Prudence is in order any time a taxpayer considers an election under the Internal Revenue Code. When it comes to Sec. 475, this axiom is especially relevant. Sec. 475 permits mark-to-market accounting for eligible taxpayers, which is a substantial deviation from the Code’s traditional standard of income recognition only when it is realized. More specifically, the election requires income recognition at the end of each year based on increases and decreases in fair market values. A Sec. 475 election can yield tremendous tax benefits with few downside risks; however, taxpayers must be wary of its potential pitfalls.
Taxpayers generally must recognize income when there is a realization event, which often comes in the form of a sale or exchange. A major exception applies to securities dealers: Even in the absence of a realization event, Sec. 475(a) requires securities dealers to mark both their inventory and noninventory securities to market annually, recognizing gains and losses as ordinary. In other words, securities are valued at their current market price, rather than book value, for tax purposes. Sec. 475(e) permits commodities dealers to elect to have these same mark-to-market rules apply; moreover, Sec. 475(f) permits securities and commodities traders to elect to have similar mark-to-market rules apply to their trading activities. Once an election is made, however, it can be revoked only with the IRS’s consent, which is granted only in unusual circumstances.
THE PROS AND CONS OF A SEC. 475 ELECTION
At first glance, the notion of any taxpayer seeking to make a Sec. 475 election appears counterintuitive. Taxpayers who own securities or commodities, which are usually defined as capital assets for income tax purposes, would normally seek to exploit the preferential capital gains rate and defer recognition of gain as long as possible. A Sec. 475 election, on the other hand, converts income and losses to ordinary income and losses, and any opportunity to defer income recognition is eliminated.
A Sec. 475 election nevertheless offers several important countervailing benefits. One primary result of making this election is that all losses are characterized as ordinary. This makes the capital loss limitation rules of Sec. 1211 inapplicable and enables taxpayers to use the losses as net operating losses that may be carried back and forward. In addition, when a Sec. 475 election is made, the wash-sale rules do not apply.
Other noteworthy advantages of making a Sec. 475 election include the following: (1) The uniform capitalization rules and interest expense capitalization rules of Secs. 263A and 263(g), respectively, are negated; (2) the loss disallowance rules for transactions between related parties under Secs. 267 and 707(b) do not apply; (3) the constructive sales rules of Sec. 1259 do not apply; (4) tracking historical cost basis is unnecessary (insofar as every year the security or commodity in question is accorded a new tax basis); (5) financial and regulatory reporting requirements may be coordinated; and (6) income from mark-to-market transactions is not considered self-employment income under Sec. 1402.
As with almost any tax election, there are potential downsides. The first significant disadvantage to making the election is that what otherwise would be treated as capital gain income is transformed into ordinary income. Given that the top federal capital gain tax rate is currently 20%, whereas the top federal ordinary income tax rate is 39.6%, the election comes at a steep price. Second, taxpayers making a Sec. 475 election cannot defer gains; deferring gains can often produce significant tax savings.
One less-obvious drawback of making a Sec. 475 election is that Sec. 1256 does not apply. Thus, the electing taxpayer forgoes the potential benefit of having gains and losses treated for tax purposes as 60% long-term capital gain or loss and 40% short-term capital gain or loss. A further disadvantage is that a taxpayer who makes a Sec. 475 election and constructively recognizes income may lack liquidity to pay the tax liability on the recognized gains. This problem may prove particularly acute in the first election year if the taxpayer owns assets with significant amounts of unrealized income.
WHO QUALIFIES TO MAKE THE ELECTION?
A thorough understanding of how the Code defines (1) dealers, traders, and investors and (2) securities and commodities is necessary to identify who may make a Sec. 475 election. A securities dealer is required to apply mark-to-market accounting to securities, whereas a commodities dealer may elect mark-to-market treatment. A trader who is engaged in the trade or business of trading securities or commodities also may elect mark-to-market treatment under Sec. 475(f). An investor, however, cannot make a Sec. 475 election and must treat all gains and losses from investment activities as capital.
Dealers, traders, and investors. Sec. 475 defines a dealer as a taxpayer who regularly purchases from or sells to customers, or regularly “offers to enter into, assume, offset, assign or otherwise terminate positions in securities with customers in the ordinary course of a trade or business.” In the context of commodities, this definition includes dealers of physical inventories as well as derivatives. The fundamental concept is that dealers’ transactions must be with customers (see, e.g., Kemon, 16 T.C. 1026 (1951) (a taxpayer who regularly transacts business with customers is a dealer)).
