Trader Status for Crypto

If you buy and sell crypto, when you file a tax return with the IRS, the IRS treats you as an investor by default. Being an investor, your income from trading is classified as either long term or short term gains or losses by the IRS and is taxed (when realized) as capital income.

We previously discussed that here -  https://htj.tax/2021/05/crypto-tax-calculations/

While long term capital gains enjoy a lower tax rate, this is not an ideal situation for you if you want to treat your trading as a business and generate substantial income from it.  Especially if you're an algorithmic or high frequency trader

As an investor,
1. There are limits on deducting expenses
2. Losses incurred can only be deductible against your ordinary income up to $3000.
3. Most importantly for crypto especially, the wash sale rule may also apply to bar you from claiming certain losses (which prevents you from claiming a loss on a sale if you buy replacement crypto within the 30 days before or after the sale).
4. Because you are filing as an individual, you do not enjoy any fringe benefits and medical reimbursements or educational costs to better your trading. They would be pure expenses for you.

If you elect trader status and leverage mark to market accounting with the IRS, then the IRS regards you as an active trader and all of your losses from trading become active, ordinary losses for tax purposes. This avoids the applicability of the $3000 capital loss deduction limit and all the other limitations mentioned above.

Because the IRS regards your primary source of income as trading, you are allowed to deduct various business expenses that are ordinary and necessary to your trading activities. Expenses such as accounting fees, automobile expenses, trading software, trading advice, office equipment, and costs of attending seminars, etc. are now tax deductible to you. Further, due to the election of mark to market accounting, the wash sale rule no longer applies.

Many of our clients may also elect to form a corporate structure (onshore and/or offshore) to derive certain additional benefits including accessing offshore crypto exchanges. such as Binance, Bitmex etc

The US tax courts have attempted to simplify the determination of trader status over the years. However, these attempts have never successfully clarified exactly what a trader is under the law. There are major inconsistencies. For example, in Commissioner v. Nubar, the court found that 137 transactions a year qualified Mr. Nubar as a trader. That would lead you to conclude that 137 somehow qualifies, but there are cases where traders with over 1000 trades per year did not qualify. For example, in Estate of Yaeger v. Commissioner, the court found that despite over 1000 transactions per year in question, Yaeger did not qualify as a trader. In Holsinger & Mickler v. Commissioner, 372 trades did not qualify.

Over the years, the lower courts developed a test for classifying taxpayers as traders rather than investors based on three primary  factors:
(i)  intent  to carry on  a trade or  business,
(ii) the buying and selling of Securities or Commodities as a frequent and continuous activity, and
(iii) the seeking of profits from short-term price swings rather than from interest, dividends and capital appreciation

Applying the case law, a taxpayer who does not intend to purchase and sell Securities or Commodities for investment purposes, has a large volume of trades, and has predominantly short-term capital gains can sustain trader status.  Qualification as a Securities or Commodities trader would then permit the taxpayer to make the Section 475(f) election.  In this discussion, I’m avoiding taking a position as to whether the virtual currency is to be classified as a commodity and / or a security.  That’s a whole pandoras box of its own and discussed elsewhere.

OPERATION OF SECTION 475(f)

Securities or Commodities traders have a timing option under realization accounting. Section 475(f) provides Securities or Commodities traders an alternative for accounting for Securities or Commodities trading gains and/or losses. The Securities or Commodities trader has the choice of continuing to use realization accounting or can opt in to the mark-to-market accounting regime of Section 475(f).

Once an effective election is made, the electing trader treats each security "held in connection" with  his Securities or Commodities  trading  business as sold and then immediately repurchased at its fair market value ("FMV") on the last business day of his taxable year.  The electing trader's gain or loss for each security equals the difference between his adjusted basis in the security and its FMV.

