For more information
scroll down to the bottom or click here! |
BEING A TRADER-
THE BEST KEPT SECRET AROUND
Introduction
Most people don’t realize that being
in business is the last great tax reduction opportunity left. In fact,
as noted in our tax strategies system, we actually have two tax systems.
One is for employees, and one is for business. If you are an employee,
you can deduct your home interest, property taxes, charitable contributions,
and IRA’s or 401(k) contributions- that is until some sort of
flat tax or consumption tax is passed. However, if you are in business,
you get all the deductions that employees get plus you can
deduct part of your house, vacations ,education for kids(if done correctly),
some automobile expenses and set up a pension plan that makes any
government pension seem paltry by comparison and much more.
Wouldn’t it be great if you could
take advantage of all the business deductions that traditional and
home-based business owners get by simply trading in stock and securities
for your own account. You can, if you are a deemed a "trader."
Overview
When buying stocks and bonds, you are
considered to be one of three types of entities: a dealer, an investor
or a trader. We will discuss all the pros and cons of each category.
However, being a trader has a lot of the advantages of the other two
categories with few of the disadvantages. All gains and losses from
securities results in a capital gain/loss. Moreover, all investment
related expenses are business expenses deductible on Schedule C as
with all other types of business expenses noted in our Tax Strategy
program. Moreover, traders can claim deductions available to most
home-based businesses if the trading occurs out of the home. Thus,
this is one circumstance where you can " have your cake and eat
it too."
Who is a Dealer
A dealer is someone who has an established
place of business and regularly purchases securities for resale to
customers. In addition, the courts generally note that
to be a securities dealer, you must be licensed in securities and
have an office that sells stocks and bonds.
Observation
The IRS will rarely even consider you
to be a dealer if you are not licensed in securities and work for
or own a securities brokerage. Even if this is the case, it is still
rare to be treated as a dealer in your own portfolio. Thus, most people
will not be considered dealers.
Advantages of Dealer Status
If you are a dealer, you can deduct all
investment expenses as a business deduction. In fact, even expenses
normally not deductible by investors(such as convention and seminar
expenses) would be deductible by dealers. Dealers can, therefore,
set up qualified pension /profit sharing plans and even claim home
office expenses if the business is operated out of their home. Moreover,
if there is a loss from their activity, the loss may be used against
any form of income(such as wages, interest, dividends, pensions etc).
Any loss that exceeds your yearly income may either be carried back
two years or carried forward twenty years and offset future income
from any source. Finally, unlike investors, dealers may sell
securities at a loss and buy it back shortly thereafter and still
claim the loss. Investors and traders must wait at least thirty days
after the sale to buy back the security to keep the loss.
Disadvantages
of being a Dealer
The one significant disadvantage is that
all income is ordinary income, and thus, you can rarely take advantage
of long term capital gain rates that can be as low as 10%. In addition,
Dealers pay social security on all income including stock sales.
In addition, dealers must recognize gains and losses on all inventory
on hand as if they sold it on December 31. This is called mark to
market. All gains recognized is considered ordinary income and
all losses result in ordinary losses not capital losses.
Observation
Unless you own a stock brokerage company,
don’t worry about being classified as a dealer. You will probably
either be an investor or a trader.
What is an Investor
For the most part, court decisions have
treated taxpayers as investors. In fact, it is very difficult not
to be classified as such. The following are factors that the courts
examine in order to be classified as an investor:
- A major source of income is dividends or interest,
- Generally holds securities long term or at least
six months,
- Doesn’t generally have lots of frequent
trades(usually less than 200 per year).
Example: Mary buys and sells stocks
and options for her own investment account. She usually holds stocks
for at least one year or more and conducts about 50 trades a year.
She makes substantial income from dividends from her stocks.
Her status would be deemed to be an investor.
Advantages of being an Investor
Without question, the single biggest advantage of
being an investor is that most gains constitute long term capital
gain. The rules for long term gain have been greatly complicated by
the Taxpayer Relief Act of 1997. Who says tax relief and simplification
go hand in hand because they don’t!! The capital gain rate is
dependent on the length of the holding period and your current tax
rate. The following chart summarizes these rates:
|
Holding Period
|
Capital Gain Rate
|
Other Requirements
|
Less then 12 months and a day
|
normal tax rate (15%-45+%) |
None |
More than 12 months
|
Maximum rate of 20% |
None |
More than 12 months
|
Maximum rate of 10% |
15% tax Bracket |
Disadvantages of Being an Investor
Congress is very good at giving benefits
and taking some back. It is their way of increasing taxes without
anyone knowing. This may be a major reason so many Congressmen and
Senators get reelected. Investors have some serious disadvantages.