In contrast, traders and investors trade on their own behalf rather than on behalf of customers. Unlike its treatment of dealers, Sec. 475 does not define traders and investors. A great deal of controversy has surrounded the determination of whether taxpayers are traders who may make Sec. 475 elections or are simply investors who cannot make the election. In Arberg, T.C. Memo. 2007-244, the Tax Court made the following general observation: A trader is a taxpayer who buys and sells for his own account as part of his trade or business, while an investor is a taxpayer who buys and sells for his own account but not as part of a trade or business.
Ascertaining whether a taxpayer is in the trade or business of buying or selling is an imprecise science. A seminal case on this issue is Chen, T.C. Memo. 2004-132. In Chen, the taxpayer became a day trader while he was still employed full time as a computer engineer. During the course of the tax year in question, the taxpayer engaged in more than 300 securities transactions, primarily between February and April. To realize an immediate benefit from significant trading losses, the taxpayer attempted to make a late Sec. 475 election on his tax return, which he filed only after receiving an IRS deficiency notice. In conducting its analysis, the Tax Court declared that a trader must meet the following two-prong test: (1) The taxpayer’s trading strategy must attempt to “catch the swings in the daily market movements”; and (2) the trades must be “frequent, regular, and continuous.” Applying this test, the Tax Court ruled against the taxpayer, holding that he was an investor rather than a trader and therefore ineligible to make a Sec. 475 election.
Numerous other cases have clarified the differences between traders and investors for tax purposes. These cases suggest that for a taxpayer to be classified as a trader, the trading must be a full-time endeavor, and the transactions must occur throughout an entire year (see, e.g., Levin, 597 F.2d 760 (Cl. Ct. 1979)). Investors, in contrast to traders, typically buy and hold and further seek to profit by maximizing capital gains and dividends (see, e.g., Mayer, T.C. Memo. 1994-209).
Securities and commodities. The Code puts financial products into two distinct categories, namely, “securities” or “commodities.”
Sec. 475(c)(2) broadly defines securities to include the following: stock in a corporation; partnership or beneficial ownership interests in a widely held or publicly traded partnership or trust; notes, bonds, debentures, or other evidence of indebtedness; interest rate, currency, or equity notional principal contracts; and evidence of an interest in, or a derivative financial instrument in, any of the foregoing.
Commodities, on the other hand, are tangible goods such as gold, oil, cattle, pork bellies, and orange juice (Sec. 475(e)(2)). Commodities can be traded as physical inventories, although they are more commonly traded in the form of financial products related to particular commodities. Under Sec. 475, commodities are defined to include any commodity treated as actively traded under the Sec. 1092 straddle rules; any notional principal contract with respect to the commodity; or any evidence of an interest in, or a derivative financial instrument in, any commodity. It is also important to note that only commodities traded on organized commodities exchanges satisfy this definition.
Hedging transactions can obscure these otherwise straightforward definitions. More specifically, if a commodity is hedged, it may be transformed into a security; conversely, if a security is hedged, it may be transformed into a commodity.
WHO SHOULD MAKE THE SEC. 475 ELECTION?
A working knowledge of what constitutes a trader, dealer, and investor for tax purposes, as well as the delineation between securities and commodities, serves as a basis for identifying those taxpayers who are appropriate candidates to make a Sec. 475 election.
Securities traders should always consider making a Sec. 475(f) election. The very nature of the trading business, which seeks to profit from “swings in the daily market movements,” suggests that most, if not all, of a security trader’s transactions will be short-term. Under Sec. 1222, income from short-term transactions is subject to ordinary tax rates, whereas losses from short-term transactions are subject to the Sec. 1211 capital loss limitation rules. Securities traders who make a Sec. 475(f) election will thus be taxed at the same rate on their income but will receive the more valuable ordinary loss treatment to the extent of any losses.
