The Trader vs. Investor Hurdle Just Gets Higher

A few months back I wrote about the Nelson case, a Tax Court case dealing with a U.S. individual who claimed she was a “trader” for federal income tax purposes [https://withumonwallstreet.com/2013/12/04/another-investor-in-trader-clothing/]. In that piece I suggested that the trader / investor analysis being utilized by the modern-day Tax Court had become so stringent that it is virtually impossible for individuals to qualify as traders for tax purposes unless they are professional traders, trading every single day as their full time profession. Recently, the Tax Court once again repeated their purely objective and analytical analysis of the individual investor / trader issue. Assaderaghi v. Commissioner, T.C. Memo 2014-33, No. 7677-12 (02/24/2014).

As stated in my previous writing, being classified as a trader for tax purposes as opposed to an investor can provide substantial benefits. Traders essentially have a business for tax purposes and can deduct all of their related expenses. Investors, on the other hand, are engaged in an activity for profit and are able to deduct expenses, but only as itemized deductions subject to substantial restrictions. It’s basically an “above the line” versus a “below the line” distinction for the expenses. Moreover, traders have the ability, if they desire, to make what’s called a “Section 475 election” to treat their gains and losses from securities (and/or commodities, if that’s what they trade) as ordinary income and expense as opposed to capital gain and loss. Mere investors don’t have the ability to make such an election.

Similar to the facts of the 2013 Nelson case, Mr. Assaderaghi had a day job in addition to his securities investing activities. Mr. Assaderaghi held a Ph.D. in electrical engineering and computer science and was the vice president of engineering at a successful technology company during 2008 and 2009, the tax years at issue in the case. The facts of the case stated that Mr. Assaderaghi normally worked nine to ten hours a day at his day job. In his non-work time he traded stocks (both long and short) as well as options. He traded in a margin account and utilized a semi-professional electronic trading platform.

In typical modern era Tax Court fashion the court went to work laying out the taxpayer’s trading statistics. According to the court findings, in 2008 Mr. Assaderaghi executed 535 trades (of which 40% were day trades) across 154 trading days (61% of available trading days) and had gross trade receipts of $2.659 million. More than half of his 2008 trades were executed in January, June and July. He traded fewer than 10 times in the months of February, August and October. In 2009 Mr. Assaderaghi executed 180 trades (of which 19% were day trades) across 94 trading days (37% of available trading days) and had gross trade receipts of $350,000. He traded fewer than 10 times per month in January through June 2009 and zero trades in the month of February. In both years the taxpayer reported his gains and losses as ordinary but never filed a Section 475 election.

Based on these facts the Tax Court found that Mr. Assaderaghi was an investor and not a trader for federal income tax purposes. The Tax Court concluded that the trading activity of Mr. Assaderaghi during the years at issue was neither substantial nor regular and continuous. As in other recent trader / investor cases, the Court made special note of time periods in which trading activity was particularly light or altogether absent. In this particular case, Mr. Assaderaghi’s trading style was not an issue. His trading patterns did indicate that he was attempting to profit by capturing short term swings in the market prices of securities which is typical of a trader. However, his trading activity level simply did not rise to the level the Court expects of a trader. This was the result despite the fact that Mr. Assaderaghi traded on more than half the trading days available in 2008 (query if the result may have differed if his trades were more evenly spread across the year, i.e., trading at least every other day of the year). Nevertheless, the taxpayer in the Assaderaghi case was not subject to penalties which was the result in other recent trader / investor cases (note: It appears the IRS may have relented on the penalties prior to trial and the Court provides no discussion on the subject).

The series of trader / investor cases that came through the Tax Court over the past twelve months demonstrates a clear pattern in analysis. U.S. individuals will not be permitted trader status for tax purposes unless they trade on a near continuous basis throughout the year and do so in requisite amounts and with the proper trading intent. To be safe, an individual should trade on more than half the available trading days every month, execute more than 1,000 trades per year and seek mainly short-term capital gains.

 

As I’ve written before, I am of the opinion that the standards for trader status which individuals are being held to by the Tax Court are not the same standards to which a comingled trading fund would be held. A comingled fund which is professionally managed by a third-party manager for an arm’s length fee should be seen as a trader provided the manager’s trading style seeks to profit from short-term swings in market prices as opposed to long-term appreciation, dividends and interest. The actual number of trades per year and trading days should be immaterial for a professionally managed fund. However, there has never been a published case or ruling involving a professionally managed comingled fund so we’ll have to wait and see.

If you have any questions regarding the trader / investor distinction or any other tax matters please consult your normal WithumSmith+Brown partner.

 

Tony Tuths

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