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Tax News
Richard Kay, Jr v. Comm’r – Trader or Investor, Sometimes it Feels like a Coin Toss
July 07, 2011
Cases
Richard Kay, Jr v. Comm’r., T.C. Memo. 2011-159 (July 6, 2011) is yet another case that tackles the facts and circumstances query of a trader v. investor. Facts and circumstances is one of those things that you really cannot be sure what would come out of.  Many would argue that in cases that turn on the facts and circumstances inquiry there is a very high element of chance and sometimes they feel more or less like a coin toss.

Why does the question of a trader v. investor matter to many people? Well, if a person buys and sells the same securities within the taxable year, in either case the income will be taxed at ordinary rates. However, losses and expenses are treated differently. The losses of an investor cannot offset non-investment income and are subject to the $3,000 limitation. Conversely, the trader’s losses are not limited in this way and can offset the trader’s other ordinary income assuming the trader has made a 475(f) mark-to-market election. Furthermore, investor’s expenses are limited to the 2% floor and deductible on Schedule A as an itemized deduction. On the other hand, the trader’s expenses are deductible as trade or business expenses against adjusted gross income. To many, including LPs of private equity and hedge funds, these distinctions are material.

In this case the taxpayer had a small ball bearing manufacturing business from which it derived income that was significantly below $1,000,000. The taxpayer also engaged in purchasing and selling securities for which he made a mark-to-market election under Section 475(f). In this securities venture the taxpayer incurred significant losses. In the 3 years at issue the taxpayer executed 313 trades, 172 trades, and 84 trades respectively. For the same 3 year period, the taxpayer purchased and sold securities worth 20 million, 1 million and 2.5 million. As to the frequency of the activity, the taxpayer conducted trading activity 29 percent, 7 percent, and 8 percent of the possible trading days in each year. Finally, the majority of the stock trades were held longer than 30 days. The Tax Court basically relied on some of its previous rulings with similar fact patterns and held that the taxpayer’s activity was not substantial, i.e. it wasn’t frequent, regular, and continuous enough to constitute a trade or business.

Was the taxpayer trader or investor? Well many would argue that in common parlance the taxpayer comfortably fits within the definition of a swing trader. What matters, however, is that the Tax Court thought the person was not a trader. But the whim of the facts and circumstances query is not what this post is mainly about. There is a practical lesson to be learned here. The taxpayer was subject to Section 6662 accuracy related penalty and the Tax Court affirmed it. The taxpayer was simply unprepared to prove reasonable cause or substantial authority. One would wonder why, considering that trader v. investor is a particularly thorny issue. Instead of having some solid evidence such as memoranda or correspondence with a professional tax advisor, the taxpayer merely made references to his accountant. Naturally, the Tax Court held that this was insufficient to prove reasonable cause. The lesson is obvious. When an investment professional purports to be a trader, it is worthwhile to pay a reputable tax practitioner to evaluate the merits of the position. Not doing so could cost the taxpayer significantly.
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Tags: Kay v. Commissioner, Section 162, Section 212, trader v. investor