“Trader Tax Status” Takes Another Hit by the IRS

kay, comissioner, trader taxWhat does it take to be a “trader” for tax reporting purposes?  Obviously not $20 million in purchases and sales over a 3-year period according to the Tax Court in Kay v. Commissioner

Facts:  Between 2000 and 2002 Mr. Kay, the owner an operator of a ball bearing manufacturing and distribution business, embarked on an uncharted journey into the business of stock trading.  As the boss in his day job, Mr. Kay had ample time to ply his skills in the stock market.  After obtaining advice on how to claim “trader status”, Mr. Kay made a valid MTM election to be a “Trader” and was off in search of his fortune. 

Excited and ambitious was Mr. Kay in his passion for the ticker but caution, as any successful businessman knows, must be respected.  So after careful study and planning, Mr. Kay entered into the following number of targeted transactions over the corresponding days: 73 days and 313 transactions in 2000; 18 days and 72 transactions in 2001; and 21 days and 84 transactions in 2002.

Unfortunately Mr. Kay’s new found love for the market was not reciprocated and on his Schedule C, Profit or Loss from Business, on which Kay indicated his principal business or profession as “day trader,” Mr. Kay claimed $1,960,060 in losses from sales of stocks and $92,577 in expenses for 2000; $399,162 in stock losses and $578 in expenses for 2001, along with a $1,396,943 net operating loss (NOL) carried over from 2000; and $262,921 in stock losses and $15,376 in expenses for 2002, along with the same $1,396,943 NOL carried over from 2000.

Despite his setbacks Mr. Kay was not unduly discouraged and may have continued but for the IRS’s disallowance of his trading related expenses of over $93,000 and stock losses beyond the $3,000 limit.  Mr. Kay appealed this setback but lost and here is why.

Why Trader’s Lose in Court:  The Tax Court looks at the facts and circumstances of each case (IRS code does not constrain the Court when it comes to traders because the code does not exist) and in the present case it found Mr. Kay’s trading activity was (1) not substantial, i.e. it wasn’t frequent, regular, and continuous enough to constitute a trade or business; and (2) he didn’t seek to catch the swings in the daily market movements and to profit from these short-term changes rather than to profit from the long-term holding of investments. 

As to the first requirement, the Court found that Mr. Kay’s trading activity wasn’t substantial because he traded only for a small portion of the trading days during each year at issue (typically you must trade every day with a reasonable amount of days off), the number of trades wasn’t substantial (minimum threshold appears to begin north of 350 trades per year), and he didn’t rely on his trading activity as his sole or primary source of income (give up trying to support yourself from another job, your trading must pay the bills), but rather relied on income from his ball bearing business.   The Court did recognize the fact Mr. Kay traded over $20 million in both purchases and sales, but size doesn’t matter. 

As to the second requirement, the Court found that Mr. Kay generally couldn’t let go (don’t fall in love with your stocks be prepared to discard daily them like a used piece of tissue – nothing good comes from keeping either around for too long) by holding on to his positions for over 30 days on average.  Longer holding periods tend to indicate investment vs. trading activity (2 to 3 round trips a day may keep the IRS away). 

This case illustrates the frustration individuals face when struggling with the facts and circumstances query of a trader v. investor. Facts and circumstances are akin to a schoolgirl determining a boy’s love from the pulling of pedals off a dandelion.  Why leave your tax status to chance when you can traverse safer waters by creating a Trading Business. Let us show you how by either calling our office or downloading our Trader Status report for more information on creating your own Trading Business.

Posted by Clint Coons

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