How to Qualify for Tax-Favored Securities Trader Status

It’s advantageous for short-term investors to qualify as traders, rather than investors, for federal income tax purposes. Unfortunately, there’s no bright-line distinction between trader and investor status. Here’s an overview of the IRS and U.S. Tax Court guidance to help determine if you qualify as a tax-favored securities trader.

Review the IRS Guidance

According to the IRS, you must meet 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 factors to help determine if you engage in the business of trading securities:

• The typical holding periods for the securities you buy and sell,
• 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 your trading activities don’t amount to a business, you’re considered an investor. It doesn’t matter if you prefer to call yourself a trader or a day trader.

Important: You can be a trader in some securities and hold other securities for investment. The special federal income tax rules apply only to your trading portfolio. So, you should 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.

Take the Trader vs. Investor Quiz

What’s the right classification for your trading activity? In the absence of specific IRS definitions of the terms “trader” and “investor,” ask yourself these seven questions to help you get it right.

1. Do you spend significant time researching and executing your trades?

The more time you spend on trading-related activities, the more likely you’ll be considered a trader. A good rule of thumb might be that traders spend at least 16 hours a week on such activities.

2. Can you demonstrate a regular and continuous pattern of averaging several round-trip trades for every day the market is open?

A so-called “round trip” consists of a buy and the related sale. Traders usually engage in at least 1,000 trades per year. Although traders can take vacations like everybody else, they generally can’t go weeks or months without any trading activity. However, exceptions may be allowed if, for example, the market is dropping and you have no borrowing capacity to sell stocks short.

3. Are you strictly playing short-term positions?

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

A 2015 Tax Court decision illustrates this point. In Poppe, the taxpayer was found to qualify as a securities trader for the year in question because he: 1) executed about 60 trades per month, 2) devoted four to five hours per day to trading on days when the markets were open, and 3) always traded during the last hour of the day when there’s heavier market activity. His trading was largely in stocks and options that were held for less than one month. (William Poppe, TC Memo 2015-205.)

4. Can you answer “yes” to all the preceding questions for an unbroken string of at least six months?

If these six months are the last six months of the year, you’re 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, unless you answered “yes” to everything so far, you’re probably an investor rather than a trader.

“Yes” answers to the following questions are preferred, but not mandatory. If some of your earlier yes answers were 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 make money after all deductible expenses?

Examples of deductible items include the costs of online investment advice services, computer hardware/software and seminars. While traders are allowed to have bad years, the tax law says a legitimate business activity generally must be profitable at least three years out of five. If you don’t have that much history yet, making a net profit (however small) always helps.

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

People with full-time jobs may not have time to participate actively enough in trading activities to qualify for trader status. A 2014 Tax Court decision highlights this point. In Assaderaghi, 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 second 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.

The Tax Court found that taxpayer didn’t qualify for trader status—but didn’t provide any bright-line thresholds for making this determination. However, it looked at earlier decisions in which the 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. Likewise, in earlier decisions, the court 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. (Fariborz Assaderaghi, TC Memo 2014-33.)

7. If you claim trader status for last year, will you also be able to do so for this year?

Traders 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.

Tax Benefits to Trader Status

From a federal income tax perspective, traders potentially may enjoy the following three important advantages over garden-variety investors:

1. Exemption from the annual limit on deductible net capital losses,
2. Exemption from self-employment tax on their net trading profits, and
3. Exemption from the burdensome wash-sale rule

This tax-favored treatment isn’t available to everyone who buys and sells securities. Contact your SSB tax advisor for more information.

Seeking Outside Guidance

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. (See “Tax Benefits to Trader Status,” above.)

The question of who qualifies as a trader is subject to interpretation. Contact your SSB tax professional to help decide what’s right for your circumstances.