Many individuals (and businesses) buy stock and securities with the hopes and intent of the securities appreciating and perhaps paying interest or dividends. What determines when an individual is treated as an investor, dealer, or trader? Furthermore, what are the tax treatment and proper way to report income and expenses when one is classified as an investor, dealer, or trader?

The article below has been prepared by a Denver business attorney and tax attorney to provide information related to the above issues and questions. Please remember to always discuss your specific facts and circumstances with your tax attorney and tax advisors, as this article is for informational purposes only.

The Internal Revenue Service applies different definitions and meanings to investors, dealers, and traders. Thus, we will begin with an explanation of these terms.  

What’s An “Investor”?

An investor would typically buy and sell securities in anticipation of the securities appreciating and producing other returns such as interest or dividends. In short, the investor would buy a security and hold the security for personal investment as opposed to conducting these activities in a trade or business. Generally, the investor would hold the securities for themselves and a substantial period. When an investor sells or disposes of the securities, the transactions are reported as capital gain or loss on the investor’s 1040 via a Schedule D.

As an investor, capital loss limitations under IRC Section 1211(b) would apply as well as wash sale rules under IRC 1091. Investors may be able to deduct expenses associated with creating the taxable income on their Schedule A itemized deductions. Further, interest paid for money to buy an investment property that generated taxable income may be deducted. The cost of commissions and related fees to dispose of the stock are not deductible but should be accounted for in calculating the gain or loss from the sale or disposition of the securities.

Who’s A “Dealer”?

Securities dealers are required to register with the SEC under section 5(a)(1) of the Securities Act and section 15A(b)(4) of the Exchange Act. A dealer must file Form BD, Schedule 13D, and Form 10K/10Q within 30 days of registration.

The term “dealer” refers to both individual and corporate persons. An individual dealer engages in activities involving offering, purchasing, or selling securities for their account. Corporate dealers include broker-dealers, investment banks, clearing agencies, and others involved in similar activities.

Individual dealers are subject to regulation under federal securities laws. In addition to registration requirements, they are prohibited from engaging in certain types of transactions without prior approval, including short sales, options contracts, futures contracts, and forward contracts.

Corporate dealers are regulated primarily by state law. However, the federal government regulates some aspects of their conduct. For example, brokers, dealers, and agents must comply with recordkeeping rules promulgated by the National Association of Securities Dealers (NASD). These rules require that dealers maintain books and records to comply with applicable federal securities laws and regulations.

Dealers must maintain inventories of securities that represent the interests of their customers. This includes holding shares of stock for customers’ accounts. Dealers must also keep records showing the identity of each customer and the number of securities held for such customers.

Dealers are permitted to engage in activities that involve purchasing and selling securities for their accounts. Such activities include buying and selling securities to make markets, hedging, managing risk exposure, arbitrating, and providing liquidity.

Dealers are sometimes referred to as market makers. Market makers provide a service to buyers and sellers of securities by maintaining a continuous bid. They do not buy or sell securities for their account; instead, they act as intermediaries between buyers and sellers.

Who’s a “Trader”?

Apart from being designated as an investor or dealer, special rules can apply when you are determined to be a trader in securities. In short, a trader would be considered buying and selling securities for your account. Under certain circumstances, you could be regarded as a business even if you do not hold an inventory and maintain customers. The IRS could consider you to be in business as a trader in securities if you meet the following conditions:

• The activity is substantial;
• You are attempting to profit from daily market movements if the pricing of securities and not so much from appreciation, interest, or dividends; and,
• The activity is practiced with continuity and regularity.

If you are a trader in securities,, you can report your income and expenses on a Schedule C with your 1040,, and thus, Schedule A limitations would not apply. Further, the gains and losses from selling securities are not subject to self-employment tax.

What’s A Security?

Security is an item that represents ownership interests in something else. Examples include stocks, bonds, mutual funds, ETFs, REITs, commodities, currencies, and real estate. Securities are traded on exchanges and over-the-counter markets.

 Reporting The Sale of Securities

When you sell a security, it’s called a “sale.” You generally receive cash or another form of payment for the sale. For example, you’ll receive cash or a check if you sell stock shares. When you sell a bond, you usually receive coupon payments.

You need to report the sale of a security on Form 1099-DIV, Short Form Miscellaneous Transaction Information if the proceeds exceed $10,000.

The Mark-to-Market Election

You’ve probably heard about the mark-to-market rule if you’re a trader. This rule allows specific trades to be treated as though they occurred during the current taxable year. For example, if you sold shares of stock at $10 per share, you could elect to treat the gain as ordinary income rather than capital gain. You’d then pay taxes on it at regular rates. In addition, you couldn’t deduct any loss on those shares.

However, there are some restrictions on how this works:

1. You can’t take advantage of the rule unless you sell the stock.
2. You can’t do this if you bought the stock for less than the cost.
3. You can’t use the rule if the security you sold was held for investment purposes.

In addition, you must file a form called Form 4797, Sales or Exchange of Certain Securities. On this form, you’ll list each transaction you want to include in calculating your capital gains and losses. Then, you’ll attach a statement explaining why you believe the transactions qualify for the mark-to-mark rule. Once you’ve filed this form, you’ll be able to calculate your capital gains and losses based on the amount you originally paid for the stocks.

The article above has been prepared by John McGuire of The McGuire Law Firm.  John is a Denver tax attorney and business attorney with the firm and can be reached at John@jmtaxlaw.com

It is likely that the majority of your personal possessions and investments are capital assets.  The list below provides examples of capital assets:

–          Your personal residence

–          Stocks and bonds

–          Household furnishings

–          Your cars used for pleasure or business

–          Timber grown on your property or an investment property

–          Stamp collections

–          Coin collections

–          Jewelry

–          Gold, silver and other metals

In general, property that is held for personal use is a capital asset and the gain from the sale or exchange of this property is considered capital gain.  However, loss from the sale or exchange of such property is not deductible as a capital loss.  You can only deduct a loss from personal use property when the loss is the result of a casualty or theft.

Investment property such as stocks and bonds (think stock in Google, Microsoft, GM etc) is a capital asset and the gain or loss from the sale or exchange of this property is deductible as a capital gain or loss.  However, this treatment would not apply to property that produces rental income.

Now that we have looked at capital assets and the gain and/or loss associated with these assets, what is a noncapital asset?  As you can probably guess, a noncapital asset is an asset that is not a capital asset and below are examples of noncapital assets.

–          Accounts or notes receivable acquired in the ordinary course of business for services rendered or from the sale of inventory or stock that is held mainly to sell to customers

–          Stock in trade, inventory and other property that you would hold primarily for the sale to customers in the normal course of business- see publication 538.

–          Depreciable property used in trade or business or as a rental property

–          Real property used in trade or business or as rental property

–          Copyrights, artistic compositions

–          Any commodity derivative financial instrument

–          Supplies that are regularly used and/or consumed in your ordinary course of business

The gain recognized from the sale or exchange of these noncapital assets is ordinary income.

If you have questions relating to the types of property you or your business may own, or the tax implications of the sale or exchange of personal or business property, you can speak with a tax attorney and business attorney by calling The McGuire Law Firm.