trade or business.
Eligibility and Reporting Requirements
Sec. 475, enacted in 1993, contains the mark-to-market rules for securities dealers, electing commodities dealers, and electing traders in securities and commodities. (31) Under the mark-to-market method of accounting, any security held by a dealer or an electing trader, whether inventory or not, must be included in inventory at its FMV at year end. This rule causes the taxpayer to include in gross income any gains or losses on securities in inventory since they were purchased during the year or valued as of the end of the preceding year. In essence, there is a constructive sale of the securities on the last day of the year for their FMV, and any gains or losses are included in determining the taxpayer's taxable income for that year. Congress created the mark-to-market method out of fear that securities dealers would sell their loss assets but retain their gain assets, thus accelerating losses. Since the wash sale rules (32) do not apply to securities dealers or electing traders, these taxpayers could manufacture losses without any real change in the taxpayer's economic position.
There are special reporting requirements when the mark-to-market rules apply. If the taxpayer is an individual and has not made the Sec. 475(f) election, the gains and losses from the constructive sale are capital gains and capital losses and are reported on Schedule D of Form 1040, U.S. Individual Income Tax Return. If the taxpayer has made the Sec. 475(f) election, he or she reports the amounts on page 1 of Form 4797, Sales of Business Property, in Part II, line 10, as ordinary gains or ordinary losses. (33)
Sec. 475 generally applies to all securities owned by the dealer or electing trader. The term "security" is broadly defined to include a share of stock; a partnership interest; a beneficial interest in a trust; a note, bond, debenture, or other evidence of indebtedness; and certain other contracts or positions. Certain securities are exempt from Sec. 475 treatment (e.g., the constructive sale). For those securities that are exempt, the normal rules apply. The exempt securities are:
* Securities held as investments under Sec. 1236;
* Notes, bonds, debentures, or other evidence of indebtedness originated or acquired by the taxpayer and not held for resale; and
* Any security that serves as a hedge for a security to which Sec. 475 does not apply or a position that is not a security.
The first exception is the familiar rule that allows dealers to identify certain securities and treat them as capital assets. The second exempts debt instruments either purchased or issued by the taxpayer and is extended by Sec. 475(c)(4) to "nonfinancial customer paper," generally accounts or notes receivable. The third exception exempts securities that hedge certain securities. In addition, the regulations (34) provide that Sec. 475 does not apply to any security that the taxpayer has never held in connection with his or her activity as a dealer or trader. Thus, the statute does not change the rule that for the gain or loss to be ordinary, the security must relate to a trade or a business.
Making the Election
Sec. 475 is mandatory for dealers in securities but is elective for dealers in commodities and traders in securities or commodities. The procedures for filing the election are relatively straightforward, but importantly, because mark-to-market is a method of accounting, the taxpayer must observe the rules for a change in accounting method. (35)
There is no special form for making the election. Instead, the taxpayer simply files a statement containing certain information. For elections effective for tax years beginning on or after January 1, 1999, and not requiring a change in accounting methods (e.g., the first year of business), the statement must include the following:
* A description of the election being made (i.e., the election under Sec. 475 to use the mark-to-market method of accounting);
* The first tax year for which the election is effective; and
* The trade or business for which the taxpayer is making the election.
The statement must be filed not later than the unextended due date of the tax return for the tax year immediately preceding the election year and must be attached either to that return or, if applicable, to a request for an extension of time to file that return. For example, if an individual taxpayer wants the election to be effective for 2010, the statement has to be filed with the individual's 2009 tax return on or before the due date of April 15,2010, or with a timely filed request for an extension of the due date for the 2009 return (e.g., Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Return, filed on or before April 15). If the taxpayer is not required to file a 2009 tax return, he or she makes the election by placing the above statement in his or her books and records no later than March 15, 2010, and attaching a copy of the statement to the 2010 return.
For years beginning on or after January 1, 1999, that require a change in accounting method (i.e., established business changing to the mark-to-market method), the election must be made on Form 3115, Application for Change in Accounting Method, with the original attached to the tax return and a copy filed with the national office. The due date for this election is the extended due date of the tax return. The taxpayer must file a copy with the National Office no later than he or she files the tax return. (36)
Sec. 9100 Relief
If a taxpayer fails to file a timely election, all is not lost. Regs. Sec. 301.9100-(3)(c) allows taxpayers to seek extensions for certain elections, including the election to use the mark-to-market method of accounting. As seen in the Vines case discussed below, such relief, if granted, may save a taxpayer who failed to file the election in a timely manner.
