Trader Status For Covered Call Writers

by Mike Scanlin

The IRS makes a distinction between "traders" and "investors". There are many tax advantages to being a "trader" but achieving the distinction does come with some disadvantages, too. At least one covered call writer claimed trader status only to be denied during an IRS audit.

Advantages Of Being A Trader

Some of the benefits of being a trader instead of an investor include:

1. Deduct margin interest on Schedule C (instead of as an itemized expense on Schedule A, so the investment interest limitation does not apply).
2. Deduct investment seminar expenses. Investors can't deduct; traders can.
3. Deduct home office expense. Investors can't; traders can.
4. Deduct other expenses, not subject to 2% rule: Traders deduct all trading related expenses (books, subscriptions, etc) on Schedule C, while investors have to itemize them on Schedule A and have them exceed 2% of adjusted gross income.
5. Mark-to-market rule. Traders have the option (but not requirement) of making a mark-to-market election which, if made, means wash sale rules won't apply and they are not limited to $3000 capital loss per year (if they have an overall loss in a year).

Disadvantages Of Being A Trader

1. Increased audit risk.
2. If you take the mark-to-market election then all your trading profits are ordinary income, not capital gains (you can't use the [lower] long term capital gains tax rate on positions held more than 12 months).
3. At the end of the year you report all your profits, even unrealized ones.

Are You A Trader Or An Investor?

There are no clear standards for determining whether you are a trader. If you claim to be a trader, and the IRS determines that you are not a trader, you may end up with substantial liability for tax, interest and penalties.

The general concepts the IRS will look at to determine if you are a trader include:

1. You must seek to profit from daily market movements in the prices of securities and not from dividends, interest or capital appreciation.
2. Your activity must be substantial.
3. You must carry on the activity with continuity and regularity.

Real World Example With A Covered Call Investor

A few months ago, in Endicott v. Commissioner of Internal Revenue, the US Tax Court determined the covered call writer in question was an investor and not a trader, and thus disallowed several years of deductions he had taken.

The taxpayer in question had these facts:

1. Retired in 2002.
2. In 2006 began actively writing covered calls, and claimed trader status in 2006, 2007 and 2008.
3. In 2006 he had 204 trades ($7M of purchases and sales); in 2007 he had 303 trades ($15M); and in 2008 he had 1543 trades ($16M).
4. He traded on margin and in 2006 and 2007 had over $310,000 of margin expense each year. This was the majority of his trading expense deductions.

The court found that although 1543 trades in 2008 was significant, he actually only traded on 112 different days. Thus, he was not trading every day, nor trying to catch the swings in daily market movements. Instead, his average holding period was 35 days, and some positions were held for as long as 5 months.

The covered call writer in this case had significant dividend income during the years in question (between $30K and $50K per year). Receiving significant dividends is considered an "investor" activity and not a "trader" activity.

Traders generally get the majority of their income from their trading activity. This particular taxpayer had consulting income not related to trading of between $65K and $225K for each year in question.

Bottom Line

The tax court determined that this taxpayer did not have substantial trading activity in 2 of the 3 years in question, and was not seeking to profit from daily swings in the market (average holding period too long). In addition, he received significant income from dividends and consulting. Thus, the court disallowed his trader status (and related expense deductions).

After recalculating his taxes as an investor (instead of a trader), the court found this taxpayer had underpaid taxes by $52K, $9K and $9K for the 3 years in question. They also levied a 20% accuracy-related penalty.

If you are claiming trader status, or even considering it, please read the case Endicott v. Commissioner of Internal Revenue. If you are day trading but also doing covered call writing you may want to split the two activities and report one as 'investing' (the covered call part) and the other as 'trading' (the day trading part).

Disclaimer: Born To Sell is not an accounting or tax firm, and we do not give accounting or tax advice. Please consult your tax professional.

Mike Scanlin is the founder of Born To Sell and has been writing covered calls for a long time.

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