In contrast, commodities dealers generally have little incentive to make a Sec. 475(e) election. The reason is twofold. First, many commodities dealers are engaged in buying and selling so-called Sec. 1256 contracts, which include regulated futures contracts, foreign currency contracts, nonequity options, dealer equity options, and dealer securities futures contracts. For tax purposes, Sec. 1256 contracts are treated as 60% long-term capital gain or loss and 40% short-term capital gain or loss, regardless of the actual holding periods. Making a Sec. 475 election would eliminate the more favorable tax treatment of being taxed at a capital gains rate. Second, commodities dealers who hold inventory apart from Sec. 1256 contracts must separately account for the inventory gains and losses as being ordinary, so a Sec. 475 election offers no augmented benefits.
Commodities traders, in contrast to commodities dealers, fall somewhere in the middle of the decision-making continuum. Commodities traders need to closely scrutinize their business transactions before deciding whether to make a Sec. 475 election. If their trades are predominantly concentrated in Sec. 1256 contracts, commodities traders should avoid making a Sec. 475(f) election. If, however, their trades are predominantly concentrated in non-Sec. 1256 contracts, commodities traders should consider making a Sec. 475(f) election.
A taxpayer’s trading strategy is another factor to consider when deciding whether to make a Sec. 475 election. For example, if a taxpayer’s strategy involves numerous and repeated sales and purchases of the same security, a Sec. 475 election is eminently sensible; if, however, a taxpayer’s trading is premised on a buy-and-hold strategy, a Sec. 475 election may prove tax inefficient.
TIMELY ELECTIONS AND MAKING A LATE ELECTION
The specific requirements of how to make a Sec. 475 election are not contained in the Code or regulations but rather in Rev. Proc. 99-17. To make a valid Sec. 475 election, a taxpayer must submit a written statement affirming the election for the first tax year that the election is effective and, in the case of an election under Sec. 475(f), the trade or business for which the election is being made.
Existing taxpayers must file the statement no later than the due date (without regard to extensions) of the original federal income tax return for the tax year immediately preceding the election year. The statement must be attached either to that return, or, if applicable, to a request for an extension of time to file that return. For example, if an individual taxpayer wants to make a Sec. 475 election effective for 2014, the statement should be attached to the taxpayer’s timely filed 2013 Form 1040, U.S. Individual Income Tax Return, or, alternatively, with the taxpayer’s request for a filing extension for the 2013 Form 1040 (i.e., Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Return).
For new taxpayers (i.e., taxpayers who have not previously filed returns) to make a timely election, the taxpayers must place in their books and records, no later than two months and 15 days after the first day of the election year, a statement similar to the one described in Rev. Proc. 99-17. A copy of the statement must also be attached to the original federal income tax return for the election year.
Once a Sec. 475 election is made, an electing taxpayer must continue to use the mark-to-market accounting method unless the taxpayer obtains the IRS’s consent to revoke the election. Rev. Rul. 97-39 indicates that the IRS will grant revocations only in unusual circumstances. Therefore, taxpayers must consider not only the pros and cons of a Sec. 475 election in the first year of the election but also must anticipate how their business and investment dealings may unfold in the future.
For an existing business that chooses to make a Sec. 475 election, the change to the mark-to-market rules for reporting securities and commodities constitutes a new accounting method that requires attaching Form 3115, Application for Change in Accounting Method, to the taxpayer’s timely filed original income tax return for the year of change. The request will receive automatic approval if the election is proper, the taxpayer’s method of accounting properly conforms to the mark-to-market rules, and the year of change is the election year.
Notwithstanding the straightforward process for making the election, some taxpayers do not comply with all of the procedural requirements. Often, these taxpayers have sought administrative relief to file a late election under Regs. Sec. 301.9100-3(a). For a taxpayer to be granted administrative relief from the procedural Sec. 475 election requirements, the regulations require proof that (1) the taxpayer acted reasonably and in good faith and (2) the granting of relief will not prejudice the government’s interest.
To prove good faith, taxpayers must meet one or more of the following conditions: The request for relief must be made before the IRS discovers the failure to make the election; circumstances existed beyond the taxpayer’s control that prevented making a timely election; the taxpayer reasonably relied on either IRS written advice or a qualified tax professional who failed to advise about the availability of the election; or, even after exercising due diligence, the taxpayer was unaware of the necessity for making the election (taking into account the taxpayer’s level of sophistication). Notwithstanding the existence of any of the foregoing conditions, a taxpayer will not be found to have acted in good faith if the taxpayer makes the election in hindsight. A taxpayer will generally be held to have acted in hindsight if specific facts change after the original election due date that make the election advantageous to the taxpayer. Finally, even a taxpayer who is able to demonstrate good faith without the use of hindsight will nevertheless be denied relief if the election reduces the taxpayer’s tax liability and thereby prejudices the government’s interest.
