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 they can also choose to use 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. The greatest benefit to electing professional trader status may be that no Social Security or Medicare taxes have to be paid on the income, 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
The professional trader can deduct many more types of expenses than a casual trader, without limitation. Previous to the 2017 Tax Cuts and Jobs Act (TCJA), expenses deductible by a casual investor were much more limited as itemized deductions subject to the 2% adjusted gross income floor. However, the TCJA eliminated these 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 courses were taken to enter a new profession. Hence, most courses taken after the attainment of professional trader status will 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.
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 done by keeping investments in a separate brokerage account.
Advantages of Mark-to-Market Accounting
If a professional trader chooses mark-to-market (MTM) accounting, then there are no long-term capital gains or losses, since all open positions must be marked 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.
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 some risk in electing the professional trader status, especially since no bright lines in the IRS guidelines or the court record distinguish the professional trader from the casual investor.
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 considered by the IRS to determine whether trading is 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 satisfying the trading requirements. Any other securities held by the investor are considered an investment rather than a business, and thus, subject to the usual tax rules regarding investments. Records must be kept to distinguish between those securities traded as a business and those traded as an investment, since they are subject to different tax rules, usually done by keeping them in separate accounts. If long-term investments are commingled with 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 expenses are reported by filing 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.
There are some disadvantages to using mark-to-market accounting. All 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, this is not really a disadvantage, since all trades must be short-term,.
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 2023 is Tax Day in April, 2023, when the return for 2022 is due.
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. This election may only be revoked by receiving permission from the IRS, by re-filing Form 3115 to change the accounting method and paying a fee for the change.
Why Professional Trader Status Eliminates Self-Employment Tax Liability
There is an unusual feature with the professional trader status, especially in the way that income and expenses are reported. Ordinarily, if you have a business, then both income and expenses are reported on Schedule C, Profit or Loss from Business. However, professional traders only have income from trading securities.
If regular accounting is used, then:
- trading income must be reported on Form 8949, Sales and Other Dispositions of Capital Assets,
- then the income is transferred to Schedule D, Capital Gains and Losses.
- From Schedule D, the income is transferred to Form 1040.
If mark-to-market accounting is chosen, then:
- income is reported in Part 2 of Form 4797, Sales of Business Property.
- Then the income is transferred to Schedule 1, Additional Income and Adjustments to Income of Form 1040.
- Then the income is transferred to Other Income from Schedule 1 on Form 1040.
Income is never transferred to Schedule C. However, business expenses can only be listed on Schedule C, which means Schedule C will always show a loss.
Self-employment tax is calculated from the net profit from Schedule C. So, if there is no net profit, then there is no self-employment tax.
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 longer-term investments or investments that pay interest or dividends, then those investments should be held in a segregated account, outside of the business. Without bright lines to distinguish the professional trader from an investor, the IRS may dispute the professional trader status, making the election of professional trading staus risky. It may be difficult to win such a case, especially if the taxpayer is operating in a gray area.
So, consult with a professional tax advisor. Be sure to select a tax professional who has experience with trader status, to ensure that you are complying with the law. A professional should be able to answer any detailed questions that you may have, but understand that that is no guarantee that the advice is correct. However, penalties may be avoided or lessened if you relied on the advice of a tax professional.