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In a message dated 9/16/99 8:29:06 AM Eastern Daylight Time,
Mmangiafico@xxxxxxxxxxx writes:
<< Warren Buffet doesn't trade that
frequently??? >>
Warren Buffet is probably not a Trader! His average holding period is for a
"lifetime".
<>
Gary and Michael
You both ask good questions to which there is no definitive answers, but I
will do my best to give you my opinion which is based on some years of doing
this. First let me state the determination of whether or not someone
qualifies as "Trader Status" is highly subjective. Furthermore, it is not
based on one or two factors, but rather a combination of them. Some of the
criteria that came to light in 1992 in the Ropfogel decision in Kansas were
that:
1) A Trader must trade on a frequent, regular and continuous basis;
2) A Trader must have a substantial number of trades,
3) A Trader's trades must be short term and
4) A Trader must not derive a large amount of dividends from holding the
positions the Trader says he or she is trading.
But there was a slight problem with this decision, which you probably have
already guessed - that is they never told us what a frequent regular and
continuous basis is; they never told us how many trades you must have for it
to be considered to be substantial trading; they never told us whether short
term is a day, a week, a month or under a year (as it is for tax purposes);
and they never told us how much dividend income you can have before they
disqualify you. They did tell us that they wanted to reserve the right to
decide on a case by case basis whether one qualifies. (And in fact that was a
restatement of an earlier case Higgins vs the Commissioner, 1941, where they
said they would reserve the right to determine this on a case by case basis).
So where does that leave us? Well it is both good and bad. We can thereby
make a case for just about anything, within reason. What we do in our firm is
to subscribe to all the major services which inform us of the decisions and
the interpretation of them. And then I reread them and get my own
interpretation as well.
I believe that determining Trader Status is almost like painting a picture.
It takes more than one or two colors and the picture is comprised of many
components. The Trader questionnaire that I have developed asks many
questions. Let me give you some of the factors, and then tell you why I ask
about them. Then I make my determination based on all of them.
1. What do you trade/invest?
It has been determined through several court cases that the courts give the
presumption to those trading commodities and options that these are not
investment vehicles. Therefore
if you trade something other than stocks, you are presumed to be engaged in a
trading non- investment vehicles (I did not say presumed to be a trader -
that depends on a compilation of factors)
The two cases that come to mind are Reinach v. Commissioner : Where an
option writer did not have to prove this activity was a trade or business due
to nature of instrument (options) and
Marlowe King v. Commissioner Where a futures Trader allowed to deduct all
expenses incurred with business of trading futures, even though some gains
were long term. In other words, the Trader's business of trading futures was
upheld because of the nature of futures contracts.
So the type of vehicle you trade has something to do with how strictly
everything else lines up. Also if someone trades only IRA accounts there is a
whole other consideration, which needs to be addressed. There has never been
a case on the books that I know of, but I have been told from the head of the
IRS division on trading policy that if they find you Trading your IRA and
considering yourself in the business of TRADING then they might disallow the
IRA because you should not be running a business in a retirement account.
I don't agree with this, but I would be careful not to point this out to
anyone in the IRS! What I would suggest is that you may need to do an
allocation of your trading activity between investing and trading, putting
some expenses a investment expenses, and leaving some as Trading. I would
need to speak to you specifically. Anyway back to the factors.
2. How many transactions do you average per month?
This is clear cut, I want to see how substantial nature of trading activity.
Now how much is enough? I can't say for sure. Again it depends on the other
factors as well. Do you do it full time? Do you have another job? You better
have more trades if you work a day job as well. If you do it full time, you
may be able to get away with less trading activity.
I can tell you how many trades is not enough. In 1995 Rudolph Steffler was
denied Trader Status. It was all he did. He told the courts he was a full
time trader, and in fact, he did nothing else. But he had 27 trades in 3
years! Now I don't know what his strategy was, maybe it was based on entering
in very select trading situations, but they do want to see you doing this as
an ongoing business. 9 trades a year can not be considered an ongoing trading
business. If it were, his time frame was probably too long term - even if he
was watching the positions each day. Now if he watched the market every day
and only decided to trade just 9 days and they were all very short term
trades - I don't know. I think the IRS would still consider this not to be
substantial trading activity.
On the other hand, I will tell you about another case, one which disturbs me
a great deal.
That is the case of Stephen A. Paoli vs the Commissioner in 1992. Paoli had
526 trades one year and he also stated he did this full time. His trades fell
in a very concentrated part of the year. 75% of his trades came in four
months and 40% in three months, and he did not trade in November and
December. He also received a rather large salary from a chemical firm he
said he had nothing to do with anymore. The courts asked him if he traded on
a frequent, regular and continuous basis and he told them he did. In fact he
told them specifically that he traded every single day of the year. They said
"are you sure you traded every single day of the year". He answered yes. It
was my feeling that this blew his credibility and had he been honest and told
them he took time off, it would have been OK. Also, had he kept a log of his
trading activity to back up his statement, it would have been OK. But there
were two incongruous statements he made,-that he didn't manage the firm
anymore, but yet took $200,000 in salary, and that he traded every single day
of the year. But yet he had no trades in two months. He didn't back either of
those up with logs. And when dealing with the IRS or in Tax Court, your
credibility is everything. He lost his, and also lost the case.
Now like I said this case disturbs me more than any case I have ever
reviewed. The problem, though was with his writeoffs. He wrote off a full
year of expenses including a substantial amount of margin interest in an
account that he had just 4 Trades out of. I think if he allocated his
expenses he would have been alright, also not lied to the IRS. I have to
believe that the key point was credibility not the continuity of his trading.
