I get frequent emails from readers wanting to know how to qualify for trader tax status.
Since the IRS is not very clear in their “rules” of trader status, I rely on the trader tax cases that have gone to court for a better idea of what the IRS looks for in determining if someone qualifies as a business trader. Well, as luck would have it, another investor lost their battle with the IRS over their claim of trader tax status recently.
RECENT COURT CASE
The court’s decision in Sharon Nelson vs. Commissioner (TC Memo 2013-259) provides another glimpse at what the IRS focuses on if they question your trader status. Let’s review the case.
For tax years 2005 and 2006, Sharon resided in California with John Zabasky. Even though they were not married, Mr. Zabasky had access to trade in Sharon’s brokerage account. In 2005, Sharon claimed $470,473 in short term capital gains on her individual tax return. In 2006, she claimed $36,852 in short term capital gains. Believing that she qualified for trader status, Sharon also filed a schedule C for her expenses, claiming $504,117 in 2005 and $303,910 in 2006.
I don’t have the time or space to cover it here, but most of the expenses she tried to claim have me scratching my head. For instance, in all the years I’ve been doing trader taxes, I have never seen a trader try to claim “advertising” expenses. I do believe the enormous size of her claimed “expenses” triggered the audit from the IRS.
In reviewing the case, the tax court seemed to focus their attention on two aspects: the trading activity must be substantial and the trading activity must be continuous and regular.
TRADING ACTIVITY MUST BE SUBSTANTIAL
One of the problems Sharon had in this case is she let Mr. Zabasky trade her individual account. The court could not determine who generated the trading activity at the center of this case. Even when all the activity was considered to be Sharon’s, the court decided she failed to prove that her activity was substantial. In her favor, Sharon had $66 million worth of buys and sells in 2005 and $49 million in 2006. However, the court deemed that the 535 trades executed in 2005 and 235 trades executed in 2006 were not substantial enough.
ACTIVITY MUST BE CONTINUOUS AND REGULAR
Sharon really failed this test. Looking at her activity for 2005, the court saw that she traded on 49% of the available trading days. Even more damaging was the fact that 95 out of the 535 total trades occurred during a one week period. It was even worse in 2006. Sharon had trades on 26% of the available trading days, clearly not continuous or regular. The court focused on the long stretches of time where no trading activity took place in determining that Sharon should be classified as an investor and not a trader.
CONSEQUENCES OF THE COURT’S DECISION
As a result of the court’s decision, Sharon Nelson was taxed as an investor and not a trader. She was not allowed to deduct any of her business expenses on Schedule C. Sharon owes deficiencies of $355,403 for 2005 and $307,911 for 2006, as well as accuracy related penalties of $71,081 and $61,582 respectively. She also gave traders more clarity on qualifying for trader tax status.
If you are not sure whether you qualify for trader tax status, consult with an accountant who specializes in this area. I offer a free trader tax status analysis on my website.
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