For tax purposes, there are three statuses that may apply. This article explains how they are defined, why they are desirable (or not).
By claiming Trader Tax Status, people can gain access to some of the preferential tax treatment that a Dealer in Securities receives. In doing so the regular investor classifies themselves as a Trader. The reason people want to do this... it's simply to have a more favorable tax outcome. However, I'd caution anyone considering Trader status to view tax as an expense. It might cost more than you'd like, but it is the price you pay for simplicity. Almost all strategies to reduce tax will come at a cost.
Traders are not defined in IRS Regs. There is guidance in IRS Publications 429 and 550. These are less authoritve than Regs.
To be engaged in business as a trader in securities, you must meet all of the following conditions:
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; and
You must carry on the activity with continuity and regularity.
The following facts and circumstances should be considered in determining if your activity is a securities trading business:
Typical holding periods for securities bought and sold;
The frequency and dollar amount of your trades during the year;
The extent to which you pursue the activity to produce income for a livelihood; and
The amount of time you devote to the activity.
(IRS Publication 429)
A "Dealer" is defined, whereas a "Trader" is described.
The "Dealer" in Securities description is concise. It is defined explicitly within IRS Regulations (Regs). Contrast this with the "Trader" description. It is not codified in the Regs, and found in IRS Publications. Critically, the difference here is that the Trader is described, rather than defined. Because of this, investors will seek to fit their activities into some of the descriptive terms, but they have a burden of proof using facts and circumstances tests.
Also note, that in order for the Trader to benefit from preferential treatment, tax items must be elected and reported in particular way. Failure to elect in a timely manner, or reporting incorrectly will result in the IRS overtly rejecting the request, or simply result in
Let's keep in mind that the fact that you owe tax, while irritating, is generally a good sign. It implies that you made a profit. The exception being with regard to tax periods (the calendar year) and how gains are realized, unrealized, and recategorized (under the wash sale rules). It is noteworthy that one of the benefits of Trader status is they are able to avoid wash sale rules by mechanism of electing a mark-to-market accounting method. However, mark-to-market can help in some, but not all tax situations, and will always have added costs for compliance. This is an important concept to keep in mind from the perspective of risk and reward.
The Mark-to-Market election sometimes is beneficial, but always is complicated.
Mark-to-market is an election under §457(f) to treat unrealized gains as realized at the close of the fiscal year. Theoretically this can help in situations where there are unrealized losses. Without mark-to-market when you invest (or trade) in publicly traded securities, there are three possible states of your investment at any moment in time:
Conceptually, the difference between mark-to-market is that the state of the asset is always priced as though you have sold the position on the day that it is marked, which tends to be 12/31 for general investments, though some forward derivatives might mark-to-market more frequently than this.
This clearly has some pros and cons. For example, investors are frustrated by the wash sale rule, which occurs when you sell at a loss, but also repurchase a substantially similar security within a 61 day (30 before, 30 after) window. When this happens, the loss is trapped while realized, cannot be recognized until the replacement position has been sold. Here's an example of how a wash sale can impact you, even if unwittingly:
He realized a loss on the transaction of $4,500. However, VTI went ex-dividend on 09/24/2021, so the owner is entitled to $0.72420 per share. The dividend is paid in cash, and the owner receives $7,242 on 09/29/2021.
Due to the wash sale rule, if the investor had taken (and held) the dividend in cash, they would be able to report:
From this transaction, we would have $4,242 dividend income and $1,500 in capital loss carryforward, as the loss is limited to $3,000 against income that is not capital gain. There's no wash sale here. However, if the investor had enrolled in a DRIP, they would have triggered a wash sale when the dividends were subsequently reinvested. This example shows two distinct benefits of the Trader vs the Investor:
At this point, it appears that the Investor is in a superior position in each of the three events, however this is misleading. What is really happening is that the Trader isn't required to sell their position in order to have favorable tax treatment. They are benefited by freedom from the wash sale rule, and also benefit from being able to apply the entire $4,500 against dividend income, but these two benefits do not always result in a superior outcome vs the Investor tax treatment. Arguably, there is value in being able to claim the tax treatment without selling (for purposes of holding hedging positions) but other than that, there is often very little difference.
