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. Thus, all normal or necessary expenses are deductible, and the professional trader can set up qualified retirement accounts to benefit from the tax savings 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 limit. Before 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 if they did not take the courses before attaining professional status. 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. 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 regular investment accounts treated according to the usual tax rules that apply to investments, but the account must be identified as such before any securities are acquired for the account.

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, electing professional trader status is risky, especially since IRS guidelines or the court record have no bright lines to distinguish the professional trader from the casual investor.

To treat trading as a business, these 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:

• 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 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.

Mark-to-Market Accounting

If a professional trader chooses mark-to-market (MTM) accounting, all capital gains or losses are short-term since all open positions must be marked to market by year-end, so none of these trades in the professional trading account will qualify for the lower long-term capital gains rate. Hence, all income or loss is treated as ordinary income or loss. However, the mark-to-market election 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 need not be reported; instead, a professional trader reports the account values at the beginning and end of the tax year to determine profit or loss.

The mark-to-market election is made by attaching a statement with this 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 1^st 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 Year 1 is Tax Day in April Year 2, when the return for Year 1 is due.

Since the mark-to-market election requires a change of the accounting method for reporting gains and losses, Form 3115, Application for Change in Accounting Method must be filed.

This election may be revoked by attaching a revocation statement to your tax return for the year before when the change is to be effective. Permission will be automatically granted if the request conforms to Revenue Procedure 2011-14.

Why Professional Trader Status Eliminates Self-Employment Tax Liability

Trading expenses are reported by filing Schedule C, Profit or Loss from Business. Other advantages of trading as a business is that there is no limit on the deductibility of investment interest expenses or other expenses of the business. 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 is an unusual feature with the professional trader status: how 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, so Schedule C will always show a loss. Self-employment tax is calculated from the net profit from Schedule C. So, without a net profit, there is no self-employment tax.