Requirements for Relief
To obtain Sec. 9100 relief, the taxpayer must meet two tests: (1) the taxpayer acted reasonably and in good faith and (2) granting relief will not prejudice the government's interests. (37)
The regulations (38) provide that the taxpayer is deemed to have acted in good faith if he or she fails to make the election in reliance on the advice of the IRS or a qualified tax professional. Alternatively, the IRS will grant relief under the following circumstances:
* The taxpayer exercised reasonable diligence but was unaware of the need for the election;
* The taxpayer requests relief before the failure to make the election is discovered by the IRS; or
* The taxpayer failed to make the election due to events beyond his or her control. Under certain circumstances, the taxpayer is deemed to not have acted reasonably (39) or in good faith. For example, if the taxpayer was fully informed about the circumstances of the election and chose not to make the election, relief is not available. Similarly, the IRS will not grant relief if the taxpayer uses hindsight in requesting relief (e.g., waits to see if the election is beneficial before making the election).
The prejudice condition tries to protect the government's interests. Those interests are prejudiced if granting relief will lower the taxpayer's tax liability or if the election affects a year closed by the statute of limitation. (40)
The importance of properly making the Sec. 475(f) election and, when that fails, seeking Sec. 9100 relief cannot be overemphasized.
The Vines case (41) is a perfect illustration of why practitioners should be familiar with Sec. 475(f). In 1999, L. S. Vines, a high-profile personal injury lawyer, won a class-action lawsuit and received almost $36 million in contingency fees. Vines then decided to retire and try his luck in the stock market as a day trader. His strategy involved buying stocks on margin. When the price of technology stocks plummeted, he received a margin call that he failed to cover. As a result, in April 2000, Vines's brokerage firm liquidated his entire account, resulting in a loss of over $25 million.
At about the same time that he suffered this loss, Vines met with his accountant about filing his 1999 tax return. The accountant, a CPA with over 30 years of experience, had worked with Vines for the previous 13 years and was well aware of Vines's securities trading business. However, when the accountant, who did not know about Sec. 475, filed an extension for Vines's 1999 tax return, he did so without filing the Sec. 475(f) mark-to-market election. In early June, a friend told Vines that there might be a way to deduct his losses as ordinary losses. Vines immediately contacted a second accountant, who was also unfamiliar with any rule that would allow such treatment. Vines then obtained a specific citation of the applicable provision and gave it to the second accountant. Using this new information, that accountant determined that the first accountant should have made a Sec. 475(f) election and recommended that Vines hire other tax counsel to make the election and file for Sec. 9100 relief. Vines engaged a Washington law firm for this purpose.
On July 21, 2000, the law firm submitted a Sec. 475(f) election to the IRS, along with a letter outlining the reasons Vines should qualify for Sec. 9100 relief. The IRS reviewed the request and subsequently denied it in a private letter ruling. (42) It was apparent from the IRS's refusal that it felt Sec. 9100 relief was inappropriate for Sec. 475(f) elections, emphasizing that because the election did not need to be filed until April 15, taxpayers already had 3 1/2 months of hindsight. Indeed, had Vines known about Sec. 475, he could have waited until April 15 to decide whether he would have been better or worse off should he make the election. The IRS opined that it never anticipated that Sec. 9100 relief would be allowed in this situation; otherwise it would have taken steps to prevent it. After reviewing the IRS's response, Vines decided to litigate.
Unlike the many cases discussed above, the question of whether Vines was a trader and therefore eligible to make the Sec. 475 election was not an issue. The parties stipulated that Vines was engaged in the trade or business of being a securities trader. The dispute was whether the IRS should have granted him Sec. 9100 relief extending the time to make the Sec. 475(f) election.
Vines contended that the IRS should have granted the extension because he had met the necessary conditions of Sec. 9100: He had acted reasonably and in good faith, and the government's interests would not be prejudiced. The IRS argued that Vines had not overcome the presumption that the government's interest would be prejudiced unless there were unusual and compelling circumstances. (43) The court rejected this argument, finding that Vines had met this test and had acted reasonably. His reliance on a qualified professional, a CPA with over 30 years of experience, was consistent with the actions of a prudent person. In addition, Vines had applied for relief as soon as he learned about the provision.
However, the regulations also state that it is presumed that a taxpayer has not acted reasonably and in good faith if the taxpayer used "hindsight" in requesting relief. (44) Although the IRS asserted that Vines benefited from hindsight, the court did not agree. It explained that the "relevant inquiry is whether allowing a late election gives the taxpayer some advantage that was not available on the due date." In this situation, Vines conducted no trading activity and incurred no further losses between the time he should have filed the election and the time he filed the request for relief. The facts did not change from the time of the election to make the election more advantageous to Vines. Thus, his loss deduction was exactly the same whether he had filed the election timely or the IRS had granted his later request for relief.
In this regard, the court compared Vines's situation to that of the taxpayer in the 2005 Lehrer decision. (45) Lehrer had traded securities in 1999, 2000, and 2001, generating substantial capital losses during the last two years. Lehrer did not file the Sec. 475 election until 2004 and the IRS denied him the right to make the election. The Vines court pointed out that Lehrer's situation was a classic case of a taxpayer trying to benefit from hindsight, which was far different than the situation in Vines. In the end, the court believed that Vines had met all the conditions required to obtain Sec. 9100 relief and therefore granted him an extension for the election.
