Maximize Tax Benefits by Understanding Trader Status

Is it wise to trade in one’s own name and claim trader status?

Updated March 15th, 2023

If you are a day trader in securities, when you file a tax return with the IRS, the IRS treats you as an investor by default. Being an investor, your income from trading is classified as either long term or short term gains or losses by the IRS and is taxed as capital income. While long term capital gains enjoy a lower tax rate, this is not an ideal situation for you if you want to treat your trading as a business and generate substantial income from it.

As an investor, you must report all expenses incurred while trading as investment expenses on Schedule A of your tax return. These expenses would then only become deductible if they add up to exceed 2% your adjusted gross income before itemized deductions. You can only deduct the amount exceeding the 2% floor and only if you utilize itemized deductions.

Additionally, all trading losses incurred can only be deductible against your ordinary income up to $3000. The wash sale rule may also apply to bar you from claiming certain losses (which prevents you from claiming a loss on a sale of stock if you buy replacement stock within the 30 days before or after the sale). Because you are filing as an individual, you do not enjoy any fringe benefits and medical reimbursements or educational costs to better your trading. They would be pure expenses for you.

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Key Takeaways: Trader Status / Trader Taxation / Day Trader

• Trading in your own name and claiming trader status with the IRS has potential tax benefits but also comes with significant challenges, uncertainties, and risks.
• Qualifying for trader status is difficult and unpredictable, as there is no clear definition or criteria for being classified as a trader.
  Trader status allows for the deduction of various business expenses, avoidance of the wash sale rule, and elimination of the $3,000 capital loss deduction limit.
• Electing mark-to-market accounting, a requirement for trader status, can lead to paying excessive taxes before realizing gains on securities, and the election is irrevocable.
• Trading in your own name and claiming trader status provides no asset protection or estate planning benefits.
• A better alternative is to operate like a business using a proper business structure that maximizes asset protection, estate planning, and tax benefits.
• This comprehensive structure avoids the uncertainties and risks associated with claiming trader status and mark-to-market accounting while still providing many tax benefits and additional protection.

Trader Taxation and Tax Status

On the contrary, you may be able to claim trader tax status and elect mark to market accounting with the IRS. If you qualify for trader status, the IRS regards you as an active trader and all of your losses from trading become active, ordinary losses for tax purposes. This avoids the applicability of the $3000 capital loss deduction limit.

Because the IRS regards your primary source of income as trading, you are allowed to deduct various business expenses on your Schedule C. Expenses such as accounting fees, automobile expenses, trading software, trading advice, office equipment, and costs of attending seminars, etc. are now tax deductible to you. Further, due to the election of mark to market accounting, the wash sale rule no longer applies as well.

By now you are probably thinking, “Great! Trader status is exactly what I need.” However, you should probably hold that thought. Why? Here are the reasons why:

The Reality of Trader Taxation: Why Qualifying For Trader Status Is Difficult

If you are just starting out to trade, chances are that you will not qualify for trader status. “Trader” is not defined in the Revenue Code. The IRS has laid out general guidelines in Publication 550 regarding the requirements for trader status. To qualify as a trader, you must at the very least (1) trade substantially, regularly, frequently, and continuously; (2) seek to profit from the short term price swings of the securities. While this may sound simple, it is actually very confusing because this attempted definition is overly vague.

From the guideline itself, you may ask
“What constitutes the required frequency?”
“What fulfills the continuous requirement?”
“What qualifies as profiting from short term price swings?”
“Will trading 300 times a year qualify?”
The answer is that there is no definite answer.

The courts have attempted to simplify the determination of trader status over the years. However, these attempts have never successfully clarified exactly what a trader is under the law. There are major inconsistencies. For example, in Commissioner v. Nubar, the court found that 137 transactions a year qualified Mr. Nubar as a trader. That would lead you to conclude that 137 somehow qualifies, but there are cases where traders with over 1000 trades per year did not qualify. For example, in Estate of Yaeger v. Commissioner, the court found that despite over 1000 transactions per year in question, Yaeger did not qualify as a trader. In Holsinger & Mickler v. Commissioner, 372 trades did not qualify.

Why? The court considers many factors when deciding. In Nubar, it was the 50’s and electronic trading such as we have today did not exist. Yaeger was in 1989 and the court used the fact that the taxpayer held on to stocks for a long period of time (over a year) prior to selling to deny the taxpayer trader status. Holsinger was in 2008 and the court held that the actual days where trades occurred (i.e. the taxpayer executed 372 trades in 110 days) was a rationale for excluding the taxpayer from trader status as the trading failed the “frequency, continuity and regularity” test.

Who knows what a sufficient amount to qualify as a trader will be in 2010? In fact, based on our research since 2000, there are NO court opinions where trader status was granted. Yikes.

Over the years, the courts’ analysis of whether a taxpayer qualifies for trader status treatment really has become a true case-by-case analysis involving all aspects of a taxpayer’s trading pattern, amount, and volume. There is simply no way to predict for certain whether you will qualify for trader status when the IRS comes knocking on your door.

