Taxpayer’s Securities Trading Activities Too Infrequent to Justify Business Expense Deductions

A taxpayer’s attempt to claim hundreds of thousands of dollars in business tax deductions based upon her claim that she was in the business of trading stocks went awry when the US Tax Court agreed with the Internal Revenue Service and ruled that the taxpayer’s trades were too few to qualify as “substantial,” and therefore her activities were not a business. The ruling constituted a huge financial setback for the taxpayer a strong reminder to day traders everywhere to remain cognizant of the standards for “substantial activity” required to claim such deductions.

During the years of 2005 and 2006, Sharon Nelson made 770 stock trades. Nelson, claiming to be in the securities trading business, claimed deductions totaling in excess of $808,000 across the two years on her Schedule C forms. The IRS disallowed the expenses and imposed a deficiency and penalties.

Nelson appealed to the Tax Court, contending she was in the business of securities trading. The court, however, sided with the IRS. Nelson’s trades did not indicate the “substantial activity” needed to qualify as being in the trade or business of buying and selling securities. The “trading activity must be frequent, regular, and continuous enough to qualify as a trade or business,” the court wrote. In Nelson’s case, her trading lacked these attributes. Nelson had only 535 trades in 2005 and 235 in 2006, while previous findings of substantial activity by the court have involved numbers above 1,000, the court noted.

Also, the court pointed out that Nelson only traded on approximately one-half of the available days. In fact, in 2006, from late January to early May, she executed only two trades. The court explained that its previous findings of substantial activity involved traders who traded on “an almost daily basis.” As a result, she lacked the required level of regularity and continuity.

The court additionally upheld the penalty against Nelson. The taxpayer argued that she made a proper effort to comply because she spoke to a friend who was an accountant. However, without a record of what information Nelson gave the accountant and what advice the accountant gave the taxpayer, the court concluded there was not enough evidence to support Nelson’s claim of a good-faith effort.

The Nelson case speaks to the important of obtaining qualified professional advice regarding one’s income taxes, and maintaining written documentation of all aspects of one’s business activities. This is especially true in the area of securities trading, where the IRS is particularly vigilant in analyzing taxpayer’s businesses for the necessary “substantial activity.” At the very minimum, a taxpayer’s records may help establish that taxpayer’s good-faith effort to comply with the law and save him/her thousands of dollars in penalties.

To ensure you’re not overreaching in what you claim is a qualifying business activity, consult the tax attorneys at Samuel C. Berger, P.C. and the CPAs at S.C. Berger, P.C. Our tax attorneys and CPAs can help you understand the requirements the law imposes and the options the code provides to you. Reach us online or call (201) 587-1500 or (212) 380-8117.

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Photo credit: MrChrome at Wikimedia Commons.