Shortly after Vines won relief, he filed a second suit seeking recovery of his litigation costs. (46) In this case, however, he was unsuccessful, but in dicta the court disclosed that Vines had already taken action against his first accountant for failure to advise him of the Sec. 475 election. In that case, Vines was successful, recovering approximately $2.5 million in damages.
The Vines decision contains a detailed discussion of all the issues presented here and is a blueprint for practitioners and taxpayers in similar situations. (47)
Another recent case raised issues about the proper filing of the Sec. 475 election when a husband and wife file separate returns. In Arberg, (48) Melissa Quinn (the wife of Lee Arberg) opened a brokerage account with E-trade in 1998. Quinn and Arberg filed separate returns for 1998 and 1999 and a joint return in 2000. Quinn reported all the activity from the E-trade account on her 1999 return as short-term capital gains on Schedule D. Arberg filed a mark-to-market election in 1998 but did not report the results of any trades from the account on his 1998 or 1999 returns. In 2000, the couple reported the overall loss from the trades in the account as ordinary loss on Schedule C as if a deemed sale under the mark-to-market rules had occurred. They also deducted various expenses they claimed were related to the trading activity on Schedule C.
The IRS challenged the couple's treatment of the E-trade account trades and the trading expenses. Quinn and Arberg took the dispute to the Tax Court. In Tax Court, they claimed that all the trading in the account since Quinn opened it was attributable to Arberg, who was a trader and had made a Sec. 475(f) election. Presumably, they recognized that the Tax Court would disallow their mark-to-market treatment of the loss from the E-trade account if the trades in the account were attributed to Quinn because of her treatment of the trades from the account as capital transactions on her 1999 return and her failure to make a Sec. 475(f) election.
The Tax Court ruled against Quinn and Arberg. It held that the duty of consistency (which precludes a taxpayer from taking contrary positions in two tax years after the statute of limitation on the earlier tax year has expired) prevented the couple from taking the position that the trades in the E-trade account were attributable to Arberg in 2000 when Quinn had reported the trades from the account as capital transactions on her separate return for 1999. Therefore, because the E-trade account trades could not be attributed to Arberg, the Tax Court further held that regardless of whether Arberg was a trader, he was not a trader with respect to those trades.
The court did not have to address what the result would have been if both Arberg and Quinn were considered traders. Must both file the Sec. 475 election? The answer is not clear. However, the prudent action would be for both the husband and the wife to file the election, especially if they are filing separate returns.
The vast majority of taxpayers are investors and are locked into reporting their gains and losses from buying and selling in the usual manner. However, the downturn in the economy, increasing retirements, and layoffs may cause a boom in the number of people trading securities on a part-time or full-time basis. For those whose trading activities constitute a trade or business, practitioners should consider trader status and the Sec. 475(f) election to use the mark-to-market method of accounting. A taxpayer who qualifies as a trader and makes the Sec. 475(f) election can convert capital losses to ordinary losses--a possibly huge benefit that may be increased by the ordinary and necessary business expense deductions that trader status allows. Indeed, the election is so valuable that, as was demonstrated in Vines, practitioners who fail to suggest it are at risk of costly malpractice claims.
Electing mark-to-market treatment is different for new entities than for current dealers and traders, but making the election is not troublesome. Moreover, for those who do not make the election correctly, Sec. 9100 relief may be available. In this situation, it is far better to get permission than to beg forgiveness. In short, practitioners and clients alike should not overlook the election.
(1) See Vines, 126 T.C. 279 (2006). See also Vines, T.C. Memo. 2006-258, regarding the client's successful suit against his accountant.
(2) In 1975, the Securities and Exchange Commission made fixed commission rates illegal, leading to lower commissions that made the cost of day trading affordable.
(3) See Exhibit 1 on p. 127, which summarizes the various tax treatments.
(4) Secs. 1236(a) and (b).
(5) Sec. 475(c)(1).
(6) Regs. Sec. 1.475(c)-1(a)(2)(ii).
(7) See King, 89 T.C. 445 (1987), and Kemon, 16 T.C. 1026 (1951).
(8) See H.R. Conf. Rep't No. 73-1385, 73d Cong., 2d Sess. 627, 632, 1939-1 C.B. (Part 2).
(9) Archarya, 225 Fed. Appx. 391 (7th Cir. 2007).
(10) Rev. Rul. 97-39, 1997-2 C.B. 62.
(11) See Secs. 1091 and 475(b).
(12) The Sec. 68 phaseout of itemized deductions terminates for years after 2009. However, absent Congressional action, it will return in its pre-2006 form for years after 2010.