This is not the only reason why you should not trade in your own name and claim trader status. From the legal standpoint in assessing what structure is best for someone to do business in, three aspects should be evaluated: asset protection, estate planning, and tax. By claiming trader status and trading in your own name, you may think you have the tax arena covered, but the truth may be surprising to you. Also, you are taking a big risk with regards to asset protection and estate planning.

How Trader Tax Status Can Influence Your Asset Protection Plan

Conducting trades in your own name and claiming trader status provides no asset protection at all. All of your assets including cash, securities, and potentially real estate and equipment are sitting under your name – up for grabs by any creditors. In this litigious society, there are too many ways you could be the subject of a lawsuit. We have seen everything from car accidents involving kids, quad runner accidents, injured guests at parties, defamation suits, pseudo partnerships gone bad as well as plenty of other matters turn people’s lives upside-down. Should you unfortunately come out on the wrong side of a lawsuit and are pursued by creditors, it would simply be too late to set up any sort of asset protection structure. In fact, any structure established at such time may be pierced by the court because the sole purpose would appear to be siphoning assets away from your creditors.

Estate Planning

Trading in your own name with trader status also provides no benefit in terms of estate planning. Again, all your assets are simply exposed and disorganized under your name. This only makes the settlement of your estate more complicated and costly for loved ones.

Understanding the Benefits of Trader Tax Status

As previously described, claiming trader status and mark to market election gives you the ability to reap certain tax benefits:

• Mark to market election is not subject to the wash sale rule;
• Not subject to $3000 cap for capital loss deductions;
• Deduct interest and operating expenses as ordinary expenses.

However, once you claim the trader status, these benefits may not turn out to be as wonderful as they seem.

Electing mark to market accounting has to be done prior to the year you wish to utilize such a method. This adds uncertainty because you do not know whether you will benefit from such an accounting method at the time you elect it. Further, the election is irrevocable. Once you make the election – you are stuck.

You will need a written permission from the IRS in order to elect out of mark to market. This is very inconvenient and ironic especially considering that trading is the kind of activity where lots of flexibility and anticipation are needed.

Mark to market accounting gives you the benefit of avoiding the wash sale rule. The wash sale rule is avoided because mark to market requires you to report gains and losses on all securities held at the end of the year, even if you have not sold them. This is actually a major downfall for this accounting method because you could end up paying excessive taxes before you realize any gains on securities. For example, if a security peaks its price at the end of the year, you will have to pay taxes at that peak as if you have realized a gain even though you have not. When you finally sell such security and the price has fallen off, you essentially have paid a higher tax than you would have had to. Do you remember Qualcomm’s end of year run-ups in the late 90’s and early 2000’s. Can you imagine having to pay 20%+ in gains on stock you never sold that is now worth less than the taxes you owe? Why would you willingly put yourself in that situation?

The unlimited ordinary loss deduction available to traders is plainly a counter-intuitive idea for claiming trader status. The whole purpose of claiming such status is because you seek to trade securities and conduct such activity as a business, in order to make a profit. It makes no sense for you to claim the status in order to write off the losses. If you know you are going to lose money trading, you might as well not trade in the first place.

Further, this benefit can actually never be realized for a single taxpayer who claims trader status. The reason is because the IRS and the courts would not allow someone who has other employment to qualify as a trader. In other words, you would not have any other ordinary income other than the income from trading. However, to claim the loss deduction you would have lost money from trading. Because you have no ordinary income from trading and you are not permitted to have other ordinary income from activities outside of trading, you would not be able to write off the trading losses against anything.

Alternatives to Claiming Trader Tax Status:

Considering all three aspects (asset protection, lawsuits and taxes), for a trader, there is a much better solution than claiming trader status with the IRS and trading in your own name. Since you are serious about trading, the best solution is to operate like a business. Operating a business with a proper business structures ensures that you are treated as a business by the IRS and receive the maximum tax benefits that a legitimate business should receive.

At Anderson, we have done diligent research and carefully devised a structure that best serves this purpose for people trading in the stock market. The purpose of the structure is to maximize asset protection, estate planning and tax benefits in a comprehensive structure.

Trader Taxation Solutions:

While using a structure is not the equivalent of claiming trader status, it is a much more comprehensive and safer structure for an individual who trades. Even though the wash sale rule stays effective with this structure, it can be easily navigated by a careful trader. This structure ensures that you would not have to deal with the burden and uncertainty of complying with the requirements of the trader status. It also avoids the rigidity and risk that accompanies mark to market accounting.

The trading structure also provides you with the benefits in asset protection and estate planning, which is otherwise unavailable to individuals merely attempting to claim trader status.

In addition, it provides many tax benefits that are not available to individual taxpayers.

All in all, this is a much better system for traders in security to run as a business. If you are serious about trading, it is highly recommended that you establish the business structure rather than claiming trader.

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