Generally, with respect to securities transactions individuals are investors for tax purposes. However, the IRS allows a special tax status if you are a “trader in securities, in the business of buying and selling securities for your own account.” Under the special provision noted herein, the “law considers this to be a business, even though a trader does not maintain an inventory and does not have customers.”
To be eligible for the classification, you must meet all of the following conditions:
- You must seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation;
- Your activity must be substantial; and
- You must carry on the activity with continuity and regularity.
The following facts and circumstances should be considered in determining if your activity is a securities trading business:
- Your typical holding periods for securities bought and sold… generally, the longer your holding period, the less likely you are to meet this guideline;
- The frequency and dollar amount of your trades during the year… the guidelines don’t give exact figures as it is considered on a sliding scale… day traders meet this guideline pretty easily;
- The extent to which you pursue the activity to produce income for a livelihood… the more of a side hustle it is, the less likely you are to have this point covered; and
- The amount of time you devote to the activity… same as above.
So how easy is it to get trader status? Pretty easy… if you’re actually a trader (especially a day trader). The folks who generally have a problem are the side hustle folks who want the benefits of the designation. If you’re one of these people, be very careful. The IRS will audit you for years past and crack you over the head for claiming the designation without actually meeting the criteria.
What happens if you don’t meet the requirements? Pretty simple actually…
If the nature of your trading activities does not qualify as a business, you are considered an investor and not a trader. It does not matter whether you call yourself a trader or a day trader, you are an investor. A taxpayer may be a trader in some securities and may hold other securities for investment. The special rules for traders do not apply to those securities held for investment. A trader must keep detailed records to distinguish the securities held for investment from the securities in the trading business. The securities held for investment must be identified as such in the trader’s records on the day he or she acquires them (for example, by holding them in a separate brokerage account).
In other words, unless you meet all of the requirements… and easily I might add, you are an investor and not a trader.
- Like calling yourself a trader to impress the ladies? Have at, but won’t work with the IRS.
- Working on the building the best business in the world for yourself (day trading)? Awesome, but make sure you meet the requirements before you go calling yourself a day trader to the IRS.
Incidentally, things like having a separate legal entity for your trading business, separate bank accounts for said business, and, basically, getting after it as a day trader will take you a long way toward meeting the requirements for Trader Status.
The primary benefit of Trader Status has to do with the Mark To Market (MTM) election. Under that election, capital loss limits and wash sale rules do not apply. Depending on your trading approach, this can be an enormous deal.
Making the election is pretty simple.
In general, a trader must make the mark-to-market election by the due date (not including extensions) of the tax return for the year prior to the year for which the election becomes effective. You can make the election by attaching a statement either to your income tax return or to a request for an extension of time to file your return. The statement should include the following information:
- That you are making an election under section 475(f);
- The first tax year for which the election is effective; and
- The trade or business for which you are making the election.
Refer to the Form 1040, Schedule D Instructions (PDF), Capital Gains and Losses, for more information on how to make the mark-to-market election. It is important to note that in general, late section 475(f) elections are not allowed.
After making the election to change to the mark-to-market method of accounting, you must change your method of accounting for securities under Revenue Procedure 2015-14. In addition to making the election, you will also be required to file a Form 3115 (PDF),Application for Change in Accounting Method (see Revenue Procedure 2015-13). Publication 550 describes the procedures for making an election under the section called “Special Rules for Traders in Securities.” Non-filing of the Form 3115 mentioned above will not invalidate a timely and valid election.
Note, once the election is made, it remains in force unless and until you take the steps to revoke it.
If you have made a valid election under section 475(f), the only way to stop using mark-to-market accounting for securities is to file an automatic request for revocation under Revenue Procedure 2015-14, Section 23.02. Under that revenue procedure, the request for revocation must be filed by the original due date of the return (without regard to extensions) for the taxable year preceding the year of change. This revocation notification statement must be attached to either that return or if applicable, to a request for extension of time to file that return. Late revocations will not generally be allowed except in unusual and compelling circumstances.
Sound like fun? Great, have at. But be sure to check out Topic 429 – Traders in Securities (Information for Form 1040 Filers) before you start making moves… in fact, make a reference copy for yourself.
And before you take any steps at all, be sure to talk to your accounting/tax advisor.
Hope it helps…