OptionsTaxGuy

Everybody wants to achieve “trader status” - because of the tax benefits - in similar fashion to everybody wanting to go to heaven but not wanting to die ...  there is a cost to achieve this.

Based on the above cases, a lot of taxpayers meet the time threshold in that they spend a substantial amount of time researching stocks, developing a watch list and monitoring overall stock market movement.

So why did these investors not qualify as traders?

The two major criteria illustrated in Holsinger are:

1. Substantial amount of trading, either measured in dollar or trade volume, and

2. Attempting to profit from short-term stock market movement as opposed to long-term capital appreciation and collecting dividends.

 

Cited above is Liang v Commissioner, 23 TC 1040 (1955), that provides the defining language used by subsequent courts in distinguishing between investor activities and trader activities:

In the former [investing], securities are purchased to be held for capital appreciation and income, usually without regard to short-term developments that would influence the price of securities on the daily market.  In a trading account, securities are bought and sold with reasonable frequency in an endeavor to catch the swings in the daily market movements and profit thereby on a short-term basis.

Most of courts agree on the following criteria:

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1. The taxpayer’s intent - profit from short-term volatility

2. Nature of the income from the activity - not interest, dividends or long-term appreciation

3. Frequency, extent and regularity must be substantial

 

When capital appreciation or even conservation of capital are mentioned, especially in light of the possibility of dividend income, taxpayer’s rarely prevail as a trader.  However, as options traders, conservation of capital is easily maintained with the purchase of a put close to one’s cost basis until the impending specter of a sudden downturn fades.  Even a covered call or a collar relies on “capital appreciation” when the goal is to be called out of the stock while also protecting your position - as in the collar trade.

With regard to the first criterion, Holsinger mentioned $9 million in dollar volume and 1,100 trades.  So would $7.5 million qualify? Or what about $5 million? Or what about $2.5 million?  And how is it measured?  Would churning the same shares over and over so that one’s Form 1099-B showed gross proceeds of over $2.5 million qualify?  So your portfolio, for example, could only be $275,000 and you purchase 1,000 shares of Apple at $250 per share and sell 10 calls and they are exercised each month for twelve months.  Your gross proceeds would approximate $3 million but your portfolio started at less than $300,000.

What if the same trades as above were executed only on the S&P 500 Index (SPX)?  Yaeger’s trading reached this threshold but he was deemed to be an active investor engaged in security management and not a trader.  But Yaeger invested for long-term appreciation in purchasing what he perceived to be undervalued stock and then letting it rise to its proper valuation.  So he was denied because his trading was not substantial on a round-trip basis.

So, back to our AAPL/SPX example.  Holsinger noted that a substantial number of trades were more than 31 days.  If one’s covered calls are called each month, that represents a holding period of less than 31 days and profit has been captured based on this “short-term” movement.

Here’s another example, exploring the same principles.

A pool service company owner examines a homeowner’s green pool and determines that the chemicals are drastically out of balance.  The pool service company owner determines the right amount of chemicals to apply to the pool, applies them and then waits to see the outcome.  During the waiting period he telephones or emails the homeowner as to the current condition of his pool.

Now, the pool service has fifty homeowners for whom he provides this service.  Once the initial chemicals are applied he leaves and simply calls the homeowners and/or comes by periodically to monitor the pools.

How is the pool service treated for tax purposes?  He initially treats a pool (the trade) and then monitors the application of the chemicals (watching the trade).  He may do this for twenty to over sixty homeowners during “pool season” and then just monitors their pools during non-pool season.

The pool service company owner operates a trade or business just like a trader.  What differentiates them?  Number of trades versus number of pools served or the frequency with which the pools are monitored?

The point is, the standards are higher for a trader in securities to be classified as a trade or business versus other businesses.

The classic example is the real estate agent who may work a tremendous amount of hours obtaining real estate listings, showing homes, preparing marketing and advertising media and preparing paperwork for the sale and only sell a few homes in a year.  IRS classifies that as a trade or business.  If the agent sells $1.625 million in real estate and averages 4.5% commissions, that is over $73 thousand in income for the sale of as few as 5 homes - one home every 2½ months.

The IRS, based in large part on the court cases presented, now defines in Publication 550 a number of conditions necessary to qualify as a trader.

 

1. You must seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation.

2. Your activity must be substantial

3. You must carry on the activity with continuity and regularity.

 

So, does that mean a trader cannot receive interest, dividends and hold a particular stock for over one year?  What if you had held Apple for one year ... you would have a nice long-term profit.  What if you had day-traded or swing-traded Research in Motion (Blackberry) or GoPro?  You'd be licking your wounds and finding something else to fill your time.

Just what does “substantial” mean?  In Levin, who prevailed, it was 332 trades but Holsinger lost with 372 trades.

The carrying on of the activity with continuity and regularity would seem to mean that most of one’s day is spent on trading activities.

IRS Publication 550 goes on to say that:

The following facts and circumstances should be considered in determining if your activity is a   securities trading business:

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• Typical holding periods for securities bought and sold.

• The frequency and dollar amount of your trades during the year.

• The extent to which you pursue the activity to produce income for a livelihood.

• The amount of time you devote to the activity. [emphasis mine]

 

Here again, we are left with a facts and circumstances decision on the part of the taxpayer.

The holding period issue would encompass the short-term aspect of seeking profit.  But the court cases do not define short-term.  For capital gain purposes, short-term is less than one year.  However, the cases seem to present that even a 30-day holding period is not “short-term” enough, see Holsinger [(372 trades ÷ 2) ÷ (251 trading days per year × 45%) = around 1.6 round-trip trades per day.]

 

The frequency and dollar amount issue also leaves quite a lot of latitude.  Levin won with $3.5 million and Paoli lost with $11 million.

 

The extent to which one pursues the activity to produce income is, in and of itself, easy to achieve.  If one shows a nice profit and spends some time researching stocks and options, this threshold is met.  However, IRS added, which is in none of the court cases, nor is it contained in the Internal Revenue Code or Regulations, “for a livelihood.”  Therefore, if you have another source of income, and that income is substantial, ie, retirement pension, IRA, or a spouse is earning a meaningful salary, this could be a substantial hurdle to overcome.

 

Time devoted to the activity seems to have little or no bearing if one does not initiate a “substantial” number of “short-term” trades.

 

So there you have it!  Probably more than you wanted but at least it will give you criteria to ponder before deciding if you are indeed a trader in securities.