Skip to content 
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
THE PROS AND CONS OF A SEC. 475 ELECTION
At first glance, the notion of any taxpayer seeking to make a Sec. 475 election appears counterintuitive. Taxpayers who own securities or commodities, which are usually defined as capital assets for income tax purposes, would normally seek to exploit the preferential capital gains rate and defer recognition of gain as long as possible. A Sec. 475 election, on the other hand, converts income and losses to ordinary income and losses, and any opportunity to defer income recognition is eliminated.
A Sec. 475 election nevertheless offers several important countervailing benefits. One primary result of making this election is that all losses are characterized as ordinary. This makes the capital loss limitation rules of Sec. 1211 inapplicable and enables taxpayers to use the losses as net operating losses that may be carried back and forward. In addition, when a Sec. 475 election is made, the wash-sale rules do not apply.
Other noteworthy advantages of making a Sec. 475 election include the following: (1) The uniform capitalization rules and interest expense capitalization rules of Secs. 263A and 263(g), respectively, are negated; (2) the loss disallowance rules for transactions between related parties under Secs. 267 and 707(b) do not apply; (3) the constructive sales rules of Sec. 1259 do not apply; (4) tracking historical cost basis is unnecessary (insofar as every year the security or commodity in question is accorded a new tax basis); (5) financial and regulatory reporting requirements may be coordinated; and (6) income from mark-to-market transactions is not considered self-employment income under Sec. 1402.
As with almost any tax election, there are potential downsides. The first significant disadvantage to making the election is that what otherwise would be treated as capital gain income is transformed into ordinary income. Given that the top federal capital gain tax rate is currently 20%, whereas the top federal ordinary income tax rate is 39.6%, the election comes at a steep price. Second, taxpayers making a Sec. 475 election cannot defer gains; deferring gains can often produce significant tax savings.
One less-obvious drawback of making a Sec. 475 election is that Sec. 1256 does not apply. Thus, the electing taxpayer forgoes the potential benefit of having gains and losses treated for tax purposes as 60% long-term capital gain or loss and 40% short-term capital gain or loss. A further disadvantage is that a taxpayer who makes a Sec. 475 election and constructively recognizes income may lack liquidity to pay the tax liability on the recognized gains. This problem may prove particularly acute in the first election year if the taxpayer owns assets with significant amounts of unrealized income.
WHO QUALIFIES TO MAKE THE ELECTION?
A thorough understanding of how the Code defines (1) dealers, traders, and investors and (2) securities and commodities is necessary to identify who may make a Sec. 475 election. A securities dealer is required to apply mark-to-market accounting to securities, whereas a commodities dealer may elect mark-to-market treatment. A trader who is engaged in the trade or business of trading securities or commodities also may elect mark-to-market treatment under Sec. 475(f). An investor, however, cannot make a Sec. 475 election and must treat all gains and losses from investment activities as capital.
Dealers, traders, and investors. Sec. 475 defines a dealer as a taxpayer who regularly purchases from or sells to customers, or regularly “offers to enter into, assume, offset, assign or otherwise terminate positions in securities with customers in the ordinary course of a trade or business.” In the context of commodities, this definition includes dealers of physical inventories as well as derivatives. The fundamental concept is that dealers’ transactions must be with customers (see, e.g., Kemon, 16 T.C. 1026 (1951) (a taxpayer who regularly transacts business with customers is a dealer)).
In contrast, traders and investors trade on their own behalf rather than on behalf of customers. Unlike its treatment of dealers, Sec. 475 does not define traders and investors. A great deal of controversy has surrounded the determination of whether taxpayers are traders who may make Sec. 475 elections or are simply investors who cannot make the election. In Arberg, T.C. Memo. 2007-244, the Tax Court made the following general observation: A trader is a taxpayer who buys and sells for his own account as part of his trade or business, while an investor is a taxpayer who buys and sells for his own account but not as part of a trade or business.
Ascertaining whether a taxpayer is in the trade or business of buying or selling is an imprecise science. A seminal case on this issue is Chen, T.C. Memo. 2004-132. In Chen, the taxpayer became a day trader while he was still employed full time as a computer engineer. During the course of the tax year in question, the taxpayer engaged in more than 300 securities transactions, primarily between February and April. To realize an immediate benefit from significant trading losses, the taxpayer attempted to make a late Sec. 475 election on his tax return, which he filed only after receiving an IRS deficiency notice. In conducting its analysis, the Tax Court declared that a trader must meet the following two-prong test: (1) The taxpayer’s trading strategy must attempt to “catch the swings in the daily market movements”; and (2) the trades must be “frequent, regular, and continuous.” Applying this test, the Tax Court ruled against the taxpayer, holding that he was an investor rather than a trader and therefore ineligible to make a Sec. 475 election.
Numerous other cases have clarified the differences between traders and investors for tax purposes. These cases suggest that for a taxpayer to be classified as a trader, the trading must be a full-time endeavor, and the transactions must occur throughout an entire year (see, e.g., Levin, 597 F.2d 760 (Cl. Ct. 1979)). Investors, in contrast to traders, typically buy and hold and further seek to profit by maximizing capital gains and dividends (see, e.g., Mayer, T.C. Memo. 1994-209).
