What are the IRS requirements for claiming Trader Status?

Generally speaking the IRS is looking for someone who:

• trades on a frequent, regular and continuous basis
• has a substantial number of trades
• does short-term trading
• spends a substantial amount of time trading
• has a small percentage of income derived from dividends
• takes their trading expenses on a Schedule C
• has the existence of an office - either home office or otherwise

Keep in mind, however, there are no hard and fast rules and the determination of Trader Status remain subjective. What I have outlined is derived from my research and experience as is based upon my review of applicable statutes, court decisions, IRS regulations, procedures and protocols. Since the determination remains subjective you should seek professional guidance based upon your particular circumstances. Our office offers a FREE Trader Status Evaluation Questionnaire.

If dividends are received on the investment part of my portfolio on what section of the tax return would the dividends be declared?

Dividends will always be reported on Schedule B because dividends are not trading income. The proper way to report all of your trading profits, (unless you elect section 475) is to put the income part on schedule D. The expenses will go on a Schedule C.

How do you get around the fact that after the third year the IRS wants to see a profit in the business?

There is nothing in the law which says that if your business shows a loss for more than two years, it is no longer considered a business. The primary purpose of most (if not all) businesses is to generate profits. The problem occurs when a "business activity" continuously shows losses the IRS may not view it as a business at all but rather as a hobby. They have established the "hobby-loss" rule whereby they take the position that if you don't have a profit in the business after two years that you are presumed to have a hobby and not a business, thus disallowing the loss deductions. This "rule" is actually merely a presumption on their part -there's nothing written in stone. However, it shifts the burden to the Taxpayer to prove that the activity actually is a business and not a hobby. There have been circumstances - not even trading circumstances - where people have run losses for three, four and five years before showing a profit; and I've been called down to justify the legitimacy of the business enterprise, and I've done it! Basically, you have to demonstrate that this is a business. In a trading business you must reference the fact that only your losses are reported on the Schedule C and that the income is being reported on the Schedule D. The best way to document that there is a legitimate business is to maintain logs and journals.

Will a Schedule C always show there's going to be a loss?

Yes. Unless you use mark-to-market, Section 475, in which case the income would be reported on the Schedule C.

Because of this loss every year on my Schedule C I will never have to report self-employment tax, right?

Right. So long as the income is still capital income, you will not have to pay self-employment tax on it, however, you will also not be allowed to take a pension deduction against it. Now, there are certain circumstances in which this will not be the case. There are ways that you can set this up so that you can have it both ways. For example, by utilizing a sub-chapter S corporation to conduct your business you will be permitted to set up a pension plan and since your personal income from the corporation is in the form of 'salary income' you will be subject to self-employment tax. Keep in mind that this is not a hard and fast rule and there are exceptions. You will need to consult with your tax professional to see if this applies to your particular circumstances. Now, if you're a member of a nationally recognized commodity exchange, you still report the income on a Schedule D, but you are required to take self-employment tax against that income. Anybody who's a member of a nationally recognized commodity exchange must pay self-employment tax even though that income is capital.

On a Schedule C can you merge two variant small businesses that you run?

The real answer to that is 'no'. You must keep every business that you have separate. The IRS is very insistent on segregation of assets, segregation of income, segregation of funds, segregation of bank accounts, etc.. They don't like to see everything merged together. You know why? It makes it real hard for them to figure out what's a real expense and what's not. So the law requires that you must separate various business interests on your tax return. For example, If you're a Trader as well as a weekend car mechanic, as well as a consultant in something else, you must file three Schedule C's. If the businesses are somewhat related, however, you may have more room for combining them.

What are the advantages and disadvantages of operating as a sub-chapter S?

I could devote an entire book to that question alone, but let me see if I can summarize quickly. Some of the advantages are:

1. as a sub-chapter S you are sheltered from a lot of personal liability since you are in fact a corporation;
2. the corporation is only limited in liability to the extent of the corporation's assets;
3. the corporation can set up a pension plan through the sub-chapter S;
4. the sub-chapter S allows all income and expenses to flow through to the individuals that own it for reporting on the personal tax returns of the owners.
   The major disadvantage is that the advantages only apply so long as the corporation is conducted as a corporation. If the IRS, creditors or others can demonstrate that the corporate entity is a sham and are able to "pierce the corporate veil" then the individuals who own the corporation may be held liable for the debts, liabilities and actions of the corporation. Thus, it is very important that even a sub-chapter S corporation be conducted in a corporate manner, which means that the owners should receive "salaries" with deductions, not just draws, there must be shareholder meetings, major decisions must be made by written resolutions and the corporate book must be maintained. Additional disadvantages include some restrictions on the amounts in which certain type of retirement plans can be funded and certain insurance premiums are nondeductible.

If I conduct a trading business as a Schedule C filer am I required to make quarterly estimated tax deposits?

