Do you qualify for trader status in the eyes of the IRS? Take this quiz to find out

Do you qualify for trader status in the eyes of the IRS? Take this quiz to find out

The recent GameStop

short-squeeze saga made for compelling drama. On a practical note, it brings attention to the issue of who is eligible for the favorable federal income tax treatment that’s available to individuals who trade stocks with sufficient intensity to qualify as securities traders. I covered the tax advantages of trader status in a previous column.

Less-favorable tax treatment applies to folks who actively trade in stocks, but without sufficient enthusiasm to be classified as anything other than garden-variety investors with short attention spans. 

Unfortunately, there is no bright-line distinction between trader and investor status. Instead, we must rely on murky IRS language and some court decisions for guidance. In this column, I’ll explain what I think it takes for you to qualify as a tax-favored securities trader. Here goes. 

What the IRS says about ‘securities traders’

According to the IRS, you must meet all of the following three conditions to be properly classified as a securities trader for federal income tax purposes. 

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

2. Your activity must be substantial.

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

Consider the following in determining if you engage in the business of trading securities.

1. Your typical holding periods for securities bought and sold.

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

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

4. The amount of time you devote to the activity.

If your trading activities don’t amount to a business, you’re considered an investor and not a trader. It doesn’t matter if you prefer to call yourself a trader or a day trader. 

Key point: You can be a trader in some securities and hold other securities for investment. The special federal income tax rules explained in my earlier column only apply to your trading portfolio. You are advised to keep detailed records to distinguish securities held for investment from securities bought and sold in your trading business. Securities held for investment must be identified as such in your records on the day you acquire them. The easiest way to meet this requirement is to simply hold all your investment securities in a separate brokerage account. So, please do that. 

Key point: You can be a trader in some securities and hold other securities for investment

Now take the quiz to see if you qualify as a securities trader

As stated above, the IRS doesn’t consider you to be a securities trader just because you like the way it sounds. But the government also hasn’t gotten around to clearly defining the term. All we have to go by are court cases, some of which were decided long before anyone imagined that folks would be clicking the “trade now” buttons on their computer keyboards or mobile devices while waiting for the microwave oven to count down. Nevertheless, I’m going to step out on a limb and tell you how I think you should make the call on your status.

Please take the following quiz.

1. Do you spend lots of time researching and executing your trades? Just to pick a figure, I’d say you need at least 16 hours a week to be a trader. Of course, more is better.

2. Can you demonstrate a regular and continuous pattern of averaging several “round trips” (a buy and the related sale) for every day the market is open? Vacations are allowed. But you can’t have weeks or months without much going on unless you have a good reason like the market is dropping and you have no borrowing capacity to sell stocks short. Having at least 1,000 trades a year is good. Less could be problematic.

3. Are you strictly playing short-term positions? Getting in and out of all your positions on the same day proves you intend only to profit from short-term market swings, as befits trader status. While every round trip doesn’t have to be a day trade, most should be, and holding some stocks for as long as a month or two flushes your claim to be a trader unless these are very isolated instances. You can, however, keep longer-term holdings in a separate investment portfolio without jeopardizing your trader status, as explained above. 

Instructive Tax Court decision: In the facts underlying a 2015 decision, the taxpayer was found to qualify as a securities trader for the year in question because he executed about 60 trades per month, devoted four to five hours per day to trading on days when the markets were open, and always traded during the last hour of the day when there is heavier market activity. His trading was largely in stocks and options that were held for less than one month.   

4. Can you answer yes to all the preceding questions for an unbroken string of at least six months? Of course, all year is best. If the six months are the last six months of the year, you are probably OK. Starting and stopping after six full months but before year-end may allow you to claim you entered the business of trading and then abandoned it. But that is pushing the envelope. Unless you answered yes to everything so far, you’ve already flunked. You are an investor in my book. Sorry.

If, however, you’ve made it this far, then yes answers to the remaining questions are preferred but not mandatory.

If some of your earlier yes answers were a bit shaky, resounding affirmatives to the remaining questions will bolster your case for claiming trader status. On the other hand, two or three no answers weaken your position, even if you have nothing but solid yes responses to the earlier questions.

5. Did you actually make money after all your deductible expenses (online investment advice services, computer and software costs, seminars, etc.)? While traders are allowed to have bad years (just like baseball players), the tax law says a real business generally must be profitable at least three years out of five. You probably don’t have that much history yet, but making a net profit (however small) always helps.

6. Can you say you have no regular full-time job or profession?

I believe you can be a part-time trader while also having a regular job. Some court decisions agree. But the IRS is skeptical.

Instructive Tax Court decision: In the facts underlying a 2014 decision, the taxpayer worked full-time as a corporate vice president of engineering. He also traded securities on the side. During the two tax years in question, his trades included security purchases and sales, put and call options, and short sales. In the first year, he executed 535 trades on 154 days. However, over half of those trades occurred in just three months (January, June and July).

In the following year, the taxpayer executed 180 trades on 94 days, but he traded on fewer than 10 days each month from January through June. In the first year, the taxpayer had $2,659,696 of gross trading receipts, and he had $349,991 for the following year. In earlier decisions, the Tax Court concluded that making 189, 204, 289, 303, 313, and 372 trades in a year was insufficient to qualify for trader status, but that making 1,136 and 1,543 trades was sufficient. In earlier decisions, the Tax Court further opined that having $754,277 of gross trading proceeds in one year was insufficient to qualify for trader status, but gross trading proceeds of nearly $15 million was sufficient.

In the 2014 decision, the Tax Court found that taxpayer was found to not qualify for trader status. IMHO, this conclusion was too strict, but it is what it is.  

7. If you are claiming trader status for last year, will you be able to do so for this year as well? Remember you are supposed to be in the continuous business of trading stocks. A multiyear commitment looks more like a business, while a one-year (or shorter) commitment looks more like an aborted investment strategy or a hobby. Granted, a restaurant can rise and fall in the same year, and so can your business of being a trader. It just doesn’t look as good. Having said all that, this question is probably the least important one in this quiz.

That concludes the quiz, which is nothing more than my humble interpretation of some court cases along with what I think are appropriate adjustments for the online trading era and the recent trend of very-short-term stock holding periods. If you’re trying to sort this out for yourself, please seek a tax pro’s help.

The bottom line

The recent GameStop day trading saga illuminates the issue that individuals who actively trade in stocks can potentially qualify as securities traders for federal tax income purposes. This is important, because traders are eligible for favorable tax treatment, as explained in my earlier column. However, the question of who qualifies as a trader is subject to interpretation. Deciding the question is more of an art than a science. You can take my word for what it takes to be a trader, but I suggest getting your tax pro’s input as well.   

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