By Jim Forester, Tax Director of Traders Accounting*
Posted: September 7, 2007

If you're a new securities trader or thinking about becoming one, you're probably wondering: What's all this fuss over trader tax status? You make your trades, report your income, select your accounting method and voilà -- you're a trader, right?

Not exactly. Although you may buy, sell and profit in securities, futures and foreign exchange, unless you do so in such a way as to qualify for "trader in securities" status with the Internal Revenue Service, come tax time, you won't be enjoying the numerous tax advantages reserved for traders only.

The fuss over trader status lies in the definition -- or rather lack of definition -- as to what constitutes a securities trader in the view of the IRS. In its attempt to separate true securities traders from the greater herd of hobbyists and investors, the IRS has issued a general set of guidelines.

To qualify for trader status:

• You must seek to profit from daily market movements in the prices of securities and not from dividends, interest or capital appreciation.
• Your activity must be substantial.
• You must carry on the activity with continuity and regularity.

To help determine if you meet these three tests, the IRS considers these qualifiers:

• Typical holding periods for securities bought and sold
• Frequency and dollar amount of trades during the year
• Extent to which you pursue trading to produce income for a livelihood
• Amount of time you devote to the activity

Clearly, these guidelines contain any number of trap doors through which the unsuspecting trader might fall at any time. For instance, what exactly is meant by "substantial" activity? Or "continuity and regularity?"

So far, the IRS has left further delineation in the hands of the tax court, whose rulings tend to uphold the denial of trader status without shedding much light on how individuals might qualify for trader status in the first place.

Courting a Consensus

Court rulings on trader status date back at least six decades.

In Higgins v. Commissioner (1941), the Supreme Court ruled that, although the plaintiff had a vast operation, its primary purpose was merely to record his trades and, hence, denied deductibility of his investment expenses.

In Estate of Yaeger v. Commissioner (1989), a similar large-scale, full-time trader was denied trader status because he held his securities for long periods of time and, hence, was considered an investor, not a trader.

In re Frederick R. Mayer (1994), the court ruled that Mayer, like Yaeger, was an investor because, although he bought frequently, he profited primarily from long-term holding periods.

In re Rudolph Steffler (1995), the plaintiff was denied trader status because he conducted a very small number of trades each year.

In re Stephen A. Paoli (1991), the court ruled that the plaintiff's trading activity was concentrated primarily during one time of the year, with little activity occurring the rest of the year and, hence, was not continuous, resulting in denial of his trader status.

In re Frank Chen (2004), the court denied trader status based, in part, on the fact that "securities trading was not the sole or even primary activity in which the taxpayer engaged for the production of income", casting a shadow over the status of all part-time traders.

How can you be sure that the trader tax status you enjoy today will still be there tomorrow? In lieu of specific language in the IRS code that more clearly defines the qualification for trader status, the best way is to establish a legal entity for your trading business.

Also, a trader's tax accounting professional can help you choose from among the most popular legal entities -- limited or general partnership, C Corporation, limited liability company (LLC) -- the structure that makes the most tax sense for your business.

*Reprinted (and modified) with permission from Online Trading Academy www.onlinetradingacademy.com Jim Forrester is Tax Director of Traders Accounting (http://www.tradersaccounting.com/)