Tax Update Blog: Permalink

« Previous · Tax Update Blog Home · Next »

WHEN IS DAY TRADING A BUSINESS?

June 02, 2004

Frank Chen got caught up in the day-trading frenzy of the late 1990s. After making 12 trades in January 1999, he geared up to 133 trades in February and 145 in March. Sometime in April he apparently began to reconsider this financial strategy, as he only made 25 trades that month. The $84,794 in trading losses he was to report on his 1999 return may have had something to do with this decision. In May he was down to four trades, and he made no trades at all in June.

When he filed his return, he claimed that he was a stock "trader." Stock traders can fully deduct their capital losses as ordinary losses; lesser mortals, being mere investors, can only deduct capital losses to the extent of their capital gains, plus $3,000. Unused losses carry forward indefinitely.

WHAT MAKES A TRADER?

The Tax Court, in considering Mr. Chen's 1999 tax return, said that there are two hurdles to cross to become a trader:

1. You must buy and sell frequently enough to try "to catch the swings in the daily market movements." The court said Mr. Chen met this test in February and March, 1999.

2. The trading activity must be "regular, frequent and continuous." The court said Mr. Chen failed to clear this hurdle:

   In the cases in which taxpayers have been
   held to be traders in securities, the number 
   and frequency of transactions indicated that
   they were engaged in market transactions 
   almost daily for a substantial and continuous 
   period, generally exceeding a single taxable 
   year; and those activities constituted the 
   taxpayers’ sole or primary income-producing
   activity.  Conversely, where, as in this case,
   (1) the taxpayer’s daily trading activities 
   covered only a portion of a single taxable 
   year, and (2) securities trading was not the 
   sole or even primary activity in which the 
   taxpayer engaged for the production of 
   income, trader status was denied.  Daily 
   trading in securities for only a quarter of a
   single taxable year is reasonably 
   characterized as “sporadic” rather than 
   “frequent, regular, and continuous”, and, 
   therefore, insufficient to achieve trader 
   status.

                            (citations omitted.)

Mr. Chen would have had to continue his trading into 2000 to get to the tax treatment he desired. Considering that he lost $84,000 in less than 3 months of heavy trading, that might have been an expensive tax accomplishment.

Trader status is, perversely, only a tax advantage if you are unsuccessful. Traders with gains don't qualify for reduced capital gain rates.

Still, Mr. Chen can work through his losses at the rate of $3,000 per year on future returns. Assuming no more capital gains, he will use the last of them on his 2027 tax return.

Link: Frank Chen v. Commissioner, T.C. Memo. 2004-132 (pdf file).

      Bookmark: del.icio.us • Digg • reddit