I have successfully defended Traders in audit who have had as little as 100
Trades a year and I have filed Traders with less (but never been audited on
them). So it depends on a lot of things.
By the way, logs and journals are two of the most important tools you as
traders can use. I have a whole appendix in my new book on how to support
your case through the use of contemporaneous journals. It can turn your
statements into court room evidence that no one can refute. You must keep a
trading diary. Keep a log of you computer and home office use. It will go a
long way.
Furthermore, if you take time off during the year. Keep a record of that, and
if you are ever asked, tell it like it is. I can't believe that any business
owner would be denied a vacation or time off. Especially traders who burn out
with excessive activity.
I think it is important to allocate the expenses incurred while you take time
off to something other than Trading activity. This will go a long way to
increase your credibility and allow the IRS to rule in your favor if it is
ever looked at. In other words, if you paid for a year's worth of signal, and
took 3 months off, allocate 3 months of your data feed to something other
than trading - ie as an investment expense. If you bought TradeStation and
the allocation of amortization (you can't depreciate software, you must
amortize over three years) is $1000 per year, but you took 3 months off,
allocate $250 of the amortization to investment (not trading)expense. This I
think will take care of the time off problem unless you spend most of the
year not trading. T hen you might have a problem.
3. What is your average holding period?
Well they want to see that you are doing short term trading to take advantage
of the swings in the market. In Levin vs the Commissioner(1979), the courts
ruled the a Trader is someone who moves his positions just to take advantage
of upswings and downswings in the market and in . There are many others which
supports this view of frequency of trading. Look at the cases I listed in my
last post. They have all the issues the courts ruled favorably on. Although
in Fuld v. Comm (1943): Betty Fuld and her husband were held to be Traders
because of a large number of trades, none of which were held for as long as
two years. That's what the courts said - two years! Talk about inconsistency!
4. Do you trade/invest full time?
In my audit experience with the IRS, I have found it much easier to let the
other factors slip a bit if the person is doing this full time. Nowhere does
it say you must do it full time, and in fact many traders I file as such do
not do it full time. As I stated before, if you do it part time I will be
more stringent on what is required - a journal to prove you are trading with
substantial time put into the activity. The 100 Trade a year Trader did it
full time.
5. If you have another job, what is it? Full time/part time?
Again to see how easy it will be to substantiate in audit. A part time job
leaves more time to trade. A job in the industry substantiates the case a
little more. Related background makes it easier for me to prove in audit. But
again nothing here absolute or required. Remember this is just another
component.
6. How frequently do you trade (intraday, daily, weekly, monthly)?
I like people who trade daily or intraday. If you trade monthly you better
have a lot of other supporting factors..
7. When you are not making trades, how closely do you watch the market to
evaluate whether or not you should trade (intraday, daily,
weekly, monthly)?
How close are you watching your business?
8. Do you keep a trading journal to evidence time spent trading/watching the
market?
As I said a big factor in my mind.
9. How many hours per week do you devote to your analysis and your
trading/investing?
10. Do you have the expectation of Short or Long Term profits from a
position?
In Liang v. Commissioner (1955): The courts looked at intent. They stated
that a relevant consideration to Trader status is intent of Trader to derive
Short term profits from a frequent trading.
11. Do you intend to receive dividends from your position?
Again intent! See the Ropfogel case I spoke about before.
12. Do you have an office to trade from? In home or out?
If you say you are a business, you better have a place to do business from -
ie an office. In fact a home office which many people say is a red flag, is
in fact a requirement if you have no other office to trade out of.
13. Do you trade by Technical Analysis or by Fundamentals?
In Frederick R. Mayer (1994) vs the Commisioner:The guy had trading advisors
trading his account, but they were using fundamental analysis. This alone was
enough for the courts to rule against him being a Trader. The courts never
addressed the IRS complaint that he would not qualify because he gave up sole
discretion on his account to others.
Anyway I have gone on long enough. I hope I have answered both your
questions. But probably not definitively.
Micheal, 2 to 4 trades a month may not cut it - I am not sure. That is really
low for a trader. I am not saying I agree with the IRS position, but that is
just my experience. Because that is all you do, you have a better case. but
it would take logs, trading journals, diaries and some doing to prove that
you are watching the market full time as a job. We could probably make a case
for it - but it is an agressive one. I would need to see the other factors on
your questionnaire. The 4-7 days holding period is less of a problem.
Gary, your original question of "Are these holes in my activity likely to
cause a problem (on your 1998 tax return)?" can only be answered at this
point by "I don't know".
I haven't seen your tax return, and even if I do, I could only give you the
potential problems. Problems aren't problems until the IRS pulls it and
creates a problem. Whether or not they ever catch it is another issue.
I have seen some pretty bad tax returns prepared by other CPAs which have
passed through and never gotten caught. You wouldn't believe some of the
stuff I have seen. Remember only about 1% of the tax returns as a whole get
audited - more in certain areas, less in others. Also income and expense and
various ratios from year to year are factors in audit selection. if you have
read any of my books I include the details on the way the IRS pulls returns.
If you like I will look at it for you and give you my opinion. Call my office
to discuss after 10/15 - Tell Marcia we have spoken by email. We are only
dealing with clients until the deadline, or new clients that have deadline
issues this year (remember the second extension deadline is 10/15 and we
still have a bunch of tax returns to still get out.) You did say you filed
the return already, right, so there is no deadline problem with it? Our
number is.1- 800-556-9829 I would have you fill out a questionnaire if you
haven't already done so to get a better sense of your complete trading
activities. If there is something which I think will stick out, we can
always amend it - that's not a problem. Good luck!
Regards
Ted Tesser
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