A Sec. 475(f)(1) Trader Election May Present Opportunities to Deduct Capital Losses as Ordinary

Because of the performance of the stock market over the last few years, some taxpayers may be interested in making a Sec. 475(f)(1) election or may have heard about it from their colleagues or friends.

The Sec. 475(f)(1) election may be attractive because it permits a taxpayer to mark to market securities and change the character of the gain or loss to ordinary. These elections may be made by individuals, hedge funds, partnerships, single member LLCs and corporations that engage or plan to engage in trading activities. In the past year we’ve handled inquiries from a number of clients interested in the election – most focused on converting large unrealized capital losses into ordinary losses and one focused on the financial reporting implications of benefiting the loss.

The due date for individuals and calendar year partnerships to make this election is April 15 and the due date for calendar year corporations is March 15. For new taxpayers, the due date is two months and 15 days from the first day of the new taxpayer’s year (i.e., August 15 if the entity was formed in June and June 1 was the first day of its tax year). The requirements of a valid election are set forth in Sec. 5.04 of Rev. Proc. 99-17 and include a statement describing the election being made, the first taxable year for which the election is effective and the trade or business for which the election is made.

This article is intended to provide a high-level discussion of this election to apprise the reader of some of the criteria for being a trader, the benefits and downside of the election, and the pitfalls to avoid. Because late elections are not permitted, you should take immediate and affirmative action if you believe you might benefit for a Sec. 475(f)(1) election in 2009.

The Sec. 475(f)(1) election is filed with the preceding year’s tax return or extension and is due by the original (not the extended) due date of the return. For example, a Sec. 475(f)(1) election for an individual’s 2009 tax year is due by 4/15/2009 with either the original Form 1040 or an extension for the Form 1040 for the 2008 tax year.
In addition to the election, the taxpayer must file a Form 3115 to change the accounting method for securities to mark-to-market. The Form 3115 generally is automatic and is filed with the tax return for the first year of the election. For example, an individual who filed the Sec. 475(f)(1) election on 4/15/2009 for the 2009 tax year would file Form 3115 with the original tax return for 2009 either by 4/15/2010 or 10/15/2010 (if extended). That Form 3115 includes a Sec. 481(a) adjustment that will mark to market all securities held by the taxpayer on the first day of the year of change – in the example, the mark would be a 1/1/2009 – and the character of that gain or loss would be ordinary.
The effect of a Sec. 475(f)(1) election is generally to mark all securities to market either at the end of the year or immediately before a sale transaction and to make the character or the gain or loss ordinary. Therefore, a taxpayer with substantial unrealized capital losses may be able to convert them to ordinary losses. Conversely, all future gains will be ordinary as well.
The Sec. 475(f)(1) election is available only to traders. There is no statutory or regulatory definition of trader. The criteria for trader status have developed through case law, most of which has been decided outside of Sec. 475. While these cases do not set forth identical standards, following are a sampling of the criteria that are considered:
- Trading must be the principal occupation and source of revenue for the taxpayer.
- Documentation must be consistent with intent to engage in the trade or business of trading securities, i.e., tax returns should reflect occupation as trader, Schedule C should reflect occupation as trader, stated business objectives should reflect short-term rather than long-term investment strategies.
- Taxpayer handles many transactions in the course of a single day so as to take advantage of short-term swings in the market.
- Transactions are substantial, regular, continuous and frequent rather than occasional or isolated.
- Taxpayer studies market reports and financial periodicals, regularly consults with experts and personally directs the purchases and sales of securities.
- The average holding period of securities sold is less than 30 days.
- The majority of taxpayer’s revenue is from trading gains and losses rather than dividends, interest or long-term gains.

Some trader-status foot-faults that could prevent a taxpayer from being a trader are:

Extensive investments with many transactions but without the requisite daily transactions that take advantage of short-term swings in the market.
Devoting time and energy to the affairs of a single corporation in which the taxpayer has invested with investment-type earnings, i.e., dividends, interest, and long-term capital gains, rather than short-term trading profits.
Listing occupation on tax return or in other documents as attorney, failing to file Schedule C for business of trading in securities, and describing investment objectives as long-term gains.
Conducting trading activity during only a part of one year thus making activity sporadic rather than frequent, regular and continuous.

Foot-faults, risks and downside from the Sec. 475(f) election include:

Failure to timely file the election by the original due date of the preceding year’s return – no 9100 relief generally granted.
Failure to include all of the information required by Rev. Proc. 99-17 in the Sec. 475(f)(1) election.
Failure to file an election for both spouses if both spouses are traders.
Failure to file Form 3115.
Inability to terminate the election without IRS permission.
When market turns around, gains realized will be ordinary.
While securities can be identified as held for investment by the close of the day acquired, rules surrounding such identifications require scrupulous documentation and segregation and are subject to disallowance by IRS.
Finalization of proposed regulations with retroactive effective date may limit opportunities to reflect ordinary treatment of built-in losses on date of election and on certain other securities.

The above laundry lists make it clear that satisfying the requirements of trader status is more than a mere numbers game. As a consequence, 100 trades a month will not make a taxpayer a trader if those trades are insufficient to allow the taxpayer to profit from daily swings in prices, if the average holding period of securities is longer than 30 days, the trading is not continuous throughout one or more years, dividends and interest are the principal source of revenue, and the trading is not the full-time occupation of the taxpayer. While there is limited authority that a single long-term investment may not be inconsistent with trader status (and Sec. 475(f)(1) does permit identification of occasional investments), traders should be careful to limit the number of investments and scope of investment activity. If substantial investments are expected, the taxpayer may be well-advised to segregate trading and investment activities in separate single member LLCs to negate the need to identify investments.

There are many questions outside the scope of this short article that should be thoroughly considered before making a Sec. 475(f)(1) election including the impact of substituted basis securities, the due date for the election for new taxpayers, the impact of proposed regulations that presently have a retroactive effective date, the logistics of filing the Form 3115 and the impact of activities in prior years. If you may be interested in making a Sec. 475(f)(1) election and would like to probe these rules in greater detail, consult your tax advisor well before the filing deadline so you have an opportunity to consider thoroughly all of the ramifications of the election.

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