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Dec 1993

Trader or an investor? (Personal Financial Planning)

by Holt, Michael A.

    Abstract- Individuals buying and selling securities for their personal account may take steps to enable them to be classified as traders instead of investors and thus permit them to charge their expenses as wholly deductible trade or business expenses. By regularly and frequently engaging in securities transactions, an individual can avail of long-term capital gain treatment while claiming to be engaged in a trade or business on a continuous basis. However, individuals should not be misled into thinking that being a trader is always an advantageous tax position. Rather than base their stock participation, as either trader or investor, on purely tax-related considerations, individuals should look at such non-tax factors as their ability to predict everyday market fluctuations and to conduct profit-making transactions. For persons determined to enter the market as a trader, the steps for becoming 'traders' are discussed.

Investor, Trader, and Dealer Defined

An investor in securities may be loosely defined as one who provides money or other assets for purchasing securities for his or her own account with an expectation of making a future profit without providing any significant services. In stark contrast, a dealer in securities is generally defined as one who purchases securities for resale to others. Because securities purchased by a dealer are held in inventory for sale to others, a dealer is generally not allowed preferential long-term capital gain treatment upon the sale of such securities.

Somewhere between these two is the definition of a trader. Like the investor, a securities trader does not hold items of inventory for resale to others, but rather holds securities purchased for his own account. Consequently, long-term capital gain treatment is available to a trader for securities held for the required period (currently one year). Unlike the investor, however, a trader engages in frequent and continuous transactions and can therefore claim to be regularly engaged in a trade or business. As indicated earlier, a trader is therefore able to deduct all ordinary, necessary, and reasonable expenses incurred in that trade or business from gross income in determining adjusted gross income. in effect, it might appear as if the securities trader is able to reap the tax benefits accorded to both investors and dealers without suffering the negative tax implications accompanying either.

Individuals buying and selling securities for their own account may therefore be interested in learning how they may attain the status of a trader. Before exploring these necessary conditions. however, let us first look at some of the other tax implications associated with trader versus investor status.

Benefits of Trader vs. Investor Status

Provided he or she materially participates in the activity, interest incurred by a trader and traceable as an ordinary, necessary, and reasonable expense of his trade or business is not subject to the investment interest expense limitation imposed on investors.

Certain investment-related expenses of an investor, such as investment subscriptions and professional fees, are classified as miscellaneous itemized deductions. These are allowed for regular tax purposes only to the extent that they exceed 2% of the adjusted gross income (AGI) reflected on the investor's individual income tax return and are not allowable at all for alternative minimum tax purposes. Furthermore, any expenses in excess of the "2% AGI limitation" may begin to be "phased- out" to the extent that the investor's 1993 AGI exceeds $108,451 (or $54,226 if married filing separately). On the other hand, these same expenses are fully deductible by a trader (for both regular tax and AMT purposes) to the extent that they represent ordinary, necessary, and reasonable expenses incurred in his trade or business. Commissions on purchases and sales must continue to be capitalized, however, by either increasing the basis of securities purchased or offsetting their sales price when sold.

Because the expenses of a trader are deducted for AGI, a trader's correspondingly lower AGI may enable him to deduct more of his other, non-business related expenses subject to the various limitations and phase-outs based on AGI.

If a trader's activity is unprofitable, a net operating loss may be carried either back three years or forward fifteen years, at his or her option. However, a capital loss--whether incurred by a trader or an investor--cannot generate a net operating loss and can only be carried forward.

Although a trader is deemed to be engaged in a trade or business, this will generally not subject him or her to any additional self-employment tax liability since dividends, bond interest, and capital gains generated in the trade or business do not represent self-employment income. Although this may be beneficial for many individuals seeking trader status, it may be viewed negatively by some since such income would thus not enable them to establish a self-employment retirement plan.

The IRC Sec. 179 election to expense, rather than depreciate, certain business property may be available to a trader, whereas this election would not be available to an investor. A trader may be able to deduct "home-office expenses" allocable to his trade or business, whereas these expenses are not available to an investor.

New York State and New York City personal income tax laws limit the deductibility of 25 to 50% of itemized deductions if an individual's adjusted gross income exceeds certain levels. To the extent that a trader need not claim expenses as itemized deductions, the limits are avoided.