(13) Note that some of these costs could be considered startup and investigation expenses that should be capitalized and amortized under the rules of Sec. 195 unless the taxpayer is already in business as a trader.
(14) Sec. 172(b)(1). Note that 2008 and 2009 net operating losses can be carried back for three, four, or five years (Sec. 172(b)(1)(H)).
(15) Sec. 1091(a).
(16) Jamie, T.C. Memo. 2007-22.
(17) See Moller, 721 F.2d 810 (Fed. Cir. 1983).
(18) Higgins, 312 U.S. 212 (1941).
(19) See id. and Estate of Yaeger, 889 F.2d 29 (2d Cir. 1989).
(20) See Groetzinger, 771 F.2d 269 (7th Cir. 1985).
(21) Levin, 597 F.2d 760 (Ct. Cl. 1979).
(22) See Mayer, T.C. Memo. 1994-209.
(23) See Liang, .23 T.C. 1040 (1955), cited with approval in Moller, supra n. 17; Purvis, 530 F.2d 1332 (9th Cir. 1976); and Chen, T.C. Memo. 2004-132.
(24) See Estate of Yaeger, supra n. 19.
(25) Mayer, supra n. 22.
(26) Paoli, T.C. Memo. 1991-351.
(27) Chen, supra n. 23.
(28) Estate of Yaeger, supra n. 19.
(29) Holsinger, T.C. Memo. 2008-191.
(30) IRS Publication 550, Investment Income and Expense (2008), p. 72.
(31) Commodity dealers and traders in securities or commodities were permitted to elect the mark-to-market treatment by an amendment made in 1998. See Secs. 475(e) and (f).
(32) See Sec. 1091(a).
(33) See 2009 instructions for Form 4797, p. 2.
(34) Regs. Sec. 1.475(d)-1(a).
(35) Rev. Proc. 99-17, 1999-1 C.B. 503, [section]5.02, modified by Rev. Proc. 99-49, 1999-2 C.B. 725.
(36) Id., [section]6.02.
(37) Regs. Sec. 301.9100-3(a).
(38) Regs. Sec. 301.9100-3(b)(l).
(39) Regs. Sec. 301.9100-3(b)(3).
(40) Regs. Sec. 301.9100-3(c).
(41) Vines, 126 T.C. 279 (2006).
(42) IRS Letter Ruling 200209053 (3/1/02).
(43) The regulations provide that "the interests of the Government are deemed to be prejudiced except in unusual and compelling circumstances if the accounting method" election is one to which Sec. 481, requiring an adjustment for accounting method changes, applies (Regs. Sec. 301.9100-3(c)(2)). The court never decided whether Sec. 481 applied but found that the government would not be prejudiced because Vines did not realize any gains or losses between the time he should have made the mark-to-market election and the time he actually did make the election.
(44) Regs. Sec. 301.9100-3(b)(3)(iii).
(45) Lehrer, T.C. Memo. 2005-167.
(46) Vines, T.C. Memo. 2006-258.
(47) For other cases in which the election was filed late and hindsight was a determining factor, see Acar, 545 F.3d 727 (9th Cir. 2008), aff'g No. C 06-0344 PJH (N.D. Cal. 8/16/06); and Marandola, No. 05-252T (Fed. CI. 4/4/07). See also Knish, T.C. Memo. 2006-268. where the taxpayer unsuccessfully filed a late Sec. 475(f) election and was denied Sec. 9100 relief.
(48) Arberg, T.C. Memo. 2007-244.
RRELATED ARTICLE: EXECUTIVE SUMMARY
* Under Sec. 475(f), taxpayers who are traders of stocks or other securities can make an election to mark to market the stock and securities they own in their capacity as traders at the end of each year. The trader recognizes ordinary gains or losses on the deemed sales involved in the mark-to-market process.
* The IRS frequently challenges whether a taxpayer who makes the mark-to-market election is a trader. Although an important factor is the volume of the taxpayer's trades during a year, the case law criteria for trader status also involve a number of other factors, all of which typically must be met for the taxpayer to be considered a trader.
* A taxpayer makes the markto-market election using the procedures set out in Rev. Proc. 99-17. In some circumstances, a taxpayer who fails to make a timely mark-to-market election will qualify for Sec. 9100 relief.
Michael Harmon is an associate professor of accounting at Indiana State University in Terre Haute, IN. William Kulsrud is an associate professor of accounting in the Kelly Business School at Indiana University in Indianapolis, I.N. For more information about this article, contact Prof. Harmon at firstname.lastname@example.org or Prof. Kulsrud at email@example.com.
By: Michael R. Harmon, J.D., CPA William N. Kulsrud, Ph.D., CPA
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|Author:||Harmon, Michael R.; Kulsrud, William N.|
|Publication:||The Tax Adviser|
|Date:||Feb 1, 2010|
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