Trader Tax Status (TTS) plays a significant role in accessing various key tax breaks for businesses, such as business expense deductions, business ordinary trading losses through the Section 475 election, and the ability to deduct employee benefit contributions for retirement plans and health insurance premiums. These benefits are deducted from gross income without any restrictions, unlike investment expenses, which are subject to itemized deductions, AMT preferences, and Pease limitations. Additionally, there are limitations on capital losses and wash sale loss deferral adjustments for investors. Unfortunately, only a small fraction of active traders qualify for TTS, and the rules can be vague and confusing. TTS remains advantageous both before and after tax reform efforts. While Congress and President Trump were working on tax reform in 2017, any changes were not expected to take effect until 2018. To optimize tax planning, traders were advised not to wait for concrete plans but to act based on the current law in 2017, hoping that the tax reform would favor their planning. TTS is an excellent option for 2017, and tax reform could potentially make it even more appealing by offering a lower tax rate on business income and possibly repealing investment expense deductions. Thus, traders may find that TTS becomes even more attractive after tax reform.
Determining whether you qualify for TTS is the first step. Unlike other tax statuses, there is no specific election for TTS; it is based on the facts and circumstances of each case. Consequently, a trader may qualify for TTS one year but not the next. It is akin to checking if bread has risen (TTS) or remains flat (investor tax status) after baking it each year. If a trader elected for Section 475 treatment and later fails to qualify for TTS, they must suspend using Section 475 treatment until they requalify since it is conditional on TTS eligibility. It is possible to qualify for TTS for part of a year. For example, if a trader qualified for TTS in 2016 but ceased active trading on June 30, 2017, they can include the period of qualification on their tax return and deduct business expenses during that part-year period. In such cases, Section 475 can also be used for the TTS period. TTS allows traders to use business expense treatment for their trading expenses instead of the default investment treatment. This brings significant advantages, including full ordinary deductions for various expenses like home-office costs, education, Section 195 start-up expenses, Section 248 organization expenses, margin interest, tangible property expensing, Section 179 (100%) depreciation, amortization on software, seminars, market data, stock borrow fees, and more. The benefits offered by business expense treatment are far superior to investment expenses, which do not allow for deductions like home-office and education expenses. Moreover, investment expenses are only deductible as miscellaneous itemized deductions in excess of 2% of adjusted gross income (AGI) and are not deductible against the alternative minimum tax (AMT). Investment expenses are further limited by the "Pease" itemized deduction restriction for taxpayers with AGI above specific thresholds. The great advantage of TTS is that traders can claim it after the tax year ends; there is no need to make an election in advance as is required for Section 475 MTM and the forex election to opt out of Section 988. Traders can claim TTS for the tax year that just ended and even for the previous three tax years with amended returns, by including a Schedule C as a sole proprietor for individual accounts or by changing the character of expenses on Schedule K-1s for entities. However, filing amended tax returns may raise the chances of IRS inquiries or examinations, so traders should be sure of their status.
Full-time traders generally have an easier time qualifying for TTS, while part-time traders face more challenges. The IRS sets a higher bar for part-time traders, particularly if they have significant trading losses with business ordinary loss treatment (Section 475) rather than capital loss limitations.
The IRS relies on case law and Publication 550, "Special Rules for Traders," to determine eligibility for TTS. While there are no objective tests defined in statutory law, case law suggests two critical criteria for TTS:
1. Taxpayers' trading activity must be substantial, regular, frequent, and continuous.
2. The taxpayer must aim to profit from short-term market movements rather than from long-term investments. Publication 550 outlines certain factors that the IRS considers when determining if a taxpayer's activity qualifies as a securities trading business, including typical holding periods for securities bought and sold, the frequency and dollar amount of trades made during the year, the extent to which the activity is pursued to produce income for a livelihood, and the amount of time devoted to the activity.
While there is no bright-line test with exact numbers, based on trader tax court cases and experience with IRS and state controversies, some Golden Rules have been formulated for qualifying for TTS:
1. Traders should engage in full-time or part-time trading regularly throughout market hours. Part-time traders should demonstrate enough volume and frequency to meet the Golden Rules.
2. Traders should spend more than four hours per day, almost every market day, working on their trading business. This includes activities like research, administration, accounting, education, and more. Most active business traders spend more than 40 hours per week on their trading business, while part-time traders usually spend more than four hours per day.
3. Traders should have few to no occasional lapses in trading activity. Extended breaks from active trading may affect TTS qualification, so traders should explain such breaks in their tax-return footnotes.
4. Traders should execute trades on close to four days per week, every week, or approximately 75% of available trading days. Trading should carry actual economic risk.
5. Traders should make around 720 total trades per year (annualized basis). The court has considered having 60 trades per month as sufficient volume, and each buy/sell or open/close should be counted as two total trades.
6. Traders should have proceeds in the millions of dollars per year on equities to demonstrate their active trading status. Traders using futures or forex should provide an explanation in footnotes, as proceeds for these instruments are not reported on 1099s.
7. Traders should have an average holding period of 31 days or less, as holding period is considered a critical factor by the IRS.
8. Traders should have the intention to run a separate trading business, even if it is not their exclusive or primary means of making a living. The key is that the trading activity contributes to their livelihood.
9. Traders should have significant business equipment, education, business services, and a home office to demonstrate the seriousness of their trading business operation.
10. Traders should maintain sufficient account size to qualify for Pattern Day Trader (PDT) status if trading securities. For futures and forex, an account size of over $15,000 is recommended.
It's essential to note that certain factors do not qualify for TTS, including fully automated trading without much trader involvement, using professional outside investment managers, and trading in retirement funds. Furthermore, traders should be aware of the potential risks and challenges associated with seeking TTS status and carefully consider the implications before making any decisions.
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