Trader or investor?

In two decisions in 2013, Endicott, T.C. Memo. 2013-199, and Nelson, T.C. Memo. 2013-259, the Tax Court maintained a high hurdle that taxpayers must clear to show they are in the trade or business of trading in marketable securities rather than acting as investors.

Aside from dealers in securities (those who regularly buy securities and resell them to customers—see Regs. Sec. 1.471-5(c)), individual taxpayers with income or loss from trading in securities may be either traders or investors. Traders, those who engage in the trade or business of buying and selling securities for their own account, possess several advantages over investors, chiefly the ability to deduct ordinary and necessary expenses of their trading activity under Sec. 162(a) in calculating adjusted gross income (AGI). In addition, they may fully deduct interest expenses where debt proceeds are used to buy or carry investments used in the trade or business, and their deductible expenses reduce alternative minimum taxable income (AMTI). A trader who makes the Sec. 475(f) mark-to-market election recognizes gain or loss for the tax year as ordinary, including a net loss greater than the $3,000 capital loss limitation of Sec. 1211(b).

By contrast, investors, those whose buying and selling of securities for their own account does not rise to the level of a trade or business, may deduct only the more limited category of nonbusiness expenses for the production of income under Sec. 212. Such deductions are further limited as itemized deductions subject to the threshold of 2% of AGI under Sec. 67(a) and do not reduce AMTI. Also, unlike traders, investors may deduct investment interest expense only to the extent of net investment income for the tax year under Sec. 163(d). An investor may not make a valid mark-to-market election and cannot thereby escape the $3,000 capital loss limitation (see Kay, T.C. Memo. 2011-159).

Therefore, many taxpayers have tried—and failed—to persuade the IRS and courts that they were in the trade or business of trading in securities. The tests commonly applied to distinguish other business activities from hobbies are of little avail (see “Tax Practice Corner: Business or Hobby? The Nine Factors,” JofA, Oct. 2013, page 71).

As far back as the Supreme Court’s decision in Higgins, 312 U.S. 212 (1941), courts have held that even a businesslike approach to investing marked by “sufficient extent, continuity, variety and regularity” is not enough. Traders, distinguished from investors, must also trade frequently, relying more on direct management of gain from short-term buying and selling of securities than on the benefits of holding them, such as dividends, interest, and capital appreciation (see, e.g., Moller, 721 F.2d 810 (Fed. Cir. 1983)). In Nelson, the Tax Court has adopted a two-part test for determining whether a trading activity constitutes a trade or business within the meaning of Sec. 162(a): Traders’ trades must (1) be substantial in amount of money involved, number of trades in a year, and number of days on which trades were executed (Nelson, slip op. at 12–13) and (2) attempt to “catch the swings in the daily market movements and profit thereby on a short-term basis” (Liang, 23 T.C. 1040, 1043 (1955)). 

In Nelson, taxpayer Sharon Nelson executed 535 trades in 2005 and 235 trades in 2006, on 250 available trading days in each year. That might seem substantial, but the Tax Court noted it has previously held that as many as 372 trades in a year were not substantial, and among cases cited in Nelson, 1,136 trades were the fewest it has previously held to be substantial (Nelson, slip op. at 15). The court acknowledged that the aggregate dollar amount involved in Nelson’s trades was “considerable”—purchases and sales of more than $32 million in 2005 and more than $24 million in 2006—but amounts alone are not determinative. The court, taking into account 15 seven-day gaps in the two years in which there were no trades and a span of more than three months in 2006 in which Nelson made only two purchases, found the total number of days of trading activity was not substantial.

So, while the facts-and-circumstances nature of the substantiality determination allows no bright-line qualifications, it is clear that the number of trades and their frequency and regularity are important considerations for the court, and more trades and greater frequency and regularity of trades helps the taxpayer obtain a favorable result. While the scenarios from previous cases may be helpful, taxpayers must remember that they provide at best very rough guidelines as to what a particular court may consider substantial.

In Endicott, taxpayer Thomas Endicott established that his number of trades (1,543) was substantial for one of the three years at issue, but not for the other two (204 and 303). Like Nelson’s, his activity involved millions of dollars. But in none of the three years was his trading frequent, regular, and continuous, the court held.

The taxpayer argued that because of his trading strategy, his trading activity should not be judged by the frequency and “daily swings” requirements. Endicott typically bought a certain number of stock shares and then sold call options on the stock. He earned a profit mainly from receiving premiums from selling the call options, hoping that the options, which carried terms of up to five months, would expire without being exercised, and he would then pocket the premiums. If the buyer of an option exercised it, he could then deliver the stock he held, but he tried to avoid that if the position appeared unprofitable (such as if the stock dropped in price) by purchasing an identical call option and thus exiting from the position. He held the stock for an average of 35 days but held some for as long as four years. He received dividends on his stock holdings.

The taxpayer testified that high commission costs for the options made it impractical for him to buy and sell them on a daily basis, but the court, noting that options can be traded daily on exchanges, said his inability to profit in that way was not a reason to relieve him from the frequency requirement. He argued that because of the nature of options trading, he should be allowed to add the number of days he maintained an option position to the number of days he executed trades. The Tax Court said that would subvert the rule, turning long-term option investors into high-frequency traders. The court also declined to consider the average period he held option positions instead of the period he held the underlying stocks, but even considering them together, found he did not attempt to catch swings in the daily market and therefore was an investor, not a trader.

Besides substantial deficiencies, the Tax Court also upheld accuracy-related penalties in both cases. Thus, taxpayers attempting to claim trader rather than investor status should be well-apprised of the requirements and their inflexibility in the face of strategies other than substantial, frequent trading that attempts to profit from daily market fluctuations.

By Paul Bonner, a JofA senior editor, tax. To comment on this article or to suggest an idea for another article, contact him at pbonner@aicpa.org or 919-402-4434.