It Really Matters - Recent Tax Court Decisions Offer Some Additional Insight
Hedge fund managers should be aware of two recent U.S. Tax Court memorandum decisions that shed further light on when a taxpayer, such as a hedge fund, is considered to be a "trader" or "investor" for tax purposes -- a designation which may affect the deductibility of fund expenses. While these cases are more in a long line of decisions involving individuals who trade for their own account, they highlight the factors that courts focus on when making the trader versus investor determination. In Endicott v. Commissioner, T.C. Memo 2013-199, the Tax Court determined that an individual selling covered calls for his own account was an investor rather than a trader and, consequently, disallowed his treatment of expenses as trade or business expenses. Similarly, just last week, the Tax Court once again found, in Nelson v. Commissioner, T.C. Memo 2013-259, that the taxpayer did not qualify as a trader even though in her case she made trades on almost half of the total available trading days in one of the years at issue.
The "trader" versus "investor" classification is an important consideration for hedge funds that pass through profits, losses, and deductions to their investors. The income tax on a fund's taxable investors may be significantly less if the fund is classified as a "trader" rather than an "investor." If a hedge fund is classified as a "trader" for tax purposes, management fees, and other fund expenses may be considered to be incurred in carrying on a trade or business thus allowing investors to deduct their share of such expenses "above the line" as trade or business expenses. On the other hand, if the hedge fund is classified as an "investor," then passed through expenses may be deductible only as miscellaneous itemized deductions, which are subject to severe limitations or in some cases disallowed entirely.
ENDICOTT V. COMMISSIONER
In the Endicott case, Thomas Endicott was a retired executive who took up a new endeavor four years after retirement -- purchasing and selling stocks and call options. Endicott's strategy was to purchase stock, fully margined, and then sell call options on the underlying stock. His goal was to earn a profit from the premiums received from selling the call options. Although he did not execute trades on every business day, he did monitor his portfolio and research new positions every business day. Endicott executed 204 trades in 2006 (purchases and sales of $7 million), 303 trades in 2007 (purchases and sales of $15 million), and 1,543 trades in 2008 (purchases and sales of $16 million). He traded on 75 days in 2006, 99 days in 2007, and 112 days in 2008. His average holding period of the stock across the three-year period was 35 days, but he held a significant number of stocks for well over a year and some for over four years. The option positions were usually maintained for a period of between one and five months.
The Tax Court, citing precedent, emphasized that two elements must be satisfied in order for trading activities to constitute a trade or business: (1) the taxpayer's trading must be substantial which, means frequent, regular, and continuous; and (2) the taxpayer must seek to "catch the swings in the daily market movements and to profit from these short-term changes" rather than to profit from the long-term holding of investments. The number of trades, the dollar amount of the trades, and the number of days on which a taxpayer trades all contribute to whether trading is substantial.
The Court acknowledged that the amount of money involved in the trades was considerable, but noted that managing a large amount of money is not conclusive as to whether a taxpayer's trading activity amounts to a trade or business. With respect to the number of trades executed, the Court found that the 204 trades in 2006 and the 303 trades in 2007 were not substantial, but that the 1,543 trades in 2008 were substantial (prior case law had determined that 1,136 trades executed in a year were substantial). However, the Court determined that the number of trading days for each of the years, including 2008 (75, 99, and 112 days, respectively) was not sufficient to conclude that Endicott's trading activity was frequent, continuous, or regular. Rather, the Court stated that the taxpayer needed to execute trades on "an almost daily basis" and Endicott did not do this in any of the years. The Court also rejected Endicott's argument that options were unique and that his trading days should include the days his options were open -- not just the execution days for buys and sells.
Endicott also failed to show that he sought to profit from daily market movements. The Court determined that the 35-day average holding period for the stocks didn't demonstrate that Endicott was attempting to catch the profit from daily market swings. Likewise, the holding period of the options (one to five months) was also too long to try and catch the swings in daily market movement. The Court's conclusion was aided by the fact that Endicott had significant dividend income during the years at issue -- receiving significant dividends is in the nature of an "investor" activity and not a "trader" activity.
Since the Court concluded that Endicott did not have substantial trading activity and was not seeking to profit from daily swings in the market, it treated Endicott as an investor for all the years and disallowed his trade or business expenses and imposed a tax deficiency and penalties.
NELSON V. COMMISSIONER
In Nelson, the taxpayer bought and sold securities for her own account (she also received income from work as a mortgage broker but the Court did not discuss this). In 2005, Nelson executed 535 trades on a total of 121 days (purchases and sales of approximately $33 million). In 2006, Nelson executed 235 trades on a total of 66 days (purchases and sales of approximately $24 million). The holding period for the stock during 2005 ranged from 1 day to 48 days; the holding period for the stock during 2006 ranged from 1 day to 101 days.
In its opinion, the Tax Court reiterated the two requirements that must be satisfied to qualify as a trader -- the trading must be substantial and the taxpayer must try to profit from the daily swings in the market. The Court acknowledged, as it did in Endicott, that the amount of money traded by Nelson during the years was considerable, but pointed out that the amounts traded are not determinative of whether a taxpayer's trading activity is substantial. With respect to the number of trades executed, the Court, citing Endicott, found that the 535 trades in 2005 and the 235 trades in 2006 were not substantial.
The Court also analyzed the number of trading days on which Nelson traded. It confirmed that there were a total of 250 available trading days in each of 2005 and 2006. Thus, in 2005, trades were made on 121 days, or on 48.4 percent of the 250 available trading days. In 2006, trades were made on 66 days, or on 26.4 percent of the 250 available trading days. The Court emphasized that in order to be a trader, a taxpayer should be engaged in market transactions on an almost daily basis. Accordingly, the Court concluded that the total number of days on which trades were executed in 2005 and 2006 was not substantial, and found that Nelson was not a trader and, consequently disallowed her trade or business expenses for both years and imposed a tax deficiency and penalties.
Although the Tax Court in the Endicott and Nelson cases did not provide any bright line tests for determining trader status, it did place a significant emphasis on the number of days trades were executed. The Court informs us that some level of trading must be undertaken on "an almost daily basis," but it does not articulate how many trading days are required in order to be considered "almost daily." After Nelson, we now know that making trades on almost 50 percent of available trading days may not qualify one for trader status. But we still do not know what percentage of trading days it will take to satisfy the "almost daily" test. Hedge funds or anyone seeking to attain "trader" status would be wise to ensure they are trading significant dollar amounts, trading almost every day open for trading during the week, and to be able to demonstrate that they are seeking to capture profits from daily market movements, rather than long-term investment.