Tax Rules for Day Traders Revisited

In January the JofA ran a second article by Marc I. Lebow, P. Michael McLain and Wayne Schell regarding the taxation of day traders (see “Day Trading and Self-Employment Taxes,” page 80 ). This was in response to a number of queries about two articles in the October 2000 issue ( “Paying the Piper: Some Tax Rules for Day Traders,” page 115, and “Being a Trader in Securities,” page 118 ) on the same subject. The following is further commentary on the January article; The first is by Lebow and McLain, and the second is from the IRS.

Tax Rules for Day Traders Revisited

In the October 2000 JofA , we explained how day traders could report their gains and losses on schedule C ( “Paying the Piper: Some Tax Rules for Day Traders,” page 115 ). The gains and losses would be ordinary income and not subject to the $3,000 capital loss limitation. Our position was based on various court rulings that equated gambling on the security markets with other forms of gambling. A taxpayer following our recommendation would have to pay self-employment taxes on his or her gains.

The “From the Tax Adviser” column in the same issue ( “Being a Trader in Securities,” page 118 ), said day traders could report their gains and losses on form 4797 and their expenses on Schedule C if they elected “mark-to-market” accounting. The gains and losses would be ordinary income and not subject to the $3,000 capital loss limitation. The taxpayer also could avoid paying self-employment taxes on his or her net gains.

In an attempt to clarify the differing positions, we explained the various court rulings supporting our position in a January 2001 JofA article ( “Day Trading and Self-Employment Taxes,” page 80 ). Since that position was based on court rulings, it is not free from potential challenge by the IRS. We also cited several rulings that did not support our position.

Unfortunately, in that article, we failed to adequately address all the relevant IRC sections and, therefore, made a misleading statement. We stated that the “mark-to-market” election only covered the yearend adjustment from cost to market for the investment portfolio and failed to address several related code sections. IRC section 475(d)(3)(A)(ii)(II) explains that all dispositions of securities for taxpayers taking the mark-to-market election are treated as ordinary gains and losses, and section 475(f)(D) says all income from security transactions for taxpayers electing the mark-to-market position is not subject to self-employment tax.

The difference between the various articles, therefore, is whether the taxpayer uses the “mark-to-market” election. By using it, the taxpayer can achieve the same results we advocate for others not electing “mark-to-market” and still not be subject to IRS challenge. If the election is not made, then both our October 2000 and January 2001 articles are correct without further explanation.

—Marc I. Lebow, CPA, PhD,
associate professor of accounting at
Christopher Newport University
in Newport News, Virginia, and
P. Michael McLain, CPA, DBA,
assistant professor of accounting
at Hampton University, Hampton, Virginia.