Technological advances have greatly improved access to financial information and likewise improved the ability for many Americans to trade for their own accounts. While most casually trade a few securities for pleasure, a growing number engage in high-volume trading. These traders may perform adequate research on their investments before engaging in these transactions; however, not all understand the tax effects of their trades and some rely on information that does not give a complete picture of potential issues. Some of these include whether the trading activity is considered a “trade or business”, whether losses from transactions can (or cannot) be recognized due to wash sale rules, and whether substantiation of basis can be provided for trades reported on an income tax return.
“Trade or Business” or Investor?
Not all day traders are the same. Some have day jobs as professionals and others are solely dedicated to trading. Some hold securities for a matter of minutes, while others may buy and sell monthly or annually. And still others may trade more sophisticated financial products, such as derivatives. These distinctions can have a material effect on the taxation of these activities. While such a characterization will have an effect on deductibility of many expenses related to the venture and can change the character of income, there are also a host of other potential considerations beyond the scope of this article. With that in mind, it is in a trader’s best interest to know if their activity will be considered that of a trader, a dealer, or an investor – different consequences stem from each classification. (For most individuals who trade a high volume of securities over short periods of time, it is advantageous to be classified as a trader so that a larger quantum of business expenses can be deducted.)
One of the seminal cases regarding the definition of a trade or business, for tax purposes, is Commissioner v. Groetzinger, 480 U.S. 23 (1987). In that case, the Supreme Court opined on whether or not a gambler’s activity could suffice to support a trade or business for tax purposes. In finding that the taxpayer was a “professional gambler,” the Supreme Court based its decision on the facts underlying his profit motive and the scope of his activities. This ruling provided that the more specific the plans are to achieve a profit (and evidence that a profit was being made) and the greater the scope of activity – in terms of time, effort, and capital outlays – the more likely it is that a taxpayer’s activity will be considered a trade or business.
Following this logic, other courts have set forth more detail on what it means to have a trade or business for day traders. These opinions focus on (1) intent, (2) the nature of income to be derived, and (3) the frequency, extent, and regularity of trading. For example, in Endicott v. Commissioner, TC Memo 2013-199, the Tax Court looked to the substantiality of trading and the desire to make profit from short-term swings in the market as the main factors in determining whether the individual was an investor or a trader. In particular, the Tax Court found that hundreds, even thousands, of trades per year would not be sufficient to prove that a trade or business existed. In Nelson v. Commissioner, T.C. Memo 2013-259, where an individual conducted more than 1,100 trades in one year, the Tax Court still looked to other factors, such as the number of days traded, the holding period for securities, and the magnitude of securities traded, in order to determine whether a trade or business existed. Several other cases from the last decade underscore the notion that a substantial undertaking must be made to justify classification as a trader (as opposed to an investor). See, e.g., Kay v. Commissioner, T.C. Memo 2011-159; Assaderaghi v. Commissioner, T.C. Memo 2014-33.
Bottom line: While there is often a clear benefit of tax classification as a trader (and not an investor), an individual must be prepared to present a clear picture that such trading was their primary profit-seeking activity and that they frequently executed many trades on a near-daily basis. Failure to do so can result in a large tax deficiency and significant accuracy-related penalties.
Aside from the trader versus investor issue, a variety of special tax rules can negatively affect day traders. Some of these rules require taxpayers to alter their tax accounting method, such as by requiring use of mark-to-market income recognition. One of these relatively unknown rules relates to “wash sales.” See I.R.C. § 1091. In a very general sense, the wash sale rules prevent an individual from transacting in substantially the same investment in order to recognize or lock-in losses before they exit a position from an economic perspective. Take the following example. A trader buys 50 shares of XYZ stock on December 1, 2016 at $60/share. On December 10, 2016, XYZ stock drops to $50/share and the trader cuts his losses and sells all 50 shares of the stock. On December 30, 2016, XYZ stock rebounds to $55/share and the trader purchases another 50 shares of the stock and it is sold in March, 2017 at $60/share. In this scenario, the trader would not be permitted to recognize the loss of $500 on the initial sale of XYZ stock in 2016. Instead, the losses would be deferred until the sale in March, 2017. While the trader would still net the same tax result, in the aggregate, over the two transactions (here, no taxable gain or loss), the timing of the recognition could have a significant effect on his or her ability to offset other taxable gains in a given taxable year. In other words, these deferral principles can make the loss transaction less valuable (from a tax perspective). Depending on the taxpayer’s income and the profitability of other trading activities, other tax rules could cause even greater deferral of valuable tax losses.
While many trading platforms now have the capability to account for the wash sale rules, it still behooves traders to understand the ins and outs of the wash sale rules. This concept can have a potentially significant effect on their bottom line. For those that do not have the benefit of such a platform, recordkeeping and assistance from a competent tax compliance professional is a must.
Common Audit Pitfall: Substantiation
Aside from an understanding of the tax laws, day traders should be mindful of their recordkeeping requirements. When trades are executed through a brokerage, sale information is typically reported to the Internal Revenue Service. For most transactions, this will include identifying information (e.g., the name of the company, amount of shares sold, and account from which the sale was executed), the date of the transaction, and the gross proceeds. Some, if not most, transactions executed through a brokerage will now include basis information (e.g., the purchase price and date of purchase).
However, if trades involve an exotic underlying or if a purchase is made outside of a brokerage account, basis information will frequently not be readily determinable by the Internal Revenue Service. In situations such as these, it is incumbent on the trader to retain necessary information regarding the purchase. If not available, the Internal Revenue Service may assume that there was no basis in the investment and/or that any gain was short-term. This can result in a substantial tax deficiency if there are a high volume of trades without basis information or if the magnitude of a trade is significant. Moreover, characterization of a gain as short-term (as opposed to long-term) can result in significantly increased tax liability due to disparities in long-term versus short-term capital gains treatment. Dealing with this issue on the front-end, through good recordkeeping, can save significant time and expense in dealing with the Internal Revenue Service (or the state taxing authority) on the back-end.
Rosenberg Martin Greenberg, LLP is experienced in all aspects of federal and state tax laws, including the provision of tax advice for investors and traders and the representation of such individuals in audits and administrative appeals. For a free consultation, please contact Brandon N. Mourges at firstname.lastname@example.org or 410.951.1149.