If we fast forward to 12/31/2021, where hopefully VTI is valued at $245 per share.
The investor who was caught in a wash sale can sell their position and free their loss. Any appreciation between 09/29 and 12/31 will be recognized, and the wash sale will be released. When the position appreciates, the gain from the sale is absorbed (the appreciation eats into the carryforward). If VTI has depreciated, then they would end the year as though the reinvestment wash sale didn't happen, but still be limited to $3,000 to offset the dividend income.
The Investor has optionality, the Trader does not
Fundamentally, the issue here is that the Investor can always decide to sell, harvesting gains or losses in doing so, whereas the Trader lacks this optionality. Clearly, when it comes to loss harvests and wash sales, this seems favorable to the Trader, but the same is also true for gains, and we would hope that as a successful Trader you would have lots of those. Losing the optionality to realize gains can be very costly.
In addition to this risk of creating an unfavorable position from mark-to-market elections, you also need to consider if the ongoing increase in compliance provides a tangible return on investment. Broker statements will generally be reported in the traditional (non mark-to-market) manner, and therefore adjustments will be necessary not only at year end, but also when transactions occur throughout the year.
Mark-to-market is a major part of the Trader vs Investor decision, and it should be remember that this is an election. By design, you are not required to use mark-to-market as a Trader, but you have the ability to elect it, whereas an Investor does not. One thing that you would certainly seek to do by being considered a Trader is expense business costs. But again, we would want to know if the juice is worth the squeeze. For example, if your goal from achieving status is the ability to write off a home office expense, first ask, what it is the quantifiable value of that:
For argument's sake, if we use $1,500 here, that is a reasonable deduction and has tangible impact to your taxes, however, the key here is regarding how the trader views long term and short term gains.
This should be a line in the sand for the Investor seeking to be a Trader, they should ask themselves, are they simply generating too much in short term capital gains that they would like to offset with business expenses. If so, why, and what upside is being truly generated. Remember, to be a Trader you are supposed to be investing significant amounts of time and energy into the pursuit of 'upside'. Your benchmark is the passive investor and index. Also, we should keep in mind that there is more than one way to claim a home office. If you are retired or have (been) 'FIRE'd' then there are other forms of self employment that would allow you to expense things and also keep up hobbiest trading activities.
Trading in 2021 has very low barriers of entry, people are pulling up Robinhood and Coinbase on their phones between (and probably during) work meetings. That doesn't make you a 'Trader' for purposes of tax, but would quitting your job and doing this full time qualify you?
We're also seeing this a lot with those people who earned a lot of money via employee stock from companies that IPO. They have sudden wealth, and enough time on their hands to get bored, but if you are lucky enough to have found sudden wealth and in a position to retire from the workforce, does the narrative of being a Trader really make sense?
Conceptually, by seeking to be labeled a Trader you are trying to create a fact pattern where the IRS views you as someone that is diligently pursuing income production, and you need to keep receipts and prove your case. Surely, the point of sudden wealth is not to be able to quit your job and then try to construct a narrative to defend some tax deductions. To me, this is like saying you quit because you don't want a boss any longer, but you are not free, you are beholden to a new boss, the IRS. You need to spend the time that you so aggressively defended by quitting the full time job building a narrative to save some money on a home office. This isn't the goal of financial independence!
So, before embarking on a journey to try to build a world where you can prove that you work all day as being a trader in exchange for a home office deduction, ponder the cost and complexity that you bring to your world as part of the price of a tax deduction.
And, if you aren't one of the lucky ones with sudden wealth, and you really need the proceeds of trading to support your lifestyle, you should be very careful and very honest with yourself about whether your plan to make a living from trading is feasible. You need enough money to start with and should consider a viable sustainable growth rate from your strategy. For example, if you need $100,000 per year to live on, no strategy in the world is going to work long term if you start out with $50,000.
Keep real, tangible goals and be careful about your mental health. It is not uncommon to hear about Traders (tax qualified or otherwise) to hide their losses and eventually take their own life out of shame. Again, this is adds to your hurdle rate in the decision to pursue trading rather than investing. Most traders that I have spoken with are not able to maintain their lifestyle without consistent annual gains, and eventually the pressure of that can be too much.
