Investor's Trading Activities Weren't Frequent Enough to Constitute a Trade or Business; Longer Holding Period Showed He Wasn't Interested in Daily Market Swings
(Parker's Federal Tax Bulletin: September 21, 2013)

An investor was not a trader in securities because his trading activities did not have the frequency, continuity, and regularity to constitute a trade or business and the long holding periods showed that he was not seeking to profit from the swings in the daily market. Endicott v. Comm'r, T.C. Memo. 2013-199 (8/28/13).

Thomas Endicott was the president of a tool and stamping company before retiring in 2002. In 2006, Thomas began purchasing and selling stocks and call options. His strategy was to purchase shares of stock and then sell call options on the underlying stock with a goal of earning a profit from the premiums received from selling call options against a corresponding quantity of underlying stock he held. Thomas typically sold call options with a term of one to five months. During the years in issue, some of Thomas's call options expired, some were exercised by the option's purchaser, and for some options Thomas exited out of the position before the option expiration date.

In February 2006, Thomas purchased 20,000 shares of stock in SLM Corporation. From February 2006 through March 2007, Thomas sold call options on the SLM stock and exited out of the position before the expiration date. He earned net premiums of $166,000 from selling the call options and reported the amount as short-term capital gain. During this time period, Thomas received approximately $24,400 in dividends from the SLM stock. He sold the stock in July 2007 and reported a $212,700 long-term capital loss. From other stock in his portfolio, Thomas earned a total of over $120,200 in dividends in 2006, 2007 and 2008. During these years, the brokers allowed Thomas to use margin for his stock purchases. The process of using margin entailed the broker lending money to Thomas for him to purchase additional shares of stock. By using 100 percent margin, Thomas would double the number of shares of underlying stock that he could purchase, which allowed him to double the number of call options he sold, thereby doubling the amount of premiums he received. The brokers would charge Thomas interest on the amount he borrowed. The brokers charged him interest of more than $694,800 in 2006 2008. Although he did not execute trades every business day, Thomas monitored his portfolio and research new positions on a daily basis.

On each of his 2006, 2007, and 2008 federal income tax returns, Thomas attached two separate Schedules C, Profit or Loss From Business. On one Schedule C, Thomas listed his principal business as other financial investment activities and reported the expenses associated with his trading activities. On the second Schedule C, he listed his principal business as consulting. He reported the gains and losses from the sale of stock and options on Schedules D, Capital Gains and Losses. Thomas used the services of a tax return preparer for each of his returns. The IRS assessed deficiencies in Thomas's income tax of over $71,100 for 2006, 2007, and 2008 and assessed accuracy-related penalties.

Code Sec. 212 provides that nontrade or nonbusiness expenses incurred in the production of income are deductible as itemized deductions. Under Code Sec. 163, the deduction for investment interest expenses is limited to the amount of net investment income.

Thomas argued that he was a trader in securities. The IRS contended that Thomas was an investor during the years in issue. Traders can deduct their losses because they are in a trade or business; investors are subject to the $3,000 capital loss limitation on their losses.

The Tax Court held that Thomas was not a trader in securities and the investment expenses he claimed as business expenses on his Schedules C were disallowed. The court looked to case law in Kay v. Comm'r, T.C. Memo. 2011-159, which states that generally, for federal tax purposes, a person who purchases and sells securities is categorized as a dealer, trader, or investor. A trader is defined as engaged in the trade or business of selling securities for their own account and their profit is derived through acts of trading such as the direct management of purchasing and selling. Investors are defined as selling securities for their own account and are not engaged in the trade or business of selling securities. The court also cited Moller v. U.S., 721 F2d 810 (Fed. Cir. 1983), in which the Federal Circuit held that, in determining whether a taxpayer is a trader, the taxpayer's intent, nature of the income to be derived from the activity, and frequency, extent, and regularity of the taxpayer's transactions are to be considered. In Thomas's case, the court found that Thomas did not execute a substantial number of trades and the number of days that he executed trades did not have the requisite frequency, continuity, and regularity to constitute a trade or business.

The court rejected Thomas's argument that call options were unique and different from stocks, and in determining if he met the frequency requirement, the number of days he maintained an option position should be added to the number of days he executed trades. While the court agreed that options were different from stock, both were purchased and sold on a daily basis on exchanges. Thomas's inability to profit from frequent purchases and sales of options did not relieve him from the frequency requirement. In addition, the longer average holding periods during which Thomas held stock and maintained option positions showed that he was not seeking to profit from the swings in the daily market. The court noted that Thomas received a substantial amount of dividend and other income during the years at issue.

Finally, the court concluded that Thomas was liable for accuracy-related penalties. His understatements of income tax were substantial and he failed to show reasonable cause. Although his returns were prepared by a tax return preparer, Thomas did not show that the return preparer was a competent professional with sufficient expertise to justify his good-faith reliance. Thomas also did not have substantial authority to support his position that he was a trader.

For a discussion of the differences between investors and traders, see Parker Tax ¶242,350.

Parker Tax Publishing Staff Writers

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