Part Time Traders

If any one person could expect to be more highly scrutinized by the IRS, it is the part-time trader claiming Pro Trader status. Part-time traders have been targeted by the IRS for several years now. In the ‘Frequently Asked Questions’ section of the IRS website regarding trader status, it states:
“Basically, if your day trading activity goal is to profit from short-term swings in the market rather than from long-term capital appreciation of investments, and is expected to be your primary income for meeting your personal living expenses, i.e. you do not have another regular job, your trading activity might be a business.”

Since many part-time traders may have another regular job or another business that provides a source of income, the above statement may cause some anxiety. It should not however deter you from pursuing trader tax status. Nowhere in IRS Pub 550 does it explicitly state that taxpayers cannot have more than one job, or operate more than one business at the same time. Nor does it limit a taxpayer from enjoying business tax treatment only if that individual exclusively operates it. Nowhere in any tax court case dealing with traders has a decision stated that a taxpayer was precluded from owning and operating more than one business.

The IRS’s website and Form 1040 instructions are misleading as they advocate the taxpayer’s sole, or even primary source of income, must be from trading in order for the taxpayer to qualify for “trader in securities” status. It is widely accepted by the tax courts that a taxpayer can be engaged in more than one trade or business. This point is well documented in Snyder v. Commissioner, 295 U.S. 134 (1935), Bell v. Commissioner, 615 F.2d 226 (5th Cir. 1980), and Cottle v. Commissioner, 89 T.C. 467 (1987).

It should not matter that the taxpayer may be able to support themselves on the income from one business but not the other, from the two combined, or from neither. The courts have stated, “A taxpayer may have sufficient income-producing assets so that the taxpayer does not need additional income from one or more trade or businesses to subsist. That should not preclude the taxpayer from treating activities that constitute a trade or business as such.

One of the areas that concern me the most is the potential for the IRS to mishandle the criteria that focuses on the extent to which the taxpayer pursues a trading activity. The IRS says that your trading activity must produce income for your livelihood, and the amount of time devoted to that trading activity must be substantial. Pub 550 and the Form 1040 instructions could be interpreted to mean that the taxpayer can have only one trade or business and must dedicate all of his or her time to trading to qualify for trader status.
As discussed above, it has been established beyond dispute that a taxpayer can have more than one trade or business. It is only logical that a person does not have to devote 100 percent of his or her time during a working day to a particular trade or business for it to be successful. A taxpayer should be able spend less than full-time trading in order to qualify as a trader for tax purposes as long as he or she meets the case law standard of “active trader.”

An Example of a Part-Time Trader

Stan is a practicing accountant also involved in an affiliate marketing business. He owns and operates several websites promoting other companies’ products and services, and spends eight to nine hours each week on his affiliate marketing business interests. At the same time, Stan is devoted to trading securities, spending an hour or two each night studying the results of the day’s market activity, analyzing technical patterns on his charts and evaluating his current positions. Stan also monitors his positions and tracks market conditions periodically throughout his workday. He actively buys and sells online throughout the day without devoting more than a total of an hour or so of his day to this activity. On occasion, Stan also performs these activities while working on client matters, talking on the phone with clients, and interacting with his staff.

Prepare to be Scrutinized

I will say it again. Please be aware that there is a risk of an IRS audit as a part-time trader claiming trader status. Essentially, every taxpayer is at risk of a tax audit, but high-risk groups such as part-time traders especially are. Be prepared to have your business expenses and trading losses challenged by the IRS. Be ready to prove that your trading activity is not only substantial, but also performed continually and regularly.
As discussed in Chapter 1, I suggest that if you want to qualify for part-time tax trader status you should be, at a minimum:

· Executing at least 400 – 500 trades per year, which equates into 1.6 – 2.0 trades per day (assuming 250 trading days per year);
· Spending at least three to four hours per day as a minimum, in your trading business every day;
· Trading a high percentage number of trading days (with some exceptions);
· Holding securities for no longer than a few days (swing traders should be fine);
· Generating gross proceeds from your trades that are in the millions of dollars each year;
· Incurring significant trading-related expenses each year for dues and subscriptions, software, charting services, seminars, trading books, professional journals, computer equipment, and other services; and
· Keeping a trading journal that tracks the time you spend on trading, along with your trades. Your trading journal should also demonstrate that you are making your own trading decisions and not relying on others.

In the article, Trading Journals That Work author Brett N. Steenbarger, Ph.D. makes five recommendations for the creation and maintenance of a trading journal. I think it is important to list his recommendations, and to reiterate the importance of documenting what you do in your trading business every day. If you implement Steenbarger’s five suggestions, and also track your time (at least by the hour), you will have all the evidence needed to prove to the IRS that you are devoting substantial, continual, and regular daily time to your trading business.

