Online Trading Academy Lessons from the Pros 04/5/05: How Do You Qualify as a Good Trader? Good Question!

Traders Accounting: How Do You Qualify as a Good Trader? Good Question!

How Do You Qualify as a Good Trader? Good Question!
By Jim Forrester, CPA

Traders Accounting provides tax consulting, entity formation, tax preparation and 401(k) services that help you efficiently establish and maintain your trading business. They teach you the IRS rules that allow you, as a trader, to deduct the widest range of business expenses and fringe benefits available to business owners. The goal is to help you lower your taxes, save you time, and maximize the benefits of your trading business. Visit their web site at: www.tradersaccounting.com

How Do You Qualify as a Trader? Good Question!

If you're a new securities trader or thinking about becoming one, you're probably wondering: What's all this fuss over trader tax status? You make your trades, report your income, select your accounting method and voile - you're a trader, right?

Not exactly. Although you may buy, sell and profit in securities, futures and foreign exchange, unless you do so in such a way as to qualify for "trader in securities" status with the Internal Revenue Service, come tax time you won't be enjoying the numerous tax advantages reserved for traders only.

The fuss over trader status lays in the definition - or rather lack of definition - as to what constitutes a securities trader in the view of the IRS. In its attempt to separate true securities traders from the greater herd of hobbyists and investors, the IRS has issued a general set of guidelines. To qualify for trader status:

You must seek to profit from daily market movements in the prices of securities and not from dividends, interest or capital appreciation;
Your activity must be substantial, and
You must carry on the activity with continuity and regularity.

To help determine if you meet these three tests, the IRS considers these qualifiers:

Typical holding periods for securities bought and sold;
Frequency and dollar amount of trades during the year;
Extent to which you pursue trading to produce income for a livelihood, and
Amount of time you devote to the activity.

Clearly, these guidelines contain any number of trap doors through which the unsuspecting trader might fall at any time. For instance, what exactly is meant by "substantial" activity? Or "continuity and regularity?"

So far, the IRS has left further delineation in the hands of the tax court, whose rulings tend to uphold the denial of trader status without shedding much light on how individuals might qualify for trader status in the first place.

Courting a Consensus

Court rulings on trader status date back at least six decades:

In Higgins v. Commissioner (1941), the Supreme Court ruled that although the plaintiff had a vast operation, its primary purpose was merely to record his trades, and hence denied deductibility of his investment expenses.

In Estate of Yaeger v. Commissioner (1989), a similar large-scale, fulltime trader was denied trader status because he held his securities for long periods of time, and hence was considered an investor, not a trader.

In re Frederick R. Mayer (1994), the court ruled that Mayer, like Yaeger, was an investor because, although he bought frequently, he profited primarily from long-term holding periods.

In re Rudolph Steffler (1995), the plaintiff was denied trader status because he conducted a very small number of trades each year.

In re Stephen A. Paoli (1991), the court ruled that the plaintiff's trading activity was concentrated primarily during one time of the year with little activity occurring the rest of the year, and hence was not continuous, resulting in denial of his trader status.

In re Frank Chen (2004), the court denied trader status based in part on the fact that "securities trading was not the sole or even primary activity in which the taxpayer engaged for the production of income," casting a shadow over the status of all part-time traders.

How can you be sure that the trader tax status you enjoy today will still be there tomorrow? In lieu of specific language in the IRS code that more clearly defines the qualification for trader status, the best way is to establish a legal entity for your trading business.

Also, a Traders Accounting tax professional can help you choose from among the most popular legal entities - limited or general partnership, C Corporation, limited liability company (LLC) - the structure that makes the most tax sense for your business. Just click here and register for a FREE Tax Action Plan! Again, the plan is free so sign up today at http://www.tradersaccounting.com/taxplan.asp

Jim Forrester, CPA is the Tax Director of Traders Accounting, the nation's leading provider of tax consulting, entity formation, tax preparation and 401(k) services to the trading industry. Traders Accounting teaches traders how to properly set-up their trading business and take advantage of all the money-saving tax strategies available to home-based businesses. Explore the website that Forbes has declared "Best of the Web" for six straight years and find out exactly how to make your trading into a 'business' and receive tax breaks and tax deductions worth up to $25,000 each year. Visit www.tradersaccounting.com for more info.