They can not deduct any expenses of attending a convention or seminar
on investing. This disallowance applies to food, lodging and transportation
as well as the cost of the actual seminar. Yuch! Moreover, investors
are also subject to some of their investment interest being disallowed.
Investment interest(such as margin interest) is limited to investment
income. However, you may carryover any excess and use it against investment
income in the future! In addition, you would think that capital
gains count as investment income. Think again!! In an effort to raise
taxes without anyone knowing, Congress noted that capital gains don’t
count as investment income for purposes of offsetting investment interest. However, in order to avoid too much criticism, Congress allows investors
to elect to have all capital gains treated as investment income. However,
before you run to make this election, you should be aware that any
election to treat capital gain as investment income will invalidate
you from using the much lower long term capital gains rates for that
year.
Example: John has $5,000 of margin
interest(investment interest). If he has $2,000 of dividends and $10,000
of capital gain resulting from the sale of stock, he may only use
$2,000 of investment interest. The remainder gets carried forward.
However, if John elects to treat his capital gains as investment income,
he may use the full $5,000 of investment interest to offset his gain.
Making the Election
You may make the election by filing IRS
form 4952. This form must be filed by the due date for you tax return(including
any extensions).
Observation
It usually is NOT advisable to make this
election if you have substantial long term capital gain. However,
if most of your gain is short term or if you have a lot of investment
interest with little investment income(i.e. dividends and interest),
you may want to make this election.
Major Investor Problem
The major problem for investors is that
most of their investment expenses such as newsletter subscriptions,
computer charges, accounting fees etc. are subject to numerous phase
outs. First, all allowable investment expenses must exceed 2% of your
adjusted gross income. Only the excess is deductible as an itemized
deduction. Adjusted gross income simply means interest, dividends,
stock gains, wages, pensions etc. with some limited deductions(such
as for moving expenses). If this isn’t bad enough, most of the
remaining investment expenses(except investment interest) is then
subject to another threshold amount. Most itemized deductions such
as investment expenses get eliminated. The rule is that for every
$10,000 of adjusted gross income that you make in excess of $124,500(for
single or joint filers), you loose $300 of itemized deductions. However,
this disallowance never exceeds 80% of your itemized deductions.
Example: Scott has $7,000 of investment
expenses such as stock advisory fees, management fees, and newsletters.
Assuming his adjusted gross income is $200,000, he first is subject
to the 2% rule. This means that 2% of the $200,000 of investment expenses
are eliminated. This leaves him with $3,000 of investment expenses
that are deductible as a miscellaneous itemized deduction. He then
is subject to the 3% rule. Thus, since his adjusted gross income exceeds
$124,500 by $75,500, he would loose another $2,265 dollars of itemized
deductions(which include home interest, property taxes, state income
taxes, charitable contributions and investment expenses. In short,
Scott, will not be able to deduct most of his investment expenses.
He can only deduct $735.
Observation
Welcome to the beginning of flat and
consumption taxes. You are taxed on your income but get to deduct
very little expenses against it. As you can see this is a big disadvantage
for investors and for the public at large. The main hidden goal of
most of these tax reform proposals is to raise taxes.
Trader Overview
As you can see being an investor has
some big advantages(capital gains on security sales) and some big
offsetting disadvantages(either no deduction for expenses or phase
outs of those deductions that would be allowed.) There is a third
category available to you. This category is called a trader. Amazingly,
many people are not aware of this status and are also not aware of
how beneficial this status can be. Traders get many of the advantages
of being a dealer with the ability to get capital gains on stock,
bond and option sales. Thus, it achieves the best of all worlds yet
eliminates most of the negatives.
Trader Advantages
There are a number of advantages to being
considered a trader. First, all gains from the sale of stock, bonds
and options are treated the same way as with investors; they result
in capital gains and capital losses. However , as you will learn,
most of the gains and losses must be short term in duration.
Secondly, and most importantly, traders
may treat all investment expenses as business expenses and not as
itemized deductions. Traders are deemed to be in business. This
means that , as a trader, you can deduct all convention and seminar
expenses that are directly related to your trading business(unlike
an investor) and all investment expenses are deductible with no thresholds(as
with a dealer). Moreover, you can deduct all other reasonable business
expenses since a trading business is considered to be a business as
any other type of business. In fact, the expenses are reported on
IRS Schedule C and not as itemized deductions. Thus, there is no 2%
elimination or 3% threshold amounts that must be exceeded as with
investors. In short, you get the best of being a dealer without most
of the negatives of being an investor.
