Paul S. Mann, CPA actively consults on tax issues specific to professional stock traders through his accounting firm, Mann & Company CPA's P.C. He is also the founder of DayTraderTax.com, a financial web site providing tax expertise to the active stock trader.
Mr. Mann is licensed as a Certified Public Accountant in the state of Colorado. He conducts an active nation wide tax practice for both individuals and closely held businesses. He also regularly conducts seminars on the many tax issues facing active stock traders and is widely considered an expert in this area of tax law. He is a member of the American Institute of Certified Public Accountants, and the Colorado Society of Certified Public Accountants.
For additional information on this or related subjects please visit his site by clicking the banner above.
PTS: Let's talk about the difference between a professional trader and a non-professional trader. How does the IRS distinguish the difference?
Paul Mann: In order to be considered a professional trader, two conditions must be met:
First, the individual must meet the strict definition of a "trader", and secondly to obtain the benefits of that status, the IRS has established very strict guidelines as to forms and elections that must be filed with them to notify them of your "trader status".
The internal revenue code does not actually define what constitutes a professional trader, the relevant information is contained in tax court cases and revenue rulings.. In (Cmssr v. Groetzinger 1987) the Supreme Court held that "to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity, and that the taxpayer's primary purpose in engaging in the activity must be income or profit". The Taxpayer Relief Act of 1997 further stated that "traders in securities generally are taxpayers who engage in a trade or business involving active sales or exchanges of securities on the market, not to customers".
What we take from this, is that a "professional trader" is one who trades on a regular basis, on his own behalf, and his trading style is to catch short term swings in stock prices, rather than long term capital appreciation. This type of trader is now commonly referred to as a "Day Trader"
A non professional trader would encompass all other stock traders or investors who either do not fit the above definition, or if they do satisfy the definition have not made the proper income tax elections.
PTS: What does being a professional trader mean from a tax standpoint?
Paul Mann: Once an individual has elected professional trader status (also referred to as a "trader in securities") the impact on their tax situation is dramatic. The changes are too numerous to list here, but I'll discuss some of the major items:
First of all, the results of trading activities are no longer treated as capital gains and losses but as "ordinary income or loss". The major significance being that an individual who has lost money trading stocks is no longer limited to the net $(3,000) capital loss rule. If unfortunately you lose $(25,000), then you deduct $(25,000) from your taxable income. A professional trader may still take advantage of long-term capital gain rates in their mutual funds or in brokerage accounts that are clearly separate from their active trading account. Profits from trading activities, even though from a "trade or business" are not subject to self employment tax. A professional trader is not subject to the "wash sale rules" applied to non- professional traders. This alleviates a tremendous accounting nightmare of the active trader. A professional trader does not need to track individual stock trades, he may report his net income or loss for the year simply by comparing account values at the beginning and ending of the tax year, and then make a few easy adjustments.
PTS: What are some areas that traders need to be aware of in order to reduce their tax burden?
Paul Mann: This brings up another good point about the tax differences between professional and non professional traders.
Professional traders may deduct all of their direct and indirect trading or business expenses without limitation. This includes margin interest and all other types of expenses. The expense categories are very much broadened for professional traders as well. For example a professional trader can deduct automobile mileage, meals and entertainment, cell phones, trader chat room fees, dues and subscriptions, home office expenses, and the list goes on and on.
A non-professional trader, can only deduct margin interest to the extent of investment income (interest and ordinary dividends), and the definition of investment related expenses is very narrow. Many of the deductions allowed for a professional trader would be disallowed on a non-professional trader's tax return.
PTS: Are there any "gray areas" in terms of write-offs for professional traders?
PTS: If a trader had trading losses of well-over the $3,000 limit for deductibility, is there anything they can do?
Paul Mann: I touched on this briefly in the answer to your second question. A professional trader can deduct all of his trading losses if he qualifies as a professional trader, and elects "Mark to Market Accounting Treatment" with the IRS. This election process is very complex, however, and I would definitely recommend that an individual seeking to do this obtain professional advice. For example, let's say a trader (without the proper elections) lost $(25,000) during 1999, and decides to make the proper IRS elections for "professional status" for the year 2000. This may be a mistake because he could only write off $(3,000) on his 1999 taxes, and has a $(22,000) capital loss carry forward. If he elects "professional status" for 2000, his profits will be taxed as ordinary income and therefore the $(22,000) loss carry forward will not offset his year 2000 gains. He would be better off remaining as non professional until he recouped his losses and then contacting us about strategies from that point forward. Unfortunately, for now anyway, all non professional traders are stuck with the $3,000 loss rule. That's why it's so important to seek professional advice if you are an active trader.
PTS: Is it o.k. for traders to deduct ongoing educational expenses?
Paul Mann: Absolutely. The only limitation is educational expenses incurred to qualify for a new trade or business, and even this is somewhat of a gray area. You do not have to be licensed to be a professional trader. A professional trader is more defined by his or her behavior (i.e. trading style). So, the question becomes does the training class "qualify" you for a new trade or business. This comes back to an individual's tolerance for risk and aggressiveness on their tax return. All other educational expenses incurred by an active trader would be deductible, including travel and meals.
PTS: Do "traders" have to pay Social Security and Medicare taxes?
Paul Mann: Not generally. Profits obtained by a self-employed professional trader are not subject to these taxes. However, in certain instances we recommend that a trader form a corporation to conduct his trading activities. In this instance, depending upon the trading results, we also may recommend that a salary be drawn from the corporation. In this case, like all salaries, the amount taken would be subject to social security and medicare taxes.
PTS: Can a daytrader fund a Keogh? If not, what alternatives are there?
Paul Mann: Absolutely. If the trader has done the proper paperwork to obtain professional trader status, they can fund a Keogh, Simple IRA, Regular IRA, SEP IRA, or a Defined Benefit plan. If they have not completed the proper paperwork then they are not considered to be conducting a "trade or business" and their options are severely limited. In this case they most likely will be limited to a regular IRA.
PTS: What about paying quarterly taxes?
Paul Mann: That's a good question. Traders need to carefully monitor the results of their trading activities quarterly. If you show a profit then send the IRS and your state dept of revenue estimated tax deposits. The IRS uses form 1040ES, a very simple procedure, each state of course has their own forms. If you pay quarterly taxes and later determine that you did not owe them, then they will be refunded when you file your tax return at the end of the year. If you don't pay quarterly, and it is determined that you should have, you will be penalized, so in most cases its better to pay as you go. Also you won't receive any nasty surprises when April 15th rolls around if you keep up with your estimates.