Because a trader does not hold property primarily for sale to customers, the trade or business income resulting from transactions in securities held for his own account is exempt from the New York City unincorporated business tax.

Detriments of Trader vs. Investor Status

Because of the higher portfolio turnover necessary for an individual to attain trader status, the likelihood that securities will be held for the one-year period required for long-term capital gain treatment may be less than it typically would be for an investor.

If a trader generates losses in three out of five years, he or she will face a higher burden of proof that he or she is engaged in a trade or business for profit and would thus be exposed to a greater risk that some or all of his expenses may be disallowed.

Because a trader's AGI may be lowered by expenses claimed against trade or business income, the maximum charitable contribution deduction that may be claimed in a particular year may be reduced. Conversely, the medical expense deduction may be increased.

Choosing Between Investor vs. Trader Status

Neither status, i.e., that of a trader not an investor, always results in a more favorable taxation in all circumstances. Based solely on an examination of the tax factors, many individuals might conclude that trader status would be more desirable. It cannot be emphasized enough, however, that the activities of investing and trading are fundamentally different, and not distinguished merely by the individual's degree of participation.

The decision to participate in the securities markets as a trader rather than an investor should be based primarily on non-tax considerations, such as the individual's confidence in his ability to anticipate day-to- day fluctuations in the markets and to timely execute profitable transactions. In light of this, let us turn how to the conditions necessary for trader status to be attained.

Investors vs. Traders

At their extremes, the activities of trading and investing in securities may be defined according to the criterion described in a 1955 Tax Court case, Liang v. Commissioner.

"|In an investment account securities are purchased to be held for capital appreciation and income, usually without regard to short-term developments that would influence the price of the 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 movements and profit thereby on a short-term basis."

At the margin, however, the distinction between these two activities becomes blurred, a problem that has plagued this area of the tax law for a number of years. Obviously, the number of transactions in which an individual engages is an important factor. Unfortunately, it is not possible to delineate the exact number of transactions in which an individual must engage before trader status may be attained. Mention of such a threshold level was made in a 1974 case, Ferguson v. Commissioner (33 TCM(CCH) 1082). In the stipulated facts, it was indicated that an individual telephoned the taxpayer assistance section of an IRS District Director's office to inquire how he could establish himself as a "day trader" in stocks and commodities. The taxpayer was advised that he could be so qualified if he engaged in 200 transactions per year. However, the decision in this case does not make it clear whether that would be a valid benchmark. The court did hold that the individual was a trader, thus implying that 200 transactions per year would be sufficient to attain this status. But it is important to note that the court made no reference to the number of transactions engaged in by the taxpayer in reaching its decision. In fact, with respect to the taxpayer's phone call, the court noted only that, "it is regrettable that petitioner sought advice from taxpayer assistance and relied thereon to his own detriment, but the law is well settled that erroneous advice as to the law from agents of the Commissioner...is not binding on the Commissioner." Readers are urged to heed this same warning.

In sum, whether an individual has attained trader status does not appear to be merely a function of the number in which the individual engages, although this is an important factor. Rather, this determination is dependent upon whether the individual is deemed to be engaged in a trade or business, and that, in turn, is to be based on an examination of all the facts and circumstances.

For example, regardless of the number of transactions or the amounts involved, an individual will not be deemed to be a trader rather than an investor if either 1) the individual's purchases and sales of securities are transacted merely to preserve his investment or 2) the individual merely passively receives the dividends and interest, the details being taken care of by others. An individual must be prepared to show that his trading activities could result in substantial short-term gains and losses (rather than merely attempts to secure income or capital stability), and that he or she is not just relying on interest and dividends to generate profits. If an office is maintained, and/or assistants are employed, those facts would also be significant, but would not be conclusive. Of course, the individual's primary purpose for engaging in the activity must be to generate profit. By virtue of the very nature of the activity, this would not seem to be a difficult motive to prove. But, as indicated earlier, individuals will face a higher burden of proof if losses are incurred in at least three out of five years.

Ancillary Issues

In cases involving activities other than securities trading, the courts have held that the availability of trade or business deductions are not confined to a single business or only to a principal business of a taxpayer. Consequently, it does not appear that an individual would be denied trader status if he or she is also engaged in another trade or business. However, it should be noted that one of the factors that may be considered in determining whether an individual has attained trader status is the nature, extent, and degree of success of the taxpayer's other business pursuits.

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