Example: Susan has $20,000 of
gains as a trader and has incurred $4,000 of investment expenses such
as stock advisory fees, safe deposit fees, accounting fees and management
fees. The $20,000 is capital gain(probably short-term) and the fees
are completely deductible dollar-for-dollar on Schedule C.
In addition, traders are exempt from
the investment interest limitations just like dealers because traders
are deemed to be in a business. Traders may also use the mark to market
rules like dealers and recognize gain and loss on all securities held
on December 31. Last, but not least, a trading business is NOT
subject to social security taxes unlike most traditional businesses.
What is a Trader
Amazingly, there is no Internal Revenue Code sect
ion defining "trader status." However, there are literally
dozens of cases dealing with the subject. Thus, the concept
of being in the business of trading your own securities is well established
in tax law. The cases note that being a trader lies somewhere between
being a dealer and being an investor. Although "Trader status"
is a factual question, there are a number of factors that the courts
examine in order to determine whether you meet this status.
Traders trade securities on a frequent
and regular basis in order to catch the short term market swings.
This frequency must be regular. Simply working hard at managing your
portfolio is not enough if your trading is not frequent and regular.
Thus, in one case Mr. Boatner was held to be an investor and not a
trader even though he worked 40-60 hours a week in managing his portfolio
because he only had 5-12 days of trading per year. Moreover, the tax
court has held that 29 purchases and 22 sales in a year was not deemed
frequent enough. Like wise, only 75 transactions per year wasn’t
held to be frequent and regular enough. In one case, however,
332 transactions worth a total of 3.2 million qualified the taxpayer
as a trader. Here the taxpayer not only put in a substantial
amount of time in managing his portfolio but also talked to officers
of companies. He also attended numerous lectures on security and investment
topics and on trading.
Observation
You can never get enough training. You
should document any training that you attended and any other day-
to- day activities involved in managing your portfolio. A good diary
works wonders here.
The transactions should be throughout the year
and not solely over a short period:
In fact, even large number of transaction
are not enough if made in a short period of time. Thus, in one case
a taxpayer had 326 substantial transactions in a year. Normally, this
would be enough to constitute being a trader. However, 40% of all
transactions occurred in a one month period.
Observation
Being in business is a year round occupation. The
courts have not allowed trader status for people who don’t have
numerous transaction all year round!
- Traders do not have a substantial amount
of dividends, interest and long term capital gains
Regardless of the frequency of transactions,
if a substantial part of your income is from dividends, interest or
long term capital gains, you will be deemed an investor and not a
trader. This point cannot over emphasized. A great illustration
of this is found in two cases. Mr. Moeller had over 1000 transactions
throughout the year. He was not held to be a trader because
most of his income was comprised of interest and dividends.
A great but gross example of this point occurred in a little publicized
case call Ropfogel. Here that taxpayer had over 12,000 transaction.
You certainly can’t beat this for frequency and regularity.
However, because most of the profit came from dividends and long term
capital gain and not short term gain, he was held to be an investor.
Likewise, having a thousand or more transactions during the year is
immaterial regardless of how hard you work or how much time you put
in if most of your gain is long term gain.
Observation
There are numerous other cases involving
this issue. The bottom line is that traders hold securities, for the
most part, for a short period of time(usually less than 30 days).
This results in most gains being short term and very little dividends
accruing.
- Most of the gain should be short term gain
from securities held less than 30 days
As noted the type of income that you
generate is very important. Traders trade for short term market swings.
They usually do not hold stock for long term gains like investors.
This is a vital distinction. Mr. Mayer was a good illustration of
this point. He worked full time managing his portfolio. He has
enough transactions that a brokerage firm provided him with an office.
He had over 1000 purchases and sales during the year totaling over
one million shares. However, only 6% of these shares were held less
than 30 days. Most were held long enough to obtain long term capital
gain(at that time there were a six month holding period for long term
gain). The court held that Mr. Mayer was not a trader but was an investor.
Interestingly, Mr. Mayer was so upset with this decision that he fought
IRS twice on this issue in two different courts by altering some minor
facts. I guess some people don’t take a hint.
Observation
Traders can have some long term gain.
