Tax Status – Trader or Investor?

Study Notes:

Trader or investor

This module is not a comprehensive look at this topic which is complex. It is intended as an overview. If
you consider yourself a trader for tax purposes, a conversation covering the requirements in detail
should be held with your tax advisor.

Investor

Many of us are investors. We trade our own accounts sporadically and do not actively participate in the
market daily. Managing our investments is not a primary activity or even a major activity for us.
Generally, investors hold securities for a longer time period and look to generate income from
dividends, interest and capital gains. If you are more active in the marketplace than occasional trading
then you may be a trader.

Trader

A trader is a person for whom investing and trading in the market for their own account is a trade or
business. Generally, a trader participates in the marketplace daily and may hold positions for a short
time.

Requirements to be a Trader

The IRS has laid out specific conditions to be met to be considered a trader in securities. Although
seemingly fairly simple, multiple court cases have further defined the conditions making them more
complex than they appear. IRS topic 429 – available on IRS.gov – gives a readable explanation of the
basics of being a trader.

There are three conditions that must be met for the IRS to consider a taxpayer as engaged in the
business of being a trader.

1) A trader must seek to profit from daily market movements in the prices of securities, and not
from dividends, interest or capital appreciation
2) A trader’s activity must be substantial
3) A trader must carry on the activity with continuity and regularity

Facts and circumstances

Facts and circumstances play a large role in the determination of a taxpayer’s status as a trader. The IRS
– and the courts – consider:

• Typical holding periods for securities bought and sold;
• Frequency and dollar amount of your trades during the year;
• Extent to which you pursue the activity to produce income for a livelihood; and
• Amount of time devoted to the activity.

If the nature of your trading activities doesn’t meet these qualifications, then you are an investor.

Tax Advantages

The primary advantage of being a trader is the deduction of investment expenses such as account fees
and stock borrow fees. Beginning with 2018, a trader is also eligible for a qualified business deduction
under the new section 199A of the tax code. This deduction, subject to certain income limits, allows for
a 20% deduction of business income.

Traders may also hold securities for investment – or over a longer term. However, detailed records must
be kept. A trader can also choose to use mark to market rules. Investors do not have this option. The
mark to market rules recognize gain and loss as business income daily – not just when a security is sold.
This is an annual election that must be made on a timely basis with the IRS. The election for the current
year must be made by the due date – without extension – of the prior year’s return – or 4/15.

Audit Considerations

Much of the law surrounding the meeting of the requirements to be a trader comes from tax court and
court cases when the IRS has challenged a taxpayer as to their status as a trader. Obviously, this cannot
be summarized in the time here – which makes it essential that you discuss designating yourself as a
trader with a tax professional familiar with the area.

Note that the courts have struck down arguments that an individual was a trader when the taxpayer
only made a few (10) trades a day, as well as when the taxpayer traded actively only a few days a week
(or month).

Think about your activity carefully and be certain that you meet the requirements. This is an area that
the IRS views as extremely auditable (meaning they believe that there is underpaid tax to be collected)
so approach the decision to report as a trader with good documentation of your activities and
anticipating that the likelihood of being audited will increase.

Section 199A

As mentioned before, since being a trader is considered a trade or business under the tax code, the new
(late 2017) Section 199A allowing for up to a 20% reduction of business income apply.