Back in October I blogged about Mr. Endicott who got himself embroiled in a skirmish with the IRS over his status as a trader or investor for tax purposes -[http://frankandtothepoint.com/2013/10/09/clearing-back-the-brush-between-trader-and-investor/]. The Tax Court took a detailed look at Mr. Endicott’s activities, counting his trading days, number of trades, calculating an average holding period, etc. Ultimately, the court found him to be an investor as opposed to a trader. Not only that, the Tax Court slapped the taxpayer with penalties to boot!
On November 13, 2013, the Tax Court was back in action and the result was the same; however, this time it was Sharon Nelson in the hot seat. Ms. Nelson was the sole shareholder of a mortgage brokerage company. During 2005 and 2006 she was actively trading her TD Ameritrade securities account. As with Mr. Endicott, the Tax Court was diligent in reviewing Ms. Nelson’s trading activity. In 2005 she traded 535 times on 121 days (48.4% of total available trading days) with holding periods ranging from 1-48 days. In 2006, she traded 235 times on 66 days (26.4% of total available trading days) with holding periods ranging 1-101 days. It turns out that Ms. Nelson was a pretty good trader. She generated $470,472 of net short-term capital gains in 2005 and $36,852 of net short-term gains in 2006.
Ms. Nelson met the same fate as Mr. Endicott, her deductions were denied and she was also hit with penalties. She was hit with penalties despite the fact that her intention was to be a trader and the facts demonstrated that her trading activity was to capture short-term market movements as opposed to interest, dividends and long-term gains. The court again focused on whether the taxpayer traded on an “almost daily basis.” The court specifically identified blocks of days and weeks where no trades were executed.
The culmination of the Endicott and Nelson cases clearly demonstrate that the Tax Court has no sympathy for individual taxpayers claiming to be traders as opposed to investors when their fact patterns do not demonstrate frequent and substantial trading on a near daily basis. Nevertheless, the two cases are welcome in that they move away from the historical case law analysis of attempting to observe objective trading factors to determine the taxpayer’s subjective intent. These two cases turn the analysis in a way that solely focuses on the size and frequency of the taxpayer’s trades. This may or may not be the correct analysis but at least it gives individual investors who wish to qualify as traders as opposed to investors a roadmap to doing so.
If an individual wants to qualify as a trader for tax purposes he or she needs to: (i) devote the majority of their time to the activity; (ii) execute more than 1,000 trades per year; (iii) trade on over 80% of the available trading days; (iv) do not have more than a week at a time with zero trades; and (v) maintain an average holding period less than 60 days (shorter is better). The 80% figure and the one week trading void may be conservative targets but this is clearly the direction the Tax Court is heading.
Obviously, if this same analysis were applied to the hedge fund arena there would be many funds that would fail trader status based on their trading style alone. For example, an event driven fund by definition only trades around events and would have no trading activity on many days. Additionally, there some equity long / short funds and credit arb funds that take strategic positions and have low portfolio turnover. However, there has never been a published investor vs. trader case involving a professional asset manager (i.e., being compensated to manage third-party assets) or comingled fund. And it is not entirely clear that the same analysis would or should apply. For one thing, it is factually inapposite to argue that an asset manager earning fee income from unrelated third parties is not engaged in an active trade or business and should therefore constitute a trader as opposed to a mere investor. Moreover, as a practical matter, attacking hedge funds in this manner may not be appealing to the IRS. Assuming the Service could be successful in its attack there is no tax at the fund level. Rather the Service is left to locate the individual taxable investors (sometimes tracking through multiple layers of pass-through entities), and then recovering relatively small amounts (if anything – the individual may not have been in a position to benefit from the pass-through deductions).
Based upon the history in this area and the recent case law discussed above, it appears that individual investors managing their own money (or their family’s) will need to meet an incredibly high factual hurdle to qualify as a trader whereas hedge funds and other professional asset managers a relatively lower hurdle. While this may leave a bit of a mystery for fund managers the cases above highlight how a fund can adjust its trading behavior to aid its cause.
If you have any questions regarding this matter or any other tax matters please contact your normal WithumSmith+Brown partner.