If you feel that you have a winner, you surely can hold on to it for
a long period of time. Although there is no hard and fast rule as
to how much of your gain must be short term, a good rule of thumb
should be that approximately 80-90% or more of all securities purchased
should not be held for more than 30 days.
Hot Tip: Since traders must hold
most securities under 30 days, if you want to hold some securities
over a longer term, put the title to these securities in a different
name. You could title the securities in the name of your kids, spouse
or even set up a separate corporation for your investments.
The best entity for a trader is a flow
through entity. Your options are either an S corporation, LLC taxed
as a partnership or a single member LLC. For overall ease and maximum
protection an LLC may be your best choice (this depends upon your
SE level also).
As in any business, you must materially
participate in order to deduct business expenses above business income.
This means that you must be involved in your business regularly and
continuously. This generally means working at least 500 hours per
year and putting in more hours than anyone else. Likewise, you
should be making all purchase and sales decisions. If you are delegating
this responsibility to money managers, you may well be treated as
an investor and not as a trader. A good rule of thumb is as
follows: the more involvement by you and less by others- the better!
The Greater the Volume, the Better!
There are certainly no numbers set in
stone as to what amount of funds should be at stake to be a trader
or what amount of shares should be traded. Most cases leaning
toward trader status usually involved hundreds of thousands of shares
per year. Note: you do not need this amount per transaction. It is
a per year figure. You may not need to trade this many shares yearly.
Probably the cases that have appeared in the courts with these high
numbers have done so because of the vast amount of money involved.
You may very well be able to be deemed a trader with as few as a couple
of hundred shares traded weekly. To be safe, however, the higher the
volume traded per week, the better!
Treat your Trading Business as a
Trading Business for IRS Purposes
This simply means that put the beans
in the right jar. If you are a trader, file schedule C for your expenses
and document your business expenses well.
In short, if you read our analysis of
what constitutes a trader, you will get a good "feel" for
what criteria are important in being considered a trader. This should
provide a strong framework for you to plan your business.
What Expenses are Deductible as
a Trader?
As noted above, being a trader means
that you are in business. You can, therefore, take all the ordinary
and necessary business deductions that most other "traditional"
businesses get. In addition, there generally are no limits, phase
out, thresholds to exceed to these expenses. Many of the business
expenses that are available are found in our Tax Advantage system.
However, the following is an overview of some of the more usual trader’s
expenses:
Safe deposit box rentals
- Accounting and bookkeeping fees
- A portion of your home expenses (ie. Depreciation,
maid service, utilities, taxes and interest)
- Car expenses allocable to your business
- Subscription for investment publications and
periodicals
- Books on investing, trading, and security analysis
- Seminars on investing, trading and security analysis
- Video and audio tapes on investing and on security
analysis
- Tax advice
- Equipment depreciation for business (computers,
calculators, cell phones, tape recorders)
- Any investment reporting service
- Salaries of assistants and helpers
- Brokerage fees (which may be added to basis or
subtracted from sales price)
- Meals and Entertainment of analysts, brokers
and other related people
- Season tickets (where business related discussion
occurs before or after the event)
- Golf, movies and plays (where business related
discussion occurs before or after the event)
- Qualified plans and IRA’s
- Travel to care take investments or meet with
money managers or corporate officers
- Deduct the equivalent of your children’s
education and weddings by hiring them
TAX TREATMENT SUMMARY FOR DEALERS, TRADERS AND
INVESTORS
DEALERS
|
Type of Investment
|
Character of Gain or
Loss |
Investment/ Interest
Expenses |
Business Expenses
|
| Stock or bonds |
Normal tax rates for gains and losses |
Business Expenses |
Business Exp. |
| Stock options |
Capital gain-60/40 Lt/St |
Business Expenses |
Business Exp. |
INVESTOR
| Stock or bonds |
Capital gain/loss |
Investment Exp. (with limits and thresholds) |
Investment Int limits |
| Options |
Capital gain/loss |
Investment Exp. Limits |
Investment Int.limits |
TRADER
| Stock or bonds |
Capital gain/loss |
Business Expenses |
Business Interest |
| OptionsCapital gain/loss |
Business Expenses |
Business Expenses |
Business Interest |
Copyright 1998 by Sanford Botkin and Lori Kaplan.
All Rights Reserved
Reproduced in part for NCP,Inc. with
the permission of Sandy Botkin and Lori Kaplan.
How to Keep Your Business in the Top 5%!