I know that this might seem jaded so far, but here's a case where I do agree is worth pursuing trader status. You can view it here: https://casetext.com/case/kohli-v-commissioner in this case Kohli had reported a mark-to-market election under §457(f) in an attempt to gain favorable tax treatment.
Kohli joined Infospace in 1996, and along with working there he traded stocks (presumably via fax machine, as Robinhood was a distant dream back then). By 1999 his options were valued at $17M. In early 2000, he left Infospace and exercised the remaining options, with a value of $55M. By the end of 2000 his stock had declined from $55M to $9.5M.
Let's pour one out for employer risk and diversification.... that's $45M wiped out
But it gets worse for Mr. Kohli. The tax code puts him in a very difficult situation:
Pause for a moment here. The tax treatment seems unfair, but it isn't. What happened is that Kohli received $55M in stock in exchange for his work, he just happened to either:
In either case, he didn't have to lose, there was either a conscious choice by selling and trading it, or an unconscious choice by holding it and not trading it. This is worth noting because it is what almost all employees who receive incentive stock will do, and it is a particularly bad choice for those who receive Restricted Stock Units (RSU).
You got cash (in the form of stock) you're taxed on it like cash, and you continue to hold it as stock for no reason whatsoever.
Whenever I hear about stock stories like this, I just wish that the person receiving the stock instead were forced to accept cash instead, and be offered the chance to invest that cash into the stock at the fair market value on that day, I'm sure it would change many strategies, but I digress, back to Mr. Kohli.
To help soften the blow of $57M of earned income, Kohli reported a loss via mark-to-market of $60,728,125.89. He also claimed to be a Trader, so that he could apply that loss against ordinary income. The IRS pushed back on this position, not because it isn't allowed, but rather because they said Kohli made a late election. So, in the case of Kohli, if he had timely filed a 457(f) and could substantiate the position, he would have actually been allowed the deduction via Trader Tax Status.
You can see that if you know you have a tremendously large tax event coming, you could consider making this election sooner, rather than later. But also, when seeking this preferential treatment, are you in the position of Kohli? You could argue that Kohli never knew he would end 2020 with $60,728,125.89 in losses, but that's missing the point. If you want to benefit from Trader tax status and mark-to-market you need to understand the bet you are taking. It isn't a bet that you'll win or lose, but that your stakes are high enough for the bet to always win.
Recall earlier where I mentioned:
The Mark-to-Market election sometimes is beneficial, but always is complicated.
You couldn't know in Kohli's case that he would need to rely on mark-to-market in advance, but in hindsight you can see that it didn't matter if he won or lost in 2020. The benefit of the mark-to-market election is that if he had unrealized gains, he would need to pay more tax than if he was not using the mark-to-market, but he would also have resources with which to pay those taxes, whereas if he lost (as he did) he could claim the losses.
In either outcome, mark-to-market is a no lose decision, and it is only because of the level of income that was generated from the original exercise of the options. The moment this became something of a strong possibility, mark-to-market was better than not.
As the Kohli case proved, retroactively seeking mark-to-market once you know you need it (when you have lost it all) was disallowed. But the mistake isn't that he applied late, after the fact where he knew the win or lose outcome of 2000, but because he didn't recognize that he was presented with a relatively no-lose bet and failed to make it. The driver here is that he was actively trading throughout his employment, coupled with the large ordinary income event. If you took a different fact pattern:
Mr Madeup, also at Infospace, also got $55M in options, but divested into a diversified position, it would be much harder to lose vs actively trading or holding a concentrated position. The decision to diversify changes the decision to mark-to-market (not to mention excludes Mr Made up from having the option to elect this).
Electing into mark-to-market can be a bet, but we can influence the outcome of this by thinking of the bet as an equation, where one of the variables is other earned income. Once this has been identified as being very likely, things like mark-to-market become more viable, so we would look first to other earned income, and next to a fact pattern of trading to see if we have a viable path.
Mark-to-market can be very powerful, but you are betting when electing into it. In the Kohli case, it wasn't the investment loss that made this a good bet, it was the earned income that made it a good bet. If you don't have this earned income, your chances of winning the bet are smaller, and your upside more limited. If you have retired, and have no other income then the upside from mark-to-market is limited to the extent that your realized gains exceed your unrealized gains, and unless you are trading at substantial levels, it will often be not very valuable.
