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Trader Status and U.S. Income Taxes – Part One

[Ed: Member karmcon submits the following important information. Part Two will appear tomorrow after the close.]

The “How-to’s” of making the election for 2007 U.S. Individual Income Tax purposes, the Pro’s and Con’s of making the election on federal income tax computations and a few important documentation requirements to remember.

Important:  the information provided is true and factual to the best of my knowledge as a CPA.  However, it is in no manner or interpretation to be considered complete. I will provide the appropriate IRS publications and/or IRC section citations where you can find other important information concerning the section or procedure discussed.  You should discuss with a tax professional before you proceed with any directions and/or suggestions mentioned in this article.  State tax laws are not discussed.  The information provided herein should provide you with the ability to correctly organize and separate data you provide to your accountant and/or to identify the additional forms you will have to complete when filing your federal tax return,  Compilation of Form 3115 (Change in Accounting method and discussed below) should probably be completed by  an accountant.

Phil’s Stock World web site and it’s affiliates, owners or representatives do not have direct or indirect knowledge of the validity of the statements contained herein, and, therefore can not express an opinion on or confirm the correctness of any statement.  Accordingly they have no expressed or inferred liability for the opinions or statements of the author.

Before we delve into the procedural and pro-con discussions of the trader in securities election, it is imperative that each individual determine if they meet the IRS’s definition of a “trader in securities”. If you are a licensed broker or dealer you are not eligible to make this election. 

Special rules apply if you are a trader in securities, in the business of buying and selling securities for your own account. To be engaged in business as a trader in securities, 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 substantial and thus, a securities trading business:

  • 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, and 
  • The amount of time you devote to the activity. 

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”.  This is one area where the IRS will come down hard on you if you elect trader status inappropriately.  (It is very similar to the hobby loss rules.  I have seen physicians lose tens of thousands on horse breeding farms or stables and then claim as a business loss only to wind up with an audit.  Their claim of, why would I do this as a hobby and lose all this money never works because most times they can afford to lose real dollars because of the cash flow from their jobs as physicians.  In other words, if you have some doubts whether you meet the trader definition; you probably don’t, so understand the audit roulette casino you’re entering if you decide to elect anyway).  W-2 wages, 1099’s listing non-employee income and distributions of capital gains and interest are red flags to the IRS when the amounts are significant.  Large losses incurred by a legitimate trader in securities can also raise an eyebrow of the IRS. I am not saying claiming losses or expenses that you have documents to substantiate are disallowed or illegal; just that this is an area of your tax return you don’t want to inflate deductions and/or losses. 

Making the “Trader in Securities” Election

In general, the “tax trader” election (referred to as the mark-to-market election in the IRS documentation, as explained below) must be made by the due date (not including extensions) of the tax return for the year prior to the year for which the election becomes effective. (Translation = file in 2007 for the election to be in effect for the 2007 tax year.)  The election is made 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:

  1. That you are making an election under section 475(f) of the Internal Revenue Code;
  2. The first tax year for which the election is effective; and
  3. The trade or business for which you are making the election
  4. Include the name and social security number of the person making the election.

Refer to the “form 1040, schedule D instructions” for further instructions on how to make the tax trader, or, mark to market election.

So for the 2007 tax year, if you qualify to make the election (and wish to make the election after reading the pro’s and con’s section below) you must file the statement referred to above on, or before April17, 2007.  If you file an extension simply attach the statement to your extension and mail both with a postmark on, or before, April 17, 2007.  When filing your extended tax return you must attach a copy of the election again.  The election is good for all subsequent tax years.

After making the election to change to the “tax trader” or mark-to-market method of accounting, you must change your method of accounting for securities under Revenue Procedure 2002–9, as modified by Revenue Procedure 2002–19. This requires filing form 3115, (Application for Change in Accounting Method). The procedures for making an election are described in publication 550 under the section called "Special Rules for Traders in Securities". You may also refer to Revenue Procedure 99–17.

I have heard the main reason for the IRS requiring Form 3115 is to cause many persons to just say, “fork it!!” and then they don’t make the election. Many of you may be thinking the same, but I firmly believe the tax savings you will receive will justify the minor headache or the 1-2 hours (at most) of a tax professional’s billing to formally complete the election.  You will also be able to understand from some of the specific rules highlighted below that many of the IRS rules and regulations stem from the (religious right’s?) belief that this business of day-trading is actually just gambling in disguise.  Accordingly, they make it a little less easy for those contribute-nothing-to- society, working in their underwear, money loving scoundrels to comply with the election rules that some gambling-loving, payola-purchased senator was able to piggy-back on page 210 of an important, and unrelated, legislative bill!  But, I digress.

Next time:

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  1. Wow Karmcon,

    Great stuff. . Gave all my tax stuff to CPA and taxes already done. . Didn’t even have a clue about the trader status

  2. I’ve heard that its valuable (if ever audited) to have a journal, or some log of your planning and trades beyond the broker’s statement, in order to prove the amount of time and time duration that you dedicated to trading as ‘your business’ -

  3. Thank you Karmon, this is very helpful.


  4. John, if you have already filed your 2006 1040 you can file another “version” on or before April 17, 2007 without needing to amend your first one. Technically, you could file an unlimited number of different versions of the federal income tax return on or before the due date. The IRS accepts the last filing received. I would imagine if there were multiple filings received that it might cause an audit flag, but many people receive tax information after their initial filing and refile prior to the due date. It is very common to file a more complete tax return prior to the due date. If you qualify, and desire to make the election, for 2007, simply refile your 2006 return with the election attached on or before April 17, 2007. (Normally the due date would be April 16, 2007, since April 15 is on a Sunday, but April 16 is a holiday in Washington D.C (for some reason I cant remember) so the due date has been extended until the 17th.)

    TW, as always when dealing with the IRS, the more detail and documentation you have to support a position, the better. This is especially true in this instance if you have other sources of income that indicate you “could” have a primary business or position NOT as a trader in securities. Also, don’t forget that the election is for the 2007 calendar tax year and NOT for 2006.

  5. Thanks so much Karmcon!

  6. karmcon

    Thanks for the effort and the article.

  7. In the eyes of the IRS, is the trader status a claim that trading is intended to be your primary occupation and source of income or that it is intended to be a significant portion of your occupation and income?

  8. Thank you Karmcon, I am looking forward to the second part. What good and generous people we have on this site. Thanks again.

  9. Great info !!! Looking forward to tomorrow’s post. Thanks, Mark.

  10. mrn,

    This election applies if trading of securities is your PRIMARY occupation. Of course there are people that have two full-time jobs, but if you wind up claiming a loss for your position as a trader and have significant employment income from another source you will be playing audit roulette in the IRS casino (and their roulette wheet has better odds than the standard casino’s 35:1). It is possible to have both, but I would strongly suggest talking with your tax professional before making the election.

  11. Thanks all and your welcome.


  12. Karmcon – Thanks and great job!

  13. Thank you Karmcon.