Another Diversion while Tax Law Legislation for 2010 Is Settled – The Trader Tax

• IRON100
• December 18th, 2009

I have to confess that this week I have been working on my own trading blog, working on my own taxes (yes, it is that time of year again), and doing some equipment repair, so I am not as completely prepared to write the normal treatise in the Tax Law Changes for 2010 series. That legislation is still being formulated in Congress, so there will be plenty of time to cover it in the very near future. I decided that I would provide at least an initial response to a reader request regarding the Trader Tax (Covered in IRS Topic 429) and the steps one might take to start some kind of trading business.

As I think most of you know, I do pretty much all of my "aggressive" (meaning short-term, higher risk trading strategy) trades within my Individual Retirement Accounts. In that way, I avoid most of the problems associated with tax accounting issues, as there are no tax consequences in the IRA. I have other investment and business entities (primarily limited liability companies (LLCs)) that I can flow expenses through as the revenues come in. There are, however, good reasons to form a trading business when it comes to expenses. The key characteristics for deciding the right business entity to use are basically:

1) Where you live, which will determine the applicability of one-member for multiple member limited liability companies (LLCs) as opposed to Subchapter C or Subchapter S corporations. The classification and qualification for single member LLCs and multiple member LLCs vary state-to-state within the U.S.A.

2) The nature of other income that you receive from working or other forms of non-securities related investing. That will ultimately determine which form of business you will choose in item one to maximize your income legally under United States tax law. The reason for that is revenue can flow and be taxed differently for corporations than for LLCs and that income can be legally sheltered under the proper business entity.

The rules for traders are specified in IRS Publication 550 the latest copy of which is linked in blue from the IRS website.

Without getting too deep into the discussion (as I have a longer-term plan in mind), one must be willing as an individual in a trading business to follow the rules that qualify one to be considered a trader. The rules are somewhat vague, but include the following:

1) One must seek to profit from daily movements in the price of securities bought and sold and not from dividends interest or capital appreciation (remember, long term capital gains kick in after a year and a day).

2) One's activity must be substantial, and

3) One must carry on this activity with continuity and regularity( Those are the words of the IRS, and not mine. Those terms need further clarification, and I will find some).

As stated in Publication 550, certain facts and circumstances come into play when determining whether one is a trader, among them are:

1)      the typical holding period for securities traded

2)      frequency of trades and size of trades during the course of a given year

3)      Extent to which an income is derived from this activity

4)      The amount of time one devotes to trading

 

There are also the issues of marking to market and separating investments from trading capital. With regard to marking-to-market, one would calculate the value of trading capital at the end of each day, and not at the end of the transaction (particularly if it were held for less than a year and a day, qualifying it as a short-term gain). If one wishes to mark-to-market, one must ELECT to do so by April 15 of the applicable tax year. It is already too late to do so for 2009, but can be done for 2010 if one files under Section 475(f) of the Internal Revenue Code by April 15 of 2010.

What marking to market allows one to do is to lump all expenses associated with trading onto a Schedule C form as business expenses and report all gains and losses on Part II of Form 4797. Investment security gains as losses would continue to appear on Schedule D (Form 1040) and all investment expenses would be handled on Schedule A (Form 1040).

A word of warning for the above set up. If one is smart, one should never trade shares in stocks that one owns for investment, because any confusion in such matters will set alarms off with the IRS in most cases. There should be a clear separation between the trading and the investing activities, as marking-to-market is a way to claim revenues from which all expenses may be written off. The type of business entities used to do that need to be discussed at another time. One must keep accurate records at all times for this entity to work.

Here is what I will do. Since I am an editor and am not owner of this blog, I am going to avoid recommending tax help at this point. Here is why:

1)      I do not want it to appear as an endorsement of one firm or another (nor, I doubt StockTwits.com does either, and                                                                                               

2)      I want YOU to determine that for yourself as a trader. In most cases around the USA, you will even find tax attorneys in many cases unwilling to work with you if you are in a trading business, as these businesses are not seen frequently in flyover country. You will likely have to find some specialized help (and there is a lot of competent help in that arena)

What I will do this week is to purchase a book that covers these topics (by a competent source of this information) and I will set out to make generic but helpful recommendations as to the types and forms of businesses and their tax structures for trading operations, and then let you run with it from there. Remember, individual states tax rates, tax policies, and legal business entities vary, so making a uniform recommendation is impossible. Still, I think I can point you in a direction that will help you find the right answers. From that point, you can find your own specific advice to fill in the empty spaces in terms of knowledge.

At some point, I may myself set up a trading business, but because of my current business structure, I want to keep my business forms simple (as I do not want to become a paper shuffling bureaucrat. Life is too short for that). I know how to minimize taxes and expenses. I simply do not want to confuse the issue with the IRS in terms of accounting for revenues. That is why I have avoided a trading business entity up to this point in my life. I also sat in briefly on a teleconference dealing with the proposed trader tax, and that could at some point affect tax accounting in trading businesses, further adding to tax filing complications.

Because of my interest in trading business formation, I will attempt to guide you through that wilderness. I would also appreciate anyone in the StockTwits community to add their expertise into this mix as well. I think we have the smartest investment community in social media. If one wants to contribute to this project, e-mail me at buffalotrader100@gmail.com. We can discuss your contribution in depth.

Sorry to end this abruptly, but I will gather information as I go. Make sure to read IRS Publication 550 and search for trader classification. All the basic forms, rules, and documents are included within its pages. The quest to provide you up to date issues on this and other personal finance issues goes on. Thanks so much for reading and participating!

Tickers: IRS, IRS Topic 429, Publication 550, trader designation for tax purposes, trading expenses

blog comments powered by Disqus