Terms and Definitions

Tax, Stock, Trading - Important Terms of the Day Trader Business

Investment Property

Is generally property purchased to be held because of capital appreciation and/or income produced by the property. Investment property can include stocks, mutual funds, collectibles, etc.

Capital gain/loss:

Capital gain/loss is generated by buying and selling investment property.

Capital gain is split into two categories.

Long Term Capital Gain: If the property is held for more than one year it is considered long term. At this point long term capital gain is taxed at a maximum of 15%.

Short Term Capital Gain: If the property is held for one year or less it is considered short term. Short term capital gain is taxed at the taxpayer's normal tax rate.

Capital loss is categorized as either long term or short term and is generally deductible up to $3000 per year against other types of income. Any amount over $3000 is carried forward and deducted at $3000 per year until it is completely deducted or offset by capital gains.

For example: A taxpayer incurs a $100,000 capital loss in 2010. In 2011 he incurs a $50,000 capital loss and in 2012 he incurs a $20,000 capital gain. From 2013 on the taxpayer stops trading and does not have any future capital gain or loss. With these facts the following would be true.

	2010	2011	2012	2013	2014
W2 Wages	$150,000	$150,000	$150,000	$150,000	$150,000
Capital Gain	$0	$0	$0	$0	$0
Deductible Capital Loss	$3,000	$3,000	$3,000	$3,000	$3,000
Gross Income	$147,000	$147,000	$147,000	$147,000	$147,000
Capital Loss Carry forward to next year	$97,000	$144,000	$121,000	$118,000	$115,000

Business Property

Is property held by the taxpayer for use in a trade or business. Business property can include inventory, equipment used in the normal course of business, etc.

Ordinary gain/loss:

Ordinary loss can be generated through the sale of business property. However, certain investment property can be treated as ordinary gain/loss if the mark-to-market election is in place.

See mark-to-market definition below.

	2010	2011	2012	2013	2014
W2 Wages	$150,000	$150,000	$150,000	$150,000	$150,000
Ordinary Gain	$0	$0	$20,000	$0	$0
Deductible Ordinary Loss	$100,000	$50,000	$0	$0	$0
Gross Income	$50,000	$100,000	$170,000	$150,000	$150,000
Loss Carry forward to next year	$0	$0	$0	$0	$0

Business Property

Is property held by the taxpayer for use in a trade or business. Business property can include inventory, equipment used in the normal course of business, etc.

Ordinary gain/loss:

Ordinary loss can be generated through the sale of business property. However, certain investment property can be treated as ordinary gain/loss if the mark-to-market election is in place.

See mark-to-market definition below.

Ordinary gain, like short term capital gain, is taxed at the taxpayer's normal tax rate. Ordinary loss is differentiated from capital loss by the fact that there is no $3000 cap on how much can be deducted against other income. If the facts from the capital loss example above are the same except for the losses were ordinary instead of capital the following would be true.

	2010	2011	2012	2013	2014
W2 Wages	$150,000	$150,000	$150,000	$150,000	$150,000
Ordinary Gain	$0	$0	$20,000	$0	$0
Deductible Ordinary Loss	$100,000	$50,000	$0	$0	$0
Gross Income	$50,000	$100,000	$170,000	$150,000	$150,000
Loss Carry forward to next year	$0	$0	$0	$0	$0

Stocks and Stock Options

These instruments are generally treated as capital gain/loss when they are traded.

Exchange Traded Funds (ETF's)

These instruments are generally treated as capital gain/loss. The treatment will vary depending on what is held by the fund.

Collectible

A collectible is defined as works of art, rugs, antiques, metals (such as gold, silver, and platinum bullion), gems, stamps, coins, or alcoholic beverages held more than one year. If these items are held more than one year they are taxed at a maximum rate of 28%. If they are held one year or less they are taxed at the taxpayer's tax bracket.

Foreign Exchange

Also, referred to as forex this instrument is normally considered ordinary gain/loss. It is possible however, for a taxpayer to opt out of ordinary treatment.

Futures, Commodities, Index Options

These instruments have a special tax treatment under Section 1256 of the internal revenue code. 60% of the gain/loss is considered long term capital and 40% of the gain/loss is considered short term capital. This is true no matter how long the position is actually held.

