Richard Kay, Jr., TC Memo 2011-159
The Tax Court has held that a businessman's stock-market trading activities didn't rise to the level of a trade or business. Accordingly, his losses claimed over the $3,000 capital loss limitation were disallowed, as were his business deductions for associated trading costs.
Capital losses. Under Code Sec. 1211(b), noncorporate taxpayers can recognize capital losses only to the extent of capital gains plus $3,000. Code Sec. 1212(b) allows noncorporate taxpayers to carry forward unrecognized capital losses, treated as either short-term or long-term capital losses, to subsequent tax years, but it does not allow them to carry back unrecognized capital losses to prior tax years. A taxpayer's capital loss carryover is reduced to the extent a deduction is allowed, regardless of whether the taxpayer benefits from the deduction or chooses not to claim it.
Investors vs. traders. Stock market investors, regardless of how frequently they trade, have sales that generate capital gain or loss. However, those engaged in the trade or business of trading securities may elect to have the Code Sec. 475(f) mark-to-market (MTM) rules apply. Under these rules: (1) gain or loss is recognized on these securities held at the close of any tax year as if they were sold for their fair market value on the last business day of the tax year; and (2) gain or loss is taken into account for the tax year as ordinary income or loss. (Code Sec. 475(f)(1)(A); Code Sec. 475(d)(3))
Observation: A taxpayer with stock losses usually would prefer to be a trader in securities (rather than an investor) in order to bypass Code Sec. 1211(b)’s capital loss limitation rules. Losses of an electing trader in securities incurred in the ordinary course of business generally are not subject to these limitations and may be deducted in full against ordinary income.
The expenses of a stock market investor are miscellaneous itemized deductions that are allowed only to the extent they cumulatively exceed 2% of adjusted gross income. (Code Sec. 212) By contrast, expenses connected with the trade or business of trading stocks are deductible in full (e.g., on Schedule C) under Code Sec. 162.
Whether a taxpayer's investment activities rise to the level of carrying on a trade or business is based on, among other things, the taxpayer's intent; the nature of income to be derived from the activity; and the frequency, extent, and regularity of the taxpayer's securities transactions. (Purvis v. Commissioner, (CA 9 1976) 37 AFTR 2d 76-968, affirming TC Memo 1974-164)
Facts. During 2000 through 2002 (the years at issue), Richard Kay, Jr., operated a ball bearing manufacturing and distribution business. He was the business's sole shareholder, officer, and director from the date of its incorporation. He reported wages from the business of $36,400, $43,600, and $52,000 during the years at issue.
Kay traded securities prior to and throughout the years at issue. He made a MTM election in’99 and did not revoke that election through 2002. The number of days that he spent trading and number of transactions for each year were as follows: 73 days and 313 transactions in 2000; 18 days and 72 transactions in 2001; and 21 days and 84 transactions in 2002.
On a Schedule C, Profit or Loss from Business, on which Kay indicated his principal business or profession as “day trade,” Kay claimed $1,960,060 in losses from sales of stocks and $92,577 in expenses for 2000; $399,162 in stock losses and $578 in expenses for 2001, along with a $1,396,943 net operating loss (NOL) carried over from 2000; and $262,921 in stock losses and $15,376 in expenses for 2002, along with the same $1,396,943 NOL carried over from 2000.
IRS disallowed Kay's deductions for ordinary losses beyond the $3,000 limit for his trading activities during 2001 and 2002, and also disallowed deductions for the 2000 NOL carryover.
Taxpayer not a trader in securities. The Tax Court held that Kay was not a trader in securities, but rather an investor. Citing King v. Commissioner, (1987) 89 TC 445, the Court said that for a taxpayer to be considered a trader, (1) the activity must be substantial (defined as frequent, regular, and continuous); and (2) he must seek 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. Kay didn't meet either of these conditions.
As to the first requirement, considering the number of executed trades and the amount of time spent buying and selling securities, the Court found that Kay's trading activity wasn't substantial. Notably, he traded only for a small portion of the trading days during each year at issue, the number of trades wasn't substantial, and he didn't rely on his trading activity as his sole or primary source of income, but rather relied on income from his ball bearing business. Although the amount of money involved in 2000 was substantial, consisting of over $20 million in both purchases and sales, the Court found that this was insufficient in light of the overall infrequency of Kay's trading activity.
Observation: This case, as well as those cited by the Tax Court, illustrate how difficult it is for a stock market investor to show that his activities rise to the level of a trade or business.
As to the second requirement, the Court found that Kay generally didn't hold stocks for periods of time that showed an intent to profit from day trading. Rather, the majority of the stocks that he purchased and sold were held for over 30 days—which tends to indicate investment vs. trading activity. (Holsinger, TC Memo 2008-191)
Result: Kay's losses on his trades were capital losses, not ordinary losses, and as such were limited to a $3,000 deduction under Code Sec. 1211(b) for 2001 and 2002. Additionally, Kay wasn't entitled to carry forward the NOL generated in 2000. The expenses relating to his trading activity similarly weren't deductible as business expenses.
References: For rules on trader in securities versus investor status, see FTC 2d/FIN ¶L-1112; United States Tax Reporter ¶280A4.013; TaxDesk ¶256,010.