OK, you've thought it over and you still want to be a Trader, how can you convince the IRS that you are? One answer I have heard is to form a LLC as it appears to lend legitimacy to things. While I can see the logic here, an LLC alone is not enough, but in tests like Trader vs Investor it is a mosaic of facts that help prove a case, so I see no harm in the LLC route, but it isn't going to be the sole reason that you'll be considered a Trader. I can many see situations where a person without a LLC would be considered a Trader and a person with an LLC would not.
A bigger concern may be that if you wanted to form a LLC for Trading, and turn your hobby into a profession, how do you transfer assets into the LLC without causing tax complications? There's a myriad of tax rules here, and the more you think about it, the more they become quite logical.
If we look at §351 for single member LLC and §721 for a multi-member LLC (a partnership). The latter is more complex, but also more explanatory as a single member LLC (or other solely owned corporation) may become a multi-member owned corporation or partnership after establishment. Imagine a scenario where three friends each have a personal account valued at $10,000,000, but the compositions are different:
We can clearly see that this partnership might be unequal in design. The goal of Partner 2 might be perceived as being to move appreciated stock into the account so that it may be netted against the losses that Partner 3 has. It is not uncommon to find unrelated people that have either a large capital gain they are reluctant to recognize, or a large capital loss carryforward that they've struggled to utilize due to the $3,000 annual limit against other income.
Because of this, there is an obvious motivation for someone with a substantial gain to seek someone with a substantial loss and seek to blend the two into a net $0 event. Because of this, there are additional rules surrounding the §721 transfer of property into a partnership, ( and §351 into a corporation or disregarded entity) when we are dealing with investment companies. However, these tests do not explicitly deny such reorganization of gains and losses, but they do add provisions to allow or disallow them.
Essentially, §721(a) allows partners (and §351(a) individuals) to transfer property without recognition of gain. However 721(b), and §351(e), respectively exclude investment companies from this treatment. For the single member LLC, such a transfer under 351(a) is allowable, but we must remember that the LLC could later elect C Corporation status or transfer ownership, and in such a case, it would have to trace back the basis of the contributed assets.
A single member LLC is a Partnership without a Partner (yet!)
There are a number of rules that exist in the formation of a single member LLC and the subsequent transfer of appreciated assets simply because it is very easy (and very cheap) to:
Therefore, if there were rules in §721 or §368 that didn't apply with regard to the transfer of assets into a disregarded entity (a single member LLC with no entity election) it would be simple to do this, then simply transfer ownership at the LLC level to others and circumvent any restrictions. The best way to think about the difference between a single member LLC and a multi-member LLC is simply that you're a partnership that hasn't found a partner yet. If you ever do find that partner, you'll have to look back to the incorporation and original transfer in order to meet the rules, no different than if you formed as a multi-member on day 1.
If ownership does not change, and it moves from individual to single member LLC, then there is no tax recognition providing that a statement and election under §351 is used. Think of this as being something that books the transfer in a way to trace the basis back if you were to ever transfer ownership in the future.
Interestingly, the tests for the investment company that becomes a partnership can actually allow for this blending of gains and losses if there is evidence that the formation creates a diversified position under §368(a)(2)(F)(ii). The two tests measured are to have no more than 25% in a single stock, and no more than 50% of total assets invested in a portfolio of less than five securities.
A corporation meets the requirements of this clause if not more than 25 percent of the value of its total assets is invested in the stock and securities of any one issuer, and not more than 50 percent of the value of its total assets is invested in the stock and securities of 5 or fewer issuers. ( §368(a)(2)(F)(ii)).
The takeaway here is that it can be (fairly) straightforward to transfer into an LLC, but you need to consider the subsequent exit from the transaction. While it is not disallowed to use this model to diversify concentrated positions, the rules to prevent abuse of this benefit can cause complexity for the Trader who seeks to simply transfer assets into a 'business account'.
When seeking Trader Tax Status, we should consider:
Ultimately, for many the savings will be small, and the complexity large, but for those who truly are Traders for a living, it isn't about the LLC, but rather the broader facts and circumstances of how you approach your business.