Securities and commodities – The Code puts financial products into two distinct categories, namely, “securities” or “commodities.”
Sec. 475(c)(2) broadly defines securities to include the following: stock in a corporation; partnership or beneficial ownership interests in a widely held or publicly traded partnership or trust; notes, bonds, debentures, or other evidence of indebtedness; interest rate, currency, or equity notional principal contracts; and evidence of an interest in, or a derivative financial instrument in, any of the foregoing.
Commodities, on the other hand, are tangible goods such as gold, oil, cattle, pork bellies, and orange juice (Sec. 475(e)(2)). Commodities can be traded as physical inventories, although they are more commonly traded in the form of financial products related to particular commodities. Under Sec. 475, commodities are defined to include any commodity treated as actively traded under the Sec. 1092 straddle rules; any notional principal contract with respect to the commodity; or any evidence of an interest in, or a derivative financial instrument in, any commodity. It is also important to note that only commodities traded on organized commodities exchanges satisfy this definition.
Hedging transactions can obscure these otherwise straightforward definitions. More specifically, if a commodity is hedged, it may be transformed into a security; conversely, if a security is hedged, it may be transformed into a commodity.
WHO SHOULD MAKE THE SEC. 475 ELECTION?
A working knowledge of what constitutes a trader, dealer, and investor for tax purposes, as well as the delineation between securities and commodities, serves as a basis for identifying those taxpayers who are appropriate candidates to make a Sec. 475 election.
Securities traders should always consider making a Sec. 475(f) election. The very nature of the trading business, which seeks to profit from “swings in the daily market movements,” suggests that most, if not all, of a security trader’s transactions will be short-term. Under Sec. 1222, income from short-term transactions is subject to ordinary tax rates, whereas losses from short-term transactions are subject to the Sec. 1211 capital loss limitation rules. Securities traders who make a Sec. 475(f) election will thus be taxed at the same rate on their income but will receive the more valuable ordinary loss treatment to the extent of any losses.
In contrast, commodities dealers generally have little incentive to make a Sec. 475(e) election. The reason is twofold. First, many commodities dealers are engaged in buying and selling so-called Sec. 1256 contracts, which include regulated futures contracts, foreign currency contracts, nonequity options, dealer equity options, and dealer securities futures contracts. For tax purposes, Sec. 1256 contracts are treated as 60% long-term capital gain or loss and 40% short-term capital gain or loss, regardless of the actual holding periods. Making a Sec. 475 election would eliminate the more favorable tax treatment of being taxed at a capital gains rate. Second, commodities dealers who hold inventory apart from Sec. 1256 contracts must separately account for the inventory gains and losses as being ordinary, so a Sec. 475 election offers no augmented benefits.
Commodities traders, in contrast to commodities dealers, fall somewhere in the middle of the decision-making continuum. Commodities traders need to closely scrutinize their business transactions before deciding whether to make a Sec. 475 election. If their trades are predominantly concentrated in Sec. 1256 contracts, commodities traders should avoid making a Sec. 475(f) election. If, however, their trades are predominantly concentrated in non-Sec. 1256 contracts, commodities traders should consider making a Sec. 475(f) election.
A taxpayer’s trading strategy is another factor to consider when deciding whether to make a Sec. 475 election. For example, if a taxpayer’s strategy involves numerous and repeated sales and purchases of the same security, a Sec. 475 election is eminently sensible; if, however, a taxpayer’s trading is premised on a buy-and-hold strategy, a Sec. 475 election may prove tax inefficient.
TIMELY ELECTIONS AND MAKING A LATE ELECTION
The specific requirements of how to make a Sec. 475 election are not contained in the Code or regulations but rather in Rev. Proc. 99-17. To make a valid Sec. 475 election, a taxpayer must submit a written statement affirming the election for the first tax year that the election is effective and, in the case of an election under Sec. 475(f), the trade or business for which the election is being made.
Existing taxpayers must file the statement no later than the due date (without regard to extensions) of the original federal income tax return for the tax year immediately preceding the election year. The statement must be attached either to that return, or, if applicable, to a request for an extension of time to file that return. For example, if an individual taxpayer wants to make a Sec. 475 election effective for 2014, the statement should be attached to the taxpayer’s timely filed 2013 Form 1040, U.S. Individual Income Tax Return, or, alternatively, with the taxpayer’s request for a filing extension for the 2013 Form 1040 (i.e., Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Return).
For new taxpayers (i.e., taxpayers who have not previously filed returns) to make a timely election, the taxpayers must place in their books and records, no later than two months and 15 days after the first day of the election year, a statement similar to the one described in Rev. Proc. 99-17. A copy of the statement must also be attached to the original federal income tax return for the election year.
Once a Sec. 475 election is made, an electing taxpayer must continue to use the mark-to-market accounting method unless the taxpayer obtains the IRS’s consent to revoke the election. Rev. Rul. 97-39 indicates that the IRS will grant revocations only in unusual circumstances. Therefore, taxpayers must consider not only the pros and cons of a Sec. 475 election in the first year of the election but also must anticipate how their business and investment dealings may unfold in the future.
