T
A X F O C U S
Trader or Investor? The IRS Knows ...
By Dan Katsoudas, CPA
There are lucrative tax write-offs for day traders
whose investing qualifies as a business, but passing muster with
the IRS takes a firm grasp of reality.
If you're not careful, your vision of tax savings
can turn into an audit nightmare. It all comes down to whether the
IRS thinks you're a day trader or an investor.
And there's a big difference:
- Day traders who buy and sell from their own portfolios
may qualify as a "trade or business" in IRS lingo and deduct investment
expenses as business costs on Schedule C, Profits from a Trade
or Business.
- Investors generally are limited to claiming some expenses
from trading as itemized deductions on Schedule A. As such, those
deductions must surpass 2 percent of your adjusted gross income
to qualify.
The profits on securities are generally claimed as
capital gain, not ordinary income. But for someone in a trade or
business, their losses may be considered capital losses, and in
a down year that means the deduction may be severely limited.
Qualifying for tax consideration as a trader engaged
in a business is tough to pull off and requires meeting some stringent
standards with the gnomes at the IRS.
Which are you?
The IRS actually recognizes three types of people operating in
financial markets under the tax law: dealers, traders and investors
in the market. For our purposes, a dealer is someone who buys, sells
or holds stocks or bonds for customers. A dealer's income is based
on commissions, and he has ordinary income or losses -- not capital
gain or loss on the rise or fall of market prices.
The more ticklish question is separating traders from
investors in the eyes of tax auditors. What constitutes a trader
isn't defined in the tax code so the definition has evolved in court
rulings. For the IRS, the entire assessment will require a look
at the specific facts and circumstances of an individual case, according
to IRS Technical Coordinator Joe Calderaro.
What the courts say
The courts have held that traders generally receive profits from
short-term swings in market prices -- people who buy and sell frequently
but don't have customers. By definition, this would exclude someone
who gets a large chunk of income from long-term capital gain or
dividends. Long-term gains and dividends suggest to the IRS you're
an investor.
In addition, courts and the IRS couple the type of
income with a look at how much time and effort you devote to trading.
If you have a large volume of trades on a regular basis that will
go a long way to convincing the IRS you're a trader.
But if you only occasionally trade in the market or
if you have a discretionary account with a broker who engages in
short-term trading for you, you're more than likely going to be
considered an investor, subject to capital gain limitations.
A federal appeals court in San Francisco distinguished
traders from dealers in a 1991 ruling by noting that traders are
sellers of securities or commodities who depend upon a rise in value
or advantageous purchase that allows them to sell at a profit. A
trader doesn't engage in merchandising and gets no compensation
by commission.
Calderaro said the IRS has been very strict about
allowing Schedule C, trade or business, deductions for people claiming
to be traders.
"Even if you are only trading for yourself, and even
if you have substantial trades, we're going to look at whether you
hold yourself out to be in a trade or business, or whether this
is simply an investment account," he said.
Audit targets
The IRS headquarters in Washington couldn't identify any specific
audit projects aimed at the day trader practices. But along with
the growth in on-line trading, there has been a predictable growth
in the numbers of people claiming Schedule C, business deductions
as traders.
This means the IRS may start looking closer. Audit
projects are most likely in areas the practice proliferates such
as the New York, Chicago or the West Coast.
Usually, the IRS tests the level of potential abuse
in sample audit projects to determine whether they need to focus
more resources on stopping what it considers illegal deductions.
If you think your level of day trading qualifies you
as operator of a business, contact a tax expert that understands
specific rules involving investment instruments and get an assessment
of what you may safely claim.
Dan Katsoudas is a Certified Public Accountant
with the firm of Wakefield, Darby and Lawrence in New York City.
He may be reached at dkatsoudas@investmentlife.com.
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