One of the key tax determinations in the financial sector is whether an investor or a fund is a “trader” or “investor” for tax purposes. Every U.S. taxpayer that trades securities (or fund with U.S. taxable investors), must be categorized as an investor, trader or dealer. Each is treated differently, for tax purposes, and the distinction is meaningful. Dealers mark-to-market their holdings and treat the resulting gain/loss as ordinary income or loss. Traders are able to treat their securities dealings as a trade or business and deduct expenses on Schedule C. This category of taxpayer does not get bogged down with deduction limitations related to their investment activities. Investors are the mass of the population – ordinary people who sometimes buy or sell securities for themselves but don’t trade securities as a profession. An investor can only deduct expenses (including fund management fees) as miscellaneous itemized deductions subject to the 2% AGI limitation. Additionally, investment interest expense is limited to investment income.
Dealers are normally easy to recognize since they deal with customers as opposed to trading for themselves and typically hold themselves out to the public as dealers. Then there’s the rest of the investing universe. They all buy securities and sell securities and often look very much alike. The tax code does not define a trader or investor. Thus, there is a long line of case law which has attempted to decipher a dividing line between the two. For more than 35 years various courts have thrown out a multitude of tests to resolve the tax classification of trader or investor. The result, as you may have guessed, is an opaque hodgepodge of legal reasoning. The best that can be said is a court will look to three items to determine trader or investor status: (i) the taxpayer’s intent; (ii) the nature of the income to be derived from the activity; and (iii) the frequency, extent and regularity of the taxpayer’s transactions. In short, a trader seeks to capture profits from short-term market movements while an investor seeks to profit from dividends, interest and long-term growth of investments.
Recently, the Tax Court took a new stab at clearing the brush standing between “trader” and “investor” tax status. Endicott v. Comm’r, T.C. Memo 2013-199 (August 28, 2013). Tom Endicott was a retired executive that took up trading his personal portfolio on a somewhat full-time basis (that is, he had no other profit activities). His trading strategy consisted of buying equities (fully margined) and writing covered call options over such equities. He executed 204 trades in year 2006, 303 trades in 2007, and 1,543 trades in 2008. He traded on 75 days out of the year in 2006, 99 days in 2007, and 112 days in 2008. His average holding period of the equities was 35 days across the years at issue but he held a significant number of stocks for well over a year. He made purchases of approximately $7 million during 2006, $15 million in 2007, and $16 million in 2008. On these facts the Tax Court found that Mr. Endicott was NOT a trader for tax purposes but merely an investor. The Court also applied tax penalties against Mr. Endicott for taking the position that he was a trader (Ouch!!).
The Tax Court in Endicott relied mainly on the frequency, extent and regularity of the trading. Despite the relatively high dollar amounts of trades the Court found that the number of trading days on which the taxpayer executed trades was insubstantial in 2006 and 2007. However, the Court found (based on past precedent) that the 1,543 trades Mr. Endicott made in 2008 was substantial. Nevertheless, the Court reasoned, Mr. Endicott only traded on 112 days during the year in 2008. Since this was not trading on “an almost daily basis” it did not rise to the level of “Trader” despite the high quantity of trades and dollar amounts involved.
The case is important since it provides some precise detail around what will and will not be considered the proper magnitude of trading to hit “Trader” status. The Court tells us that some level of trading must be undertaken on “an almost daily basis”. There are approximately 250 trading days per year on the NYSE (depending on the year). This would imply a minimum of 126 days of trading is needed (i.e., trading every other day). Obviously, more is better. Additionally, the Court cited cases where the number of trades totaled 372 per year and less where trader status was denied. It also cited precedent where 1,136 trades per year was in the nature of “trader” status (and it found that Mr. Endicott’s 1,543 trades in 2008 was indeed substantial).
Thus, anyone (including a hedge fund) seeking to affirmatively declare “Trader” status for U.S. tax purposes should ensure that they are trading significant dollar amounts, executing trades on more than half the available trading days (if not more) and executing in excess of 1,000 trades per year (with more being better). There are literally thousands of hedge funds and individuals that take the tax position each year that they constitute a trader. More often than not, the conclusion is questionable. This doubt puts billions of dollars of tax deductions in jeopardy. The Endicott case doesn’t totally clear the landscape but it at least provides a decent path to follow.
If you have any questions about this or any other tax topic please contact your regular WithumSmith+Brown partner.