For an existing business that chooses to make a Sec. 475 election, the change to the mark-to-market rules for reporting securities and commodities constitutes a new accounting method that requires attaching Form 3115, Application for Change in Accounting Method, to the taxpayer’s timely filed original income tax return for the year of change. The request will receive automatic approval if the election is proper, the taxpayer’s method of accounting properly conforms to the mark-to-market rules, and the year of change is the election year.
Notwithstanding the straightforward process for making the election, some taxpayers do not comply with all of the procedural requirements. Often, these taxpayers have sought administrative relief to file a late election under Regs. Sec. 301.9100-3(a). For a taxpayer to be granted administrative relief from the procedural Sec. 475 election requirements, the regulations require proof that (1) the taxpayer acted reasonably and in good faith and (2) the granting of relief will not prejudice the government’s interest.
To prove good faith, taxpayers must meet one or more of the following conditions: The request for relief must be made before the IRS discovers the failure to make the election; circumstances existed beyond the taxpayer’s control that prevented making a timely election; the taxpayer reasonably relied on either IRS written advice or a qualified tax professional who failed to advise about the availability of the election; or, even after exercising due diligence, the taxpayer was unaware of the necessity for making the election (taking into account the taxpayer’s level of sophistication). Notwithstanding the existence of any of the foregoing conditions, a taxpayer will not be found to have acted in good faith if the taxpayer makes the election in hindsight. A taxpayer will generally be held to have acted in hindsight if specific facts change after the original election due date that make the election advantageous to the taxpayer. Finally, even a taxpayer who is able to demonstrate good faith without the use of hindsight will nevertheless be denied relief if the election reduces the taxpayer’s tax liability and thereby prejudices the government’s interest.
Although the regulations suggest that administrative relief should be available when a taxpayer makes a late Sec. 475 election, their rigor often results in IRS denial. To date, the courts have routinely sustained the IRS’s denials, with one notable exception. In Vines, 126 T.C. 279 (2006), the taxpayer became a securities trader in January 2000 and conducted numerous trades until April 14, 2000, at which time there was a margin call on his account. Once the margin call was made, the taxpayer ceased trading. When the taxpayer filed a request for an extension of time to file his 1999 income tax return, neither the taxpayer nor his accountant knew that the Sec. 475 election existed. In June 2000, when the taxpayer learned of the election’s existence, he took immediate steps to comply. The Tax Court found that the taxpayer did not make the election in hindsight because he did not make any trades after the due date for the election and the government’s interest was not prejudiced because the taxpayer’s liability under the late election was not lower than it would have been if the taxpayer had made a timely election. Under these unique circumstances, the Tax Court held that the taxpayer met the two conditions for administrative relief.
PRACTICAL PLANNING ADVICE
Taxpayers who are dealers or traders are not precluded under the Code from making long-term investments subject to the more favorable capital gains tax rates. Proper protocol, however, requires that those taxpayers open a segregated account to hold such long-term investments and clearly identify the assets held in the account as investments. Keeping trade and business accounts separate from investment accounts will yield the most efficient tax outcomes and, when possible, enable those taxpayers to capitalize on preferential capital gains rates insofar as the latter accounts are concerned.
Another practical planning point to consider is that, absent extenuating circumstances, taxpayers who desire trader status should make trading their primary occupation. Indeed, the easiest way to negate trader status is to be employed full time in another trade or business and only dabble in spotty trading (see, e.g., Endicott, T.C. Memo. 2013-199, which requires an “almost daily” standard to qualify as a trader).
The type of entity that may benefit from a Sec. 475 election is a final planning point to consider. If the taxpayer is a corporation, a Sec. 475 election may prove attractive because corporations typically have limited use of capital gains (except to offset capital losses). Conversely, in the case of a passthrough entity (e.g., a partnership or S corporation), a Sec. 475 election may prove disadvantageous because it eliminates the preferential capital gain tax rate that might otherwise be available to its individual owners.
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.
When it comes to elections under the Code, the associated advantages and disadvantages of each must be weighed and carefully scrutinized. Sec. 475 is no exception to this rule. Taxpayers must carefully examine their portfolios and understand how the IRS classifies the type of assets in which they deal or trade in order to determine the most beneficial tax treatment available. Given the ever-growing types of financial products available to dealers and traders, this can be a daunting task. Sec. 475 elections affect not only current-year activities but also anticipated future dealing and trading activities, which makes the determination even more challenging. Once a Sec. 475 election is made, it is not easily undone, which is why knowledge and an understanding of the impact of the election are paramount.
EXECUTIVE SUMMARY
A mark-to-market election requires taxpayers to recognize ordinary gains or losses at the end of each year in the amount of the difference between the basis and the fair market value of the securities that the taxpayer holds.
The mark-to-market method is required for dealers in securities and may be elected by commodities dealers or traders in securities or commodities, but not by investors.
Making the election has many advantages, not the least of which is that any losses incurred become ordinary losses, which qualify to be carried forward or back as net operating losses.
Taxpayers who are interested in exploring an election into I.R.C. § 475 should consult with their International 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.