Wash Sale Rule

The IRS states if you close a position at a loss and either 30 days before the loss is realized or 30 days after the loss is realized you open a position on a substantially identical security the loss is deferred and added to the basis of the position opened within the sixty day window. For example if you sell 100 shares of Yahoo stock for a $1,000 loss on Dec 23, 2010 and you purchase 100 shares of Yahoo stock on Jan 05, 2011 you cannot deduct the loss on the 2010 Income Tax Return. Instead the $1000 loss is added to the basis of the shares bought in 2011.

Substantially identical securities include:

• Stock options are considered identical to shares of the underlying stock.
• Stock options are considered identical to other stock options if they are on the same underlying stock. This is true even if there are different strike prices and expiration dates.
• If two separate companies merge the new stock formed by the merger can be identical to the old stock of either company.
• If preferred stock of a company is convertible into common stock then the preferred stock and the common stock of the company is identical.
• Two different Exchange Traded Funds can be considered identical if their components are similar.

Trader in Securities/Commodities

Generally, to write off trading expenses as a business the taxpayer must be considered a trader in securities/commodities.

The IRS guidelines state: To be engaged in business as a trader in securities/commodities the taxpayer must meet the following conditions.

• Short Term Profits: The taxpayer must look to make money off of short term moves in the market. The taxpayer cannot be looking to make your money off of capital appreciation, interest, or dividends. A recent court case stated that a taxpayer who rarely bought and sold positions on the same day and held a significant amount of the positions for more than thirty one days was not looking to profit from short term moves in the market.
• Activity must be Substantial: The IRS does not define what constitutes substantial activity. In a recent court case the court stated that a trader who had 372 trades and placed those trades on less than 45% of the total trading days in a year did not have substantial trading activity.
• Continuity and Regularity: Again, the IRS does not give a definition. But, the same court case used the fact that the taxpayer traded on less than 45% percent of the trading days in the year to determine the trading was not conducted with continuity and regularity.
• Other Income: The IRS will look at whether the taxpayer has income from other sources besides trading. If the taxpayer has another major source of income, such as wages, it can be difficult to convince the IRS that the taxpayer is a trader.

Mark-to-Market (M2M)

Is an accounting election that can be made by a taxpayer if the taxpayer qualifies as a trader in securities/commodities. The actual mechanics of making the mark-to-market election varies on whether the election is for an existing taxpayer or a new taxpayer.

In general the Mark-to-Market election can cause the following to become true:

• Change gain/loss from being capital to being ordinary. This can be very beneficial for traders who lose money.
• Suspend the wash sale rule. This can also be a very big advantage to a trader as the wash sale rule can have a significant impact on their taxes.
• At the end of the year all open positions are closed for tax purposes and the unrealized gain/loss is recognized on the income tax return. This can be beneficial for clients who have opened positions during the year that have lost value.

Investment Expenses

If a taxpayer is not considered a trader in securities then they are considered an investor. Expenses they incur during the act of investing are considered investment expenses.

Schedule C

This schedule is used to report business operations from sole proprietorships and is part of the taxpayer's individual income tax return. It is possible for a taxpayer who qualifies as a trader in securities/commodities to use a Schedule C to report their trading business. Increased Audit Risk: Income tax returns that have a schedule C are more likely to be audited than returns that do not have a schedule C.

Single Member LLC

An LLC is an entity that is considered a partnership for most purposes. However, an LLC can be composed of a single member. If the LLC has a single member it is considered a disregarded entity for tax purposes and is filed on the taxpayer's schedule C.

Legal Entities

Some taxpayer's choose to setup legal entities to trade in such as LP's, LLC's and Corporations. Legal entities can offer benefits from tax planning to asset protection.

Start-up Costs

These are expenses the taxpayer pays prior to actually starting business. Start-up costs include amounts paid in connection with creating a business or investigating the creation of a business.

Organization Costs

These are costs the taxpayer incurs to actually setup an entity. This could include secretary of state fees and fees paid to professionals to setup the entities.

Medical Reimbursement Plan (MRP)

When a taxpayer forms a C corporation they can establish an MRP. The MRP generally allows the corporation to reimburse corporate employees for any out of pocket medical expenses they incur including but not limited to health insurance premiums, co-pays, and deductibles.