Tax Benefits of Professional Trader Status
Because securities are considered capital assets, gains and losses on the sale of those securities are treated as capital gains and losses. However, some traders can choose a professional trader status, by classifying their trading as a business and using the mark-to-market method of accounting if they satisfy the applicable tax rules.
A professional trader (aka trader in securities) is one who engages in investing as a business. As a consequence, all normal or necessary expenses are deductible, and the professional trader can set up qualified retirement accounts to take advantage of the tax benefits offered by such accounts. The professional trader can also deduct relevant educational seminars, including travel and lodging expenses, expenses that a casual investor cannot deduct at all. However, probably the greatest benefit to electing the professional trader status is that no Social Security or Medicare taxes have to be paid on the income, which is equal to about 14.1% of self-employment income, up to the Social Security income cap. The savings on any income above that limit will only be the 2.9% Medicare tax, which comes out to about 2.68%, since self-employment taxes only apply to 92.35% of self-employment income.
Tax Overview of Professional Traders
Because a professional trader must use mark-to-market (MTM) accounting, there are no long-term capital gains or losses, since all open positions must be mark-to-market by yearend. Hence, all income or loss is treated as ordinary income or loss. However, this tax treatment has significant advantages:
- Losses can be used offset other income, rather than being limited to the $3000 capital loss rule.
- Trades are not subject to wash sale rules, since MTM accounting eliminates the need for such rules.
- The sale of individual securities does not have to be reported; instead, a professional trader reports the account values at the beginning and end of the tax year to determine profit or loss.
Professional traders can also have investment accounts that are treated according to the usual tax rules that apply to investments, but they must be identified as such on the day that the security is acquired; most often, this is done by keeping investments in a separate brokerage account.
The professional trader can deduct many more types of expenses than a casual trader, without limitation. The expenses that can be deducted by a casual investor are much more limited. Furthermore, they are itemized deductions subject to the 2% adjusted gross income floor. So if a casual investor claims the standard deduction, which most do, then even these limited investment expenses cannot be deducted. There is also an itemized deduction phase-out rule for claiming itemized deductions, reducing the deduction for higher income taxpayers. Consequently, many upper-income taxpayers can claim only 20% of their itemized deductions.
For instance, professional traders can deduct the full cost of any educational courses, as long as they did not take the courses to actually enter the profession. Since the professional trader status does not require a license, it would be difficult to prove that the course was taken to enter a new profession. Hence, most courses taken after the attainment of professional trader status will probably be deductible if it clearly benefits trading. On the other hand, a casual investor cannot deduct any such courses at all. Likewise, the casual investor cannot deduct meals and entertainment, transportation mileage, home office expenses, cell phones, and trader chat room fees. However, any investment losses incurred before attaining professional trader status cannot be used to offset professional trader income.
Professional traders must also pay quarterly estimated taxes. Since income can vary widely throughout the year, the quarterly payments may be a lot more or a lot less than what could have been paid given the final income for the tax year. Overpayments, of course, will be refunded when the trader files his tax returns after the end of the tax year. However, since the penalty for underpayments in estimated tax payments = the underpayment amount × IRS's short-term interest rate, it may be more beneficial simply to pay the interest.
Requirements for Professional Trader Status
According to the Taxpayer Relief Act of 1997, traders in securities engage in a trade or business involving active sales or exchanges of securities on the market, not by trading with customers. However, professional trader status is not defined by the tax code – it is defined by IRS guidelines and case law. Hence, there is a certain amount of risk in electing the professional trader status, especially since there are no bright lines in the IRS guidelines, or the court record, for that matter.
To treat trading as a business, the following requirements must be met:
- the trader must seek to profit from changes in security prices — not from dividends, interest, or capital appreciation;
- the activity must be substantial, continuous, and regular; and
- the trader must make the election to use the mark-to-market method of accounting under IRC §475(f).
Factors that the IRS considers when determining whether trading is actually being conducted as a business include the following:
- typical holding periods for the securities — shorter holding periods indicates trading to profit from short-term price changes,
- frequency and dollar amount of trades, with greater frequency and amounts indicating a business,
- whether trading is pursued to earn income for a livelihood, and
- the amount of time spent trading.
What does not matter is whether the trader calls himself a trader or a day trader.
The trading of securities is only considered a business for those securities that satisfy the trading requirements. Any other securities held by the investor are considered an investment rather than a business, and thus, subject to the investment rules. Records must be kept to distinguish between those securities that are traded as a business and those that are traded as an investment, since they are subject to different tax rules, which is generally done by keeping them in separate accounts. If long-term investments are commingled with the short-term investments in the same account, then the owner's professional trading status may be in jeopardy, since the IRS regularly audits professional traders.
Trading as a business is reported in the same way that any business reports its income and expenses, by filing Form 1040, Schedule C, Profit or Loss from Business. Other advantages of trading as a business using the mark-to-market method of accounting is that there is no limitation on the deductibility of investment interest expenses. The gains earned from selling securities are not subject to self-employment tax, since any gains or losses are reported on Part 2 of Form 4797, Sales of Business Property.
A distinct disadvantage to the professional trader status is that the trader must use mark to market accounting, which is more complex than recording sales and profits or losses. Furthermore, all capital gains and losses from trading securities are treated as short-term, so none of these trades in the professional trading account will qualify for the lower long-term capital gains rate. However, gains or losses from the trading of futures are treated as 60% long-term and 40% short-term, regardless of the holding period.
The mark-to-market election is made by attaching a statement with the following information:
- that the election is being made under IRC §475(f);
- the name of the business or some other designation that distinguishes the trading business from other activities by the taxpayer; and
- the 1st tax year for which the election applies.
The election must be made before the non-extended due date of the previous tax year. So the deadline for making the election for 2015 is April 15, 2016.
Since the mark-to-market election requires a change of the accounting method for reporting gains and losses, the taxpayer must file Form 3115, Application for Change in Accounting Method. If the request conforms to Revenue Procedure 2011-14, then permission will be automatically granted. Once the election is made, the trader can only revoke the election by seeking permission from the IRS, by re-filing Form 3115 to change the accounting method and paying a fee to effect the change.
Warning! Professional Trader Status May Be Revoked
Judging by some court cases, the IRS seems to require day trading or at least very short-term trades. Trades must also be conducted on most of the trading days during the tax year. Additionally, most of the income must be earned from capital gains, not from interest or dividends. Otherwise, the IRS may decide that the professional trader is actually an investor, thereby revoking the professional trader status, which will incur a hefty liability of back taxes, penalties, and fines. If the trader wants to make longer-term investments, or investments that pay interest or dividends, then it should be done in a segregated account, outside of the business. The risk is that there are no bright lines distinguishing the professional trader from an investor, so if the IRS disputes the professional trader status, it may be difficult to win in such a case, especially if the taxpayer is operating in a gray area.