A Wealth of Knowledge - Winter 2012 Issue - Trader vs. Investor: Introduction and Overview
Determining trader vs. investor status is often difficult, given the disparity between the goals and objectives of both. It is agreed however, that anyone who is considered to be “in the market” is making financial decisions for the sole purpose of making a profit.
Generally investors put their money into stocks, real estate, etc., under the assumption that, over a long-term time horizon, the underlying investment will increase in value, and the investment will be profitable. Typically, investors anticipate declining markets with fear and anxiety and do not have a strategy should their investment decline in value. When faced with bear markets, investors hold their positions and continue to lose with the hope that their investments will bounce back again and become winners.
On the other hand, traders generally take a short-term view towards their investing. Many traders use a systematic investment approach that utilizes mathematical algorithms which will identify when to enter and exit a position for the purpose of making a profit on fluctuations in the market.
One of the more common elements of being a trader is moving in and out of the markets frequently. How many trades does it take to justify the term frequently, and for what duration of time, and is this movement covering one specific holding or an entire portfolio? Indeed there is no predetermined rule book here; therefore, the courts have determined trader status and investor status based on the individual’s unique set of facts and circumstances, which will be discussed in greater detail later.
Lacking any specific statutory or regulatory definition distinguishing between traders and investors, the courts have articulated certain distinctions, which have been the subject of numerous case law interpretations. For example, the Tax Court’s description of an investor is one who purchases securities “for capital appreciation and income, usually without regard to short-term developments that would influence the price of the securities on the daily market.” By contrast, a trader buys and sells securities “with reasonable frequency in an endeavor to catch swings in the daily market and profit thereby on a short-term basis.” Although the courts have been able to apply factual tests which focus on the rate at which a taxpayer recycles their portfolio, the fine line between a trader and an investor continues to be a grey area and the subject of continuous controversy.
So why is there so much hoopla over determining trader status vs. investor status? Aside from the variation in the investment strategy, short-term trading vs. long-term holding, the answer is that the tax rules are generally more favorable for taxpayers who are treated as traders as opposed to being treated as an investor.
ADVANTAGES AND DISADVANTAGES OF TRADER AND INVESTOR STATUS
The tax advantage commonly sought by traders often refers to how gains and losses upon disposition of securities are reported on an individual trader’s income tax return, as well as the deductibility of various trading expenses. With proper planning, a trader’s tax attributes can be strategically used to minimize exposure to income taxes. In contrast, an investor’s gains and losses upon disposition of securities and the deductibility of investing expenses are more limited in scope as to how they are required to be reported for tax purposes. Consequently, there is a preference of having trader status.
Trading and investing expenses are similar in nature, which can include the operation of business (i.e., home office, payroll, etc.), broker fees and interest expense. The key distinction between the deductibility of these expenses by a trader or investor is whether or not the expenses are “ordinary and necessary” and are incurred in connection with a “trade or business.” The classification of these expenses by a trader reduces income dollar-for-dollar and is deducted “above-the-line” on a taxpayer’s individual income tax return pursuant to Internal Revenue Code (“IRC”) §162. In contrast, investor expenses are not considered to be business expenses, and therefore are deducted as an itemized deduction on a taxpayer’s individual income tax return subject to limitations governed by IRC §212.
TAX IMPLICATIONS ASSOCIATED WITH TRADERS AND INVESTORS
As noted above, a partnership will typically incur substantial expenses in connection with its operation, exclusive of interest expenses. If the partnership is properly characterized as a trading partnership, the general and limited partners with trader status would be entitled to fully deduct their proportionate share of the partnership’s trade or business expenses as an above-the-line deduction governed under IRC §162. These business expenses could be used to offset other business expenses from other operations.
However, not all operating expenses are deductible. Pursuant to Revenue Ruling 2008-39, a non-corporate investor (i.e., individual taxpayer) may not fully deduct management fees and other related expenses incurred by an affiliated management company (i.e., fund of funds). The basis for this ruling is that in the context of trading partnerships, where the existence of a lower-tiered partnership exists solely for the purpose of investing, these activities do not constitute a trade or business. As such, any management fee paid by the upper-tiered partnership to the lower-tiered partnership will not retain the character of a trade or business expense. Accordingly, these expenses are considered to be investment expenses subject to the limitations under governed IRC §212.
By contrast, a partnership that does not meet the qualifications of a trading partnership (i.e., investment partnership) may have similar expenditures which are classified as investment expenses and deducted by an individual taxpayer below the line on Schedule A in the miscellaneous itemized deduction section. With a true business operating expense, an individual taxpayer would not have limitations on deductibility. However, with the same expense categorized as an investment expense, only a portion of the expense may be deductible on an individual taxpayer return to the extent that the aggregate of such miscellaneous itemized deductions exceeds 2% of the individual’s adjusted gross income.
