Determining whether the trading activity will allow the fund to qualify for trader vs. investor status is nothing new to portfolio managers and tax practitioners, but continues to leave the industry with questions due to the lack of guidance from the IRS to differentiate between the two. The distinction is not a formal election that is submitted with the tax return, but is an annual assessment.
The trader or investor designation will significantly impact the tax treatment of the partnership and its investors ever more so now with the enactment of Tax Cuts and Jobs Act of 2017 (TCJA) effective through 2025 along with its temporary modifications under the Coronavirus Aid, Relief and Economic Security Act (CAREs Act).
Differentiating Between the Two
In general, investor funds tend to buy and hold assets to long-term maturity and generate interest and dividend income, while trader funds trade frequently seeking to profit from daily short-term swings in the market. To successfully meet the test for trader status, the IRS says the trading must be substantial. With no bright-line “test” from the IRS on what constitutes substantial, the courts have defined it as frequent, regular and continuous enough to constitute a trade or business. The holding period, number of trades, dollar amounts of trades, intention to produce income and continuous trading on most of the available trading days in a year are all determining factors.
Tax Implications to Consider
TCJA made several significant changes that impact investors, making the determination of trader vs. investor fund more prevalent than before. Prior to TCJA, investors of an investor fund who itemized deductions were able to deduct management fees and administrative expenses as miscellaneous itemized deductions to the extent those deductions exceeded 2% of adjusted gross income (AGI) and reported on Schedule A of the Form 1040. Note, these deductions were often phased out and essentially non-deductible for high-net worth individuals before these changes, but some could benefit. TCJA, for tax years 2018 through 2025, modified the rules so that investors are no longer be able to deduct miscellaneous itemized deductions as they could before, essentially making them completely non-deductible. The advantage for trader funds is that investors of a trader fund are able to fully deduct management fees and administrative expenses related to trading income as business expenses and reported on Schedule E of the Form 1040. These are above the line deductions that reduce an investor’s AGI as opposed to below the line deductions which have been eliminated by TCJA. Other tax considerations include the $10,000 cap on state and local tax deductions, new limits on business interest expense and the limitation of excess business losses from partnership (CAREs Act has suspended this for tax years 2018 through 2020).
Prior the 2021 Final Regulations under Section 163(j), the limitation on business interest expense had a more meaningful impact on non-materially participating investors of a trader fund. Under the new regulations, interest expense allocated by a trader fund to an investor who does not materially participate in the trading activity, is treated as investment interest expense subject to 163(d) as opposed to business interest expense under 163(j). The change in the regulation now equalizes the tax treatment of allocated interest expense for non-materially participating investors in a trader and an investor fund.
Court Cases Setting Precedence for Trading Individuals and Family Office Groups
While there have been no court cases for third party managed commingled funds, we have a few cases to look to for guidance when it comes to individual trading and family offices. We summarize three notable cases here for context that the industry often looks to for guidance.
In Endicott v. Commissioner (8/28/2013), Endicott executed 204 trades in 2006 ($7M), 303 trades in 2007 ($15M) and 1,543 trades in 2008 ($16M). He traded on 75 days, 99 days and 112 days in each respective year and his average holding period over the three years was 35 days. The Tax Court did acknowledge the dollar amounts traded were considerable, but ultimately the court concluded the number of trades in 2006 and 2007 were not substantial. The court acknowledged the 1,543 trades in 2008 were considered substantial. The number of trading days was determined not to be frequent, continuous or regular and were not executed on a daily basis. The 35 day average holding period was determined to not be reflective of a strategy to seek profits in daily swings in the market. With these factors taken into consideration, Endicott was denied trader status for all three years and assessed a tax deficiency and penalties. The Court’s conclusion was supported by the fact that Endicott had significant dividend income during the three years in question which is more indicative of investor activity, not trader activity.
Nelson v. Commissioner (11/13/2013), In 2005, Nelson executed 535 trades over 121 days ($33M) and in 2006, 235 trades over 66 days ($24M), averaging a 1 to 48 day and 1 to 101 day holding period over the two respective years. The court acknowledged, as it did in Endicott, the dollar amounts traded by Nelson during the years was considerable, but determined the number of trades and trading activity was not substantial. The court also considered the number of available trading days in which Nelson traded and determined there were 250 available days in each year, thus only 48.4% of the 250 available were used in 2005 and 26.4% in 2006. The court emphasized that in order to be a trader, a taxpayer should be engaged in market transactions on an almost daily basis. 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, consequently disallowed her trade or business expenses for both years. She was imposed a tax deficiency and penalties.
In Lender Management LLC v Commissioner (12/13/2017), the Tax Court stated that the following three requirements must be present for purposes of determining whether a trade or business exists: (i) the taxpayer must undertake the activity intending to make a profit, (ii) the taxpayer must be regularly engaged and actively involved in the activity and (iii) the taxpayer’s business operations must have actually commenced. Having found that these general threshold requirements were met, the Tax Court considered whether (1) the investment management services provided by Lender Management could be treated as trade or business instead of investment activities and (2) the familial connections between Lender Management and the Investment LLCs could result in trade or business treatment.
Finally, based on the conclusion that Lender Management “carried on its operations in a continuous and businesslike manner for the purpose of earning a profit, and it provided valuable services to clients for compensation,” the Tax Court overruled the IRS and awarded business expense treatment to Lender Management.
Contact Withum’s Financial Services Team for any further insight or questions.
The Lender Management Case gave us other factors to consider other than carrying on substantial trading to be considered a trade or business which include some of the following:
- Establish a professional business with employees, salaries, office, equipment and daily operations
- Professional staff who provide value to clients
- Compensation arrangement other than profits based on capital
- Portfolio manager spends most of their time at company making investment decisions and operating for profit
- Engages third party service providers for bookkeeping, advisory and tax compliance
- Caters to individual financial needs of family members and not a single vision
- Family members are not obligated to invest and can withdrawal their money
- There should not be majority common ownership between the management company and investment partnerships
- Helpful fact includes engaging with third-party money if possible
Family offices may consider consolidating trading activity to their investment partnerships in order to achieve trader status. They could then apportion related business expenses from the management company to the trading entity to benefit from trader deductions.
After Nelson, we know that making trades on almost 50 percent of available trading days may not qualify for trader status. It’s not clear exactly what percentage of trading days it will take to satisfy the almost daily test. It would be advised for anyone looking to obtain trader status to ensure they are trading significant dollar amounts, trading almost every day open for trading during the year, executing more than 1,000 trades per year and to be able to show short-term capital gains derived from daily market swings.