The mark-to-market income or loss, and any income or loss from Securities or Commodities subject to mark-to-market accounting that are sold before the end of the taxable year, is ordinary in character rather than capital (as would be the case for a dealer or a non-electing trader). This provides the following benefits to the electing trader:
1 An electing trader can deduct losses from trading Securities or Commodities against ordinary income, without the limitations imposed by Section 1211
2   An electing trader can carry net operating losses back two years and forward twenty years under Section 172.
3  The electing trader also is excepted from other rules that address issues arising under realization accounting:
4  The wash sale rules of Section 1091 do not apply to an electing trader.
5. The constructive sale rules of Section 1259 are limited in their application to electing traders.

Importantly, for Securities or Commodities traders that also hold investment Securities or Commodities, Section 475(f) permits  the electing trader to segregate his trading and investment activities. If an electing trader clearly identifies a security before the close of the day on which it was acquired, originated, or entered and the security has no connection to the trading activities of the Securities or Commodities trader, then Section 475{f) will not apply to that security.28

PROCEDURE FOR ELECTING UNDER SECTION 475(f)

Section 475(f)(3)  states that taxpayers are not required  to obtain the consent of the Secretary of the Treasury to elect under Section 475(f).29 The legislative history provides that the I.R.S. can prescribe the method for making the Section 475(f) election.30 The I.R.S. has published rules for making the Section 475(f) election in Revenue Procedure 99-1731 which rules are summarized in relevant part below. These rules are specific and, in private letter rulings ("PLR"), the I.R.S. has not granted relief to taxpayers requesting permission to file a late Section 475(f) election.

 In order  to comply with the I.R.S.' rules, a taxpayer must file a statement  by the due date of his original tax return (without regard to extensions) for the tax year immediately preceding the tax year for which the Section 475(f) election  is being made. For taxpayers requesting an automatic extension for the filing of their return, the statement must be filed with the extension request on or before the due date for filing the request.

A different rule applies to a "new" taxpayer, i.e., a taxpayer that did not file a return in the tax year immediately before the tax year for which the Section 475(f) election is to be effective.   New taxpayers  must make a statement in their books and records no later than the 15th day of the third month after the beginning of the election year and file a copy of the statement with their tax return for the election year. The statement that the electing trader files must provide information on the election being made (e.g., "Election Under Section 475(f)"), must identify the first tax year for which the election is effective, and must identify the trade or business for which the Section 475(f) election is made.

The change to mark-to-market reporting is treated as a change in method of accounting subject to Sections 446 and 481.34 Although the I.R.S. may require a taxpayer to obtain its consent before the taxpayer can change its method of accounting, this consent is automatically granted where  the electing trader satisfies the rules for making the Section 475(f) election, changes to a method of accounting in accordance with its Section 475(f) election, makes the change for the first tax year for which the election is effective, and meets the following filing requirement.

 An electing trader must file an I.R.S. Form 3115 (Application for Change in Accounting Method) for the year of the change with his timely filed return (including extensions). A copy of this form must be filed with the National Office of the I.R.S..  The Form 3115 must be labeled with a reference to Section 10A of the Appendix to Revenue Procedure 2002-9.36

 CONCLUSION
The Section 475(f) election presents Securities or Commodities traders with the opportunity to elect an alternative method of taxation for their Securities or Commodities gains and losses. Securities or Commodities traders may benefit from better matching of income or losses in their Securities or Commodities positions without the application of various tax law restrictions. When considering how to report one's buying and selling of Securities or Commodities as either a trade or business or an investment  activity and whether one is eligible to make the Section 475(f) election, taxpayers must first determine whether  they can sustain  the position  that they are a trader. The taxpayer must  then determine whether a Section 475(f) election will provide benefits (e.g., from  the broader ability to utilize any Securities or Commodities trading losses) that outweigh any detriments (e.g., from the loss of any ability to time, for tax purposes, gains or losses from trading Securities or Commodities). The Section 475(f) can prove to be a valuable option for Securities or Commodities traders, but one that must be carefully evaluated.

Taxpayers who are interested in exploring an election into I.R.C. § 475 should consult with their tax advisors about the availability of the election and the federal and state tax implications of making such an election. Many states do not follow federal tax returns in computing state taxes.

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