Day Trading and Self-Employment Taxes

In the October 2000 issue of the JofA, t wo tax articles discussed day traders and day trading. One, “Being a Trader in Securities”(page 118), was an excerpt from a longer Tax Adviser article, “Securities Trader Reporting Requirements,” by Thomas Rolfe Pudner. It said a “trader’s activity is not subject to self-employment tax.” The second article, “Paying the Piper: Some Tax Rules for Day Traders” (page 115), by Marc I. Lebow and P. Michael McLain, said day trading is subject to self-employment taxes. The JofA and the authors received many inquiries asking for clarification. Below is a second article by Lebow and McLain (joined by Wayne Schell, an associate professor at Newport University) that explains why they believe the tax law in this area is ambiguous and why a day trader may want to pay self-employment tax.

In the October 2000 JofA, we argued that taxpayers whose trade or business is trading marketable securities (a.k.a day traders) should report gains and losses from their business on schedule C, form 1040, so they can ignore the $3,000 capital loss limitation. However, another alternative is for the taxpayer to report business expenses on schedule C while reporting gains and losses on schedule D. In this instance, the $3,000 capital loss limitation applies. If the taxpayer elects to use schedule C for both expenses and gains, the net gains are subject to self-employment taxes.

We have received several requests for a clarification of our position. Most concerns related to the practitioners’ interpretation of IRC section 1401, which says, “The 1998 act provides that the rule treating gain or loss as ordinary by reason of the taxpayer’s election to apply mark-to-market rules does not apply for purposes of applying IRC section 1402 (rules relating to the self-employment tax).” In other words, gains or losses caused by the mark-to-market election do not affect self-employment tax expense and liability.

Tax practitioners have told us that many accountants advise clients they are not liable for any self-employment tax on their day-trading activities. This position comes from a misunderstanding of the mark-to-market concept. In its explanation of mark-to-market, the code says, “In the case of a person who is engaged in a trade or business as a trader in securities and who elects to have this paragraph (mark-to-market) apply to the trade or business:

“Such person recognizes gain or loss on any security held in connection with the trade or business at the close of any tax year as if the security were sold for its fair market value on the last business day of such taxable year, and

“Any gain or loss is taken into account for such taxable year. (IRC section 475(f)(1)(A).)”

The code then explains that gains and losses from applying the mark-to-market provision, while they may be ordinary income or loss, they are not subject to self-employment taxes (IRC section 475(f)(1)(D)). That is, the ability to avoid self-employment taxes from this section does not apply to realized gains or losses; it merely applies to the revaluation of a portfolio of securities from cost to market value occurring at the end of a tax year.

The argument that day traders are liable for self-employment taxes follows a different path. First, we argued the day trader will want to report business transactions using schedule C to avoid the $3,000 limitation on capital losses. The courts ruled that individuals whose main business was gambling on fluctuations in the value of securities were in a trade or business and thus subject to the self-employment tax. For example, in Groetzinger v. Commissioner, (480 U.S. 23; 107 S. Ct. 980 (1987)), a person involved in a trade or business was identified as one whose activities were regular, frequent, active and substantial. The case involved a gambler who was recording his income and losses on schedule C. In a footnote, the U.S. Supreme Court cited Barrish v. Commissioner (49 TCM 115 (1984)) and Baxter v. United States (633 F.Supp 912 (1986)), and determined that there was no distinction between a gambler and an active market trader (a day trader). The Court also said “the courts have properly assumed that the term includes all means of gaining a livelihood by work, even those which would scarcely be so characterized in common speech.”

In Trent v. Commissioner (291 F.2d 669, 671 (CA2 1961)), the courts ruled that gamblers involved in trade or business are subject to self-employment taxes. An example of this relationship can also be found in the court ruling in Groetzinger :

“If a taxpayer, as Groetzinger is stipulated to have done in 1978, devotes his full-time activity to gambling, and it is his intended livelihood source, it would seem that basic concepts of fairness (if there be much of that in the income tax law) demand that his activity be regarded as a trade or business just as any other readily accepted activity, such as being a retail store proprietor, or, to come closer categorically, as being a casino operator or as being an active trader on the exchanges.”

In another case, Meredith v. Commissioner (TC Memo 1984-651), an active trader of securities was also defined as a gambler. To quote the ruling, “one may gamble in stocks while another may gamble in dogs.” Finally, citing Fuld v. Commissioner (139 F.2d 465 (1943)), 26 section 1236 USCS Interpretive Notes and Decisions says, “Taxpayers purchasing and selling securities for themselves for speculation may constitute a ‘trade or business’ for reporting taxes on profits derived from such dealings.”

A taxpayer who follows the logic of the gambling and similar cases, knows that gains and losses should be reported on schedule C, and therefore be subject to self-employment taxes and not be subject to the $3,000 loss limitation.

This is not to say the courts were unanimous in their rulings. In King v. Commissioner, (89 TC 445, 458 (1987)), for example, the Tax Court found traders “occupy an unusual position under the tax law because they engage in a trade or business [that] produces capital gains and losses.”

Using the logic of King , the gains from the sale of capital assets (marketable securities) should be treated as capital gains and not be subject to self-employment taxes. The argument here is that day trading is a unique business that generates capital gains and losses. Logically, the $3,000 loss limitation would apply. This position is strengthened if the taxpayer is not considered to be in a trade or business but is instead merely an investor.

The difficulty lies in determining whether the taxpayer is in a trade or business. In King , the court ruled that “a trader’s activities must seek profit from short-term market swings, unlike those of an investor who seeks capital appreciation and income and who is usually not concerned with short-term developments that would influence prices on the daily market.”

In Paoli v. Commissioner (TC Memo 1991-351 (1991)), the court found 326 trades during the year did not make the taxpayer a trader. If the taxpayer had other employment or other sources of income in a taxable year, he or she might not be able to report gains and losses on schedule C. It was also noted in King that not every individual who trades in securities is considered to be participating in a trade or business. In Beals v. Commissioner (TC Memo 1987-171 (1987)), the IRS initially took the position that someone who managed investments was subject to self-employment taxes but later said that its initial position was in error—that one who merely managed investments was not subject to the tax. In a response to a September 1999 taxpayer inquiry on this subject, the IRS said, “Self-employment tax does not apply since the sale of a capital asset is involved and the profit or loss is ordinary only because of the mark-to-market election.”

Whether or not a day trader is subject to self-employment tax is ambiguous. If the taxpayer is in trade or business and elects to report both expenses and gains and losses on schedule C, there is significant case law supporting that position. As a matter of consistency, the taxpayer would be subject to self-employment taxes and not subject to the $3,000 capital loss limitation. If the taxpayer follows King and similar cases, gains and losses may be reported on schedule D and self-employment taxes are not relevant. Here, the $3,000 capital loss limitation applies. An interesting solution to this problem has been proposed by several tax practitioners. The taxpayer elects to report income on Form 4797, Sales of Business Property, and expenses on schedule C. This will allow him or her to maximize both trading losses and business expenses. The appropriateness of reporting gains and losses on the sale of marketable securities on form 4797, however, is not addressed in this article.

—Marc I. Lebow, CPA, PhD, and Wayne Schell, CPA, PhD,
associate professors 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.