Brokerage statements are not a sufficient record to show the time you are devoting to your business. Your brokerage statements will only show the number of trades and the dollar amount of those trades. They do not provide the complete picture of the hours that you spend analyzing, researching, strategizing, etc. If you keep a trading journal, as Dr. Steenbarger (www.brettsteenbarger.com) suggests, your IRS audit will go much smoother and you will have a better chance of a positive outcome (not to mention improving your trading success).

Make sure the journal includes observations about you and your trading and about the markets themselves. I’ve found that trader journals usually are skewed toward self-analysis and include little in the way of market observation. When I began as a trader, I printed out intraday charts of each day’s action and wrote comments on these, pointing out the patterns that I wanted to watch for in the future. After doing this for months, I sensitized myself to the point where I could see the patterns emerging in real time. The trading journal is a learning tool and a great mechanism for training your eye to see the setups you want to be trading.

Make sure the journal includes observations about your best trades. As I emphasized in my book, the idea is to discover the trader that you are when you’re at your best. Many traders use the journal as a means of self-criticism, and they only journal when they’re having problems in the market. Over time, you want to isolate what you’re doing when you’re making money, create a model of those success elements, and then rehearse them so that they become habits. The journal can be a tool for discovery, helping you find out what you do well.

Make sure the journal truly prepares you for the coming trading day. Many times journals chronicle what has happened in the past, but do not include concrete plans for the next day’s trade. If you run statistical analyses to determine if there is an edge the next day, these should be part of the journal. If there are setups that have been working in the recent market (sectors that are leading your market; intermarket relationships), these go in the journal as well. The idea, as I mentioned in the article, is to make your journal your business plan for the day.

Make sure the journal outlines specific steps for improvement. It is not enough to write vague generalities, such as “I need to hold my winners longer” or “I need to stick with my discipline”. Identifying specific steps you will take to hold winners (proper setting of profit targets, self-control strategies, etc.) or maintain discipline (risk management, taking breaks, etc.) makes the journal a game plan for the next day. Your journal, outlining how you’ll approach the market—and how you’ll approach yourself—each trading session will allow you to review each day and see if you met your goals. Such review is an essential step in the kind of continuous improvement that marks winners across all disciplines.

Make sure the journal includes performance metrics. Some of the ones I prefer are:

• Number of long and short trades – I correlate this to the trend condition of the market to see if I’m trading with the current or against it; if I’m trading in a one-sided way in a range-bound market. The number of trades also tells me if I’m overtrading.
• Number of winning and losing trades – When I’m trading well, I have more winning trades than losers by a reasonably healthy margin. When the ratio dips for more than a short time period, I need to re-evaluate my trading and my trading strategies.
• Time holding trades – I’m a short-term trader, and I tend to have a relatively narrow time band in which I hold trades. Moving beyond that band tells me I’m either cutting trades short or going for home runs—and neither of those have worked for me in the past.
• Time holding losing trades versus winners – It is very hard to make money over time by holding losers. Eventually, the size of the losers becomes greater than the winners so that even a trader who has more winning trades than losers can end up in the red.
• Profit/Loss broken down by long and short trades and broken down by market condition. This tells me if I’m trading ranges better than breakout movements; whether I’m doing better on the long side or the short side. If my performance is significantly worse in one mode than another, I start to examine my trading for needed improvements.

Dr. Steenbarger goes on to say, “By now you’re probably getting the idea that the journal is a time-intensive process.” That is exactly right. Keeping a journal is the equivalent of an athlete’s practice. In other words, it is not unusual to spend far more time training for an event than actually participating in it. If your journal is a hurriedly scribbled paragraph per day, the odds are good that it lacks the specifics you need to accurately assess what you are doing well and what needs improvement. For full-time traders, trading is a business. The journal is a business plan. The right plan, executed faithfully, can be the difference between success and failure in any endeavor.”

A trading journal is essential to convincing the IRS and establishing your trader tax status. It is very difficult to go back and recreate a time log after-the-fact for your trading business. Having an accurate, detailed, day-by-day trading journal that documents your process, thoughts, trades, the outcomes, performance, and logs your time will be a huge advantage when the IRS auditor comes calling. Granted you still need to execute 400 to 500 short-term trades per year, and meet the other criteria, but having a time-logged trading journal will improve your odds in a tax audit.

For more information on what the IRS considers substantial, continual and regular trading activity, review the IRS cases included in Chapter 6, and consider contacting a qualified tax specialist who can provide additional guidance.

Brett Steenbarger, Trading Journals That Work, retrieved 2/1/2010 from www.brettsteenbarger.com