Trader or Investor
In two decisions in 2013, Endicott, T.C. Memo. 2013-199, and Nelson, T.C. Memo. 2013-259, the Tax Court maintained a high hurdle that taxpayers must clear to show they are in the trade or business of trading in marketable securities rather than acting as investors. Aside from dealers in securities (those who regularly buy securities and resell them to customers--see Regs. Sec. 1.4715(c)), individual taxpayers with income or loss from trading in securities may be either traders or investors. Traders, those who engage in the trade or business of buying and selling securities for their own account, possess several advantages over investors, chiefly the ability to deduct ordinary and necessary expenses of their trading activity under Sec. 162(a) in calculating adjusted gross income (AGI). In addition, they may fully deduct interest expenses where debt proceeds are used to buy or carry investments used in the trade or business, and their deductible expenses reduce alternative minimum taxable income (AMTI). A trader who makes the Sec. 475(f) mark-to-market election recognizes gain or loss for the tax year as ordinary, including a net loss greater than the $3,000 capital loss limitation of Sec. 121 l(b). By contrast, investors, those whose buying and selling of securities for their own account does not rise to the level of a trade or business, may deduct only the more limited category of nonbusiness expenses for the production of income under Sec. 212. Such deductions are further limited as itemized deductions subject to the threshold of 2% of AGI under Sec. 67(a) and do not reduce AMTI. Also, unlike traders, investors may deduct investment interest expense only to the extent of net investment income for the tax year under Sec. 163(d). An investor may not make a valid mark-to-market election and cannot thereby escape the $3,000 capital loss limitation (see Kay, T.C. Memo. 2011-159). Therefore, many taxpayers have tried and failed--to persuade the IRS and courts that they were in the trade or business of trading in securities. The tests commonly applied to distinguish other business activities from hobbies are of little avail (see "Tax Practice Comer: Business or Hobby? The Nine Factors," JofA, Oct. 2013, page 71). As far back as the Supreme Court's decision in Higgins, 312 U.S. 212 (1941), courts have held that even a businesslike approach to investing marked by "sufficient extent, continuity, variety and regularity" is not enough. Traders, distinguished from investors, must also trade frequently, relying more on direct management of gain from short-term buying and selling of securities than on the benefits of holding them, such as dividends, interest, and capital appreciation (see, e.g., Moller, 721 E2d 810 (Fed. Cir. 1983)). In Nelson, the Tax Court has adopted a two-part test for determining whether a trading activity constitutes a trade or business within the meaning of Sec. 162(a): Traders' trades must (1) be substantial in amount of money involved, number of trades in a year, and number of days on which trades were executed (Nelson, slip op. at 12-13) and (2) attempt to "catch the swings in the daily market movements and profit thereby on a short-term basis" (Liang, 23 T.C. 1040, 1043 (1955)). In Nelson, taxpayer Sharon Nelson executed 535 trades in 2005 and 235 trades in 2006, on 250 available trading days in each year. That might seem substantial, but the Tax Court noted it has previously held that as many as 372 trades in a year were not substantial, and among cases cited in Nelson, 1,136 trades were the fewest it has previously held to be substantial (Nelson, slip op. …