Trader vs. Investor – Why the distinction is important in the new tax law environment

On December 22, 2017 President Trump signed the Tax Cuts and Jobs Act of 2017 (the TCJA) which contained the most sweeping changes made to the tax code in almost four decades.  Many people, including those invested in the stock market, hedge funds, private equity funds, or other investment vehicles, began wondering how tax reform would affect them personally.

An increase in the standard deduction, repeal of personal exemptions and 2% miscellaneous itemized deductions, along with a new limitation on the state and local tax deduction, are just some of the major changes that have many investors questioning how their bottom line will be affected moving forward.  Most investors pay fees either to brokers or to investment managers plus many investors have state taxes passed through to them from investment partnerships. Two of the provisions of the TCJA that will likely create some concern for many investors and investment managers are the elimination of the miscellaneous expense deduction, which includes investment advisory fees, and the $10,000 cap on the state and local tax expense deduction. These two changes make the distinction between trader and investor, and their different tax treatment even more important than it has been in the past.

A trader in securities is engaged in the trade or business of trading securities and all items of income and deductions are treated as trade or business income for federal income tax purposes and generally, state income tax purposes.  Trader funds pass income and expenses through to underlying partners as ordinary income items, and the partners then report the items on their tax return as ordinary income.  Expenses to generate trader income and losses from selling investments are generally unlimited and ordinary, which reduce gross income and offset a taxpayer’s other sources of ordinary income, such as wages, etc.  Even though any income from trader funds is considered ordinary and will be taxed at the taxpayer’s tax rate, any expenses (including state income taxes) used to generate trading income are, in turn, fully deductible. This is a more favorable tax treatment than the limitations imposed on taxpayers the IRS considers as investors.

Before an entity can take the position that it is a trader fund, it is important to understand some of the guidelines that the IRS has used to differentiate those who are in the business of buying and selling securities for their own account (a trader), and those who are typically buying and selling securities that produce dividends, interest, or long term capital gains (an investor).

Although no one factor is determinative and there is no bright line test to determine if one qualifies as a trader, courts have historically analyzed several factors in assessing trader vs. investor status.

  • Nature of the income derived
  • Substantiality (frequency, regularity, and continuity of trading activity)
  • Holding period (whether the taxpayer is seeking to capture short-term swings in the daily market or seeking to profit from long-term holding of investments)

Although investor is the default classification by the IRS, a fund may be able to take the trader position after considering the volume and frequency of its trading, portfolio turnover, average holding periods for securities, and the description of the fund’s investment strategy in its offering documents.  Trader vs. investor status can change from year to year depending on the taxpayer’s activities and strategies.

An investor or an investment fund is engaged in activity for long term investment purposes, as opposed to short term market fluctuations or volatility. An investor typically relies on income from interest, dividends, and long term capital appreciation of their investment over time.  Sales of these securities result in capital gains and losses.  Gains are taxed at more favorable capital gains tax rates as opposed to the higher income tax rate. However, investors are also subject to capital loss limitations (limited to $3,000 annually) along with wash sale rules. Any unused capital losses roll forward and can be used to offset any capital gains in the future. Also, any expenses incurred to generate investor income is treated as portfolio deductions.

Prior to the 2018 tax year, taxpayers who itemized were able to deduct management fees and other portfolio expenses generated from production of investor income as miscellaneous itemized deductions to the extent these expenses exceeded 2% of their adjusted gross income.  The bulk of these expenses were incurred when brokers or investment companies charged management fees for both managing and maintaining the taxpayer’s portfolio of investments. For tax years beginning in 2018 through 2025, investors will no longer be able to deduct miscellaneous itemized deductions to the extent they exceed 2% of their adjusted gross income, as in the past.  Also, individuals, trusts, and estates that invest in investment vehicles such as private equity funds or hedge funds and are considered an investor will no longer be able to deduct their share of the fund’s administrative expenses or management fees.  Also, any state taxes that were itemized on a taxpayer’s Schedule A will be limited to a maximum of $10,000.  This will have an especially adverse effect on investors who reside in states with high state tax rates, such as New York and California.

Portfolio deductions have not always been a savings to all taxpayers.  Even though portfolio deductions have been deductible in the past, many high income and even some medium income taxpayers could not benefit from portfolio deductions.  First off only the management fees and other deductions that were incurred to produce taxable income were deductible.  Any fees paid to manage a tax exempt portfolio were considered non-deductible.  Additionally, the sum of a taxpayer’s portfolio deductions had to exceed 2% of a taxpayer’s adjusted gross income before they were able to be deducted.  The 3% Pease limitation further limited the deductibility for some taxpayers after they earned a certain amount of income. In addition, portfolio deductions were not allowed for AMT purposes and were added back for AMT calculations, so many taxpayers who were over the AMT threshold were limited or were unable to claim the deduction.

Finally, for many moderate investors, the drastic increase in the standard deduction from $6,350 to $12,000 for single taxpayers, and from $12,700 to $24,000 for married filing joint taxpayers, will further reduce the benefit of itemizing in the first place.  This coupled with the fact that many investors have typically been unable to fully realize the deductibility of management fees, etc. in the past, may make these sweeping tax law changes more palatable to investors.

We Can Help

When looking at the TJCA as a whole it is important that taxpayers don’t just focus on one or two particular aspects of the law to determine if their tax liability for 2018 and beyond could increase or decrease from the prior years.  One needs to look at the whole picture.  For investor funds, it may be beneficial to re-evaluate this designation and see if taking a trader position can be supported.  The Elliott Davis Investment Company team can help with your complex tax needs with regards to your investment portfolio