Is Trader Tax Status Worth It?

As we navigate a world with COVID-19, large swings in the stock market have become the norm. Many buy and hold-style investors are more actively managing their portfolios to take advantage of these swings. The IRS has a special trader status for taxpayers who frequently engage in trading. This status includes a special accounting method, not available to the average investor, that can come with substantial tax savings. The status allows an investor to make special deductions and opens the door to a wide range of tax reduction strategies unavailable to the casual investor. However, with potential savings also come risks that could end up costing the taxpayer/trader more than the average investor. Weighing the pros and cons of this status is crucial in minimizing tax liability. The big question for tax planning is this — does obtaining trader tax status result in less tax?

What Is Trader Tax Status?

Trader Tax Status (TTS) is a special status applied to taxpayers who are “in the business of buying and selling securities.” While there isn’t a concrete test or annual election; TTS depends on the taxpayer’s individual facts and circumstances. The three primary criteria to qualify are:

1. The taxpayer must seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation
2. The taxpayer’s activity must be substantial
3. The taxpayer must carry on the activity with continuity and regularity.^[1]

This may seem simple enough, but many of the terms in the IRS guidance, such as “substantial” and “regularity” can make this status quite complicated, yet provide the flexibility to plan how to use the benefits to pay less tax. A rich history of case law demonstrates there are no numerical thresholds to make TTS a sure thing. Courts have determined that a trader who conducted 1,569 trades in a year did not qualify for TTS^[2], while a trader with 332 trades did qualify.^[3]

A taxpayer can qualify one year and not the next, or even for part of a year. However, once the IRS deems the taxpayer a trader, he or she is eligible to deduct any ordinary and necessary expenses as any other business would under §162. These deductions (and tax savings stemming from them) would otherwise not be available to investors. TTS also allows the taxpayer to elect Mark-to-Market treatment.

Mark-to-Market

Mark-to-Market (MtM) is an accounting method governed under and sometimes referred to as §475(f), under which the trader is someone who has sold all securities on the last day of the year at their fair market value (FMV). In essence, the trader is realizing for tax purposes all unrealized gains or losses and reporting them on the tax return as ordinary income and not a capital gain or loss. This benefit allows a taxpayer to deduct losses larger than $3,000 against other ordinary income and has the potential to create a Net Operating Loss, which he or she can carry to other tax years.

The taxpayer must elect MtM treatment no later than the unextended due date of the prior year’s return. For example, to elect MtM for calendar year 2021, the election must be made by April 15, 2021. The election remains in effect until officially revoked, by filing an automatic request for revocation under Revenue Procedure 2019-43, Section 24.02. It is critical that tax professionals inform qualified taxpayers about the MtM option, they can be held liable for not doing so!^[4]

Tax Benefits

The two main benefits of TTS are the taxpayer’s ability to deduct expenses and elect MtM treatment. Common business expenses include computer and internet, investment advisors and brokerage fees, margin interest, dues and subscriptions, investment-related travel, home office, and even retirement plans. A taxpayer with TTS may also be eligible for a §199A qualified business income deduction; however, it is a specified service trade or business for §199A purposes which means high income earners may not be eligible for the deduction.^[5]

Comparatively, for the non-trader, some of these expenses were deductible on Schedule A prior to the Tax Cuts and Jobs Act of 2017 (TCJA), but subject to a 2 percent floor. Even though the Tax Cuts and Jobs Act suspended those deductions through 2025, they may be eligible for a deduction at the state level.

Electing MtM moves the entire gain or loss to Form 4797, Sales of Business Property, as ordinary income. This can provide additional benefits to the taxpayer in addition to the ability to claim an ordinary loss. MtM traders can also avoid the wash loss rule, which limits the taxpayer’s ability to claim a loss on securities if he or she reacquires the position within 30 days. But with many tax benefits, there are downsides to making this election. MtM traders lose access to preferred long-term capital gains rates; however, due to the volume and frequency of trades required to elect MtM in the first place, it is unlikely an MtM trader holds investments long enough to qualify for the long term gain rates.

Risks

TTS is not without a downside. MtM traders may end up paying tax on a gain they never realize if a security peaks near the end of the year. One of the largest benefits of MtM status is the ability to deduct losses against ordinary income. However, if a taxpayer has other sources of ordinary income, he or she may not qualify for the MtM election if the amount of time spent on other income generating activities prevents them from sufficient trading activity to qualify as a trader.  

Commingling of personal investments and business trading activity without separate trading accounts can create another level of complexity for the taxpayer. The IRS can be quick to disallow TTS on examination, requiring the taxpayer to work through appeals or go to tax court to prove their case. This route can be costly from a representation and time perspective and in almost all recent cases before the tax court, the court denied TTS. The taxpayer can also be assessed a 20 percent accuracy-related penalty under §6662(a) if the TTS position is later invalidated. ^[6]

Finally, those using trader status incur another level of tax which is typically avoided by other investors. Under TTS, investments are considered inventory and profits are subject to self-employment tax of up to 15.3%. While there are legal ways to mitigate this tax, some traders find themselves footing an unexpectedly higher tax bill at tax time without careful planning. 

Entities

Using an entity, such as a partnership or corporation, for trading activity can be beneficial for the taxpayer. An entity can help segregate business and personal assets. An entity can also provide another layer of legitimacy to the business activity. It is less likely the IRS will challenge trading done in an entity’s name versus trading done as an individual. However, maintaining an entity comes with additional compliance costs. The taxpayer must file at least one additional return for the entity and may also have to put him or herself on payroll. Using an entity for trading activity can also reduce risk of audit as the rates of audit for corporations and partnerships are substantially lower than those of individual taxpayers. Finally, traders can utilize all the tax benefits associated with entities such as income shifting, lower tax rates, and the ability to reduce payroll taxes on earnings. 

Examples

Jacob is a self-proclaimed day trader, and trading is his only source of income. He averages 15 trades per day while the markets are open and conducts his trading activity in a businesslike manner. Jacob is eligible for TTS and has $17,000 worth of expenses to deduct on Form Schedule C. He can use those expenses to offset an equal amount of trading income. Jacob can also elect Mark-to-Market accounting on a timely filed return.

Andre is also a self-proclaimed day trader. He also works a full-time job as an employee and only makes a few trades per week. He spends 40+ hours a week researching stocks online but has made little profit. Andre is not eligible for TTS because his activity is not substantial, and he does not conduct the activity with regularity.

Summary

Trader Tax Status can come with substantial benefits but is not without risk. A taxpayer with TTS can deduct ordinary and necessary business expenses the average investor cannot. A Mark-to-Market election can allow a trader to shift capital gains to ordinary income, allowing a loss greater than $3,000 to be reported in a single year. An entity can help the taxpayer defend TTS and provide additional tax reduction benefits, but can also come with additional costs. The taxpayer must calculate all these benefits and risks to arrive at the correct decision for him or herself.