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Eight Steps To Successful Trader Tax Filing

01/19/05 09:43:41 AM PST
by Jim Forrester

Taxes can always be tricky, but especially so for traders.

Each New Year brings to a close a trading tax cycle and officially begins the preparation for our annual reckoning with the Internal Revenue Service (IRS). If your income exceeded your expectations, you can bring that sense of accomplishment to the daunting job of tax planning. If your income didn't, a tax professional can help you recoup some of your shortfall through prudent tax strategies. Advance tax planning is a particularly good idea this year, due to tax code changes created by the Working Families Tax Relief Act and the American Jobs Creation Act of 2004.

Because every trader faces unique circumstances, there can be no cookie-cutter, one-size-fits-all tax solution. It is important to consult with a tax professional before making any decision that could affect your federal income tax and/or trader tax status. Here are eight points to consider when you're filing your tax return:

1. Protect your trader tax status.

Nothing can throw a monkey wrench into your tax plan like being denied trader tax status by the Internal Revenue Service. Because trader status is constantly evolving with each tax court decision, it is especially important to position yourself well within the IRS' working parameters before proceeding.

According to the IRS, to qualify as a trader, you must: 1) seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation; 2) determine that your trading activity is substantial; and 3) carry on the trading activity with continuity and regularity. Fail any one of those three and you'll be treated as an investor, not a trader, for tax purposes.

What's at stake? Investors are subject to the 2% threshold for deductible investment expenses (and hence cannot write off most of their expenses) and limited to a $3,000 capital loss deduction. But as a trader, you can write off 100% of your expenses, and — if you elect the mark-to-market (MTM) accounting option — you can offset all of your losses against income.

New this year: The Frank Chen case. A curious tax court ruling last summer cast a dark cloud over the trader tax status of certain filers. In the Chen case, the judge agreed with the IRS in denying Chen's trader tax status based in part on the fact that trading was not Chen's "sole and primary income-producing activity."

If you make more money at another job, or even have another job in addition to your trading, be sure to consult a tax professional before proceeding with your tax preparations.

2. File a timely extension.

Because of the complexities of filing a trader tax return, it's often a good idea to file an extension. If you file an automatic extension by the tax deadline of April 15, your tax deadline is automatically moved to August 16. If you need additional time to complete your taxes, you can file for a second extension by August 16, which would move your tax deadline to October 15. But this second extension is not automatic; you must provide the IRS with a reason for needing extra time and wait to receive the original form marked "granted."

Bear in mind that an extension only gives you extra time to file; you must still pay at least 90% of what you owe by the original April 15th deadline, or your automatic extension will be ruled invalid and you'll be slapped with late penalties of 5% per month up to five months, as well as interest expense on all tax payments after April 15.

3. Report on the correct forms.

Many traders mistakenly report all trading income on schedule D (capital gains and losses). To avoid this common error, if you elected mark-to-market accounting, you should list your trading activity on form 4797 (sales of business property), and if you traded in futures or foreign exchange, you should report these trades on form 6781 (gains and losses from section 1256, contracts and saddles).

4. Don't depend on IRA trades for trader status.

If you are trading in your individual retirement account (IRA) or 401(k) plan, say through a limited liability company, the IRS won't count those trades toward your trader tax status, even if you meet other trader requirements.

5. Beware missteps on "managed accounts."

If you have managed accounts in which you have hired another trader to conduct your trades, the IRS will not count that activity toward your trader tax status, nor allow you to take expenses against it. To successfully claim trader tax status, you must actually be the one pulling the trigger on the trades.

6. Prepare before proceeding with mark-to-market.

The rules of mark-to-market election couldn't be clearer: in order to use MTM this year, you must have notified the IRS of your choice by the tax deadline last year. You would then begin using MTM this year by enclosing IRS form 3115 along with your tax return.

But before you make the switch, make sure you separate your investment holdings from your trading stocks and options. Why? Because unless they are clearly separated, you will be required to mark them to market at year's end and report any gain as ordinary income. That could prove disastrous for stocks that have greatly increased in value over time.

The decision to elect mark-to-market is not to be made lightly; it can have a profound positive or negative impact on your taxes. Once you elect MTM, there is no going back without IRS approval. Consult a tax professional to see if mark-to-market is right for you.

7. Include a complete trading log.

Traders who elect mark-to-market are often under the misconception that they need only provide their beginning and ending balance on their tax return and not account for the trades in between. The IRS has requested that every trader send in a schedule showing all of his or her trades for the tax year, whether filing as a trader or investor. The lone exception is for those trading in futures or forex; you need only submit a net figure (use IRS form 6781).

8. Thank your spouse (again).

Married traders have another good reason to thank their spouse this year: The Working Families Tax Relief Act eliminates the marriage penalty by increasing the standard deduction to double the amount given to single taxpayers through 2010.

Trader tax preparation is often an arduous process that requires a thorough command of current tax law, recent tax court rulings, and IRS interpretation. Before making any decisions that could affect your trader tax status or return, we recommend that you consult a tax professional to determine your best course of action.

Jim Forrester is the head of the tax department.

Current and past articles from Working Money, The Investor's Magazine, can be found at

Jim Forrester

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