I've received a number of questions about whether an individual is a "trader" or an "investor." Being a trader implies that a taxpayer maintains a "trade or business," and will report stock gains and losses on Schedule C along with any associated business expenses. Being an investor means that a taxpayer will report stock gains and losses on Schedule D, with associated investment expenses reported on Schedule A.

Since it is virtually impossible to answer each and every specific inquiry, I think it is helpful to post a detailed analysis of the situation.

Individual investors are NOT engaged in a trade or business merely because they manage their investments. This being the case, investors who are NOT in a trade or business cannot deduct expenses connected with their investments as business expenses.

Very often the courts have looked to see whether the taxpayer is a "trader" or "investor" when the issue of expenses arises. In one case, the Ninth Circuit Court found that a taxpayer was only an investor, despite heavy involvement in securities transactions, because he didn't maintain a separate bank account, or office, or employees in connection with his securities transactions. He never filed a Schedule C with respect to his business of investing in securities.

In another case, the Second Circuit Court denied business expense deductions to a taxpayer who had deducted office rent and secretarial salaries in connection with investment activities. The taxpayer, who invested a large estate inherited from her husband, had no personal experience in business, and was held to have merely received income from investments. The Ninth Circuit held likewise where there was no evidence relating to the extent of the taxpayer's dealings in securities.

In yet another case, the Tax Court held that a taxpayer who had reported 326 sales of stock or options worth more than $9 million in the tax year at issue was an investor rather than a trader engaged in the business of stock trading. The Tax Court said that the taxpayer's pattern of buying and selling stocks wasn't sufficiently regular and continuous throughout the year. In this case, 40% of the sales were made during a one month period, and the proceeds realized from these sales totaled more than 54% of the total sales proceeds for the year. The court did not accept the taxpayer's brief testimony that he spent four to five hours per day throughout the year engaged in the activity, since there was a three month period where the taxpayer made only one sale and did not buy any stock.

As you can see from the above examples, the courts have been pretty restrictive in their interpretation of a "trader" status. Lets look at some other cases and explanations.

The distinction between traders and investors is that a traders' activities are directed to short-term trading, not the long-term holding of investments, and their income is principally derived from the sale of securities rather than from dividends and interest paid on those securities. In reversing a lower court's decision, the Court of Appeals held that the lower court erred in relying on the Kales case. That is, the lower court erred in ruling that the "regular, extensive, and continuous" test was determinative of whether a taxpayer was engaged in the trade or business of managing his own investments.

In Kales, the Sixth Circuit had allowed business expense deductions to a taxpayer who made all the investment decisions with respect to funds inherited from her father. She had an arrangement where she paid $3,000 a year to a law firm that kept her books and set aside an office for her that she visited three to four times a week. The court found that her investment activities were extensive, varied, continuous, and regular.

But the Second Circuit Court ruled that the relevant factors in determining whether a taxpayer is a trader or an investor are the taxpayer's investment intent, the nature of the income to be derived from the activity, and the frequency, extent, and regularity of the securities transactions. The two fundamental criteria that distinguish traders from investors are: (a) the length of the holding period of the securities, and (b) the source of the profit. Investors derive profit from the interest, dividends, and capital appreciation of securities. Traders, on the other hand, buy and sell securities with reasonable frequency to profit on a short-term basis.

For example, the Second Circuit Court considered a taxpayer an INVESTOR who had initiated over 2,000 securities transactions during the two years in question. He worked every day of the week on his securities "business" and was provided with an assistant, a telephone, use of the secret"arial, helvetica" pool, and access to research staff and facilities by his broker. HOWEVER, his strategy was to buy undervalued stocks and hold them until their market value improved. Most of his sales were of securities held for over a year. He did not sell any securities held for less than three months. He had also received significant dividend income.

As was previously noted, the number of trades is NOT the controlling issue. There are many, many more cases that can be cited where the taxpayer was ruled an investor, and NOT a trader, simply because of the number of the transactions.

In a 1994 case, the Tax Court, in determining whether a taxpayer who manages his own investments is a trader, considered the following NONEXCLUSIVE factors:

-- The taxpayer's investment intent;
-- The nature of the income to be derived from the activity; and
-- The frequency, extent, and regularity of the taxpayer's securities transactions. This being the case, a taxpayer's activities may constitute a trade or business of trading only where both of the following are true:

1. The taxpayer's trading is substantial (i.e., sporadic trading will not constitute a trade or business); AND
2. The taxpayer seeks to catch the swings in the daily market movements and to profit from these short term changes, rather than to profit from the long-term holding of investments.

So there you have it. A very recent (1994) tax court case that clearly states that the trading must be substantial, and the trading must be short-term. However, the court did not define substantial, nor did it define short-term. Therefore, each taxpayer must take all of the facts and circumstances into consideration in order to determine if his or her activities meet or exceed the standards set forth by the Tax Court.

I'll leave you with two other cases for your consideration.

In 1991, a District Court held that a taxpayer who engaged in more than 12,000 stock trading transactions during the two tax years in question was an investor, since the sheer volume of transactions wasn't determinative. Moreover, the predominance of dividend income and long-term capital gain income over short-term capital gain income indicated that the taxpayer may have intended to be an investor. The standard that the District Court used was as follows:

-- The length of time that the taxpayer held his securities.
-- Whether the taxpayer expected short-term or long-term capital gains.
-- The percentage of stocks held for one year or more.
-- The ratio of margin debt to portfolio value.
-- Whether the taxpayer's intent was to benefit from interest, dividend, and capital appreciation or from short-term trading.
-- What occupation the taxpayer listed on his tax returns.
-- Whether he filed separate business tax returns for his securities business.
-- Whether he maintained an office.

And perhaps other factors as well.

And finally, just to show you that the entire deck isn't stacked against the trader, in a 1982 decision the Tax Court held that a taxpayer was in the trade or business of buying and selling securities for his own account where his original tax return showed his numerous dealings in securities as short-term capital gains and losses under Schedule D. But on his amended tax return, he filed a Schedule C that listed his trade or business as dealing in stock purchases and reflected his securities transactions as income from a trade or business. The Court also found it significant that NO dividend income was reported from any of these securities, indicating that the purpose of acquiring such securities was not for their income element, but for the purpose of making a profit on resale.

Just remember that the 1994 Tax Court case sets the standard, and if you decide to report your stock gains and losses as business income, you had better be prepared to prove that you live up to that standard.

So, after taking ALL of the above information into consideration, are you an investor or a trader? Hmmmm??

- Article 26

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