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Recent IRS techniques against traders

GreenTraderTax | Thu, 08/06/2009 - 1:32pm |  Add a comment

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April 30, 2009

Part 3 in our series of new blog articles continues with a look at a specific exam we encountered — a 55-year-old business executive turned part-time stock-option trader. This person was denied trader tax status at the exam level. We’re expecting to overturn this decision at the appeals level.

We have noticed the IRS giving part-time business executive traders a hard time in tax exams, especially if large Section 475 MTM ordinary business losses are at stake. The IRS doesn’t necessarily consider this type of activity to be a true business activity. Often, the account size is under $50,000 and the executive is losing money.

Number of round trip trades, frequency of trades, average holding period, and number of days on which trades were executed vs. total available trading days are the biggest bones the IRS picks. These qualifications are easy to analyze and verify. Conversely, number of hours per day and intention are subjective and impossible to prove by the IRS.

The numbers of days on which trades are executed vs. total available trading days seems to be the new Achilles heel for option traders. Option trading programs involve putting on complex positions and spreads (with multiple legs), which is set up to keep positions open for several weeks or longer.

In the recent landmark Holsinger vs. IRS tax court case, the IRS denied trader tax status because Holsinger only executed trades on 45 percent of available trading days, holding options trades open for 30 to 45 days. Being a retiree put Holsinger at a disadvantage vs. a younger person trading full time in the eyes of the IRS. It’s hard for a retiree to raise the full-time argument, as they are out of the fulltime workforce already. See our blog article on the Holsinger case here http://www.greencompany.com/blog/index.php?postid=7 .

We are handling an IRS exam for a business executive facing downsizing and retirement at age 55. The IRS raised these same types of issues in seeking to deny trader tax status and large Section 475 ordinary loss treatment.

Trading days and hotel stays
I have a huge bone to pick with the IRS over the number of executed trading days argument, which is unfortunately approaching a new “case law” standard (Holsinger and others). In my recent tax exam for this part-time stock option trader (a California-based 55-year-old executive facing downsizing), I raised this “hotel analogy” argument and the agent did not fully listen to it or agree to it. But he seemed curious on the logic and it could have an impact in the next step of appeals. Sometimes you need to agree to disagree with an agent on the exam level and pursue the case in the appeals process. I recently wrote an article for Fidelity’s Active Trader e-Newsletter, “IRS Strategy for Active Traders” at http://personal.fidelity.com/misc/framesets/iwarticle.shtml?pagename=AT0902IRS_Strategies .

My analogy: A hotel guest checks into a hotel on a Monday and checks out on a Saturday. Monday and Saturday are two executed transaction days of a seven-day week — 29 percent of the week, which is well under the 60 percent standard amount (which is a working guess at the IRS’s current standard amount). My argument is that the hotel guest needed hotel services (towels, room service, etc.) on the part of hotel management and workers Monday through Saturday, five of seven days of the week (70 percent).

This is comparable to trading — traders monitor trades daily, every day of the week, even on weekends. They often also initiate unexecuted trades and stop-loss and limit orders. In my opinion, the IRS should count daily activity in addition to executed trades.

I told the last IRS agent I spoke to that tax code and case law does not mention the concept of “executed” trades vs. “unexecuted trades” anywhere. It’s not clear in case law that executed trades set the standard for material participation of business activity. Business hours spent has always set that standard. In this exam, the agent started off by raising the passive loss activity “material participation” standards.

Material participation calls for 500 hours of work spent per year before a taxpayer can rise above passive activity loss rules and claim business loss treatment. Otherwise, passive losses are offset only against passive activity income and if not, they are carried over to the subsequent tax year(s). (There are other standards that call for only 100 hours.)

Over the years, we made the point that a trading business may not be subject to “passive activity loss” rules (Section 469 and IRS publication 925) because a trading business falls under the “trading rule” exception. The trading rule exception in Section 469 was enacted to prevent a taxpayer otherwise stuck with passive activity loss deferrals from using a hedge fund or investment company to generate passive activity income, thereby unlocking the passive-activity loss deduction. That would make it too easy to navigate around Section 469 intentions. The trading rule is part of Section 469, and maybe a trader should be able to still use material participation standards to claim trader tax status. Most traders would easily qualify under these standards because they trade well more than the 500 hours the rule requires.

Material participation standards would certainly help trump the IRS’s standard on number of days for executed trades vs. total available trading days. Our golden rules for trader tax status call for more than four hours trading every day of the week (approximately 25 hours a week). If a trader works 48 weeks per year (not including vacation weeks), it totals 1,200 hours per year, well over the 500 hours required in the material participation standards.

The above California-based trader spent over 1,200 hours per year, consistently throughout the year. The IRS agent agreed to this fact, which was first supported by extensive business plans and archived work product.

Your personal life, examined. Another interesting aspect of this exam is that the IRS agent asked the trader about his personal life. Questions included whether or not he spent time on a daily basis with his children coaching sports teams or otherwise. The agent tried to add up the hours reported to make sure they made sense. They did.

Most business traders can impress an IRS agent on the complex nature of a highly technical trading business. Charts, computers, software, systems, research, analysis and much more is very impressive. Along with material participation rules (if they can be deployed for business traders), this type of support can lead to a winning argument on qualifying for trader tax status.

The risk factor. In this exam, the IRS agent figured total proceeds per trade (total trading proceeds divided by total trades). He argued the risk was not material enough vs. the trader’s overall net worth. This trader had much more capital committed in prior years when he had high profits; recent losses caused his account size reduction. This tentative argument never made it the agent’s conclusions.

In terms of risk per trade, it raises another interesting concern. When we tell some clients they may have trouble with the IRS on the number of executed trading days, many ask if they can just execute smaller day trades with less risk to overcome this concern. It is not clear if the IRS will raise the risk-per-trade argument more going forward.

The IRS code talks about risk, but it doesn’t do much to quantify risk per net worth or otherwise. I think this IRS agent’s argument about risk is flawed. Putting on trades with no risk (offsetting positions) would clearly not help.

A bright-line test? The IRS appears to be allowing the courts to help define a rule or standard, composed of objective factors, which leaves little or no room for varying interpretation. The purpose of a bright-line rule is to produce predictable and consistent results in its application.

The agent on this exam argues that days with just one trade should not be counted — only days with more than one trade should be counted. That argument is very unfair and is not supported by any case law precedent. It's self-serving because it stacks the deck for the IRS on counting days traded — the entire basis for the IRS's argument against this trader qualifying for trader tax status. This is the problem with bright-line tests: One can argue over how the lines of demarcation are drawn, and then traders have a shooting target to surpass for qualification.

The bottom line
We weren’t successful during the exam process, but we expect to win at the IRS appeal stage of the game. If you are facing an IRS exam on trader tax status, be prepared for many questions about your daily activities and for your trading activity to be scrutinized. Always consult a trader tax professional for guidance on this topic.

Check back soon. Our next article will go into further detail on trader tax status, describing the groups of traders who easily qualify, and those who don’t. If you’re in the latter group, learn about significant tax savings as well.

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