Although the regulations suggest that administrative relief should be available when a taxpayer makes a late Sec. 475 election, their rigor often results in IRS denial. To date, the courts have routinely sustained the IRS’s denials, with one notable exception. In Vines, 126 T.C. 279 (2006), the taxpayer became a securities trader in January 2000 and conducted numerous trades until April 14, 2000, at which time there was a margin call on his account. Once the margin call was made, the taxpayer ceased trading. When the taxpayer filed a request for an extension of time to file his 1999 income tax return, neither the taxpayer nor his accountant knew that the Sec. 475 election existed. In June 2000, when the taxpayer learned of the election’s existence, he took immediate steps to comply. The Tax Court found that the taxpayer did not make the election in hindsight because he did not make any trades after the due date for the election and the government’s interest was not prejudiced because the taxpayer’s liability under the late election was not lower than it would have been if the taxpayer had made a timely election. Under these unique circumstances, the Tax Court held that the taxpayer met the two conditions for administrative relief.
PRACTICAL PLANNING ADVICE
Taxpayers who are dealers or traders are not precluded under the Code from making long-term investments subject to the more favorable capital gains tax rates. Proper protocol, however, requires that those taxpayers open a segregated account to hold such long-term investments and clearly identify the assets held in the account as investments. Keeping trade and business accounts separate from investment accounts will yield the most efficient tax outcomes and, when possible, enable those taxpayers to capitalize on preferential capital gains rates insofar as the latter accounts are concerned.
Another practical planning point to consider is that, absent extenuating circumstances, taxpayers who desire trader status should make trading their primary occupation. Indeed, the easiest way to negate trader status is to be employed full time in another trade or business and only dabble in spotty trading (see, e.g., Endicott, T.C. Memo. 2013-199, which requires an “almost daily” standard to qualify as a trader).
The type of entity that may benefit from a Sec. 475 election is a
final planning point to consider. If the taxpayer is a corporation, a
Sec. 475 election may prove attractive because corporations typically
have limited use of capital gains (except to offset capital losses).
Conversely, in the case of a passthrough entity (e.g., a partnership
or S corporation), a Sec. 475 election may prove disadvantageous
because it eliminates the preferential capital gain tax rate that
might otherwise be available to its individual owners.
When it comes to elections under the Code, the associated advantages and disadvantages of each must be weighed and carefully scrutinized. Sec. 475 is no exception to this rule. Taxpayers must carefully examine their portfolios and understand how the IRS classifies the type of assets in which they deal or trade in order to determine the most beneficial tax treatment available. Given the ever-growing types of financial products available to dealers and traders, this can be a daunting task. Sec. 475 elections affect not only current-year activities but also anticipated future dealing and trading activities, which makes the determination even more challenging. Once a Sec. 475 election is made, it is not easily undone, which is why knowledge and an understanding of the impact of the election are paramount.
A mark-to-market election requires taxpayers to recognize ordinary gains or losses at the end of each year in the amount of the difference between the basis and the fair market value of the securities that the taxpayer holds.
The mark-to-market method is required for dealers in securities and may be elected by commodities dealers or traders in securities or commodities, but not by investors.
Making the election has many advantages, not the least of which is that any losses incurred become ordinary losses, which qualify to be carried forward or back as net operating losses.
Once made, the election is not easily revoked, and taxpayers should also be aware that the election must be made on the tax return for the year before the taxpayer wants to first use it.
Jay A. Soled ( firstname.lastname@example.org ) is a professor of accounting and director of the Masters of Accounting in Taxation program at Rutgers Business School in Newark, N.J. Mary B. Goldhirsch ( email@example.com ) is counsel to Porzio, Bromberg & Newman PC in Morristown, N.J., and an adjunct professor at Rutgers Business School. Kristie N. Tierney ( firstname.lastname@example.org ) is an accounting student at Rutgers.
To comment on this article or to suggest an idea for another article, contact Sally P. Schreiber, senior editor, at email@example.com or 919-402-4828.
- “Tax Practice Corner: Trader or Investor?” Feb. 2014, page 56
- “Tax Matters: Securities Trader Status Not Satisfied,” Feb. 2009, page 70
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