Generally yes. There are, however, certain circumstances in which you can avoid being penalized for not paying quarterly estimates. Basically, if you cover at least 90% of this year's tax liability or 100% of last year's liability through either estimates or withholding tax you can avoid the penalty.

If somebody employs your services how would you handle an audit which is in a city distant from those cities in which you maintain offices?

The first thing I would do is to request that the audit be transferred to a service center near me. This is a very good strategy because many times during the transfer the file will fall through the cracks and even when they don't fall through the cracks they're put at the bottom of the pile at the new service center, in either event it gives us more time in which to prepare for the audit. The IRS is obliged to transfer audits to a service center that I can deal with as a practitioner; as your accountant, they have to do that. It's one of my rights - one of your rights. Additionally, a lot of times I have seen it happen that they would fall through the cracks for such a long period of time that the statute of limitations for the tax year would run out thus precluding them from proceeding. So having your audit shifted between service centers is actually a very good strategy. But that's how I handle it for out of town clients. Many times, however, we can handle matters with the IRS by phone and mail. And if necessary I will go to your IRS district. I have clients all over the country and travel quite a bit.

If I meet the qualifications of a Trader but I have another job can I still file a Schedule C as a Trader and receive the benefits of Trader Status?

Yes. There is no requirement that Trading be your only source of income. Clearly if you derive 100% of your income from Trading the IRS will have a more difficult time disqualifying you, however, if you have another job it only means that you must be more diligent in documenting your trading business - keeping a trading journal, filing a schedule C, etc. In many circumstances, the establishment of a trading entity (such as a corporation, partnership or limited liability company) can substantiate the business.

Can I be considered both a Trader and an Investor?

Yes. The basic distinction between a Trader and an Investor is that Traders hold their positions for short periods of time and derive their profits/income from short term market swings and fluctuations. Investors, on the other hand, hold their positions on a long-term basis seeking capital appreciation and dividends/interest as their sources of income. Therefore, it is entirely possible that a person can hold part of his portfolio in long term investments, while at the same time trading another part of his portfolio in which case you are both an investor and a trader. What you would have to do is allocate a portion of your expenses to the longer term holdings and a portion to the trading. There are no fixed rules on how to do that. You can allocate it based upon a percentage of total capital; you can allocate it based upon hours spent. Perhaps you can come up with a formula which allows you to allocate a portion of your computer expense to investing, and a portion to trading, or, a portion of your data which is used by each activity. Any reasonable method of allocation should be acceptable.

Are "Traders" one of those specific categories whom the IRS targets for audits?

Not at all. Rather it depends on your income level and other factors. The IRS recognizes that certain types of professions and occupations are more likely to fail audits (thus generating income for the government) and they pull those for examination. Traders, per se, are not one of those.

Do you have to list all of your trades on your return when you file?

My experience is that you don't, but be sure you can prove all of your transactions if requested to do so. I have several clients who have literally thousands of trades a year. My general practice in such circumstances is to summarize all transactions and put the totals on the return. I also attach a little note stating that I have the statements available if they so desire. Make sure, however, that you tie in gross proceeds.

Can I trade in my retirement plan?

Probably so. The reason I say "probably" is because the IRS hasn't said you can't; although they haven't specifically said you can either. Nowhere, in any case that has been handed down does it say that the income has to be currently taxable - nowhere. Okay? They will tax that income eventually. So I would say yes. You can't write it off as a trader ten years from now when it's taxable if you have the expenses today. So, when else are you going to do it? I would say yes. There may be a problem though, with the retirement plan - if they see it as a business they may disallow it as a retirement plan. You can't run a business in a retirement plan.

If you're classified as a Trader can you still utilize long-term capital gains treatment on the investments portion of your portfolio?

Yes, absolutely. But remember, if you trade in certain commodities, futures contracts, and certain non-equity options contracts you may be eligible for section 1256 treatment in which your gains will be treated as if 60% of the gain were long term and 40% will be taxed as short term -This applies even if you hold the position for less than a year. Keep in mind that not all securities are taxed the same; be sure that your tax preparer is aware of this. ("Securities" as used in this context is broadly defined to include stocks, bonds, futures, commodities, currencies, etc.)

I understand that Traders of OEX options can no longer take 60% of their gain as long term unless they hold the position for at least one year. Is that true?

No. They still can.

Do Wash-Sale rules prohibit me from selling stock at year end and then re-purchasing it within thirty days?

False. Only if you have a loss. If you have a gain, you can do it all the time.

As a Trader can I deduct 100% of my son's $25 per week allowance as a business expense if he has helped out with some business related chores?

That is true. Generally speaking, you can employ your child (age 7 or over) and pay him/her a salary which becomes 100% tax deductible to the business, reported on Schedule C. Better still, wages paid to children under 18 years of age are not subject to unemployment tax or social security tax!

Do I have to pay FICA on trading income?