Audit Possibility

Discussion in 'Professional Trading' started by Trader5287, Dec 1, 2002.

  1. This will be my first year as a professional trader with elected m to m status. I will show a loss though the size of it can't be determined yet. Because I also generate significant gains from other self employment, I am wondering about the likelihood of audit or other troubles I should be preparing for now. Also, would an audit likely confine itself to the trading or include the other biz too?

    I think I have a pretty convincing case that the trading is a lot more than a hobby. Expense-wise, I could break out what was needed for trading if I had to but a lot of it meshes in with my other biz such as computer, subscriptions, etc.. Investments are clearly separate so that isn't a problem.

    My accountant keeps telling me not to worry - that people don't start trading businesses like mine to lose money. I'm still not convinced because the other biz does very well and makes me think my trading would just look like a sham to reduce taxes.

  2. The issue of hobby status involves reporting losses in 3 of the last five years. Trading would never be a "hobby" like model rocketry. You could lose 20 consecutive years and I don't think the hobby argument could be made here.
  3. Aaron


    The issue the IRS could raise is whether you qualify for trader status versus investor. A trader can deduct trading expenses on a Sch. C but investors must use Sch. A and can't deduct as many things.

    I was just audited and had my trader status questioned. The auditor asked the following questions and appeared to be satisfied with my answers:

    How many hours do you spend trading per week?

    Do you have any other employment?

    How old are you?

    What did you do before trading?

    How long have you been a trader?

    Where did you learn to trade?

    What do you trade?

    What exchanges or markets do you trade on?

    I had read in Ted Tesser's books that holding period and number of trades mattered in deciding trader status, but the IRS didn't ask me about them.

    From the audit I learned that you have to be able to "verify" everything in your taxes. And that's exactly how the IRS words it in their letters: "Please verify blah blah blah" which means "Please show us your documentation to prove blah blah blah".
  4. That's just the kind of thing I was looking for. I bought Tesser's book a while back for the accountant. I scanned it but don't recall a lot on tackling the problem of the first year or two of switching from an established business to the new biz of trading as opposed to just trading from the outset.

  5. sunnie


    Provide documentation for the number of hours trading (& related research)??? Does that mean keeping time records of such activities???:confused:
  6. Aaron


    No, I didn't have to provide documentation for the answers to the trader status questions. I mean: be able to provide documentation for numbers you put down on your tax forms.
  7. egusc


    Self employed people have the highest audit rate. So since you are already self employed, the extra trader sch. C should not increase your audit risk very much.

    I do not think hobby loss rule apply to traders. As others have stated the issue will be if you qualify as a trader. Your trades will need to be short-term and your effort sufficent to qualify as self employment. You will need to consistantly engage in trading activity and trade often enough or in sufficent volume to justify the expense claimed. There are virtually no detailed guidlines from the irs as to what specifically would qualify one as a trader.
  8. sunnie


    Thank goodness!!!! Thank you for the clarification....
  9. This is fairly subjective. Primarily, you must satisfy the auditor when the time comes and "prove to him" that you trade for a living. If you still believe you are, but he claims that you aren't (which is possible since its such a grey area), then you must contact his superior.

    As far as the IRS is concerned, the below rules are about as concrete as you can get at this time.


    Special rules apply if you are a trader in securities in the business of buying and selling securities for your own account. To be engaged in business as a trader in securities, you must meet all the following conditions.

    You must seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation.
    Your activity must be substantial.
    You must carry on the activity with continuity and regularity.
    The following facts and circumstances should be considered in determining if your activity is a securities trading business.

    Typical holding periods for securities bought and sold.
    The frequency and dollar amount of your trades during the year.
    The extent to which you pursue the activity to produce income for a livelihood.
    The amount of time you devote to the activity.
    If your trading activities are not a business, you are considered an investor, and not a trader. It does not matter whether you call yourself a trader or a "day trader."
  10. Very interesting information. Yes, it is subjective. I meet all of the standards as far as I can see. I sleep little and basically have two full time jobs. One the profitable profession, etc. and the other the trading where my heart is and where I hope to be profitable in the future with suitable experience and equipment. I was concerned that an auditor would approach it that I had just created a huge deduction out of thin air to offset taxable gains doing the profession.

    The situation as I saw it seemed more "fishy" because I am also starting a third small business with its associated start up costs and initial loses as well as paying alimony.

    Guess I don't see why I can't be treated the same as say HPQ, which has, say, five losing divisions and then the one hugely successful one that sells ink jet cartridges or whatever that makes the real money.

    #10     Dec 5, 2002