In addition to the 2% rule, miscellaneous itemized deductions incurred may have another limitation hurdle to climb in 2013 should there be a return of the 3% rule. (Prior to 2006, high-income taxpayers were only allowed to claim most itemized deduction to the extent that such deductions exceeded the lesser of 3% of the individual taxpayer’s adjusted gross income over a specified amount. Beginning in 2006, the 3% limitation was phased-out under the 2001 Tax Act. Unless the reduction or repeal is extended, the 3% phase out will return in 2013 at its permanent level.)
In addition to the 2% and 3% limitations, investors should also be concerned with alternative minimum tax (“AMT”), and whether or not their investment expenses are deductible. The reason for this is that miscellaneous itemized deductions are not deductible at all by an individual taxpayer in calculating their AMT liability. AMT is an income tax imposed on individuals, corporations, estates and trusts for the purpose of ensuring that a minimum tax rate is paid by high income tax payers. A rate of 26% applies to the first $175,000 of income and 28% once this threshold is met. To alleviate low income taxpayers from being subject to AMT, Congress has intervened in prior years and instituted an AMT patch. In 2011, the patch amount was $74,450 (married filing joint) and $48,450 (single tax filers). For 2012, the patch expired, thus the exemption amounts are only $45,050 (married filing joint) and $33,750 (single tax filers). It is anticipated that Congress will retroactively pass a patch for 2012 prior to the end of the year.
Aside from AMT and the 2% and 3% limitations, there is an interest expense deduction limitation applicable to investors. The amount of interest paid to borrow money to acquire and hold securities may only be deducted to the extent that such interest expense exceeds net investment income. Net investment income is defined as income received from investment assets before taxes such as bonds, stocks, mutual funds, loans and other investments less related expenses.
To expand on the preceding paragraph, it is important to note that interest expense is very common for both traders and investors. Under the passive activity regulations, an activity of trading personal property for the account of owners of interests in a partnership is not considered to be a passive activity. Thus, limited partners in the partnership, which by definition is not a passive activity whether or not it is a trading partnership, will be subject to the interest expense deduction limitation under IRC §163(d). On the other hand, an individual taxpayer who does materially participate in the business activities will be exempt from the limitation and the deduction will be applied above-the-line as ordinary business deduction.
Generally, when a trading partnership has some de minimis allocation of long-term investments, the courts will rule in favor of having trader status on the grounds that the partnership is actively and professionally managing its own portfolio. Of course, the regulations suggest that where the overall trading strategy of the partnership is to maintain certain positions long-term, there must be an allocation based on a “reasonable basis.”
Also available to traders are special mark-to-market rules that are made on an elective basis. Investors are not allowed to make this special election. Any gain or loss recognized under the elective mark-to-market regime is treated as ordinary gain or loss, not capital gain or loss. A mark-to-market election under IRC §475(f) applies to all securities or commodities held by the trader except any securities or commodities that the taxpayer can “establish to the Commissioner's satisfaction are not related to the taxpayer's trading activities and that are clearly identified in the taxpayer's records by the close of the acquisition date as not being related to the taxpayer's trading activities.”
If a taxpayer is engaged in two or more distinct trade or business activities as a trader, an election may be made for one trade or business, but not for the other. An election under IRC §475(f) applies to the current year and all future years and may not be revoked without the Commissioner's consent. An election applies not only to securities or commodities acquired beginning with the year of the election but also to securities and commodities acquired before the year the election was made.
The reason why the mark-to-market election is attractive for traders is that it offers a simplified method of reporting numerous annual transactions without the burden of having to worry about capital losses limitations wash sale issue.
To make a timely mark-to-market election, the taxpayer must file a statement that describes the election under IRC §475(f) the year the election is in effect and the name of the trade or business for which the election is being made. The statement must be filed not later than the due date (without regard to extensions) of the original federal income tax return for the taxable year immediately preceding the election year and must be attached either to that return or, if applicable, to a request for an extension of time to file that return.
A new taxpayer for which no federal income tax return was required to be filed for the taxable year immediately preceding the election year is required to make the election by placing in its books and records no later than two months and 15 days after the first day of the election year a statement that satisfies the same requirements cited above. To notify the IRS that the election was made, the new taxpayer must attach a copy of the statement to its original federal income tax return for the election year.
Many taxpayers hold themselves out as security traders without considering the definition established under prevailing case law or the special tax rules associated with its classification. If based on the nature of the activities, the taxpayer does not qualify as a trader, investor status will follow.
To summarize, a trader is one who seeks to profit from daily market movements in the prices of securities and not just profit from dividends, interest, or capital appreciation. Trading activities must be substantial, continuous, and regular. The classification as a trader depends on the facts and circumstances in each case, with a person holding securities for less than 30 days and having short-term trades being indicative. The extent the trading activity furthers one’s livelihood and significant time devoted also weigh favorable to trader status.
Proper classification holds the key to minimizing the federal and state income tax consequences of the trading activities with certain elections being considered for trader status only.
Most sophisticated taxpayers invest in hedge funds and private equity funds which the general partner classifies as a trading partnership with very little challenge. As Wall Street continues to develop new products, the trader vs. investor classification will continue to be ripe for audit review and ultimately litigation by the courts.
A Wealth of Knowledge - Winter 2012 Issue