Defining the ‘professional’ trader

The Tax Court recently ruled that a taxpayer who made just three trades in 2005 didn’t qualify as a “professional trader” that year. As a result, the income from his investments wasn’t considered compensation and he was ineligible to receive a deduction for an IRA contribution.

In 2005, 68-year-old Robert Kobell made a $4,500 contribution to his traditional individual retirement account. He had significant experience working with various financial instruments, and he had “participated in the financial markets by trading stocks and derivatives at times with partners,” according to the court ruling.

But such was no longer the case in 2005, when Mr. Kobell made just three stock transactions, yet claimed on his 2005 return that he was actively working as an “investor/ trader.”

In addition to $71,523 of corporate-bond interest and $4,908 of Social Security benefits, he also reported $915 of dividend income. Mr. Kobell reported these dividends on Schedule B (Interest and Ordinary Dividends), rather than on Schedule C (Profit or Loss From a Business), as would be expected if he were reporting income from a professional trading business.

Upon review, the IRS determined that he didn’t have any compensation and therefore wasn’t entitled to take a deduction for an IRA contribution. Mr. Kobell thought differently, so he filed a petition and the two sides went to court.

THE RULING

In its decision, the court determined that the deduction for an IRA is limited by the lesser of the deductible amount ($4,000 + $500 catch-up contribution for 2005) or a taxpayer’s earned compensation.

Here, Mr. Kobell had no earned-compensation income, so the maximum deduction available was $0. The court further explained that he was clearly not a professional trader, as he met none of the general guidelines for that line of work.

The court ruled that Mr. Kobell wasn’t entitled to a deduction for the IRA contribution. In fact, he wasn’t eligible even to make the contribution in the first place.

IRA and Roth IRA contributions require that an individual have earned compensation, and here, Mr. Kobell had none.

There are no specific qualifications that must be met in order to be considered a “professional trader” but making a few trades here and there certainly won’t qualify anyone.

However, there are tests that you can use to see if your clients stand a chance.

Number of trades: Professional traders tend to have extremely high trade volumes. Many accountants use a minimum of 1,000 trades a year as a guideline, but others consider an average of 10 trades a day, or about 3,000 trades a year, to be a typical starting point. In addition to having a high volume of trades, professional traders also generally don’t hang on to their acquisitions very long. They often buy and sell a position on the same day.

Time spent trading: The courts and the IRS repeatedly have maintained that to qualify as a professional trader, one must engage in the act of trading on a frequent, regular and continuous basis.

So why do so many people claim that they are professional traders?

It is the tax benefits, of course. If you are a professional trader, that means trading is your business, and the Tax Code allows for a deduction from ordinary income for any “ordinary and necessary” expenses incurred while carrying on a trade or business.

Professional traders are also able to make what is known as a 475(f) election, which allows for “mark-to-market” tax treatment. Per Revenue Procedure 99-17, this election must be made for a tax year by the due date of the previous year’s return (not including extensions).

Using mark-to-market accounting, all the securities in the account are treated as if they were sold on the last day of the tax year and any losses are treated as ordinary losses.

Of course, because any loss is considered an ordinary loss, any gain will be considered an ordinary gain and subject to ordinary income tax instead of the lower rates for qualified dividends or long-term capital gains.

There are two more benefits for the professional trader. Even though they are able to deduct business expenses as other self-employed persons are, their income from trading isn’t subject to self-employment taxes.

Plus, the income is considered compensation, which means it can be used to make IRA, Roth IRA or other retirement plan contributions.

Ed Slott, a certified public accountant, created The IRA Leadership Program and Ed Slott’s Elite IRA Advisor Group. He can be reached at irahelp.com.